Audit Quality and Regulation

• Published date: 01 November 2016
• Author: W. Robert Knechel
• DOI: http://doi.org/10.1111/ijau.12077
• Date: 01 November 2016

Audit Quality and Regulation

W. Robert Knechel

Fisher School ofAccounting, University of Florida, USA

Since 2002, there has been a significant and rapid growth in regulation related to the audit profession. However,

despite significant progress in the quality of audits, as well as some complaints about over-auditing, there are still

concerns that audit quality is lower than wished by some stakeholders. In the end, the question of whether audit

quality is good or not, dependson one’s viewpoint. In order to reconcile potentially competing views of audit quality,

it may be helpful to re-consider what is meant by the term ‘audit quality’. Audit quality is generally defined as

consisting of two important attributes:competence (expertise) and independence(objectivity). In this paper, I analyze

how these two attributes interact with each other, creating different points of view for regulators and practitioners.

Further, I illustrate how fundamental economic theory can be used to analyze how regulation might influence

competence and independence to impact overall audit quality. However, because regulation may not always

appropriatelyconsider the economic theory underlying the market for assurance services, it is likely that thepositive

benefits obtained from regulation will also be tempered by negative unintended consequences.

Key words: Audit quality, audit regulation, economics of auditing

INTRODUCTION

The past decade has seen tremendous changes in the

regulation of the auditing profession. Auditors have gone

from an essentially self-regulated profession prior to 2002

to what is now a profession that is highly supervised by

government oversight and independent regulators across

the world. The story of these changes tells us much about

the impetus for regulation as well as providing insightinto

what regulation may, or may not, be able to accomplish in

regards to audit quality. Analysis of regulatory

developments over the past decade suggests that we can

expect to observe unintended consequences arising from

the current regulatory climate. While those unintended

consequences are difficult to predict, there are increasing

indications that they exist. The purpose of this article is to

consider how regulation that is intended to improve audit

quality may, in fact, have some undesired effects on the

auditing profession and the conduct of audits.

As a result of the regulatory attentionit now receives, the

auditing profession faces an interesting and awkward

conundrum. The mostcommon complaints about auditors

take two basic forms: (1) fees are too high (or the

complementary statement that the Big 4 have too much

pricing power),and (2) audit quality is too low in too many

instances. The former problem is captured by a quote by

Annette Nazareth, a member of the US Securities and

Exchange Commission(SEC) in 2007: ‘[The SEC has] heard

complaints about auditors over-auditing in part because

they fear that PCAOB inspectors would otherwise find

their audits insufficient.’

1

The latter problem is reflected in

a quote by Pierre Delsaux who was a member of the

European Commission at the time of the Global Financial

Crisis: ‘[There was] not enough control on what the banks

were doing. We need good external control, specifically,

auditing.’

2

The reasonwhy these two viewpointsconstitute

a conundrum isbecause neo-classical economictheory tells

us that it may be difficult to reconcile these problems in a

competitive market foraudit services.

For example, efforts to reduce prices (fees)may lead to a

loss of quality unlesssignificant effectiveness improvements

can be realized. On the other hand, efforts to increase

quality may lead to higher prices unless significant

efficiency improvements can be realized. The profession

occasionally seems to confuse these two issues whenever

they argue that auditors should ‘compete on quality’

(Mayhew & Wilkins, 2003; Polimeni, Burke, & Benyaminy,

2010; Sirois & Simunic, 2011; Newton, Wang, & Wilkins,

2013). This is certainly a noble idea but chasing quality

without considering cost may not result in an

economically viable equilibrium. While regulators may

be less concerned about cost, it might be more

constructive to argue that the profession should ‘compete

on value’, which implicitly recognizes the tradeoff of costs

and benefits of the audit.

Failure to achieve the mentioned improvements in

efficiency or effectiveness can, in extremis,leadtoa

downward spiral for an industry, i.e., as prices (fees) are

beaten down via competitive pressures, quality may

deteriorate, which puts further pressure on prices. This

potential problem is compounded in an industry with flat

(or declining) demand. These problems can be

simultaneously addressed only if the market for audit

services is noncompetitive, meaning the auditor is earning

economic rents that can be wrung from the system with

appropriate regulation or increased competition,

3

or

auditors can be incentivized to innovate in ways that

simultaneously reduce costs and improve quality. A great

deal of previous research suggests that audit markets are,

in fact, competitive on balance (Ferguson, Francis, &

Stokes, 2003; Hamilton, Li, & Stokes, 2008; Numan &

Willekens, 2012) so the first approach is unlikely to yield

the intended results. Current regulatory approaches may

make the second approach, incentives for innovation,

difficult as will be explained in more detail below. So the

question is: Can the audit quality conundrum be solved

via regulatory intervention? While mandated auditing is

likely to keep the profession relatively lucrative, we may

find that regulation will both helpand harm the profession

as we know it today. The extent to which the profession

improves depends on the nature of auditing, the form of

regulation, and the inevitable unintended consequences

of changingthe fundamental regulatory regimeof an entire

Correspondenceto: Fisher Schoolof Accounting, Universityof Florida, 210

Gerson Hall,Gainesville, FL 32601, USA. Email:w.knechel@cba.ufl.edu

International Journal of Auditing doi: 10.1111/ijau.12077

Int. J. Audit. 20:215–223 (2016)

©2016 John Wiley& Sons Ltd ISSN 1090-6738