Auditing Essay

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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 louise.maslen@icaew.co.uk. 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

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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

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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

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Bibliography

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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,…