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Audit Quality, Auditing Standards, and Legal Regimes:
Implications for International Auditing Standards*
By
Dan A. Simunic
University of British Columbia
Minlei Ye
University of Toronto
Ping Zhang
University of Toronto
ABSTRACT:
We summarize the analyses detailed in two papers on the relation between audit quality, auditing
standards, and legal regimes. We show that optimal auditing standards for a country are a
complex function of the legal system in that country. We then discuss its implications for the
adoption of international auditing standards.
Keywords: Auditing standards, legal regime, audit quality
*
This paper is a summary of the presentation made by Dan Simunic at the 2014 Journal of International Accounting
Research Conference held on June 5-7, 2014 at Hong Kong Polytechnic University. The authors thank the
participants at the JIAR Conference for their feedback. We also thank the participants at the 2013 Accounting
Theory and Practice Conference of the Taiwan Accounting Association held at Soochow University on October 24
& 25, 2013, who also provided feedback on a previous version of this presentation.
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I.
BACKGROUND
In this paper, we examine two interesting and quite complex research questions:
1.
How (if at all) can optimum auditing standards for a country be expected to differ with
differences in the underlying legal liability regime that auditors face for a failure to detect
material misstatements in audited financial statements?
2.
If optimum auditing standards differ across legal regimes, then what are the implications
for the adoption of the International Standards on Auditing (ISAs) by a country?
That legal regimes facing auditors vary across countries is not particularly controversial.
For example, research by Wingate (1997) and others (e.g. LaPorta, Lopez-DeSilanes, Schleifer,
and Vishny, 1997) suggests that the “onerousness” of legal regimes across groups of countries
can be broadly rank-ordered as follows:

U.S.A. → globally the most onerous legal regime

British Commonwealth countries (e.g. U.K, Canada, Australia, etc.)

Continental European countries

Other major countries (e.g. Japan, China, India, etc.) → least onerous legal regimes
Audit fees and auditor effort also appear to vary systematically across countries. For example,
Choi, Kim, Liu and Simunic (2008), using both public and proprietary data sets, report that both
audit fees and audit hours across samples of clients of Big 4 firms, ceteris paribus, were ordered
as follows:
U.S.A. (KPMG data) > Australia (Ernst & Young data) > Netherlands (Big 4 firm data) > South
Korea (Big 4 firm data)
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Note that while the U.S. has its own auditing standards that are issued by the Public Company
Accounting Oversight Board (PCAOB) for the audits of listed companies – which are “rules
based” and arguably “tougher” than the ISAs – the other countries in the Choi et al sample –
namely Australia, the Netherlands, and South Korea – all use the ISAs as their domestic auditing
standards.
This raises two puzzling questions: Why doesn’t the U.S. adopt the ISAs, but opts instead
to expend considerable resources to develop its own auditing standards? Why do audits appear to
vary systematically across Australia, the Netherlands, and South Korea - countries that all use the
same auditing standards, namely the ISAs? We believe that the answer to these questions lies in
the fact that the legal liability regimes facing auditors differ significantly across the countries.
This suggests that the average or typical level of audit quality in a country depends on both
auditing standards and a country’s legal regime. Moreover, these two factors interact and
influence auditors’ rational, self-interested behavior in complex ways to drive auditor effort and
thereby audit quality.
Our goal in this paper is to highlight the essential logic and arguments that underlie the
relations between characteristics of legal systems, auditing standards, and resulting audit quality.
To do this, we draw upon two papers:

Minlei Ye and Dan A. Simunic, 2013. “The Economics of Setting Auditing Standards”,
Contemporary Accounting Research, Vol. 30 (Autumn): 1191-1215.
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
Dan A. Simunic, Minlei Ye, and Ping Zhang, 2014. “The Joint Effect of Multiple Legal
System Characteristics on Auditing Standards and Auditor Behavior”, working paper,
UBC and University of Toronto: SSRN#2281270.
These papers are analytical, and we refer the interested reader to these original manuscripts for
the detailed analyses underlying the results that are described and discussed in this paper.
II.
