Financial Misreporting, Bribery and Penalty

Abstract

The recent outburst of corporate failures has brought financial frauds and the liability of auditors to policy debates. According to GAAS, as the client firms need to pay the auditing fee, the better informed auditors could collude with the client firm and give a report of compliance for the clients. This paper first characterizes the current system in a principal-agent model considering the setting of penalties for frauds. We show that, the setting of penalties can indeed squeeze the size of feasible bribes. However, since the maximal penalty is fixed and given by law, there can be cases where there are still feasible bribes. No matter whether there are still feasible bribes or not, we conclude that the bad status will not be reported under the current auditing system. Then we propose a co-payment scheme, which requires the auditing fee be shared by a third party. We demonstrate that there exists an equilibrium in this scheme, where the social optimal contract is offered, the auditor puts in full effort and the client firm does not offer any bribe. The overall equilibrium rewards will be the same as the social optimal contract. We then single out the factors in the co-payment contract to compare the existing systems in the US and the UK.