Unregulated Markets for Audit Services
K J

S S*School of Business
UNIVERSITY OF ALBERTA

School of Management
YALE UNIVERSITY

ABSTRACT
Certification of financial reports is tightly regulated with the intent to ensure the qualityof this service. In order to place this market within a larger perspective, Part I of this paper
presents archival data on certification activity in the economy. e finding of widespread
availability of a diverse set of certifiers for most goods and services points to the competitive
conditions that accounting firms may encounter as they attempt to expand their range ofservices. In Part II we examine an instance of audit firms unsuccessfully competing with
non-traditional assurance providers of e-commerce privacy certification. eir failure
appears to be attributable, at least in part, to the high cost of certification, inferior standards,
and poor compliance by their clients. In Part III we document the types of certification
reports issued by government agencies and private certification services. Private certification
agencies issue more detailed and informative certification reports compared to government
agencies. We discuss the implications of these findings for the market for audit services.
JEL Classifications: M49; G34; G38
Key Words: Private Audit; Regulation; Certification Services; Audit Reports

Introduction
e auditing of financial reports is tightly regulated in all developed countries. e market foraudit services has matured; such services have become a commodity characterized by falling prices,
declining margins, and little growth (Elliott 1995, 1998). is has spurred audit firms to expand
the scope of their services to broader “assurance” markets. ey have also attempted to create a new
designation to signal and legitimize a broader role for their profession (Covaleski et al., 2003). We
explore how markets for certification services function in absence of regulatory mandates.
* Corresponding Author. Address Yale School of Management, 135 Prospect Street, New Haven, CT 06511, USA.
Telephone +1 203-432-6160 E-mail shyam.sunder@yale.edu.
Received August 1, 2011; accepted October 14, 2011

Copyright©2011 Research Institute for Economics & Business Administration - Kobe University.

2

e Japanese Accounting Review, 1 (2011), 1-16

When audit firms seek to sell additional services to their audit clients, concerns about theaudit firms’ independence arise. Accounting firms can grow by expanding into services thatare not perceived to be incompatible with their role as financial auditors, e.g., corporate social
responsibility audits. Better yet, they could try to sell financial audit services in new markets,
such as Russia and Eastern Europe (Mennicken 2010). Expanding into unrelated fields in which
they have little expertise is a more complicated and risky move. e WebTrust seal of privacy andsecurity for corporate websites is a recent example of such a move. Upon entering what they may
believe to be virgin territory without adequate knowledge and understanding, audit firms may besurprised, frustrated, and even defeated by a variety of entrenched professional and non-professional
competitors. In this paper, we examine unregulated certification services in the economy to provide
some evidence about the competitive conditions that audit firms might find in such markets.
Michael Power draws attention to the expansion of the scope of certification services, calling it“an audit explosion” in society (Power 1994, 1999). e demand for certification is usually believed
to be driven by the need to control agency costs (Antle 1984), or by shifts in regulatory demand forbetter accountability and control (Radcliffe 1998). However, our research suggests the possibility
that at least a large part of the demand for certification is private, personal, and mundane, pervading
all sectors of the economy. Certification is routinely demanded (and supplied) for baseball cards,
toasters, and washing machines in markets that lack organizational relationships or government
regulation. Changes in information technology have made it easier to access opinions of traditional
experts as well as a host of non-professional expert and peer opinions. Demand for most kinds ofcertification seems to arise from their information value, not from concerns relating to enforcementof accountability.
We use “certification” in its broad meaning of “the act of giving assurance of quality or validity,”in the sense conveyed by terms such as corroboration, verification, validation, measurement andguarantee.1 e present study compares examples of certification services in unregulated markets
across sectors of the economy. e WebTrust seal of privacy and security for corporate websites is agood example of auditors’ attempts to compete in a non-traditional market. Since this product was
designed to appeal to the retail visitors to the websites of corporate clients, its features are publicly
observable, obviating the need for expert judges to ascertain independently their quality.
Competition can also influence the nature of audit reports. Lizzeri’s (1999) model indicatesthat a monopolist certifier provides coarsely graded “pass/fail” reports whereas competition in thecertification market leads to the provision of more informative reports. e Dubey and Geanakoplos(2010; henceforth DG) model indicates that an optimal grading scheme should have an intermediatelevel of fineness, an elite grade for a few, and an absolute rather than relative grading scheme. eelite grade motivates high-ability clients to exert effort; the absolute grading scheme motivates clientsof medium skill to exert effort; and the intermediate level of fineness balances measurement error
with the limited capacity of users to process grade differentiation.
e present study has three parts. In Part 1, we report data on the types and ubiquity ofcertification services available in the economy. We select a representative sample of private goods(chosen from the producer and consumer price indices published by the government and from
eBay), and search for certification services available for each. In Part 2, we assess and compare thecertification standards for internet privacy developed by WebTrust in the accounting profession
with those developed by the non-accounting competitors. We also compare the privacy practices
of websites certified by WebTrust and by non-accounting certification agencies. In Part 3, wecompare certification by government and private agencies. We find that: (1) there is large and1

is broad usage of audit as a monitoring technology extends beyond the narrower usage prevalent in the context of financial
reporting (Power 1994).

Jamal and Sunder: Unregulated Markets for Audit Services

3

widespread private supply (and, therefore presumably, demand) for certification services in virtually
all parts of the economy, both online and offline, and receptive to both professional and nonprofessional providers; (2) accounting firms who ventured into e-commerce privacy certification
had weaker standards, as well as weaker compliance with those standards, compared to their nonprofessional competitors; (3) fineness of grading scales used by private certification agencies are used
as instruments of competition, and they are consistent with one of the three predictions of the DG
model. Government agencies on the other hand, generally provide pass/fail reports consistent withthe prediction of Lizzeri (1999). We return to these issues in concluding remarks.

