Optimal Auditing Standards

We study regulation of the auditing profession in a model where audit quality is unobservable and enforcing regulation is costly. The optimal audit standard falls short of the first-best audit quality, and is increasing in the economy’s wealth, in the riskiness of firms and in the amount of funding they seek. The model can encompass collusion between clients and auditors, arising from the joint provision of auditing and consulting services: deflecting collusion requires less ambitious standards. The optimal audit standard depends also on the corporate governance of client firms: audit standards and corporate governance are complements. Finally, banning the provision of consulting services by auditors eliminates collusion but may not be optimal in the presence of economies of scope. JEL classification: G28, K22, M42