Audit Theories – Theories of Demand for Audit

Audit refers to an examination of the financial reports of a firm by an independent entity. The separation of business ownership and management in modern society has created a need for accountability; causing the role of audit to change as the needs of stakeholders’ change. Audit, in itself, caters to the relationship of accountability; independent from other parts of the firm to provide a true and fair view of the financial reports of an organisation. Whereas, the ‘value relevance’ refers to the auditors’ ability and responsibility to provide reasonable assurance that financial statements are free of material misstatement, either due to fraud or error; or both.

Audit theories provide a framework for auditing, uncovers the laws that govern the audit process and the relationship between different parties of a firm, forming the basis of the role of audit.  There are many theories which may explain demand for audit services in modern societies. These include, but are not limited to;

  1. The policeman theory  asserts that the auditor is responsible for searching, discovering and preventing any fraudulent activity. However, the role of auditors is to provide reasonable assurance and an independent, true and fair view of the financial statements. Although, there has been more pressure on auditors to detect fraud after recent reporting scandals e.g. Enron. It can be argued that in modern societies, the users of statements want auditors to be responsible for fraud detection as they use audit reports to analyse and make decisions. However, auditors are not responsible for finding all fraud but should improve their detection rate to instill public confidence. The primary responsibility of fraud prevention and detection rests with the management and the governance of an organisation; it is also important that more emphasis is placed on prevention of fraud. However, the auditor also has a duty of care to the end users of audit reports and should consider risks of material misstatements due to fraud when calculating audit risk.
  2. The credibility theory  suggests that adding credibility to financial statements is an integral part of auditing, making it a fundamental service auditors provide to clients. Audited financial statements boost users’ confidence in an organisations financial records and management’s stewardship; in turn, improving their decision quality such as, investment or new contracts, based on reliable information. This is because stakeholders need to have faith in the financial statements. The credibility gained by financial statements would affect decisions by stakeholders (e.g. Credit limits provided by suppliers) and also helps shareholders put trust in management; reducing the ‘information asymmetry’ between stakeholders and management.
  3. The theory of inspired confidence  focuses on both the demand and supply of audit services. The relationship of accountability is realized with financial statements; however, as outside parties cannot monitor any material misstatement or bias in financial reports, the demand for an independent reliable audit arises. The supply of audit services should satisfy the public confidence that arises from the audit and fulfill community expectations, as the general function of audit is derived from the need for independent examination and an expert opinion based on findings; due to the confidence society places in an independent auditors’ opinion. It can be assumed that if society lost confidence in audit opinion, the social usefulness of audit would cease; as audit delivers benefits to the users of financial statements. The auditor should maintain appropriate business practices to maintain his independence from the firm being audited, in order to satisfy his obligation to examine business practices and provide a credible opinion on the financial statements.
  4. The agency theory  emphasizes that audit services are employed in both the interests of third parties and management. An agency relationship exists between the agent (management) and principals (shareholders, employees, banks etc.); where the authority of decision-making is delegated to the agent. If both principals and agents want to maximize utility, the agent may not always act in the best interests of the principal as their interests may differ e.g. shareholders may want to maximize share value, management may be interested in company growth. Hence, agency theory focuses on the costs and benefits of an agent-principal relationship. Costs that arise due to the decision-making authority given to agents, in modern companies due to separation of ownership and control are ‘agency costs’, agency costs are the sum of the monitoring expense by the principal, the bonding expense of the agent and the residual loss. A beneficial agency cost would maximize shareholder value and an unwanted agency cost would arise due to conflict of interest between shareholders and managers. Analysis of agency costs give an indication of how well an agent is discharging his responsibilities towards the principal, enabling the principal to observe and introduce controls to reduce any conflict of interest. As an organisation has many contracts, several parties (e.g. suppliers, employees etc.) which add value to the company for a given price, for their own personal interests; it is the agents responsibility to optimize the contracts to maximize the value of the organisation.

An audit is a monitoring mechanism for principals to gain an independent and reliable opinion on the financial statements provided by the agent, reinforcing accountability and maintaining confidence and trust in the organisation. Agency theory is the most widely used audit theory.

These audit theories demonstrate the need of accountability in modern society and the role of audit in providing reasonable assurance and unbiased opinion to users of financial statements, about an organisation. Stakeholders place trust in auditors due to the credibility of audit; lenders, suppliers and employees may want reasonable assurance on the accounts of an organisation before any business contracts are established. Shareholders want an independent opinion on the running of the organisation and how the management is executing its stewardship, they also require a true and fair view of financial statements to analyse their investment in the organisation and to gain confidence in the management and in turn, the organisation.

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