Part I: Demand for Certification Services and Competition in the Broader Economy
In Part 1, we document the explosion of audit services (Power 1994) in the unregulated sector.
We selected a sample of 817 items sold online and offline. Goods sold online were selected from
eBay.com (400 items, chosen at the category level used by eBay). e “all categories” page on eBay
listed all the items available for sale in 31 main categories and a hierarchical structure organizing
thousands of items under layers of subcategories. We selected all items at the first subcategory
level (e.g., sports cards) resulting in a sample of 400 items, excluding catch-all subcategories suchas “other.” Goods sold offline were selected from the U.S. Producer Price Index (PPI – 358 items)
and Consumer Price Index (CPI – 59 items), as published by the U.S. Bureau of Labor Statistics(www.bls.gov). e PPI has a hierarchical structure with 15 main categories. We selected a sample
of all items at the second subcategory level, resulting in a sample of 358 items. e CPI has a flatterhierarchical structure, and in some cases there are no subcategories (e.g., college textbooks). We chose
all unique items in the CPI that were not in the PPI sample.
Of the variety of certification services available for goods and services in the private economy,
the most formal and traditional service is the offer of an expert opinion on compliance with therelevant formal written standards. is is also the option most favored by the accounting profession,and accountants are discouraged from offering opinions in the absence of written standards. It isalso possible to obtain expert opinions in the absence of a formal set of standards, laypersons’ ratings
without formal standards, and a variety of audience/popularity meters that simply record the level orrank of activity (e.g., bestseller book, music, and film lists).
Panel A of Table 1 indicates that out of the 817 goods in the sample, we were able to findexperts who would provide a certification with compliance to a formal set of standards for 743 of
the goods (91%). For another 59 goods (7%), we were able to find experts who would provide an
opinion, but without use of a formal set of standards (e.g., to rate sculptures, antiques, paintings, andgardening services). Among the remaining items, we were able to find laypersons’ ratings for 8 (1%),
and a meter for 3 (0.5%). We were unable to find any kind of certification service for only 4 items(0.5%, e.g., parking services, tattoos, other body art, and sale of coupons). Overall, for 813 or 99.5%of the goods in our sample, it was possible to find some kind of certification service.
Panel B of Table 1 provides the available combinations of certification services. For 322 items(40% of the sample) the full range of certification services was available: standards with expert
opinion, expert opinion only with no formal standards, lay opinion, and meter. For 114 items (14%of the sample), only an expert opinion using a formal set of standards was available. For all theremaining items, more than one kind of certification was available.
ese findings support Power’s (1994) characterization of our civilization as an “audit society.”4e Japanese Accounting Review, 1 (2011), 1-16

T 1: C S  P S O  O   U

Panel A: Four Levels of Certification Activity

344
45
5
3
3

399
14
3
0
1

743
59
8
3
4

% of
Total
(817)
91%
7%
1%
0.5%
0.5%

221

101

322

40%

4

110

114

14%

33

57

90

11%

47

34

81

10%

17

34

51

6%

8

28

36

4%

11

15

26

3%

3

20

23

3%

56

18

74

9%

EBay PPI/CPI
Total(N=400) (N=417) (N= 817)
Expert Opinions Based on Written Standards
Expert Opinions Without Written Standards
Lay People Ratings
Meter
No Certification / Rating
Panel B: Breakdown of Certification Activities
All Certification Available (Expert Opinions Based on
Written Standards, Expert Opinions Without WrittenStandards, Lay People Ratings, and Meters)
Expert Opinions Based on Written Standards only
Expert Opinions Based on Written Standards, Lay People
Ratings and Meter
Expert Opinions Based on Written Standards and Expert
Opinions Without Written Standards
Expert Opinions Based on Written Standards, Expert
Opinions Without Written Standards, and Lay People
Ratings
Expert Opinions Based on Written Standards, and Meter
Expert Opinions Based on Written Standards, Expert
Opinions Without Written Standards, and Meter
Expert Opinions Based on Written Standards, and Lay
People Ratings
All other combinations

Note: 400 goods sold on eBay and 417 goods included in the U.S. CPI and PPI (www.bls.gov) wereselected. We then searched for the existence of written standards, expert opinions based on written
standards (e.g., Michelin guide rating of restaurants), expert opinions that are not based on any written
standards (e.g., New York Times Food Critic Rating of restaurants), lay people ratings (on various
websites), and meters recording level of activity (e.g., revenue of a restaurant, or reservation time to get
into a restaurant) which people can use to infer quality and/or popularity of a product. ese results are
summarized in panel A. e panel A results indicate that for 91% of the goods in our sample, we were able
to find an expert opinion based on written standards. For the remaining 9%, we were able to find an expert
opinion but without reference to any written standards (7%), lay people rating (1%), a meter (0.5%) or no
certification of any kind (0.5%).
For many goods, multiple forms of certification are available; in some cases everything from expert
opinions based on written standards, expert opinions which are not based on any written standards, laypeople ratings, and even meters recording level of activity. In panel B, we summarize the different forms ofcertification available for goods in our sample. e Panel B combinations are presented in order of their frequency.
e most frequent combination (occurring 40% of the time) is to have all forms of certification available (Expert
Opinions Based on Written Standards, Expert Opinions Without Written Standards, Lay People Ratings, and Meters).

