Audit Quality and Agency Cost

Audit Quality and Agency Cost

Since the advent of industrialization, there has been the presence of a bond between the people who invest and the people who manage those investments, forming a vital relationship amongst the two groups. Although with the rise of such relationships, the soaring issues of trust and confidence have been a hindrance in economic growth. Viewing the high percentage of the capital of investors or shareholders in companies being utilized to cover the costs of bearing these barriers, it is clear that the audits are being considered a necessity in the business model for the shareholders so that they are assured that their investments are secure and are ensured that they are being properly rewarded in return.

The fundamental purpose of audits has been to reinforce trust and promote confidence in the financial information that the management publishes for the shareholders. Bearing this in mind, it is vitally important that the audit services one receives are of adequate quality so that its purpose is fully served and the users of the financial information feel safe with their investments.

Being a qualitative measure, it is necessary to understand the ways to assess and maintain a high standard of quality in the audit services. This can be judged by the reputation as an organization and the past history of performance of the audit firm recruited for the audit services. The existence of professional bodies, regulators and law also assist in clarifying any questions regarding the quality of the work performed by auditors.

One very important aspect of the audit quality is the audit risk associated with the audit task at hand. The understanding of an entity by an auditor plays a vital role in the auditor's attitude towards the audit risk of that entity. It is this attitude that decides the amount of work necessary to be carried out and the extent of the audit techniques to be involved during the course of the audit that would eventually assist in the shareholders' decision making process.

Introduction

The modern corporate system heavily relies on the relationship that separates the domain of the ownership and the control of a business. This relationship between the owners and the managers of a business is called the agency relationship, where the shareholders (i.e. The Principals) enter into a contract with the managers (i.e. The Agents) to perform services on their behalf that involves the delegation of some decision-making powers and the management and control of their business, in a way that benefits the investors and rewards the managers as well. Such entrustment of power and authority by the principal and the resulting division of labor are supportive in encouraging and promoting a productive and an efficient economy.

However, the involvement of the principal's confidence and trust in an agent to act for the principal's best interest is a vital consequence of this relationship. And the lack of this trust usually results in serious conflicts between the shareholders of an enterprise and its managers or directors. This is because of reasons such as that shareholders cannot monitor the running of the business, given the time constraints, the presence of an imbalance of information available to both the principal and the agent, the possibility of misalignment of the self-interest of both parties, and more importantly, almost no knowledge on how to run the business efficiently.

Since agents are not the owners, their motives are most likely to be different than those of the principals. Various factors may have bearing on their motives, factors such as relationships with other parties that are irrelevant to the principal, opportunities in the labor market and rewards in terms of finances, their different attitude towards risk than that of the principal and the possession of information that the principals do not have access to and the opportunity of benefiting from it.

To avoid such conflicts, motivation for the managers and supervision of their work by reducing the extent of imbalance of information and opportunistic conduct and bringing in mechanisms to line up their interests with those of the shareholders, are the solutions the principal can use. Various mechanisms can be used by the principal to align their interests with the interests of the agent, and to allow the principal to monitor and control the agent's behavior and to strengthen the confidence and trust in the agent. The provision of incentives, bonus and share options, performance-related salaries and remuneration packages to the directors and managers can be a few of such mechanisms.

Another mechanism that can be used for monitoring is the audit of the work carried out by the managers in running the entity.

'The origin of auditing goes back to times scarcely less remote than that of accounting.. Whenever the advance of civilization brought about the necessity of one man being entrusted to some extent with the property of another the advisability of some kind of check upon the fidelity of the former would become apparent.' (Brown, 1968)

Body of the Assignment

An audit is an independent examination and check of the financial information created and presented by the management of an entity and the work they carry out in the running of the business. This check is carried out by external auditors representing an auditing firm for an audit fee, to provide an assurance to the shareholders, which in turn helps to maintain their trust and confidence towards the agents.

