Optimal Audit Quality, Agency Conflicts and Efficient Investment Decisions

Abstract:     
This paper examines how audit quality mitigates investment inefficiencies that result from manager-shareholders agency conflicts. A manager’s ability determines whether he generates or destroys value while running a project. Investment inefficiencies arise when shareholders fail to fire a manager that destroys value. To prevent this, shareholders hire an auditor to attest the firm’s accounts and establish the manager’s ability. The auditor’s effort determines whether or not he makes mistakes, and consequently, it dictates audit quality. The auditor fees are derived from an optimal contract to induce effort exertion. An auditor that makes mistakes produces a low quality audit but may be cheaper to hire than one that does not make mistakes. Therefore, shareholders balance fee costs against gains from improving investment efficiency when deciding which auditor to hire. This decision is shown to depend on effort costs, the probability of a mistake, and the ex-ante information about the manager’s ability.

Number of Pages in PDF File: 30

Keywords: Audit quality, Agency conflicts, Investment, Optimal contract, Corporate governance

JEL Classification: M41, M42, G30, G31

working papers series