Audit Quality and Agency Cost Research Paper

Audit Quality and Agency Cost

Since the advent of industrialization, there has been the presence of a bond between the people who invest and the people who manage those investments, forming a vital relationship amongst the two groups. Although with the rise of such relationships, the soaring issues of trust and confidence have been a hindrance in economic growth. Viewing the high percentage of the capital of investors or shareholders in companies being utilized to cover the costs of bearing these barriers, it is clear that the audits are being considered a necessity in the business model for the shareholders so that they are assured that their investments are secure and are ensured that they are being properly rewarded in return.

The fundamental purpose of audits has been to reinforce trust and promote confidence in the financial information that the management publishes for the shareholders. Bearing this in mind, it is vitally important that the audit services one receives are of adequate quality so that its purpose is fully served and the users of the financial information feel safe with their investments.

Being a qualitative measure, it is necessary to understand the ways to assess and maintain a high standard of quality in the audit services. This can be judged by the reputation as an organization and the past history of performance of the audit firm recruited for the audit services. The existence of professional bodies, regulators and law also assist in clarifying any questions regarding the quality of the work performed by auditors.

One very important aspect of the audit quality is the audit risk associated with the audit task at hand. The understanding of an entity by an auditor plays a vital role in the auditor's attitude towards the audit risk of that entity. It is this attitude that decides the amount of work necessary to be carried out and the extent of the audit techniques to be involved during the course of the audit that would eventually assist in the shareholders' decision making process.

Introduction

The modern corporate system heavily relies on the relationship that separates the domain of the ownership and the control of a business. This relationship between the owners and the managers of a business is called the agency relationship, where the shareholders (i.e. The Principals) enter into a contract with the managers (i.e. The Agents) to perform services on their behalf that involves the delegation of some decision-making powers and the management and control of their business, in a way that benefits the investors and rewards the managers as well. Such entrustment of power and authority by the principal and the resulting division of labor are supportive in encouraging and promoting a productive and an efficient economy.

However, the involvement of the principal's confidence and trust in an agent to act for the principal's best interest is a vital consequence of this relationship. And the lack of this trust usually results in serious conflicts between the shareholders of an enterprise and its managers or directors. This is because of reasons such as that shareholders cannot monitor the running of the business, given the time constraints, the presence of an imbalance of information available to both the principal and the agent, the possibility of misalignment of the self-interest of both parties, and more importantly, almost no knowledge on how to run the business efficiently.

Since agents are not the owners, their motives are most likely to be different than those of the principals. Various factors may have bearing on their motives, factors such as relationships with other parties that are irrelevant to the principal, opportunities in the labor market and rewards in terms of finances, their different attitude towards risk than that of the principal and the possession of information that the principals do not have access to and the opportunity of benefiting from it.

To avoid such conflicts, motivation for the managers and supervision of their work by reducing the extent of imbalance of information and opportunistic conduct and bringing in mechanisms to line up their interests with those of the shareholders, are the solutions the principal can use. Various mechanisms can be used by the principal to align their interests with the interests of the agent, and to allow the principal to monitor and control the agent's behavior and to strengthen the confidence and trust in the agent. The provision of incentives, bonus and share options, performance-related salaries and remuneration packages to the directors and managers can be a few of such mechanisms.Another mechanism that can be used for monitoring is the audit of the work carried out by the managers in running the entity.

'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.' (Brown, 1968)

Body of the Assignment

An audit is an independent examination and check of the financial information created and presented by the management of an entity and the work they carry out in the running of the business. This check is carried out by external auditors representing an auditing firm for an audit fee, to provide an assurance to the shareholders, which in turn helps to maintain their trust and confidence towards the agents.

When carrying out an audit, the auditors are acting as agents to the principals, creating a new agency relationship, and like the shareholders-management agency relationship, it also brings the similar concerns in relation to the issues of trust and confidence. Auditors might also have motives and interests that benefit themselves rather than serve the purpose of the audit task at hand. For example, they might have a rather risk averse approach towards the audit to avoid a potential liability or might collude with the management for their personal benefits and interests, thus killing the purpose of an independent audit in the first place. To counter this and to protect the audit profession, there is the presence of regulation. For the principals, there are regulators to make sure that their interests are safe and are appropriately observed by the agents. Regulation can be present on many levels; it can be national or international, regulation of companies or regulation of auditors. Some examples of regulation are the Sarbanes-Oxley Act 2002 in the U.S. (Sarbanes-Oxley Act, 2002) and the Company Act 2006 in the UK (Companies Act 2006). In presence of such regulations, the confidence and trust in the auditor by the principal is reinforced.

Agency Cost and Audit Quality

Putting in place these mechanisms always results in an additional cost to the principal than that of the original agency contract cost. This additional cost arising due to such measures is called the agency cost. This can be defined as the sums of the expenditures carried out by the principal for the purpose of monitoring the acts of the agents and the bonding expenditures by the agent and the residual loss towards the principal. By residual loss, we mean the losses the principal has to face because of the decisions the agent makes that are not in alignment with those decisions that would maximize the welfare of the principal.

The cost of audit that the principal has to bear is a major chunk of the total agency cost. Mostly it involves the fee an audit firm charges for the services it provides to an entity. This fee can vary to the extent of the audit work required by the principal. The size of the audit firm hired to provide audit services and the total audit cost give expression to the audit quality to a certain extent. Entities that require audit work of a high quality usually choose large audit firms and are most likely to incur a high agency cost. This shows that the relationship between the quality of the audit work and the agency cost is directly proportional, i.e. The higher the audit quality, the higher the agency cost and vice versa.

Although audit quality is not defined in law or through regulations, nor do auditing standards provide a simple definition, at its core audit quality is about delivering an appropriate professional opinion to the principal by the auditor that is supported by the necessary evidence. Many values contribute to audit quality; including good leadership, experienced judgement, technical competence, ethical values and appropriate client relationships, proper working practices and effective quality control and monitoring review processes.

Although we can say that audit quality with these characteristics can be deemed appropriate, it should not be forgotten that that as human beings, auditors are always prone to mistakes that give misleading information to the shareholders, such as giving an unqualified opinion on the basis of false data or evidence . Sometimes these mishaps can happen unknowingly and unwillingly by the auditors and that is where the codes of corporate governance and local….....