Important Role of Audits in the Economy - Essay Example

Finance and accounting Introduction Mautz and Sharaf (1961) had referred auditing as a field of knowledge that is built on the foundation of s, such as, metaphysics, mathematics and logic. They have expounded that auditing offers solutions to several problems and also, provides clues which can help to overcome difficulties. Audits play an important role in the economy by strengthening accountability among public and reinforcing trust and confidence regarding financial reporting. It helps to enhance economic prosperity as well as the number of transactions that people are prepared to enter in. With advent of corporate scandals, the global demand for quality audit has raised. There were huge changes in the auditing system in United Kingdom regarding transparency issue. However, changes and modifications are still being made due to new issues, emerging from scandals (Institute of Chartered Accountants, 2005). In the 20th century, auditing has transformed from a traditional audit system into a modern management audit. The development, encountered in management audit, was a result of accountability that was established in various ways. The demand for audit increased with the passage of time. Auditing refers to careful scrutiny of financial statements, so that the decision makers can take necessary decisions properly and rely upon the information that is given in these statements. The decision making process is harmed if deficit remains in auditing by the auditor. It is the duty of the auditor to check transactions that are given in the book of accounts and then opine regarding appropriateness. The essay elaborates auditing theories that are in demand and their value relevance in modern management is depicted clearly. ‘Value relevance’ refers to the auditor’s ability to communicate the process of audit effectively. It also reflects responsibilities of the auditor as well as assurances given by the auditor, during the decision making process. Auditing Elder, Beasley and Arens (2010) have stated that users can obtain reliable information by undertaking independent audit that are performed by auditors. It reduces risk of using wrong information, which may later lead to misrepresentation of financial data. The degree of confidence among users is increased by providing them with a statement of audit. The decision makers use the audited information on an assumption that those are complete, unbiased and accurate. An audit report is issued based on the audit conducted and these reports consist of auditor’s view regarding findings in the financial statement. The audit also detects whether these statements are prepared in accordance with the accounting principles (Elder, Beasley and Arens, 2010). Auditing refers to systematic evaluation of the book of accounts of a business in order to ascertain that they are prepared as per the accounting principles, without any fraudulence. The primary objective of auditing is to determine whether relevant information is provided about the economic events, which have occurred during a period of time. Auditing identifies clerical errors and prevents the management from taking wrong decisions by considering an incorrect financial statement. There are errors of duplication, which arise due to lack of concentration of accountants, while preparing book of accounts and then, the financial statements. Auditing eliminates these problems and allows decision makers of an organisation to take an appropriate decision regarding its finance (Kumar and Sharma, 2011). Theories of auditing The theories of auditing explain the demand for audit in different situations. The agency theory is regarded as the most important one among them. The less significant ones are the policeman theory and lending credibility theory. The policeman theory states that the primary objective of an auditor is to search, discover and prevent fraud in the financial statements. The main aim of audit has, however, transformed into verification of fairness and truth of the financial statements and also, reassuring provisions that are mentioned in the financial statements (Julkaisuja, 2010). Nonetheless, the theory is incapable of thoroughly explaining the role of auditing. The lending credibility theory states that audit adds reliability to financial statements. The audited financial statements enhance confidence of users, who are able to gain trust on the stewardship of management. Then again, the lending credibility is incapable of explaining other functions of audit services and has limited explanatory power (Julkaisuja, 2010). The following are the theories of auditing: Limperg’s Theory of Inspired Confidence The theory of inspired confidence (Limperg, 1932) identifies the demand and supply of audit services. The demand for audit services is directly related to involvement of third parties in the company. These parties demand accountability from the management and in return, invest in the company. Carmichael (2004) has identified the social responsibility of independent auditors and has ensured that the mechanisms of audit are capable of meeting needs of the society. He had highlighted the role of regulators in restoring trust and confidence among investors from the work of independent auditors of public companies. The theory of Inspired Confidence connects need of the community for reliable financial “information to the ability of audit techniques to meet the needs” (Wierik, 2013, p. 75). The theory also stresses on the increasing needs of community and delivering the techniques of auditing during the course of time. One of the famous citation by Limperg (1932) is “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” (Limperg, 1932, p. 18). The citation states that there are no definite rules for describing the behaviour of auditor in a particular case, i.e. there is no principle. The changes in desire of the community and the modifications made to auditing techniques result in changes in function of the auditors. After assessing the statement, Carmichael (2004) stated that criterion of auditor is to perform their duties and gather necessary evidences for providing assurance to the society and fulfil their needs. Information theory Agency theory has considered financial reporting to be at the centre of monitoring purposes. There is an alternative to monitoring purposes known as the information principle. It focuses on the provision of information, which enables users to undertake economic decisions. The investor needs audited financial information to support their decision making regarding any investment. This helps them to assess the risk and return associated with a certain investment. The investors value the audit report, since it represents improvement of quality of the financial statements. The audit report is also used by the internal management of a company so as to take various decisions. The accurate data will enhance success of the decisions made or undertaken by the internal management. In the modern society, the demand of audit has become an essential part of the