Why Regulate Auditing? Externalities and the Limits of Regulation

ABSTRACT Good audits have benefits to the broader economy (externalities) that transcend the private benefits to companies that contract for audits. Because companies will only pay for the private benefit of an audit, there is a potential market failure in which audit quality is underproduced relative to the theoretical social optimum, which is Pigou's classic argument for regulation to correct the market failure. While Pigou's framework can identify the need for regulation, it cannot determine the optimum level of regulation. This means regulators must focus on the net benefits of regulations on a case‐by‐case basis, and not presume regulation is needed because of externalities, per se. Careful assessment of costs and benefits is necessary to prevent overregulation that has potentially harmful consequences for audit firms and clients. However, this assessment is challenging given the difficulty in defining and measuring the benefits of higher quality audits, suggesting a need for restraint in regulatory policy‐making.