Escolar Documentos
Profissional Documentos
Cultura Documentos
'
0
t
{(1-t) (E[X | r
m
v
] - Var(X | r
m
v
)) + t (E[X | r
m
i
] - Var(X | r
m
i
))}j(t)dt.
23
This is the price of the firm given that t' is the expertise of the last auditor hired. The proof to Proposition 2
shows that for j(t) uniform on [0, 1], an equilibrium exists if u
v
< V
v
, and it is unique if u
i
> (V
i
- V
v
). Proposition
2 examines auditors' preferences over reporting standards in this setting.
Proposition 2 (Auditor Expertise Unobservable): Assume auditors' reservation utilities are invariant to changes
in reporting standards.
A) Auditors of all levels of expertise prefer both finer and harder reporting standards.
B) The equilibrium level of auditor expertise increases in both the fineness and hardness of reporting
standards.
The intuition for Proposition 2 is that when investors cannot observe the auditors expertise, managers
pay all auditors the same market wage. Hence, the opportunity for one type of auditor to gain a competitive
advantage over another type is lost. An increase in standard fineness makes all auditors more valuable, and so is
preferred by all auditors. An increase in standard hardness makes auditors of expertise t < 1 more valuable,
without affecting in absolute terms the value of the most expert auditor. Since all auditors hired benefit from the
increase in the value of low-type auditors, harder standards are also generally preferred. Taken together,
Propositions 1 and 2 imply that investors' ability to differentiate among auditors is crucial for predicting auditors'
preferences over changes in financial reporting standards.
We now compare the preferences of auditors to the preferences of managers and regulators, when
auditor expertise is unobservable. The objective functions of managers and regulators are the same as in the
previous section, except that since auditor expertise is unobservable, managers and regulators maximize their
objective functions on an expected value basis. Managers wish to maximize
( ) [ ]
i i v v t
m
u V u V w r P E , , , | * *
*
.
where the * indicates the equilibrium level of price, auditor type, and auditors wage. Regulators wish to
24
maximize
( ) [ ] [ ] [ ] ( ) [ ]
i i v v t
m
i i v v t
u V u V r X Var X Var E u V u V d h V E , , , | , , , | ,
* *
.
Given these objective functions, the preferences of managers and regulators for bright-line reporting standards
can be characterized as follows.
Corollary 2 (Managers and Regulators Preferences for Bright-line Standards when Auditor Expertise
is Unobservable): Suppose the conditions of Proposition 2 hold.
A) Managers are indifferent to the level of standard hardness.
B) Regulators prefer harder standards.
Proposition 2 shows that the equilibrium level of auditor expertise increases in standard hardness.
Corollary 2 shows that regulators prefer harder standards because increasing the equilibrium level of auditor
expertise increases both the average and the total expected value of the audited reports. Managers are indifferent
to the hardness of standards because managers hire auditors at the marginal auditors reservation wage, which
ensures that all rents go to the auditors hired (except the marginal auditor, who receives no rents). As is true with
auditors preferences, we find that whether auditor expertise is observable is critical in determining the
preferences of managers and regulators for bright-line reporting standards.
4. SUMMARY AND DISCUSSION
This paper has examined how two characteristics of reporting standards affect the value of auditing.
These characteristics are the extent to which reporting standards are bright-line, and the amount of detail that
reporting standards require. With respect to the bright-line criterion, when the auditors level of expertise is
exogenous, the value of the basic auditor increases under bright-line standards relative to soft standards. For the
auditor with financial reporting expertise, the value of this expertise relative to the auditors basic verification role
25
decreases under bright-line standards.
When auditors of different levels of expertise compete in the audit market, results depend on whether
investors can observe auditor expertise. If investors can observe the auditor's expertise, basic auditors prefer
bright-line standards and expert auditors prefer soft standards. If investors cannot observe the auditor's expertise,
all auditors prefer bright-line standards, and the average level of auditor expertise increases under bright-line
standards. The relative descriptive validity of these two alternative assumptions about the observability of auditor
expertise is an open question. For example, in his testimony to Congress, Berardino stated: The vast majority of
[Andersens employees] had nothing to do with Enron. These talented and dedicated people serve clients every
day, offering the highest quality work, delivered with integrity, objectivity and skill. They know it; our clients
know it. Hence, Berardino says that auditor expertise is observable (at least to client management), but his
remarks beg the question of whether the quality of the Enron audit was observable to investors.
