Optimal Auditing Standards

Transcription

1 Optimal Auditing Standards Maro Pagano Università di Napoli Federio II, CSEF and CEPR Giovanni Immordino Università di Salerno and CSEF Preliminary draft: November 20, 2004 Comments welome Abstrat We study regulation of the auditing profession in a model where audit uality is unobservable and enforing regulation is ostly. The optimal audit standard falls short of the first-best audit uality, and is inreasing in the eonomy s wealth, in the likelihood of a mistaken investment and in the size of typial investment. The model an enompass ollusion between lients and auditors, arising from the joint provision of auditing and onsulting servies: defleting ollusion reuires less ambitious standards. The optimal audit standard depends also on the orporate governane of lient firms: audit standards and orporate governane are omplements. Finally, the deision to ban the bundling of onsulting and audit servies should depend on the auditors eonomies of sope, the intensity of their onflit of interest, and their lients orporate governane. JEL lassifiation: G28, K22, M42. Keywords: auditing standards, enforement, opinion shopping. Authors addresses: Maro Pagano, CSEF, Faoltà di Eonomia, Università di Napoli Federio II, Via Cintia, Napoli, Italy, phone , fax ; mrpagano@tin.it. Giovanni Immordino, Faoltà di Eonomia, Università di Salerno, Fisiano (SA), Italy, phone , fax ; giimmo@tin.it. Aknowledgements: We thank Gianarlo Spagnolo and seminar partiipants at the University of Salerno, the London Shool of Eonomis, and the Stokholm CEPR-SITE Workshop Understanding Finanial Arhiteture: On the Eonomis and Politis of Corporate Governane. Maro Pagano gratefully aknowledges finanial support from the Fondazione IRI. This paper is produed as part of a CEPR researh network on Understanding Finanial Arhiteture, funded by the European Commission under the Human Potential Researh Network ontrat No

2 1. Introdution The reent orporate sandals involving major ompanies (Enron, Worldom, Qwest, Sunbeam, Parmalat, et.) have highlighted that the regulation of auditing ompanies and its enforement are key determinants of the reliability of orporate information. For many of the ompanies involved in orporate sandals, auditors failed to report any misbehavior or substantive inauray. These audit failures have damaged auditors reputation as independent experts and monitors of aounting information. As a result of this loss of onfidene, there has been a shift from self-regulation and litigationbased enforement of audit rules towards government regulation and publi-driven enforement. 1 In the United States, the Sarbanes-Oxley At of 2002 established the Publi Company Aounting Oversight Board (PCAOB), whih, under the oversight of the Seurity Exhange Commission (SEC), will register publi aounting firms, and establish rules for auditing, uality ontrol, ethis, independene and other standards. Moreover, it will inspet aounting firms, arry out disiplinary proeedings and impose penalties. A similar shift is under way in the other ountries: for instane, also the United Kingdom moved away from self-regulation by establishing a UK Aounting Standards Boards, and in Italy new legislation is being drafted that will extend the power of the national seurities ommission (CONSOB) to regulate and oversee auditors ativity. Now that the role of the publi regulation of auditors is widely reognized, the natural uestion arises of what is the optimal design of suh regulation. In this paper, we show that the answer to this uestion depends on three main ingredients. First, the ost of enforing regulation, whih inludes both the neessary publi funding (salaries of bureaurats and judges, paperwork, investigations, et.) and the ompliane osts borne by audit firms and their ustomers. Seond, the aountants inentives to ollude with their lients, whih in turn depend both on the auditors onflit of interest and on their lient ompanies governane. Third, the possible eonomies of sope that may be reaped through the joint provision of auditing and onsulting servies to the same firm. We haraterize the auditing standards that a benevolent regulator should impose if the uality of the aounting information provided by auditors is privately unobservable, so that in the absene of regulation the euilibrium level of audit uality would be zero. To avoid the implied loss of informational effiieny (and misalloation of investment), the regulator an impose a minimum uality standard on auditors, but in hoosing it must take its enforement ost into aount. As a 1 Auditing rules apply to the ondut of auditors: they presribe how audits must be onduted. In ontrast, aounting standards apply to firms: they onern the reporting priniples and proedures that firms an use. 1

3 result, the optimal standard will fall short of the first-best audit uality level, and must be lower the less effiient is the enforement tehnology. Moreover, the optimal standard depends on the eonomy s wealth: it rises with inome in ountries where onsumption is at the subsistene level. If onsumption exeeds subsistene, the optimal standard must be hosen on the basis of the informational value of audits for investment deisions: it must be higher the greater is the danger of making a mistaken investment, and the larger is the typial investment at stake. This baseline model assumes that the moral hazard problem lies only in the ativity of auditors, while firms always seek a truthful report. But the reent orporate sandals suggest that also the behavior of ompanies may be plagued by moral hazard, beause empire-building managers may want to arry out investment at all osts, irrespetive of its profitability, and therefore may want to bribe auditors into produing positive reports under all irumstanes. To bribe auditors, managers an award a profitable onsulting ontrat for to the auditor, on ondition that he files a positive report. In order to deflet the danger of ollusion between firm and auditor, the regulator will have to spend more resoures to polie any given audit standard. As a result, when the managers of lient firms seek to orrupt their auditors, the regulator must optimally hoose a less ambitious standard. Whether managers will want to orrupt their auditors or not, however, depends on the uality of the orporate governane of their ompanies. We show that as managers inentives beome more aligned to shareholders interests, the optimal audit standard inreases, exept for a disontinuous downward jump. Depending on the uality of orporate governane, the regulator should either try to disourage auditors from taking bribes or it an attempt to disourage managers from offering them. When orporate governane is very bad, it is less distortionary to disourage auditors from aepting bribes. Above a ritial uality of orporate governane (where the disontinuity ours), it is more effiient to disourage managers from offering bribes. In the latter region, the optimal audit standard inreases monotonially in the uality of orporate governane, until it reahes the seond-best level. In this region, audit standards and orporate governane are omplements. An additional regulatory tool is to sever the link between onsulting and auditing ativity, by forbidding auditors to provide onsulting servies, as indeed presribed by the Sarbanes-Oxley At. If this is the only way in whih lient firms may bribe their auditors, this poliy would appear as a superior option to tampering with auditing standards. Indeed, in our model it would allow the regulator to leave the standard at the seond-best level. However, this onlusion may no longer hold if the joint provision of auditing and onsulting servies generates eonomies of sope. We show that banning suh joint provision is soially ineffiient if the implied ost savings are suffiiently large and the onflit of interest is not too aute, and in any event if the orporate 2

