Audit Externalities and Regulation

In his paper on regulation, Jere Francis explains why audits are regulated. Audits are regulated because the major parties (auditors and their clients) settle for lower levels of assurance. Society requires higher levels of assurance since they (e.g., future shareholders, banks, employees, customers)  benefit from higher levels of assurance.

Legislation and regulation purportedly motivate auditors to set higher levels of assurance (and thus audit quality). However, since auditors are required to produce on average a higher level of quality audit than the market requires, and arguably incur higher costs than the client is willing to pay, the question is who foots the bill for the higher cost: the auditor, the client, future shareholders, banks, society as a whole?

Read Jere’s insightful paper,. It is important to understand why under the current system there will always be tension between what the firms believe is an appropriate level of assurance versus what auditors are expected to deliver.