Audit Quality, Auditing Standards, and Legal Regimes:Implications for International Auditing Standards*

By

Dan A. SimunicUniversity of British Columbia

Minlei YeUniversity of Toronto

Ping ZhangUniversity of Toronto

ABSTRACT:

We summarize the analyses detailed in two papers on the relation between

audit quality, auditing standards, and legal regimes. We show that optimal

auditing standards for a country are a complex function of the legal system in that country. We

then discuss its implications for the adoption of international auditing standards.

Keywords: Auditing standards, legal regime, audit quality

* This paper is a summary of the presentation made by Dan Simunic at the 2014 Journal of International Accounting Research Conference held on June 5-7, 2014 at Hong Kong Polytechnic University. The authors thank the participants at the JIAR Conference for their feedback. We also thank the participants at the 2013 Accounting Theory and Practice Conference of the Taiwan Accounting Association held at Soochow University on October 24 & 25, 2013, who also provided feedback on a previous version of this presentation.

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I. BACKGROUND

In this paper, we examine two interesting and quite complex research

questions:

1. How (if at all) can optimum auditing standards for a country be

expected to differ with differences in the underlying legal liability regime that

auditors face for a failure to detect material misstatements in audited

financial statements?

2. If optimum auditing standards differ across legal regimes, then what

are the implications for the adoption of the International Standards on

Auditing (ISAs) by a country?

That legal regimes facing auditors vary across countries is not

particularly controversial. For example, research by Wingate (1997) and

others (e.g. LaPorta, Lopez-DeSilanes, Schleifer, and Vishny, 1997) suggests

that the “onerousness” of legal regimes across groups of countries can be

broadly rank-ordered as follows:

U.S.A. → globally the most onerous legal regime

British Commonwealth countries (e.g. U.K, Canada, Australia, etc.)

Continental European countries

Other major countries (e.g. Japan, China, India, etc.) → least onerous

legal regimes

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Audit fees and auditor effort also appear to vary systematically across

countries. For example, Choi, Kim, Liu and Simunic (2008), using both public

and proprietary data sets, report that both audit fees and audit hours across

samples of clients of Big 4 firms, ceteris paribus, were ordered as follows:

U.S.A. (KPMG data) > Australia (Ernst & Young data) > Netherlands (Big 4

firm data) > South Korea (Big 4 firm data)

Note that while the U.S. has its own auditing standards that are issued by the

Public Company Accounting Oversight Board (PCAOB) for the audits of listed

companies – which are “rules based” and arguably “tougher” than the ISAs –

the other countries in the Choi et al sample – namely Australia, the

Netherlands, and South Korea – all use the ISAs as their domestic auditing

standards.

This raises two puzzling questions: Why doesn’t the U.S. adopt the

ISAs, but opts instead to expend considerable resources to develop its own

auditing standards? Why do audits appear to vary systematically across

Australia, the Netherlands, and South Korea - countries that all use the same

auditing standards, namely the ISAs? We believe that the answer to these

questions lies in the fact that the legal liability regimes facing auditors differ

significantly across the countries. This suggests that the average or typical

level of audit quality in a country depends on both auditing standards and a

country’s legal regime. Moreover, these two factors interact and influence

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auditors’ rational, self-interested behavior in complex ways to drive auditor

effort and thereby audit quality.

Our goal in this paper is to highlight the essential logic and arguments

that underlie the relations between characteristics of legal systems, auditing

standards, and resulting audit quality. To do this, we draw upon two papers:

Minlei Ye and Dan A. Simunic, 2013. “The Economics of Setting

Auditing Standards”, Contemporary Accounting Research, Vol. 30

(Autumn): 1191-1215.

Dan A. Simunic, Minlei Ye, and Ping Zhang, 2014. “The Joint Effect of

Multiple Legal System Characteristics on Auditing Standards and

Auditor Behavior”, working paper, UBC and University of Toronto:

SSRN#2281270.