With respect to the level of detail required by reporting standards, results show that if the auditors
financial reporting expertise is exogenous, the value of audits performed by auditors of all levels of expertise
increases in the amount of detail. When expert and basic auditors compete in an audit market in which the
auditors expertise is unobservable, all auditors prefer more detailed reporting. If the auditors expertise is
observable, results are ambiguous and depend on the parameters of the model.
We also examine managers and regulators preferences for bright-line standards. We find that their
preferences also depend on whether auditor expertise is observable. If auditor expertise is observable, managers
prefer harder standards if auditors are in excess supply and expert auditors are relatively more valuable, but
managers are otherwise indifferent. Regulators may prefer either harder or softer standards, depending on
whether auditors are in excess demand or supply, and on how changing standards changes the relative value of
each auditor. If auditor expertise is not observable, regulators prefer harder standards, and managers are
indifferent.
Our framework for relating auditor expertise to reporting standards may add to an understanding of
26
certain institutional features of the auditing profession, and recent trends. Increased auditor litigation might reflect
increasing importance of the auditor's interpretation role. If auditors are perceived as providing a verification
function only, courts might acquit auditors when financial statement estimates prove materially incorrect, as long
as management's estimate was reasonable ex ante and the auditor satisfied GAAS. This scenario suggests a due
diligence legal regime. On the other hand, if auditors are viewed as providing an interpretation function to help
ensure that financial information is properly interpreted by investors, then any incorrect inference by investors
indicates an audit failure. This scenario suggests a strict liability regime.
The extent of bright-line reporting varies by industry. Some industries are characterized by the existence
of significant intangibles and contingent liabilities. For example, chemical and pharmaceutical companies face
substantial litigation risk in connection with their products, and many natural resource companies face large
environmental liabilities. The audit of these companies requires expert judgment regarding the valuation of
contingent liabilities. Applicable GAAP for other industries is primarily bright-line, in which case the auditor's role
is almost entirely one of verification. This might describe a mutual fund in equity securities, or a law or
accounting firm for which most economic assets are off the balance sheet.
Changing circumstances in an industry affects the relative importance of the auditor's two roles. Prior
to the savings and loan crisis of the 1980s, audits in the thrift industry were often viewed as routine and low risk.
Interest rates were stable, competition from other financial-sector institutions was minimal, and collateral was
usually adequate; as long as client management was honest, little could go wrong. The savings and loan crisis
arose primarily from the emergence of significant valuation issues caused by changing interest rates and real estate
prices, and competition from deregulation. Hence, the circumstances that led to the crisis also created a demand
for the auditor's interpretation role in an industry in which auditors were accustomed to providing verification
services. Some auditors appear to have been caught unprepared by this shift in required expertise. Enron provides
another example of a company in changing circumstances, due to the nontraditional methods Enron management
developed to conduct business and structure transactions in the natural resources industry.
27
The importance of the auditor's interpretation role can be compared across reporting regimes. Reporting
standards in different countries can be ranked according to the extent to which they are bright-line. For example,
reporting regimes that require expensing of research and development costs have harder standards with respect
to these costs than regimes that allow capitalization. Reporting standards in Mexico require adjustments for
inflation, including revaluation of plant and equipment to current cost. This is a softer standard than U.S. GAAP.
In reporting regimes with softer standards, valuation is a more important part of the auditor's role. This might be
reflected in the auditors training, the evaluation of client risk, and the nature of auditor litigation.