4 governane of lient ompanies is suffiiently good. So the uality of orporate governane allows not only to go for a more ambitious auditing standard, but also to reap more easily the ost saving from eonomies of sope in auditing. Our model is losely related to the miroeonomi analysis of the auditor-firm relationship proposed by Dye (1993) and to the normative analysis of regulation and enforement developed by Immordino and Pagano (2003). As in Dye (1993), auditors an ontribute to the effiient alloation of investment but the uality of their audits is unobservable, leading to a moral hazard problem. But in our setting this problem is not left to litigation between investors and aountants, but entrusted to regulation and its enforement by publi offiials. The hoie of the optimal regulatory response takes into aount its enforement ost, along the lines of Immordino and Pagano (2003). The result is a systemati normative analysis of the regulation of the auditing profession, whih takes into aount also the possible onflits of interest within auditing firms, and the ageny problems between managers and shareholders within lient firms. These aspets are partiularly topial in view of the ongoing debate about the appropriate regulatory response to the reent orporate sandals, and of the slate of reent empirial work produed in the aounting profession on the relationship between auditor independene, audit fees and lients orporate governane. The studies on the orrelation between auditors fees for MAS and abnormal aruals, used as a measure for biased reporting, report ontraditory results (Frankel, Johnson and Nelson, 2002; Kinney and Libbey, 2002; Antle, Gordon, Narayanmoorthy and Zhou, 2002, among others). The evidene on the relationship between orporate governane and measures of auditors misreporting is more learut. The inidene of aounting fraud and earnings management is lower in firms with more independent boards (Beasley, 1996; Dehow, Sloan and Sweeney, 1996; Klein, 2002), and the freueny of earning restatements is lower in firms whose board or audit ommittees inlude an independent diretor with finanial expertise (Agrawal and Chada, 2005). The struture of the paper is as follows. In setion 2 we present the model, derive the first-best audit uality, and haraterize the seond-best audit standard to be hosen if audit uality is privately unobservable. In Setion 3, we analyze the optimal poliy when firms ollude with the auditors, by exploiting the latter s onflit of interest. Setion 4 studies the relationship between the optimal audit standard and the firms orporate governane. Setion 5 onsiders how the design of regulation is affeted one one allows for potential eonomies of sope arising from bundling auditing and onsulting servies. Setion 6 plaes the paper in perspetive, by omparing the analysis of regulation with alternative mehanisms so far tried or proposed in order to improve the informativeness of audits. Setion 7 onludes. 3

5 2. The model This setion explains the rationale for regulation of auditing. It starts by introduing a setting similar to Dye (1993) to highlight the informational value of auditing to raise new finane, in a setting where the value of ompanies is unertain. We start from a situation where auditors ativity is observable and ontratible, so that the eonomy ahieves the first-best outome. We then examine what happens if investors annot observe the level of effort that auditors invest in their task. This moral hazard problem in auditing implies that auditors will hoose the minimal level of uality. Under our assumptions, the soial ost of this moral hazard is that ompanies will alloate the investment less effiiently Informational value of auditing Consider an eonomy with risk neutrality and no disounting by all agents, and a ontinuum of firms. The representative ompany is managed in the interest of the shareholders, so that the manager s objetive is to maximize its urrent value. The ompany an effet an investment of size I. To ath this opportunity, it must get a ash infusion that euals the investment I plus any fees F to be paid to an auditor. Assuming that the reuired of return on the new apital is standardized to zero, shareholders provide the needed ash infusion in exhange for shares in the ompany that are worth I + F, out of their endowment Y. 2 Their budget onstraint is: Y = I + F + T + X I, (1) whih states that investors spend their endowment Y to buy shares in the ompany (paying I + F), pay taxes T, and purhase onsumption X I. Eventually, the projet may turn out to be a suess (state s = H) or a failure (state s = L). State H ours with unonditional probability p, and state L with probability 1 p. If the projet is a suess, the ompany s final value V is V H ; if not, it is VL < I < V H. This implies that in the bad state the new investment is unprofitable. Sine there is a ontinuum of firms, p is also the fration of suessful firms. The firm s initial shareholders are supposed to have no private information about 2 A larger stake would leave them with a surplus; a smaller one would violate their partiipation onstraint. In most of the paper, it is indifferent whether this ash infusion is ontributed by the initial shareholders or by new shareholders. It will beome relevant only in Setion 5. 4

