Verification of Historical Cost Reports

This paper studies a stylized model in which a division manager's historical cost reports are verified. In a one-period setting, the problem of tacit collusion between the verifier and the division manager is so severe that no mechanism can be constructed under which there is a unique equilibrium that has the verifier exercising anything other than the minimal level of care. However, by extending the contractual relationship to two periods, the tacit collusion problem can be resolved. A feature of the optimal collusion-preventing long-term contract is that it relies on history-contingent production decisions.