A Copayment Auditing Scheme for Financial Misreporting

Abstract

This paper proposes a copayment scheme to prevent collusion in auditing contracts, offering as a solution to financial misreporting. In the copayment scheme, both the client firm and a third party, such as PCAOB, are asked to share the auditing fee. The key feature of the copayment scheme is that the third party's expenses should be funded by the client firm. We demonstrate that the participation of a third party can create an endogenous collusion cost to the client firm, to such an extent that in the equilibrium, the client firm will not make any offer of bribery. Most importantly, the total equilibrium auditing fee is the same as in the bribery-free contract. This result makes an important contribution to the literature in addressing the issues of financial frauds and collusion between the auditor and the client firm within a principal-agent model.