1

A Model of Auditing Under

Bright-Line Accounting Standards
Dennis Caplan, Iowa State University
&
Michael Kirschenheiter, Columbia Business School
Most Recent Update: May 28, 2002
Current Date: June 11, 2002
Please address correspondence to:
Michael Kirschenheiter
Associate Professor of Accounting
Columbia University
Graduate School of Business
3022 Broadway
618 Uris Hall
New York, NY 10027
We would like to acknowledge helpful comments, on this and on earlier versions of the paper, from seminar
participants at Iowa State University, Lehigh University, the University of New Hampshire, and Washington
University in St. Louis. We would especially like to thank Nick Dopuch, Dermot Hayes, Diane Janvrin, Ron King,
James Largay, Gilad Livne, Rachel Schwartz, and Amir Ziv.
2
ABSTRACT
This paper models the demand by auditors for bright-line financial reporting standards, and compares auditors
preferences for bright-line standards with managers and regulators preferences. Bright-line standards are
unambiguous, requiring no judgment in their application. Standards that are not bright-line are soft reporting
standards. The model allows auditors to vary in their financial reporting expertise. All auditors have a basic role
to verify the accuracy of the financial statements. Expert auditors also fill an interpretation role. Under soft
standards, expert auditors use their financial reporting expertise to help generate a report that investors can
understand. Results show that auditors of different levels of expertise can differ in their preferences over financial
reporting standards, and that these preferences depend on whether auditor expertise is observable to investors.
If expertise is observable, expert auditors prefer soft standards, and auditors without such expertise prefer bright-
line standards. If investors cannot observe auditor expertise, all auditors prefer bright-line standards, and the
average level of auditor expertise increases under bright-line standards. The paper also models auditors
preferences for the amount of detail required in the financial statements. We formally distinguish this attribute of
financial reporting standards from our measure of bright-line standards, and we compare auditors preferences
for bright-line standards with their preferences along this second attribute.
Key Words: Auditing, Financial accounting standards, Audit competition, Information economics.
3
BRIGHT-LINE ACCCOUNTING STANDARDS: INTRODUCTION
In early 2002, Arthur Andersen CEO Joseph Berardino testified before Congress on Andersens ongoing
response to the events at Enron.
1
Berardinos remarks focused on the issues confronting the public accounting
profession and Andersens proposed remedies, including the need for significant reforms in the areas of financial
reporting and auditor reporting standards. Berardino testified that GAAP in anything like its current form does
not provide investors the kind of nuanced disclosure they need. Berardino advocated changing Generally
Accepted Auditing Standards (GAAS) from the current pass/fail system with an auditors report that grades
the quality of the companys accounting practices. Berardino also remarked that auditors are not asked to be on
the cutting edge of business. He said that auditors are told to produce a standard report that effectively
discourages differentiation among audit firms, and that if the profession wants to attract the best and most
innovative young people, we must ask them to produce a more useful and intellectually challenging report.
This paper examines some of the issues raised by Berardino in an analytical framework. We build a model
of reporting standards, auditor expertise, and the value of information to investors that we think is consistent both
with Berardinos depiction of the accounting profession, and with the conceptual framework of Statement of
Financial Accounting Concepts (SFAC) No. 2. Our model contains the following elements.
First, we define financial reporting standards along a continuum. At one end of the continuum are
bright-line standards, and at the other end are soft standards. Bright-line accounting standards are
unambiguous, in the sense that no judgment is required in their application. Soft standards, on the other hand,
require the auditors expertise and judgment. Our definition of bright-line standards captures certain
characteristics of the concept of reliability as defined in SFAC No. 2. Also, our definition is similarbut not
identicalto the idea of hard information previously studied in the accounting literature. Berardinos testimony
argues for soft reporting standards, but the accounting profession has not always advocated this position. In its

1 Mr. Berardinos comments referenced in this paper comprise part of his testimony to the Financial Services
Committee of the U.S. House of Representatives, which occurred on February 5, 2002.
4
report Strengthening the Professionalism of the Independent Auditor, the Advisory Panel on Auditor Independence
discouraged the auditing profession from seeking authoritative bright line guidance for every accounting
question. The Advisory Panels report stated that the search for bright lines is a symptom of a problem, not a
solution. Auditors often ask standard setters for rules that enable the auditor to draw lines with clients and not
run the risk of a competitor not drawing the same line (1994, p. 21).
2
One implication of the Advisory Panels
report is that although auditors are financial reporting experts, the auditing profession sometimes prefers not to
exercise this expertise.
The second component of our model is auditor expertise. Berardinos testimony expressed concern that
current GAAS reporting standards do not allow auditing firms to differentiate themselves with respect to quality,
and also that auditing firms are experiencing difficulty recruiting the best talent. To capture Berardinos concern,
we operationalize auditor expertise and its relationship to reporting standards in an information economics
framework. We then allow auditors of different levels of financial reporting expertise to compete in the audit
market. We consider two roles for the auditor. All auditors have a basic role to verify the accuracy of the financial
statements. A basic auditor serves this role only. Expert auditors also fill an interpretation role: when standards
are soft, expert auditors use their financial reporting expertise to insure that financial information can be
understood by financial statement users. These modeling elements allow us to examine auditors preferences for
bright-line standards in a setting in which auditor expertise can provide a benefit to financial statement users, and
hence, a potential competitive advantage to auditors who possess it.

2 This report was submitted to the Public Oversight Board of the SEC Practice Section of the AICPA. Berardino
sometimes echoes recommendations from this report. For example, the report encourages auditors to improve
financial reporting by informing client audit committees of "better accounting principles, more appropriate
estimates and more informative disclosurescompared with what the client is currently using," even when
current disclosures are "acceptable" (Kirk and Siegel 1996, 56). The Report and Recommendations of the Blue
Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees expressed a similar view. It
recommended that GAAS should require the auditor to discuss with the audit committee the auditors judgment
about the quality, not just the acceptability, of the companys accounting principles as applied in its financial
reporting (1999, 33). Mautz and Sharaf said that an auditor does not borrow accounting principles blindly, he
accepts them with reservations. . . . [G]enerally accepted accounting principles may not always realize in
application a satisfactory standard of quality (1961, 159). Thus, while Berardinos testimony might be a
5
We first examine a non-strategic setting in which the auditors level of expertise is exogenous. In this
setting, the value of the basic auditor increases under bright-line standards relative to soft standards. For the
expert auditor, the value of the auditors expertise relative to the auditors basic verification role decreases under
bright-line standards. We then examine a market setting in which auditors of different levels of expertise compete
in the audit market. Results depend on whether investors can observe the auditors level of expertise. If investors
can observe auditor expertise, basic auditors prefer bright-line standards and expert auditors prefer soft standards.
If investors cannot observe auditor expertise, all auditors prefer bright-line standards, and the average equilibrium
level of auditor expertise increases under bright-line standards. We also compare auditors preferences for bright-
line standards with the preferences of their clients and regulators. Under certain circumstances, clients prefer
bright-line standards when auditor expertise is observable, but otherwise, clients are indifferent between bright-line
and soft standards. Regulators preferences depend on specific parameter values when auditor expertise is
observable, but when auditor expertise is unobservable, regulators always prefer bright-line standards. Thus,
auditors and regulators both prefer bright-line standards when auditor expertise is unobservable.
The third component of our model is the amount of detail provided in the financial statements. Berardino
discusses several opportunities to modernize financial reporting, including the disclosure of more information
about unusual transactions and events, and more business segment information. We interpret these
recommendations as more detailed disclosures, and we model the amount of detail by the fineness of information
sets. We formally distinguish the amount of detail required by financial reporting standards from the hard-soft
attribute of reporting standards discussed above. Taken together, these two criteria of accounting standards seem
to describe the important trends in GAAP over the past several decades. Most new pronouncements require either
more detailed disclosures, or more judgment in their application, or both, than the GAAP that they replace. We
believe this reflects a movement towards more relevant but potentially less reliable standards.
We examine auditors preferences for more detailed GAAP disclosures. Results show that if the auditors

