Accurate audits and honest audits

Abstract A regulator hires an auditor and designs the audit to be performed on a firm. The anticipation of an accurate audit can induce a non-compliant firm to bribe the auditor. An inadequate salary from the regulator can induce the auditor to accept the bribe. Yet, we show that (1) as the budget available to the regulator increases, the optimal audit might become less accurate, and (2) as the regulator gets access to complex contractual forms to deal with the auditor, the odds of collusion can increase. Key to these results is the observation that a regulator might induce the firm to invest more in compliance by tolerating collusion rather than by preventing it.