Financial Effects of External Auditing

Abstract

The paper develops a model of optimal auditing behavior when the economic environment adds a noise term to the firm's cash flows, which can be reduced by employing an external auditor. The paper connects the optimal auditing policy and (i) share prices of the firm and (ii) auditor's compensation. Results show that the optimal auditing amount is below the amount needed to totally eliminate the noise in the economy. Moreover there exist a cut-off point for the auditing costs (economic noise) above (below) which auditing is not anymore optimal. In the presence of incomplete information setting, the theory of global games is used to determine the optimal auditing behavior.

Keywords: Optimal auditing, auditor's compensation, coalitional game theory, entropy

JEL Classification: M42, G12, C71