milestone in the public discussion of the auditors role in financial reporting, there is precedent for his remarks.
6
financial reporting expertise is exogenous, the value of audits performed by auditors of all levels of expertise
increases in the amount of detail required by financial reporting standards. When expert and basic auditors
compete in an audit market in which the auditors expertise is unobservable, all auditors prefer finer standards.
If the auditors expertise is observable, results are ambiguous and depend on specific parameter values.
While some of our results are consistent with Berardinos recommendations, there is an important caveat.
If auditors of different levels of expertise compete in the audit market, and if auditor expertise is unobservable,
then all auditors prefer bright-line standards. This result holds because bright-line standards increase the value of
reports issued by auditors who are not experts, without affecting the value of the expert auditors report; thus
increasing the value of the average audit report. This implies that the question of whether audit quality is
observable is critical in assessing the auditing professions position on bright-line financial reporting standards.
1. PRIOR RESEARCH
Our paper shares similar motivation with Krishnan and Thoman (1997), which examines the role that
standard clarity plays on client opinion shopping and auditor independence. Krishnan and Thoman (KT) uses the
term flexible standards where we use the term soft standards, and clear standards where we use the term
bright-line standards, but the concepts are similar. KT studies how flexible standards increase the threat that
opinion shopping poses to incumbent auditors. KT directly addresses the accounting professions concern
referenced in the Advisory Panels report, that auditors want bright-line standards to reduce the threat of opinion
shopping. Both the Advisory Panel and KT assume that the client wants to report a particular result to investors.
By contrast, our paper is an attempt to derive a meaningful role for bright-line standards and for the auditors
reporting expertise in a world where everyone is honest, but where the complexity of financial information
constitutes an obstacle to clear communication.
To model competition in the audit market, we adapt the framework developed by Dye, Balachandran and
Magee (1990). Like Dye, et. al., all firms in our model are identical at the time the auditor is employed. This
7
assumption implies that the type of auditor hired (and even the decision to hire an auditor) has no signaling value.
The remainder of this section discusses two aspects of the literature. First we relate our characteristics
of financial reporting standards to the information economics literature in accounting. We then reference support
in the literature for the way we model auditor expertise.
The Information Economics Literature
We characterize reporting standards along two dimensions: the level of detail in the information reported,
and the potential for ambiguity in the information reported (bright-line versus soft standards). Both of these
criteria have been addressed in the literature. We model the level of detail by the information economics concept
of the relative fineness of information sets. This treatment is similar to Demski (1973) and Baiman (1974). We
assume that the level of detail required by reporting standards is less than the level of detail in investors payoff-
relevant information set, so that finer standards result in more relevant information to investors.
Our characterization of soft versus bright-line standards is in the spirit of Ijiri (1975), Gjesdal (1981),
Penno (1990), Penno and Watts (1991), and Dye and Verrecchia (1995). Bright-line standards are analogous to
hard information in those papers (rigid G.A.A.P. in Dye and Verrecchia). Although these papers do not all use
the term "hard information" in precisely the same manner, they all capture some aspect of the notion that a hard
measure "is one constructed in such a way that it is difficult for people to disagree," (Ijiri 1975, 36). A key
difference in our approach is that soft information poses a risk not because it is susceptible to manipulation, but
more fundamentally because even in the absence of manipulation, soft information can be interpreted differently
by different people. Hence, reporting under soft standards benefits from an expert auditor, who helps ensure that
the financial information is understandable to financial statement users.
Hard information in our model is closely aligned with the concept of reliability as discussed in SFAC No.
2. Hard information has a high degree of representational faithfulness, which SFAC No. 2 defines as the
agreement between a measure or description and the phenomenon it purports to represent (p. 63).
8
Representational faithfulness is one attribute of reliable accounting information.
3
Also, the two dimensions of
reporting standards in our model can be discussed in the context of financial reporting pronouncements. As an
example of fineness, the main effect of Statement of Financial Accounting Standards (SFAS) No. 14, "Financial
Reporting for Segments of a Business Enterprise," is to increase the amount of detail communicated to financial
statement users. An example of bright-line standards is SFAS No.2, which requires research and development
costs (R&D) to be expensed when incurred. The strongest argument in favor of SFAS No. 2 seems to be that
expensing avoids the ambiguity that could arise in the interpretation of capitalized R&D.
Auditor Expertise
A basic premise of our model is that the auditors task can be separated into two components: a
verification role and an interpretative role. The interpretative role employs the auditors financial reporting
expertise. This decomposition of the auditors activities has precedent in the literature. In The Philosophy of
Auditing, Mautz and Sharaf (1961) differentiate accounting from auditing:
Accounting . . . involves the measurement and communication of business events and conditions
. . .. The task of accounting is to reduce a tremendous mass of detailed information to manageable and
understandable proportions. Auditing does none of these things. Auditing must consider business events
and conditions too, but it does not have the task of measuring or communicating them. Its task is to
review the measurements and communications of accounting for propriety (p. 14, italics added).
Mautz and Sharaf explain in a later chapter that the auditors expertise must include both accounting and auditing.
Moonitz (1974) asserts The distinction between auditing and accounting also points up another feature. Since

3 SFAC No. 2 states that the reliability of a measure rests on the faithfulness with which it represents what it
purports to represent, coupled with an assurance for the user, which comes through verification, that it has that
representational quality (p. 59). Our model captures the notion of verification via the basic role that all auditors
(basic and expert) fulfill, and captures the notion of representational faithfulness via hard-soft standards. (See
Kirschenheiter 2002 for a related model that expands on the notion of representational faithfulness in accounting.)
However, we do not attempt to completely characterize the information content of the financial report as a
function of reporting standards. SFAC No. 2 states that ideally, accounting standards are chosen to provide
information that is both reliable and relevant. Soft standards may provide more relevant information than hard
standards, and hence, may be preferred. This is implicit, not explicit, in our model. Hence, increased relevance
may be associated with standards that are both finer and softer. For a model that examines the trade-off between
9
they are different in certain respects, particularly in the kinds of discipline in which they have their roots, the
training, aptitude, and point of view of an expert auditor is somewhat different from that of an expert accountant
(p. 4).
In our model, all auditors are expert at the auditing function, but auditors differ with respect to their
accounting (i.e., financial reporting) expertise. We refer to auditors who perform the audit function but have
minimal financial reporting expertise as basic auditors. The basic auditor attests to the truthfulness or accuracy
of management's report, but has little or no opportunity to add new information to the report or to change its
content. Our basic auditor plays a role similar to auditors in Antle and Nalebuff (1991), Finley (1994), Melumad
and Thoman (1990), Newman and Noel (1989), Penno and Watts (1991), and Shibano (1990).
Our expert auditor fills an interpretation role. The expert auditor makes the financial report more
informative to financial statement users than would be the case if management did not hire the auditor, in a
manner similar to auditors in Dye (1995), Dye, Balachandran and Magee (1990), and Titman and Trueman (1986).
Expert auditors can change the content of information communicated to financial statement users, sometimes by
providing management new information. For example, the auditor might conclude the allowance for doubtful
accounts is inadequate, and convince management to adjust the account. In his testimony to Congress, Berardino
focused on increasing the auditors opportunity to exercise an interpretation role, without conceding deficiencies
in his firms record for fulfilling the auditors verification role. We assume the interpretation role subsumes the
verification role, so that an expert auditor verifies the information and also exercises financial reporting expertise.
2. THE MODEL
Derivation of the Value of Auditing
This is a single period model. There are three sets of players: risk-neutral managers, auditors, and risk-
averse investors. The manager initially owns the firm, and sells it to investors at the end of the period at the price