When carrying out an audit, the auditors are acting as agents to the principals, creating a new agency relationship, and like the shareholders-management agency relationship, it also brings the similar concerns in relation to the issues of trust and confidence. Auditors might also have motives and interests that benefit themselves rather than serve the purpose of the audit task at hand. For example, they might have a rather risk averse approach towards the audit to avoid a potential liability or might collude with the management for their personal benefits and interests, thus killing the purpose of an independent audit in the first place. To counter this and to protect the audit profession, there is the presence of regulation. For the principals, there are regulators to make sure that their interests are safe and are appropriately observed by the agents. Regulation can be present on many levels; it can be national or international, regulation of companies or regulation of auditors. Some examples of regulation are the Sarbanes-Oxley Act 2002 in the U.S. (Sarbanes-Oxley Act, 2002) and the Company Act 2006 in the UK (Companies Act 2006). In presence of such regulations, the confidence and trust in the auditor by the principal is reinforced.

Agency Cost and Audit Quality

Putting in place these mechanisms always results in an additional cost to the principal than that of the original agency contract cost. This additional cost arising due to such measures is called the agency cost. This can be defined as the sums of the expenditures carried out by the principal for the purpose of monitoring the acts of the agents and the bonding expenditures by the agent and the residual loss towards the principal. By residual loss, we mean the losses the principal has to face because of the decisions the agent makes that are not in alignment with those decisions that would maximize the welfare of the principal.

The cost of audit that the principal has to bear is a major chunk of the total agency cost. Mostly it involves the fee an audit firm charges for the services it provides to an entity. This fee can vary to the extent of the audit work required by the principal. The size of the audit firm hired to provide audit services and the total audit cost give expression to the audit quality to a certain extent. Entities that require audit work of a high quality usually choose large audit firms and are most likely to incur a high agency cost. This shows that the relationship between the quality of the audit work and the agency cost is directly proportional, i.e. The higher the audit quality, the higher the agency cost and vice versa.

Although audit quality is not defined in law or through regulations, nor do auditing standards provide a simple definition, at its core audit quality is about delivering an appropriate professional opinion to the principal by the auditor that is supported by the necessary evidence. Many values contribute to audit quality; including good leadership, experienced judgement, technical competence, ethical values and appropriate client relationships, proper working practices and effective quality control and monitoring review processes.

Although we can say that audit quality with these characteristics can be deemed appropriate, it should not be forgotten that that as human beings, auditors are always prone to mistakes that give misleading information to the shareholders, such as giving an unqualified opinion on the basis of false data or evidence . Sometimes these mishaps can happen unknowingly and unwillingly by the auditors and that is where the codes of corporate governance and local or international regulations and local laws come in to the picture. All of these play a major role in minimizing the chances of such occurrences of errors in the audit report. But sometimes these incidents do not only happen because of mistakes of the human nature. The auditors might provide such misleading information deliberately and knowingly. They can do this to avail benefits for themselves by colluding with the management, thus becoming involved in a fraud or scandal. This gives rise to the concern of improper auditor independence, the effects of these on the audit quality, and the issues of trust and confidence in the auditors by the shareholders.

The Enron and WorldCom Scandals

History has proved that this is not only a myth as there have been cases, most recently that is, that have witnessed such frauds being committed by companies and their auditors to work against the shareholders' interests to benefit themselves instead. One of such cases has been the history's biggest corporate collapse, the Enron scandal of 2001 in the U.S., followed by the demise of its auditors, Arthur Andersen (one of the big five audit firms then). This case jolted the roots of accountancy and audit in the business world, tarnishing the image and reputation of the accounting profession and its members worldwide as a whole, and questioning the adequacy of rules and regulations and laws in place at that time.

Enron was a company in the U.S. energy sector and was formed in 1985 by merger as a natural gas pipeline company based in Houston, Texas. Enron had become the 7th largest U.S. based company by early 2001 and was also seen as the largest seller and buyer of electricity and natural gas in the U.S. The business failure of the Enron was discovered in December 2001, when it filed for bankruptcy (BBC News World Edition, 2001). It was said to have been one of the biggest failures in business history that involved a staggering amount of 8.5 billion dollars in debt. This was eventually viewed by many as a result of failure of audit, questioning the audit quality directly.

The auditors of Arthur Andersen, the audit firm that provided audit services to Enron, were under the limelight, particularly their ability to investigate any signs of questionable accounting practices followed by Enron and failure to report to the shareholders. Investigating more in to the case by the authorities brought to attention that for almost 20 years, Arthur Andersen had been providing audit services to Enron. These services were not only external audit services, but also internal audit services to Enron. This clearly showed that Arthur Andersen had violated the U.S. Securities Exchange Commission's laid down principles for impairing independence that when provided to an audit client, internal audit services was one of the 'nine non-audit services' that could impair the auditor's independence, and thus could affect the audit quality of the assignment (U.S. Securities and Exchange Comission, 2003).

