The Effects of Mandated versus Voluntary Auditing Policy on the Quality of Auditing

Abstract

In this paper, I develop a formal model of the auditing market that is useful in predicting the economic consequences of the Securities Acts of 1933-34. The demand side of the market I study consists of a large number of firms, and the supply side consists of two auditors who compete in quality and price. I use the model to examine the impact of certain regulatory actions on (1) the quality of the auditing that each auditor chooses to offer, (2) the quality of the auditing that each firm chooses to undergo, and (3) welfare related variables. In particular, the following results are obtained. Under all regulatory regimes the auditors choose to differentiate their audits by quality. Relative to an unregulated market, the mandating of auditing widens the disparity between the qualities by inducing an improvement in the high-quality audit and a degradation in the low-quality audit; as a result, some firms undergo more effective auditing (including those firms which switch from the low-quality auditor to the high-quality auditor), whereas some firms undergo less effective auditing. These results are helpful in assessing the costs and benefits of the Securities Acts of 1933-34.