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

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Figure 1: Agency Theory Overview (Eisenhardt, 1989, 59)
The ‘model of man’ underlying the Agency Theory is that of a rational actor who seeks to maximize his or her utility with the least possible expenditure. Both agents and principals seek to receive as much possible utility with the least possible expenditure. Thus, given the choice between two alternatives, the rational agent or principal will choose the option that increases his or her individual utility (Davis et al., 1997).
According to Eisenhardt (1989, 60), the agent is more risk averse than the principal. Agents, who are unable to diversify their employment, should be risk averse and principals, who are capable of diversifying their investments, should be risk neutral.
Eisenhardt (1989, 61) cites two main aspects of the agency theory, that is, ‘moral hazard’ – the agent usually has more information about his or her actions and intentions than the principal does (information asymmetry) and ‘adverse selection’ – the principal cannot completely verify the agent’s skills and abilities, either at the time of hiring or while the agent is working.
Subsequent to unobservable behavior (moral hazard or adverse selection), the principal could choose to contract on outcome (Eisenhardt, 1989, 61). According to Eisenhardt (1989, 61) an outcome-based contract motivates behavior by co alignment of the agent’s and principal’s preferences, but at the price of transferring risk to the agent. Opposite, the principal could choose to contract on behavior, i.e., investing in information systems (reporting systems, boards of directors etc.), which reveal the agent’s behavior to the principal.
Davis et al. (1997, 23) put forward the executive compensation schemes, being an example of mechanisms to ensure agent-principal interest alignment and to minimize agency costs. Those financial incentive schemes provide rewards and punishments aiming aligning principal-agent interests. Following Davis et al., incentive schemes are particularly desirable when the agent has an informational advantage and monitoring is impossible.
Deegan and Unerman (2006, 215) notice that within the agency theory literature, the firm itself is considered to be a ‘nexus of contracts’. These contracts are used with the intention of ensuring that all parties, acting in their own self-interest, are at the same time motivated towards maximizing the value of the organization.
According to Donaldson and Davis (1991, 50), a major structural mechanism to restrict managerial opportunism is the board of directors, which provides a monitoring of managerial actions on behalf of the shareholders. The authors assert that an unbiased review will occur more fully, where the chairperson of the board is independent of executive management.
Davis et al. (1997, 23) further mention that the application of agency control does not imply that all managers’ decisions will result in increased wealth for principals; it implies only that managers will strive to attain outcomes favorable for the principals. According to Davis et al., there are many reasons other than poor motivation for agents’ failing to deliver high performance, e.g. low ability, lack of knowledge and poor information.
Agency theory and the role of audit

A principal-agent relationship arises when principals engage another person as their agent to perform some service on their behalf. Delegation of responsibility is helpful in promoting an efficient and productive economy, however delegation also means that the principal needs to place trust in an agent to act in the principal’s best interests.

Because of information asymmetries between principals and agents and differing motives, principals may lack trust in their agents and may consequently need to put in place mechanisms to reinforce this trust.
As described in an earlier part of this paragraph, applying ‘executive compensation schemes’ and monitoring through information systems are examples of mechanisms using in aligning agents’ and principals’ interests. Another monitoring mechanism is the audit. 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 (Audit quality, 2005, 7).
On behalf of the principal, the auditor assesses whether the financial statements, prepared by the agent, present a true and fair view of the company and are prepared in accordance with general accepted accounting principles. The financial statement audit makes management accountable to shareholders for its stewardship of the company.
“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” (Audit quality, 2005, 9).

2.1.5 The assurance theory

An assurance service is a service in which a public accountant expresses a conclusion about the reliability of a written assertion that is the responsibility of another party (Cosserat, 2009, 20). Elder et al. (2010, 8) define an assurance service as an independent professional service that improves the quality of information for decision makers.

Individuals responsible for making business decisions seek assurance services to help improve the reliability and relevance of the information used as the basis for their decisions.

