Optimal Auditing in Hierarchical Relationships

This paper studies a principal-agent model with third-party auditing. Auditing technologies are distinguished according to the quantity (frequency) and the quality (accuracy) of the information they deliver. We show that the frequency of audits is irrelevant if the auditor either is honest or colludes with the agent but auditing evidence can only be concealed and not forged. Only if auditing evidence can be falsified does the principal benefit both from the frequency and from the accuracy of the auditor's observations. The findings therefore indicate that firms should opt for accurate rather than frequent audits under a wide range of circumstances.