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Theories of Demand for Audit: An Analysis

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. Mautz and Sharaf expressed that ‘concepts provide a basis for advancement in the field of knowledge by facilitating communication about it and its problems’.
There are many theories which may explain demand for audit services in modern societies. These include, but are not limited to;
The policeman theory
The credibility theory
The theory of inspired confidence
The agency theory
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 instil public confidence. ISA (UK and Ireland) 240 states that 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.
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. However, Porter (1990) concluded, that “audited information does not form the primary basis for investors investment decisions”, but in my opinion audit reports may still play a part; albeit small, in investment decisions.
The theory of inspired confidence focuses on both the demand and supply of audit services. The relationship of accountability is realised 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 fulfil 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. However, as Limperg argues an auditor should try to meet the expectations of a ‘rational outsider’ but not create higher expectations from his audit report than is justifiable by his examination of audit evidence.
As Limperg states “… 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). 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.
The agency theory emphasises 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 maximise 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 maximise 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 maximise 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 optimise the contracts to maximise 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 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.
Societal expectations from auditors may exceed the capability of audit creating an audit expectation gap, where users of financial statements expect an auditor to detect all material fraud; due to their legal access to company records and right to gain explanation from employees for the purpose of audit. ISA 200 also emphasises that due to the limitations of an audit, there is an unavoidable risk that some material misstatements will not be detected, even when the audit is done in accordance with the ISAs (UK and Ireland). Hence, while auditors discharge their duties, they should educate the public about the inherent limitations of audit and their role in financial reporting. It should be understood that auditors too rely on the management to gain information about the activities of an organisation. Imparting that the audit is based on calculated audit risk which would have been reduced to an acceptable level however, it is not possible to provide an audit opinion without any audit risk present.
Audit theory has evolved over time as needs of society changed, so did audit techniques resulting in a change of auditor function. A considerable investment into the development of auditing theory is justified as it will help us address audit deficiencies with a more tailored approach towards the complex needs of modern society, with the fast-paced trading of stocks and extensive contracts of organisations. Auditors are placed in a position of trust to provide an independent and unbiased opinion on financial statements. Extensive research in developing audit theory might help auditors to discharge their duty with more competence and may reduce audit risk substantially. However, it can be argued that the expectation gap should be filled by means of education in order to enable stakeholders and third parties to interpret and analyse audit reports correctly, with rational expectations from the auditors. Also, to help them make informed decisions based on audit reports, fulfilling the purpose of the audit.

Importance of Accounting Information in Business Development

Describe how accounting information helps shareholders and lenders to make decisions concerning the operations and performance of the entity.
Accounting information can be used by shareholders and lenders to look at an entity’s financial position and whether it is viable to invest or lend to the entity. If the performance of a company has been poor and there is no indication of this improving, a potential shareholder will not invest in the company as there is nothing to gain from the investment and a lender will not loan money to the company due to the risk of not seeing that money again. If however, the company is turning a profit, indicates that it will continue to do so in the future and has a great many assets, both shareholders and lenders will consider investing in the company in line with their personal interests.
List five/six stakeholders of accounting information. Describe the information requirements for each one; for example, lenders would need information regarding the business’s ability to repay debt and service a loan.
Information Requirements
Whether the company in it’s capacity can repay a loan should it decide to take one out.
Whether the company can support an employee’s lifestyle and longevity in the company. The employee may also seek opportunities in the company such as promotion
The about of tax the company should be paying and whether the company will pay any more tax in the future.
Whether the company is an asset to the community, providing jobs and resources to other organisations within the community such as sponsorship.
Whether the company is providing quality products or services and not cutting corners on the quality of the products. They may also like to see whether their favourite product will continue to be available.
Whether the company can fulfil the financial obligation of purchasing products from the supplier so the supplier itself can make a profit.
Darby Davis is considering purchasing a sushi bar in the inner Brisbane suburb of Paddington. Outline the importance of a business plan for Darby and the type of accounting information she will require to assist her in making the decision.
Business plans are important for new businesses as they provide the background and the purpose of the forthcoming business. In reference to the textbook, “All business plans, whatever their structure, should cover the key issues of marketing, operations and finance”[i]. Specifically, a business plan should include strategy including a background profile, marketing strategy, timeline of business implementation, financial backing and any other issues the business may have.
How can the professional accounting bodies assist in standard setting?
Accounting firms can assist companies in many ways with their accounting methodology. This can include identifying technical issues, educating members, students and accountants of the company. By doing this, the accounting firms can ensure that the rules enforced by the AASB (Australian Accounting Standards Board), IFRS (International Financial Reporting Standards) and the GAAP (Generally Accepted Accounting Principles) are being met with compliance.
What is meant by business sustainability?
Business sustainability is the act of preserving aspects of the business for the present and future. This can include social, environmental and financial aspects of the business.
Outline the benefits for organisations in considering business sustainability.
By complying with business sustainability, the business is not only benefiting themselves by making plans to preserve their company but also having an impact externally. This can include within the local community, where the business is providing jobs to people. Environmentally, where the business is applying green strategy to benefit the future of the planet. And as one last example, to the shareholders who have invested in the company. By accepting sustainable practices, the business will be able to pay dividends to those shareholders and those shareholders will continue to invest in the company.
What are the three pillars of sustainability?
The three pillars of sustainability are: Social (People), Environmental (Planet) and Economic (Profit).
Outline the possible consequences for an entity that breaches its ‘social contract’.
When a business breaches it’s social contract, the company risks being rejected or boycotted on a social level. Society has an impact on how the business conducts itself within the public, and when a company breaches that expectation they may see negative effects from members of the wider community consequently.
Identify some social performance aspects on which entities report.
Businesses may report on several social performance aspects. These can include:
Ethical and Integral Performance
Environmental Performance
Community Participation and Sponsorship
Community Employment
Improvement of Stakeholder relations
Illustrate with an example how sole traders and partners are taxed in Australia. What are the advantages or disadvantages compared to paying company tax?
Sole traders and partnerships both have their tax assessed as their personal income, this is treated as tax out of their salaries. This means that they do not have to submit to formal reporting standards about their tax, but many use MYOB or Quicken to keep track of their accounts. A disadvantage of this is that the tax rate can be higher than that of a company. Currently the tax rate of a company is 30% and the personal rate can vary on how much they make annually.
[i] Birt, Jacqueline, Keryn Chalmers, Suzanne Maloney, Albie Brooks, Judy Oliver. Accounting: Business Reporting for Decision Making, 6th Edition. John Wiley