reliability and relevance in a valuation setting, see Kirschenheiter (1997).
10
that makes investors indifferent. The requirement for the sale is exogenous.
If no audit occurs, the selling price is determined by investors' beliefs about firm value based on existing
information. We assume that the manager always issues a financial report, but that if no audit occurs, there is no
accompanying audit opinion issued.
4
If an audit occurs, the manager and auditor jointly issue a financial report
accompanied by an audit opinion on that report. The financial report along with the audit opinion is referred to
as the audit report. In this case, the selling price reflects investors' beliefs about firm value based on the audit
report. The audit report of a basic auditor consists of the financial report in accordance with the reporting
standards in effect, accompanied by an audit opinion on that report.
5
The audit report of an expert auditor also
includes the audit opinion, but the financial report itself (i.e., the financial statements) may differ from the report
that would have been issued by a basic auditor, because the expert auditor interprets management's report for
investors.
6
Investors' beliefs about firm value subsequent to observing an audit report also depend on the reporting
standards in effect.
The set denotes the states of the world, with (notation is summarized in Table 1). A probability
distribution is assumed to exist over these states. f( ) denotes the probability density function and F( ) denotes
the cumulative density function. Investors' payoff-relevant information is represented by the set X, which
contains a finite number of elements denoted as x
n
, n = 1, . . ., N, so that |X| = N where || denotes the cardinality
operator. If no auditor is hired, investors form expectations about the net cash flow of the firm based on X. If
an auditor of type t {v, i} is hired, where v refers to the basic auditor and i refers to the expert auditor, an audit

4 Our no-audit scenario is intended as a benchmark for measuring the value of the basic audit, and not an
assertion of the descriptive validity of a voluntary auditing regime.
5 The model does not explicitly consider the situation in which the manager misreports, because the manager's
incentive to do so is not the focus of the paper. Implicitly, such behavior is off the equilibrium path in a larger
unmodeled game, as would generally be the case if auditing were perfect. However, the possibility of the manager
misreporting is necessary to motivate the value of basic auditing.
6 However, if standards are bright-line, there can be no room for interpretation, and the manager's report in
accordance with those standards will not be modified as the result of the expert audit.
11
report is issued consisting of the financial report together with the type t auditor's opinion on that report. R
v
denotes the set of basic audit reports and R
i
denotes the set of expert audit reports, with realizations r
m
v
R
v
and
r
m
i
R
i
. The subscript is used to index the report, and we assume | R
v
| = |R
i
| = M N, so that m = 1, , M. As
discussed below, we compare standards of differing cardinality, which we denote by indexing the reports by k
= 1, , K, so that for r
k
v
R
v
we have |R
v
| = K N. Investors condition their expectation of firm value based
on the type of audit report issued. We use r
0
as a benchmark, to denote a financial report without an audit opinion.
The Financial Reporting Information System
The audit report depends on financial reporting standards. Standards are distinguished along two
dimensions. The first dimension is the level of detail required in the financial report, which is denoted by the
variable d [0, 1]. The second dimension is the extent to which standards are hard or soft, which is denoted by
the variable h [0, 1]. Hence, the variables R
v
and R
i
depend on reporting standards, denoted as = (h, d), but
the variable X does not. Since all three variables are defined in terms of the set of states of the world, each
defines a joint probability distribution, f(x, r
v
(), r
i
()). This distribution is common knowledge.
The Amount of Detail Required by Reporting Standards
The level of detail required in the financial report is operationalized using the information economics
concept of fineness. One reporting standard is finer than a second standard if the information partition represented
by the first standard is finer than the information partition represented by the second standard. The equivalent
probabilistic definition follows:
Definition of Relative Fineness: Given any two equally hard reporting standards, ' = (h, d') and
" = (h, d"), " is finer than ' if for all r
m
v
(') and r
k
v
("), f(r
m
v
(')| r
k
v
(")) = 0 or 1.
12
Demski (1973) shows that fineness does not, in general, completely order a set of standards. We use the
term "comparable" to refer to reporting standards that can be ranked by fineness. For tractability, we assume that
any two reporting standards are comparable if they lie on the same point on the hard-soft continuum. d" > d'
implies " is finer than '. As noted above, both the set of reports and the set of payoff relevant states of the
world are finite, with cardinality M and N respectively. The fineness criterion is normalized by assuming that for
d = 0, M = 1; for d = 1, M = N; and for 0 < d' < d" < 1, we have 1 < M' < M" < N. Thus, if reporting standards
are perfectly coarse (i.e., d = 0), an audit report conveys no additional information to investors beyond r
0
, the
financial report without an audit opinion. Also, all decision-relevant information can be conveyed only under
perfectly-fine reporting standards.
The Hard-Soft Criterion of Reporting Standards
We define bright-line standards as one end of a continuum, and we also refer to the endpoints of this
continuum as hard and soft information. Bright-line standards represent hard information, which is always
understood the same way by managers, auditors, and investors. For example, when property, plant and equipment
is shown at historical cost, there is relatively little room for disagreement about what the amount represents. If
property, plant and equipment were shown at replacement cost, the reported amount might not produce the same
agreement. Numerous judgments would be implicit in the calculation, and footnote disclosure about the company's
accounting policies might not eliminate the ambiguity. This is an example of soft information. Hard information
describes messages or reports that have the same meaning for everyone, while soft information may have
different meanings for different people.
Intuitively, one financial report is harder than a second report if there is more agreement between
managers and financial statement users, and among financial statement users, about what the first report is
supposed to mean in terms of the payoff-relevant information. This requires linking the reports to their
purported meaning, and hence, to investors information partition. To do this, we introduce the concept of
13
payoff-relevant "anchors":
Assumption A1 (Anchor Sets): Assume that for each of the N payoff-relevant elements in X, there
exists a state of the world, denoted as t
n
, called the anchor of x
n
. Furthermore, assume that for
every perfectly-fine reporting standard, the anchor for each of the N different reports remains the
same, regardless of where the standard lies on the hard-soft continuum.
7
The role of Assumption A1 is to clarify what a report is supposed to mean (in the language of SFAC No.
2, what the report purports to represent). Assumption A1 accomplishes this objective by linking every report
to investors information partition in a consistent fashion via its anchors. Under perfectly-fine reporting standards,
the n
th
report purports to represent the n
th
element in the payoff-relevant set. Our definition of anchor sets ensures
that there is always a positive probability that the n
th
report will be issued when the anchor of the n
th
payoff-
relevant element of X is the actual state of the world. Formally, if t
n
is the state of the world, there is a positive
probability that the auditor will issue the n
th
report.
An important aspect of Assumption A1 is that it does not restrict our definition of fineness. Each report
under an imperfectly-fine standard is associated with one or more reports under a perfectly-fine standard of the
same level of hardness. Hence, the anchor set for the perfectly-fine set of reports extends to an imperfectly-fine
set of reports in a direct fashion. For example, under Assumption A1, the n
th
realization under the perfectly-fine
reporting standard R
v
(h, 1) is associated with the n
th
realization of X via the n
th
anchor. Consider a reporting
standard of the same hardness that is imperfectly fine, denoted as R
v
(h, d), d < 1. Each report generated under
R
v
(h, d) is associated with one or more of the reports generated under R
v
(h, 1). Suppose the m
th
report under
R
v
(h, d) is associated with the n
th
and (n+1)
th
reports under R
v
(h, 1). In this case, the m
th
report purports to
represent the set of payoffs represented by the union of the n
th
and (n+1)
th
elements of the payoff set X. In

