incumbent  auditor  would earn

C(q) R ,  that  is,  the  sum of  the  cost  saving in auditing

C(q)

obtained by choosing zero quality instead of the statutory quality q and the cost saving R in the production of advising。

The manager’s payoff from bribing the auditor derives from the implied increase in the probability of grabbing the private benefit: with the bribe, the firm continues with  certainty, whereas without the bribe it would continue only if the auditor’s report were positive, that is, with probability Pr(r H ) 。 Therefore the additional expected gain to the manager is [1Pr(r H )]B 。19

practitioners regard this conflict as the main source of auditors’ involvement in corporate scandals (see Crockett, Harris, Mishkin and White, 2003)。

17 The zero-cost assumption is made purely to save notation and implies no loss of generality: all that is needed is a potential cost advantage of the incumbent auditor over the competition。

18 Admittedly, the potential for collusion may arise even within the market for auditing services, if this market is not perfectly competitive or if the incumbent has a cost advantage relative to the competition in the provision of auditing services。 Also in this case, auditors could be “bribed” by the threat of losing their rents。 But in reality the rents appear to arise mainly from the joint provision of auditing and consulting services。

19  Therefore, the total surplus available to the manager and the incumbent auditor is the sum of the  auditor’s

cost savings

C(q) R

and  the  manager’s  additional  private  benefits   Pr(r L)B 。  Since  no monetary

transfers are allowed, they cannot split their joint surplus in any way that differs from the one considered in the text。 However, it must be noticed that this assumption is not crucial to our results。 We could allow monetary transfers and therefore any possible split of the joint surplus between manager and auditor, as long as the bargaining leaves part of the total surplus to the incumbent auditor, so that the potential for collusion remains。

This changes in two ways the regulator’s problem of choosing the optimal audit standard and the associated enforcement spending。 On one hand, the cost efficiency of the incumbent auditor increases social welfare。 On the other hand, the implied rent can be used by the firm’s manager to bribe the auditor。 Formally, the regulator’s objective function must be modified by including the cost savings R of the incumbent auditor:

max

l,qc ,e

Wˆ   (qc ) qc (1p)(I VL ) R C(qc ) e , (13)

where qc

denotes the standard chosen by the regulator when there is the danger of collusion。    The

new  symbol Wˆ

indicates that the social welfare function has been modified to include also the

efficiency gain R。 Instead, the presence of private benefits B does not affect the expression for social welfare, since they are a pure transfer。

The incentive compatibility constraint of the auditor must be rewritten to take into account that managers can use the rent R  to corrupt incumbent auditors:

F (qc ) C(qc ) F (qc ) R f (e)l*。 (14)

Now regulation and enforcement must be designed also to deter the auditor from accepting the bribe。 Going through the same steps as in the previous section, one finds that now the optimal enforcement level is:

ec (qc ) 

f 1 (C(qc )  R) / l* 。