AUDIT QUALITY AND PROFESSIONAL SELF-REGULATION - A SOCIAL DILEMMA PERSPECTIVE AND LABORATORY INVESTIGATION

While the concept of audit quality is broad, it can ultimately be defi ned in terms of the probability that material financial misstatement, if it exists, will be identified and, if necessary, reported by the au dit firm. Consideration of audit quality raises questions about effect ive and efficient ways to obtain beneficial levels of audit quality, i ncluding possible roles for various regulatory regimes. This paper mod els auditing as a multiperson social dilemma, in which the fees earned by auditors depend on the audit quality provided by all auditors in p rior periods. In this setting, firms can signal quality only as a memb er of a group. The defining characteristic of the social dilemma is th at audit firms are best off in a single period by providing a low-qual ity audit, but all firms are best off in a multiperiod setting when al l provide high-quality audits. A series of laboratory experiments is c onducted to gather data on multiperiod cooperative decisions in settin gs without regulation and with professional self-regulation. The data analysis demonstrates the difficulty of obtaining a high level of audi t quality without a regime of voluntary self-regulation. Low-quality a uditing dominates in an unregulated laboratory setting, while availabi lity of a self-regulatory coalition effectively raises both average qu ality level and the consistency with which high-quality auditing is pr ovided. These results strongly support one role for professional organ izations such as the Securities Exchange Commission Practice Section a nd the AICPA. Such organizations can improve the quality of auditing w hen there exist effective, quality ensuring mechanisms such as fines a nd sanctioning powers.