Auditor Independence as a Unique Equilibrium Response

Abstract

This paper demonstrates how strong auditor independence, as defined by Antle (1984), can be achieved through an indirect reporting mechanism. A stylized principal-agent model based on Antle (1982) is analyzed. In the model, an owner hires a manager and an auditor. In the optimal contracts for the manager and the auditor, an equilibrium is desired where both the manager and the auditor provide high levels of effort and report their findings truthfully. However, two alternative equilibria exist where the auditor and the manager coordinate their strategies and perform tasks undesirable from the owner's perspective. Indirect reporting mechanisms are then constructed and shown to implement the owner's preferred equilibrium. The owner provides both the manager and the auditor an additional reporting signal. Each of the two signals removes one of the two undesirable equilibria. Because, in an equilibrium, neither the manager nor the auditor uses the additional signal or cheats, the additional signals are costless to the owner. The model demonstrates how allowing the manager to impose additional costs onto the auditor effectively increases rather than decreases the auditor's incentives to remain independent.