Role of auditing standards
Auditing standards play two roles in the real world. First, the standards may simply serve
as a guide for audit service production. That is, they provide “how to do it” advice that can be
useful to both auditors - who render the service - and to consumers of the service, namely
investors and company managers. Note that this production role may be useful even in a situation
where auditors face strict legal liability for audit failure. Strict liability describes a situation
where an auditor would be liable to investors, etc. in all situations where the auditor failed to
detect a material misstatement in the financial statements and erroneously issued an unqualified
opinion. In this situation, a “production guide” may simply help auditors to perform audits, and
investors and others to assess the value of this service. However, in reality, auditors everywhere
operate in negligence based legal regimes. This leads to a second role for auditing standards,
namely to serve as a basis for assessing auditor negligence by courts. In a negligence regime,
audit failure is a necessary but not a sufficient condition for legal liability. If there is an audit
failure, compliance with auditing standards (which, we reasonably assume are the standards of
performance used by court systems) will eliminate an auditor’s legal liability, both to investors
and to the client company itself.
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But how can courts, as well as auditors themselves and investors know whether or not
there is compliance with auditing standards? This depends on the characteristics of these
standards. If standards are perfectly precise, then – by definition – (non) compliance can be
known by comparing actual auditor effort to the perfectly precise standard. If standards are
imprecise, then (non) compliance is uncertain. In general, auditing standards can be
characterized by degrees of both “toughness” and “vagueness”. Toughness describes the typical
level of audit effort that would be deemed adequate for compliance; while vagueness refers to
variation in possible compliance effort around toughness reflecting imprecise wording, choices
in procedures, intensity of testing, and other factors.
Some examples may be useful to reinforce these ideas. Suppose an auditing standard
states that:
“Possible audit procedures in a given situation are P1, P2, P3, P4, P5, and P6.”
Comment: This is a rather vague standard as the auditor can choose to perform any one or
combination of procedures at unspecified levels of intensity.
Suppose the standard is changed to read as follows:
“The auditor should perform P1 and P2, and may also perform P3, P4, P5 and P6”
Comment: This is definitely more precise than the first standard, but is it also tougher? The
answer is yes, since on average, auditors can be expected to perform three of the six possible
procedures described in the first standard, while they are required to perform two procedures and
are expected to perform two of the four possible procedures or a total of four procedures, on
average, under the second standard.
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Finally, consider this standard:
“The auditor should perform P1 and P2 at a specified sample size level, n*, and need not perform
any other procedures.”
Comment: This is arguably a perfectly precise standard, and surely more precise than the prior
two standards. If the auditor indeed performed procedures P1 and P2 at a level n*, as required,
the auditor would be deemed in compliance and therefore not negligent in performing the audit.
Is this standard tougher than the first two? That’s ambiguous since fewer procedures will be
performed, on average, thereby reducing toughness, but the effect on audit intensity is unknown.
From this discussion, we conclude that a useful way to describe a set of auditing
standards, such as the PCAOB standards or ISAs, is to say that they have a mean and a variance
(standard deviation) as well as some probability distribution, which we assume to be the uniform
distribution (however results are not contingent on this distributional assumption). Selfinterested, rational auditors will (somehow) choose a level of audit effort, and if audit failure
occurs, courts will determine whether or not the effort level chosen complies with standards.
The cumulative probability that an auditor has complied with vague auditing standards increases
as the level of effort increases. Because a uniform distribution is bounded, there is also an effort
level (upper bound) where the auditor can be certain that he has complied, and an effort level
(below the lower bound) where the probability of compliance is zero – the auditor is certain that
he has not complied. An effort level between these bounds implies that compliance is uncertain,
but – as noted above – the probability of compliance increases with greater audit effort.
But what effort level will an auditor choose? This is an economic decision, to which both
the auditing standards in place and the legal system the auditor faces are parameters. Consider
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an extreme example. Suppose that the auditor faces a legal system where the cost of noncompliance is trivial. Will a rational, self-interested auditor comply with tough, precise auditing
standards? Probably not, since non-compliance carries no costly consequences. But, of course
investors and managers who purchase audit services are also rational and the value of and
voluntary demand for audit services in these circumstances would also approach zero. One could
also ask a more subtle question – are tough, precise auditing standards optimal under these
circumstances? Probably not, since no one cares about these standards so why waste resources
in their development? This example, while extreme, illustrates the problems that need to be
solved to answer the two questions posed at the beginning of this paper. These problems are:
1.