It was also reported that Arthur Andersen had received earnings of about 52 million dollars during the time as auditors of Enron, and it was further expected that the amount was to get doubled soon. It also came to the knowledge of everyone that Arthur Andersen had also stationed a permanent office space in the Enron's building. Additionally, many of the events organized by Enron's management were joined and attended by employees of Arthur Andersen as well. It became evident that Arthur Andersen's profitable role as the auditors of Enron that earned them a hefty fee and the close intimacy with the company had gravely affected the independence of the auditors of Arthur Andersen, which eventually resulted in overlooking of compliance issues with relevant policies and regulations and making sure proper and adequate accounting practices were in place. Auditors of Arthur Andersen had known all along that the financial position of the Enron was not good and had serious issues, but they signed off the financial statements regardless of that.

Another major case that occurred such as the Enron scandal was related to a company called the WorldCom. The WorldCom was also a U.S. based company in the telecommunications sector that was formed in 1983 with the name of 'Long Distance Discount Services (LDDS)'. It grew in to one of the largest companies of U.S. And a telecom giant by the year 2000, by going through a series of acquisitions since its advent. In 1995, it changed its name from LDDS to the WorldCom Inc. Eventually in July 2002, the WorldCom filed for bankruptcy. This bankruptcy was the largest in the U.S. history, beating the record that was set by the Enron in December 2001. The company admitted that it had falsely booked an amount of 3.85 billion dollars of expenses as capital expenditure to make the company look more profitable. After an internal investigation was carried out by WorldCom itself and its auditors, it was revealed that since 1999 WorldCom was involved with some improper accounting practices. The internal auditors also uncovered that other than the original amount, another 3.83 billion dollars were found to be wrongly dealt with, bringing the total errors since 1999 to the value of almost 7.70 billion dollars.

Here also the auditors of the WorldCom were from Arthur Andersen. For the audit related to the year 2001, Arthur Andersen had given an unqualified opinion on the WorldCom's financial statements. At a meeting with the Audit Committee of WorldCom in February 2002, among other things related to the end of year financial statements of 2001, Arthur Andersen presented that:

1) There were no significant or unusual transactions, or material transactions in controversial or emerging areas for which there was a lack of authoritative guidance or consensus.

2) Andersen has assessed the Company's key accounting practices to determine whether management had adequate controls to prevent a material error in the financial statements as s result of a failure to properly record data in the general ledger.

3) It was Andersen's assessment that the Company's processes for line cost accruals and for capitalization of assets in Plant, Property and Equipment accounts were effective.

4) It was Andersen's assessment that the Company's process for formulating judgments and estimates for accrued line costs was effective, noting that line costs as a percentage of revenue had remained flat at 41.9% on a YTD basis. During the meeting, Andersen advised in response to specific questions by the Committee hat Andersen had no disagreements with management and that there were no accounting positions taken by the Company with which Andersen was not comfortable. (Anderson, February,2002)

Since the Enron scandal, Arthur Andersen was already under fire and subsequently after the bankruptcy of WorldCom, a number of cases were lodged against Arthur Andersen, where it was accused of not being able to protect the shareholders. To save their selves, Arthur Andersen blamed the WorldCom's Chief Financial Officer Scott D. Sullivan for withholding information during the course of the audit. But as soon as they discovered that certain expenses were reported as capital expenditure, Arthur Andersen straight away announced that the audit report for the WorldCom's financial statements for 2001 should not be relied upon by all the stakeholders.

In light of such huge scandals and frauds, the auditors of the Big Five firms claimed that they had adhered to ethical standards and guidelines. But unluckily, most of the corporate failure cases involving large companies such as Enron, WorldCom, Parmalat and Xerox were closely related to audit failures that affected the audit quality, involving large audit firms. Therefore, it becomes clear that it is of grave importance that the audit quality is properly controlled and maintained so that a proper audit report can be presented.

