Auditing as a Public Good and the Regulation of Auditing

Abstract

Regulation of auditing and accounting is a key component of corporate governance. This paper examines recent changes in the regulation of auditing, in particular those relating to auditor independence. Audit output, of which a key feature is auditor independence, has many of the characteristics of a public good (analogous to clean streets), but in contrast to other public goods, all costs are borne by the audit client. This creates adverse incentive effects and makes absolute independence difficult if not impossible to achieve. It is an example of the private provision of a public good and hence results in considerable public regulation of audit output. The concept of auditor independence is complex. The structure of the auditing industry and services provided by audit firms affect the independence of the performing auditor. Because of the world dominance of the US financial system, the actions of state regulation in the US has affected the “audit industry” not only in the US but worldwide, with considerable implications for corporate governance.