Theories For Auditing

Figure 1: Four theories of auditing (Hayes et al.
2005)
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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Figure 1: Four theories of auditing (Hayes et al.

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