Finally, changes in reporting standards can affect the relative importance of the auditor's verification and
interpretation roles. Some recent pronouncements by the Financial Accounting Standards Board can be viewed
as softening the reporting process in order to provide more relevant information to users. These include SFAS
No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and SFAS No. 123,
"Accounting for Stock-Based Compensation." Financial statement and footnote disclosure of these items require
subjective accounting estimates, increasing the importance of the auditor's interpretation role. Our results suggest
that expert auditors are more likely than basic auditors to support such pronouncements. These results are
consistent with Berardinos testimony: We must transform . . . the ways in which companies report their
financial results. . . . Many participants in the system have lots of crucial information about companies . . .. We
auditors have certain of that information . . .. But this crucial information is simply not communicated to the
public.
28
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(Spring): 43-59.
_____. 2002. Representational Faithfulness in Accounting: A Model of Hard Information. Working paper,
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Mautz, R.K. and H.A. Sharaf. 1961. The Philosophy of Auditing. Sarasota, FL: American Accounting
Association.
Melumad, N. and L. Thoman. 1990. On Auditors and the Courts in an Adverse Selection Setting. Journal of
Accounting Research 28 (Spring): 77-120.
Moonitz, M. 1974. Studies in Accounting Research #8: Obtaining Agreement on Standards in the Accounting
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Titman, S. and B. Trueman. 1986. Information Quality and the Valuation of New Issues. Journal of
Accounting and Economics 8: 159-72.
U.S. House. 2002. Committee on Financial Services. Subcommittee on Capital Markets, Insurance, and
Government Sponsored Enterprises. Hearing on the Enron Matter. February 5, 2002. Remarks of
Joseph F. Berardino; Managing Partner Chief Executive Officer, Andersen Worldwide.
www.house.gov/financialservices
31
Table 1: Notation
. The set of states of the world.
X x X. A random variable denoting the firms net cash flows; this represents the pay-off relevant
information to investors. X has a finite number of elements denoted x
n
, n = 1, . . ., N. |X| = N where
|| denotes the cardinality operator.
t t {v, i}. The type of auditor. v (i) is a basic (expert) auditor. We sometimes assume t [0,1].
j(t) The density function of auditor types, when t [0,1].
R
v
r
m
v
R
v
. The information contained in the basic audit report, where |R
v
| = M N, m = 1, , M.
R
i
r
m
i
R
i
. The information contained in the expert audit report, where |R
i
| = M N, m = 1, , M.
r
0
Information contained in the unaudited report, used as a benchmark.
f( ) The joint probability density function over , and hence, defined also over X, R
v
, and R
i
.
F( ) The cumulative density function over , and hence, defined also over X, R
v
, and R
i
.
d d [0,1]. The level of detail (i.e., fineness) of the reporting standards.
h h [0,1]. The extent to which reporting standards are hard (bright-line) or soft.
= (h, d). Reporting standards: each defines a probability distribution f(x, r
v
(), r
i
()).
The price of risk.
V
t
V
t
(d, h) = (Var[x] - E[Var[x|r
t
]]). This is the value of auditing.
w
t
The equilibrium wage paid to an auditor of type t.
u
t
The reservation utility of an auditor of type t.
32
APPENDIX - PROOFS
This Appendix provides the proofs of all results. We begin by providing formal statements of Assumption A1 and
the definition of relative hardness, and the derivation of the price of the firm.
Assumption A1 (Anchor Sets): Assume there exists a subset of , denoted T, having N elements t
n
,
n = 1, . . ., N, such that f(t
n
, x
n
) > 0, and such that for every perfectly fine reporting standard at any
level of hardness h, then for r
n
v
(h, 1) R
v
(h, 1), f(t
n
, r
n
v
(h, 1)) > 0. Call the set T={t
n
}
nN
the anchor
set of X, and for the m
th
realization of an imperfectly fine reporting standard, r
m
v
(h, d) R
v
(h, d), call
the set t(m) = {t
n
|f(r
m
v
) > 0} the anchors of r
m
v
.
Definition of Relative Hardness: For any two reporting standards of equal fineness, ' = (h', d) and
" = (h", d), having cardinality of order M N, " is harder than ' if for realizations r
m
v
and r
k
v
, k m,
and for each element x
n
of X, the following hold:
a) for x
n
anchored at r
m
v
(i.e., for {x
n
| t
n
t(m)}), then f(r
m
v
(")| x
n
) f(r
m
v
(')| x
n
) f(r
k
v
(')| x
n
),
b) for x
n
not anchored at r
m
v
(i.e., for {x
n
| t
n
t(m)}), then f(r
m
v
(")| x
n
) f(r
m
v
(')| x
n
),
with at least one inequality strict.
