Precision in auditing standards: effects on auditor and director liability and the supply and demand for audit services

Abstract

This paper analyses the economic implications for a company's directors and its auditors of variations in the degree of precision (or, conversely, the degree of vagueness) in generally accepted auditing standards (GAAS), as well as variations in the degree of precision in legal standards of due care faced by directors. Directors and auditors are assumed to be jointly and severally liable to investors and creditors for unintentional misstatements in audited financial statements that are not detected because of either or both parties' negligence. Directors choose expected cost minimising levels of audit quality and internal control quality, which together define the quality of a firm's financial reporting system. Auditors choose a level of effort, given the level of audit quality demanded by directors. The interaction between directors and auditors is modelled in a leader-follower framework, where the directors' demand decisions reflect their own vague legal standards as well as a conjecture of the auditor's production behaviour as a function of the degree of precision in GAAS. We show that decreasing the precision of GAAS initially induces an auditor to produce higher audit quality by exerting more effort. But beyond a certain critical value, decreasing precision leads to decreasing effort and auditors gamble on violating GAAS. When vagueness exceeds a second critical value, auditors exert no effort at all. The demand decisions of directors with respect to the overall quality of a firm's financial reporting system are more complex. We show that when legal due care standards are precise, or somewhat imprecise, directors will demand levels of financial reporting system quality that comply with due care standards. But as legal standards become more imprecise, the precision of GAAS becomes important and affects the quality of internal control and audit quality demanded. Initially, directors will gamble on violating due care standards, and if the degree of vagueness in legal standards becomes sufficiently large, directors will have no demand for financial reporting system quality. In the final section, we develop hypotheses concerning the effects of decreasing precision in GAAS and suggest ways in which these hypotheses could be tested using international, inter-industry, and inter-temporal comparisons of the Big 4 audit firms' market shares, audit fees, and litigation rates.