6 its future value. So, absent any additional information, the ompany s initial value V is the unonditional expetation of its final value, EV ( ) = pv + (1 pv ). We assume that E( V ) > I, so that the investment is worthwhile even if no information is gathered via an audit report. However, an audit may still be worthwhile as it allows the firm to ondition its investment deision on more aurate information. If the ompany is audited before it raises additional euity, its market prie will reflet also the information onveyed by the audit. As in Dye (1993), auditors have a ostly tehnology that aids in distinguishing high-value from low-value firms. If an auditor performs an audit of uality C(), whih is inreasing and onvex in, with H (0,1), he produes a report r about the firm s final value at a ost C (0) = 0, 0 L lim C'( ) = 0 and lim C'( ) =. 1 If the auditor believes that the projet will fail, he reports r = L. Otherwise, he reports r = H. The auditor s report is perfetly aurate when positive, while it may err if negative. Formally the onditional probabilities of the auditor s report being orret are: Pr( r = L s = L, ) =, Pr( r = H s = H, ) = 1. Using Bayes rule, the probability that the ompany will sueed onditional on a good report is: Pr( s = H r = H) p Pr( s = H r = H) = =. Pr( r = H) p+ (1 p)(1 ) (2a) while the probability that it will sueed onditional on a bad report is zero: Pr( s = H r = L) Pr( s = H r = L) = = 0. Pr( r = L) (2b) For onveniene, we denote by r = N the ase in whih no audit is arried out. In this ase, the probabilities of the states H and L will be the unonditional ones, p and 1 p. The initial value of the ompany V takes three different values depending on whether: (i) a positive report is filed; (ii) a negative one is filed; (iii) no audit is arried out. Correspondingly, the shareholders surplus from the investment I, before netting out the audit fee F (if an audit is performed), S = E( V r) I, will take different values in eah of these ontingenies: V (1 )(1 ) ( ) [ Pr(, ) Pr(, ) H p+ VL p SH = VH s= H r= H+ VL s= Lr= H ] I= I, (3a) p+ (1 p)(1 ) [ ] S ( ) = V Pr( s= H r= L, ) + V Pr( s= L r= L, ) I= V I, (3b) L H L L 5

7 S = E( V) I, (3) N where we have used the onditional probabilities in (2a) and (2b). By assumption, SL ( ) < 0 and S > 0. From the latter ineuality, it follows that S ( ) > 0. Therefore, the investment is arried N out when no audit report is filed or when it is favorable. It will not be arried out if the report is unfavorable, so that in this ase the surplus, onditional on the optimal investment deision, is zero. However, whenever an audit is ommissioned, it must be paid for. So we define the net surplus: H SH ( ) F if r = H, r = F if r = L, SN if r = N, (4) whih takes into aount both the ost of the audit F and the optimal investment deision. The informational value of an audit is the differene between the expeted value of with an audit and its value without an audit: Ω ( ) = Pr( r = H) + Pr( r = L) = (1 p)( I V ) F, (5) H L N L whih is easily obtained from (4). This expression is inreasing in the uality of auditing, dereasing in the uality of available projets p (the worse the pool, the more valuable is information), and inreasing in the losses that would arise from investing in bad ones. The term I V L is a measure of the potential misalloation of investment that an be prevented by auditors information The unregulated outome If the audit fee F just euals the auditors ost C(), i.e. if auditors make zero profits, then expression (5) beomes the net soial surplus (on a per-firm basis): W( ) = (1 p)( I V ) C( ), (6) Indeed, sine auditors earn zero profits, the entire net soial surplus arues to the shareholders. The first-best outome is obtained by maximizing the net soial surplus W(). Given our assumptions about the auditor s ost funtion, W() is onave and has an internal maximum where L 6

8 the marginal value of audit uality euals its marginal ost. This identifies the first-best uality FB value (0,1) : Sine the ost funtion C() is onvex, FB (1 p)( I VL ) = C'( ). (6) FB is dereasing in the uality of the pool and inreasing in the potential misalloation of investment, just as the informational value of auditing. If the audit uality is observable, the first-best outome emerges as the ompetitive market euilibrium. Firms managers hoose their demand for audit uality by maximizing the informational value of auditing, Ω( ). Auditors hoose their supply of audit uality by maximizing their profit per audit, F ( ) C ( ), and make zero profits. The market-learing prie of FB an audit will then be the fee orresponding to the first-best level of audit uality, F ( ). It is easy to show that if uality is observable, the first-best alloation oinides with the Bertrand euilibrium of the model, that is, the Nash euilibrium of an extensive-form game where auditors hoose the uality of the audit and a fee funtion F(). The strategy of auditor j is a hoie of uality and fee, whih is the best response to the ualities and fees hosen by ompeting auditors. The situation in whih all firms hoose the first-best uality and prie is a Nash euilibrium, sine no firm an profitably deviate. If instead the audit uality is privately unobservable, then for any positive audit uality expeted by investors, auditors have an inentive to hoose a lower level and save the orresponding ost. As a result, the only euilibrium audit uality is zero, the market prie will eual the unonditional expetation E(V), and the firm will be more likely to arry out ex-post unprofitable investments. So in this ase there is a rationale for publi intervention. To this we turn in the next subsetion. 2.3 Regulated auditing The government sets an auditing uality standard. This implies that auditors must hoose a uality level at least eual to and must truthfully report the signal that they observe with this uality level. If they deviate from either one of these duties, they are liable to pay a penalty l. The uality hosen by auditors is observable and verifiable at a ost by a regulator, who hooses also the amount of resoures e devoted to enforement, i.e. to detetion of violators. The penalty is monetary and annot exeed an upper bound l. This bound an be thought as the entire wealth of 7

