Agency Theory and Audit Function

Agency Theory and Audit Function

Introduction

Audits serve a vital economic purpose and play an important role in serving the public interest to strengthen accountability and reinforce trust and confidence in financial reporting. As such, audits help enhance economic prosperity, expanding the variety, number and value of transactions that people are prepared to enter into. However, in recent years, and in the light of corporate scandals, we have witnessed ongoing global demands for improvements in audit quality. Changes have been made in the UK to promote greater transparency in the audit and accountability in auditors but there are continuing demands for further improvements to be made. This raises questions about how (and to what extent) these various demands and concerns can be addressed. In trying to answer these questions, it is important to understand what an audit means to stakeholders such as shareholders, boards of directors, regulators and other third parties. What is the purpose and scope of the independent audit and what are the limitations and relationships that surround the audit role? This background paper draws on agency theory to help consider such questions. The principal-agent conflict depicted in agency theory, where principals lack reasons to trust their agents because of information asymmetries and differing motives, is critical to understanding the development of the audit over the centuries as well as its usefulness and purpose. However, in today's economy where companies' audited financial information is widely available in the public domain, other factors are at work and different interests come into play. In this environment, a simple agency view of audit is unlikely to provide complete answers. This background paper focuses on the role and importance of the agency relationship in the development of the audit historically and how that relationship may be useful in understanding the role of the statutory audit in the UK today. It also introduces other issues, interests and relationships, which impact on the application of this theory and point to potential alternative purposes of an audit. It builds on a presentation on agency relationships delivered at the March 2005 meeting of the Audit Quality Forum.  The purpose of this paper is to use agency theory to inform discussion and set the scene for the broader agenda of the Audit Quality Forum. However, it is recognised that other economic theories might also be relevant to providing a comprehensive answer to the purpose and role of audit. 

Literature Review

Agency Relationship

An agency relationship arises when one or more principals (e.g. an owner) engage another person as their agent (or steward) to perform a service on their behalf. Performance of this service results in the delegation of some decision-making authority to the agent. This delegation of responsibility by the principal and the resulting division of labour are helpful in promoting an efficient and productive economy. However, such delegation also means that the principal needs to place trust in an agent to act in the principal's best interests. What happens when concerns arise over the motives of agents and cause principals to question the trust they place in them? 

Agency Theory

Agency theory is part of the positivist group of theories which derives from the financial economics literature. It postulates that the firm consists of a ...