He focused on how audit firms and/or governments seek to make a variety of entities “auditable.” Our
results suggest that the process of making things auditable is a general phenomenon and is pervasive
throughout the economy. Even in the most mundane economic activity (e.g., buying a toaster), a
consumer can get one or more types of certification.
In the accounting literature, a recurring theme is the importance of establishing an aura of

Jamal and Sunder: Unregulated Markets for Audit Services

5T 2: Q  E P O  XYZ W
1. Art and Antiquities (n=14)
2. Books, Maps, Manuscripts (n=5)
3. Clocks, Watches and Timepieces (n=4)
4. Clothing, Linens, Rugs and Quilts (n=6)
5. Coins, Stamps, Numismatics (n=7)
6. Electronics (n=3)
7. Famous People (n=4)
8. Furniture and Accessories (n=8)
9. Glass (n=5)
10. Guns, Knives and Swords (n=5)
11. Jewelry (n=6)
12. Knick Knacks and Collectibles (n=7)
13. Music (n=4)
14. Nature’s Treasures (n=1)
15. Photography, Cameras, Projectors (n=3)
16. Porcelain, Ceramic and Pottery (n=10)
17. Silver (n=7)
18. Sports (n=6)
19. Tools, Kitchenware & Equipment (n=3)
20. Toys, Dolls, Games (n=9)
21. Transportation (n=4)
22. Wine (n=2)
23. General Appraisers (other) (n=6)
Total (n=128)

Accreditation
64%
20%
25%
33%
29%
33%
25%
50%
40%
60%
50%
14%
25%
0%
33%
50%
43%
17%
33%
44%
25%
50%
33%
50(39%)

Education
50%
20%
25%
17%
14%
0%
0%
0%
20%
0%
33%
28%
25%
100%
67%
20%
29%
17%
0%
11%
25%
50%
67%
32(25%)

Business
71%
80%
100%
100%
100%
67%
100%
75%
100%
100%
83%
86%
75%
100%
67%
60%
71%
67%
100%
78%
25%
50%
83%
101(79%)

Hobby
7%
20%
0%
0%
0%
33%
0%
13%
0%
0%
0%
0%
0%
0%
33%
20%
14%
33%
0%
0%
25%
0%
17%
12(9%)

Note: A site we call XYZ is an official partner of eBay and has 128 experts who offer opinions on 1,850
separate items for a fee of $9.95 (basic service) or $29.95 (enhanced service). e site provides a descriptionof some of its experts. Data in this table on accreditation, education, and business interests of experts wereobtained from XYZ and reflects attributes of competence of all experts providing opinions on the site. As
far as we know, these are self-assessments of competencies with no independent verification that we areaware of. Most of the experts who provide an opinion on this site (79%) also run a related business (e.g.,
the wine expert owns a wine shop, and the carpet expert owns a carpet shop).

expertise and legitimacy through professional associations. Powerful lobbies representing accountants
and other professionals interact with state regulators in order to influence the terms of entry to theprofession (Cooper and Robson 2006, Gendron et al., 2007). However, the results presented in Table
1 suggest that the markets for expert certification are more flexible in accepting claims of various
kinds of expertise. While a restaurant certifier like Zagat may have many of the attributes of an audit
firm (written standards, a certification process, standardized report), the markets are also willing touse self-appointed experts who do not issue standard reports (e.g., a New York Times restaurant
critic) or even laypersons’ reports of their personal, idiosyncratic experiences in restaurants.
For additional evidence on individuals’ willingness to carry out transactions with certifiers ofvarying degrees of expertise, we approached a website (which we call ABC) for information about
the panel of experts whose opinions are made available on the Internet. ABC is an official partnerof eBay and has 128 experts who offer opinions on 1,850 items for a fee of $9.95 (basic service) or$29.95 (enhanced service) per assessment. ese experts do not follow any written standards, nor are6e Japanese Accounting Review, 1 (2011), 1-16

their opinions based on reference to standards. For some of its experts, the site provides a description,
educational background, relevant business and other experience, and, in some cases, accreditation byprofessional bodies.
Since the list of ABC experts is rotated periodically, we could not be sure that all their experts
were listed at any given time. We obtained data on accreditation, education, and business interests of
all listed experts available to provide opinions on the site (see Table 2). Of the 128 experts, 50 (39%)
held formal accreditation from a professional body; 32 (25%) had relevant educational credentials(e.g., opinions on art being offered by persons having an advanced degree in art history); and 101(79%) ran a business involved in the activity they were providing opinions on (e.g., a carpet shop or awine store). Only 12 experts (9%) did not report any formal credentials and indicated that they were
hobbyists interested in activity on which they opined.
Implications for Auditing
e accounting profession has tried to create a professional identity by requiring its members
to develop written standards and then issue a report certifying their client’s compliance with thosewritten standards. is gives accounting firms a distinct but not unique identity. For about 91%
of the private goods in our sample, we document the presence of certification agents with similar
profiles of having written standards, an audit process and standardized reports. However, nonaccountant competitors may also operate with and without written standards, and with and without
formal credentials. e accounting profession has recently added a 5th year of schooling requiredfor becoming a CPA in the U.S., and similar proposals are being considered in other countries, suchas Canada. Our findings call for more research on the value of formal credentials in certification
markets.

