Economics of auditing standards
Auditing standards play two roles in the real world (Simunic et al. 2015). First, the standards may simply serve as a guide for audit service production. That is, they provide “how to do it” advice that can be useful to both auditors—who render the service—and consumers of the service, namely investors and company managers. Note that this production role may be useful even in a situation where auditors face strict legal liability for audit failure. Strict liability describes a situation where an auditor would be liable to investors, etc. in all situations where the auditor failed to detect a material misstatement in the financial statements and erroneously issued an unqualified opinion. In this situation, a “production guide” may simply help auditors to perform audits and investors and others to assess the value of this service. This also creates social norms as to what is acceptable auditing.
However, in reality, auditors everywhere operate in a negligence-based legal regimes. This leads to a second role for auditing standards, namely to serve as a basis for assessing auditor negligence by courts. In a negligence regime, audit failure is a necessary but not a sufficient condition for legal liability. If there is an audit failure, compliance with auditing standards (which we reasonably assume are the standards of performance used by court systems) can help reduce an auditor’s legal liability, both to investors and to the client company itself.
Although compliance with professional standards may not immunize the auditor from liability, a defense of complying with the standards can help reduce liability. For example, American International Group (AIG) was fined SI.6 billion by the U.S. Securities and Exchange Commission (SEC) in February 2006 to resolve claims related to improper accounting, bid rigging, and practices involving workers’ compensation funds. However, its auditor PricewaterhouseCoopers complied with the Generally Accepted Auditing
Standards (GAAS) and met the appropriate standards. Therefore, the auditor was found to have acted with due diligence and was not fined.
But how can courts, as well as auditors themselves and investors, know whether or not there is compliance with auditing standards? This depends on the characteristics of these standards. If standards are perfectly precise, then—by definition—(non)compliance can be known by comparing actual auditor effort to the perfectly precise standard. If standards are imprecise, then (non)compliance is uncertain.
Characteristics of auditing standards
To analyze the economic incentives of auditors and the role of auditing standards in an economic framework, Ye (2009) proposes to characterize auditing standards by two properties: toughness and vagueness. The toughness of auditing standards is the average level of audit work required by the standards. This concept is important in analyzing auditing standards because the standards determine the amount of work auditors must undertake. The vagueness of auditing standards is the range of possible audit effort levels that could be considered by different parties as “in compliance” with auditing standards.'
For example, paragraph 6 of the PCAOB AS 1215 “Audit Documentation” states that “the auditor must document the procedures performed, evidence obtained, and conclusions reached with respect to relevant financial statement assertions. Audit documentation must clearly demonstrate that the work was in fact performed.” This paragraph requires auditors to document the procedures, evidence, and conclusions, but the extent of the documentation required is unclear. AS 1215, paragraph 7, states: “In determining the nature and extent of the documentation for a financial statement assertion, the auditor should consider the following factors: (1) ... (5). Application of these factors determines whether the nature and extent of audit documentation is adequate.” This paragraph reduces the uncertainty associated with the documentation procedures. The toughness of this standard is the number of possible factors the auditor needs to consider, and vagueness is the uncertainty of possible factors that may apply in a particular situation.
Accounting and auditing standards, or any standards or laws for that matter, are inherently vague, since such standards cannot possibly anticipate every possible future event. There is always room for interpretation as required in each context.8 As is well known, the vagueness (uncertainty) of auditing standards varies among different countries, and may vary within any given country over time. For example, the auditing standards in the U.S. are generally viewed as being the most detailed and precise in the world, while the International Standards on Auditing are regarded as vaguer. Calfee and Craswell (1984) find that uncertainty about the application of legal standards can give parties economic incentives to “overcomply” or “undercomply”; that is, to modify their behavior to a greater or lesser extent than a legal rule requires. Since there are no legal standards for auditors, professional auditing standards can serve as a substitute. Hence, uncertainty about the application of auditing standards affects auditors’ behavior.
Since the level of toughness of auditing standards affects auditors’ and investors’ preferences toward the vagueness of the standards, it is important to investigate the interaction between the toughness and vagueness of auditing standards in order to analyze players’ incentives when setting the standards.
