International Journal of Auditing doi: 10.1111/ijau.

12077
Int. J. Audit. 20: 215–223 (2016)

Audit Quality and Regulation

W. Robert Knechel
Fisher School of Accounting, 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, depends on 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
appropriately consider the economic theory underlying the market for assurance services, it is likely that the positive
benefits obtained from regulation will also be tempered by negative unintended consequences.

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

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

loss of quality unless significant effectiveness improvements
The past decade has seen tremendous changes in the can be realized. On the other hand, efforts to increase
regulation of the auditing profession. Auditors have gone quality may lead to higher prices unless significant
from an essentially self-regulated profession prior to 2002 efficiency improvements can be realized. The profession
to what is now a profession that is highly supervised by occasionally seems to confuse these two issues whenever
government oversight and independent regulators across they argue that auditors should ‘compete on quality’
the world. The story of these changes tells us much about (Mayhew & Wilkins, 2003; Polimeni, Burke, & Benyaminy,
the impetus for regulation as well as providing insight into 2010; Sirois & Simunic, 2011; Newton, Wang, & Wilkins,
what regulation may, or may not, be able to accomplish in 2013). This is certainly a noble idea but chasing quality
regards to audit quality. Analysis of regulatory without considering cost may not result in an
developments over the past decade suggests that we can economically viable equilibrium. While regulators may
expect to observe unintended consequences arising from be less concerned about cost, it might be more
the current regulatory climate. While those unintended constructive to argue that the profession should ‘compete
consequences are difficult to predict, there are increasing on value’, which implicitly recognizes the tradeoff of costs
indications that they exist. The purpose of this article is to and benefits of the audit.
consider how regulation that is intended to improve audit Failure to achieve the mentioned improvements in
quality may, in fact, have some undesired effects on the efficiency or effectiveness can, in extremis, lead to a
auditing profession and the conduct of audits. downward spiral for an industry, i.e., as prices (fees) are
As a result of the regulatory attention it now receives, the beaten down via competitive pressures, quality may
auditing profession faces an interesting and awkward deteriorate, which puts further pressure on prices. This
conundrum. The most common complaints about auditors potential problem is compounded in an industry with flat
take two basic forms: (1) fees are too high (or the (or declining) demand. These problems can be
complementary statement that the Big 4 have too much simultaneously addressed only if the market for audit
pricing power), and (2) audit quality is too low in too many services is noncompetitive, meaning the auditor is earning
instances. The former problem is captured by a quote by economic rents that can be wrung from the system with
Annette Nazareth, a member of the US Securities and appropriate regulation or increased competition,3 or
Exchange Commission (SEC) in 2007: ‘[The SEC has] heard auditors can be incentivized to innovate in ways that
complaints about auditors over-auditing in part because simultaneously reduce costs and improve quality. A great
they fear that PCAOB inspectors would otherwise find deal of previous research suggests that audit markets are,
their audits insufficient.’1 The latter problem is reflected in in fact, competitive on balance (Ferguson, Francis, &
a quote by Pierre Delsaux who was a member of the Stokes, 2003; Hamilton, Li, & Stokes, 2008; Numan &
European Commission at the time of the Global Financial Willekens, 2012) so the first approach is unlikely to yield
Crisis: ‘[There was] not enough control on what the banks the intended results. Current regulatory approaches may
were doing. We need good external control, specifically, make the second approach, incentives for innovation,
auditing.’2 The reason why these two viewpoints constitute difficult as will be explained in more detail below. So the
a conundrum is because neo-classical economic theory tells question is: Can the audit quality conundrum be solved
us that it may be difficult to reconcile these problems in a via regulatory intervention? While mandated auditing is
competitive market for audit services. likely to keep the profession relatively lucrative, we may
find that regulation will both help and harm the profession
as we know it today. The extent to which the profession
improves depends on the nature of auditing, the form of
Correspondence to: Fisher School of Accounting, University of Florida, 210 regulation, and the inevitable unintended consequences
Gerson Hall, Gainesville, FL 32601, USA. Email: [email protected] of changing the fundamental regulatory regime of an entire

