3。3 Regulated auditing

The government sets an auditing quality standard q*。 This implies that auditors must choose a quality level at least equal to q*。 If they deviate, they are liable to pay a penalty l。 The quality chosen by auditors is observable and verifiable at a cost by a regulator, who chooses also the amount of resources e devoted to enforcement, i。e。 to detection of violators。 The penalty  is monetary and cannot exceed an upper bound,11 denoted by l*。 This bound can be thought as the entire wealth of the auditing company, which is taken as exogenous in the context of  the relationship with a specific client。12

Figure 1 illustrates the sequence of moves。 First, nature chooses the state s。 Second, the regulator chooses the audit standard q*, the penalty l and the enforcement e。 Third, auditors choose the quality level of their audit q charging the fee F(q), and produce the corresponding report r。   Fourth,

bureaucrats enforce the standard by inspection, detecting non-compliance with   probability

f (e) 。13

Next, the stock market sets the price P of the company at a level reflecting the actual report filed by the auditor and the perceived quality of auditing; depending on the report, shareholders may contribute equity to finance the company。 Finally, the company’s actual value is determined。

[Insert Figure 1]

10 Here we are assuming that the auditor’s fee is not conditional on the ex-post accuracy of the report。 Admittedly, such a contract could elicit a positive level of effort from the auditor, but it would not generally elicit the first-best auditing quality if auditors have limited liability。 Moreover, in the auditing profession “contingent contracts cannot be used as an incentive device because auditors’ code of professional ethics (rule 302) prohibits them from accepting incentive contracts for audit-related work” (Dye, 1993, p。 888, footnote 5)。 This ban arises from efficiency reasons: auditors are hired by managers, and incentive contracts would provide easy ways to bribe auditors。

11 Auditors’ limited liability implies that the first-best cannot be achieved even via a more sophisticated design of the penalty or of enforcement, for instance by making them contingent on the accuracy of the auditor’s report。 (The point is analogous to that made in footnote 10。)

12 Auditors’ wealth can derive from interaction with previous customers and from the sale of non-audit services。 In reality it may be impossible to confiscate the entire wealth of the auditor, due to the danger of “subversion of justice” (Glaeser and Shleifer, 2003)。

13  In our setting, the regulator commits to the probability of detection   f (e) , by allotting the level of

resources e to enforcement activity。 One can think of e as the salaries paid to the officials in the authority that oversees the application of audit standards: once hired, these detect violations with a probability given by their enforcement technology。

To enforce the audit standard, the regulator must back it up by a sufficiently high expected penalty L in case of non-compliance。 The auditor’s profit is:

F (q) C(q) L , (7)

where the expected penalty L is the product of the probability f(e) of detecting a non-complying auditor and the statutory penalty l。 The probability of detection is increasing and concave in the

regulator’s effort:

f '(e) 0 ,

f "(e) 0 , with

f (0) 0 , lim

e0

f '(e) and   lim

e

f '(e) 0 , that is,

the enforcement technology has decreasing marginal productivity。 So the expected penalty is: