Auditors' skill, auditing standards, litigation, and audit quality

This paper introduces a model of the market for audit services in which auditors differ in their levels of skill, which may or may not be observable and capture differences in ability. The model captures the interplay amongst auditing standards, litigation, and auditors’ levels of skill, which determines auditors’ responses to auditing standards. The paper shows that the quality of audit supplied by any auditor is increasing in the auditor's level of skill regardless of whether or not auditors’ levels of skill are observable. An increase in the quality of audit prescribed by auditing standards is shown to induce some auditors endowed with low levels of skill to decrease the quality of their audits so that the average quality of audit and economic welfare may actually decline as auditing standards are raised. Auditors’ choices of audit quality are furthermore shown to be increasing in trial awards. Incentives for trials and out-of-court settlements are shown to depend crucially on whether or not auditors’ levels of skill are observable. Only when auditors’ levels of skill are unobservable do trials obtain with some probability. When auditors’ levels of skill are unobservable, the introduction of either restrictions on costs awarded by the courts or an imperfection in the courts’ technology is shown to lead the most skilled auditors to supply audits of a quality strictly exceeding the quality prescribed by the prevailing auditing standards. When the courts err often enough, the most skilled auditors having exercised due care furthermore make offers to settle when sued.