© 2016 John Wiley & Sons Ltd ISSN 1090-6738

216 W. R. Knechel

profession. These will be discussed in turn in the following in a client’s financial statements, and (2) auditor objectivity
sections. (independence) which relates to the likelihood that an
auditor will correct (via accounting adjustments) or reveal
(via the auditor’s report) a client’s error when it is
THE REGULATORY STORY
discovered.5 In general, these two traits are treated as
There is little doubt that the regulatory infrastructure has separate constructs, but they suggest two desirable aspects
expanded dramatically in the past decade. Prior to 2002 of the audit – independence and competence – that are
and the twin audit fiascos of Enron and WorldCom, the essentially service ‘traits’ for which a consumer is willing
auditing profession was mostly self-regulated with to pay. That is, independence and competence (expertise)
auditing standards being issued by US or international are valuable aspects of an economic good in much the same
bodies such as the Auditing Standards Board and the way that good mileage and engine power are desirable
International Auditing and Assurance Standards Board attributes of a car. Both traits are considered positive, i.e.,
(IAASB, previously known as the International Auditing more auditor independence improves audit quality, as does
Practices Committee). These bodies had one general trait more auditor expertise. However, it is important to note
in common: they were more or less self-regulatory, meaning that the DeAngelo definition implicitly treats the two
the auditing profession had a great deal of influence over ‘traits’ as orthogonal, i.e., the level of one has minimal
the standards issued by these bodies. This structure influence on the level of the other. This is a significant
radically changed with the passage of the Sarbanes-Oxley unstated assumption because, while it allows regulators,
Act of 2002 which, among other things, established the researchers and the profession to consider each aspect of
Public Company Accounting Oversight Board (PCAOB) quality in isolation, there may be a significant relationship
to set regulations and standards for the auditing profession between the two that will impact how changes in audit
in the United States. No longer would the profession regulation and the audit process influence audit quality.
control its own operations, or even its own destiny. To illustrate the potential connection between auditor
Among notable changes ushered in with the PCAOB independence and expertise, consider Figure 1. The ray
were restrictions on the nature of non-audit services that emanating from the origin of the graph indicates increasing
an accounting firm could offer to its audit clients and, levels of audit quality as a function of independence and
potentially most importantly, the introduction of expertise. Depicting audit quality in this manner reveals
inspections of audit work by government inspectors. These that there are four extreme conditions that may limit the
changes quickly spread beyond the US. For example, demand and supply of auditing, at least in an unregulated
Australia ushered in similar, albeit less draconian, changes or lightly regulated market (i.e., pre-2002). First, some
to auditing regulation with the Corporate Law Economic engagements might entail low independence and low
Reform Program (CLERP 9) in 2004, which came on the expertise. Such an engagement may not be desirable from
heels of the HIH Insurance audit scandal. These legal a societal point of view and, to the extent that auditing is
mandates have been mirrored in other countries, leading an economic good, such a condition may have little or no
to the creation of the International Forum of Independent economic value to clients, investors or other stakeholders
Audit Regulators (IFIAR) to facilitate audit regulation on in the financial reporting process. Consequently, there
a global basis. As of November 2015, over 50 countries may be few or no buyers for this service. At the opposite
had formed a national audit regulatory body and joined extreme, we may see no suppliers because extremely high
IFIAR. The vast majority of countries that comprise the independence and competence may not be technologically
‘developed’ world now have mandated regulation of the feasible given the uncertain outcome of the audit process.
audit profession and much of the ‘developing’ world is At best, audit quality will asymptotically approach a
following this lead. Some evidence suggests that audit theoretical maximum. Asymptotic convergence to a limit
quality has indeed improved as a result of these regulatory suggests significantly decreasing marginal benefits as audit
developments (DeFond & Lennox, 2011; Ettredge et al., effort increases. This theoretical limit on audit quality is
2011). However, it is still an open question as to whether implicitly recognized in the audit risk model which
all these regulatory changes have – or will – continue to
result in systematic improvements in audit quality. The
answer depends very much on how new rules, standards
and regulation interface with the fundamental economics
of auditing as a professional service. A mismatch between
regulation and the underlying economic fundamentals of
the auditing profession runs the risk of extensive, and
potentially undesirable, unintended consequences. In the
remainder of this paper, I will discuss how the economics
of the auditing profession may influence the impact of
increased regulation on audit quality.

DEFINING AUDIT QUALITY

The most commonly used definition of audit quality comes
from DeAngelo (1981) who offers the following: audit
quality is ‘the market-assessed joint probability that a given
auditor will both (a) discover a breach in the client’s
accounting system and (b) report the breach.’4 This
definition has two distinct and convenient elements: (1)
auditor expertise (competence or knowledge) which
influences the likelihood that an auditor discovers errors Figure 1. Defining audit quality