These papers are analytical, and we refer the interested reader to these

original manuscripts for the detailed analyses underlying the results that are

described and discussed in this paper.

II. Role of auditing standards

Auditing standards play two roles in the real world. First, the standards

may simply serve as a guide for audit service production. That is, they

provide “how to do it” advice that can be useful to both auditors - who

render the service - and to consumers of the service, namely investors and

company managers. Note that this production role may be useful even in a

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situation where auditors face strict legal liability for audit failure. Strict

liability describes a situation where an auditor would be liable to investors,

etc. in all situations where the auditor failed to detect a material

misstatement in the financial statements and erroneously issued an

unqualified opinion. In this situation, a “production guide” may simply help

auditors to perform audits, and investors and others to assess the value of

this service. However, in reality, auditors everywhere operate in negligence

based legal regimes. This leads to a second role for auditing standards,

namely to serve as a basis for assessing auditor negligence by courts. In a

negligence regime, audit failure is a necessary but not a sufficient condition

for legal liability. If there is an audit failure, compliance with auditing

standards (which, we reasonably assume are the standards of performance

used by court systems) will eliminate an auditor’s legal liability, both to

investors and to the client company itself.

But how can courts, as well as auditors themselves and investors know

whether or not there is compliance with auditing standards? This depends

on the characteristics of these standards. If standards are perfectly

precise, then – by definition – (non) compliance can be known by comparing

actual auditor effort to the perfectly precise standard. If standards are

imprecise, then (non) compliance is uncertain. In general, auditing

standards can be characterized by degrees of both “toughness” and

“vagueness”. Toughness describes the typical level of audit effort that

would be deemed adequate for compliance; while vagueness refers to

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variation in possible compliance effort around toughness reflecting imprecise

wording, choices in procedures, intensity of testing, and other factors.

Some examples may be useful to reinforce these ideas. Suppose an

auditing standard states that:

“Possible audit procedures in a given situation are P1, P2, P3, P4, P5, and

P6.”

Comment: This is a rather vague standard as the auditor can choose to

perform any one or combination of procedures at unspecified levels of

intensity.

Suppose the standard is changed to read as follows:

“The auditor should perform P1 and P2, and may also perform P3, P4, P5 and

P6”

Comment: This is definitely more precise than the first standard, but is it also

tougher? The answer is yes, since on average, auditors can be expected to

perform three of the six possible procedures described in the first standard,

while they are required to perform two procedures and are expected to

perform two of the four possible procedures or a total of four procedures, on

average, under the second standard.

Finally, consider this standard:

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“The auditor should perform P1 and P2 at a specified sample size level, n*,

and need not perform any other procedures.”

Comment: This is arguably a perfectly precise standard, and surely more

precise than the prior two standards. If the auditor indeed performed

procedures P1 and P2 at a level n*, as required, the auditor would be

deemed in compliance and therefore not negligent in performing the audit.

Is this standard tougher than the first two? That’s ambiguous since fewer

procedures will be performed, on average, thereby reducing toughness, but

the effect on audit intensity is unknown.

From this discussion, we conclude that a useful way to describe a set

of auditing standards, such as the PCAOB standards or ISAs, is to say that

they have a mean and a variance (standard deviation) as well as some

probability distribution, which we assume to be the uniform distribution

(however results are not contingent on this distributional assumption). Self-

interested, rational auditors will (somehow) choose a level of audit effort,

and if audit failure occurs, courts will determine whether or not the effort

level chosen complies with standards. The cumulative probability that an

auditor has complied with vague auditing standards increases as the level of

effort increases. Because a uniform distribution is bounded, there is also an

effort level (upper bound) where the auditor can be certain that he has

complied, and an effort level (below the lower bound) where the probability

of compliance is zero – the auditor is certain that he has not complied. An

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effort level between these bounds implies that compliance is uncertain, but –

as noted above – the probability of compliance increases with greater audit

effort.

