| Abstract: | The business of auditing is heavily regulated. Auditor regulation exists through licensing, professional standards and liability. The auditor's liability for losses to financial statement users from audit failure is subject to a test of negligence. What constitutes due audit care is, however, not generally well-specified. Furthermore, reviews of litigation against auditors conclude that compliance with professional audit standards does not always act as a complete defence to allegations of negligence. The current situation can be described as one where (ex ante)—from the point of view of the auditor—uncertainty exists about the ‘legal’ standard of due audit quality (as seen by the courts in the event of litigation). This uncertainty about legal standards fundamentally affects audit behaviour in ways that are not immediately intuitive. This paper draws on insights from the economics and law literature (e.g., Kolstad et al., 1990; Shavell, 1984a, 1984b and 1987; Calfee and Craswell, 1984 and 1986) and provides an analysis of the effects of uncertainty about auditor negligence on the produced level of audit quality and on audit fees. The auditor subject to a negligence rule will produce too low or too high an audit quality level, as compared to the socially optimal level. It is shown that uncertainty about the legal standard of ‘due audit quality’ is fundamental to understanding audit quality supplied. This uncertainty is the explicator of an insurance component in audit fees. A surprising insight is that a large uncertainty about the legal standard of care can reduce rather than increase the quality of audit work supplied and increase the insurance component. Relying on insurance premiums can be more effective than direct expenditure in reducing risk. The effect of the imposition of ex ante precise audit quality standards, in combination with an uncertain negligence rule, is discussed. Since the influence of ex ante standards is indirect through its effect on ex post liability, auditing standards cannot be analysed independently of ‘legal’ standards. If the legal standard of care were clear, there would be no role for audit standards. Audit standards only affect audit behaviour if legal standards of care are unclear, and they help to clarify the legal standard. An effective combination is for ex ante standards to be set below the ex post standards of care so that they provide a lower bound on acceptable work. Under a lowest common denominator approach set too far below legal standards, audit standards would be irrelevant as far as operational decisions were concerned. As the level of standards are raised, so costs are first imposed on the lowest quality providers. |