7 Assumption A1 and the definition of relative hardness are given informally here to convey intuition for these
14
general, we use t(m) to denote the set of anchors of the m
th
report under R
v
(h, d), so for this example, t(m) =
{t
n
, t
n+1
}. It is clear from the statement of Assumption A1 that each perfectly-fine reporting standard has the same
set of anchors. More generally, reports generated by two standards of equal fineness have the same anchor set.
Assumption A1 allows us to compare reports generated by standards that differ on the hard-soft
criterion. The relative hardness of two equally-fine standards is given by the following definition.
Definition of Relative Hardness: For any two reporting standards of equal fineness, the first reporting
standard is harder than the second if all of the following hold. First, for each element x
n
of X, if the m
th
report is anchored at the anchor of x
n
, then the probability of issuing this report when x
n
occurs is
weakly greater than the probability of issuing any other report. Second, the probability of issuing this
report is higher under the first standard than under the second standard. Third, the probability of issuing
any report that is not anchored at x
n
is weakly lower under the first standard than under the second
standard.
As this definition implies, a softer standard can be obtained from a harder standard of equal fineness by
reallocating probability from the anchored reports to the unanchored reports. This is similar to obtaining one
distribution from a second distribution by a series of mean-preserving spreads, except the process of spreading
the probabilities is centered on the anchored report instead of the mean of the distribution.
In general, hardness does not completely order a set of standards. The term "compatible" is used to
denote that two reporting standards can be ranked by their hardness. For tractability, we assume that any two
reporting standards are compatible if they are equally fine, and h" > h' implies that " = (h", d) is harder than '
= (h', d). The endpoints of the hard-soft continuum are normalized. Under bright-line standards (i.e., h = 1), for
all d and for all r
m
v
(1, d),
{x
n
|t
n
t(m)}
f(r
m
v
| x
n
) = 1. Under perfectly soft standards (i.e., h = 0), for all d, for

concepts. The Appendix provides formal definitions.
15
all 1 < k N, and for all r
m
v
(0, d), f(r
m
v
| x
n
) = f(r
k
v
| x
n
). Hence, under perfectly-soft reporting standards, a basic
audit report conveys no additional information to investors beyond the information provided by an unaudited
report. Bright-line standards allow the manager to communicate perfectly to investors, contingent on the fineness
of the standards.
While conditions exist such that ranking standards by hardness is equivalent to ranking them by fineness,
this is not true in general. We exploit this lack of equivalence to distinguish between basic and expert auditors.
8
Expert auditors convey perfectly-hard information to investors regardless of the reporting standards in effect.
Formally, for all h and d, P(r
i
(h, d)) = P(r
i
(1, d)), where P() is the equilibrium price of the firm.
3. RESULTS
First we examine how prices and the value of auditing depend on reporting standards and on the auditors
expertise. Then we examine auditors preferences for reporting standards in a competitive audit market, both
when auditor expertise is observable and when it is not.

Preliminary Results on Reporting Standards and the Value of Auditing
Denoting as the price of risk, the firm is sold to investors according to the following pricing formulas:
9
(1) P(r
0
) = E[X] - Var[X]

8 Blackwell (1951) provides sufficient conditions under which ranking standards by hardness is equivalent to
ranking them by fineness. Demski (1973) provides an early application of Blackwell's theorem to accounting.
Marschak and Miyasawa (1968) clarifies that these conditions are unnecessary and the equivalence is not general,
and Malueg (1985) provides necessary conditions for fineness and hardness to be equivalent. Blackwell's
equivalency holds if and only if the reports are "noiseless" with respect to the payoff-relevant variable, where a
report R
v
is noiseless for the variable X if, for each x X and for each r
v
R
v
, f(r
v
|x) = 0 or 1. Permitting
reports to be noisy allows one standard to be finer but softer than another standard.
9 This pricing equation can be derived as per Stapleton and Subrahmanyam (1978). The derivation assumes
investors have an exponential utility function and maximize the expected value of their utility, where the cash flow
variable is normally distributed. For an early example of its use in the auditing literature, see Dye, Balachandran
and Magee (1990).
16
if no auditor is hired; and
(2) P(r
m
t
(h, d)) = E[X | r
m
t
(h, d)] - Var[X | r
m
t
(h, d)]
if an auditor is hired and issues report r
m
t
, t {v, i} under reporting standard = (h, d).
Since the manager is risk-neutral, the value of auditing is defined as the amount the audit moves price,
which is the difference in the expected price of the firm with and without the audit.
10
Therefore, the value of an
audit report of type t is given by the difference between Equations (1) and (2):
(3) V
t
(d, h) = (Var[X] - E[Var[X | r
m
t
]])
Hence, the value of auditing derives from decreasing investor uncertainty about future cash flows, and it may
depend on the reporting standards in effect. The relationship between the value of auditing and characteristics of
reporting standards depends on the auditor's expertise. This is stated in Observation 1.
Observation 1: The value of the basic audit report increases in both the fineness and hardness of the reporting
standards, while the value of the expert audit report increases in the fineness but does not vary in the
hardness of reporting standards. (See the Appendix for all proofs.)
The intuition for Observation 1 with respect to the basic auditor is straightforward. The auditor adds
credibility to management's assertions in the financial statements. The greater the information content of the
financial statements, the greater the benefit derived from the auditor's verification role. Conditional on the
credibility of the manager's report, both fineness and hardness increase the information content of that report to
investors by improving their ability to map the report into their value-relevant information partition.
The intuition for the impact of finer standards on the value of the expert auditor is identical to the impact
on the basic auditor. With respect to harder standards, the benefit of the expert auditor's interpretation role derives

10 To derive Observations 1 and 2, we ignore the cost of the audit and how economic rents are shared.
Incorporating audit fees would affect these results in a straightforward and potentially significant manner. We
explicitly incorporate audit fees and economic rents when we derive Propositions 1 and 2.
17
from making the manager's report understandable to investors. An expert auditor makes an otherwise soft
message hard. Softening standards has no effect on the value of the expert auditor's report because of two
modeling assumptions. First, we assume the expert auditor always produces a perfectly hard report, and second,
the value of an unaudited report is assumed invariant to the characteristics of reporting standards. Relaxing the
latter assumption suggests that the value of the expert auditor decreases in standard hardness. Relaxing the former
assumption requires additional structure on the model to obtain results.
Observation 1 suggests that the relationship between bright-line standards and the value of auditing
depends on how auditor expertise is characterized. If the auditor's role is one of verification only, implementation
of bright-line standards increases the value of the audit, by increasing the value of the financial report itself. If
the auditor interprets financial information to make the financial report understandable to investors, the
implementation of bright-line standards does not affect the value of the audit. This is because the auditor always
provides a report that is perfectly hard, and the value of an unaudited report is invariant to reporting standards.
11
The next observation examines the importance of the auditor's interpretation role relative to the
verification role. The value of these two roles is measured by how much each type of audit increases price: an
expert audit relative to a basic audit, and a basic audit relative to no audit. The setting can be interpreted as a
comparison of basic auditors to expert auditors, and as a measure of the relative importance of each role
performed by an expert auditor.
Observation 2: The value of the interpretation role, relative to the verification role, decreases in standard
hardness: the ratio [P(r
m
i
(h, d)) - P(r
m
v
(h, d))] [P(r
m
i
(h, d)) - P(r
0
)] decreases in h.
According to Observation 2, when soft reporting standards are implemented, the auditor's ability to

