Audit Quality: Attributes, Private Safeguards and the Role of Regulation

Abstract

This article examines the private mechanisms used to safeguard quality in auditing, with a view to defining rules capable of facilitating the performance of market forces. An outline is given of a general theory of private quality assurance in auditing, based on the use of quasi-rents to self-enforce quality dimensions. Particular attention is paid to the role of fee income diversification as the key ingredient of private incentives for audit quality. The role of public regulation is then situated in the context defined by the presence of these safeguard mechanisms. This helps in defining the content of rules and the function of regulatory bodies in facilitating and strengthening the protective operation of the market. By making sense of the interaction between regulation, quality attributes and private safeguards, the analysis helps to evaluate the relative merits of different regulatory options.

Independent auditing mainly serves to reduce any conflicts which may arise in contracting with those providing financial resources, whether shareholders or creditors. Clients are therefore interested in users of the audited accounting information perceiving the auditor as independent of the client. Such client concern leads to a concern amongst auditors themselves and it is understandable that they should implement policies of all types aimed at reinforcing their independence. For this purpose, codes of good practice have been adopted by professional self-regulatory bodies and firms themselves. Firstly, professional organizations must maintain a good reputation if they are to survive. Over the years, they have taken care to adopt various standards and organizational patterns with a view to reducing risks which could harm auditor independence and, in particular, the appearance of independence. Secondly, many incentive and control devices of an individual, hierarchical and mutual nature ensure that both individual auditors working for audit firms as well as divisions within a firm and affiliated firms within a network have strong incentives to maintain the required attributes of service quality, including independence. The following are a few of these devices: partners’ remuneration is not based primarily on revenue generation or short-term local profits, but on performance variables which encourage them to take a broad perspective, including the global results of the firm and measures of service quality; internal procedures to avoid individual biases and overconfidence are common, such as having audit engagement partners serve public companies for no longer than a certain number of years; finally, control is also exercised among offices and countries, by having personnel from one area inspect the work of another geographic area.

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