The Enron collapse in 2001 has become synonymous with accounting fraud. One of the worrying revelations of the case was that advice from the Professional Standards Group of the firms' accountants, Arthur Andersen, was ignored by the partner-in-charge of the Enron file. This has led to questions about what the best relationship framework should be between the principal (headquarters) and the agent (the local office).

The principal wants to encourage the agent to provide pertinent information. The agent does not want to exert more effort than is necessary, nor tie itself to decisions by the principal that could hurt its interests, including its client relationships. So who should have the final say? And how should they share information to keep abreast of thorny problems?

Paul Newman and Kirill Novoselov construct a model that finds it is optimal to formally allow the agent to disagree when neither the agent nor the principal has all the information needed to make an expert decision - that is, a handle on the "true state of the world". This is consistent with what happened at Arthur Andersen.

But there is also another, more surprising result: the principal might adopt an informal agreement with the agent that allows the agent to disagree when he or she is the better expert. Although authority remains centralised under the principal, the agent has tacit permission to choose whatever course of action he or she deems fit.

The authors say there is a reason why the principal would pursue this arrangement rather than delegate authority to the agent: they want to encourage the agent to report information in the first place. Under delegation, the agent may decide not to report a problem if it is unlikely the principal will discover it in order to protect his or her client base, which will be smaller than the principal's.

Under centralisation, the agent theoretically should report more problems because the principal will be in charge of the response. However, if the agent is the greater expert, he or she may not agree with the principal's recommendation and may find it requires extra effort. In this case, the principal may be willing to let the agent ignore the recommendation in order to get the agent to report information in the first place.

These predictions were borne out in 2007, after the authors wrote their paper, in the Societe Generale scandal. It was reported that the supervisors of rogue trader Jerome Kerviel were aware of his activities but chose to turn a blind eye since Kerviel's expertise in derivatives was superior to that of his supervisors.

The authors note that their model has wide application. For instance, a plant manager may disagree with a chief operations officer on acceptable levels of product defects. Or a division manager may disagree with the CEO on transfer pricing policies.

"Situations where the principal and agent disagree over appropriate action occur routinely in various organisational settings. The principal, by lack of proximity to the problem, may not learn of the issue if the agent believes the principal will require an action detrimental to the agent's issues," they say.

Firms therefore need to find a model of reporting that will suit their circumstances. The authors caution, though, that external factors such as legal action can result in "catastrophic results" under delegation, as seen with Enron.

"An exogenous increase in an agent's penalty for failing to take corrective action when such action is appropriate, can lead to an increase in catastrophic risk for the principal, where catastrophes can be thought of as major audit failures or product failures," they say.