© 2016 John Wiley & Sons Ltd Int. J. Audit. 20: 215–223 (2016)
Audit Quality and Regulation 217

assumes that zero risk is not an economically feasible we first need to reconsider the assumption that
outcome and every audit has a non-zero level of residual independence and expertise are truly orthogonal
risk.6 constructs. While this may be the case when considered
The other two extremes are potentially more interesting separately from any specific engagement, within an
because they reflect conditions where an auditor is either engagement an auditor can only gain expertise with regards
highly independent but possesses low levels of expertise to that client by interacting with the system and personnel
or knowledge (‘uninformed independence’) or has that are the subject of the audit. This is a fundamental
excellent expertise but exhibits a low level of independence element of our profession – to audit a system, you must
(‘conflicted expertise’). In the extreme, neither of these interact with the system.7 This interaction – whether due
conditions would be desirable and their existence might to economic, psychological or personality reasons – is likely
undermine the credibility of the profession as a whole. to influence an auditor’s judgment such that decisions
Further, since none of the four ‘corner’ conditions may be based on expertise cannot be completely separated from
desirable or attainable, this diagram implies the potential the social familiarity and economic relationship with the
existence of an ‘assurance opportunity set’ bounded by client. This perspective results in an inverse relationship
infeasible or nonviable extremes (Figure 2). between the two traits. Both traits are desirable
If an assurance opportunity set exists, the next step is to (complementary), meaning that clients would like more
assess the viable combinations of independence and of both traits (subject to a cost constraint), but there is an
expertise that might be reasonably demanded by the implicit tradeoff in the context of a single client.
market within that set. Figure 3 illustrates how the tradeoff A unique combination of objectivity (independence) and
between independence and expertise might be depicted expertise (competence) will implicitly indicate a given level
using indifference curves. To understand this perspective, of audit quality (assurance). That is, holding competence
constant while increasing independence, or vice versa,
results in higher assurance.8 This relationship suggests an
implicit tradeoff between independence and competence
such that the frontier for any given level of assurance takes
the shape of a classic convex indifference curve, i.e., higher
levels of audit quality (assurance) are depicted with a set of
non-intersecting curves moving away from the origin,
while points on each curve represent a unique combination
of independence and objectivity. Figure 3 illustrates that
consumers (clients) might contract on (i.e., demand) many
different combinations of assurance, independence and
expertise that fall within the assurance opportunity set.
For example, the curve A1A2 could reflect a relatively
‘low’ level of overall audit quality, which might be
described as ‘moderate assurance’ using the terminology
of auditing standards. This level of audit quality might be
desired by a client that simply needs an audit to qualify
for a bank loan or to satisfy some other contractual
requirement. B1 is on an indifference curve that could
reflect ‘reasonable assurance’ under current auditing
standards – which actually means ‘high’ assurance – and
might be appropriate for a typical publicly-traded client.
Figure 2. The assurance opportunity set Finally, C1 falls on an indifference curve where assurance
is very high and potentially exceeds what is required by
auditing standards.9
The shape of the curves implies that for any given level
of audit quality, there is an implicit tradeoff between
independence and expertise. The slope of the curve (as
measured by a tangent to the curve at any point) reflects
the marginal rate of technical substitution between
independence and expertise for a given level of assurance.
The curves are drawn to suggest that independence and
expertise are not perfect complements10 but that there is a
diminishing marginal benefit of substituting more
expertise for less independence, or vice versa, i.e., an
auditor can be too close to a client or do too little work
during an engagement.11 It is the failure to recognize this
implicit tradeoff (i.e., treating independence and expertise
as unrelated) that could lead to negative unintended
consequences for some regulation. This is explained in
more detail in the next section.

REGULATING AUDIT QUALITY

Figure 3 might be used to describe the demand for auditing
Figure 3. Tradeoff of independence and expertise in an unregulated market. However, the profession,

