information and the evaluation made by the market) in a reduced-form process, by viewing the auditor’s report as an assessment of the value of the company。

An auditing firm can choose the precision of its signal that it observes。 The signal is assumed to be perfectly accurate when the state is H, while it may be inaccurate if the state is L。 The auditor truthfully relates the signal in his report r。9 Formally the conditional probabilities of the auditor’s report being correct are:

Pr(r L | s L, q) q, Pr(r H | s H , q) 1。

(1)

We assume that the accuracy q of the auditor’s signal is influenced by the “quality” of the audit, as determined by the procedures adopted (e。g。, external confirmation of accounting data) and on the auditor’s internal organization (e。g。, personnel selection criteria)。 But better audit quality comes at a

cost。 Formally, the auditor chooses the audit   quality

q [0,1)

at a cost C(q), which is  continuous,

increasing and convex in q, with C(0) 0 ,

lim C '(q) 0 and

q0

lim C '(q) 。

q1

Using Bayes’ rule, the probability that the company will succeed conditional on a good report is:

Pr(s H | r H ) Pr(s H r H ) 

Pr(r H )

p 。

p (1p)(1q)

(2a)

while the probability that it will succeed conditional on a bad report is zero:

Pr(s H | r L) Pr(s H r L) 0。

Pr(r L)

(2b)

8 Auditors also solicit the production of additional information from the company’s managers and accountants, when they are dissatisfied with its reliability。 If met with refusal, they can threaten a “disclaimer of opinion”。

9 Even though the auditor cannot misreport the observed signal, he can choose to rely on a totally uninformative one。 In this case, the signal will always be favorable to continuation of investment, as will be shown below。

The initial price of the company P equals the expectation of the company’s value conditional on the auditor’s report, which using the probabilities in (2a) and (2b) can be written as

E(V˜ | r H ) VH p VL (1p)(1q) V

p (1p)(1q)

(3a)

if the report is favorable, or

E(V˜ | r L) VL

(3b)

if it is unfavorable。 If no audit is carried out, the probabilities of the states H and L will be the unconditional ones, p and 1p, and the market price of the company will be equal to V 。

The shareholders’ surplus from continuation, before netting out the audit fee F (if an audit is

performed),

E(V˜ | r) I , takes different values in each of these cases。 With no audit, the surplus

from continuation is V I , which is positive by assumption。 So a fortiori the surplus is positive

when the audit report is favorable。 If instead the report is unfavorable, the surplus is

VL I 0 。

Therefore, the firm is refinanced only if no audit report is filed or if the report is favorable。 It is liquidated if the report is unfavorable, so that in this case the surplus, conditional on the optimal investment decision, is zero。

Whenever an audit is commissioned, its cost F must be deducted from the shareholders’ surplus。

Let us denote by

r the shareholders’ surplus net of the audit fee F and conditional on a report r