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(Solved) Give in 5 major points about what you consider the following


Give in 5 major points about what you consider the following article is about: ?ICAEW ? Agency Theory & The Role of Audit?


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AuditQuality

 

Agency theory

 

and the role of audit

 

The Audit Quality Forum comprises representatives

 

of the audit profession, investors, business and

 

regulators who have an interest in high quality

 

and confidence in the independent audit.

 


 

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AuditQuality

 


 

The Audit Quality Forum brings together representatives

 

of auditors, investors, business and regulatory bodies.

 

Its purpose is to encourage stakeholders to work together

 

by promoting open and constructive dialogue in order

 

to contribute to the work of government and regulators

 

and by generating practical ideas for further enhancing

 

confidence in the independent audit.

 

The initial focus of the Forum was to improve audit

 

transparency and support shareholder involvement in

 

the audit process. At its meeting in May 2005 the Forum

 

agreed to explore a broader agenda which will examine

 

the relationships between shareholders, boards, auditors,

 

regulators and other stakeholders in the audit.

 

Anyone interested in providing feedback on this paper

 

should send their comments to

 

[email protected]

 

Further information on the Audit Quality Forum,

 

the current work programme and how to get involved

 

is available at www.icaew.co.uk/auditquality or contact

 

020 7920 8493.

 


 

© December 2005 Institute of Chartered Accountants

 

in England & Wales

 

Dissemination of the contents of this paper is encouraged.

 

Please give full acknowledgement of source when reproducing

 

extracts in other published works.

 

No responsibility for any person acting or refraining to act as

 

a result of any material in this document can be accepted

 

by the ICAEW, the Audit and Assurance Faculty or authors.

 

ISBN 1 84152 404 2

 


 

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AuditQuality

 


 

Agency theory

 

and the role of audit

 


 

CONTENTS

 


 

3

 


 

Contents

 

Page

 

Executive summary

 


 

4

 


 

Introduction

 


 

5

 


 

Principal-agent relationships

 


 

6

 


 

What is an agency relationship?

 


 

6

 


 

Agency theory

 


 

6

 


 

Motives of agents and information asymmetries

 


 

6

 


 

Mechanisms to align interests and the role of audit

 


 

6

 


 

Trust

 


 

7

 


 

A simple model of audit

 


 

8

 


 

UK historical context

 


 

8

 


 

The expert auditor

 


 

8

 


 

The statutory audit concept in the UK

 


 

8

 

10

 


 

Auditors as agents

 


 

10

 


 

Regulatory purposes

 


 

10

 


 

Regulatory corporate reporting model in the US

 


 

11

 


 

Public interest in audit and the needs of contracting parties

 


 

11

 


 

The interests of agents and unconscious bias

 


 

12

 

13

 


 

Bibliography

 


 

14

 


 

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Summary and implications

 


 

AuditQuality

 


 

Complicating factors

 


 

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AGENCY THEORY AND THE ROLE OF AUDIT

 


 

Executive summary

 

Audits serve a fundamental purpose in promoting confidence and reinforcing trust in

 

financial information. The principal-agent relationship, as depicted in agency theory,

 

is important in understanding how the audit has developed.

 

Principals appoint agents and delegate some decision-making authority to them. In so

 

doing, principals place trust in their agents to act in the principals? best interests. However,

 

as a result of information asymmetries between principals and agents and differing

 

motives, principals may lack trust in their agents and may therefore need to put in place

 

mechanisms, such as the audit, to reinforce this trust.

 

Agency theory is a useful economic theory of accountability, which helps to explain the

 

development of the audit. This background paper sets out to provide a context for that

 

development and specifically focuses on agency relationships between shareholders and

 

directors in the development of the UK statutory audit. However, this simple model of the

 

role of audit, depicted through agency theory, is complicated by other factors, which are

 

highlighted in this paper. For example, auditors are also agents of principals, which can

 

lead to further concerns about trust, threats to objectivity and independence and an

 

ongoing need to find further mechanisms such as regulation to align the interests of

 

shareholders, directors and auditors.

 

Alongside this, we know that there are other stakeholders, such as regulators, who have an

 

interest in the audit and agency theory does not provide a simple or complete explanation

 

of their expectations.

 

Furthermore, whilst agency theory would suggest that principals do not trust their agents,

 

we know that there must be some trust in agents because of the volume of unaudited

 

information that directors provide to shareholders.

 

This background paper has been developed to inform and stimulate discussion on the

 

role of audit and to help set the scene for the broader agenda of the work of the Audit

 

Quality Forum.

 


 

INTRODUCTION

 


 

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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.

 


 

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. A revised

 

version of this presentation which takes account of issues raised in this paper is included

 


 

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.

