Figure 2: Comparison of Agency Theory and Stewardship Theory (Davis et al., 1997, 37)
In answer to the question: ‘Given the advantage of stewardship to principals, why isn’t there always a stewardship relationship?’ Davis et al. (1997, 26) explain that within the governance contract between owners and executives, owners must decide how much risk they are willing to assume. Risk-adverse owners consequently will perceive that executives are self-serving and will prefer agency governance prescriptions.
Stewardship theory and the role of the audit
The agency model assumes a principal-agent relationship in which differing motives and information asymmetry lead to concern about the reliability of information. Within the agency theory, the role of the audit is to reinforce trust and confidence in financial reporting.
Unlike the agency theory, the stewardship theory holds that no inherent, general problem of executive motivation exists. The model of man is based on a steward whose behavior is pro-organizational and collectivistic.
Following the basic thoughts of stewardship theory, there is no need of implementing monitoring mechanisms. There is no need of engaging audit services in order to secure the reliability of information. However, within stewardship theory an audit could be of value as a means of assisting the executive’s stewardship.
According to stewardship theory, the executive manager places greater value on collective rather than individual goals. The executive is motivated to be a good steward of corporate assets and an audit could help to express good stewardship. Displaying audited financial statements, the steward expresses truth and fairness of financial and non-financial performances.
This chapter provided a theoretical framework for auditing, describing theories on auditing. The ‘agency theory’ is the most prominent of the existing theories on auditing and explains the purpose of audit services in communication between a company and its environment.
Perceiving the principal-agent relationship in which the principal and the agent have partly differing goals and risk preferences, the financial statement audit is functioning as a monitoring mechanism. The audit makes management accountable to shareholders for its stewardship of the company.
Limperg’s Theory of Inspired Confidence (1932); a basic theory on the auditor’s function, stresses the social responsibility of the auditor. According to Limperg, the auditor derives his general function in society from the need for expert and independent examination and independent opinion based on that examination.
Other theories (principles) on the role of the audit focus on, for example, the provision of audited information to enable users to take economic decisions. Here, the audit is valued as a means of improving the quality of financial information.
Based on a theoretical framework, describing the role and the purpose of the audit function, the next chapter more extensively addresses the contents of audit services and auditors’ communications, the audit report. In addition, this chapter will focus on the form and the content of the audit report and comments the shortcomings of the audit report.
3. The contents of auditing and the audit report
This chapter introduces auditing and assurance services and discusses types of audit reports and the development of the standard audit report. This chapter includes a description of the form and the content of the audit report and presents the main criticisms concerning the standard audit report.
This paragraph introduces the nature and content of performing auditing and assurance services and describes the types of audit services. In addition, this chapter briefly discusses the audit process and attends to the European Commission Green Paper on Audit Policy.
3.1.1 Introduction to auditing and assurance services
Concerning economic decisions, decision makers like investors, creditors, financial institutions, and analysts rely on financial accounting information. Financial information is useful if it helps users in their decision-making.
Financial accounting information provides information on behalf of the user’s economic decision-making. Financial reporting furthermore helps investors predict future cash flows. Investors use disclosed and undisclosed information to produce estimates of future cash flows. At last, financial reporting provides information on the company’s economic resources, obligations and the effect of economic transactions on the existence of resources and obligations.
Publication of financial accounting information does not solve the ‘agency problem’, which is due to the information asymmetry and due to the conflicts of interest. Because the management is responsible for the financial reporting and in addition has a position to exercise discretion, a risk exists that the information is inaccurate, the ‘information risk’.
