Audit Quality in Regulatory Regimes

Abstract

In this paper, I evaluate the impact of regulatory interventions on the quality of auditing services. Because of the recent financial crisis the European Commission has come up with proposals to introduce a Single Market for Statutory Audits. Hereby, the European Commission wants to open the audit services market to cross-border competition, to standardize provided services and it wants to allow for voluntary quality certification in order to reduce the adverse effects from asymmetric information about audit quality in the market. This paper investigates the impact of the EC proposals on social welfare and the well-functioning of the market. I set up a pair of signaling games to theoretically analyze the relationship between an auditor, a firm and a regulator. The analysis reveals that standardization of audit services is optimal if the costs for verifying quality are sufficiently low. On the other hand, certification leads to a separating equilibrium where only high-quality auditors certify. This regime maximizes social welfare whenever verification costs are large. The results are robust against a number of extensions.

Keywords: asymmetric information, audit services, EC regulation, certification, signaling, standardization