5 Collusion can hinder the effectiveness of a FSI scheme in two ways。 First, the fact that auditors are chosen and paid by the insurance company does not rule out that client firms might try to bribe them。 Second, the client company might bribe the insurance company to underreport FSI premiums in exchange for higher premiums on other insurance contracts, and thereby mischievously appear in the eyes of investors as companies with high-quality financial statements。

6  We thank Giancarlo Spagnolo for pointing this out to us。

3。The model

This section explains the rationale for regulation of auditing in a setting where auditing has informational value in raising new finance, as in Dye (1993)。 As a benchmark case, we first analyze a setting where the auditors’ activity is observable and contractible, and the economy achieves the first-best outcome。 We then examine what happens if investors cannot observe the level of effort that auditors invest in their task。 This moral hazard problem in auditing implies that auditors will choose the minimal level of quality。 Under our assumptions, the social cost of this moral hazard is that investors will allocate their funds less efficiently。

3。1。Informational value of auditing

Consider an economy with risk neutral agents and a continuum of firms。 The representative company is managed in the interest of the shareholders, so that the manager’s objective is to maximize its current value。

To continue operating, the company needs a cash injection (investment) of size I。 Absent such refinancing, the company is liquidated at a value that for simplicity is normalized to zero。 The firm also needs to raise cash to pay for any fees F required by its auditors。 Assuming that the required rate of return on new capital is standardized to zero, shareholders provide the needed cash infusion in exchange for shares that are worth at least I + F。7

Eventually, the company may turn out to be a success (state s = H) or a failure (state s = L)。 State H occurs with unconditional probability p, and state L with probability 1p。 If the company is successful, its final value V˜ is VH ; if not, it is VL I VH 。 Thus, in the bad state it is not worth refinancing the company。 Since there is a continuum of firms, p is also the fraction of successful firms。 The initial shareholders and the manager are supposed to have no private information about the company’s future value。 So, absent any additional information, its market price P is the unconditional expectation of its final value, V  pVH  (1p)VL 。 We assume that V  I , so that  it

is worth refinancing the company even if no information is gathered via an audit report。

However, an audit may still be worthwhile as it allows investors to condition the refinancing decision on an early signal of the firm’s prospects。 If the company is audited before it raises

7 A smaller stake would violate their participation constraint。 It is indifferent whether this cash infusion is contributed by the initial shareholders or by new shareholders。

additional equity, its market price will reflect also the information certified by the audit。 Auditors have a costly technology to elicit a signal that aids in distinguishing high-value from low-value firms, and relate this signal by filing a report r on the value of the firm。 In practice, auditors assess only the reliability of the historical and prospective information provided by the company’s accountants,  and  deliver  this  “filtered”  information  to  investors  who  use  it  to  evaluate     the

company。8    As  in  Dye  (1993),  we  collapse  these  two  phases  (the  validation  of      accounting