GRANTING AN EXIT OPTION TO CONDUCT AN AUDIT

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 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.