The Joint Effects of Multiple Legal System Characteristics on Auditing Standards and Auditor Behavior

Abstract

This paper derives the impacts of legal system characteristics and auditing standards on auditor behavior (audit quality), and analyzes the determination of optimal auditing standards under different legal regimes. Legal regimes are characterized by differences in the uncertainty concerning the outcome of legal proceedings (termed vagueness of legal systems) and differences in the average size of damage awards. Auditing standards as determined by standard setters can vary in both toughness and vagueness. Our analysis provides implications for the adoption of International Standards on Auditing (ISA). Countries, such as the United States, where auditor legal liability is significantly more onerous than the global norm are not likely to adopt ISA, since these standards may not induce auditors to provide the optimal level of audit quality. Conversely, the adoption of ISA by countries, such as China, where the legal system makes the recovery of damages from auditors quite difficult, is not by itself likely to result in a high level of audit quality. Furthermore, our model suggests that auditor rotation can help improve audit quality, but only in certain circumstances.Les r epercussions conjointes des caract eristiques des r egimes juridiques multiples sur les normes d'audit et le comportement des auditeurs r esultat des proc edures judiciaires (ce que les auteurs appellent l'impr ecision des r egimes juridiques) et a l'ampleur moyenne des dommages-int erêts accord es. Les normes d'audit etablies par les normalisateurs peuvent varier sur le plan de la rigueur et de l'impr ecision. L'analyse des auteurs nous renseigne sur les cons equences de l'adoption des Normes internationales d'audit. Les pays comme les Etats-Unis, o u la responsabilit e civile de l'auditeur est sensiblement plus lourde que dans la norme mondiale, ne sont pas susceptibles d'adopter les normes internationales d'audit, puisque ces normes risquent de ne pas inciter les auditeurs a offrir une qualit e optimale d'audit. Inversement, l'adoption des normes internationales d'audit par des pays comme la Chine, o u le syst eme juridique complique passablement le recouvrement de dommages-int erêts aupr es des auditeurs, n'est pas en soi susceptible d' elever la qualit e de l'audit. En outre, le mod ele que proposent les auteurs semble indiquer que la rotation des auditeurs peut contribuer a am eliorer la qualit e de l'audit, mais uniquement dans des circonstances donn ees.

Adoption of International Standards on Auditing (ISA): Do Institutional Factors Matter?

“…In this respect, both Zeghal and Mhedhbi () and Leuz () express doubts on the accounting convergence process, whether in developed or developing economies. In contrast, there has been little research on the adoption and/or degree of commitment to auditing standards, and specifically the case of international standards on auditing (ISAs) (Needles et al, ; Ye & Simunic, ; Simunic, Ye & Zhang, ), in spite of the fact that ISAs are considered to be one of the key standards for sound financial systems by the Financial Stability Board (FSB) alongside IFRS. According to Simunic et al ():

Audits are performed to improve the validity and reliability of information produced in compliance with a set of accounting standards, and auditing standards provide a measure of audit quality and articulate the objectives to be achieved in an audit (p. 4).

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“…Other forms of adoption admittedly also communicate a commitment, inclusive of countries that have so far only stated an intention ‘on paper’ to adopt ISAs, but our contention is that the different classifications of adoption represent varying forms of ‘obligation’ or engagement to ISAs. Furthermore, Simunic et al () contend that traditionally, how national auditing standards were developed and enforced tend to reflect a country's business environment and legal systems, but the authors assert that recently more countries have tended to adopt a more uniform set of standards, and in particular, it is predicted that ISAs will be adopted (with or without modifications) by countries with similar legal characteristics. However, to date, there has been no empirical validation of such predictions, and more importantly in our view, Simunic et al () do not consider the relevance of other non‐legal national characteristics that might lead to different forms of commitment to ISA adoption.…”

“…Furthermore, Simunic et al () contend that traditionally, how national auditing standards were developed and enforced tend to reflect a country's business environment and legal systems, but the authors assert that recently more countries have tended to adopt a more uniform set of standards, and in particular, it is predicted that ISAs will be adopted (with or without modifications) by countries with similar legal characteristics. However, to date, there has been no empirical validation of such predictions, and more importantly in our view, Simunic et al () do not consider the relevance of other non‐legal national characteristics that might lead to different forms of commitment to ISA adoption. The above discussion thus raises two related questions:

First, what are the factors that have influenced national ISA adoption, and second, to what extent do these factors explain the different levels of commitment or engagement with ISA as defined by the IFAC?

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“…First, an understanding of the extent of commitment to ISA adoption cross‐nationally and the determinants of such engagement can enlighten one's understanding of the national factors influencing the spread (or not) of global auditing standards. Recent work by Humphrey, Loft and Woods (), Humphrey and Loft () and Simunic et al () have revealed how ISAs have gained prominence within the international financial architecture (Humphrey et al, , p. 811), which is controlled by the ISA issuer (International Federation of Accountants; IFAC), international financial regulators (such as International Organisation of Securities' Commissions; IOSCO) and large audit firms. Anecdotally, the World Bank's Reports on the Observance of Standards and Codes (ROSC) indicate that (1) many countries' auditing standards are not in line with ISAs, (2) even amongst those countries that have implemented ISAs, full compliance has not occurred mainly due to the lack of qualified professionals, adequate education and training, and enforcement (see also Kohler, ).…”

Comments of the Auditing Standards Committee of the Auditing Section of the American Accounting Association on Proposed Statement on Standards for Attestation Engagements, Amendments to the Description of the Concept of Materiality

“…While the Proposal appears to be a reversal of these efforts, there may be legitimate reasons for differences in auditing standards among countries. Simunic, Ye, and Zhang (2017) propose a country's optimal auditing standards (degree of toughness and vagueness) is dependent upon its legal regime and mandatory rotation policies.…”