 


 

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on the Audit Quality website at www.icaew.co.uk/auditquality.

 


 

AuditQuality

 


 

This background paper focuses on the role and importance of the agency relationship in

 


 

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AGENCY THEORY AND THE ROLE OF AUDIT

 


 

Principal-agent relationships

 

What is an 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

 

A simple agency model suggests that, as a result of information asymmetries and selfinterest, principals lack reasons to trust their agents and will seek to resolve these concerns

 

by putting in place mechanisms to align the interests of agents with principals and to

 

reduce the scope for information asymmetries and opportunistic behaviour.

 


 

Motives of agents and information asymmetries

 

Agents are likely to have different motives to principals. They may be influenced by factors

 

such as financial rewards, labour market opportunities, and relationships with other

 

parties that are not directly relevant to principals. This can, for example, result in a

 

tendency for agents to be more optimistic about the economic performance of an entity or

 

their performance under a contract than the reality would suggest. Agents may also be

 

more risk averse than principals. As a result of these differing interests, agents may have an

 

incentive to bias information flows. Principals may also express concerns about

 

information asymmetries where agents are in possession of information to which

 

principals do not have access.

 


 

Mechanisms to align interests and the role of audit

 

Differing motivations and information asymmetries lead to concern about the reliability of

 

information, which impacts on the level of trust that principals will have in their agents.

 

There are various mechanisms that may be used to try to align the interests of agents with

 

principals and to allow principals to measure and control the behaviour of their agents

 

and reinforce trust in agents.

 

Remuneration packages and incentives for agents can provide an effective mechanism, as

 

can the market for corporate control and hiring and firing by the board of directors.

 

Typically, the less trust there is in an agent the more likely it is that principals will opt for

 

certain performance-related pay measures and incentives that will align interests. In such

 

scenarios the basic salary is likely to be set at a relatively low level, but it would go hand in

 

hand with a package of other benefits which might include bonuses and share options.

 

Such mechanisms, however, create potential new agency problems related to the

 

measurement of performance. Duties can be written into contracts and made the subject

 

of enforcement and penalties or an alternative is to embody the duties of agents in statute

 

(and introduce sanctions for those who do not comply), such as duties placed on directors

 

under company law.

 


 

P R I N C I PA L - A G E N T R E L AT I O N S H I P S

 


 

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Another monitoring mechanism is the audit:

 

The origin of auditing goes back to times scarcely less remote than that of

 

accounting?Whenever the advance of civilization brought about the necessity of one man

 

being entrusted to some extent with the property of another the advisability of some kind of

 

check upon the fidelity of the former would become apparent.

 

(Richard Brown (ed), A History of Accounting and Accountants, T.T. and E.C. Jack,

 

1905, page 75.)

 

An audit provides an independent check on the work of agents and of the information

 

provided by an agent, which helps to maintain confidence and trust.

 


 

Trust

 

The simplest agency model assumes that no agents are trustworthy and if an agent can

 

make himself better off at the expense of a principal then he will. This ignores the

 

likelihood that some agents will in fact be trustworthy and will work in their principals?

 

interests whether or not their performance is monitored and output measured. The degree

 

of untrustworthiness is therefore a key factor in determining the extent to which

 

incentives and monitoring mechanisms need to be put in place.

 


 

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AuditQuality

 


 

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AGENCY THEORY AND THE ROLE OF AUDIT

 


 

A simple model of audit

 

UK historical context

 

In the UK, the modern audit function has evolved over centuries, apparently in response

 

to agency issues. According to Baker and Collins, the origins of the modern audit function

 

in England were visible in medieval times in the verification of public accounts such as

 

Exchequer accounts, borough accounts and the accounts of public bodies and in the

 

verification processes of merchants and nobility for commercial ventures, manors and

 

landed estates. Agents were given responsibility for the safekeeping or management of the

 

property of others which led to questions of trust, integrity and competence, and hence

 

the need for audit.

 

There were significant developments in financial reporting in the nineteenth century as

 

the UK economy grew and the capital markets were transformed through the expansion of

 

banks and investment. This resulted in a separation of ownership and control within

 

companies and audits developed as a means of protecting shareholders? interests. It was

 

not until the Companies Act 1900, however, that a general legal obligation for annual

 

audits was imposed on registered companies.

 


 

The expert auditor

 

In an historical context, there was little conception of auditors as independent experts.

 

Watts and Zimmerman highlight the fact that audits of merchant guilds were conducted

 

by a committee of guild members and in the mid nineteenth century company audits were

 

often undertaken by individual shareholders whose independence from the agents running

 

the company was not an issue. Hence, principals acted as auditors. However, in many

 

agency relationships principals do not have the expertise and skills to check whether

 

agents have met their responsibilities. Faced with such information asymmetries, principals

 

turn (and increasingly so in modern times) to expert auditors. However, the appointment

 

of expert auditors generates a further agency relationship which in turn impacts on trust

 

and creates new issues relating to their independence.