© 2016 John Wiley & Sons Ltd Int. J. Audit. 20: 215–223 (2016)
218 W. R. Knechel

potential clients and regulators would probably all agree

that allowing auditors and clients to contract on any level
of assurance or any combination of independence and
expertise might eventually undermine the credibility of
the profession and reduce the perceived value of all
audits.12 As a result, the profession (or regulators) may
wish to impose a minimum level of assurance. For
example, they might conclude that the engagement
implied by A2 is not socially desirable because of the low
level of independence. To avoid such audits, the profession
(or regulators) might impose minimum requirements for
independence as illustrated by the horizontal line in
Figure 4. Note, this line is meant to illustrate the existence
of an independence constraint and is not intended to
indicate the ‘optimal’, or even an adequate, level of
independence. The impact of the independence constraint
is to make A2 an unacceptable engagement, as well as some
of the engagements associated with the lower end of the Figure 5. Constraining expertise
curve containing B1. It is interesting to note that the
auditing profession had independence rules, typically unacceptable levels of independence and expertise that are
embedded in a code of professional conduct or ethics, long associated with an otherwise acceptable level of overall
before there were regulatory rules for independence, so this assurance illustrates an important point raised in Knechel
type of limitation existed prior to the growth of the current (2013). Namely, the outcome of the audit – level of achieved
regulatory environment.13 assurance – is unobservable, so the audit process, audit
A further examination of Figure 4 might suggest that an effort and level of perceived independence tend to be the
audit with high independence but low expertise (A1) may focal points for assessing whether an audit is acceptable
not be a good idea either as it is not clear if the auditor under the standards. That is, the need to demonstrate
would have an adequate basis for issuing an informed compliance with standards and regulations, particularly
audit opinion. This observation suggests that a minimum competence, causes an auditor to adopt certain approaches
level of expertise (i.e., knowledge) is also desirable. This to an audit that can be documented and defended,
can be depicted by imposing a vertical constraint as potentially constraining the manner in which an auditor
illustrated in Figure 5 to reflect the impact of audit practice brings ‘expertise’ to bear in an engagement. An audit that
standards such as issued by the IAASB or PCAOB. Now rises up the upper left portion of the ‘C’ curve might be
we can observe that A1 is no longer an acceptable judged after the fact (e.g., during quality review) to exhibit
engagement. The net effect of the two inadequate expertise even though, in theory, it achieves the
regulatory/standard constraints is to essentially preclude same level of assurance. One wonders if some of the audit
any audits with the assurance level associated with A1 or ‘failures’ flagged by PCAOB inspection actually fit these
A2 (i.e., current auditing standards do not consider circumstances, i.e., adequate assurance but an inadequate
‘moderate’ assurance appropriate for an examination of level of documented ‘knowledge’ that would be preferable
financial statements). Further, some combinations of in hindsight. This issue is discussed in more detail when
independence and competence may not be appropriate unintended consequences are addressed later in the paper.
even if the theoretical level of achieved assurance is This simple series of illustrations demonstrates how
acceptable, i.e., many of the engagements on the B regulation and standard setting can influence audit quality
assurance curve are no longer allowed, although B1 would in theory. Whether the constraints illustrated in Figure 5
be an acceptable audit as it reflects a ‘reasonable’ balance are, on balance, good or bad is not the question for this
between independence and expertise.14 paper but it is important to keep three key points in mind.
Truncation of the assurance opportunity set for First, regulation prohibits consumers from purchasing
certain economically viable options (e.g., A1 or A2). This
may be good if the consumer is uninformed or otherwise
might be misled by the seller into purchasing too little
‘assurance’ (e.g., a credence good). For example, this
problem could occur if management contracts with the
auditor, or unduly influences the selection of the auditor,
while emphasizing their own purposes over the objectives
of the other stakeholders in an organization (e.g.,
shareholders). This is one reason why many jurisdictions
now lodge the power to hire or fire an auditor with the
Board of Directors or Audit Committee.
Second, by construction, the costs of audits will need to
increase to compensate for higher levels of independence
and expertise, that is, more assurance will cost more for
most clients. However, this decision is being made by
regulators rather than the parties directly involved in the
contract and might not reflect the stakeholders’ desired
tradeoff of cost and benefit, resulting in a potentially
Pareto-inefficient outcome (Knechel, Suijs, & Willekens,
Figure 4. Constraining independence 2007; Donovan et al., 2014). This may create an economic

© 2016 John Wiley & Sons Ltd Int. J. Audit. 20: 215–223 (2016)
Audit Quality and Regulation 219

