Planned audit quality

Abstract

Our study was motivated by suggestions to impose mandatory rotation of independent auditors and by the passing of a bill by the U.S. Congress which reduces the auditor's civil liability for audit failure. We offer a multiperiod model for the planning of optimal audit quality by external auditors, and examine five propositions concerning the relations between planned audit quality and: 1) the auditor's relative efficiency, 2) audit fees, and 3) the expected loss due to audit failure. The major results suggest that: 1) cet. par. efficient independent auditors will plan a higher level of audit quality than less efficient independent auditors, 2) higher audit fees will result in an increase in the planned audit quality level for all expected engagement periods except the final one, and that 3) irrespective of the penalty regime, the level of planned audit quality will diminish over time. It is possible to motivate the auditor to plan a higher audit quality level for the last engagement period by increasing the penalty for audit failure in that period. Such a strategy will result, however, in reduced planned audit quality levels in all periods prior to the final one. Although the analysis increases our understanding about the above relations, it is not sufficient to conclude whether the newly-enacted tort reform is socially desirable.