But what effort level will an auditor choose? This is an economic

decision, to which both the auditing standards in place and the legal system

the auditor faces are parameters. Consider an extreme example. Suppose

that the auditor faces a legal system where the cost of non-compliance is

trivial. Will a rational, self-interested auditor comply with tough, precise

auditing standards? Probably not, since non-compliance carries no costly

consequences. But, of course investors and managers who purchase audit

services are also rational and the value of and voluntary demand for audit

services in these circumstances would also approach zero. One could also

ask a more subtle question – are tough, precise auditing standards optimal

under these circumstances? Probably not, since no one cares about these

standards so why waste resources in their development? This example,

while extreme, illustrates the problems that need to be solved to answer the

two questions posed at the beginning of this paper. These problems are:

1. How will audit effort change under a given legal regime as auditing

standards vary in toughness and vagueness?

2. What level of toughness and vagueness would be set within a country

with a given legal regime by standard setters who are investors in audited

companies, and how (if at all) would such standards differ from those set by

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auditors themselves? Note that this second question is important in that,

historically, auditing standards have largely been set by auditors. However,

recent years have seen more investor involvement in standard setting and,

in the extreme case of the PCAOB, standard setting by regulators who are

(by design) not auditors.

3. How would optimal toughness and vagueness change with changes in

the underlying legal regime. This third question deals with the issue of when

(if ever) “one size fits all” or under what circumstances can countries be

expected to adopt common standards, such as ISAs.

4. Finally, what problems would arise if ISAs ≠ optimal auditing standards

in a country, and how can these problems be resolved?

This is a challenging menu of problems for a short paper (presentation), to

be sure. We hope that the main arguments we develop here motivate the

reader to delve more deeply into these interesting issues.

III. Basic setting of our analyses

Our analyses use a relatively simple, stylized, game-theoretic model of

the interactions among investors, company managers, and auditors. The

basic structure of the model was first developed in Dye (1993). In the

model, a manager offers an investment opportunity (project) to investors

and claims that the project is “good”. This can be thought of as managers

offering investors an investment opportunity described by financial

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statements that they claim are free from material misstatements. Once this

offer is made, managers essentially play no further role. However, an

auditor whose role is to detect a “bad” investment project (i.e. detect

material misstatements in the information managers provide to investors) is

available for hire, and this auditor may be retained by investors before the

investment is made. So this is a voluntary audit model.

The investors’ and auditor’s objectives and the sequence of events

after considering the effect of legal liability regimes and auditing standards

are summarized in Figure 1.

(Insert Figure 1 about here)

IV. The auditor’s effort choice problem

Figure 2 shows the auditor’s total costs (TC) – which are the sum of resource costs plus

expected legal liability losses, EL(a) – as a function of the auditor’s level of effort, a, for any

given audit fee, an auditor will be motivated to minimize total expected costs. Note that if the

auditor does nothing (a = 0), then expected losses are the lesser of the auditor’s wealth or the

investment amount lost by investors who accept a bad project. If there are no auditing standards

in place, then the expected minimum costs are at effort level as .

(Insert Figure 2 about here)Now consider the situation where auditing standards are perfectly precise. If the standard

equals s', then the auditor's cost of complying c (s' ) is less than TC ( as ). If the standard equals s' ',

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then the auditor's cost of complying c (s' ') is greater than TC ( as ). Therefore, the highest standard

with which the audit will comply is such that the auditor is indifferent between compliance and

noncompliance (i.e., c (s )=TC ( as ). The auditor will comply with the auditing standards so long as

the toughness of auditing standards is less than the critical value s. Otherwise, the auditor will

not comply with the auditing standards. The highest standard s varies with auditor wealth.

