Auditing: Incentives and Truthful Reporting

Abstract

In recent years much attention has been given to analyzing the economics of asymmetric information.' In most studies, it is agreed that monitoring arises in a context in which there exists information asymmetry between two or more parties. However, most of these studies focus on one specific aspect of information asymmetry, namely, the action selected by the manager is not observable to the owner.2 Ng [1978b] points out that, in general, not only is the manager's action not observable to the owner, the firm's payoff is also unobservable to him. Because of the unobservability of the firm's payoff by the owners, managers are required to issue financial reports periodically. Furthermore, since these financial reports represent a major source of information to the owners, frequently managers' remunerations are based on these reports. Given the unobservability of manager's action and the firm's payoff by the owners, Ng [1977; 1978a] shows that if a manager's remuneration is directly proportional to his reported performance, then a risk-averse manager would have incentives to increase the bias and coarseness of a firm's reporting function. In particular, if the optimal production decisions by the manager are independent of his financial reporting choices, then