Abstract
In this paper, we resolve the auditor independence problem that arises in the model studied in Antle (1982, 1984). We argue that the owner-manager-auditor relationship exhibits a "separability" that facilitates the use of a particularly simple mechanism that prevents collusion. The mechanism prevents collusion as long as the agents do not play strictly dominated strategies and assume the same to be true of the other agent; the owner's profits under this mechanism are arbitrarily close to second-best (the optimal Nash contract). The fact that a simple mechanism can be used to maintain auditor independence in a theoretical model strengthens our belief that, in practice, there exist institutions (e.g., the courts) that can maintain auditor independence with relative ease. This may be one reason why the institution of auditing is so enduring.
1. Introduction
Auditing is a vital institution. It seems unlikely that the modern firm, which is characterized by a separation of ownership and management, would be viable without auditor-verified financial statements. Preventing auditor-manager collusion (maintaining auditor independence) is critical to the survival of auditing, because when the auditing process "breaks down because of collusive behavior ... [it] can have severe economic repercussions and can erode public confidence in the profession" (Deloitte and Touche 1993, 13). Defining auditor independence precisely, however, has proved to be a daunting task for the standard-setting bodies. In a seminal paper, Antle (1984) articulated various definitions of auditor independence in the context of a formal model.
Antle modeled both the manager and the auditor as economic agents and explored the extent to which the two parties may wish to cooperate while acting in their self interests. He showed that a naive extension of the owner-manager contract to include the auditor raises serious concerns about auditor independence. The solution to the naive program, the second-best....