Information asymmetry causes a need for an independent intermediary, the auditor, to verify and provide assurance of financial accounting reports, prepared by management. The role of the audit is to reinforce trust and confidence in financial reporting. Auditing can be qualified as a social control mechanism in securing the stewardship and the accountability of the agent. The demand for auditing in addition can be attributed to users’ needs of reliable information and the consequences of users’ erroneous decision when dealing with inaccurate information. The audit function adds to the credibility of the financial statements and, consequently, users create decisions that are more accurate. Accounting and reporting practices become more and more complex. To evaluate the quality of financial statements, a thorough understanding of accounting and reporting practices and business processes governance practices is required. Most financial statement users are not enough knowledgeable to fully understand financial reports, neither to detect errors. The auditor is hired to provide users an assessment of the quality of the information.
Financial statement users do not have direct access to the accounting records from which financial statements are prepared. Due to this remoteness, users are restricted from ‘auditing’ the financial statements themselves and consequently have to rely on the auditors’ services that assist them in assessing the quality of financial information. Elder et al. (2010, 9) state that the most common way for users to obtain reliable information is to have an independent audit performed. Decision makers use the audited information on the assumption that it is reasonably complete, accurate, and unbiased.
The audit or review of historical financial statements is one example of an assurance service; 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).
Individuals responsible for making economic decisions seek assurance services to help improve the reliability and relevance of the information used as the basis for their decisions. Some other categories of assurance services are the attestation on internal control over financial reporting and assurance services on information technology.
3.1.2 Audit services
Elder et al. (2010, 4) report the next definition of auditing: “Auditing is the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established criteria. Auditing should be done by a competent, independent person.”
Major types of audits conducted by external auditors include the audit of financial statements, the operational audit, and the compliance audit. A financial statement audit examines financial statements, records, and related operations to ascertain adherence to generally accepted accounting principles. In determining whether the financial statement information is true and fair (in accordance with GAAP), the auditor gathers and evaluates evidence on which he finally bases his opinion.
An operational audit examines an organization’s activities and procedures in order to assess performances and develop recommendations for improved use of business resources. A compliance audit is conducted to determine whether an organization is following established procedures or rules, for example laws and regulations and internal procedures.
When reporting on the audit, in this research this is the ‘financial statement audit’. Issuing an opinion on the financial statements is the primary focus of a financial statement audit. Auditors obtain reasonable assurance about whether the financial statements are free of material misstatement.
Assurance is a measure of the level of certainty that the auditor has obtained at the completion of the audit. According to Elder et al. (2010, 144), reasonable assurance is presumably less than certainty or absolute assurance and more than a low level of assurance. The auditor is not an insurer or guarantor of the correctness of the financial statements.
A financial statement audit is conducted to enhance the degree of confidence of intended users in the financial statements. Without an external audit, the accounting information used for decision-making lacks credibility.
In planning a combination of audit objectives and the evidence that need to be accumulated to meet these objectives, the auditor will follow an audit process. Elder et al. (2010, 161) define the audit process as a well-defined methodology for organizing an audit to ensure the evidence gathered is sufficient a competent and that all audit objectives are met.
The audit process has four specific phases. In ‘planning and designing an audit approach’ (phase I), the client’s business strategies and processes are studied. The auditor assesses the risk of misstatements in financial statements, and evaluates internal controls and their effectiveness (Elder et al., 2010, 162).
In phase II of the audit process, tests of controls and substantive tests of transactions are conducted. In phase III, analytical procedures and tests of details are performed. The auditor assesses whether account balances or other data appear reasonable and performs procedures to test for monetary misstatements in account balances. In phase IV at last, evidence is combined and an overall conclusion concerning the financial statements is formulated (Elder et al., 2010, 163).
Audit services have been changing rapidly since the early 1990s. Audit practices have been evolving in response to growing public expectations of accountability and to the complexities in economic and technological advances implemented in business organizations. The main goal of a financial statement audit however, is still to reduce the information risk; the risk that the financial statement information may be inaccurate, incomplete or biased.
To address the complexity of the information needs of users, auditors nowadays are expected to provide value-added services, such as reporting on irregularities, identifying business risks and advising management on internal control weakness as well as consideration of other governance issues (Cosserat, 2009, 10).