incentive for audit firms to innovate the audit process to this standard microeconomic perspective, it is quite
offset some of these costs if the auditor is unable to simply possible that not only will regulation have unintended
pass the costs on to the client. However, this is only likely to consequences but that those consequences could be quite
occur if the audit firm has adequate free cash flow from the severe because the regulations will not have the expected
revenues of the audit process to invest in the research and impact on practice and the profession. In the end, the same
development needed to support such innovation. exact curves could be used to illustrate the tradeoff of
A third point to consider is that the nature of the bagels (x-axis) and toasters (y-axis), as possession of a
constraints must be ‘interpreted’ by various parties or toaster is likely to increase the enjoyment one obtains from
stakeholders to the audit contract. Given the ‘credence’ a bagel. However, to state the obvious, an audit is not a
nature of auditing and the unobservable outcome of the toaster, so the question then remains: Does audit quality
audit (Causholli et al., 2013), this may be particularly behave as expected in the presence of increased regulation?
important in an environment where there is ex post The answer depends on what we mean when we consider
inspection of audit work by a regulator. In that case, the auditing as an economic activity.
ex ante interpretation of auditing standards – even by
standard setters – may differ from the ex post interpretation
WHAT IS AN AUDIT?
used during an inspection, making the strictness of the
vertical constraint less clear. The potential difference Defining an audit – in contrast to audit quality – would
between ex ante interpretation of audit standards for seem to be a simple task. Merriam-Webster has a no-frills
conducting the audit and ex post interpretation of standards definition: ‘a complete and careful examination of the
by regulatory inspectors suggests the possibility that financial records of a business or person’ (http://www.
‘shadow’ standards might evolve that differ from the stated merriam-webster.com/dictionary/audit). That same
formal standards. For example, the speed limit on a source then generalizes the definition a bit by adding: ‘a
motorway may officially be 60 mph. However, many careful check or review of something.’ While those
drivers believe that as long as they do not exceed 65 mph, definitions would probably suffice for most purposes, a
traffic police will not bother them. In this case, the shadow deeper understanding of the attributes that really comprise
standard is perceived to be more lenient than the official an audit is necessary in order to begin to assess whether
standard. For auditing, the opposite case is probably more regulation will have its intended effect or potentially result
important, i.e., the shadow standard used by inspectors in negative unintended consequences. In this paper, I offer
may be perceived to be more stringent than the official the following expanded definition of auditing:
standard.
An audit is an economically motivated professional service
There is already some evidence that the inspection
designed to reduce the information risk of stakeholders that
process of the PCAOB is leading to the evolution of
relies on the knowledge and skills of experts used in a
‘shadow’ standards. Glover, Prawitt, and Taylor (2009)
systematic process that considers the idiosyncratic needs of a
describe how inspectors cited firms for improper auditing
client where the outcome is unobservable and subject to market
of software revenue recognition only for PCAOB superiors
constraints and regulatory forces.
to agree that the inspectors had reached incorrect
conclusions on the issue. Dowling, Knechel, and Moroney This definition explicitly recognizes that an audit has at
(2015) document evidence that audit firms in Australia least four critical aspects that suggest how economic theory
were concerned that inspectors would overrule partners – and regulation – could influence the conduct and
on key audit judgments without having an adequate outcomes of an audit (Knechel et al., 2013):
experiential foundation to do so. A recent working paper
by Glover, Prawitt, and Drake (2014) goes even further by 1. The value of an audit derives from the economic needs of
documenting that audit firms are dramatically reducing stakeholders independent of regulation. This means that
their use of substantive analytical procedures due to mandating an audit does not create its value, at least
criticisms from inspectors even though such procedures not all – or even a significant portion – of its value. The
are a common and generally accepted part of the auditors’ value of the audit derives from its use as a risk
evidence toolkit and are clearly allowed, and even management tool by various stakeholders inside and
encouraged, by current auditing standards. The basis for outside of an organization.
this discouraging feedback from inspectors is that the 2. The outcome of an audit is inherently uncertain and
procedures may not have adequate precision to provide ultimately unobservable. Zero risk is not possible either
sufficient evidence in an audit on their own. However, this practically or economically (O’Keefe, Simunic, & Stein,
perspective would not seem to adequately consider the 1994; Francis, 2004; Knechel, Rouse, & Schelleman,
weight of all the evidence about a set of assertions that 2009). This is especially true during the conduct of the
may be obtained from a variety of sources, thus imposing audit but is also true when an audit is examined after
a standard of practice that is more restrictive than what is its completion (i.e., inspection).
implied in the standards.15 3. The audit process is idiosyncratic to the client. While firms
In the end, the question of audit quality comes down to may use standardized approaches, the audit must be
whether the intended benefits of regulation exceed the individually tailored to the risks, controls, transactions,
increased costs. Figure 5 suggests that more regulation is systems and conditions of a specific client (Kanodia &
better than less, but this is only true before considering Mukherji, 1994).
costs. With regulators making decisions about what 4. Expertise, or professional judgment, is the ultimate source of
constitutes an acceptable audit, the typical budget value in an audit (Parasuraman, Zeithaml, & Berry,
constraint for determining the appropriate level of 1985; Sampson & Froehle, 2006). It is what a professional
assurance (and tradeoff of desirable attributes) is absent.16 knows, how they analyze a situation, and how they
More importantly, the net benefit of more regulation reach a conclusion that drives the value of their
depends on whether an audit fits the assumptions that expertise. Being ‘in compliance’ may help improve, but
underlie the indifference curves. If an audit does not fit into cannot replace, auditor judgment.