Part II: Provision of WebTrust Privacy Certification
Accountants usually respect as credible other professional competitors, such as lawyers whocompete for work in established accounting markets (e.g., for provision of tax services). Lawyers have
all the professional attributes valued by accountants, including formal education, an examination
process, a codified body of knowledge, and an elaborate code of ethics. One explicit argument for
creating a new, international XYZ professional designation was the desire to expand the zone ofmarket permission (legitimacy) to broaden the range of services that accounting professionals could
offer (Elliott 1995, Covaleski et al., 2003).
Accountants tend to be dismissive of non-traditional competitors, however, viewing them asproviders of lower quality services (see, for example, responses of accountants in the Gendron andBarrett 2004 study of web assurance services). Yet, these non-traditional competitors dominate
accountants in non-accounting markets (see market shares documented in Part I). Failure to expand
into markets for web assurance services is a good example of the consequences of accountants notunderstanding this non-traditional competition.
In 1997, the American Institute of Certified Public Accountants (AICPA) and the Canadian
Institute of Chartered Accountants (CICA) jointly introduced a service called WebTrust, intended
as a marquee product for accountants wanting to provide high-value assurance services in the new
economy. Yet, despite the full institutional marketing muscle of large networks of the AICPA
and CICA, WebTrust was a commercial failure. WebTrust faced competition from a consortiumsponsored privacy certifier called TRUSTe, and a certifier sponsored by the Better Business Bureau

Jamal and Sunder: Unregulated Markets for Audit Services

7(BBB Online). Despite various claims by accountants that their standards and services were superior,the market favoured their non-accountant competitors.
A study of e-commerce privacy practices by Jamal, Maier, and Sunder (2003, henceforth JMS)
showed that, of the 500 most-used websites in the US, not a single site had a WebTrust seal. In
addition, two Big Five accounting firms—PricewaterhouseCoopers and Ernst and Young—defectedfrom the accounting profession’s common marketing effort, and developed competing seals based on
their own proprietary standards (PWC’s BetterWeb and EY’s CyberProcessor Certification). Boththese firms also sponsored competing web seals such as TRUSTe, which had 2,000 clients as of thesummer of 2001 ( Jamal, Maier and Sunder 2003, 2005).
Members of AICPA and CICA, and accounting firms participating in the WebTrust program
were puzzled by their failure, bitter at the firms for breaking rank, and generally unsure about what
to do next (Gendron and Barrett, 2004). AICPA and CICA continued to revise WebTrust standards
to make it more attractive. WebTrust 1.0 (issued in 1997) focused heavily on the authenticationof businesses and security and was replaced by WebTrust 2.0. In 2000 AICPA and CICA issued
WebTrust 3.0 to break the service into modules, including a new privacy assurance module. Since
AICPA was convinced that its WebTrust service was superior to that of its competitors, it attributed
its poor performance to the higher prices charged for its service. WebTrust’s Module 3 sought toaddress pricing pressure by selling individual modules that could be packaged to serve the customized
needs of specific clients at a lower price. However Module 3 also failed in the marketplace.
It is easy for accountants to deride TRUSTe and BBB Online, because neither entity conducts
manual audits. Instead, they review their clients’ posted privacy policies and pose as customers to“audit” the customer experience in visiting and using the sites. ey also rely on customer complaints
to police the clients. While this may seem to be a weak enforcement mechanism, compliance with
their disclosure standards is remarkably high. In a study of privacy policies, JMS programmed a web
crawler to visit 100 high-traffic websites and record the cookies (small text files on a visitor’s hard
drive that allow the website to recognize a user) used by each site.2 TRUSTe and BBB Online privacy
policies require disclosure of tracking mechanisms, such as cookies, used by websites, and especiallyrequire disclosure of third-party cookies popular with online advertisers such as Doubleclick, which
aggregate data from hundreds of websites to create user profiles for marketing purposes.
JMS found that 100% of websites with a privacy seal from TRUSTe or BBB Online had
a posted privacy policy that was easy to find. All these sites disclosed their use of cookies; 88%
explained what cookies are and what information they collect; and 56% even explained how to turnoff or monitor the cookies. Almost all of the sites that used third-party cookies (97%) disclosed theirpractices, and 63% provided a link to the privacy policy of the third party or a link to opt-out of thethird-party cookie. is rate of compliance is remarkably high, and significantly better than websites
with similar traffic volume that did not have a web seal (see also Jamal, Maier and Sunder 2005 forthe effect of EU privacy law in the UK).
e high quality of privacy policies and actual disclosure practices by TRUSTe and BBB Online
clients suggests there is little room for accounting firms to develop superior privacy-disclosure
standards or compliance practices. JMS also sent their web crawler to 20 randomly chosen WebTrustclients and 20 randomly chosen PWC BetterWeb clients.3 Disclosure of cookie usage was good (85%for WebTrust clients, 95% for PWC clients), though none of their clients disclosed the presence
2
3

If you log onto a site and the site remembers your password, or greets you by name, then the site is using a cookie to recognize youese data were collected and reported in an early working paper by Jamal, Maier, and Sunder, but were removed during the review
process and were not reported in the published JMS (2003) paper.

8e Japanese Accounting Review, 1 (2011), 1-16of third-party cookies on their website. WebTrust and PWC standards do not require disclosureof third-party cookie usage, and their clients don’t provide such disclosures. More than 50% of
WebTrust (and PWC) clients did not even allow users to opt-out of receiving commercial messages
from the website. On average, privacy disclosures and opt-out practices of accounting firm clients arepoorer than those of TRUSTe and BBB Online clients. WebTrust’s privacy module and the practices
of websites with a WebTrust seal appear not to be at the cutting edge of privacy practices. WebTrustis a follower, not a leader in setting new privacy standards and appears not to have an effective
compliance mechanism.
In 2011 the AICPA/CICA alliance is still developing a new privacy framework and issued a
new privacy maturity model (PMM) on March 11, 2011 (see www.aicpa.org/privacy). ere is no
indication that the accounting profession has understood how to compete with non-accounting
competitors in the web privacy market. e accounting profession is also seeking to create newmarkets for certifying corporate social responsibility activities, though we know of no index that canbe used to assess their success in providing quality standards or assurance in this non-accounting
domain.

