Auditing Guarantees Truthfulness of Financial Statements - Literature review Example

Auditing Guarantees Truthfulness of Financial Statements Name University Abstract Auditors take on an important for companies by validating the fairness and truthfulness of financial statements. However, owners, as per the agency theory, must trust the auditors, and any doubt about the independence of the auditor compromises the credibility of financial reporting. However, there exists audit expectations gap, which auditors need to address through sound financial reporting, and fulfilling the interest of the investors and the owners, which is in line with the information and insurance hypotheses. Introduction Audits are associated with playing an important economic purpose, particularly when dealing with public interest, by firming accountability, confidence, and trust in creatingfinancial reports (AICPA, n.d). Many corporation hire auditors to enhance their economic prosperity, which has seen them expand the number, variety, and value of transactions that they are ready to undertake. However, the rise of corporate scandals, such as the Parmalat case in Italy and the Enron case in the US, has heightened the questioning whether auditing guarantees the truth of financial statement information (Hassink et al., 2009). Ideally, as the writers pointed out, auditing has gained tremendous speculation that it may not be as effective as was thought to be owing to the rise in fraud. This current paper seeks to ascertain the validity of the statement, “auditing does not guarantee the truth of the information in financial statements and is a waste of time,” by analyzing audit theories, including the agency theory, information hypothesis, and insurance hypothesis, as well as looking into the expectation gap. Evaluation of the Statement The agency theory revolves around the agency relationship which arises whenever principals, such as the business owner, engages with an agent, who is often referred to as the steward to perform a certain service on their behalf. As a result, the owner delegates the task to the steward, which as (Donaldson and Davis, 1991) assert, results in the division of labor, which in turn, is helpful in the promotion of efficient and productive economy. The delegation, however, means that the principal has placed trust in the agent to act in the best interest of the principal. For this reason, the agency theory purports that, due to the self-interest and information asymmetries, principals may lack reasons to trusting their agents, and to counter that, they have to put in place tools that will enable the alignment principle and agent interests. By putting in place these mechanisms, there is an increased probability that opportunistic behavior and information asymmetries will reduce significantly(Donaldson and Davis, 1991. For this reason, it can be argued that as the there exists a level of mistrust between the owner and the agent, and this can be extrapolated to the scenario of auditing. In this environment, the auditor is the agent while the Chief Executive Officer is the owner. Their interests are very different in this case, as the CEO has to pay the auditor. Therefore, the CEO wants to check the authenticity of the financial reporting by delegating the task to the auditor, and the auditor demands to be paid(Donaldson and Davis, 1991). In essence, the auditor’s motivation is financial rewards. Consequently, the auditors are more optimistic about the economic performance of the company than the actual reality. In addition, the auditors may be more risk averse compared to the managers or CEOs. Evidently, these are differing interests on the part of the agent and the principals. The relationship affirms that auditors are biased. For this reason, as Healy and Palepu (2001) assert, auditing can be biased, and can provide limited information about the financial asymmetries in the organization. The differing information asymmetries and motivations can compromise the reliability of the financial reports, which greatly impacts trust levels of principals on the agents. However, these can be kept under control by incorporating various mechanisms that may be used to align the interest of the auditors with those of the owners, which will enable the principals to oversee through the controlling and measuring the behavior of the auditors and reinforcing the element of trust in them (Holm and Zaman, 2012). Some of the steps that can be taken are putting in place remuneration incentives and packages for the auditors. Consequently, their performance is greatly improved thereby increasing the credibility of financial reporting in the organization. Therefore, besides the salary package, auditors can be awarded a benefits package that includes various bonuses. In addition, since trust is a concern, by adopting these incentives can be handy in aligning the interest of the auditor with those of the owner. However, the degree of untrustworthiness is a key indicator of the amount of monitoring systems and incentives to be