International regulation of audit quality: full harmonization or mutual recognition? An economic approach

Abstract

The market for audit services is modelled as a market with vertical product differentiation, rigid demand, third-party externalities and a liability rule. This framework is used to choose between full harmonization and mutual recognition as possible international regulatory regimes for audit quality. It is shown that if third-party externalities are zero, then full harmonization is at least as good as mutual recognition. If, however, externalities are not zero, then mutual recognition can yield a higher level of social welfare than full harmonization. These results are relevant for the debate on the international regulation of the provision of audit services, especially within the EU, and show that full harmonization is not necessarily the best option.