Frequent Audits and Honest Audits

Abstract

A regulator hires an auditor to inspect a firm. Audits serve two purposes: to detectviolations and to motivate the firm to invest in compliance. Auditor and firm can colludeto hide violations. Honest audits require sufficient monetary incentives for the auditor,and more frequent audits call for larger incentives. We link the optimal audit frequencyto the budget constraint faced by the regulator, and to the firm’s bargaining powerin the collusive agreement. We show that (i) the optimal audit frequency need notbe monotonic in the regulator’s budget size, (ii) tolerating collusion can foster ex-anteinvestment, and (iii) a regulator that enjoys more flexibility in designing the auditor’scompensation scheme might be less willing to deter corruption.