Indeed, as mentioned in the introduction, the recent corporate scandals highlighted the weaknesses of self-regulation and private litigation as exclusive discipline devices for auditors。 The reliability of audit companies as self-regulating entities has been tarnished by the increasing conflict of interest between their auditing role and their consulting role, as the share of consulting fees kept increasing in their revenues。 This point is reminiscent of the result in DeMarzo, Fishman and Hagerty (2005), that a self-regulatory organization accountable to its members tends to choose laxer enforcement than customers would。

Of course, even in a system of public regulation, enforcement can be entrusted to litigation rather than to regulatory intervention, as postulated in our model。 The limitation of litigation-based enforcement is that the costs of suing auditors may deter dispersed investors from taking action against violations, due to collective action problems。 In contrast, a well-endowed and highly motivated public prosecutor can be very effective against financial fraud, as witnessed by the activity of New York State Attorney General Eliot Spitzer since 1999。

Reputation is another decentralized mechanism that might enhance the reliability of auditors, especially considering the limited number of active auditing firms, the repeated nature of their

interactions with client firms and investors, and especially the large stakes represented by the auditors’ equity base。 Therefore, in principle this mechanism could be effective。 However,  it appears not to have deterred negligent or fraudulent behavior so extensive as to wipe out established companies such as Arthur Andersen。 Even though the reasons why reputation has been ineffective are still unclear, its limitations suggest that it needs to be complemented by regulatory intervention。

Alternative mechanisms that could in principle be used to improve the reliability of auditors are intermediaries that “certify” the quality of their information (Lizzeri, 1999) or the creation of a “financial statement insurance” (FSI) scheme, by which companies purchase insurance that protects investors against losses due to misrepresentation in financial reports and the insurer itself appoints and pays auditors (Dontoh, Ronen and Sarath, 2004)。 Certification intermediaries would tend to realign the incentive of auditors towards truth-telling by creating a second layer of monitoring, while the FSI scheme would eliminate the conflict of interest arising from managers hiring auditors。 But neither of these mechanisms is completely collusion-proof: both a certification intermediary

and an insurance company providing FSI might collude with the client firm, unless they are themselves under the purview of a public enforcement mechanism。5 Thus, rather than dispensing with public intervention, these mechanisms simply shift the need for such intervention to a higher layer。 The FSI scheme suffers also from another problem: auditors appointed by outsiders may be unable to access sensitive data placed under management’s control, and this lack of cooperation by management may prevent them from performing effective audits。

The danger of collusion between auditors and their clients suggests that “whistle-blowing” mechanisms might be particularly suited in this case, being designed to break collusion。 Such mechanisms could reward inpiduals (e。g。, employees) who report fraud by auditors and/or their clients, by entitling them to a portion of the penalty paid by the latter。 Such schemes may deter collusion, as shown by Spagnolo (2004) in the context of antitrust regulation。 But in our case whistle-blowing is unlikely to be effective, since the “whistle-blower” would hardly be able to document the tacit exchange of favorable audits against consulting contracts。6

This discussion underscores the importance of public regulation and enforcement as “residual” mechanisms to discipline the auditing profession。