Accounting Audits: On Financing Risk in the Presence of Agency Conflicts

Abstract

This paper examines how accounting audits impact investment decisions in the presence of agency conflicts. Investors choose between a short-term risk-free asset and a long-term risky project. The manager in charge of the latter has incentives to inflate interim payoffs to be able to continue a project that destroys value. An accounting audit mitigates this problem by allowing for intermediate project valuation, and therefore, for investors to cut off financing to such project before it becomes too unprofitable. This reduces initial concerns with agency conflicts, even if the incentives of the manager to inflate payoffs remain unchanged, and boosts investors financing of the risky project. These results are particularly relevant for new and innovative firms.