Sorting the good guys from bad: on the optimal audit structure with ex-ante information acquisition

• Published in: Economic theory Vol. 57; no. 2; pp. 339 - 376
• Main Authors: Menichini, Anna Maria C., Simmons, Peter J.
• Format: Journal Article
• Language: English
• Published: Berlin/Heidelberg Springer 01-10-2014; Springer Berlin Heidelberg; Springer Nature B.V
• Subjects: Acquisition costs; Analysis; Auditing; Auditing policies; Audits; Comparative analysis; Contracts; Cost efficiency; Costs; Credit risk; Debt contracts; Determinism; Economic theory; Economic Theory/Quantitative Economics/Mathematical Methods; Economics; Economics and Finance; Expected returns; Game Theory; Information acquisition; Information management; Liability; Methods; Microeconomics; Minimization of cost; Policyholders; Public Finance; Repayments; Research Article; Revenue; Risk management; Social and Behav. Sciences; Stochastic processes; Studies; Tax audits; United Kingdom; D86; Debt contract; Ex-ante information; Contracts; D83; Auditing; D82
• ISSN: 0938-2259; 1432-0479
• DOI: 10.1007/s00199-014-0818-y

In a costly state verification model under commitment, the principal may acquire a costly public and imperfectly revealing signal before or after contracting. If the project remains profitable after all signal realizations, optimally the signal is collected, if at all, only after contracting, and it may be acquired randomly or deterministically. Moreover, audit is deterministic and targeted on some signal-state combinations. The paper provides a detailed characterization of the optimal contract and performs a comparative static analysis of signal acquisition strategy and payoffs with respect to enforcement costs and informativeness of the signal. We explore the robustness of the results, including commitment issues. The results are interpreted in light of the observed features of financial contracts, showing that the optimality of the standard debt contract with deterministic audit extends to a setting with random audit.