Granting an Exit Option to Conduct an Audit

Bulletin of Economic Research, Forthcoming

Posted: 4 Dec 2009  

Dongsoo Shin

Santa Clara University - Leavey School of Business

Sungho Yun

Hanyang University - Economics

Multiple version iconThere are 2 versions of this paper

Date Written: December 2, 2009

Abstract

We study a principal-agent relationship with auditing in which information from an audit is “soft” – by conducting an audit, the principal observes the agent’s private information, but cannot obtain a verifiable evidence on the information. Moreover, the principal’s auditing effort is unverifiable in our model. Therefore, besides the agent’s misreporting incentive, there is the principal’s incentive to accuse the truthful agent even without auditing. If the principal’s auditing effort is verifiable, granting no exit option to the agent is optimal although the principal can still accuse a truthful agent after the audit. We show that when the principal’s auditing effort is unverifiable, granting an exit option to the agent and auditing are complementary. Without granting an exit option to the agent, no auditing is optimal, and the principal grants an exit option to conduct a sincere audit, which in turn mitigates the agent’s misreporting incentive. Our analysis also reveals that, when the cost of auditing is sufficiently large, the principal conducts more sincere audits with a smaller amount of penalty.

Keywords: Auditing, Exit Option, Principal-Agent, Soft Information

JEL Classification: D82, L23

Suggested Citation

Shin, Dongsoo and Yun, Sungho, Granting an Exit Option to Conduct an Audit (December 2, 2009). Bulletin of Economic Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1517486

Dongsoo Shin (Contact Author)

Santa Clara University - Leavey School of Business ( email )

500 El Camino Real
Santa Clara, CA California 95053
United States

Sungho Yun

Hanyang University - Economics ( email )

Ansan, kyunggi-do 425-791
Korea

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