Optimal auditing

Optimal auditing is the study, in economics and game theory, of how a principal should verify reports made by strategic agents when verification is costly. Agents privately observe some piece of information — an income, a loss, a claim, a value — and report it to a principal who cannot observe it directly, but can inspect a report at a cost. Because agents anticipate the auditing policy when choosing what to report, the design of that policy is a problem of mechanism design rather than of statistics: the value of an audit lies mainly in the misreporting it deters, not in the misreporting it detects.

The theory is applied to tax enforcement, insurance fraud, the allocation of scarce resources within organizations, and financial contracting. It is distinct from the practice and institutions of auditing in accounting, which the theory idealizes.