 

These issues, and their potential impact on the statutory audit, are considered in more

 

detail later in this paper.

 


 

The statutory audit concept in the UK

 

A UK company has a board of directors (the agents) and a body of shareholders (the

 

principals). The directors have been delegated responsibility for managing the affairs of the

 

company. Control of a company may be divorced from its ownership.

 

In effect, directors act as trustees for shareholders. They are bound by certain duties that

 

are established in common law and under statute. Currently directors? fiduciary duties,

 

such as acting in good faith and in the best interests of the company, are found in

 

common law. The Companies Act 1985 prescribes clear statutory responsibilities for

 

directors in respect of the company accounts and administration of the company. In

 

addition, the Company Law Reform Bill (introduced in the House of Lords in November

 

2005) includes clauses on directors? general duties to help both directors and shareholders

 

understand these duties.

 


 

A SIMPLE MODEL OF AUDIT

 


 

9

 


 

The financial statements are the primary mechanism for shareholders to monitor the

 

performance of directors. However, as a result of the separation of ownership and control,

 

problems with information asymmetries and differing motives, there may be tension in

 

the shareholder-director relationship. Shareholders have limited access to information

 

about the operations of a company and may believe, therefore, that they are not getting

 

the right information they need to make informed decisions or that the information being

 

provided by way of the financial statements is biased. As such, shareholders may lack trust

 

in the directors and in such a situation the benefits of an audit in maintaining confidence

 

and reinforcing trust are likely to be perceived as outweighing the costs.

 

Under Section 235 of the Companies Act 1985 auditors are appointed by and report to

 

the shareholders of the company. The auditors provide an independent report to the

 

shareholders on the truth and fairness of the financial statements that are prepared by

 

the board of directors. The UK audit therefore plays a fundamental stewardship role and

 

as the Caparo case confirmed, UK auditors are directly accountable and hence owe a duty

 

of care to the company?s existing shareholders as a body.

 

Auditors are engaged as agents under contract but they are expected to be independent of

 

the agents who manage the operations of the business. The primary purpose of audited

 

accounts in this context is one of accountability and audits help to reinforce trust and

 

promote stability.

 

This is a simple agency model of audit, where an expert independent auditor is introduced

 

and a statutory audit performed to help address a simple agency conflict between

 

shareholders and directors.

 


 

from www.icaew.co.uk/auditquality. The recommendations made were presented to the

 

Government and the Financial Reporting Council for them to take forward.

 


 

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AuditQuality

 


 

The first phase of projects undertaken by the Audit Quality Forum looked at ways of

 

enhancing shareholder involvement in the audit process. The reports can be downloaded

 


 

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AGENCY THEORY AND THE ROLE OF AUDIT

 


 

Complicating factors

 

We have considered the role of audit as a solution to principal-agent conflicts but this

 

model of the role of audit is a little too simplistic. There are further complexities to

 

consider, beyond that of the shareholder-director relationship, such as the relationship

 

between auditors and other stakeholders that claim an interest in the output of the audit.

 

For example, wherever audited information is in the public domain, it will be seen as a

 

public good and other stakeholders are likely to make use of it. These stakeholders have

 

differing interests and might not fit easily into the principal-agent model depicted in

 

agency theory. The role that the audit plays, therefore, is more complex.

 


 

Auditors as agents

 

If as simple agency theory implies, principals do not trust agents to provide them with

 

reliable and relevant information, then they will hire in external experts, who are

 

independent of these agents. This, however, introduces the concept of auditors as agents

 

of principals, which leads to new concerns about trust, threats to objectivity and

 

independence.

 

Auditors act as agents to principals when performing an audit and this relationship

 

therefore brings with it similar concerns with regard to trust and confidence as the

 

director-shareholder relationship, prompting questions about who is auditing the auditor.

 

Agents (whether they are directors or auditors) may be trustworthy without a need for

 

further incentives to align interests or monitoring mechanisms such as audit or increased

 

regulation. However, the simple agency model would suggest that agents are

 

untrustworthy. Like directors, auditors will have their own interests and motives to

 

consider. For example, auditors may be risk averse and being conscious of their potential

 

liability, introduce risk management processes that result in limitations in the scope of

 

their work and caveats in their reports which principals may find frustrating.

 

Auditor independence from the board of directors is of great importance to shareholders

 

and is seen as a key factor in helping to deliver audit quality. However, an audit

 

necessitates a close working relationship with the board of directors of a company. The

 

fostering of this close relationship has led (and continues to lead) shareholders to question

 

the perceived and actual independence of auditors and to demand tougher controls and

 

standards over independence to protect them.