Following Elder et al. (2010, 9), one category of assurance services provided by auditors is ‘attestation services’. Performing attestation services, the auditor issues a report about the reliability of an assertion used by another party. Five categories of attestation services are distinguished:
Audit of historical financial statements

An audit of historical financial statements is a form of attestation service in which the auditor issues a written report expressing an opinion about whether the financial statements are fairly stated in accordance with the applicable accounting standards. Financial statement users value the auditor’s assurance because of the auditor’s independence from the client and knowledge of financial statement reporting matters.
Audit of internal control over financial reporting

An audit of internal control over financial reporting is a form of attestation service in which the auditor evaluates management’s assertion that internal controls have been developed and implemented following well-established criteria. The auditor’s evaluation increases user confidence about future financial reporting, because effective internal controls reduce the likelihood of future misstatements in the financial statements.
Review of historical financial statements

Performing an audit of historical financial statements, the auditor provides a high level of assurance. For reviews of financial statements, the auditor provides only a moderate level of assurance. Because less evidence will needed, reviews of financial statements can be performed at a lower fee than an audit.
Attestation services on information technology

Performing attestation services on information technology, the auditor evaluates management’s assertions about the reliability and security of electronic information.
Other attestation services that may apply to a broad range of subject matter

Numerous of other attestation services can be performed. In each case, management must provide an assertion before the auditor can provide the attestation.

Eilifsen et al. (2010, 630) provide examples of specific subject matter information, including reporting on sustainability, internal control, greenhouse gas, and pro forma financial information included in prospectuses.
Corporate social responsibility (CSR) reports (sustainability reports) for example, include information on the environment, social and economic performance of the reporting entity. The auditor is engaged to add credibility to sustainability reports. As basis for the sustainability assurance engagement, the auditor uses sustainability reporting guidelines, for example guidelines of the Global Reporting Initiative (GRI). An external assurance of sustainability reports can contribute to their quality, credibility, and reliability.

    1. Other theories

In this paragraph, the Positive Accounting Theory (PAT) and the legitimacy theory will be commented. PAT and legitimacy theory do not necessarily explain the demand concerning auditing. These accounting theories however, underlie the practice of financial accounting and consequently are valuable in understanding the demand for and provision of financial accounting information and the interests and behavior of different parties. In addition, this paragraph presents a description of the stewardship theory.

2.2.1 Positive Accounting Theory (PAT)

In ‘Towards a Positive Theory of the Determination of Accounting Standards’ (1978), Watts and Zimmerman seek to develop a positive theory of the determination of accounting standards. “Such a theory will help us to understand better the source of the pressures driving the accounting standard-setting process, the effects of various accounting standards on different groups of individuals and the allocation of resources, and why various groups are willing to expend resources trying to affect the standard-setting process” (Watts and Zimmerman, 1978, 112).
According to Watts and Zimmerman (1990), Positive Accounting Theory (PAT) is concerned with explaining accounting practice. It has designed to explain and predict which firms will and which firms will not use a particular method.
PAT focuses on the relationship between the various individuals involved in providing resources to an organization and in which way accounting can assist in the functioning of these relationships (Deegan and Unerman, 2006, 207). PAT is based on the central assumption that all individuals’ action is driven by self-interest and that individuals will always act in an opportunistic manner to the extent that the actions will increase their wealth.
According to Deegan and Unerman (2006), Watts and Zimmerman greatly relied upon the ‘agency theory’ when developing the Positive Accounting theory. Agency theory provided a necessary explanation of why the selection of particular accounting methods might matter, and hence was an important facet in the development of Positive Accounting Theory.
An agency relationship comes into existence when a principle engages an agent to perform some service on his behalf. When decision-making authority is delegated, this can lead to some loss of efficiency and consequent costs; agency costs. Based on the central assumption of PAT, managers behave opportunistic and intent to perform self-serving activities that could be opposite to the economic welfare of the principal.
Because of the opportunistic behavior of individuals, organizations will try to put in place mechanisms that have to align the interests of the agents and the principals. Contracts for example are used with the intention of ensuring that all parties, acting in their own self-interest, are at the same time motivated towards maximizing the value of the organization (Deegan and Unerman, 2006, 215). These mechanisms however, will not always be effective to avoid earnings management by managers. The agency problem will cause that managers are able to give a misrepresentation of the earnings figure, either in positive or in negative manner, without the opportunity of stockholders and others to see through (agency risk).
To compensate themselves for the ‘agency risk’, the expectation that the agent’s self-interest will diverge from the principals’ interest, investors will require a higher rate of return, i.e., they will pay less for the shares than their intrinsic value.
Financial reports (public disclosures) which give an account of the agent’s performance have adopted as being a monitoring mechanism. To reduce further the agency risk, principals could apply for an independent audit of these reports. The value of an audit will be recognized if the costs involved are less than the agency costs; the increase in the cost of the company’s share capital if no audit was conducted (Cosserat, 2009, 43).

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