© 2016 John Wiley & Sons Ltd Int. J. Audit. 20: 215–223 (2016)
220 W. R. Knechel

Now consider how these key attributes might interact Ang, 2011). While this degree of judgment is one potential
with a regulatory view of auditing. First, a regulatory view source for low audit quality if biased or flawed, it is also
might focus on the compliance of an audit with prescribed critical for achieving desired audit objectives. Judgment
standards, i.e., achieving the desired level of independence simply cannot be standardized or regulated out of the
and expertise without considering how they interact to process, and some attempts to do so may actually have
determine actual achieved assurance. This view may create unintended effects on the audit process. In the end, the
a perception that being in compliance with regulations and irony of standard setting and regulation is that the quality
standards drives the value of the audit. While compliance of auditor judgment determines the quality of the audit
is certainly a desirable (and necessary) attribute, it is but systematic efforts to make audit processes more
unlikely that stakeholders will purchase an audit simply standardized (less subject to judgment) may have the effect
because it ‘meets standards’. That is, stakeholders may of reducing the quality of audit outcomes. Absent
want a standards-compliant audit but that is not the reason professional expertise, a professional service may have
they would purchase an audit in much the same way that a limited value.19
consumer buys a red car to go places not simply because it The combined effects of these four key attributes are the
is red. Thus, mere compliance is probably not a sufficient foundation of any professional service, and are especially
condition for creating economic value via an audit. That relevant in the auditing profession. Yet, the attributes
is, meeting standards without reducing risk will have little may be difficult to adapt or take into account in a highly
economic value because the assumption that compliance regulated environment. Failure to adequately reflect their
equates to risk reduction may not hold in all circumstances reality in the regulatory or standard-setting process is likely
or all levels of regulation. Ultimately, it is the degree of to manifest as significant unintended consequences. It is
correlation between compliance and audit quality that will the basic nature of unintended consequences that they
dictate whether negative unintended consequences will cannot be accurately foreseen. But what is a virtually
undermine the value of the audit. certainty is that some negative unintended consequences
Second, treating the audit as if the outcome can be will arise as the regulatory structure of auditing evolves
observed after the audit is completed can lead auditors to and becomes more complex.
be more concerned with second-guessing from inspectors
than actually finding the right answers during the course CONCLUSION
of the audit. Demonstrable defense of the audit process
used in an engagement may supplant defense of an In this paper, I have argued that the evolution of auditing
auditor’s conclusions. Further, both the auditors from a self-regulated to a government-regulated profession
conducting the engagement and the inspectors examining has created significant challenges to auditors, clients and
an engagement may have different attitudes about an audit regulators. This shift has certainly had a positive and
(e.g., shadow standards) and they can both be equally important effect on audit quality in general. However,
correct (or equally wrong). That is, each may reach valid regulation will always lead to unintended consequences.
conclusions about the audit and the process that fits their Failure to match the approach taken for regulation to the
own perspective but are, nevertheless, divergent because reality of the economics of auditing could lead to results
the actual residual risk of the audit is unobservable. contrary to the objective of improving audit quality.
However, the conclusions of an inspector will supplant Further, the manner in which regulation is imposed and
the conclusions of the auditor in most situations whether managed can have far-reaching consequences for the audit
or not they are ‘more’ correct.17 Consequently, the auditor profession. Standards and regulations established to
may invest valuable effort and attention to trying to address a recent audit failure or crisis may create a dead
anticipate what an inspector will want to see regarding a weight loss for all audits that may not be justified. For
specific engagement, time that might be better used to example, causing auditors to continually defend their
examine more substantive issues related to the judgments, to answer for alleged failures that may reflect
engagement, especially in a fee-constrained environment weaknesses in process that do not translate into broader
(Dowling et al., 2015). audit failure, and to be belittled in front of the public and
This leads directly to a third implication. The focus on clients for alleged ‘failures’ is unlikely to improve their
observing the audit process ex post may cause an auditor professional standing, attitude or satisfaction in providing
to develop an overly standardized approach to an professional services.20 Such a negative environment runs
engagement that does not facilitate tailoring the audit to the risk of undermining the trust the public holds in
the idiosyncratic circumstances of the client. Variations auditors, reducing the economic benefits and rewards of
from a standardized audit process may need to be the profession, and eventually leading to a drain of
defended to inspectors, and may become the breach professional talent that could harm the long-term prospects
through which an inspector questions the entire audit. As of a profession built on trust. Failure to match regulatory
a result, auditors may find it easier to downplay the actions to the true economics of the audit profession runs
idiosyncrasies of the client when planning and conducting the risk that negative, but unintended, consequences may
an audit, or at least follow the standardized process more eventually arise. In fact, if regulators are not careful, they
rigorously than may be appropriate.18 could end up exacerbating the opening conundrum
Finally, the pre-eminent role of professional judgment resulting in more expensive audits that, simultaneously,
provides the basis for economic value, and allows an are being heavily criticized by inspectors as being less
auditor to function in an uncertain environment and to effective.
adapt to the unique aspects of each client. There is an
extremely large body of literature on auditor judgment ACKNOWLEDGEMENTS
and auditor skepticism which suggests that the quality of
an audit is critically dependent on how auditors reach Based on the Speech ‘The Future of Auditing: Is the
conclusions and are influenced by different circumstances Profession Sustainable?’ presented at Melbourne
in an engagement (Nelson & Tan, 2005; Trotman, Tan, & University, October 2013, as well as a plenary speech at