adopted. According to Holm and Zaman (2012), one way of improving audit quality is by reinforcing trust between the agent and the principal. Other factors that the authors pointed out as drivers for quality in the auditing field is focusing on expertise, transparency, and professionalism. As such, the agency theory provides evidence that audit quality is compromised in instances when the interest of the auditor and the principal do not align. However, the alignment can be realized by improving trust and providing incentives to the auditor. Also, companies should also hire professional and transparent experts in this field to promote quality. Looking at the statement, as per the agency theory, auditing is not a waste of time as it can deliver quality financial reporting and statements because the factors that can contribute to misinformation, asymmetries, and opportunistic behaviors can be mitigated. In consequence, the audit, after the elimination of factors that promote these adverse and erroneous financial reporting, the audit can be of economic importance to the firm (Nikkinen and Sahlstrom, 2004). For this reason, auditing is not a waste of time. Regarding information hypothesis, audit services are paramount to reducing the information risk to users of financial reports, such as financial statements. In this regard, the audits are very important as they ensure that the reports are correct, and, can in turn, be used by a variety of persons, including investors and stakeholders (Healy and Palepu, 2001). For this reason, the audits minimize instances of information risk, which can be referred to as the risk that user decisions can be made using incurrence financial information (Higson, 2003). For this reason, auditors are required to minimize the amount of losses resulting from faulty decisions, which are caused by irregularities in the financial statements. It is vital to point out that losses to investors can arise due to failure in disclosing all facts about the corporate management, especially on financial information. As such, auditors play a significant role in assessing whether there exists information asymmetry in financial statements, and in turn, alleviating any instances of misinformation via proper disclosure(Healy and Palepu, 2001). Financial information that is inaccurate can deter investments in the capital markets, and thus, auditing plays a vital role in solving underinvestment problems, and also ensuring that the company bolsters better resource allocation. For this reason, as per the information hypothesis, audits are paramount for ensuring correct financial reports. According to Wallace (2004), audits are important sources of information that can be used by investors as they improve the quality of financial information. Ideally, the financial information is an important aspect of consideration whenever making corporate decisions, as it facilitates the development of accurate decision models, which can in turn be used in valuing the organization through the calculation of its future cash flows and net present value. In essence, this type of information can enable an investor to make a decision whether to invest in that company or not. For this reason, when the financial information is correct due to accurate auditing, an investor can make informed and error free decision. However, if the decisions are correlated to misinformation, it can lead to future underinvestment, and may still be an alarm for mistrust for the company. Ideally, no one wants to invest based on erroneous information. Also, audits the determination of the market value of a company, thus enabling them to make rational decisions, even in instances when there is a lack of an explicit contract with the agent. There are benefits of financial information and include reduction of the risk, earnings of trading profits, and improving the decision-making process. These benefits characterize the audited financial statements, and thus, auditing is very advantageous for a company. Since investors are risk averse, they are inclined to demanding higher returns for higher risk levels, or in some cases, they pay a higher price through a risk premium so as to reduce the uncertainty level. According to Wallace (2004), the audit is cost effective in instances when the risk premium for the individual investors exceed the cost of the corporate audit. In addition, audits are sources of information for managers to enable them make company decisions. The auditing process, as per the information hypothesis, also improves the internal decision-making processes. As Wallace (2004) points out, accurate data conditioned by accurate auditing enables accuracy in investment and credit analysis, regulation decisions, regulation decisions, and labor negotiations, which in totality improves the performance of the manager, and in broader terms, the performance of the company. The insurance hypothesis asserts that he auditee and the auditor are jointly liable to third parties for any losses attributed to erroneous financial reporting. However, to shift financial