9 the auditing ompany, whih an be taken as exogenous in the ontext of the relationship with a speifi lient. 3 Figure 1 illustrates the seuene of moves. First, nature hooses the state s. Seond, the regulator hooses the audit standard, the penalty l and the enforement e. Third, auditors hoose the uality level of their audit harging the fee F(), and produe the orresponding report r. Fourth, bureaurats enfore the standard by inspetion, deteting non-ompliane with probability f () e. 4 Next, the stok market sets the prie of the ompany at a level refleting the pereived uality of auditing, and shareholders ontribute euity to the ompany to finane audit fees and possibly investment. Finally, the ompany s atual value is determined. [Insert Figure 1] For it to be respeted, the audit standard must be baked up by an appropriate expeted penalty L in ase of non-ompliane. The auditor s profit is: Π= F ( ) C ( ) L, (7) where the expeted penalty L is the produt of the probability f(e) of deteting a non-omplying auditor and the statutory penalty l. The probability of detetion is inreasing and onave in the regulator s effort: f '( e ) > 0, f "( e ) < 0, with f (0) = 0, lim f '( e) = and lim f '( e) = 0, that is, e 0 e the enforement tehnology has dereasing marginal produtivity. So the expeted penalty is: f () el if, L < = 0 otherwise. If auditors earn any positive profits, these are spent on their onsumption: Π = X A. The penalty ontributes to the government's revenue from penalties, f(e) also being the fration of auditors that are inspeted. Enforement is finaned out of the sum of net taxes and revenue from 3 This wealth an derive from previous ustomers, and from the sale of non-audit servies, in areas of tax onsulting, aounting, management information systems, etetera. In reality it may be impossible to onfisate the entire wealth of the auditor, due to the danger of subversion of justie : setting too high a penalty may indue violators to subvert it, by investing in legal strategies to avoid punishment or by intimidating and bribing offiials (Glaeser and Shleifer, 2003). 4 In our setting, the regulator ommits to the probability of detetion f () e, by allotting the level of resoures e to enforement ativity. One an think of e as the salaries paid to the offiials in the authority that oversees the appliation of audit standards: one hired, these detet violations with a probability given by their enforement tehnology. 8

10 penalties (although, as we shall see below, no revenue from penalties is olleted in euilibrium). 5 Assuming that the budgetary ost of a unit of enforement is a unit of onsumption and that the regulator spends all tax revenue on enforement, the government budget onstraint is e= T +L. Being benevolent, the regulator hooses the auditing standard, the enforement level e and the penalty l so as to maximize the soial surplus from auditing uality minus the assoiated enforement ost, W() e, subjet to the inentive-ompatibility onstraint of auditors and the feasibility onstraint that aggregate onsumption does not fall short of the subsistene level X : X X + X X. Formally, the problem is: I A subjet to the inentive ompatibility onstraint: max (1 p)( I VL ) C( ) e (8) l,, e F ( ) C ( ) F ( ) C ( ) f( el ) for any, (9) and to the feasibility onstraint, whih an be re-expressed as: 6 X Y I C( ) e X. (10) In the inentive ompatibility onstraint (9), the auditor s fee F on both sides of the ineuality orresponds to the presribed audit uality expeted by investors, while the ost C depends on the uality level atually hosen by the auditor. As in Beker (1968), for any positive enforement level it is optimal to set the penalty at the maximum feasible level: 7 l = l. To obtain the optimal enforement level, we use the inentive ompatibility onstraint (9) with euality, sine the optimal poliy reuires this onstraint to be binding. If not, the regulator ould inrease welfare by lowering enforement e, for any given l Next, notie that, in ase of non-ompliane, the auditor would optimally deviate to a zero uality level, sine this would minimize his ost. Finally, sine the detetion probability f(e) is monotonially inreasing, it an be inverted to yield the optimal enforement:. 5 Sine utility is linear, taxation auses no distortions. 6 The national aounting identity on the left-hand-side of (10) is obtained by ombining the shareholders budget onstraint (1) with the auditors budget onstraint Π = X A and the government budget onstraintt = e L. 7 To see why, notie that if the penalty were set at a lower level, inreasing it would enable the regulator to derease enforement e while keeping L onstant. The soial surplus in the objetive funtion would be unhanged but the enforement ost would be lower, so that welfare would be higher. 9

11 1 e ( ) = f ( C ( )/ l ). (11) From the properties of the enforement and audit tehnologies, it is immediate that the optimal enforement e is an inreasing and onvex funtion of the audit standard, and a dereasing funtion of the maximum penalty l. 8 The positive relationship between enforement and audit standards highlights their omplementarity: a more demanding audit standard invites nonompliane by auditors, so that it must be assisted by more intensive monitoring by the regulator. Replaing the optimal enforement (11) into the objetive funtion, the problem of maximizing (8) under the feasibility onstraint (10) an be rewritten as the Lagrangian: L λ max Y + (1 p)( I V ) C( p ) e( ) + Y I C( ) e( ) X, (12) where λ is the Lagrange multiplier. The first-order onditions of this problem are: (1 p)( I VL ) = (1 + λ)( C'( ) + e'( )), (13a) λ Y I C( ) e( ) X = 0. (13b) From these optimality onditions, one an show: Proposition 1 (Seond-best audit standard). The optimal audit standard is smaller than the first-best standard FB. The proof of this proposition (and subseuent ones) is in the Appendix. The intuition for why the optimal standard is lower than the first-best level is very simple: the regulator must take into aount the resoure ost of enforing it. The omparative statis of the optimal standard generally depend on whether onsumption is at subsistene level or not: Proposition 2 (Comparative statis). If aggregate onsumption exeeds subsistene, then the optimal standard is dereasing in the fration of suessful projets p and inreasing in the reuired investment I. If aggregate onsumption is at the subsistene level, then the optimal 8 The first derivative of enforement with respet to the standard is e' = f ' 1 ( C( )/ l ) C'( )/ l > 0. Its seond derivative is e" = f ' 1 ( C( )/ l ) C"( )/ l + f " 1 ( C( )/ l ) ( C'( )/ l ) 2 > 0. 10