Part III: Developing a Reputation for Audit Quality via Fineness of Audit Reports
No matter how thorough and effective the auditor is, he labours in vain if he cannot clearly convey the results of his
efforts in a useful form to those who need to know them.
American Accounting Association,

A Statement of Basic Auditing Concepts, (1973).

Providing informative and accurate audit reports is an obvious means of building a reputation
for audit quality among the users of financial statements (DeAngelo, 1981). In the course of his work,
an auditor develops a detailed understanding of the quality of a company’s internal control system,
governance, accounting policies, estimates, and disclosure. Yet, the standard audit reports currently
issued are, for all practical purposes, pass/fail, 4 and they convey a bare minimum of the auditor’s
detailed understanding about the company to the shareholders. Indeed, Lizzeri’s economic model(1999) predicts that a monopolist certifier will produce low precision pass/fail reports, whereas acertifier facing more competition will issue more precise (finer) reports. A coarser system also induces
managers of clients to disclose to the auditors only the minimum necessary to get a pass grade.5
e 2010 DG model of grading schemes suggests that a coarse (pass/fail) grading scheme
conveys less information and induces less motivation for agents to exert effort to raise performance.
A fine grading scheme introduces measurement error and discourages agents with intermediatelevels of talent. An intermediate level of fineness, e.g., a 3- or 10-point system, balances these two
considerations by providing useful information and motivating agents to work harder. e DG model
also suggests that the optimal grading scheme should create a small elite grade (i.e., a hard-to-get A),
and that an absolute grading scheme (e.g., a score of more than 85 percent is an A) should strictly“e report shall state whether the financial statements are presented in accordance with generally accepted accounting
principles (GAAP)…. e report shall contain either an expression of opinion regarding the financial statements, taken as awhole, or an assertion to the effect that an opinion cannot be expressed.” (http://www.pcaobus.org/standards/interim_standards/
auditing_standards/index_au.asp?series=100&section=110). Auditors are expected to add details when the report is “fail.”5Blackwell’s fineness condition suggests that, in a game against nature, a finer report would be more useful to shareholders. Since
the subjects of audit/grading are active agents, it is not useful to think of the process as a game against nature.
4

Jamal and Sunder: Unregulated Markets for Audit Services

9

dominate grading on a curve. e elite grade motivates high-talent certifiers, whereas an absolute
grading scheme motivates certifiers of intermediate talent.
We collected data on the fineness of government rating standards by visiting the websites of
80 federal government departments listed as having a standard-setting function in the most recent
edition of the U.S. government publication entitled “Standards Activities of Organizations in
the United States” (Toth, 1996). We succeeded in downloading electronic copies of standards for
64 agencies (80%). We recorded a summary of the type of standards set by each agency (e.g., theDepartment of Agriculture sets standards for food and farm products, including tobacco). Toth (1996)
provided data on whether the agency audits or certifies entities governed by its standards. We examined
the websites and/or the standards to determine whether the agency provides a minimum standard(pass/fail) or a series of grades (e.g., beef grades provided by the U.S. Department of Agriculture).
In the sample of 64, 53 of the federal agencies (83%) set only minimum (i.e., pass/fail) standards.
e other eleven agencies (17%) issue a range of grades to differentiate the quality of goods. Sincemany of these agencies are not able to create an effective enforcement and deterrence regime (seeLaw 2006), they set quality/grading standards to induce entities to use better ingredients, production
methods, and accurate labels. Given chronic complaints about under-funding of the Securities andExchange Commission (although its budget was doubled after the Sarbanes-Oxley Act of 2002),
one might also expect to observe graded reporting standards in financial markets. Such grades exist
for ratings of bonds and insurance, but not for financial reports. Of the three predictions of the DG
model, all government agencies are consistent with one (setting an absolute level for a passing grade),and most are not consistent with the other two (a grading system of intermediate level of fineness,
and an elite grade). e U.S. Department of Agriculture, with its hierarchy of grades for foods andgrains including elite grades (e.g., U.S. Prime beef ), is an exception, in that is consistent with all three
DG predictions for optimal grading systems.
Some government agencies have experimented with more detail than pass/fail reports. For
example, California changed its restaurant hygiene reporting system from pass/fail to a letter grade
system. Presently, a score of 90-100% is A, 80-89% is B, 70-79% is C, and a score from 60-70% isreported as a number. Two consecutive ratings with a score below 60% is an F and the restaurant canbe shut down for failing the inspection. All restaurants are required by law to post these grades in aprominent place, where they can be easily seen by consumers. A field study by Jin and Leslie (2003)
documented a shift in consumption patterns, with restaurants graded A reporting a significant
increase in sales while those rated C or lower reported decreases. ey also documented a significant
decrease in visits to doctors and hospitals for food-related illnesses after the change in hygiene
reports, suggesting that the change in grading scheme improved the hygiene of California restaurants.
Private-sector standards and seals exhibit greater variability. e certification of electricalappliances by Underwriters Laboratory is an example of a pass/fail standard, whereas TRUSTe’s useof a specific seal signifying compliance with laws relating to children exemplifies the use of multiple
seals to signal different levels of e-commerce privacy ( JMS 2003, 2005). Alternatively, baseball cards
are graded on a 10-point rating scale, whereas Consumer Reports employs a 100-point scale in rating
automobiles, and the ELO6 ratings for chess players are calculated according to a 3,000-point scale.
In private markets, rival standard-setting organizations compete by differentiating themselves along
a variety of dimensions, including the fineness of reports and the certification processes employed( JMS 2003). Some organizations let consumers choose the fineness and detail in the report for a
price. Alternatively, consumers can sometimes buy different levels of detail from rival certification
6

It is not clear if ELO has an upper limit; the maximum rating ever assigned to a player has been 2851.