© 2016 John Wiley & Sons Ltd Int. J. Audit. 20: 215–223 (2016)
Audit Quality and Regulation 221

the 2015 EARNet conference in Lausanne Switzerland and singular rate of substitution between the two traits. For
comments made at the University of Illinois Tax Research example, for a person with two feet, left and right shoes
Conference in Chicago Illinois, September 2013. are perfectly complementary and the marginal rate of
substitution is by definition one-to-one.
NOTES 11. Note, a full model of consumer choice for assurance
would involve imposing a downward sloping budget
1. Speech by SEC Commissioner Annette L. Nazareth, constraint. The point at which the budget constraint is
‘Remarks Before the Council of Institutional Investors’, tangent to the highest indifference curve would be the
Washington DC, March 20, 2007. Available at: http:// desired level of assurance. The slope of the budget line
www.sec.gov/news/speech/2007/spch032007aln. reflects the consumer’s willingness to trade off
htm (accessed 24 August 2016). independence for expertise. Expanding or shrinking
2. Public remarks, International Symposium on Audit the budget line would identify the optimal combination
Research held at Maastricht University in the of independence and expertise for each possible level of
Netherlands, June 2009. assurance (an upward sloping line connecting the
3. Increasing competition in audit markets was the tangential points on each indifferent curve is referred
justification for removing professional prohibitions on to as the ‘expansion path’). One issue that is
advertising and solicitation in the US in 1979. It is not unaddressed in this paper is who should set such a
clear that fees declined as a result (data on audit fees budget line: management, shareholders or the audit
was not available in the US until 2001) but what is committee?
known is that the sale of non-audit services increased 12. This phenomenon is a variation of the adverse selection
rapidly (Zeff, 2003a, 2003b; Wyatt, 2004) and a wave problem that is well known in economics – when
of firm mergers followed (Baskerville & Hay, 2006; consumers cannot evaluate or trust the quality of an
Pong, 2006). Evidence from New Zealand (Hay & economic good, demand for that good will drop, as will
Knechel, 2010) shows that deregulating advertising its value in exchange (Wallace, 1980). In the extreme,
can have the economically predictable effect of adverse selection could cause a market to collapse
increasing fees for the largest audit firms, i.e., the ones completely. This is unlikely to occur in a market where
best able to advertise on a broad basis. demand is mandated, but it could lead to a pricing
4. For a broader discussion of audit quality, see DeFond model that does not support innovation. This potential
and Zhang (2014). problem is exacerbated if the audit manifests significant
5. An important part of this definition that is often attributes of a credence good (Causholli & Knechel,
overlooked is that it is based on ‘market perceptions’ 2012; Causholli et al., 2013).
of quality rather than a grounded and measurable 13. Of course, as we have seen in the US with SOX,
aspect of actual audit quality. Many researchers have independence rules arising from regulation are likely
argued that audit quality is unobservable (Francis, to be more stringent than those that are self-imposed
2004; Knechel et al., 2009). by the profession.
6. This observation also reflects one of the limitations of 14. The independence and expertise constraints essentially
the DeAngelo (1981) model of audit quality because remove extreme rates of technical substitution from the
she does not assume an upper limit to achievable audit assurance opportunity set, especially for lower levels of
quality. assurance (audit quality). The lower the assurance
7. This observation has a parallel in the physical sciences level, the more the marginal rate of technical
where the observer effect refers to the fact that the only substitution between independence and expertise is
way to measure a phenomenon is to interact and ‘pushed’ to a point where the two attributes are
potentially change the behavior of that phenomenon. considered to be equally important. At the same time,
This is often referred to as Heisenberg’s uncertainty more extreme rates of technical substitution remain
principle when applied to the field of quantum acceptable at high levels of assurance (i.e., audits that
mechanics. exceed what is required by auditing standards). In
8. An implicit assumption of this statement is that Fig. 5, the horizontal distance between the C curve
expertise captures the ability to conduct an audit that and the vertical (competence) constraint indicates how
is adequate to actually achieve the desired level of much expertise could be reduced and still comply with
assurance. As such, this view suppresses the actual professional standards (albeit with a reduced level of
audit process itself, i.e., it is presumed that a given assurance).
combination of expertise and independence will yield 15. Note, the failure of an auditor to properly supplement
the indicated level of assurance, and abstracts away analytical procedures with other necessary evidence is
from the underlying production function for creating not a weakness of the analytical procedure. Rather, it
‘assurance’. While helpful for rhetorical purposes, this is a failure to properly integrate different types of
assumption should also be subject to more in depth evidence into a coherent overall conclusion.
consideration given that achieved assurance and audit 16. Note, as presented, the analysis does not admit that
effort (the conduct of the audit) are imperfectly there could (or should) be a maximum level of
correlated (Knechel, 2013). regulation. Without a consumer-imposed budget
9. Note, the location and slopes of the indifference curves constraint, it is not clear what the upper bound on
are meant to portray the relationship among regulation would be. In that case, the bound would be
objectivity, expertise and audit quality. They are not the product of a political process balancing the
intended to suggest the actual or precise ‘location’ of demands of various direct and indirect stakeholders
specific audits or a desired minimum level of audit who may have competing interests in the financial
quality. reporting process (Brown & Tarca, 2001; Zeff, 2002;
10. When two goods or traits are perfect complements, the Leuz, Pfaff, & Hopwood, 2004; Perry & Nölke, 2006;
indifference curves form a right angle which suggests a Glover et al., 2009).

