Financial statement users’ understanding of the messages in the audit report

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1.5 Structure

The outline of the research is as follows:
Chapter two contains an overview of existing theoretical explanations of accounting and auditing, for example: the agency theory, Limperg’s theory of inspired confidence, the information theory, and the insurance theory. These theories comprise basic principles that are important in understanding the community’s needs for reliability of financial information, the social significance of auditing and the responsibilities of the auditor.
Chapter three introduces auditing and assurance services and discusses the usefulness of performing audit services. This chapter includes an introduction to the audit report, an overview of types of audit reports, and a description of the evolvement of audit reports. In addition, chapter three provides a description of the form and the content of the standard audit report and highlights frequently heard criticisms concerning the standard audit report.
Chapter four provides a description of prior studies on developments in the standard audit report and its effectiveness in communicating important messages. Early investigations of the value relevance of the audit report date back to the 60s and 70s, for example Roth (1969) and the Cohen Commission (1978). Subsequent studies can be classified to periods 1988-1993 (adoption of the long form audit report), 1993-2004 (long form report under question), and 2004 up to now.
Chapter five continues with a description of the empirical part of this research. In this chapter, the research methodology and the design of the research will be described. In chapter six, research findings and analyses of the results will presented.
Chapter seven concludes with the answer to the main question of this research and contains an outline of the limitations of the research. In addition, this chapter contains a description of recommendations concerning further research.

2. Theoretical framework for auditing

This chapter provides an overview of the existing, explaining theories on accounting and auditing. Auditing theory helps explain why society needs auditing: the role and purpose of audit services in communication between a company and its environment.

    1. Theories of auditing

This paragraph presents some of the theories on the demand concerning auditing. The agency theory is the most prominent of the existing theories. Less significant audit theories are the ‘policeman theory’ and the ‘lending credibility theory’.
The policeman theory claims that an auditor is responsible for searching, discovering, and preventing fraud. The focus of the audit however, has moved towards the verification of the truth and the fairness of the financial statements and the provision of reasonable assurance. The policeman theory is not able to explain fully the role and the purpose of auditing.
According to the lending credibility theory, the primary function of the audit is to add credibility to the financial statements. Audited financial statements increase the financial statement users’ confidence in the financial figures and the faith in management’s stewardship. The lending credibility does not explain other functions of performing audit services; this theory is limited in explanatory power.

2.1.1 Limperg’s Theory of Inspired Confidence

In ‘The PCAOB and the social responsibility of the auditor’ (2004), D.R. Carmichael; chief auditor at the Public Company Accounting Oversight Board (PCAOB), comments the social responsibility of the independent auditor and the possible mechanisms for ensuring that audits meet society’s needs. Carmichael focuses on the role of the PCAOB and its performances in restoring the confidence of investors in the independent auditors of public companies.
In describing the PCAOB’s focus, restoring the public confidence, Carmichael (2004, 128) recalls the work of Professor Theodore Limperg (1879-1961) of the University of Amsterdam. Limperg observed that when the confidence that society has in the effectiveness of the audit and the opinion of the audit is lost, the social usefulness of the audit has destroyed.
According to Carmichael (2004, 129), the principles of Limperg’s theory are especially relevant in this phase of the development of the audit function. “We have a particular need in our current environment to try to understand and to appreciate the social significance of auditing and the implications concerning in which way an audit should be performed.”
‘The social responsibility of the auditor, a basic theory on the auditor's function’, by Professor Theodore Limperg (1879-1961) of the University of Amsterdam (Limperg Institute, 1932 [1985]), is a booklet in which Professor Theodore Limperg’s essays, exposing his general Theory of Inspired Confidence, are translated in English.
The Theory of Inspired Confidence connects the community's needs for reliability of financial information to the ability of audit techniques to meet these needs, and it stresses the development of the needs of the community and the techniques of auditing in the course of time (Limperg Institute, 1985, 3).
In developing his Theory of Inspired Confidence, Limperg (Limperg Institute, 1985, 16) describes the auditor’s function / responsibility as follows: “The auditor-confidential agent derives his general function in society from the need for expert and independent examination and the need for an expert and independent opinion based on that examination. The function is rooted in the confidence that society places in the effectiveness of the audit and in the opinion of the accountant. This confidence is consequently a condition for the existence of that function; if the confidence is betrayed, the function, too, is destroyed, since it becomes useless.”
One important citation concerning the Theory of Inspired Confidence (Limperg Institute, 1985, 18) is the next. “The normative core of the Theory of Inspired Confidence is this: the accountant is obliged to carry out his work in such way that he does not betray the expectations which he evokes in the sensible layman; and, conversely, the accountant may not arouse greater expectations than can be justified by the work done.”