management and also, of the investors. The investors greatly rely on the auditor’s report (Swinkels, 2012). The insurance theory The insurance theory states the most recent demand of auditing. It explains the ability to shift responsibility of the reported data on the auditors, thereby lessening the expected loss of managers, if they are trapped into certain legal proceedings (Gray and Manson, 2008). Such an action also lowers the loss of creditors and other professionals, who are involved in the securities market. When auditors exercise their duty, they assure that demands of users are taken care of (Cosserat, 2009). Agency theory M.C. Jensen and W.H. Meckling had referred a firm as ‘black box’, which operates for meeting marginal conditions with regard to inputs and outputs and also, concentrates on maximizing their profit or present value of the same. The authors have stated that there are no such theories, which could explain the conflicting objective of individual participants with the ability to bring in equilibrium for value maximization of a firm. Jensen and Meckling (1976) have defined agency relationship as the contract, which engages one or more individuals for performing certain task on behalf of the person, who had initially delegated the authority of decision making. The authors mentioned that if both the parties are utility maximisers and opportunistic, then there exists a good reason to consider that agents are not capable of putting their full effort in carrying out a task. They explained that there is divergence between decisions of the agent and those which will maximize well-being of the principal. The owner has the chief interest in this principal-agent relationship for maximizing the value of shares and managers are concerned about the sale of their products and growth of the firm (Walker and Vasconcello, 1997). A particular cost arises due to delegation of authority of decision making from principal to the agent. This is due to divergence of control and ownership in modern corporations (Pitt, 2011). This cost is known as agency costs. The sum of the agency cost is the following: 1) Monitoring costs refers to the expenditure, which is made by the principal for limiting aberrant activities of the agent. 2) Bonding costs reefers to the expenditures, which are made by the agent for assuring that he has not performed any actions, which will harm the principle. 3) Residual losses. The role of agency theory in audit A principal-agent relationship exists between two people, when the principal appoints a person as his/her agent for performing specific services on his/her behalf. The allocation of responsibility to an agent helps in promoting a productive and efficient economy. Here, delegation implies that the principal should trust the agent employed, so that the former can get substantial work done from the latter. There is difference in information between the principal and agent as they can have differing motives, leading to loss of trust among them. There should be certain mechanism, which will eliminate this problem between the two, enabling the principal to trust the agent. There is a mechanism called auditing, which gives assurance to the users of financial statements that these are prepared accurately, without any kind of mistakes. Here, the auditor becomes the agent and the user is the principal, who will utilize the information for his/her interest. The auditors assess the financial statements and recognize whether they are prepared properly and in accordance with the generally accepted accounting principles. Auditing builds confidence in the principal for trusting the financial data present in the annual report of a company. The financial statement plays an important role for management of a company, since the latter is accountable to shareholders. The auditors engage themselves as agents of the principal and are appointed under contract. The main aim of accounts that are audited is to prove their accountability and also, promote confidence among users, which helps them to trust the accounts. Assurance theory Assurance service is referred to as the service of public accountant, expressed as a conclusion, explaining reliability of written statement; this is also the accountability of the other party (Cosserat, 2009). Assurance service is defined as the independent service, which focuses on improving information quality; so that it is easy for decision makers to come up with any decision. Decision makers are responsible for taking business decisions, which seek assurance services for improving reliability of the source of data. Relevance of information is also needed for making the necessary decisions. Conclusion It can be concluded that audit theories have elaborated demand for auditing to a large extent and have assured the users that financial data that are provided by companies are reliable. Auditing, in modern days, has become an important criterion for taking any decision with regard to investment. The internal management of company also relies on auditing services, since it provides accurate financial data, which are helpful for them to make any judgement. The demand for auditing theories suggests that the need for auditing has increased over the past few years and users of the financial data are more cautious, while making investment choices. Auditing of a financial statement not only provides fraud free financial information, but also helps the management to detect careless work of accountants. Bibliography Carmichael, D., R., 2004. The PCAOB and the social responsibility of the auditor. Accounting Horizons, 18 (2), pp. 127-133 Cosserat, G., W. and Rodda, N., 2009. Modern auditing. New York: John Wiley & Sons Ltd. Elder, R., J., Beasley, M.S. and Arens, A., A., 2010. Auditing and assurance services: An integrated approach. New Jersey: Prentice-Hall. Gray, I. and Manson, S., 2008. The audit process: Principles, practice and cases. Connecticut: Cengage Learning. Institute of Chartered Accountants, 2005. Agency Theory and the Role of Audit. [pdf] Institute of Chartered Accountants. Available at: [Accessed 26 February 2014]. Jensen, M., C. and Meckling, W., H., 1976. Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), pp. 305-360. Julkaisuja, V., 2010. A theoretical examination of the role of auditing and the relevance of audit reports. Accounting and Finance, pp.1-56. Kumar, R. and Sharma, V., 2011. Auditing: Principles and practice. New Jersey: Prentice-Hall. Limperg, T., 1932. The Social Responsibility Of The Auditor. [pdf] Limperg Institute. Available at: [Accessed 26 February 2014]. Mautz, R., K. and Sahraf, H., A., (1961). The Philosophy of Auditing. New York: American Accounting Association. Pitt, K., 2011. The assumption of agency theory. New York: Routledge. Swinkels, W., 2012. Exploration of a theory of internal audit. Netherlands: Eburon Uitgeverij B.V. Walker, J. and Vasconcello, G., 1997. A financial-agency analysis of privatization. New Jersey: Associated University Press. Wierik, R., 2013. The landscape of sustainability assurance. Netherlands: Eburon Uitgeverij B.V. Read More