Abstract We study regulation of the auditing profession in a model where audit quality is unobservable and enforcing regulation is costly。 The optimal audit standard falls short of the first-best audit quality, and is increasing in the riskiness of firms and in the amount of funding they seek。 The model can encompass collusion between clients and auditors, arising from the joint provision of auditing and consulting services: deflecting collusion requires less ambitious standards。 Finally, banning the provision of consulting services by auditors eliminates collusion but may not be optimal in the presence of economies of scope。85082

Keywords: auditing, regulation, enforcement, collusion。

Authors’ addresses: Marco Pagano, CSEF, Facoltà di Economia, Università di Napoli Federico II, Via Cintia, 80126 Napoli, Italy, phone +39-081-5752508, fax +39-081-5752243; e-mail mrpagano@tin。it。 Giovanni Immordino, Facoltà di Economia, Università di Salerno,  84084 Fisciano (SA), Italy, phone +39-089-963167, fax +39-089-963165; e-mail: giimmo@tin。it。

Acknowledgements: We thank Ron Anderson, Claudio Borio, Mike Burkart, Rajna Gibson, Antoine Faure-Grimaud, Denis Gromb, Giancarlo Spagnolo, Oren Sussman, Roberto Tizzano, David Webb and seminar participants at Columbia University, University of Bologna, University of Salerno, University of Lausanne, London School of Economics, Oxford University, University of Zurich, the Bank of International Settlements, the 2004 Stockholm CEPR-SITE Workshop “Understanding Financial Architecture: On the Economics and Politics of Corporate Governance”, the 2005 Toulouse Conference in Tribute to Jean-Jacques Laffont and the 20th Annual Congress of the European Economic Association。 Marco Pagano gratefully acknowledges financial support from the Fondazione IRI。 This paper is produced as part of a CEPR research network on Understanding Financial Architecture, funded by the European Commission under the Human Potential Research Network contract No。 2000-00064。 A former version of this paper was circulated under the title “Optimal Auditing Standards”。

1。Introduction

The recent corporate scandals involving major companies (Enron, Worldcom, Qwest, Sunbeam, Parmalat, etc。) have highlighted that the regulation of auditing and its enforcement are key determinants of the reliability of corporate information。 For many companies involved in corporate scandals, auditors failed to report any misbehavior or substantive inaccuracy。 These audit failures have damaged auditors’ reputation as independent experts and monitors of accounting information。

As a result of this loss of confidence, there has been a shift from self-regulation and litigation- based enforcement of audit rules towards government regulation and public-driven enforcement。1 In the United States, the Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board (PCAOB), which, under the oversight of the Securities Exchange Commission (SEC), will register public accounting firms, and establish rules for auditing, quality control, ethics, independence and other standards。 Moreover, it will inspect accounting firms, carry out disciplinary proceedings and impose penalties。 The Sarbanes-Oxley Act has also greatly increased the financial resources devoted to the activity of the SEC。 A similar shift is under way in other countries。 The United Kingdom moved away from self-regulation by widening the scope and powers of the Financial Reporting Council, and specifically by creating a new subsidiary board (the Professional Oversight Board for Accountancy), entrusted with oversight of the auditing and accountancy profession。 Also the Italian parliament is drafting new legislation to extend the powers of the national securities commission (CONSOB) on regulation and oversight of auditors’ activity。

Now that the role of the public regulation of auditing is widely recognized, the natural question arises of what is the optimal design of such regulation。 The job of auditors is to certify the reliability of accounting information, but in turn the reliability of this certification can vary depending on the quality standards set by regulators。