12 standard is inreasing in initial inome Y and dereasing in the reuired investment I. In both ases, it is inreasing in the effiieny of the auditing and enforement tehnology. Intuitively, when a ountry has suffiient resoures to pay for auditing, it should hoose a more demanding standard if audits allow investors to pik the few winners in a bad pool, and/or if the audit ost is spread over a large investment. These are situations in whih the soial value of a reliable auditor is very high. If instead a ountry s resoures are already largely absorbed by onsumption and investment, as probably happens in many developing ountries, the auditing standard an be raised only insofar as additional resoures beome free to fund the implied enforement and auditing osts. This happens either if inome Y inreases, and/or if the reuired investment I dereases. 9 The only omparative statis that are ommon to these two situations are those onerning tehnologial shifts: in both ases, a ountry an afford higher standards if its auditors beome more effiient in their job and/or regulators beome better at monitoring them. 3. Auditors onflit of interest and ollusion with audited firms As disussed in the introdution, one of the alleged soures of the reent orporate sandals has been the ability of ompany managers to buy the auiesene of auditors by exploiting the onflit of interest between their onsulting arm and their auditing arm. Auditing firms an provide servies in the area of tax, aounting or management information systems and strategi advie, whih are ommonly labeled management advisory servies (MAS). The fees for the purhase of MAS an be used to redue the independene of auditing reports. To apture the auditor s onflit of interest, we amend the model by assuming that the firm s managers an ondition the purhase of MAS to a positive audit report, irrespetive of the true state of nature. We assume that the market for auditing servies is ompetitive (as in the previous setion, F() = C()), but only one auditor is already ative also in the market for MAS: other firms have 9 It an also be shown that the standard is zero if the eonomy is suffiiently poor, that is, it has at most just enough resoures for subsistene onsumption and investment (Y X + I ). In this ase, the eonomy forgoes the effiieny benefits of an audit standard, but this effiieny loss is unavoidable beause the ountry annot afford an audit standard. This result, as well as the positive relationship between the auditing standard and inome Y, would be attenuated to the extent that a poor ountry ould borrow resoures from the international apital market to relax the feasibility onstraint. In the limiting ase of perfet apital markets, both of these results would no longer hold. 11

13 only the apability of providing them. The inumbent onsulting-auditing firm an produe MAS at a lower ost than potential entrants, due to barriers to entry or to a tehnologial advantage. 10 As a result, by limit priing the inumbent earns the ost differene M from the sale of suh servies. We assume that at the resulting prie the lient firm wants to buy MAS, irrespetive of the state of nature and of the purhase of auditing servies. The lient firm an ondition a MAS ontrat with the inumbent onsulting firm upon reeiving a positive report r = H from its auditing arm, irrespetive of the true state of nature. If it aepts this bribe, the auditing-onsulting firm optimally hooses to invest no resoures in auditing: = In this setion, we assume that the deision to bribe the auditor is taken by a manager, who draws a private benefit from implementing the investment irrespetive of the state of nature, and gives no weight at all to the interest of shareholders. In the next setion we shall explore the impliations of a less drasti ageny problem within the firm. In setting the optimal audit standard and assoiated enforement spending, now the regulator must take into aount the firm s inentive to bribe the auditor via the profits from onsulting. Formally, the new regulator s problem is the same as before exept for the auditor s the inentive ompatibility onstraint. He will maximize expression (8), subjet to the feasibility onstraint (10) and to the new inentive onstraint: F ( ) C ( ) F ( ) + M fel ( ), (14) where the supersript stands for ollusion. Going through the same steps as in the previous setion, one find that the first-order onditions are the same as before (13a and 13b), but that the orresponding optimal enforement level is: 1 e ( ) = f (( C( ) + M)/ l ). (15) This expression, whih is inreasing and onvex in, shows that the enforement neessary to uphold a given audit standard exeeds the seond-best level identified in euation (11) beause the possibility of obtaining profits M from onsulting raises the enforement ativity needed to prevent ollusion. The optimal audit standard is orrespondingly lower: intuitively, the potential 10 One need not assume that there is a single inumbent firm in the market for MAS: there an be several inumbents, whih ollude in priing. Alternatively, there an be several ative ompetitive firms, only one of whih has lower osts than the others. 11 Euivalently, the firm an be thought as bribing the auditor into exerting zero effort, sine this will give a positive report with ertainty: Pr( r = H = 0) = 1. 12