11 The paper's results about the relationship between reporting standards and the value of verification is a partial
equilibrium analysis, in the sense that we ignore possible relationships between reporting characteristics and audit
risk.
18
interpret financial statement information becomes more important relative to the auditors verification role. This
is because as standards become softer, there is potentially a larger gap between what management intends to
communicate via the financial report and how investors interpret that report, even assuming "truthful" reporting.
The interpretation role of the expert auditor helps bridge this gap.
Support for Observation 2 is potentially observable. As noted by Moonitz (1974), verification and
interpretation require different skills. Verification uses sampling techniques to draw inferences about audit
populations, and requires familiarity with red flags that may indicate irregularities. Interpretation requires
familiarity with client industry practices, client business risks, and techniques used by investors to infer value
from financial statements. The relative importance of these two roles will be reflected in the skills, training, and
education of public accountants, and in the content of their continuing professional education programs.
Reporting Standards and the Demand for Auditing when Auditor Expertise is Observable
The previous section shows how the absolute and relative values of the auditors verification and
interpretation roles respond to changes in reporting standards. We now pose similar questions in a setting in which
auditors of different expertise compete in the audit market. This section examines a setting in which the auditors
expertise is observable to management and investors. The next section models a setting in which the auditors
expertise is unobservable to investors.
12
When auditor expertise is observable, we define an equilibrium in a manner similar to Dye, Bala-chandran
and Magee (1990).
13
A
t
denotes the number of auditors of type t, t {v, i}, with A
t
0. E denotes the number
of firms (i.e., managers), with E 0. The manager can hire either type of auditor, or no auditor. The audit fee

12 This is not a model of information asymmetry in the usual sense, so there is no issue of the manager signaling
private information by the choice of auditor. The only "information asymmetry" is with respect to the information
partitions of the manager and investors. This is a fundamental assumption in the sense that even a completely
"credible" signal (as provided by the basic auditor) is insufficient to eliminate the asymmetry, and only an expert
auditor can bridge the gap.

13
See the proof to Proposition 1 for details.
19
is denoted w
t
. The reservation wage of a basic (expert) auditor is u
v
(u
i
), with u
i
> u
v
. This inequality reflects the
fact that the expert auditor provides the service of the basic auditor, plus additional services. The demand for an
audit report of type t, denoted D
t
(w
t
; d, h), is defined as V
t
(d, h) - w
t
. The following proposition examines
auditors' preferences for reporting standards in this setting.
Proposition 1 (Auditors Preferences when Auditor Expertise is Observable): Assume auditors' reservation
utilities are invariant to changes in reporting standards.
A) Basic auditors weakly prefer harder standards. Expert auditors weakly prefer softer standards. These
preferences are strict for some exogenous parameter values.
B) Auditors' preferences for finer standards depend on the relative impact that increasing fineness has on
the value of the two types of audit reports (how V
v
/d compares to V
i
/d).
The intuition for Part A of Proposition 1 is that softening standards decreases the value of a basic audit
by decreasing the value of the information contained in the financial statements. On the other hand, since the
expert auditor produces a hard report regardless of the reporting standards in effect, the price investors are willing
to pay for a firm that uses an expert auditor is invariant to the hardness of reporting standards. Therefore, as
standards become softer, expert auditors gain a competitive advantage relative to basic auditors, and also relative
to an unaudited report.
Part B of Proposition 1 shows that Observations 1 and 2 do not extend in a simple way to a market
setting in which auditors differentiate themselves according to their expertise. The ambiguity in preferences for
finer standards results from the competition between the two types of auditors. Even though the absolute value
of each type of audit report increases in fineness, their relative value determines which type of auditor managers
prefer. As standards become finer, either the basic auditor or the expert auditor may gain a competitive advantage
relative to the other, depending on the parameters of the model.
20
Several simplifying assumptions used to derive Proposition 1 can be relaxed without changing the basic
nature of the result. The restriction that reservation utilities are invariant to reporting standards can be relaxed.
The result in Part A of Proposition 1 continues to hold as long as V
v
u
v
, V
i
u
i
and V
v
/dh (u
v
- u
i
)/h. The
first two inequalities are mild assumptions, requiring that each type of audit is preferred to no audit. Loosely
speaking, the third inequality ensures that as standards become harder, the benefit from hiring the basic auditor
relative to the expert auditor increases faster than the cost. To the extent that the auditor's cost of verification is
invariant in standard hardness, this condition is easily motivated.
We next compare auditors preferences for bright-line reporting standards to the preferences of
managers and regulators. We assume that managers want to maximize the equilibrium value of their firms. The
contribution of an audit by a type t auditor to the value of the firm is V
t
(d, h), while the cost of the audit is w
t
.
Hence, the manager prefers the reporting standard that maximizes the difference: V
t
(d, h) - w
t
. We assume
regulators want to minimize the cost that investors risk aversion imposes on price, which is equivalent to
maximizing the amount that auditing moves the aggregate price of all firms in the economy. Letting A
t*
denote
the number of auditors of type t employed in equilibrium, regulators seek to maximize the aggregate value of all
audited firms, denoted V*, where V* = A
i*
V
i
+ A
v*
V
v
. The following Corollary characterizes regulators and
managers preferences for bright-line standards under specific equilibria.
Corollary 1 (Managers and Regulators Preferences for Bright-line Standards when Auditor Expertise
is Observable): Assume that both types of auditors are employed in equilibrium (so that all of the following hold:
V
i
u
i
, V
v
u
v
, and E > max{A
i
, A
v
}).
A) If auditors are in excess demand (E > A
i
+ A
v
):
i) Managers are indifferent to the hardness of standards.
ii) Regulators prefer harder standards.
B) If auditors are in excess supply (E < A
i
+ A
v
):
21
i) Managers prefer harder standards as long as expert auditors are relatively more valuable than
basic auditors (i.e., as long as V
i
- u
i
> V
v
- u
v
), but are indifferent otherwise.
ii) Regulators prefer harder standards as long as the harder standards do not change the relative
value of the two types of auditors. Otherwise, regulators may prefer soft standards.
Corollary 1 shows that managers never prefer soft standards, and sometimes prefer hard standards.
Managers are always indifferent if there are more firms than auditors, because in this situation the auditor extracts
the rents created by the audit, and managers are indifferent to the level of these rents. Managers prefer hard
standards when there are fewer firms than auditors, but only if expert auditors are the first employed. The
managers preference for harder standardsespecially the manager hiring the expert auditormay seem
counterintuitive, since harder standards make the expert auditor relatively less valuable. However, the intuition is
clarified by considering who obtains economic rents. As long as auditors are in excess supply and the basic
auditor is relatively less valuable, the manager extracts the rents produced by the basic auditor. Since these rents
increase in the hardness of standards, managers employing basic auditors prefer harder standard. Less obvious
is the fact that managers who hire expert auditors also prefer harder standards, but this is because competition
from the excess supply of basic auditors determines the wage paid to the expert auditors. Specifically, as
standards become harder, the cost of hiring the expert auditor decreases by an amount equal to the increase in
the value of a basic audit (i.e., the expert auditors wage falls by the change in the amount V
v
- u
v
). When only
one type of auditor is employed in equilibrium, the comparative statics may change, but the essence of managers
preferences is given by the Corollary.
Corollary 1 shows that regulators preferences for bright-line standards depend on whether auditors are
in excess demand or excess supply, and also on the effect that bright-line standards have on the relative value of
each type of audit. If auditors are in excess demand, all auditors are employed, V* increases in standard hardness,
and regulators prefer harder standards. If auditors are in excess supply, regulators continue to prefer harder
22
standards as long as the increase in hardness does not make the expert auditor relatively less valuable than the
basic auditor. Since the increase in standard hardness increases the value of the basic audit without affecting the
value of the expert audit, one might expect regulators to always prefer hard standards. However, this is not
always the case, because increasing standard hardness may make the basic auditor relatively more valuable to the
manager than the expert auditor, in which case managers would prefer basic auditors, and more basic auditors
would be hired in equilibrium. While each basic audit report is more valuable under hard standards than under soft
standards, the shift in the composition of the type of reports being issued, from expert reports to basic reports,
may lower the aggregate price of firms in the economy.
Reporting Standards and the Demand for Auditing when Auditor Expertise is Unobservable
In the previous section we assumed the auditors expertise was characterized as one of two types, and
that the auditors type was observable. We now relax both assumptions. The auditor's expertise is now assumed
unobservable to both the manager and investors, and its support is the unit interval, t [0, 1]. A higher value of
t means greater auditor expertise. Auditor expertise is normalized: t = 0 indicates a basic auditor and t = 1 indicates
an expert auditor. Each auditor's expertise is exogenously determined, and the availability of auditors is given by
the distribution j(t), which is common knowledge. In equilibrium, low-type auditors are the first hired and last
fired. The wage paid every auditor is based on the reservation wage of the marginal (last) auditor employed, and
the value that this auditor adds to the price of the firm. The auditor of expertise t has a reservation wage of u
t