How will audit effort change under a given legal regime as auditing standards vary in
toughness and vagueness?
2.
What level of toughness and vagueness would be set within a country with a given legal
regime by standard setters who are investors in audited companies, and how (if at all) would
such standards differ from those set by auditors themselves? Note that this second question is
important in that, historically, auditing standards have largely been set by auditors. However,
recent years have seen more investor involvement in standard setting and, in the extreme case of
the PCAOB, standard setting by regulators who are (by design) not auditors.
3.
How would optimal toughness and vagueness change with changes in the underlying
legal regime. This third question deals with the issue of when (if ever) “one size fits all” or
under what circumstances can countries be expected to adopt common standards, such as ISAs.
4.
Finally, what problems would arise if ISAs ≠ optimal auditing standards in a country, and
how can these problems be resolved?
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This is a challenging menu of problems for a short paper (presentation), to be sure. We hope that
the main arguments we develop here motivate the reader to delve more deeply into these
interesting issues.
III.
Basic setting of our analyses
Our analyses use a relatively simple, stylized, game-theoretic model of the interactions
among investors, company managers, and auditors. The basic structure of the model was first
developed in Dye (1993). In the model, a manager offers an investment opportunity (project) to
investors and claims that the project is “good”. This can be thought of as managers offering
investors an investment opportunity described by financial statements that they claim are free
from material misstatements. Once this offer is made, managers essentially play no further role.
However, an auditor whose role is to detect a “bad” investment project (i.e. detect material
misstatements in the information managers provide to investors) is available for hire, and this
auditor may be retained by investors before the investment is made. So this is a voluntary audit
model.
The investors’ and auditor’s objectives and the sequence of events after considering the
effect of legal liability regimes and auditing standards are summarized in Figure 1.
(Insert Figure 1 about here)
IV.
The auditor’s effort choice problem
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Figure 2 shows the auditor’s total costs (TC) – which are the sum of resource costs plus
expected legal liability losses, EL(a) – as a function of the auditor’s level of effort, a, for any
given audit fee, an auditor will be motivated to minimize total expected costs. Note that if the
auditor does nothing (a = 0), then expected losses are the lesser of the auditor’s wealth or the
investment amount lost by investors who accept a bad project. If there are no auditing standards
in place, then the expected minimum costs are at effort level as .
(Insert Figure 2 about here)
Now consider the situation where auditing standards are perfectly precise. If the standard
equals 𝑠 ′ , then the auditor's cost of complying 𝑐(𝑠 ′ ) is less than 𝑇𝐶(𝑎𝑠 ). If the standard equals
𝑠 ′′ , then the auditor's cost of complying 𝑐(𝑠 ′′ ) is greater than 𝑇𝐶(𝑎𝑠 ). Therefore, the highest
standard with which the audit will comply is such that the auditor is indifferent between
compliance and noncompliance (i.e., 𝑐(𝑠̅) = 𝑇𝐶(𝑎𝑠 ). The auditor will comply with the auditing
standards so long as the toughness of auditing standards is less than the critical value 𝑠̅.
Otherwise, the auditor will not comply with the auditing standards. The highest standard 𝑠̅ varies
with auditor wealth.
Next consider the case where auditing standards are characterized by a certain toughness
level, m, but are imprecise, where the degree of imprecision (vagueness) is measured by σ. It can
be shown that the auditor’s effort choice for a given level of toughness (𝑚 ≤ 𝑚′′) as σ increases
varies as shown in Figure 3.1
(Insert Figure 3 about here)
1
𝑚′′ is the minimum value of 𝑚 in equation 𝑚 = 𝑎𝑣 − √3𝜎 +
and 𝑎𝑣 =
(1−𝛽) min[𝑊,𝐼](1+√3𝜎+𝑚)
2√3𝜎𝑐+2(1−𝛽)min[𝑊,𝐼]
.