Derivation of the Price of the Firm:
It is helpful to derive P(r
m
t
), the price of the firm, more formally. The states of the world include
both the payoff relevant variables, x
n
X (where n = 1, , N), as well as payoff irrelevant information or noise.
The probability distribution, f(), is defined over the payoff relevant set X and the noise included in . As
discussed in the text (see note 8), the introduction of noise enables us to rank standards by their softness as
distinct from their ranking by fineness. Under reporting standards = (h, d), an auditor of type t = {i, v}
produces a report r
m
t
R
t
, where the possible reports are indexed by m = 1,, M N. The report communicates
33
information about the payoff relevant variable; that is, it is a possibly noisy signal about X. We assume investors
price the firm using mean/variance pricing, and condition on the report issued. This implies investors condition
on the accounting standards in effect, as well as on the type of auditor issuing the report. Under accounting
standards = (h, d) and with auditor of type t, the price is
P(r
m
t
) = E[X | r
m
t
()] - Var(X | r
m
t
()).
=
1n
{x
n
f(x
n
| r
m
t
())} - (
1n
{(x
n
- E[X | r
m
t
()])
2
f(x
n
| r
m
t
())}).
OBSERVATION 1:
If one set of reports is a sufficient statistic for a second set of reports with respect to the pay-off
relevant variable, then the demand for the first set of reports is weakly greater than the demand for the second
set (see Dye, Balachandran and Magee, 1990). This inequality is strict if the conditional distributions differ on a
set of measure that is non-zero. By Blackwells theorem (e.g., see Demski, 1973), finer standards generate reports
that are statistically sufficient for reports generated by coarser standards of equal hardness. Therefore, the
demand for audited reports generated under finer standards exceeds the demand for audited reports generated
under coarser standards of the same hardness, which implies the portion of Observation 1 related to standard
fineness holds.
Next, consider the portion of Observation 1 relating to hardness. We define the expert auditor as
producing a perfectly hard report, so the invariance in the value of his report follows by assumption. To show
that the value of the basic auditors report increases in the hardness of the standard, it suffices to show that
audited reports issued under harder standards are statistically sufficient for audited reports issued under softer
standards of equal fineness. This is done in the following lemma.
Lemma 1: Consider any two reporting standards of equal fineness, ' = (h', d) and " = (h", d), having
cardinality of order M N, where h" > h' (indicating that " is harder than '). There exists a MxM
34
Markov matrix, B, having elements b
km
, such that for each realization r
m
v
, and for each element x
n
of X,
the following holds:
f(r
m
v
(') | x
n
) =
1kM
(f(r
k
v
(") | x
n
) b
km
).
Proof of Lemma 1: By the definition of hardness, the following holds for each realization r
m
v
, and for each
element x
n
of X,
i. for x
n
anchored at r
m
v
(i.e., for {x
n
|t
n
t(m)}), then f(r
m
v
(")|x
n
) f(r
m
v
(')|x
n
),
ii. for x
n
not anchored at r
m
v
(i.e., for {x
n
| t
n
t(m)}), then f(r
m
v
(")|x
n
) f(r
m
v
(')|x
n
),
with at least one inequality strict. We will show that this implies the existence of a Markov matrix B as described
in the lemma.
