The Economics of Setting Auditing Standards∗

ABSTRACT: This paper develops a theory of the negotiating positions, or preferences over auditing standards, of the interest groups that may set such standards or negotiate changes in standards. We represent auditing standards by two properties: toughness and vagueness (or lack of precision). Our model predicts that auditors and investors would consider both toughness and vagueness to influence or set auditing standards (e.g., preference over vague-ness depends on the level of toughness.) Since the market is composed with auditors with different wealth and different investment projects, the optimal level of standards would be different for these parties. Therefore, in general, auditing standards with a certain level of vagueness is preferred. By analyzing economic incentives in the process of setting auditing standards, we help explain how the standards have developed into their current form. ∗We greatly appreciate the advice from Kin Lo, Hugh Neary, and Sandra Chamberlain. An earlie