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√3𝜎(𝑎𝑠2 −𝑎𝑣2 )
𝑎𝑠 (1−𝑎𝑣 )
+
2√3𝜎(1−𝑎𝑠 )
(1−𝛽)min[𝑊,𝐼]
1−𝑎𝑣
𝑐
, where 𝑎𝑠 =
Note that as vagueness increases from zero, the auditor’s effort will be at the upper bound of the
uniform distribution (𝑎 = 𝑚 + √3𝜎) but at some level of vagueness (σ1) “a” will begin to
decrease. That is, up to the level of vagueness σ1, the auditor will choose to comply with the
standards with certainty. However, as vagueness continues to increase, the auditor will optimally
choose a level of effort within the distribution and thus comply with a probability, P(a) < 1, with
the probability of compliance decreasing as the level of vagueness increases.
Finally, Figure 4 shows the various optimal effort choices an auditor would make under
the combination of toughness and vagueness.
(Insert Figure 4 about here)
This figure illustrates the auditor's effort choice (i.e., 𝑚 + √3𝜎, or 𝑎𝑣 , or 𝑎𝑠 ) as a
function of toughness 𝑚 and vagueness 𝜎. The grey (dash dot dotted) line is the indifference
curve where 𝑚 + √3𝜎 is equal to 𝑎𝑣 . The red line (dash dotted) provides the values of 𝑚 and 𝜎
for which the auditor is indifferent between choosing 𝑚 + √3𝜎 or 𝑎𝑠 . At the blue (dashed) line,
the auditor is indifferent between 𝑎𝑠 and 𝑎𝑣 . The line indicated by 1 − √3𝜎 is the boundary for
𝑚, since 𝑚 + √3𝜎 should be less than or equal to one. The feasible region, which is below 1 −
√3𝜎, is partitioned into three sets by the grey, red, and blue lines. When 𝑚 and 𝜎 fall into region
A, the auditor chooses his effort equal to 𝑚 + √3𝜎. When the toughness and vagueness are in
region B, the auditor will choose 𝑎𝑣 to be his effort level. When 𝑚 and 𝜎 is in the upper corner,
region C, the auditor will choose 𝑎𝑠 . Note that in region C, the auditor is ignoring auditing
standards in the sense that compliance would indicate an absence of negligence, but might still
use the standards as a guide to audit production.
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From Figures 2 through 4 we can see that an auditor’s rational, self-interested response to
standards that vary in toughness and vagueness is quite complex, ranging from certain
compliance, to uncertain compliance, to ignoring the effect of standards on the auditor’s legal
liability to investors for audit failure. Note that when the auditor chooses an effort level, as , the
auditor is behaving as if he or she operates under a strict liability legal regime. That is, the
auditor anticipates and accepts that if audit failure occurs, damages (the lesser of I and W) will be
incurred and paid to investors.
V.
Setting auditing standards
In the previous section we consider how the auditor would behave under different types
of auditing standards when facing a given legal system. In this section, we consider how
auditing standards would be set, again under a given legal system, first by investors acting as
standards setters, then by auditors acting as the standards setters.
Because our model describes a voluntary audit setting with a single investment project,
the determination of the optimum auditing standards from the point of view of investors is
relatively straightforward. Consider the economic objectives of the players:
Objective function: Investors want to induce auditor to exert effort level to maximize the
value of an audit
𝑉(𝑎) = (1 − 𝛽)𝑎𝐼 + 𝐸𝐿(𝑎) − 𝐹
where:
1 − (𝛽) = probability project is “bad”,
𝑎 = auditor effort and the conditional probability auditor detects a bad project (power of test),
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𝐸𝐿(𝑎) = expected liability payment by auditor,
F = audit fee paid to auditor, and
𝐸𝐿(𝑎) = (1 − 𝛽)(1 − 𝑎)(1 − 𝑃(𝑎)) min[𝑊, 𝐼], where 𝑃(𝑎) is the probability that the auditor
complies with standards.
Objective function: Auditor’s objective is to choose an effort level to maximize profits
Max 𝐹 − 𝑐(𝑎) − 𝐸𝐿(𝑎)
where:
1
𝑐(𝑎) = total cost of audit resources = 2 𝑐𝑎2 which is convex and increasing in a.
