The Impact of the Public's Expectations of Auditors on Audit Quality and Auditing Standards Compliance*

Abstract

responsibilities. McEnroe and Martens (2001) find that investors have higher expectations for various aspects of assurance of audits than do auditors.Despite the discouraging results of past efforts to eliminate the audit expectations gap, a belief that closing the gap is important to the accounting profession is still widespread. In fact, this belief appears to have strengthened and become more pervasive after recent accounting scandals (for example, Enron) and the emergence of new regulations (for example, the Sarbanes-Oxley Act of 2002). An article in the New York Times (Glater 2003) reported that PricewaterhouseCoopers planned to close the audit expectations gap by conducting better, more thorough, and more detailed audits. Before the accounting profession exerts further effort to reduce the audit expectations gap, it behooves the profession to understand the impact of the public's expectations on audit quality and auditing standards compliance. This study analyzes the impact of the public's expectations using an economic model characterized by costly trials and pretrial settlements.In the model, an auditor is a strategic player with respect to audit effort and pretrial settlement, and investors are strategic players with respect to a court trial. If the auditor fails to detect material accounting misstatements in a firm's financial statements, the firm and the investors suffer a loss. After investors suffer a loss, they negotiate with the auditor for a settlement. If the auditor and the investors fail to reach a pretrial settlement, the investors decide whether to take the case to court, which may entail a costly trial. In the model, the public's expectations can affect audit quality through influencing courts' decisions, 4 and the significance of the public's expectations on court decisions can range from no influence at all to complete influence. The cost of trials plays a crucial role in the paper's analysis. When trials are costly, investors will not litigate if the expected gain from a trial is lower than their share of the trial cost. Consequently, auditors will not always meet the public's expected level of quality.The model in this paper is built on Hylton 1990 and Zhang and Thoman 1999. Similar to Hylton 1990, in this model, legal uncertainty exists and auditors take action to minimize expected total costs (including legal costs). The primary difference between this paper and Hylton's paper is one of purpose. My intent is to model how public expectations of auditors affect audit quality and auditing standards compliance, while Hylton considers how legal errors affect compliance. In Hylton, the level of due care is fixed and legal errors are not affected by the defendant's effort, while in this study legal uncertainty exists only if the level of audit quality lies between auditing standards and public expectations. More importantly, auditing standards are a state variable in this study and auditors do not consistently comply with standards if they are unreasonably low or high.Studies that establish t...

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