According to the citation could be concluded that The Theory of Inspired Confidence does not prescribe definite rules about the behavior of the auditor in each particular case; the principle-based approach, signaled by Carmichael (2004, 129).

“.. The theory expects from the accountant that in each special case he ascertains what expectations he arouses; that he realizes the tenor of the confidence that he inspires with the fulfillment of each specific function” (Limperg Institute, 1985, 19).

According to the Theory of Inspired Confidence (Limperg Institute, 1985, 3), changes in the needs of the community and changes in the auditing techniques result in changes in the auditor's function. Assessing this statement, Carmichael (2004, 129) states that the touchstone for the auditor is always to perform the work and obtain the evidence necessary to provide the assurance that society needs and reasonably expects.

2.1.2 The information theory

As described in the ‘agency theory’, financial reporting is central to monitoring purposes. An alternative or complement to the monitoring principle is the information principle, focusing on the provision of information to enable users to take economic decisions.
Investors require audited financial information on behalf of their investment decision-making and assessing of expected returns and risks. Investors value the audit as a means of improving the quality of financial information.
An audit is also valued as a means of improving the financial data used in internal decision- making. Data that are more accurate will improve the internal decision-making.

2.1.3 The insurance theory

The insurance theory is a more recent explanation for the demand for the role of the audit, that is, the ability to shift responsibility for reported data to auditors lowers the expected loss from litigation to managers, creditors, and other professionals involved in the securities market (Cosserat, 2009, 44). When using audit services, managers and other professionals can demonstrate that they exercised reasonable care.

2.1.4 The agency theory

In ‘Theory of the firm: managerial behavior, agency costs and ownership structure’ (1976, 306), M.C. Jensen and W.H. Meckling refer to the firm being a ‘black box’, operated so as to meet relevant marginal conditions with respect to inputs and outputs, thereby maximizing profits, i.e., present value. The authors signaled that no theory exists, explaining the way in which the conflicting objectives of individual participants will brought into equilibrium to succeed in value maximization.
Jensen and Meckling (1976, 308) define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent. The authors notice that if both parties are utility maximizers (opportunistic behavior); a good reason exists to believe that the agent will not always act in the best interests of the principal.
According to Jensen and Meckling (1976, 308) divergence exists between the agent’s decisions and those decisions which would maximize the welfare of the principal. Within this principal-agent relationship, owners have an interest in maximizing the value of their shares, whereas managers are more interested in ‘private consumption of firm resources’ and firm growth.
Costs that arise because of the delegation decision-making authority from the principal to the agent, which is due to the ‘separation of ownership and control’ in modern corporations, are referred to as ‘agency costs’. Jensen and Meckling (1976, 308) define as the sum of the agency costs:

  • Monitoring costs:

Expenditures by the principal to limit the agent’s aberrant activities;

  • Bonding costs:

Expenditures by the agent to guarantee that he did not performed certain actions that would harm the principal; and

  • The residual losses.

Agency costs (the agency loss) in addition, has exemplified as the extent to which returns to the owners are below what they would be if the principals, the owners, exercised direct control of the corporation (Donaldson and Davis, 1991, 50).

K.M. Eisenhardt (Agency theory: an assessment and review, 1989, 59) notes: “Overall, the domain of agency theory is relationships that mirror the basic agency structure of a principal and an agent who are engaged in cooperative behavior, but have differing goals and differing attitudes towards risk.” Eisenhardt (1989, 59) discloses an overview of agency theory as presented in figure 1.

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