Note that the choice variable in both the investor and auditor problem is the level of effort, a.
Now if investors can contract with auditors to undertake a level of effort which is
observable so as to maximize the value of an audit, they would (by substitution) simply:
1
Maximize: 𝑉(𝑎) = (1 − 𝛽)𝑎𝐼 + 2 𝑐𝑎2 .
𝑑𝑉
So: 𝑑𝑎 = (1 − 𝛽)𝐼 − 𝑐𝑎 = 0, and 𝑎∗ =
(1−𝛽)𝐼
𝑐
.
This is the first-best solution to the effort choice problem. Note that optimum auditing
standards equal optimum audit effort (s* = a*) which increases with the probability of a bad
project, increases with the size of the required investment, and decreases with the marginal cost
of audit resources. It turns out that the first-best solution, where auditor effort is assumed to be
perfectly observable by all players, is still an important benchmark even when effort is not
observable.
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If audit effort is unobservable, standards are set by investors at the beginning of the
game, and standards can be perfectly precise, then it can be shown that:

Investor standard setters would set the standard at the first-best solution (a*), if there
exists an auditor with sufficient (observable) wealth, W. Note that it is in the wealthy
auditor’s self-interest to comply with that standard, so long as the standard is not too
tough.
If auditor wealth is limited, then the standard would be set as close to a* as is attainable,
given the low auditor wealth.
Note the important role that auditor wealth plays in standard setting. Investors must
assume that auditors will always act in their own self-interest, since they operate as businesses
not as charities! So while investors would always prefer to set the standard at the first best, this
will not be possible when auditors lack the loss-of-wealth incentive to comply with such
standards. Note also the implicit role of the legal system in determining optimum auditing
standards. If the existing legal system would not compensate investors for their losses up to the
level of auditor wealth, then again standards cannot be at the first-best level.
The argument that investors as standard setters would seek to attain first-best audit effort
is quite intuitive. But how would auditors set perfectly precise standards? Perhaps surprisingly,
it can be shown that wealthy auditors as standard setters are also motivated to set the standard at
a*, so long as the auditor has bargaining power to retain some of the surplus audit value, since
that value is maximized at a*. Again, less wealthy auditors would set standards as close to a* as
possible consistent with their limited W (the maximum effort level to which they can credibly
commit). So, if standards can be perfectly precise we conclude that investors and wealthy
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auditors have the same preference for the toughness of perfectly precise standards, while less
wealthy auditors would prefer weaker standards. Also, if standards can be set precisely, there is
no reason for either investors or wealthy auditors to prefer imprecise (principle based) standards.
Of course, real-world standards are always imprecise. What factors may motivate a
choice of imprecise standards? Several possibilities emerge from our model:
•
If standards are set by a group of auditors who vary in wealth, wealthy auditors will argue
for tougher standards than less wealthy auditors, and imprecise standards may be the
outcome.
•
If toughness is (somehow) set at a non-optimum level, then the auditor (investor) prefers
vaguer standards either to allow an auditor to reduce effort (if toughness is too high) or to
credibly increase effort to protect auditor wealth (if toughness is too low).
•
In the model, a* depends on I. If there are multiple projects that vary in size, either size
contingent precise standards are written (which is difficult), or imprecise standards may
be written.
Following are some interesting “take-aways” concerning standard setting in our model:
•
Auditing standards set by wealthy auditors (Big 4) are likely to be quite similar in
toughness and vagueness to the standards preferred by investors in large projects.
•
Vague standards are generally not preferable to precise standards, except in certain
circumstances.
•
Small audit firms lack sufficient wealth-at-risk to be able to credibly commit to audit in
accordance with the tough standards potentially imposed by Big 4 auditors and investors,
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and are more likely to gamble and be held, ex post liable. That is, the litigation rate
involving small audit firms is expected to exceed the litigation rate of large audit firms,
which is consistent with evidence in Palmrose (1988).
•
Variations in client firm size are probably an important factor motivating the writing of
relatively vague (principle based) auditing standards, and may motivate the writing of
systematically different auditing standards for large vs. small companies (Big GAAS vs
Little GAAS).