10

e Japanese Accounting Review, 1 (2011), 1-16

agencies, as when a consumer who wants to buy a toaster can get a pass/fail report from Underwriters
Laboratories, or get a more detailed (finer) report from Consumers Reports.
Press reports indicate that the credit ratings firm Moody’s has developed a new line of businessto certify the internal control systems of hedge funds, using a report based on a five point scale(e.g., Tergesen, 2005). In September 2006, Soring Capital was the first hedge fund to be rated by
Moody’s, receiving a rating of 4. Moody’s markets the service to hedge-fund clients, who will pay forthe rating service just as companies pay their auditors. Morningstar may also offer a similar internal
control rating service, but plans to charge investors directly for its reports and thus hopes to be more
independent of the hedge-fund management (Tergesen 2005).7
An Illustrative Example: Baseball Card Certification
We chose the unregulated online baseball card certification market for a more detailed
examination of certification reports, because it is a competitive certification market where twenty
three certification agencies compete in an online environment ( Jamal and Sunder 2011). Grading
schemes used by 23 baseball card certification services are shown in Table 3.
Professional Sports Authenticator (PSA) started providing an online grading service in 1991
and currently dominates the market in volume. PSA rates cards on a 10-point scale at 1 pointintervals (e.g., 8, 9, and 10). Each point on the scale also has a qualitative label (e.g., 10 = mint). PSA
does not use a curve to grade, and does not create a super elite grade (the top grade of 10 is given to
about 10% of cards graded). Without an elite grade, PSA’s practice is consistent with two of the three
predictions (intermediate fineness, absolute grade cut-offs) of the DG model.
Starting in 1999, the privately-held Beckett Grading Service (BGS) has gained a significant
share of the market and emerged as PSA’s main competitor. BGS distinguishes itself from PSA in
three ways: First, it uses a 10-point scale with 0.5 point increments, and provides sub-grades forcentering, corners, edges, and surfaces. Second, it uses a stricter grading standard, giving the highest
grade of 10 to less than 0.1% of the cards it grades. It builds market awareness of BGS’s grading
strictness by periodically posting the distribution of grades it has issued (the BGS distribution isavailable to its customers at http://www.beckett.com/grading/popreport.asp?action=summary). ird,
BGS caters to different market segments by offering three brands of service at different prices: astandard BGS service, an elite vintage service (BVG), and a value product for more price-conscious
customers (BCCG). BGS’s ratings activities are consistent with all three predictions of the DG
model.8
e third major online rater of baseball cards, far behind the two leaders, is Sportscard Guaranty
Corporation (SGC). It entered this market in 1999 and attempted to distinguish itself by introducing
a 100-point scale. SGC later provided a nonlinear conversion table to translate its 100-point scores
into a 10-point score with the associated qualitative labels. SGC does not provide additional subgrades. is finding is consistent with observations by Krislov (1997), who provides several examples
where countries (and companies) use incompatible standards to differentiate their products from
Klein (1997) models the determinants of whether the buyer or the seller should pay for certification. e competition between
Moody’s and Morningstar may provide an interesting opportunity to test the implications of Klein’s model. In the audit literature,some preliminary evidence about having investors pay directly for audit services has been provided by Mayhew and Pike (2004).
8
Publication of the empirical distribution of grades could indirectly set a “norm” of what grades should be, even if the formal
grading scheme does not require the use of a grading curve. Publication may also influence the quality of cards offered for grading
to a service, and thus change the substantive implications of a fixed grade distribution.
7

Jamal and Sunder: Unregulated Markets for Audit Services

11F 1: E   A R R  I (MSN)

2006 Honda Accord

MSRP Price Range
Invoice Price Range
MSN Ratings
Expert
User
8.0
9.3

Overview
PricesPhotosFeatures & Specs
At a Glance Expert ReviewsConsumer Reports ®User Reviews$18,225 - $29,400$16,412 - $26,455

Overall Test Score
89 Read Snapshot

Reviews

SafetyReliability

Ratings Snapshot
2006 Honda Accord EX V6
Other Trims Tested▪ EX 4-cyl
Consumer Report Overview
Highs: Accelertion, ride, andling, driving position, front-seat
comfort, controls, crash-ts results.
Lows: Road noise.

Road Test Results
Acceleration
Accident avoidance
Comfort and convenience
Real-world fuel economy
For 20 more ratings
and theConsumer Reports
Bottom Line
Price on this model,
click here.

