AUDITING IN A PRINCIPAL-AGENT MODEL: INFORMATION AND INCENTIVES IN CONTRACT DESIGN

Agency models have been formulated to examine the relationship that develops when an agent is engaged to act on behalf of a principal. The agent is assumed to choose an action which determines a payoff. The payoff is divided between the principal and the agent according to the terms of a prespecified contract, chosen by the principal. Agency relationships exist because of information asymmetries between the principal and the agent. If the agent has no better information than the principal, for example, there would be no reason for the principal to enter into an agency relationship. The principal and the agent have different utility functions and thus different objectives. The principal\u27s problem is to design a contract so that the agent is given incentives to act in the principal\u27s behalf. The principal\u27s ability to effect the actions of the agent is limited by the amount of information available to the principal. This paper extends previous work by developing a formal principal-agent model in which the principal is allowed to audit the actions of the agent to acquire information. Auditing is treated as a productive activity which can be performed by the principal to produce an information signal. The information signal is used by the principal as an input in its decision process. Auditing to produce information is costly to the principal. The costs of auditing and the corresponding value of the information produced are compared to determine the optimal amount of effort to use in auditing. The optimal auditing solution is characterized and is compared to non-auditing solutions. Some properties of the optimal auditing solution are examined. Contracts which allow the principal to audit are shown to dominate less flexible contracts. A multilevel principal-agent model with auditing also is developed so that the behavior of society in designing incentives for the principal can be examined. A relationship between a regulator and a regulated firm is developed to illustrate the auditing model. An example is presented in which an auditing solution is compared to solutions when full information is available to the principal, when no information is available, and when delegation is used. The value of auditing and of delegation is shown to depend upon the assumptions made about the information available to the agent before production decisions are made. Finally, a formal audit process is described in a regulation setting and an audit solution is compared to an optimal incentive-compatible solution. Auditing is shown by example to be a potentially valuable activity for the regulator