VI.
Legal liability regimes and auditing standards
With the background concepts and analysis in place, we now turn to the important and
complex question of how differences in the legal regimes that auditors face would affect the
properties of optimal auditing standards. To do this, we need simple descriptors of how legal
regimes can vary across countries. Accordingly, we describe legal regimes by two parameters:
1.
The average size of damage awards paid by negligent auditors to investors, which is
denoted as D, and
2.
The degree of overall vagueness in the legal system (denoted v > 0) which depends on
the wording vagueness of auditing standards in place, (σ ≥ 0), and the unpredictability of the
courts’ interpretation of standards (denoted δ > 0). Thus v = f (σ, δ).
For example, we consider the U.S.A. to be a country where both D and v are quite high.
American courts certainly award large damages, such as in class-action lawsuits or when
assessing punitive damages against auditors. Moreover, American courts can be unpredictable in
15
that civil cases against auditors may be tried by juries whose grasp of business issues may be
limited, and who may be swayed by emotional arguments of legal counsel. On the other hand,
we consider the Peoples’ Republic of China (PRC) as a country with both low D and low v. In
the PRC it is very difficult (if not impossible) for injured investors to obtain financial
compensation through private litigation and, where litigation does occur, assessed damages are
likely to be quite low.
In the previous analyses we assumed a legal system that would compensate investors who
suffered losses (I) by investing in a bad project that an auditor had reported to be good, to be the
lesser of I or the auditor’s wealth, W. Here we assume the more general case where D can take
any value. For example, through punitive damage awards, D can be greater than I. Also, where
courts are reluctant to punish auditors, D can be less than either I or W.
Also, since we have argued that auditing standards set by investors and auditors tend to
converge on the same value (the first-best solution), we assume that auditing standards are set by
investors with a goal of inducing auditors to produce audit quality, a*, or as close to a* as is
possible, given the legal regime in place. Recall that a* is a function of the value of I, while
auditor effort choice will be a function of D, v, and s. Since the probability of loss is a function
only of 𝑎, 𝑠, and 𝑣, we discuss the optimum toughness of standards given 𝑣, the vagueness of the
legal system and the wording vagueness of standards.
(Insert Figure 5 about here)
Figure 5 shows how auditor effort, a, will vary with v and D, if the toughness of auditing
standards is set at the optimum level. That is, how will auditors behave given a set of auditing
standards that are optimal for the legal regime that they face? The top plane of the box
represents the first-best solution (a*). Investor standard setters are never motivated to induce
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auditors to exert effort greater than that level. The figure shows that where the overall vagueness
is relatively low and damage assessments are moderately high to high, auditors can be induced to
exert the first-best level of effort. As vagueness increases the level of auditor effort will fall
unless damages, D, are increased. The worst situation occurs when vagueness is high and
damages are low. In that situation, auditor effort will be low – well below first-best – even when
auditing standards are optimally set! An important point that Figure 5 clearly illustrates is that
auditing standards, by themselves, are not enough to induce a high level of audit quality. Even
with the best possible standards, a legal system with high v and low D will yield low average
audit quality – well below the quality that investors would like to prevail.
Finally, we consider how the optimal toughness of auditing standards (s*) would vary
with the characteristics of the legal system, v and D. Figure 6 illustrates the complex relation
between the two legal system parameters and s*. For example, for relatively low values of
vagueness, the toughness of auditing standards needs to increase as D increases but then hits an
upper bound when induced auditor effort attains a*. In this range of v, even if D continues to
increase, it is not optimal for s* to increase as too much effort would be induced. For high
values of v, the relation is more complex as optimal toughness, s*, first increases and then
decreases with D. Again, recall that compliance with auditing standards protects auditors against
a charge of negligence. So, if the legal regime assesses high damages and is seen as being
capricious (v is high) auditing standards need to be “fine tuned” to induce optimal audit quality.
(Insert Figure 6 about here)
VII.