The Accord V6 is our top-rated family sedan. It has fairly
agile handling, and the ride is steady and compliant. Inside
the car the Accord is roomy, quiet and refined, althoughsome road noise is noticeable. A telescoping steering column
allows drivers to find an ideal position. The automatic shifts
very smoothly and responsively. The four-cylinder engine is Overall Rating(Family sedans)smoother than many V6s. Side and curtain air bags are
standard. The V6 model is very quick and relatively fuelefficient. V6 models also get standard stability control for2006. The V6 hybrid version is even quicker and gets 25
Highest89
mpg overall, just one mpg better than the four-cylinder,
Rated
which may not justify its $30,000 price tag. Crash-test
results are impressive.
EX V6
89
Lowest Rated
ated

35

e Japanese Accounting Review, 1 (2011), 1-16

12

Name
1. Accugrade (ASA)
2. Professional Sports
Authentication(PSA)
3. KSA

T 3: S C G S
# of Grade on Super Elite
Year
GradesaFounded Issued Curve
Grade
1988
1991

13
10

No
No

No
No

1996

14

No

Yes

4. American Authentication(AAI)
5. Finest Grading (FGS)
6. Map Industries
7. Beckett Grading Service(BGS)–Vintage Grading (BVG)–Collectors Club (BCCG)
8. Sportscard Guaranty
(SGC)

1996

10

No

No

1997
1998
1999

14
14
19

No
No
No

Yes
Yes
Yes

1999

100/18NoYes

9. e Final Authority (TFA)

1999

19

No

Yes

10. Collection Monster (CM)

1999

19

No

Yes

11. Advanced Grading(AGS)
12. Mint Grading Services

2000

11

No

Yes

2000

18

No

Yes

13. CTA Grading Experts

2000

11

No

Yes

14. Bear Stats Grading(BSGS)
15. Global Authentication(GAI)
16. Pro Sports Grading(PRO)
17. Professional Grading
Service (PGS)
18. World Class Grading
(WCG)

2002

14

No

Yes

2002

19

No

Yes

---

22

No

Yes

---

19

No

Yes

---

20

No

Yes

19. Champs Grading Service(CGS)
20. Grade Tech

---

10

No

No

---

21

No

Yes

21. Premier Grading (PGI)

---

20

No

Yes

22. Gem Trading- Gem Elite

---

9/18

No

Yes

23. S por ts Memorabilia
Authenticator (SMA)

---

19

No

Yes

Other Features

Invented 10-point scale (1-10)
Standard 10 point scale (8, 9, 10)
Uses qualitative labels (e.g., 10 =mint condition)
Some grades rise in increments of 0.5(e.g., 9, 9.5, 10)
Standard 10 point scale (8, 9, 10)
Standard 10 point scale (8, 9, 10)
uses 10+ to designate elite grade
Grade increase in increments of 0.5(8, 8.5, 9, 9.5)
Sub-grades given for corners,
centering, edges and surfaces
Started with 100-point scale
Later created conversion metric to
10 point scale with some 0.5 grade
increments
10 point scale with grades increasing
in 0.5 units
10 point scale with grades increasing
in 0.5 units
10 point scale with one 0.5 unit
grade (9.5)
10 point scale with grades increasing
in 0.5 units (but no 9.5 grade)
10 point scale with one additional
elite grade
10 point scale with some grades
increasing in 0.5 units
10 point scale with grades increasing
in 0.5 units
10 point scale with grades increasing
in 0.5 units (and a 9.8 grade)
10 point scale with grades increasing
in 0.5 units
10 point scale with grades increasing
in 0.5 units (includes an elite 10*
grade)
Standard 10 point scale (8, 9, 10)
10 point scale with grades increasing
in 0.5 units
10 point scale with grades increasing
in 0.5 units (and a 9.8 grade)
Grades from 2-9 with more precision
provided (0.5 increments) if client
pays more
10 point scale with grades increasing
in 0.5 units

Note: We visited 23 sports card grading services online to identify the year of formation, and the rating scales. ey

use a 10-point scale with 1 or 1/2 point increments; some use +s or have discontinuities in their scale (e.g.,
do not award some grades such as 9.5).

Jamal and Sunder: Unregulated Markets for Audit Services

13

those of their rivals. e problems SGC faced in introducing a 100-point scale are consistent with
DG’s prediction that high levels of fineness are suboptimal, due to measurement and interpretation
errors.
Twenty other baseball card certification services vie for customers using the 10-point scale inincrements of 1 or 0.5, some adding extra grade categories (e.g. pristine), thus allowing some 10-22
possible grades. e creation of extra elite grades is consistent with DG’s prediction. None of thesetwenty sites uses a grading curve, and all have a reporting scheme of intermediate fineness. Overall,
19 out of the 23 sportscard certification agencies (83%) issue an elite grade which is consistent with
the DG model. Contrary to the usual preference in accounting for the standardization of reports,
we observe competing certification agencies introducing small variations in their grading schemes(increments of 1 or 0.5 points, use of qualitative labels, 10-21 possible grades, and even a 100
point scale in one case) as they use the report to differentiate themselves from their competitors.
(See Krislov 1997 for a detailed analysis of deliberately introducing incompatible standards acrosscountries and competitors). In contrast to the government agencies, the practices of the twenty threeprivate baseball card graders generally conform to the DG predictions.
In private, unregulated markets, the same organization often supplies both a set of standards anda certification service (see JMS for a description of competition in the e-commerce privacy market).
is results in competition among standards-certification bundles. Certification services may also
be provided by third parties licensed by the standard-setter (e.g., ISO certification). Certifiers ofprivate goods such as automobiles, wines, and baseball cards also develop reporting standards, often
using scales of varying fineness. While this notion of bundling standard setting and certification may
seem novel to accountants today, in the pre-SEC era individual accounting firms often initiated bothaccounting and auditing innovations. For example, the 1902 audit of U.S. Steel by Price Waterhouseprompted the development of consolidated financial statements, as well as the long-form audit report(Vangermeersch 1986).
For many goods and ser vices, information aggregators (e.g., MSN Auto, at http://
autos.msn.com) create composite reports from ratings provided by multiple certifiers (see Figure1). e MSN Auto report on the Honda Accord, for example, provides an average of ratings from
MSN’s designated experts; the individual reports from each expert, on a 10-point scale; a user ratingfrom volunteer members of the public; and an excerpt of an independent expert opinion from theConsumer Reports based on a 100-point scale. e Consumer Reports excerpt also provides sub-ratings
for acceleration, accident avoidance, comfort and convenience, on-the-road fuel economy (all on a
five-point scale), and a qualitative discussion of the car.
Similarly, an information aggregator for wines, www.vintages.com, tabulates ratings of listed
wines by Robert Parker Jr. and James Sucking, both using a 100-point scale; Jancis Robinson, whouses a 20-point scale; Tom Wilson, using a 10-point scale; and Shari-Mogk-Edwards, employing
a 5-point scale). In addition, qualitative comments from one or more of these experts are included.
ere is little evidence of consumers being confused by the provision of multiple assessments onvarying scales.

