15 The first derivative of enforcement with respect to the standard is e ' f '1(C(q*) / l*) C '(q*) / l* 0 。 Its second derivative is e" f '1(C(q*)/ l*) C "(q*) / l* f "1(C(q*) / l*) (C '(q*)/ l*)2 0 。

Intuitively, the audit standard should be more demanding if audits allow investors to pick the few winners in a bad pool, and/or if the audit cost is spread over a large investment。 These are situations in which the social value of a reliable auditor is very high。 Moreover, a country can afford higher standards if its auditors become more efficient in their job and/or regulators become better at monitoring them。

4。Auditors’ conflict of interest and collusion with audited firms

As discussed in the introduction, one of the alleged sources of the recent corporate scandals has been the ability of managers to “buy” the acquiescence of auditing firms by exploiting the conflict of interest between their consulting arm and their auditing arm。 Auditing firms can provide advisory services in the area of tax, accounting or management information systems as well as strategic advice, which for brevity shall be referred to as “advisory services”。 If managers behave opportunistically rather than in the best interest of investors, they can use the fees for the purchase of consulting services as “bribes” to buy the acquiescence of auditors to their objectives。 To capture this point, we shall introduce the following new assumptions。

Instead of maximizing the firm’s profits, managers are assumed to maximize the firm’s investment, so as to reap a private benefit B stemming from the continued operation of the firm。 This is a sum of money that he can appropriate at the shareholders’ expenses without being punished。  As  a  result,  the  shareholders’  payoff  from the  investment  in case of continuation  is V˜  I B 。

Under these assumptions, managers will try to induce auditors to issue positive reports so as to induce the firm’s continuation as often as possible。 We assume that, owing to collective action problems, shareholders cannot dictate the appointment of auditors, and therefore cannot prevent such opportunistic behavior by managers。 However, we rule out direct bribes to the firm’s auditor via monetary transfers, on the ground that such openly illegal bribes would be detectable via “whistle-blowing”,  and  therefore  punishable  by  law  enforcers。  Direct  monetary  bribes  are not

allowed even when disguised as auditors’ fees in excess of the competitive level: we assume that this would be detectable by inspection of the company’s accounts。16

16 If monetary bribes were allowed, the possibility of corruption would trivially arise even in the absence of the  conflict  of  interest  arising  from  the  joint  provision  of  auditing  and  consulting  services。  However,

Companies can purchase two services from auditors: auditing services at the fee F(q) = C(q), as before; and advisory services, which competitors of the incumbent auditor supply at the price R。 Companies are assumed to value advisory services more than their price R。

The incumbent auditor has a cost advantage over his competitors: he produces advisory services at zero cost, due to his acquaintance with the company and to economies of scope in the joint provision of auditing and advising。17 So, if the incumbent auditor gets the consulting contract at the going price R for the provision of advisory services to the firm, he earns a rent R。

In the hands of an opportunistic manager, this rent could be used to buy the acquiescence of auditors。 That is, the manager may condition a consulting contract with the incumbent auditor to receiving a positive report r = H, irrespective of the true state of nature。 Although formally legal, this transaction obviously plays the same role of a bribe。18 If he were to accept this “bribe”, the auditor would optimally invest no resources in auditing, that is, he would choose zero quality since in our setting this will yield a positive report with certainty:  Pr(r H | q 0) 1。 In this event,  the