Implication of our analyses for the adoption of ISAs
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Our previous analyses demonstrate that there are clear dangers in assuming that a global
set of auditing standards, such as the ISAs, can or should be adopted in all countries. For
countries where both v and D are very low (e.g. China) optimal standards will have a low
toughness and the first-best solution will likely not be attained, even under optimal auditing
standards. This implies that investors and regulators will be concerned about the low average
audit quality that prevails in the country. This situation would appear to characterize not only
China, but other countries, such as Japan (Frendy, 2014). If countries where v and D are quite
low, such as China and Japan, adopt the ISAs - which, indeed has been the case – then these
standards will likely be too tough, given the legal system in place, and auditor non-compliance
with standards can be expected.
On the other hand, for countries where both v and D are very high (e.g. the U.S.A.),
toughness needs to be high if first-best audit effort is to be attained. Also, optimal standards in
these circumstances should be precise, since required toughness is an increasing function of v, so
if σ were high, then optimal toughness would need to be even higher! Arguably, the standards set
by the PCAOB are tougher and more precise that the ISAs. As a result, our analyses predict that
regulators in the U.S. will be reluctant to adopt ISAs – which is, in fact, the case. If, on the other
hand, the U.S. were to adopt the ISAs as domestic standards, the result may be a failure to
achieve first-best average audit quality.
Basically, our analyses predict that uniform auditing standards will be adopted and will
work well for a set of countries that have roughly similar legal systems – such as the British
Commonwealth countries, and the countries of the European Union. When adopted by countries
with weak legal systems, average audit quality cannot be expected to increase significantly, and
there will be problems of auditor non-compliance with standards. This implies that imposing an
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initially non-optimal set of auditing standards on a country will require concurrent changes in the
legal environment if those standards are expected to be effective in eliciting auditor compliance
with the rules and thereby increasing average audit quality. A legal environment can, in
principle, be changed by changing average damages assessed in court cases, namely D, and/or by
changing the interpretation vagueness of auditing standards. The latter could involve countryspecific interpretations of standards that provide additional guidance to auditors.
VIII.
Concluding comments
We have shown that optimal auditing standards for a country are a complex function of
the legal system in that country. Moreover, audit quality (auditor effort) depends on the legal
system and the characteristics of auditing standards under which auditors – who are organized as
self-interested, private business enterprises - operate. Globally uniform auditing standards
cannot be optimal in all countries unless national legal systems are also sufficiently uniform. An
interesting question raised by a number of participants in the conferences at which this
presentation was made is whether or not regulatory discipline can be a substitute for discipline
by private litigation, in circumstances where the private litigation system is weak (e.g. China,
Taiwan, Japan, etc.). This is a very interesting question that lies beyond the scope of this paper,
but which is investigated in a paper by Ye and Simunic (2014).
19
Appendix Figures
Figure 1 Game tree summary and players’ objectives
The notation used is as follows:
F=
audit fee paid by investors to the auditor
a=
level of auditor effort (scaled 0,1); also the probability that auditor receives a signal of
“bad” from audit tests performed, if indeed the project is bad (power of audit tests)
β=
probability that the investment project is good; (1 – β) probability project is bad
B=
payoff to investors from a good project; bad project pays off zero
I=
investment amount
c(a) = cost function of audit resources (assumed convex)
P(a) = probability that auditor is deemed by the court to have complied with auditing standards
W = level of auditor wealth which limits the amount of damages an auditor can pay to
investors
Note that all of these values are assumed to be common knowledge.
Source: (Ye and Simunic, 2013)
20
Figure 2 The auditor’s effort choice if standards are precise
This figure illustrates the auditor’s effort choice when auditing standards are perfectly precise. If
the standard equals 𝑠 ′ , then the auditor's cost of complying 𝑐(𝑠 ′ ) is less than 𝑇𝐶(𝑎𝑠 ). If the
standard equals 𝑠 ′′ , then the auditor's cost of complying 𝑐(𝑠 ′′ ) is greater than 𝑇𝐶(𝑎𝑠 ).
Therefore, the highest standard with which the audit will comply is such that the auditor is
indifferent between compliance and noncompliance (i.e., 𝑐(𝑠̅) = 𝑇𝐶(𝑎𝑠 ). The auditor will
comply with the auditing standards as long as the toughness of auditing standards is less than the
critical value 𝑠̅. Otherwise, the auditor will not comply with the auditing standards. The highest
standard 𝑠̅ varies with auditor wealth.