[u
v
, u
i
]. u
t
is assumed increasing in t, with u
v
u
t
< u
t'
u
i
for 0 t < t' 1.
Since investors cannot observe the expertise of an individual auditor, they value the firm using the value
of the average audit report. t' denotes the expertise of the last, and most expert, auditor employed. The new
pricing equation is
P(r
m
t'
) =

'
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
REFERENCES
Antle, R., and B. Nalebuff. 1991. Conservatism and Auditor-Client Negotiations. Journal of Accounting
Research 29 (Supplement): 31-54.
Baiman, S. 1974. The Evaluation and Choice of Internal Information Systems Within a Multiperson World.
Journal of Accounting Research 13 (Spring): 1-15.
Blackwell, F. 1951. Comparisons of Experiments. Proceedings of the Second Berkeley Symposium in
Mathematical Statistics and Probability, edited by J. Neyman. Berkeley and Los Angeles: University
of California Press.
Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. 1999. Report and
recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit
Committees. New York: New York Stock Exchange and The National Association of Securities
Dealers.
Demski, J.S. 1973. The General Impossibility of Normative Accounting Standards. The Accounting Review
(October): 718-23.
Dye, R.A. 1995. Incorporation and the audit market. Journal of Accounting and Economics 19: 75-114.
Dye, R.A., B.V. Balachandran, and R.P. Magee. 1990. Contingent Fees for Audit Firms. Journal of
Accounting Research 28 (Autumn): 239-66.
Dye, R.A. and R.E. Verrecchia. 1995. Discretion vs. Uniformity: Choices Among GAAP. The Accounting
Review (July): 389-415.
Financial Accounting Standards Board. 1983. Statements of Financial Accounting Concepts 1 - 4. Stamford,
CT: FASB.
Finley, D.R. 1994. Game Theoretic Analysis of Discovery Sampling for Internal Fraud Control Auditing.
Contemporary Accounting Research. 11 (Summer): 91-114.
Gjesdal, F. 1981. Accounting for Stewardship. Journal of Accounting Research 19 (Spring): 208-31.
29
Ijiri, Y. 1975. The Theory of Accounting Measurement. American Accounting Association.
Kirk, D.J. and A. Siegel. 1996. How Directors and Auditors Can Improve Corporate Governance. Journal of
Accountancy. January 1996: 53-57.
Kirschenheiter, M. 1997. Information Quality and Correlated Signals. Journal of Accounting Research 35
(Spring): 43-59.
_____. 2002. Representational Faithfulness in Accounting: A Model of Hard Information. Working paper,
Columbia University.
Krishnan, M. and L. Thoman. 1997. The Competitive Environment in the Audit Market and the Clarity of
Accounting Standards. Working paper, Purdue University.
Malueg, D.A. 1985. Comparing Comparisons of Experiments. Working paper no. 85-39, University of Iowa.
Marschak, J. and K. Miyasawa. 1968. Economic Comparability of Information Systems. Chapter 29 in
Economic Information, Decision and Prediction: Volume II, Part II, Economics of Information and
Organization. 1974. Boston, MA: D. Reidel Publishing Co.
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
Profession. Sarasota, FL: American Accounting Association.
Newman, P., and J. Noel. 1989. Error rates, Detection Rates, and Payoff Functions in Auditing. Auditing: A
Journal of Practice & Theory (Supplement): 50-63.
Penno, M. 1990. Accounting Systems, Participation in Budgeting, and Performance Evaluation. The
Accounting Review (April): 303-14.
Penno, M., and J.S. Watts. 1991. An Independent Auditor's Ex Post Criteria for the Disclosure of
30
Information. Journal of Accounting Research 29 (Supplement): 194-212.
Public Oversight Board Advisory Panel on Auditor Independence. 1994. Strengthening the Professionalism of
the Independent Auditor: Report to the Public Oversight Board of the SEC Practice Section, AICPA
from the Advisory Panel on Auditor Independence. Stamford, CT: POB.
Shibano, T. 1990. Assessing Audit Risk from Errors and Irregularities. Journal of Accounting Research 28
(Supplement): 110-40.
Stapleton, R., and M. Subrahmanyam. 1978. A multiperiod equilibrium asset pricing model. Econometrica.
(September): 1077-93.
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
' ' : .
' ' ' ' : .
: . .
' ' ' : .
: . .
' ' ' : .
: .
, , ,