14 bribe raises the ost of enforement, induing the regulator to hoose a less ambitious standard. The problem gets worse the larger are the profits from onsulting M that an be used to bribe the auditor. As a result, the larger these profits, the less ambitious the aounting standard must be. Proposition 3 (Optimal poliy with onflit of interest). If M > 0, then the optimal standard ( M ) is lower than in the seond best, and is dereasing in the onsulting profits M. 4. Auditors onflit of interest and orporate governane It is widely agreed that the reent orporate sandals were generated not only by onflits of interest within aounting firms, but primarily by bad orporate governane arrangements within the ompanies being audited. Indeed, one of the key assumptions in the previous setion was that managers disregard ompletely the interest of shareholders, and thereby the informational value of auditing. In this setion, we explore a more general ase, where the severity of the ageny problem within the ompany an be varied parametrially. Although managers draw a private benefit from empire building (and therefore from the investment) as in the previous setion, now they also plae a positive weight on the expeted value of the ompany. This generalization enompasses the models of the previous two setions. That of Setion 2 orresponds to the polar ase where the manager s inentives are well aligned with those of shareholders, so that the manager does not want to bribe auditors and impair the informational value of the audit. Conversely, Setion 3 orresponds to the ase in whih managerial inentives are poorly aligned with those of auditors. In the present setion, we show that the regulation of audit uality must take into aount the uality of orporate governane. If managerial inentives are suffiiently aligned with those of shareholders, the regulator will not have to worry about deterring auditors from taking bribes, sine ompanies will not offer them in the first plae: in this ase audit standards will be set at the seond-best level. Managers will offer bribes to auditors only if orporate governane is suffiiently bad: in this ase, the regulator will have to take this into aount, and hoose the audit standard omputed in the previous setion. Assume that the manager s payoff is the sum of his private benefits (that arue only if the investment I is arried out) and the expeted final value of the ompany. This seond term is 13

15 weighted by the parameter γ, whih an be interpreted as the fration of shares held by the manager or, more generally, as a measure of the effetiveness of any inentive sheme intended to align his interests to those of the shareholders. 12 For brevity, from here onwards we shall refer to γ simply as the uality of orporate governane. As a result, the manager s deision to bribe the ompany s auditor hanges his payoff by: [ ] Ψ (, γ) = Pr( r = L) B γ Ω ( ) = (1 p) B γ (1 p)( I V ) C( ). (16) L The first term of Ψ (, γ ) is the inrease in the manager s expeted private benefit. With the bribe, the investment is arried out with probability 1. Without the bribe, it is arried out only if the auditor s report is positive, that is, with probability Pr( r = H). So the bribe raises the probability of obtaining the private benefit by Pr( r = L) = 1 Pr( r = H). The seond term of Ψ(, γ ) proportional to the audit s informational value Ω ( ), i.e. the loss in value borne by forgoing a truthful audit. 13 is The manager will offer a bribe to the firm s auditor only if expression (16) is stritly positive (we assume that if indifferent, the manager will not offer the bribe). This expression is zero for = 0, onvex in and inreasing as approahes 1 (sine lim C'( ) = ). If the uality of orporate governane γ is suffiiently low and/or the private benefit B is suffiiently large, the funtion Ψ (, γ ) is inreasing for any (0,1], and therefore always positive. In this ase, we are bak to the analysis of the last setion, sine the manager always wants to bribe the auditor. The novel ase to be onsidered here is that of a less severe ageny problem within the lient firm (γ suffiiently high and/or B suffiiently low), so that the funtion 1 Ψ (, γ ) is initially dereasing and then inreasing in. Figure 2 illustrates this ase. It also shows that the manager s inentive to bribe the 12 If this parameter is intended literally as the fration of shares held by the manager, it must be that ase that the manager is not allowed to sell them before the final date in the time line of the model, when the ompany s true value is determined. If the manager ould sell the shares before that date, he would be able to trade on his private information about whether he has bribed the auditor at the expense of other shareholders. Rather than realigning his inentives to those of other shareholders, this sheme would go in the opposite diretion! 13 We assume that whenever Ψ (, γ) is positive, the manager makes a take-it-or-leave-it offer to the onsulting firm to obtain that it issues a positive auditing report. Alternatively, one ould imagine a less extreme bargaining game between the two parties: speifially, the onsulting-auditing firm may offer a disount on MAS in exhange for being allowed not to heat in its auditing report. The largest disount that it ould offer is M f(e)l, of whih the manager of the lient firm would earn a fration γ. For the manager to refuse suh ounter-offer and insist in demanding the fake report, it is suffiient to assume that Ψ (, γ) > γ (M f(e)l), whih an be guaranteed by assuming a suffiiently large private benefit B. 14

16 firm s auditors dereases as the firm s orporate governane improves: the funtion Ψ (, γ ) shifts downward as a result of a parametri inrease in γ (say, from γ 1 to γ 2) for given, as Ψ / γ = Ω ( ) < 0. [Insert Figure 2] These remarks provides the basis to understand how the optimal audit standard must vary as the uality of orporate governane γ hanges. This is illustrated in Figure 3. For low values of γ, the manager s inentive to bribe auditors is so strong that deterring them would reuire an exessive distortion of audit standards away from the seond best. In this ase, the regulator prefers to turn its efforts toward auditors, by inreasing enforement in order to deter them from aepting a bribe. Therefore, for low γ the audit standard is set at the level identified in Setion 4. For higher values of γ, the manager s inentive to bribe auditors is weak, so that it is preferable to set the audit standard at a value that is just suffiient to deter them from offering a bribe, by making Ψ(, γ ) 0, where the supersript n stands for no ollusion. As γ inreases, the hoie of n n n ( γ ) an beome more ambitious sine the manager s inentive to bribe auditors weakens. In this region, the optimal audit standard inreases monotonially in the uality of orporate governane, until it reahes the seond-best level standards and orporate governane are omplements.. In this region, therefore, audit Interestingly, the region where this omplementarity holds is inreasing in the magnitude of the onsulting profits M, whih measures the intensity of the auditor s potential onflit of interest. Intuitively, as the potential bribe rises, it beomes inreasingly diffiult to ontrol the implied onflit of interest by disouraging the auditor from taking the bribe, so that one must disourage the manager from offering the bribe in the first plae. As a result, the parameter region in whih regulation is designed to prevent managers from offering the bribe expands: graphially, the boundary γ 1 between the two regimes moves towards the origin. This is shown in Figure 3, where onsulting profits M are assumed to be small in the top graph and low in the bottom graph. The region where aounting standards are inreasing in the uality of orporate governane is larger in the bottom graph. The graph also shows that in the region to the left of γ 1 an inrease of the onsulting profits M reuire a redution of the audit standard Proposition 3. ( M), in aordane with 15