Without loss of generality, let the reporting standards be perfectly fine, as the proof extends in a straight-
forward manner to imperfectly fine standards. To simplify notation, let F and G denote the matrices of conditional
distributions given by (r
m
v
(")| x
n
) and f(r
m
v
(')| x
n
), respectively, where F is harder than G. Since we assume
perfectly fine standards, there are N signals. In particular, this means we have
( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( )1
1
1
1
1
]
1
1
1
1
1
]
1
N
v
N N
v
N
v
v
N
v v
v
N
v v
NN N N
N
N
x r f x r f x r f
x r f x r f x r f
x r f x r f x r f
g g g
g g g
g g g
G
| ' | ' | '
| ' | ' | '
| ' | ' | '
L
M O M M
L
L
L
M O M M
L
L
2 1
2 2 2 2 1
1 1 2 1 1
2 1
2 22 21
1 12 11
and
( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( )
.
| " | " | "
| " | " | "
| " | " | "
2 1
2 2 2 2 1
1 1 1 2 1 1
2 1
2 22 21
1 12 11
1
1
1
1
1
]
1
1
1
1
1
]
1
N
v
N N
v
N
v
v
N
v v
v
N
v v
NN N N
N
N
x r f x r f x r f
x r f x r f x r f
x r f x r f x r f
f f f
f f f
f f f
F
L
M O M M
L
L
L
M O M M
L
L
As customary, the n
th
row and m
th
column of the F matrix is denoted f
nm
, so that for example, f
nm
= f(r
m
v
(")|
x
n
).
The Lemma says that an NxN Markov matrix B exists such that
35
G = F x B.
Besides showing that such a B exists, we need to show that it is a Markov matrix, and this entails showing
that the following two conditions hold,
(i)
1 m N
b
km
= 1 for each k.
(ii) 0 b
km
1 for each b
km
.
As above, the element b
km
is the element in the k
th
row and m
th
column of the B matrix.
The proof of the lemma relies on the definition of relative hardness, and can be explained informally as
follows. First, by the definition of relative hardness, each of the diagonal elements of both F and G is positive.
Second, F harder than G means that each of the diagonal elements of F is greater than the corresponding diagonal
element of G, while the reverse holds for each of the off-diagonal elements of F relative to those of G. The proof
consists of three steps. First, we show that each element of the B matrix can be written in terms of the elements
of the F and G matrices. This proves existence. Second, we show that the elements in each column of B sum
to zero (which is condition (i) above, required to show that B is Markov), by appropriately rewriting the
expression for these elements from step 1. The third step is more complicated, and is described below.
Since the product of two Markov matrices is also a Markov matrix, without loss of generality we need
only show that condition (ii) holds when F and G differ by only two elements. This means we can focus on
showing condition (ii) holds for the elements in the first two columns of the B matrix. To show that each element
of the first column of B is between zero and one, we start by rewriting the system of N equations so that we have
a zero on the right-hand side of each equation except the first one. Using a series of algebraic manipulations, we
zero out each of the off-diagonal probabilities, so that we have the first column of the B matrix multiplied by the
identity matrix, where the solutions are all positive. These manipulations use the facts that all the f
nm
probabilities
are non-negative and that for each n, the f
nn
probability is maximal on the set of f
nm
. Using these facts allow us
to zero out the off-diagonal elements while ensuring the elements are always positive during the interim steps.
To prove that a matrix B exists such that we can post-multiply F by B to obtain G, it suffices to show
36
that there exists a solution for the N x N linear equations
f
n1
b
1m
+ f
n2
b
2m
+ f
n3
b
3m
+ ... + f
nN-1
b
N-1m
+ f
nN
b
Nm
= g
nm
.
By the assumption of a an anchor set, we have f
nn
0 and g
nn
0 for all n. By definition of relative hardness,
there exist N x N numbers,
nk
, each less than 1 in absolute value, defined as f
nk
= g
nk
. -
nk
, where
nn
> 0,
nk
,
0 for k n and
1 n N
nk
= 0 for each m. Further, by definition, we have f
nn
f
kn
and g
nn
g
kn
for all k and
n. Substituting back into the equation, we have
f
n1
b
1m
+ f
n2
b
2m
+ f
n3
b
3m
+ ... + f
nN-1
b
N-1m
+ f
nN
b
Nm
= g
nm
. = f
nm
-
nm.
This in turn implies that the element b
km
can be written as follows:
b
nn
= 1 - (
m n
(f
nm
b
mn
+
km
))/f
nn
, and
b
kn
= (f
kn
(1 - b
nn
) -
mk, mn
f
km
b
mn
-
kn
)/f
nn
, for k n.
