A Model of Auditing Under Bright-Line Accounting Standards

Abstract

This paper models auditors' preferences for bright-line financial reporting standards. Bright-line standards are unambiguous, requiring no judgment in their application. We characterize bright-line standards as one end of the continuum in the trade-off between relevance and reliability. We formally model two attributes of relevance and reliability as identified in Statement of Financial Accounting Concepts No. 2: the representational- faithfulness dimension of reliability and the predictive-value dimension of relevance. Also, we distinguish these two dimensions of financial reporting standards from the information economics concept of fineness.

The model allows auditors to vary in their financial reporting expertise. All auditors have a basic role to verify the accuracy of the financial statements. “Expert” auditors also fill an interpretation role. If financial reporting standards are not bright-line, expert auditors can use their financial reporting expertise to help generate a report that investors will understand.

We show how our three dimensions of reporting standards affect the audit market. We find that auditors' preferences for bright-line standards depend on whether auditor expertise is observable to investors. Comparing standards of the same level of detail and relevance, if expertise is observable, expert auditors prefer standards that are not bright-line, whereas auditors without such expertise prefer bright-line standards. If investors cannot observe auditor expertise, all auditors prefer bright-line standards, and the average level of auditor expertise increases under bright-line standards.