17 [Insert Figure 3] These results an be summarized as follows: Proposition 4 (Optimal audit standard and orporate governane). The optimal audit standard euals for low values of γ, drops disretely for a ritial value γ 1 and then inreases monotonially in γ up to the seond-best level. The ritial value γ 1 is dereasing in M. Clearly, an even better poliy would be to eliminate the onflit of interest at its root, if this is possible. In the setting of our model, this is ahieved if the government an sever the link between onsulting and auditing ativity, by forbidding auditors to provide MAS. In this ase, the optimal aounting standard would inrease to the seond best level irrespetive of orporate governane. This would be effiient, sine welfare would also inrease. Indeed, this is one of the provisions ontained in the Sarbanes-Oxley At, in response to auditors misbehavior in reent orporate sandals. However, in the next setion we will show that this onlusion has to be ualified if onsulting generates eonomies of sope that lower the ost of auditing., 5. Conflit of interest versus effiieny gains from non-audit servies In priniple, the provision of managerial advisory servies (MAS) by an auditing ompany may improve the uality of its auditing servies, owing to the presene of eonomies of sope between its onsulting and its auditing arm. Indeed, empirial studies have unovered limited evidene of suh eonomies of sope (Simuni, 1984; Palmrose, 1986; Prakesh and Venables, 1993, Antle, Gordon, Narayanmoorthy and Zhou, 2002). To apture this point, we amend the model by assuming that eonomies of sope redue the ost of auditing by a fration θ, with 0< θ 1: the osts to produe audit servies of a given uality beome (1 θ ) C ( ). 14 Sine eah auditing ompany an in priniple provide MAS and exploit the implied eonomies of sope, it will make two separate offers to the lient firm, depending on whether the latter 14 More generally, our results hold if the auditor-onsultant s ost funtion has weakly lower marginal and average values ompared with an ordinary auditor s ost funtion C(). 16

18 purhases only audit servies or a bundle that inludes both audit servies and MAS. In the former ase, the lowest prie that an be harged for the auditing omponent of the pakage is C ( ), while in the latter it is (1 θ ) C ( ). Competition among auditors ensures that these are atually the pries offered in euilibrium to the lient firm. Clearly, this implies that the lient firm will always purhase an audit-um-mas bundle from the same provider. However, the lient firm may still deide to purhase the bundle from the inumbent onsulting firm or from an entrant. The differene between these two options lies in the fat that the inumbent an be bribed by the lient firm beause it an earn a profit M from the sale of MAS, while entrants annot, as assumed in the previous setion. Now onsider that the regulatory ageny has two ways of avoiding that aountants file a false report: one is by forbidding altogether the provision of MAS by auditors; the other is by setting an auditing standard and a level of enforement that deter heating. If regulation allows bundling, lient firms will enjoy the implied effiieny gains, but they may have the inentive to bribe their auditor, and the regulator must deide how to prevent it. As explained in the previous setion, the regulator an do so either by disouraging the auditor from taking the bribe or by disouraging the manager of the lient ompany from offering it. Formally, the first strategy onsists of maximizing the objetive funtion (8), subjet to onstraints (10) and (15), replaing everywhere C ( ) with (1 θ ) C ( ). This strategy results into an audit standard ( M, θ ), whih is dereasing in M (as before), inreasing in θ (as lower osts improve the objetive funtion and relax both of its onstraints). In Figure 4, this audit standard is a onstant as before, sine it does not depend on the uality of orporate governane γ. The seond strategy instead onsists of maximizing the objetive funtion (8), subjet to onstraints (10), (11) and Ψ(, γ ) 0, again replaing everywhere C ( ) with (1 θ ) C ( ). This n strategy results into an audit standard ( γ, θ ), that is inreasing in γ and in θ : better governane allows higher audit standards (as before), and so does greater ost effiieny in auditing. As shown in Figure 4, the resulting audit standard rises with γ, until it ahieves the seond-best level ( θ ). Alternatively, the regulator an hoose a third strategy: forbidding bundling altogether, and forgoing the implied effiieny gains. Then the problem reverts to that of Setion 2, and the resulting aounting standard beomes simply the seond-best level Setion 4. This is below the new seond-best, as stated at the end of ( θ ), based on a more effiient audit tehnology. 17

