Do Actions Speak Louder Than Words?∗ Auditing, Disclosure, and Verification in Organizations

We study the relative performance of disclosure and auditing in organizations. We consider the information transmission problem between two decision makers who take actions at dates 1 and 2 respectively. The first decision maker has private information about a state of nature that is relevant for both decisions, and sends a cheap-talk message to the second. The second decision maker can commit to only observe the message (disclosure), or can retain the option to observe the action of the first decision maker (auditing) or, at some cost, to verify the state. In equilibrium, state verification will never occur and the second decision maker effectively chooses between auditing and disclosure. When the misalignment is preferences reflects a bias in a decision maker’s own action relative to that of the other — we call this an agency bias — then, in equilibrium, the second decision maker chooses to audit. Actions speak louder than words in this case. When one decision maker prefers all actions to be biased relative to the other decision maker — we call this an ideological bias — then, if the misalignment is large enough, in equilibrium the second decision maker chooses disclosure. In this case words speak louder than actions. While firms are usually characterized by agency bias, ideological bias is more common in political systems. Our results indicate that the ability to commit not to audit has value in the latter case. However such commitment is rarely feasible in the political sphere. JEL Classification: C73, D63, D72, D74, H11.