Next consider the case where auditing standards are characterized by a certain toughness

level, m, but are imprecise, where the degree of imprecision (vagueness) is measured by σ. It can

be shown that the auditor’s effort choice for a given level of toughness (m ≤m ' ') as σ increases

varies as shown in Figure 3.1

(Insert Figure 3 about here)

Note that as vagueness increases from zero, the auditor’s effort will be at the upper bound of the

uniform distribution (a=m+√3 σ) but at some level of vagueness (σ1) “a” will begin to

decrease. That is, up to the level of vagueness σ1, the auditor will choose to comply with the

standards with certainty. However, as vagueness continues to increase, the auditor will optimally

choose a level of effort within the distribution and thus comply with a probability, P(a) < 1, with

the probability of compliance decreasing as the level of vagueness increases.

Finally, Figure 4 shows the various optimal effort choices an auditor would make under

the combination of toughness and vagueness.

(Insert Figure 4 about here)

1 m' ' is the minimum value of m in equation m=av−√3 σ+√3 σ (as

2−av2)

as(1−av)+

2√3σ (1−as)1−av

, where

as=(1−β ) min [W , I ]

c and av=

(1−β ) min [W , I ](1+√3 σ+m)2√3 σc+2 (1−β )min [W , I ]

.

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This figure illustrates the auditor's effort choice (i.e., m+√3 σ, or av, or as) as a function

of toughness m and vagueness σ . The grey (dash dot dotted) line is the indifference curve where

m+√3 σ is equal to av. The red line (dash dotted) provides the values of m and σ for which the

auditor is indifferent between choosing m+√3 σ or as. At the blue (dashed) line, the auditor is

indifferent between as and av. The line indicated by 1−√3 σ is the boundary for m, since m+√3 σ

should be less than or equal to one. The feasible region, which is below 1−√3σ , is partitioned

into three sets by the grey, red, and blue lines. When m and σ fall into region A, the auditor

chooses his effort equal to m+√3σ. When the toughness and vagueness are in region B, the

auditor will choose av to be his effort level. When m and σ is in the upper corner, region C, the

auditor will choose as. Note that in region C, the auditor is ignoring auditing standards in the

sense that compliance would indicate an absence of negligence, but might still use the standards

as a guide to audit production.

From Figures 2 through 4 we can see that an auditor’s rational, self-interested response to

standards that vary in toughness and vagueness is quite complex, ranging from certain

compliance, to uncertain compliance, to ignoring the effect of standards on the auditor’s legal

liability to investors for audit failure. Note that when the auditor chooses an effort level, as , the

auditor is behaving as if he or she operates under a strict liability legal regime. That is, the

auditor anticipates and accepts that if audit failure occurs, damages (the lesser of I and W) will be

incurred and paid to investors.

V. Setting auditing standards

In the previous section we consider how the auditor would behave under different types

of auditing standards when facing a given legal system. In this section, we consider how

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auditing standards would be set, again under a given legal system, first by investors acting as

standards setters, then by auditors acting as the standards setters.

Because our model describes a voluntary audit setting with a single investment project,

the determination of the optimum auditing standards from the point of view of investors is

relatively straightforward. Consider the economic objectives of the players:

Objective function: Investors want to induce auditor to exert effort level to maximize the

value of an audit

V (a )=(1−β ) aI+EL (a )−F

where:

1− (β ) = probability project is “bad”,

a = auditor effort and the conditional probability auditor detects a bad project (power of test),

EL ( a ) = expected liability payment by auditor,

F = audit fee paid to auditor, and

EL ( a )=(1−β ) (1−a ) (1−P (a ) ) min[W ,¿ I ]¿, where P (a ) is the probability that the auditor

complies with standards.

Objective function: Auditor’s objective is to choose an effort level to maximize profits

Max F−c (a )−EL (a )

where:

c (a ) = total cost of audit resources = 12

c a2 which is convex and increasing in a.

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Note that the choice variable in both the investor and auditor problem is the level of effort, a.