19 Whih of these three strategies maximizes soial welfare depends on the magnitude the onsulting profits M and of the effiieny gain θ. Figure 4 illustrates the two possible ases. The top graph portrays a situation in whih the profits from onsulting are low and eonomies of sope are high, so that the onflit of interest is less important than the effiieny gain from bundling. As a result, the regulator will not want to forbid bundling of auditing and onsulting servies, and the optimal audit standard will be that indiated by the solid line in the graph. The hoie of strategies by the regulator will be similar to that seen in Figure 3: for low values of the orporate governane uality γ, the regulator will hoose the first strategy ( M, θ ), and for higher n values it will swith to the seond strategy ( γ, θ ). It an be shown that in this ase the regulator an hoose a more ambitious standard by disouraging auditors from aepting bribes than by forbidding bundling altogether: ( M, θ ) >. The lower graph in Figure 4 portrays the opposite situation: high profits from onsulting and low eonomies of sope, so that the onflit of interest is more important than the effiieny gain from bundling. In this ase, the third strategy forbidding bundling turns out to be optimal at least for suffiiently bad orporate governane: this happens when γ < γ ' in the figure. In this region, managers will tempt their auditors with a very large bribe M, so that the standard that would deter auditors from aept the bribe would be very low and very expensive to enfore. As a result, it is more effiient to sever the link between onsulting and auditing ativity, and forgo the assoiated effiieny gains. Only for better orporate governane, it beomes possible to allow bundling, as in the previous ase. So another payoff of a better orporate governane beside that of higher audit standards is that it allows to exploit the potential eonomies of sope in auditing and onsulting. These points are summarized in the following proposition: Proposition 5 (Optimal poliy with onflit of interest and eonomies of sope). (i) For M suffiiently low and θ suffiiently high, it is optimal to allow bundling of audit and onsulting, and hoose an audit standard that euals ( M, θ ) for low values of γ, drops disretely for a ritial value γ 1 and then inreases monotonially in γ up to the seond-best level ( θ ). (ii) For M suffiiently high and θ suffiiently low, it is optimal to forbid bundling of audit and onsulting if γ is below a ritial value γ '. In this region, the optimal audit standard euals. At 18

20 this ritial value the seond-best level γ ', the standard drops disretely and then inreases monotonially in γ up to ( θ ). 6. Related literature Our analysis fouses on regulation and publi enforement as the only devie to temper ageny problems in auditing as well as the possible ollusion between auditors and lient ompanies. However, alternative mehanisms have been used or proposed in the literature in order to orret these problems: self regulation assisted by litigation-based enforement, reputational mehanisms, ertifiation by intermediaries, finanial statements insurane insurane, whistleblowing, et. In this setion we do not analyze all these alternative mehanisms in detail: we simply attempt to ompare them to the analysis of regulation and publi enforement performed in this paper. As mentioned in the introdution, until reently the standards of the U.S. auditing profession have been set through self-regulation and have been enfored via litigation. The reent orporate sandals have highlighted the weaknesses of this speifi mehanism. At least two reasons for this failure an be identified. First, the mounting litigation osts of the 1980s led the self-regulating US auditing profession to seek on safe harbor rules to defend themselves more easily against litigation. As a result, attention shifted towards formal ompliane with aounting rules, and away from the eonomi ondition of ompanies, thus reduing the intrinsi uality of aounting information. 15 Seond, the reliability of audit ompanies has been tarnished by the inreasing onflit of interest between their audit role and their onsulting role, as the share of onsulting fees kept inreasing in their revenues. Of ourse, even in a system of publi regulation, enforement an be entrusted to litigation rather than to the intervention of the regulator, as postulated in our model. The limitation of this form of enforement is that the osts of suing auditors may deter dispersed investors from taking ation against violations of suh rules, due to olletive ation problems. Reputation is another deentralized mehanism that might enhane the reliability of auditors, espeially onsidering the limited number of ative auditing firms, the repeated nature of their interations with lient firms and investors, and espeially the large stakes represented by the auditors euity base. In priniple, this mehanism ould be effetive, but in pratie it appears not 15 This is reminisent of the point by DeMarzo, Fishman and Hagerty (2001), that a self-regulatory organization aountable to its members tends to hoose laxer enforement than ustomers would. 19

21 to have deterred negligent or fraudulent behavior so extensive as to bring to their heels established ompanies suh as Arthur Andersen. Even though the reasons why reputation has been ineffetive are still unlear, its limitations suggest that it needs to be omplemented by regulatory intervention. Other mehanisms that have been reently analyzed in the literature are: (i) the reation of an intermediary that ertifies the uality of privately produed information (Lizzeri, 1999); (ii) a finanial statement insurane (FSI) sheme, by whih ompanies would purhase insurane that provides overage to investors against losses due to misrepresentation in finanial reports (Dontoh, Ronen and Sarath, 2004); and (iii) whistleblowing mehanisms, by whih a party is given a finanial inentive to report opportunisti behavior by another party, by entitling the former to a portion of the penalty paid by the latter (Buirossi and Spagnolo, 2001). Eah of these mehanisms may have some merit taken alone or in onjuntion to realign the inentive of auditors to truthtelling. However, they all have some weakness in the presene of extensive ollusion: both a ertifiation intermediary and an insurane ompany providing FSI might ollude with the lient firm, just as well as the auditors ould; and whistleblowing would hardly be appliable to the tait exhange of favorable audits against onsulting ontrats, whih are formally legal. This undersores the importane of publi regulation and enforement as residual mehanisms to disipline the auditing profession. 7. Conlusion The reent orporate sandals have highlighted the need for tighter regulation of the audit profession. However, one it is reognized that the enforement of suh regulation is ostly, three important lessons an be drawn onerning the optimal standards to be imposed on auditors. First, audit uality standards must be based on a ost-benefit analysis of audit ativity. On the ost side, they must be less ambitious in eonomies that are poorer and have less effiient enforement. On the benefit side, they must be tighter in eonomies where investments are riskier and where the typial size of projets is larger. Seond, regulatory standards must be less ambitious when auditors an ollude with the managers of lient ompanies at the expense of shareholders, beause defleting the potential for ollusion reuires more intensive and therefore ostlier enforement. 20