Auditor's professional judgment, audit efficiency and interplay between legal liability and regulatory oversight

Abstract

This paper analyzes the impact of two enforcement mechanisms – regulatory oversight (inspection by the Public Accounting Oversight Board – PCAOB) and legal liability – on audit effectiveness and audit efficiency, when auditor's professional judgment is at stake. Professional judgment is a double-edged sword: used wisely, it enables efficient audit performance, but can also be used as an excuse to put in an insufficient effort, leading to an ineffective audit. The model shows that regulatory oversight is better at enforcing audit effectiveness, while legal liability is better at inducing efficiency. Moreover, switching from a pure legal liability regime to a joint regime that includes both enforcement mechanisms is found to improve audit effectiveness, limit auditor's professional judgment, and worsen efficiency. The study provides insights into the effects of the creation of the PCAOB and offers policy implications for regulators.