Regulatory Enforcement, Internal Control Disclosures and Audit Quality

This paper studies how regulatory enforcement and penalties affect audit transparency and audit quality. In our model, the auditor first tests a firm's internal control over financial reporting before auditing the financial report, and is required to provide an opinion on both the firm's internal control and financial report. In this setting, we examine how different types of enforcement affect the auditor's effort choices, reporting strategy, and ultimately audit quality. We find that regulatory penalties can have a non-monotonic effect on audit quality, and that policies aimed at increasing audit transparency can inadvertently decrease audit quality. We also show the importance of balancing randomized and targeted inspections of audits.