Since f
nn
> 0 for each n, this proves the B matrix exists.
For condition (i), i.e., to show
1 mN
b
km
= 1 for each k, substitute g
km
. = f
km
-
km
into the expression
for g
km
and rewrite this expression as follows:
f
k1
(
1 m N
b
1m
- 1) + f
k2
(
1 m N
b
2m
-1) + f
k3
(
1 m N
b
3m
-1) + ...
+ f
kN-1
(
1 m N
b
N-1,m
-1) + f
kN
(
1 m N
b
Nm
-1) = -(
1 m N
km.
) = 0.
There are N such equalities, with f
kk
> 0 for the k
th
equation, so that the system of equations is solved by:
(
1 m N
b
km
-1) = 0 for all k.
For condition (ii), i.e., to show 0 b
kn
1 for each b
kn
, first note that the product of two Markov
matrices is itself Markov. This means we can focus on the case where F and G differ only by two elements.
Again, without loss of generality, let f
11
> g
11
, f
12
< g
12
, and f
nk
= g
nk
for all other elements of the matrices (i.e.,
for all k > 2 or n > 1). Since f
nk
= g
nk
for k > 2 or n > 1, the elements of the B matrix are given as b
nn
= 1 and
b
kn
= 0 for k n, for n > 2. Hence, we need to show condition (ii) holds only for the N elements in the first two
columns of B, (i.e., the b
nk
elements with n = 1 or 2), or equivalently, to solve the equations for the first two
columns in the G matrix.
37
To see this, consider the equations for the first column in the G matrix, denoted as
C
G
1
. The value for
each element in this row is given by the following matrix product:
.
1
1
1
1
]
1
1
1
1
1
]
1
1
1
1
1
]
1
1
21
11
2 1
2 22 21
1 12 11
1
1
21
11
1
N NN N N
N
N
C
N
C
b
b
b
f f f
f f f
f f f
B F
g
g
g
G
M
L
M O M M
L
L
M
This produces the following system of N equations.
N N N NN N N
N N
N N
f g b f b f b f
f g b f b f b f
f g b f b f b f
2 1 1 21 2 11 1
21 21 1 2 21 22 11 21
11 11 11 1 1 21 12 11 11
+ + +
+ + +
+ + +
L
M
L
L
Since the elements of the F and G matrices are given, this is a system of N equations in the b
k1
, N unknowns,
i.e., b
k1
, k = 1,...N. We also need to show that condition (ii) holds for the N elements b
k2
, k=1,...N, which are
obtained from the N equations for the elements of the second column of the G matrix; we do this after showing
it holds for b
k1
variables in equations (A.1) through (A.N) below.
Subtracting f
k1
from both sides of the k
th
equation, the N equations shown above can be rewritten as:
[ ] ( )
[ ] ( )
[ ] [ ] ( )
[ ] ( ) 0 1
1 3
0 1 2
1 1
1 21 2 11 1
1 2 21 22 11 21
11 1 1 21 12 11 11
+ + +
+ + +
+ + +
N NN N N
N N
N N
b f b f b f N A
N A A
b f b f b f A
b f b f b f A
L
M
L
L
: .
: . .
: .
: .
Since the elements of the F and G matrices are given, this is a system of N equations in the b
k1
, N unknowns,
i.e., b
k1
, k = 1,...N. We also need to show that condition (ii) holds for the N elements b
k2
, k = 1,...N, which are
obtained from the N equations for the elements of the second column of the G matrix; we do this after showing
it holds for b
k1
variables in equations (A.1) through (A.N) below.
To show condition (ii) holds, we identify a series of manipulations to the system of equations in which
we add or subtract a fraction of one equation to a second equation that insures the sign of the coefficients on the
b
k1
variables is unchanged. Before beginning, we insure that the coefficients on each b
k1
variable, k > 1 are non-
38
zero, and then start with the equations having a zero coefficient on the b
11
variable (we assumed only A.N meets
this condition). The process is given in several steps below.