Source: (Ye and Simunic, 2013)
21
Figure 3 Given 𝑚 ≤ 𝑚′′, how does the auditor’s effort vary with vagueness?
This figure shows that if 𝑚 ≤ 𝑚′′, then as vagueness increases, the auditor’s effort will be 𝑚 +
√3𝜎 and then 𝑎𝑣 , suggesting that the auditor will initially increase and then decrease his effort.
Source: (Ye and Simunic, 2013)
22
Figure 4 The auditor’s effort choice as a function of toughness 𝑚 and vagueness 𝜎
This figure illustrates the auditor's effort choice (i.e., 𝑚 + √3𝜎, or 𝑎𝑣 , or 𝑎𝑠 ) as a function of
toughness 𝑚 and vagueness 𝜎. 𝑚 is the mean and 𝜎 is the standard deviation of the distribution.
The grey (dash dot dotted) line is the indifference curve where 𝑚 + √3𝜎 is equal to 𝑎𝑣 . The red
line (dash dotted) provides the values of 𝑚 and 𝜎 for which the auditor is indifferent in choosing
𝑚 + √3𝜎 or 𝑎𝑠 . At the blue (dashed) line, the auditor is indifferent between 𝑎𝑠 and 𝑎𝑣 . The line
indicated by 1 − √3𝜎 is the boundary for 𝑚, since 𝑚 + √3𝜎 should be less than or equal to one.
The feasible region, which is below 1 − √3𝜎, is partitioned into three sets by the grey, red, and
blue lines. When 𝑚 and 𝜎 fall into region A, the auditor chooses his effort equal to 𝑚 + √3𝜎.
When the toughness and vagueness are in region B, the auditor will choose 𝑎𝑣 to be his effort
level. When 𝑚 and 𝜎 is in the upper corner, region C, the auditor will choose 𝑎𝑠 .
Source: (Ye and Simunic, 2013)
23
Figure 5 The impact of D and 𝑣 on audit quality under optimal toughness of the standards
In this figure, 𝑎𝑜 is the optimal audit quality, 𝑣 is the interpretation vagueness, and D is
the damage award. This figure illustrates how auditor effort 𝑎𝑜 varies with 𝑣 and D, if the
toughness s of auditing standards is optimally set. We use the following function and parameter
values to generate this figure: (𝑎) = 1 − exp(−0.03𝑎), 𝜇 = 0.05, 𝛽 = 0.5, I=15.
This figure shows that D needs to be large enough to induce the first-best quality,
especially when 𝑣 is high. When D is not large enough, optimal standards induce an effort as
close to the first best as possible. When 𝑣 is low, the audit effort is certain compliance 𝑠 0 + 𝑣̅ ,
which doesn’t vary with 𝑣, but is affected by D. When 𝑣 is high, the auditor will comply
possibly. When 𝑣 increases, the possible compliance effort decreases, and thus, tougher
standards are needed to increase the possible compliance effort.
Source: (Simunic, Ye and Zhang, 2014)
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Figure 6 Optimum toughness of standards given D and v
In this figure, 𝑠 ∗ is the optimal toughness of the standards, 𝑣 is the total vagueness, and D
is the damage award. We use the following function and parameter values to generate these
figures: 𝑞(𝑎) = 1 − exp(−0.03𝑎), 𝜇 = 0.05, 𝛽 = 0.5, I=15.
The figures show, for a given 𝑣(≤ 𝑣̅ ), as damage award D increases, optimal toughness
increases and then becomes a constant once 𝐷 ≥ 𝐷0 . The value of 𝐷0 is the minimum of D at
the point that the optimal toughness 𝑠 ∗ becomes a constant under a given 𝑣(≤ 𝑣̅ ). The value of
𝐷0 is around 7 in above figure and it is not a function of 𝑣. The optimal toughness decreases as 𝑣
increases when 𝑣 ≤ 𝑣̅ .
Source: (Simunic, Ye and Zhang, 2014)
25
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