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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?








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.











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 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











Agency theory


and the role of audit













Executive summary












Principal-agent relationships






What is an agency relationship?






Agency theory






Motives of agents and information asymmetries






Mechanisms to align interests and the role of audit












A simple model of audit






UK historical context






The expert auditor






The statutory audit concept in the UK








Auditors as agents






Regulatory purposes






Regulatory corporate reporting model in the US






Public interest in audit and the needs of contracting parties






The interests of agents and unconscious bias



















Summary and implications






Complicating factors









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.











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.








on the Audit Quality website at






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









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.









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.





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.

















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.









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 The recommendations made were presented to the


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











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









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




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









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




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.








financial reporting models.






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









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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Oct 15, 2019





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