Step 1: Find the equation n that has the greatest number of f
n,k
probabilities equal to zero and make this equation
A.N. Starting with equation A.N-1, re-order the equations so that the ascending equations all have zeroes
only for the same k entries for which A.N has a zero probability. For any equation that has a zero for a
f
n,k
probability that is non-zero in A.N, replace this with a new equation having probabilities denoted as
f
n,k
, with a non-zero f
n,k
probability, but where the f
kk
probabilities are still maximal. For example,
suppose equation A.2 has f
2,3
= 0. Multiply A.N by e sufficiently small to insure that f
2,2
is still maximal
over all the new f
2,k
probabilities. That such an e exists can be seen is as follows: identify all m such that
( ) 0
2
>
N Nm
f f . This set is non-empty, since ( ) 0
2
>
N NN
f f . Next choose e such that
( )
( )
e
f f
f f
N Nm
m
>
2
2 22
; this insures that f
2,2
= f
2,2
+ ef
N,2
is maximal. For the final part of this first step, for
each equation A.n, 2 n N, divide this equation by f
nn
. We now have a system of equations similar to
the following system.
[ ] ( )
[ ] ( )
[ ] [ ] ( )
[ ] ( )
[ ] [ ] ( )
[ ] ( )
[ ] ( ) 0 0 0 1
0 0 1
1 3
0 1 2
1 3
0 1 2
1 1
1 41 4 11 1
1 1 41 4 1 31 13 11 1 1
1 1 21 2 11 1
1 2 1 2 21 11 21
11 1 1 1 1 21 12 11 11
+ + + + +
+ + + + +
+ + + + +
+ + + + +
+ + + + +
N N N
N N N N N N
N kN k k k
N N k k
N N k k
b b f b f N A
b f b f b f b f N A
N A A
b f b b f b f A
N A A
b f b f b b f A
b f b f b f b f A
L
L
M
L L
M
L L
L L
' ' : .
' ' ' ' : .
: . .
' ' ' : .
: . .
' ' ' : .
: .
, , ,
+
t
i
m
i
m
v
m
v
m
t
m
dz z j r X Var r X E z r X Var r X E z r P
0
1 | | | |
(iii) u
v
< V
v
and u
i
> (V
i
- V
v
).
If investors knew the auditor's type, they would value the firm using the following equation:
(1-t) (E[X| r
m
v
] - Var(X | r
m
v
)) + t (E[X | r
m
i
] - Var(X | r
m
i
))
However, when investors cannot observe auditor type, they value firms using the average audit. This gives rise
to the pricing equation shown in (ii), since this is the price of the firm under report r
m
z
given by an auditor of type
z [0, t], averaged over all types of auditors in the market when the marginal auditor is of type t.
47
The value of auditing changes in a similar manner. The value of a report in a market where the
marginal auditor is of type t is
t( (Var(X) - E[Var(X | r
m
i
)])) + (1 - t)( (Var(X) - E[Var(X | r
m
v
)])) = tV
i
+ (1 - t)V
v
= V
v
+ t(V
i
- V
v
),
where V
i
and V
v
are the value of the report of an expert and a basic auditor, respectively, as defined above.
Hence, for the case of a uniform distribution on [0, t], the value of auditing is a linear function of the marginal
type t, parameterized on the levels of fineness and hardness of reporting standards.
In this setting, the demand for auditing can be viewed in terms of the level of expertise provided. If the
wage is the price of auditing services, and the level of auditor expertise is a measure of the quantity of auditing
demanded, the inverse demand curve (wage as a function of audit type) can be written as w(t; d, h) = V
v
+ t
(V
i
- V
v
)/2 = a + t b/2, where a = V
v
and b = (V
i
- V
v
). Following is the formal definition of an equilibrium for
this setting:
Definition of an Equilibrium when Auditor Expertise is Unobservable:
Given the standard = (h, d), an equilibrium is a triple {w*, P*, t*} that solves the following equations:
(8) 0 < w* V
v
+ (V
i
- V
v
) (t*/2)
(9) P*(r
t*
) = (1 - (t*/2)) (E[X | r
v
] - Var(X | r
v
)) + (t*/2) (E[X | r
i
] - Var(X | r
i
))}.