Now if investors can contract with auditors to undertake a level of effort which is

observable so as to maximize the value of an audit, they would (by substitution) simply:

Maximize: V (a )=(1−β ) aI+ 12

ca2 .

So: dVda

=(1−β ) I−ca=0, and a¿=(1−β) I

c.

This is the first-best solution to the effort choice problem. Note that optimum auditing

standards equal optimum audit effort (s* = a*) which increases with the probability of a bad

project, increases with the size of the required investment, and decreases with the marginal cost

of audit resources. It turns out that the first-best solution, where auditor effort is assumed to be

perfectly observable by all players, is still an important benchmark even when effort is not

observable.

If audit effort is unobservable, standards are set by investors at the beginning of the

game, and standards can be perfectly precise, then it can be shown that:

Investor standard setters would set the standard at the first-best solution (a*), if there

exists an auditor with sufficient (observable) wealth, W. Note that it is in the wealthy

auditor’s self-interest to comply with that standard, so long as the standard is not too

tough.

If auditor wealth is limited, then the standard would be set as close to a* as is attainable,

given the low auditor wealth.

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Note the important role that auditor wealth plays in standard setting. Investors must

assume that auditors will always act in their own self-interest, since they operate as businesses

not as charities! So while investors would always prefer to set the standard at the first best, this

will not be possible when auditors lack the loss-of-wealth incentive to comply with such

standards. Note also the implicit role of the legal system in determining optimum auditing

standards. If the existing legal system would not compensate investors for their losses up to the

level of auditor wealth, then again standards cannot be at the first-best level.

The argument that investors as standard setters would seek to attain first-best audit effort

is quite intuitive. But how would auditors set perfectly precise standards? Perhaps surprisingly,

it can be shown that wealthy auditors as standard setters are also motivated to set the standard at

a*, so long as the auditor has bargaining power to retain some of the surplus audit value, since

that value is maximized at a*. Again, less wealthy auditors would set standards as close to a* as

possible consistent with their limited W (the maximum effort level to which they can credibly

commit). So, if standards can be perfectly precise we conclude that investors and wealthy

auditors have the same preference for the toughness of perfectly precise standards, while less

wealthy auditors would prefer weaker standards. Also, if standards can be set precisely, there is

no reason for either investors or wealthy auditors to prefer imprecise (principle based) standards.

Of course, real-world standards are always imprecise. What factors may motivate a

choice of imprecise standards? Several possibilities emerge from our model:

• If standards are set by a group of auditors who vary in wealth, wealthy auditors will argue

for tougher standards than less wealthy auditors, and imprecise standards may be the

outcome.

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• If toughness is (somehow) set at a non-optimum level, then the auditor (investor) prefers

vaguer standards either to allow an auditor to reduce effort (if toughness is too high) or to

credibly increase effort to protect auditor wealth (if toughness is too low).

• In the model, a* depends on I. If there are multiple projects that vary in size, either size

contingent precise standards are written (which is difficult), or imprecise standards may

be written.

Following are some interesting “take-aways” concerning standard setting in our model:

• Auditing standards set by wealthy auditors (Big 4) are likely to be quite similar in

toughness and vagueness to the standards preferred by investors in large projects.

• Vague standards are generally not preferable to precise standards, except in certain

circumstances.

• Small audit firms lack sufficient wealth-at-risk to be able to credibly commit to audit in

accordance with the tough standards potentially imposed by Big 4 auditors and investors,

and are more likely to gamble and be held, ex post liable. That is, the litigation rate

involving small audit firms is expected to exceed the litigation rate of large audit firms,

which is consistent with evidence in Palmrose (1988).

• Variations in client firm size are probably an important factor motivating the writing of

relatively vague (principle based) auditing standards, and may motivate the writing of

systematically different auditing standards for large vs. small companies (Big GAAS vs

Little GAAS).