Controls for Audit Quality

The audit quality control can be carried out and maintained at two levels; one being the audit firm level and the other being on the individual auditor level. The presence of international standards on quality control (ISQC) and international financial reporting standards (IFRSs) helps audit firms to establish quality standards for their businesses and provide them a general quality control framework within which audits should be conducted. Firms are required to ensure that the appropriate training is provided to ensure there is complete understanding of the procedures and objectives. It is also essential for a firm to implement policies, such as the internal culture of the firm, where quality is considered essential. Such a culture must be inspired by the leaders of the firm, who must sell this culture in their actions and messages. The firms may appoint individuals with sufficient and appropriate experience and necessary authority to oversee the quality in the firm and its audit work.

The firms' overriding desire for quality will necessitate policies and procedures on ensuring excellence of its staff, through continuing professional development, education, work experience and coaching by more experienced staff, to provide the firm with 'reasonable assurance that it has sufficient personnel with the capabilities, competence and commitment to ethical principles necessary to perform its engagements in accordance with professional standards and regulatory and legal requirements, and to enable the firm to issue reports that are appropriate in the circumstances.

The assignment of engagement teams is an important matter in ensuring the quality of an individual assignment, and such a responsibility is to be given to the audit engagement partner of the firm who should ensure that he assigns staff of sufficient capabilities, competence and time to individual assignments. Firms often produce a manual of standard engagement procedures to give to all staff so that know the standards they ensure that engagements are performed correctly in accordance to standards and guidance, making the audit engagement of an appropriate quality.

In the presence of difference of opinions on an audit team, a report should not be issued until the dispute has been resolved, where intervention of a quality control reviewer of the audit firm's work should be made possible. The firm must also monitor their system of quality control and the monitoring activity should be reported to the management of the firm. The people monitoring the system should be required to evaluate the effect of any deficiencies found and counter them to ensure the audit quality remains of an appropriate standard.

When all such steps are carried out by the audit firm and the presence of such regulations, the quality of their work is deemed appropriate enough to be used by the shareholders, thus reinforcing the confidence and trust of the principal in the audit services provided by the audit firm. In a larger picture, the regulation and standards used by an audit firm not only reinforces confidence in the audit quality, but also fulfill the task of aligning the interests of the management with those of the shareholders and giving the worth of the agency cost incurred by the principal in the first place.

Audit Risk

As previously mentioned in relation to the risk-averse attitude shown by the auditor to avoid potential liability, one of the main reasons for such an attitude is the risk associated with auditing that an auditor has to face throughout the course of an audit engagement. The audit risk can defined as the risk the auditors may give an inappropriate opinion on the financial statements when the financial statements are materially misstated.

The materiality level of a statement can be judged by the fact that whether the misstatement of an information or fact in the financial statements will affect the decision making of the shareholders and other stakeholders or not. For example, a misstatement of a figure of a small single transaction with a small debtor of a huge multinational company can be considered immaterial, whereas an omission of a non-current asset such as land or heavy machinery from the final accounts can be considered as material and can affect the decision of a shareholder, which could have been different if the proper information was available.

The audit risk has two vital components which are the risk of material misstatement in financial statements (the risk of material misstatement) and the risk of auditor not detecting the material misstatements in the financial statements (detection risk). The risk of material misstatements itself breaks down into two different types of risk, i.e. The inherent risk and the control risk.

Thus, the audit risk can be summed up this following formula:

Audit Risk = IR x CR x DR

where,

IR stands for the Inherent Risk,

CR stands for the Control Risk,

and DR stands for the Detection Risk.

The inherent risk can be understood as 'the susceptibility of an account balance or class of transaction to material misstatement, either individually or when aggregated with misstatements in other balances or classes, irrespective of the related internal controls'.

Likewise, the control risk is defined as 'the risk that misstatement could occur in an account balance or class of transactions, could be material, either individually or when aggregated with misstatements in other balances or classes and would not be prevented, or detected and corrected on a timely basis, by the accounting and internal control systems' (International Standard on Auditing 400).

These two risks are already present in the financial statements of an entity and the audit work of an auditor does not relate to these two risks. The auditor's domain falls in the area of the detection risk. It can be said that this is the risk that the audit procedures applied by the auditors will fail to detect material errors. It relates to the inability of the auditors to examine all the evidence.

The audit evidence is usually persuasive rather than conclusive so some detection risk is usually present, allowing the auditors to seek 'reasonable assurance'. The term reasonable assurance means that the assurance the auditor is providing to the principal is reasonable, not absolute, considering the amount of information that the auditor has been provided and also considering the time limits to the audit engagement and the fact that the auditor is working on sample basis, rather than going through all the information of the entity.