(10) u
t*
w*, where u
t*
[u
v
, u
i
].
An equilibrium exists if the price given by Equation (9) holds, the reservation wage function is continuous, and
u
v
V
v
.
14
The equilibrium is unique if the reservation wage function exhibits certain regularities. Lemma 3 makes
these results explicit:
14
To see why u
v
< V
v
is required, suppose u
v
> V
v
and u
i
< V
i
hold. Then the manager would be willing to
employ an auditor at a wage the auditor would accept if the manager knew the auditor was an expert. However,
once such a wage was offered, basic auditors would enter the market, driving down the value of the audit. The
manager would respond by decreasing the wage, driving the expert auditors out of the market, decreasing the
value of the audit even further, causing the market to collapse.
48
Lemma 3: Suppose u
t
is continuous on t [0, 1], price is given by equation (9), and u
v
V
v
. Then an
equilibrium exists. The equilibrium is unique if du
t
/dt > 0, u
i
(V
i
+ V
v
)/2 and either d
2
u
t
/dt
2
0 or d
2
u
t
/dt
2
0.
The proof of existence and uniqueness is standard, and Lemma 3 is easily interpreted. u
t
is the supply
curve for auditors and w(t) = V
v
+ ((V
i
- V
v
)/2)t is the demand curve for auditors, where both curves are defined
over t [0,1] and where auditor expertise, not auditor quantity, is demanded and supplied. Unlike a usual demand
curve, demand for expertise is upward sloping. The equilibrium wage is given by the intersection of the two
curves. If they do not intersect, the wage is set between (V
i
+V
v
)/2 and u
i
, and depends on whether the auditor
or the manager has greater bargaining power. In this case, all of the auditors except for the marginal auditor
receive economic rents, and possibly the firms as well.
For Proposition 2, u
i
(V
i
+V
v
)/2 is assumed, resulting in a unique equilibrium. Given these conditions,
the equilibrium is P*() defined by equation (9) and the w* and t* that solve u
t*
= w* = V
v
+ (t* (V
i
- V
v
)) /
2. These assumptions, specifically u
i
(V
i
+V
v
)/2, rule out the case of auditors obtaining economic rents. In the
long run, one would expect that more expert auditors would enter the market to take advantage of these rents,
thus driving the price down until no rents were earned.
Given this equilibrium, Proposition 2 follows almost immediately. Increasing fineness increases both V
i
and V
v
, while increasing hardness increases V
v
, but in either case it raises the price of the audited firm, inducing
managers to pay for auditing that was not cost/effective before the change in standards. To hire the unemployed
higher-type auditors, management must pay a higher wage, making all auditors better off. The higher market wage
induces the employment of higher-type auditors, raising the equilibrium level of expertise, t*, completing the
proof.
COROLLARY 2:
Corollary 2 follows almost immediately from Proposition 2:
49
Part (A): Managers wish to maximize the following:
( ) [ ]
i i v v t
m
u V u V w r P E , , , | * *
*
1
]
1
+
,
_
Using this expression, substituting for the equilibrium wage and canceling terms:
( ) ( ) [ ] [ ] ( ) ( ) ( ) ( )
0 0 0 0
2 2 2
1 r P r P V V
t
V E V
t
V
t
r P w E r P r P E
v i v i v t
m
+
1
]
1
+ +
,
_
+
* * *
* *
*
.
This implies that the managers objective function is invariant to the level of standard hardness, so that the
manager is indifferent to the level of standard hardness.
Part (B): Regulators wish to maximize the total expected value of all audit reports, which is given by the equation:
( ) [ ] [ ] [ ] ( ) [ ]
i i v v t
m
i i v v t
u V u V r X Var X Var E u V u V d h V E , , , | , , , | ,
* *
.
[ ] [ ] [ ]
*
|
t
m
r X Var E X Var increases in the level of expertise. Proposition 2(B) shows that the average level of
expertise increases in hardness. Hence, the total expected value of the audit reports is increasing in hardness,
implying that regulators prefer harder standards.