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VI. Legal liability regimes and auditing standards

With the background concepts and analysis in place, we now turn to the important and

complex question of how differences in the legal regimes that auditors face would affect the

properties of optimal auditing standards. To do this, we need simple descriptors of how legal

regimes can vary across countries. Accordingly, we describe legal regimes by two parameters:

1. The average size of damage awards paid by negligent auditors to investors, which is

denoted as D, and

2. The degree of overall vagueness in the legal system (denoted v > 0) which depends on

the wording vagueness of auditing standards in place, (σ ≥ 0), and the unpredictability of the

courts’ interpretation of standards (denoted δ > 0). Thus v = f (σ, δ).

For example, we consider the U.S.A. to be a country where both D and v are quite high.

American courts certainly award large damages, such as in class-action lawsuits or when

assessing punitive damages against auditors. Moreover, American courts can be unpredictable in

that civil cases against auditors may be tried by juries whose grasp of business issues may be

limited, and who may be swayed by emotional arguments of legal counsel. On the other hand,

we consider the Peoples’ Republic of China (PRC) as a country with both low D and low v. In

the PRC it is very difficult (if not impossible) for injured investors to obtain financial

compensation through private litigation and, where litigation does occur, assessed damages are

likely to be quite low.

In the previous analyses we assumed a legal system that would compensate investors who

suffered losses (I) by investing in a bad project that an auditor had reported to be good, to be the

lesser of I or the auditor’s wealth, W. Here we assume the more general case where D can take

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any value. For example, through punitive damage awards, D can be greater than I. Also, where

courts are reluctant to punish auditors, D can be less than either I or W.

Also, since we have argued that auditing standards set by investors and auditors tend to

converge on the same value (the first-best solution), we assume that auditing standards are set by

investors with a goal of inducing auditors to produce audit quality, a*, or as close to a* as is

possible, given the legal regime in place. Recall that a* is a function of the value of I, while

auditor effort choice will be a function of D, v, and s. Since the probability of loss is a function

only of a, s, and v, we discuss the optimum toughness of standards given v, the vagueness of the

legal system and the wording vagueness of standards.

(Insert Figure 5 about here)Figure 5 shows how auditor effort, a, will vary with v and D, if the toughness of auditing

standards is set at the optimum level. That is, how will auditors behave given a set of auditing

standards that are optimal for the legal regime that they face? The top plane of the box

represents the first-best solution (a*). Investor standard setters are never motivated to induce

auditors to exert effort greater than that level. The figure shows that where the overall vagueness

is relatively low and damage assessments are moderately high to high, auditors can be induced to

exert the first-best level of effort. As vagueness increases the level of auditor effort will fall

unless damages, D, are increased. The worst situation occurs when vagueness is high and

damages are low. In that situation, auditor effort will be low – well below first-best – even when

auditing standards are optimally set! An important point that Figure 5 clearly illustrates is that

auditing standards, by themselves, are not enough to induce a high level of audit quality. Even

with the best possible standards, a legal system with high v and low D will yield low average

audit quality – well below the quality that investors would like to prevail.

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Finally, we consider how the optimal toughness of auditing standards (s*) would vary

with the characteristics of the legal system, v and D. Figure 6 illustrates the complex relation

between the two legal system parameters and s*. For example, for relatively low values of

vagueness, the toughness of auditing standards needs to increase as D increases but then hits an

upper bound when induced auditor effort attains a*. In this range of v, even if D continues to

increase, it is not optimal for s* to increase as too much effort would be induced. For high

values of v, the relation is more complex as optimal toughness, s*, first increases and then

decreases with D. Again, recall that compliance with auditing standards protects auditors against

a charge of negligence. So, if the legal regime assesses high damages and is seen as being

capricious (v is high) auditing standards need to be “fine tuned” to induce optimal audit quality.