In particular, for k > 1, the coefficient on the b

k,1
variables in equation A.k is 1, while the coefficient on
every other b
k,1
variable is positive but less than 1, except for the coefficients on the b
k,1
variables where
the coefficient is zero in equation A.N.
Step 2: Starting with equation A.N-1, determine if f
N-1,N
is the smallest of the f
N-1,k
probabilities for k > 1. If so,
39
zero it out by multiplying A.N by f
N-1,N
and subtracting the resulting equation from A.N-1; then proceed
to equation A.N-2 and repeat step 2 for that equation. Continue to zero out the b
N1
coefficients in this
manner until all are zeroed out, in which case proceed to Step 4, or until a non-minimal coefficient is
found, in which case, proceed to Step 3.
Step 3: Suppose the coefficient on b
N,1
is minimal for each equation A.N-1 up to A.k, but not on A.k. Find the
smallest probability in equation A.k; suppose it is f
n,k
. Then multiply A.N by f
n,k
and subtract the
resulting equation from A.k. All the coefficients remain positive, since we multiplied by the smallest
probability in A.k, and the coefficient on b
k1
remains maximal. Divide A.k through by the new coefficient
on b
k1
(so that the coefficient on b
k1
is now 1). Continue this process until the coefficient on b
N,1
is
minimal, and then repeat step 1 for A.k.
Step 4: Having zeroed out the coefficient on b
N1
for each of the equations A.1 through A.N-1, next turn to the
coefficient on b
N-1,1
for the equations A.N and A.N-2 through A.1. Using equation A.N-1, perform Steps
2 and 3 in order to zero out these coefficients in the same manner as was done for the coefficients on
b
N1
. Repeat these steps until all the off-diagonal coefficients have been zeroed out on variables b
k1
for
k > 1. Note: the right-hand side of equations A.2 through A.N is still zero to this point. Finally, zero out
the coefficients on the (1-b
11
) variable in equations A.2 through A.N by multiplying equation A.1 by the
coefficient on (1-b
11
) and subtracting from each equation A.2 through A.N.
After completing Steps 1 through 4, we are left with N equations having zero coefficients for all off-
diagonal elements. The right-hand side of equations A.2 through A.N is either positive or zero depending on
whether the coefficient on (1-b
11
) in the original equation was non-zero or zero. The right-hand side of A.1 is
negative, but so is the coefficient on (1-b
11
), so that cross-multiplying and solving for b
11
proves that b
11
is also
positive. As shown above, the sum of the on b
k1
variables equals 1, so all the b
k1
variables are between 0 and 1,
completing the proof that condition (ii) holds. This completes the proof of Lemma 1.
40
OBSERVATION 2:
From Observation 1, P(r
m
v
) is increasing in hardness, while P(r
0
) and P(r
m
i
) are invariant to changes in hardness
by construction. It follows immediately that the relative change in prices is decreasing in hardness:
{(P(r
m
i
(h, d)) - P(r
m
v
(h, d))) / (P(r
m
i
(h, d)) - P(r
0
))}/h < 0.
PROPOSITION 1:
The proof begins with the definition of an equilibrium, which is based on the equilibrium concept in Dye,
Balachandran and Magee (1990). E denotes the number of managers (i.e. firms). A
v
and A
i
are the supply of basic
and expert auditors, respectively. A = A
i
+ A
v
, the total number of auditors. Similar to Dye, et. al., we assume
that each auditor can audit only one firm. w
t
denotes the cost of a type t auditor. Reservation wages for the expert
and basic auditors are u
i
and u
v
, respectively. We assume u
i
> u
v
. An equilibrium is defined as follows:
Definition of an Equilibrium when Auditor Expertise is Observable:
For a given set of standards = (h, d), an equilibrium is a five-tuple {P
*
(), w
v*
, w
i*
, A
v*
, A
i*
} that solves
the following equations:
(4) 0 < w
t*
V
t
for t {v, i}
(5) P(r
m
t
) = E[X | r
m
t
] - (Var(X | r
m
t
)), r
m
t
and for t {v, i}
(6) Min{A
i
, E} if V
i
- u
i
0 and V
i
- u
i
V
v
- u
v
A
i*
= Min{A
i
, Max{(E - A
v
), 0}} if V
v
- u
v
V
i
- u
i
0
0 if V
i
- u
i
< 0
(7) Min{A
v
, E} if V
v
- u
v
0 and V
v
- u
v
V
i
- u
i
A
v*
= Min{A
v
, Max{(E - A
i
), 0}} if V
i
- u
i
V
v
- u
v
0
0 if V
v
- u
v
< 0
Equation (4) states that the wage paid to each type of auditor is positive, and weakly smaller than the expected
value of the audit report to the manager. Equation (5) states that the pricing equation for the firm is formed in a
41
rational manner (i.e., investors pay the expected value of the firm conditional on the type of audit report issued).
Equations (6) and (7) determine the number of expert and basic auditors hired in equilibrium. Equation (6) shows
there are three cases for determining the number of expert auditors. In the first case, expert auditors are the first
employed. In the third case, expert auditors never enter the market. In the second case, expert auditors want to
enter the market because the value of their report exceeds their reservation wage. However, the expected value
of the basic auditor's report exceeds the basic auditor's reservation wage by a greater amount, so basic auditors
are hired before expert auditors. Equation (7) determines the number of basic auditors hired. The three cases
identified in Equation (7) are analogous to the three cases in Equation (6). To ensure that the equilibrium is well
defined and that markets clear, it is assumed that auditors of both types are willing to work if offered a wage
weakly greater than their reservation wage.
For any auditor to be hired, it is necessary that u
i
w
i*
and/or u
v
w
v*
. There are many equilibria in
which the values of A
i*
, A
v*
, w
i*
and w
v*
depend on the relative values of A
i
, A
v
, E, and the two differences V
i
- u
i
and V
v
- u
v
. An equilibrium exists whenever either the auditors or the managers are indifferent about entering
the market: either w
t*
= u
t
or w
t*
= V
t
. This follows from the assumed actions of each player when the player is
indifferent. To show that an equilibrium exists, it is sufficient to show that at least one of these conditions holds.
The equilibrium is characterized in Lemma 2.
Lemma 2: The prevailing equilibrium depends on the relative values of the audit reports; i.e., which is larger,
(V
i
- u
i
) or (V
v
- u
v
). The equilibrium can be characterized as follows:
II.A. (Expert Auditor Dominated Equilibrium): Suppose V
i
- u
i
> V
v
- u
v
where V
i
- u
i
0. Then the
equilibrium depends on the values of E, A
i
, A
v
and the difference V
v
- u
v
as follows:
1) If E A
i
then A
i*
= E, w
i*
= u
i
, A
v*
= 0 and w
v*
= 0.
2) If E > A
i
the equilibrium depends on the difference V
v
- u
v
:
a) If V
v
- u
v
0, A
i*
= A
i
, w
i*
= V
i
, A
v*
= 0 and w
v*
= 0.
42
b) If V
v
- u
v
> 0, then
i) when A
v
< E - A
i
, the equilibrium is A
i*
= A
i
, w
i*
= V
i
, A
v*
= A
v
and w
v*
= V
v
ii) when A
v
E - A
i
, the equilibrium is A
i*
= A
i
, w
i*
= V
i
- (V
v
- u
v
), A
v*
= E - A
i
and w
v*
= u
v
.
II.B. (Basic Auditor Dominated Equilibrium): Suppose V
i
- u
i
< V
v
- u
v
where V
v
- u
v
0. Then the
equilibrium depends on the values of E, A
i
, A
v
and the difference V
i
- u
i
as follows:
1) If E A
v
then A
i*
= 0, w
i*
= 0, A
v*
= E and w
v*
= u
v
.
2) If E > A
v
then the equilibrium depends on the difference V
i
- u
i
:
a) If V
i
- u
i
0, then A
i*
= 0, w
i*
= 0, A
v*
= A
v
and w
v*
= V
v
.
b) If V
i
- u
i
> 0, then
i) when A
i
< E - A
v
, the equilibrium is A
i*
= A
i
, w
i*
= V
i
, A
v*
= A
v
and w
v*
= V
v
ii) when A
i
E - A
v
, the equilibrium is A
i*
= E - A
v
, w
i*
= u
i
, A
v*
= A
v
and w
v*
= V
v
- (V
i
- u
i
).
Proof of Lemma 2: First the equilibrium is derived when there are no expert auditors (A
i
= 0). This is done for
two cases, depending on the relative magnitudes of A and E. Then we extend the proof to the case of A
i
> 0.
Case 1, A
i
= 0 and A
v*
A < E:
Either A
v*
< A < E or A
v*
= A < E. If A
v*
< A < E, then u
v
= w
v*
= V
v
. To see this, note the following. It is clear
that in any equilibrium in which auditors are employed, u
v
w
v*
V
v
must hold. Since A
v*
< A, u
v
= w
v*
holds.
Otherwise, if u
v
< w
v*
, more auditors would enter the market, driving down the equilibrium wage. Also, since
A
v*
< E, w
v*
= V
v
. Otherwise, if w
v*
< V
v
, managers not employing auditors would increase the audit fee to bring
additional auditors into the market. The other case is A
v*
= A < E. In this case, u
v
< w
v*
= V
v
