Incentive vs. punitive conditional audit policy

While audit action is a prominent measure for reducing agency cost, it remains inconclusive how the previous audit experience has an effect upon current audit decision. Guo et al. (2005) conclude that it is unnecessary for the principal to use conditional audit in two-period audit policy, suggesting that the optimal audit policy in current period is to maintain the same audit probability as that in previous period. However, their analyses are based on punitive conditional audit. This paper modifies their model by introducing an incentive conditional audit regime. We find that, provided both audit cost and under-declaring benefit are moderate, the incentive conditional audit policy will dominate the punitive conditional audit policy and the conditional audit mechanism will be a desirable solution.