(Insert Figure 6 about here)

VII. Implication of our analyses for the adoption of ISAs

Our previous analyses demonstrate that there are clear dangers in assuming that a global

set of auditing standards, such as the ISAs, can or should be adopted in all countries. For

countries where both v and D are very low (e.g. China) optimal standards will have a low

toughness and the first-best solution will likely not be attained, even under optimal auditing

standards. This implies that investors and regulators will be concerned about the low average

audit quality that prevails in the country. This situation would appear to characterize not only

China, but other countries, such as Japan (Frendy, 2014). If countries where v and D are quite

low, such as China and Japan, adopt the ISAs - which, indeed has been the case – then these

standards will likely be too tough, given the legal system in place, and auditor non-compliance

with standards can be expected.

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On the other hand, for countries where both v and D are very high (e.g. the U.S.A.),

toughness needs to be high if first-best audit effort is to be attained. Also, optimal standards in

these circumstances should be precise, since required toughness is an increasing function of v, so

if σ were high, then optimal toughness would need to be even higher! Arguably, the standards set

by the PCAOB are tougher and more precise that the ISAs. As a result, our analyses predict that

regulators in the U.S. will be reluctant to adopt ISAs – which is, in fact, the case. If, on the other

hand, the U.S. were to adopt the ISAs as domestic standards, the result may be a failure to

achieve first-best average audit quality.

Basically, our analyses predict that uniform auditing standards will be adopted and will

work well for a set of countries that have roughly similar legal systems – such as the British

Commonwealth countries, and the countries of the European Union. When adopted by countries

with weak legal systems, average audit quality cannot be expected to increase significantly, and

there will be problems of auditor non-compliance with standards. This implies that imposing an

initially non-optimal set of auditing standards on a country will require concurrent changes in the

legal environment if those standards are expected to be effective in eliciting auditor compliance

with the rules and thereby increasing average audit quality. A legal environment can, in

principle, be changed by changing average damages assessed in court cases, namely D, and/or by

changing the interpretation vagueness of auditing standards. The latter could involve country-

specific interpretations of standards that provide additional guidance to auditors.

VIII. Concluding comments

We have shown that optimal auditing standards for a country are a complex function of

the legal system in that country. Moreover, audit quality (auditor effort) depends on the legal

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system and the characteristics of auditing standards under which auditors – who are organized as

self-interested, private business enterprises - operate. Globally uniform auditing standards

cannot be optimal in all countries unless national legal systems are also sufficiently uniform. An

interesting question raised by a number of participants in the conferences at which this

presentation was made is whether or not regulatory discipline can be a substitute for discipline

by private litigation, in circumstances where the private litigation system is weak (e.g. China,

Taiwan, Japan, etc.). This is a very interesting question that lies beyond the scope of this paper,

but which is investigated in a paper by Ye and Simunic (2014).

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Appendix Figures

Figure 1 Game tree summary and players’ objectives

The notation used is as follows:F = audit fee paid by investors to the auditora = level of auditor effort (scaled 0,1); also the probability that auditor receives a signal of

“bad” from audit tests performed, if indeed the project is bad (power of audit tests)β = probability that the investment project is good; (1 – β) probability project is badB = payoff to investors from a good project; bad project pays off zeroI = investment amountc(a) = cost function of audit resources (assumed convex)P(a) = probability that auditor is deemed by the court to have complied with auditing standardsW = level of auditor wealth which limits the amount of damages an auditor can pay to

investorsNote that all of these values are assumed to be common knowledge.Source: (Ye and Simunic, 2013)

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Figure 2 The auditor’s effort choice if standards are precise

This figure illustrates the auditor’s effort choice when auditing standards are perfectly precise. If the standard equals s', then the auditor's cost of complying c (s' ) is less than TC ( as ). If the standard equals s' ', then the auditor's cost of complying c (s' ') is greater than TC ( as ). Therefore, the highest standard with which the audit will comply is such that the auditor is indifferent between compliance and noncompliance (i.e., c (s )=TC ( as ). The auditor will comply with the auditing standards as long as the toughness of auditing standards is less than the critical value s. Otherwise, the auditor will not comply with the auditing standards. The highest standard s varies with auditor wealth.

