Audit Quality and Agency Theory Research Paper

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Audit Quality and Agency Theory

Auditors have existed since the 1300's and for most of that time, their role remained the same. Auditors were the life-line of governments and businesses, helping establishments maximize profit and efficiency, the benefits of which were enjoyed by everyone. As time passed, auditors were given new roles and worked routinely to assure the maximum profit of the company that employed them.

In the past 50 years, however, a tension arose between the role of the modern auditor and their employer. This tension, known as the agency theory and audit risk concept led initially to much criticism of the role of auditors in the business world. This role was further complicated as companies began giving company share incentives to their auditors to produce desirable reports. The primary case example for this abuse of accounting is the Enron case, in which the company intentionally ignored their internal auditors warnings and continued using high risk accounting practices, leading to their eventual bankruptcy. These reports started a destructive cycle that lost a great deal of money for many publicly held businesses. It is from this issue that the intrusive Sarbanes-Oxley legislation arose and the SEC gained control over the roles of auditors. This new role, known as corporate governance ensured that auditors with concerns about a businesses practices were reporting to someone other than the company and could act in accordance with the good of the company.

In this paper, I will explore the premise that modern globalism and government interference, such as Sarbanes-Oxley has resulted in diminishing the role of the auditor from an adviser to a simple statistical reporter. Further, this change, while giving the federal government an ability to review businesses private information, hindered the once positive relationship between the auditor and the higher executives within a company.


Since the 1300's governments and businesses have sought accountability and prevention of errors with regard to business efficiency and financial bookkeeping. This practice, known as auditing, has since grown into more areas than simply finances. In fact, there are currently auditors specializing in environmental, energy, and project audits. With so many audits being completed within companies, larger businesses are now finding it necessary to audit the auditors. This practice, regulated by audit certification companies and upheld by businesses, is a way of ensuring the best data and information. This form of accuracy within auditing, known as a statistical audit is yet the next step in ensuring the utmost accuracy and clarity within a company.

With so much money and time being spent within companies on auditing, it begs the question of whether society has gone too far and whether there is such a need where once there was not. This paper will seek to answer this very question by exploring the historical, legal, and practical applications of modern audit theory and its usefulness in the private and public sectors.

Audit History

Auditing is an old practice initiated in England to hold the royalty accountable for their spending. The earliest recorded audits are from 1314. While the type of audit is not particularly known, there are references made to the Auditor of the Exchequer (Matthews, 2006). Auditing then went out of fashion until the 1500's under Queen Elizabeth. By this time, there was statutory law in place which assigned auditors to the task of auditing royalty. By the 1700's, auditors were well established among Parliament and the royalty, which ensured yet again further clarity of where the rulers and government were spending funds.

Finally, in 1834, the job of Public Accountant became established. The role of the public accountant was primarily bank related. Public accountants were hired by banks to review the books of local businesses and ensure that proper payments were being given on loans (Matthews, 2006). Under William Ewart Gladstone, Parliament and all government offices reached a new level of accountability. In 1866, Gladstone enacted the Audit Departments Act, which required for the first time, that all departments perform an annual audit and submit it to the agency for inspection. This act further created the positions of Comptroller and Auditor General, which for the first time established support staff for what was once a position handled by one person (Matthews, 2006).

As can be seen by this time in history, the role of auditors progressively increased, giving more power to those who hold others accountable. Additionally, history also reveals the fact that the larger the organization, the more auditors and support staff that are needed for an accurate and efficient account. This realization and observation is key to understanding modern audit theory and the role of not just a single auditor in a company, but the entire auditing team.

Jumping across the ocean, the United States has a very different perspective on auditing and auditing practices. While auditors and accountants have existed in the United States for 200 years, it was not until the creation of the Securities Exchange Commission (SEC) that auditors began playing a crucial role in businesses (Auditing, 2010). Whereas in England auditors were initially used to hold the government accountable, America's governmental system eliminated the need for that position initially. Instead, in the United States, auditors were utilized for analyzing and determining the value of private-sector businesses.

The United States, up until recently, has been the ultimate experiment in open capitalism. Companies were left to earn money and produce goods with little to no government interference. However, with the increase in publicly held companies, there was also an increased need for accountability within these once free market businesses. The evolution of the modern business accountant, however, was very slow and typically the role was not changed nor more power given to accountants until there was yet another failure within the business system (Accounting, 2010).

The most recent intrusion into the private sector in the United States, and the one that will prompt examination for this paper, is the Public Company Accounting Oversight Board, established under the Sarbanes-Oxley Act. Drafted in 2002 in response primarily to the Enron case, this department not only oversees the publicly-held companies, but the auditors of those companies. This organization is responsible for creating the standard licensing, training, and examining of public accountants. Additionally, the department disciplines ineffective or dishonest acounting with fines up to $100,000 against a single auditor or $2 million against and auditing company (PCAOB, 2012). This recent measure was created in the United States for one reason, to standardize and form audit quality within the audit system.

Modern Audit Theory

The role of the modern auditor is not as simple as it was throughout history. Modern auditors are the eyes and ears of public companies. They operate within the company, but outside of management and are charged with remaining entirely neutral and accurate. Whereas once auditors had the role of simple information gathering, now auditors are expected to analyse and interpret that information in the most critical way possible. It is this role that has many auditors nervous and many wincing at the constant bombardment and transformation of the audit process.

Modern auditors play and hand-in-hand role with modern corporate attorneys. Both are hired and work internally within the company, but neither actually work for the better of those they come into contact with on a daily basis. The purpose of these two positions is not for the sake of efficiency or consistency within a business, but rather for whistle blowing. With more and more publicly-held companies failing right under the noses of their investors, the government has seen fit to infiltrate the private sector and force accountants to release otherwise private business strategy information (McKenna, 2011).

This new whistle-blower role was not one voluntarily accepted by American auditors. Rather, it was a governmental response to the Enron incident. During the Enron investigation it came to the attention of the investigators that the internal auditing team had predicted the non-compliance of the company's accounting practices and advised the board against further use of the practices years before the company's collapse. At the time, an auditor's job stopped at the board of a company. So, when the board told the auditors that the practice would continue and be closely monitored, the auditor's hands were tied (The Role of the Board of Directors in Enron's Collapse, 2002). In response to this, the federal government under the Sarbanes-Oxley Act, required that auditors who suspect non-compliance must continue reporting the problem past the board of the company to the SEC should the advice be ignored. While this practice does protect the company's overall interest, it also begs the question as to a business's freedom to take risks.

Modern auditors play three different roles within a modern company under audit theory. The first role that modern auditors play in the business setting is internal control. The heads of companies set particular company policies for the good of the company. These policies are meant to increase profit and efficiency and have a trickle down management effect. Along side the top…[continue]

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