. This follows
because the smaller number of auditors than managers limits competition among auditors, resulting in auditors
obtaining economic rents of w
v*
- u
v
, or equivalently, V
v
.
43
Case 2, A
i
= 0 and A
v*
E < A:
Either A
v*
< E < A or A
v*
= E < A. If A
v*
< E < A, then u
v
= w
v*
= V
v
holds. The reasoning is analogous to the case
of A
v*
< A < E above. If A
v*
= E < A, then u
v
= w
v*
< V
v
. In this case, the smaller number of managers than
auditors limits competition among managers, and they earn economic rents of V
v
- w
v*
(i.e., V
v
- u
v
). These
results imply the following. Given V
v
> u
v
, if A < E the equilibrium is A
v*
= A and w
v*
= V
v
; and if E < A, the
equilibrium is A
v*
= E and w
v*
= u
v
. The equilibrium pricing equation is the same in both cases. Two knife-edge
cases must be considered. If V
v
= u
v
, the equilibrium value of A
v*
is indeterminate, and for tractability is set at
A
v*
= Min{A, E}. If A = E, the equilibrium value of w
v*
is indeterminate, and is set at w
v*
= u
v
.
Case 3, A
i
> 0:
Extending the proof to A
i
> 0 is straightforward. The difference V
t
- u
t
shows the value of the report of
a type t auditor in excess of the auditor's reservation wage. If there are few managers, only the relatively more
valuable auditor is employed; this is the case for equilibria II.A.1. and II.B.1. If there are enough managers, the
difference V
t
- u
t
has additional influence. If the difference V
t
- u
t
is positive for one type of auditor and negative
for the other type, only the first type is employed. This explains the equilibria in II.A.2.a. and II.B.2.a.
A different situation arises when both auditor types are potentially valuable and there are more managers
than the more valuable type of auditor; cases II.A.2.b. and II.B.2.b. Suppose, for example, that case II.A.2.b.
holds; that is V
i
- u
i
> V
v
- u
v
> 0 and A
i
< E. Then the equilibrium depends on the number of managers relative
to the total number of auditors. If E > A, the auditors have the negotiating advantage and obtain the entire
economic rent, so the equilibrium wage is bid up to the value of the auditor's report for each type of auditor. If
E < A, the managers have the negotiating advantage and can extract all economic rents from the less valuable
auditors, in this case the basic auditors, so that w
v*
= u
v
. In equilibrium the value to the manager of hiring a basic
auditor is the same as the value of hiring an expert auditor, so the equality V
i
- w
i*
= V
v
- w
v*
holds. Plugging in
44
the equilibrium wage of the basic auditor and rearranging terms: w
i*
= V
i
- (V
v
- u
v
) > u
i
> 0. The economic rents
are split, V
i
- w
i*
going to the manager and w
i*
- u
i
going to the expert auditor. w
i*
- u
i
> 0 is ensured by the
assumption V
i
- u
i
> V
v
- u
v
. This proves the equilibria in part II.A.2.b, and an analogous argument can be used
to show part II.B.2.b holds, completing the proof of lemma 2.
The proof of Proposition 1 follows by inspection of the equilibria in Lemma 2. First, the wage of the
basic auditor is weakly increasing in V
v
, while the wage of the expert auditor is decreasing in V
v
for equilibrium
II.A.2.b when A
v
E - A
i
, so basic auditors weakly prefer harder standards and expert auditors weakly prefer
softer standards. This proves Part A of the Proposition. Second, in equilibrium II.A.2.b, when A
v
E - A
i
, expert
auditors prefer coarser standards if V
v
/d > V
i
/d, while in equilibrium II.B.2.b., basic auditors prefer coarser
standards if V
v
/d < V
i
/d. Both basic and expert auditors prefer finer standards if the converse holds in each
case. This proves Part B, completing the proof of Proposition 1.
COROLLARY 1:
The proof of Corollary 1 follows directly from the structure of the equilibria derived in the proof of Proposition
1. We assume that both types of auditors are employed in equilibrium, so that either the equilibria of part II.A.2.b
or part II.B.2.b of Proposition 1 applies.
For part (A)(i) of the Corollary, auditors are in excess demand, so the relevant equilibria are given by parts
II.A.2.b.i and II.B.2.b.i of Proposition 1. These equilibria are characterized as follows:
Under both II.A.2.b.i and II.B.2.b.i: A
i*
= A
i
, w
i*
= V
i
, A
v*
= A
v
and w
v*
= V
v
The manager wishes to maximize either V
i
- w
i*
or V
v
- w
v*
, depending on whether the expert or basic auditor
is employed. Substituting from the equilibrium conditions, the managers objective function always equals zero,
so managers are indifferent to the reporting standards.
45
For part (A)(ii) of the Corollary, substituting into the regulators objective function, we get
V* = V
i
A
i*
+ V
v
A
v*
= V
i
A
i
+ V
v
A
v
V* is strictly increasing in V
v
, implying that regulators always prefer harder standards.
For part (B)(i) of the Corollary, auditors are in excess supply, so the equilibria are given by parts II.A.2.b.ii and
II.B.2.b.ii of Proposition 1. Part II.A.2.b.ii is the equilibrium in which expert auditors are relatively more valuable
(i.e., V
i
- u
i
> V
v
- u
v
), and Part II.B.2.b.ii is the equilibrium when basic auditors are relatively more valuable
(i.e., V
i
- u
i
< V
v
- u
v
). These equilibria are characterized as follows:
Under II.A.2.b.ii: A
i*
= A
i
, w
i*
= V
i
- (V
v
- u
v
), A
v*
= E - A
i
and w
v*
= u
v
Under II.B.2.b.ii: A
i*
= E - A
v
, w
i*
= u
i
, A
v*
= A
v
and w
v*
= V
v
- (V
i
- u
i
)
Substituting into the managers objective function, when the expert auditor is relatively more valuable:
V
i
- w
i*
= V
i
- (V
i
- (V
v
- u
v
)) = (V
v
- u
v
), and V
v
- w
v*
= V
v
- u
v
This implies that managers prefer harder standards regardless of the type of auditor employed. When the basic
auditor is relatively more valuable:
V
i
- w
i*
= V
i
- u
i
, and V
v
- w
v*
= V
v
- (V
v
- (V
i
- u
i
)) = (V
i
- u
i
)
This implies that managers are indifferent to the level of hardness.
For part (B)(ii) of the Corollary, the equilibria are given by parts II.A.2.b.ii and II.B.2.b.ii of Proposition 1.
Substitution gives the regulators objective functions as follows:
Under II.A.2.b.ii: V* = V
i
A
i*
+ V
v
A
v*
= V
i
A
i
+ V
v
(E - A
i
)
Under II.B.2.b.ii: V* = V
i
A
i*
+ V
v
A
v*
= V
i
(E - A
v
) + V
v
A
v
Increasing hardness increases the relative value of the basic auditor. For the second equilibrium (i.e., part
II.B.2.b.ii), the basic auditor is already relatively more valuable, so increasing hardness does not change the
46
ranking, and the same equilibrium conditions continue to hold. Hence, regulators strictly prefer harder standards.
For the first equilibrium (i.e., part II.A.2.b.ii), expert auditors are initially more valuable. Increasing standard
hardness may reverse this ranking, changing the equilibrium conditions from those of part II.A.2.b.ii to those of
part II.B.2.b.ii. Numerical examples are easily generated in which choosing a harder standard will decrease V*.
For example, let E = 200, A
i
=100, V
i
= 10, u
i
= 9, A
v
= 150, u
v
= 2, and V
v
= 2.1 under relatively soft standards
and V
v
= 3.1 under relatively hard standards. In this case:
V* = V
i
A
i
+ V
v
(E - A
i
) = 10*100 + 2.1*(200 100) = 1000 + 210 = 1210
> V* = V
i
(E - A
v
) + V
v
A
v
= 10*(200 150) + 3.1*150 = 500 + 465 = 965.
This example shows that regulators may prefer softer standards, completing the proof.
PROPOSITION 2:
The proof begins with the formal definition of an equilibrium in this setting. We assume the following:
(i) The distribution of auditor types, j(t), is uniform on the unit interval. The auditor's reservation wage
is u
t
[u
v
, u
i
], where u
t
is assumed increasing in t, with u
v
u
t
< u
t'
u
i
for 0 t < t' 1.
(ii) When the marginal auditor is type t, investors price a firm that is audited according to the following
pricing equation:
( ) ( ) [ ] ( ) ( ) [ ] ( ) ( ) ( ) ( )

+
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 , , , | * *
*

Dropping the conditional variables, this expectation can be rewritten as follows

( ) [ ] ( ) ( ) [ ] ( ) ( ) ( ) [ ] [ ] ( )
0 0 0 0
r P w E r P r P E r P w r P r P E w r P E
t
m
t
m
t
m
+ + * * * * * *
* * *
Substituting for price in the first expectation following the final equality gives
( ) ( ) [ ] [ ] ( ) ( ) ( ) [ ] ( ) ( ) ( )
i v
i i v v t
m
V
t
V
t
r P r X Var r X E
t
r P r X Var r X E
t
E r P r P E
2 2
1
2 2
1
0 0 0
* *
| |
*
| |
*
*
*
+
,
_

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.