responsibility to the auditor lowers litigation costs. Therefore, as Wallace (2004) a points out, the increase of these costs will increase the insurance demand from professional participants and managers for audits. Also, most organizations have sought to shift the insurance to auditors rather than to insurance firms. In effect, the auditors can be sued if there is business failure emanating from their erroneous auditing. For instance, whenever an investor buys securities based on audited financial statements but makes losses, the law provides recourse to the auditor. As such, auditing is important, and an auditor cannot take the chance of incorporating irregularities into the statements as he acts as the indemnifier against any investment losses. For this reason, it is clear that auditing is important on either side, the auditor, and the owner. By transferring liability to the auditor makes allows the auditors to perform optimally (Wallace, 2004). They cannot afford to make mistakes as they are eligible for compensating investment losses. As such, as per the insurance hypothesis, it can be derived that it enables the auditor and the owner to be liable for any misinformation, and the pressure ensures that all financial statements are correct. For this reason, it can be concluded that auditing is not a waste of time. The “audit expectations” gap as Saha and Baruah (2008) point out, entails the assertion that investors expect that auditors will be able to safeguard their financial interest, but this has hardly been met. There has been numerous mistakes emanating from the audit expectations gap, which is an offshoot of the unresolved expectations, and have, in turn, reduced users’ confidence on auditors (Saha and Baruah, 2008). As pointed earlier, auditing has been compromised, for example, Baan case in Netherlands and the Maxwell case in the UK among others, which have been detrimental to the reputation of the audit profession (Hassink et al. 2009). As Sikka et al. (1998) point out, eliminating this expectations gap is almost impossible, and auditors cannot change the nature of their responsibility in auditing. They ensure the accuracy of information and their reporting ensure decisiveness in investing. However, the expectation gaps can be controlled by paying attention to internal control, cash counts, stock counts, and arithmetical accuracy records among other moves to eliminate fraud irregularities (Sikka et al. 1998). As such, the gaps can be eliminated, which follows that auditing is important if these gaps are taken care of. Conclusion In summation, I strongly disagree with the statement that auditing is a waste of time. In essence, even if there are “audit expectation” gaps, they can be controlled by paying attention to internal control among other factors. As per the agency theory, auditing can be compromised by the issue of self-interest, but this can be controlled via motivation, and also through the insurance hypothesis, which tries to harmonize the interests of the owner, auditor, and investor. Ideally, litigation cost is transferred to the auditors, making them more careful. In addition, the information hypothesis supports the auditing process, which hypothesizes that auditing provides crucial information for investors to make informed decisions, as well as the managers. It is in the best interest of organizations to present truthful information, and auditors have been assigned that role. For this reason, auditing is very important for companies and investors, and it is not a waste of time. References American Institute of CPAs (AICPA), n.d., Why Audit Quality is Important for Auditees? Viewed March 17 2016 Donaldson, L. and Davis, J.H., 1991, Stewardship theory or agency theory: CEO governance and shareholder returns. Australian Journal of management, 16(1), pp.49-64. Nikkinen, J. and Sahlström, P., 2004. Does Agency Theory Provide a General Framework for Pricing?. International Journal of Auditing, 8(3), pp.253-262. Hassink, H.F., Bollen, L.H., Meuwissen, R.H. and de Vries, M.J., 2009, Corporate fraud and the audit expectations gap: A study among business managers. Journal of International Accounting, Auditing and Taxation, 18(2), pp.85-100. Healy, P.M. and Palepu, K.G., 2001, Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature. Journal of accounting and economics, 31(1), pp.405-440. Holm, C. and Zaman, M., 2012, Regulating audit quality: Restoring trust and legitimacy. Accounting Forum, 36(1), pp. 51-61). Higson, A., 2003, Corporate Financial Reporting – Theory &Practice.London: Sage Publications Ltd Saha, A. and Baruah, D., 2008. Audit Expectations Gap in India: An Empirical Survey. ICFAI Journal of Audit Practice, 5(2). Sikka, P., Puxty, A., Willmott, H. and Cooper, C., 1998,The impossibility of eliminating the expectations gap: Some theory and evidence. Critical Perspectives on Accounting, 9(3), pp.299-330. Wallace, W., 2004, The economic role of the audit in free and regulated markets: a look back and a look forward. Research in Accounting Regulation, 17, 267–298. Read More