The Economics of Setting Auditing Standards

This paper develops a theory of the negotiating positions, or preferences over auditing standards, of the interest groups that may set such standards. Specifically, we consider how the preferences of auditors as standard setters may differ from the preferences of investors. We represent auditing standards by two properties: toughness and vagueness. Toughness is the level of audit effort required by the standards. Vagueness is the uncertainty of audit effort levels that could be considered by different parties as “in compliance” with the standards. Our model predicts that auditors and investors would consider both toughness and vagueness in influencing or setting auditing standards, since preferences over vagueness depend on the level of toughness. We model the market as composed of auditors with different wealth levels and investors with various investment projects and optimal standards will vary across these parties. We show that as a result of such tensions, auditing standards with a degree of vagueness are preferred. By analyzing the economic incentives of different potential standard setters, we help explain how auditing standards have developed in the real world and lay out the foundation for future research on the standards