 

As far as independence and objectivity are concerned, auditors need to be conscious of

 

threats to objectivity and apply suitable safeguards where necessary. Reputation is a key

 

factor in promoting trust and auditor independence is an important quality that

 

shareholders look for. Auditors have an important incentive to maintain independence to

 

protect their reputation and thereby help them to retain and win audits.

 


 

Regulatory purposes

 

Regulation also impacts on the demand for, and the role of, audit. In effect, the regulators

 

are there to act on behalf of ?principals? to ensure that their interests are appropriately

 

heeded and there may be more than one ?regulatory principal? e.g. where there are

 

regulators of company boards and regulators of auditors.

 

Regulatory reporting requirements can compensate for the weak rights of principals and

 

regulators can help to maintain confidence and trust in markets and the operations of

 


 

C O M P L I C AT I N G FA C T O R S

 


 

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agents. All shareholders in any company have an interest in overall market confidence

 

and hence, the audited financial statements of other companies, because it can have a

 

direct bearing on the value of the company they have an interest in.

 

Regulators therefore have a keen interest in the audit as a way of reinforcing trust.

 

Regulatory demand for audit is most clearly evidenced in the US corporate reporting

 

model through the power accorded to the Securities and Exchange Commission (SEC).

 


 

Regulatory corporate reporting model in the US

 

The US regulatory model developed from the 1933 Securities Act. The Act applies to SEC

 

registrants and the resulting financial reporting and oversight structure is directed at

 

providing information for market pricing purposes. This market pricing model of

 

governance and financial reporting was intended to act as a substitute for the lack of

 

shareholder rights in state law as well as to create a consistent framework for financial

 

reporting.

 

Audits are performed to provide protection against the provision of false information to

 

the market influencing share price. However, problems arise as markets are inherently

 

unstable and fluctuate and they do not, therefore, act like principals. As a result, US

 

regulators have developed a critical role in corporate relationships in the US, e.g. the

 

introduction of the SEC under the 1934 Securities Act to deal with the regulation of

 

securities and the 2002 Sarbanes-Oxley Act which established the Public Company

 

Accounting Oversight Board.

 

Whilst US corporations have shareholders and boards of directors, shareholders in the US

 

Auditors are, however, increasingly seen as accountable to the independent directors

 

sitting on the audit committee. In effect, they act in place of the owners of the company

 

i.e. the independent directors act as principals.

 

A more detailed interpretation of these issues can be found in a viewpoint written by

 

Tim Bush, ?Divided by common language?, Where economics meets the law: US versus non-US

 


 

Public interest in audit and the needs of contracting parties

 

UK companies are required to place certain financial information on the public record.

 

This generates public interest in the information provided and its audit, beyond that of

 

the shareholders. Whilst auditors carrying out a statutory audit of financial statements are

 

accountable and report to the shareholders of a company only, there may be other

 

stakeholders who believe that an independent audit provides some means of ensuring that

 

the company?s responsibilities to them are being met; in effect that it serves their interests

 

too. There is also an expectation among these other stakeholders that auditors should be

 

independent of shareholders. These other stakeholders may or may not have a contractual

 

relationship with the company.

 

Stakeholders such as creditors, lenders, credit agencies, customers and employees may

 

claim an interest in the audit. Some contracting parties may be forced to enter into

 

separate contracts because the statutory audit is not deemed suitable for their purpose.

 

Other contracting parties may want the ability to commission an audit for a particular

 

non-statutory purpose. However, in these circumstances this is unlikely to be a statutory

 

audit which raises issues about the ability to apply global, principles-based auditing

 

standards to different audits where the purpose of the engagement may vary.

 


 

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financial reporting models.

 


 

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have little to do with the audit process and auditors have no direct accountability to them.

 


 

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AGENCY THEORY AND THE ROLE OF AUDIT

 


 

The need to maintain trust and confidence remains important in any audit but underlying

 

principal-agent issues are not always relevant in understanding differing expectations

 

of audits.

 


 

The interests of agents and unconscious bias

 

It is not only external parties that have an interest in the audit. Some companies may not

 

have a divorce of ownership from control. For example, the shareholders in many private

 

companies are also the directors. Stewardship and the need to gain shareholder trust may

 

not be relevant as the owner-managers already have access to the information necessary

 

to make informed decisions about the financial position of the company. In such

 

situations there is no principal-agent problem for the audit to solve yet some companies

 

continue to need or want an audit. In such circumstances, the audit may be seen as the

 

price that the directors and shareholders must pay for limited liability. Alongside this, the

 

company may also have relationships with other stakeholders who benefit from audit.

 

Another important factor behind the demand for a...

 


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