Willekens , M.

English

Research Papers in Economics

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Economic aspects of audit regulation and auditor liability
Marleen Willekens a
a University of Warwick, Warwick Business School, UK
Online Publication Date: 01 January 1996
To cite this Article: Willekens, Marleen (1996) 'Economic aspects of audit regulation
and auditor liability', European Accounting Review, 5:4, 765 - 767
To link to this article: DOI: 10.1080/09638189600000047
URL: http://dx.doi.org/10.1080/09638189600000047
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Doctoral section  765 
practice is  specially significant in  the case of  option premiums, valuation 
criteria and the accounting treatment of  hedging strategies. 
NOTES 
The thesis supervisor was Professor Dr  Vicente Condor. The thesis was accepted in 
May  1995  and  is  written  in  Spanish.  Address  for  correspondence  or  more 
information:  Departamento  de  Contabilidad  y  Finanzas,  Gran  Via  2,  50.005 
Zaragoza, Spain. 
Economic aspects of  audit regulation 
and auditor liability 
Marleen Willekens 
University of Warwick, Warwick Business School  (UK) 
The dissertation provides a micro-economic analysis of audit regulation and 
auditor liability. The analysis draws on insights from the economics and law 
literature  that  liability  and  regulation  are  alternative  policy  instruments 
available to governments to monitor behaviour of  individuals and organiza- 
tions.  In  the  auditing  context, both  instruments are  used  and  they  affect 
demand  for  and  production  of  audit  services.  Liability  is  established by 
common law and/or by statute since (in most countries at that time) financial 
statcmcnt issuers and  auditors are jointly  and severally liable for economic 
losses  to  uscrs  due  to  negligently  prepared  and/or  audited  financial 
statcments. Auditing related regulations are the mandatory audit requirement 
for somc classes of firms which affects audit demand, and professional audit 
standards which put a constraint (lower bound) on the required quality of the 
audit service produced. 
Over the past years the outstanding claims against public accounting firms 
have risen exponentially, especially in the USA, but also in Australia, the UK 
and other countries. As a result audit firms claim to be used as deep pockets 
(insurers) for  business failures. Lobbies to  change the legal framework in 
which the auditor operates and to restrict auditor liability have emerged. At 
the same time, the quality of  auditing has been under much public scrutiny, 
with allegations at the address of  the profession of producing audit services 
below acceptable quality. A popular suggestion has been to increase the audit 
quality standards. However, in  the  auditing context little formal economic 
analysis exists of  the  impact of  liability rules and regulations. Without  an D
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766  The European Accounting Review 
understanding of  the effects, it is difficult to address the auditing crisis, and 
to assess whether legal and regulatory changes are indeed necessary and if so, 
what  they  should  look  like.  The  dissertation  attempts  to  address  this 
caveat. 
The  dissertation  is  organized  in  two  parts.  Part  I  of  the  dissertation 
includes critical reviews of  the  literature in  areas that  are relevant  to the 
subject:  auditor risk,  economics of  auditing, audit regulation  and  auditor 
liability. Part I1 incorporates analytical chapters which are associated with the 
formal economic analysis of  the impact of liability and regulation on audit 
demand and production, and are the proposed contribution of  the author to 
the auditing literature. Throughout the analytical part of the dissertation the 
focus is on the vagueness (ex anle uncertainty) of  what constitutes 'due care' 
for  company  directors  when  preparing  the  financial  statements, and  for 
extcrnal auditors when certifying these statements, and the impact thereof on 
audit demand and production. In the 'unrealistic' case where due care would 
be known with certainty (which would be the case should due care standards 
bc  clearly  specified in  the law) both  directors and  auditors would  always 
comply with their respective due care standards, unless these standards would 
be  extrcmely  high.  The  analysis  shows  that  the  level  of  vagueness 
(uncertainty) about due care crucially affects financial statement and audit 
quality, and sometimes in  unexpected ways. 
A  first contribution of  the  thesis  is  the  analysis of  the joint  impact of 
auditor liability and professional audit standards on audit quality production 
in  a  framework  of  vagueness  about  auditor  negligence  standards.  The 
analysis of  audit quality production is general, in the sense that a number of 
alternative  legal  scenarios  are  considered, and  therefore  hopes  to  be  of 
relevance  to  various  legal  environments. A  number  of  propositions about 
audit  quality  production for  alternative  legal  scenarios (with  and  without 
restrictions on liability) are derived, and a set of  corollaries about the social 
cfficicncy of  these scenarios are drawn. Some major conclusions from the 
analysis are that a decrease in vagueness in auditor negligence standards may 
have a positive effect on audit quality, but could also have a negative effect, 
depending on how vague the original negligence standard was. Professional 
audit standards always have a positive effect on audit quality, given that they 
are  written such that  they change auditor beliefs,  whereas mechanisms  to 
restrict auditor liability have a negative effect on audit quality. The latter may 
however promote socially efficient auditing behaviour  in situations where 
thcrc  is  overproduction of  audit  quality.  Finally, the joint  use  of  liability 
restriction mechanisms and the introduction of  additional professional audit 
standards may  lead to  a status quo in  terms of  audit quality produced and 
may  therefore not be  welfare improving. 
A second contribution to the economics of  auditing literature is a formal 
analysis of the 'liability avoidance' (insurance) hypothesis for audit demand. 
The problem is modelled  in  a leader-follower framework, where company D
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Doctoral section  767 
directors  are the  central  actor  or  the  leader  who  conjecture the  external 
auditor's (who is the follower) quality production behaviour before making a 
decision on demand. From  the  analysis, propositions  about  the director's 
demand for financial statement quality and related external auditing services 
are derived, given the liability rules applying to them  and to the auditors. 
Propositions  about  the  effectiveness of  mandatory  audit  requirements  in 
safeguarding an  acceptable  level  of  financial  statement quality  are  also 
derived. Some major conclusions from the analysis are that vagueness about 
thc  duc  care  standard  for  auditors  (and  hence  audit  quality  production 
bchaviour) does not  affect the director's  demand decision (and  hence that 
'liability avoidance' rationales for audit demand are irrelevant) if the due care 
lcvcl for directors is not too vague. Further, mandatory audit requirements are 
only  erl-cctive  in  safeguarding  an  acceptable  level  of  financial  statement 
quality under limited circumstances (for example, when due care levels are 
certain). 
NOTES 
Thc  disscrtation  supervisor  was  Professor  Anthony  Steele.  The dissertation  was 
dcfcndcd on 27 January 1995. Thc address for correspondence is: Catholic University 
Leuvcn, Naamsestraat 69, 3000 Leuvcn, Belgium. 

Economic aspects of audit regulation and auditor liability.

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