© 2016 John Wiley & Sons Ltd Int. J. Audit. 20: 215–223 (2016)
222 W. R. Knechel

17. The opinion of the inspectors has more authority by fiat Hamilton, J., Li, Y. & Stokes, D. (2008), ‘Is the audit services
than the opinion of the engagement team, but that does market competitive following Arthur Andersen’s collapse?’,
not make the inspectors ‘more right’. Deference by the Accounting & Finance, Vol. 48, No. 2, pp. 233–58.
Hanson, J. D. (2014), ‘An overview of PCAOB priorities’,
firm to the regulator’s expectation suggests that the speech, available at: http://pcaobus.org/News/Speech/
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‘meaning of compliance’ (Edelman & Talesh, 2011). August 2016).
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Do variations from a standardized audit program serve solicitation on audit fees’, Journal of Accounting and Public
as ‘red flags’ to audit inspectors. Policy, Vol. 29, No. 1, pp. 60–81.
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and auditor turnover: a dynamic analysis’, The Accounting
of house (such as seen in many modern suburbs) may Review, Vol. 69, No. 4, pp. 593–615.
have value as a technician or drafter but will have less Knechel, W. R. (2013), ‘Do auditing standards matter?’, Current
value as a creative expert (e.g., Frank Lloyd Wright). Issues in Auditing, Vol. 7, No. 2, pp. A1–A16.
20. According to the chief auditor of the PCAOB: ‘When Knechel, W. R., Krishnan, G. V., Pevzner, M., Shefchik, L. B. &
we look at an audit, the rate of failure has been in a Velury, U. K. (2013), ‘Audit quality: insights from the
range of around 35 to 40%’ (Chasan, 2014). It is a matter academic literature’, Auditing: A Journal of Practice & Theory,
Vol. 32, No. 1, pp. 385–421.
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Knechel, W. R., Suijs, J. & Willekens, M. (2007), ‘A stakeholder
is truly indicative of serious problems in the audit model of competing demands for control and auditing’,
profession (Hanson, 2014; Peecher & Solomon, 2014). Working paper, University of Florida.
Knechel, W. R., Rouse, P. & Schelleman, C. (2009), ‘A modified
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Audit Quality and Regulation 223

Wallace, W. (1980), The Economic Role of the Audit in Free and AUTHOR PROFILE
Regulated Markets, monograph, New York: Touche Ross.
Wyatt, A. R. (2004), ‘Accounting professionalism – they just do W. Robert Knechel, PhD, CPA is the Frederick E. Fisher
not get it!’, Accounting Horizons, Vol. 18, No. 1, pp. 45–54. Eminent Scholar in Accounting at the University of Florida,
Zeff, S. A. (2002), ‘“Political” lobbying on proposed standards: Gainesville, Florida. He is currently the Director of the
a challenge to the IASB’, Accounting Horizons, Vol. 16, No. 1, International Center for Research in Accounting and Auditing
pp. 43–54. (ICRAA) located within the Fisher School of Accounting. He is
Zeff, S. A. (2003a), ‘How the US accounting profession got also a Professor of Accounting Research at the University of
where it is today, Part I’, Accounting Horizons, Vol. 17, No. Auckland and Professor of Auditing at KU Leuven.
3, pp. 189–206.
Zeff, S. A. (2003b), ‘How the US accounting profession got
where it is today, Part II’, Accounting Horizons, Vol. 17, No.
4, pp. 267–86.

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