Hierarchical Agency: Double vs. Specialized Audits for Management Control

Abstract

This paper examines the economic consequences of using double audits vs. specialized audits in a hierarchical agency in order to mitigate the risk incentive problem of a risk-averse manager (agent). The distinguish feature of our model is that the auditors (supervisors) may collude on their information signals (audit reports) about the firm’s risk exposure, which are used in the manager’s performance evaluation. We show that shareholders (principal) prefer double audits to specialized audits if audit reports are of high quality, low correlation, or both; otherwise, the preference reverses. Furthermore, specialized audits are auditor-collusion proof, but double audits are not. We refer to double audits as a policy that shareholders deploy auditors to acquire information about the firm’s overall risk, and specialized audits as a policy that auditors focus on the firm’s individual risk components. Our analysis contributes to the PCAOB’s recent proposal on changes in auditors’ annual audit reports.