Implications for Auditing
Auditing standards currently require a public report which is essentially no more nuanced than apass/fail report. e size of the audit firm, care in client selection, and the monitoring of compliance14

e Japanese Accounting Review, 1 (2011), 1-16

with GAAP may be the basis of an auditor’s reputation (see the Price Waterhouse audit fee premium
reported in Simunic, 1980). Given that a major objective of the Sarbanes-Oxley Act is to convey
information to shareholders about internal controls (currently provided as a pass/fail certificate), a
graded audit report with sub-grades for internal controls, governance, quality of accounting methods,
and quality of disclosure may be more useful to the shareholders.
In the pre-1930s unregulated era, audit firms issued either a short- or a long-form report (Brief
1987). e short-form report had a standardized, pass/fail format of the type used currently, but
could be as short as a single word (“Certified”), a line (“I certify the above statement is correct”),
or a paragraph (Himmelblau 1927, pp. 12-15). e long-form reports included comments on the
propriety of accounting methods, descriptions of audit procedures carried out, and occasional
representations about the market values of certain current assets as being in excess of cost. e textof long-form reports was client-specific and varied for the same client over time (Himmelblau
1927). e 1902 Price Waterhouse report on U.S. Steel set a new standard by providing additional
information on valuation issues, such as fixed asset capitalization policy and depreciation, inventory
valuation, revenue recognition, and audit procedures conducted to verify cash (Vangermeersch, 1986, P.
24).
A century later, the richness and detail of these reports has been replaced by boilerplate text
which conveys little of the auditor’s detailed knowledge to the reader. One can argue that suchknowledge could be of use to shareholder and board decisions. e standard pass/fail report is closer
to the practices of government agencies, and is a departure from the finer reports suggested by the
DG model as well as from the dominant practice of private certifiers.9 Regulation of auditing sets afloor on the precision of audit reports, and the behaviour of audit firms does not indicate that they
are aiming any higher.

Conclusion
We report evidence that certification services are widely available in unregulated private goods
and services markets, including certification by experts who base their opinion on formal written
standards, experts who do not use formal standards, laypersons’ opinions, and meters that record
activity (e.g., number of books sold). Power’s (1994; 1999) findings on the demand for audit in the
public sector are corroborated; the phenomenon of “audit explosion” also pervades the private sector.
In some new markets such as WebTrust, accounting firms failed in competing with non-traditional
certifiers who use very different business models. Our results suggest that these non-traditional
competitors have better privacy standards and their clients have better privacy practices than theclients of accounting firms. e domain of accountant-provided assurance may be narrower than thatenvisaged by the AICPA, and accountants may need to stay closer to traditional accounting markets
to be successful. Likewise, formal professional credentials and government connections may not giveaccountants much leverage in private, unregulated markets. Accountants may not have the skills andbusiness models to become certifiers of other goods and services in the economy.
Second, we examine the fineness of certification by government agencies and private certification
9

Implementation issues such as legal liability are beyond the scope of this paper (see Bush et al., 2006). ese issues can be dealt
with by providing a safe harbor, providing these reports only to the audit committee (and not directly to investors), or by creatinga grading standard like that for U.S. Prime beef and then providing a certification for companies who have high quality financial
reporting.

Jamal and Sunder: Unregulated Markets for Audit Services

15

services. Government agencies usually issue pass/fail reports. Private certification reports use afiner scale (5, 10, or 10 points) and often include some qualitative commentary and sub-scales,
breaking down the overall rating into various sub-components. Often, multiple certification reports
are available for the same product. e pass/fail scheme in the boilerplate format of financial audit
reports appears to be driven by their mandated demand, and is focused on preventing litigation rather
than providing information for decision making by shareholders and others. e recent appearanceof voluntarily provided, graded reports on the quality of internal control of hedge funds by Moody’s
suggests that the lifting of the mandatory requirement may give rise to demand for finer gradations
in financial audit reports too.
e current study looks at unregulated markets for the certification of goods and services inorder to draw implications for the accountants. Since audit firms have to perform a complicatedlegitimating process without much leverage from their traditional networks to be successful inthese unregulated markets, more research is needed on how audit firms may have to change tomeet competitive challenges as they enter new certification markets. One possibility is that auditors
could issue more detailed and firm-specific reports for certification services provided in unregulated
markets (such a sustainability audits). Our results suggest that audit regulators should consider
allowing auditors to experiment with offering more detailed audit reports.

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