Strategic Audit Policies Without Commitment

This paper constructs and analyzes a simple model of auditing in which three principal issues are explored, namely: (i) The information contained in the report. An audit is a process of verification of a report of private information available to the reporter but not to the auditor. What information is contained in a report? Is it sufficient for the auditor to infer the private information exactly or is it imperfect? How does this affect what the auditor does? (ii) Commitment to the audit policy-how does its absence affect reporting and investigation decisions. Can the auditor commit in advance to an audit policy, even when it may not be optimal to carry out the policy at the time of implementation, and, related to this, does auditing have only a purely deterrent role or can it lead to recovery of assets as well? (iii) Audit effort. How is audit intensity or effort determined? Our attempts to answer these questions will involve using the concept of Perfect Bayesian Equilibrium; we will attempt to examine the nature of such equilibria and arguments as to which equilibrium one would expect to observe. We present the basic structure of our model in an informal fashion in this introduction, and compare it to earlier work. In the next section the model is specified, emphasizing the nature of the ability to commit or its absence. We formally derive results for the case when auditing results in perfect discovery in Sections 3 and 4. In order to examine audit effort or intensity Section 5 assumes that an audit is imperfect so that repeated auditing may be necessary to verify the report. We conclude by discussing potential empirical implications of the competing theories of auditing. All proofs are contained in an appendix.