Understanding the economic role of auditing standards is an important step toward improving audit efficiency and effectiveness. In this article, I argue that auditing standards are most important when an auditor may have incentives to perform poorly. While this conclusion may not be surprising, the conditions under which standards may or may not have a desirable effect on audit quality are less clear. More specifically, I make a number of observations about what standards can do: Standards can:
1. Compensate for the lack of observability of the audit outcome by focusing on the audit process.
2. Relatively reduce the information advantage available to the auditor as a professional expert, which may encourage the auditor to perform poorly.
3. Balance the diversity of demands among different stakeholders, which may drive the auditor to the lowest common denominator and create a market based on adverse selection.
4. Provide a standard that facilitates the regulation of the auditor’s legal liability in the event of a substandard audit.
Although I also make a number of observations about what standards should not do, they should not: 1. Discourage the use of judgment by auditors. 2. Limit the potential demand for economically valuable alternative levels of assurance. 3. Lead to excessive procedural routine or standardization in the performance of audits. and 4. Be set based on a legislative mandate. Ultimately, overreaching standards reduces the economic value of audits to many stakeholders and leads to fee pressures for audit firms. Fortunately, these insights can inform future discussions about the level and types of standards that are appropriate for the audit profession.