Source: (Ye and Simunic, 2013)

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Figure 3 Given m ≤m ' ', how does the auditor’s effort vary with vagueness?

This figure shows that if m ≤m ' ', then as vagueness increases, the auditor’s effort will be m+√3 σ and then av, suggesting that the auditor will initially increase and then decrease his effort.

Source: (Ye and Simunic, 2013)

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Figure 4 The auditor’s effort choice as a function of toughness m and vagueness σ

This figure illustrates the auditor's effort choice (i.e., m+√3 σ, or av, or as) as a function of toughness m and vagueness σ . m is the mean and σ is the standard deviation of the distribution. The grey (dash dot dotted) line is the indifference curve where m+√3σ is equal to av. The red line (dash dotted) provides the values of m and σ for which the auditor is indifferent in choosing m+√3 σ or as. At the blue (dashed) line, the auditor is indifferent between as and av. The line indicated by 1−√3σ is the boundary for m, since m+√3 σ should be less than or equal to one. The feasible region, which is below 1−√3 σ , is partitioned into three sets by the grey, red, and blue lines. When m and σ fall into region A, the auditor chooses his effort equal to m+√3σ. When the toughness and vagueness are in region B, the auditor will choose av to be his effort level. When m and σ is in the upper corner, region C, the auditor will choose as.

Source: (Ye and Simunic, 2013)

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Figure 5 The impact of D and v on audit quality under optimal toughness of the standards

In this figure, ao is the optimal audit quality, v is the interpretation vagueness, and D is the damage award. This figure illustrates how auditor effort ao varies with v and D, if the toughness s of auditing standards is optimally set. We use the following function and parameter values to generate this figure: (a )=1−exp (−0.03 a), μ=0.05, β=0.5, I=15.

This figure shows that D needs to be large enough to induce the first-best quality, especially when v is high. When D is not large enough, optimal standards induce an effort as close to the first best as possible. When v is low, the audit effort is certain compliance s0+v, which doesn’t vary with v, but is affected by D. When v is high, the auditor will comply possibly. When v increases, the possible compliance effort decreases, and thus, tougher standards are needed to increase the possible compliance effort.

Source: (Simunic, Ye and Zhang, 2014)

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Figure 6 Optimum toughness of standards given D and v

In this figure, s¿ is the optimal toughness of the standards, v is the total vagueness, and D is the damage award. We use the following function and parameter values to generate these figures: q ( a )=1−exp (−0.03 a), μ=0.05, β=0.5, I=15.

The figures show, for a given v (≤ v), as damage award D increases, optimal toughness increases and then becomes a constant once D ≥ D 0. The value of D0 is the minimum of D at the point that the optimal toughness s¿ becomes a constant under a given v (≤ v). The value of D0 is around 7 in above figure and it is not a function of v. The optimal toughness decreases as v increases when v≤ v.

Source: (Simunic, Ye and Zhang, 2014)

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References:

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Simunic, Dan A., Minlei Ye, and Ping Zhang, 2014. “The Joint Effects of Multiple Legal System Characteristics on Auditing Standards and Auditor Behavior”, working paper, UBC and University of Toronto: SSRN #2281270.

Simunic, Dan A., Minlei Ye, and Ping Zhang, 2014. “Improving Audit Value with Country Specific Interpretations after International Auditing Standards are Adopted”, working paper, UBC and University of Toronto: SSRN #2402447.

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Ye, Minlei and Dan A. Simunic, 2013. “The Economics of Setting Auditing Standards”, Contemporary Accounting Research, (Vol. 30, No. 3) Autumn: 1191-1215.

Ye, Minlei and Dan A. Simunic, 2014. “Regulatory Oversight and Audits in Capital Markets”, working paper, University of Toronto and UBC.

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