4 Such rules on how to structure and operate auditing firms are not only present in the legislation of several countries, but also detailed in the standards issued by the International Auditing and Assurance Standards Board: see IAASB (2004)。

This baseline model assumes that the moral hazard problem lies only in the activity of auditors, while firms always seek a truthful report。 But the recent corporate scandals suggest that also the behavior of companies may be plagued by moral hazard, because managers may want to go ahead with investment at all costs, irrespective of its profitability, and therefore may want to bribe auditors into producing positive reports under all circumstances。 To bribe auditors, managers can award them profitable consulting contracts, on condition that they file favorable reports。 The potential for collusion increases the auditors’ incentives to misreport, so that more resources are required to enforce any given audit standard。 Thus, when the managers of client firms seek to corrupt their auditors, the regulator must optimally choose a less ambitious standard。

In this case, an additional regulatory tool is to sever the link between consulting and auditing activity, by forbidding auditors to provide consulting services, as indeed prescribed by the Sarbanes-Oxley Act。 If this is the only way in which client firms may “bribe” their auditors, this policy would appear as a superior option to tampering with auditing standards。 Indeed, in our model it would allow the regulator to leave the standard at the second-best level。 However, this option is not necessarily superior once one takes into account that the profits arising from the joint provision of auditing and consulting are themselves part of social welfare。

Indeed, these profits have two conflicting effects on social welfare: a harmful effect, insofar as they raise the potential for collusion between auditors and their clients; and a beneficial effect, insofar as they reflect efficiencies of scope。 We find that the regulator will want to allow bundling when the implied profits do not exceed a threshold that depends on the marginal efficiency of enforcement。

The structure of the paper is as follows。 Section 2 reviews the related literature and places the paper in perspective, by comparing regulation with alternative mechanisms that can improve the informativeness of audits。 In Section 3 we present the model, derive the first-best audit quality, and characterize the second-best audit standard to be chosen if audit quality is privately unobservable。 In Section 4, we analyze the optimal regulation when firms collude with auditors。 Section 5 considers how the design of regulation is affected by economies of scope arising from the joint provision of auditing and consulting services。 Section 6 concludes。

2。Related literature

Our model is related to the microeconomic analysis of the auditor-firm relationship proposed by Dye (1993), where auditors can contribute to the efficient allocation of investment but the quality of their audits is unobservable, leading to a moral hazard problem。 In contrast to Dye’s model, however, in our setting this problem is not left to litigation between investors and accountants, but entrusted to regulation and its enforcement by public officials。 The optimal regulatory response must take into account its enforcement cost, as in Immordino and Pagano (2005)。 The result is a systematic normative analysis of the regulation of the auditing profession, which takes into account the possible conflicts of interest of auditing firms, as well as the agency problems between managers and shareholders within client firms。

Therefore, our paper is relevant to the ongoing debate about the appropriate regulatory response to the recent corporate scandals。 Our analysis focuses on regulation and public enforcement as the only device to temper agency problems in auditing and collusion between auditors and client companies。 Private mechanisms have been suggested in the literature as alternative remedies to these problems: auditors’ self–regulation assisted by litigation-based enforcement, reputational mechanisms, certification by intermediaries, financial statements insurance, whistleblowing, etc。 But none of these mechanisms is indisputably superior to public regulation。