Audit Quality and Agency Theory

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.

Introduction

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 executives of a company are auditors whose role is to inspect and sort out the good from the bad company policies. Additionally, financial company policies are measured against legislation from agencies such as the Internal Revenue Service to make certain that the policies are within the confines of current law (Vrettos, 2010).

The second role auditors play within modern audit theory is that of the traditional financial review. This role has barely changed in the past 400 years with regard to its purpose, although the measures necessary to complete the task have changed. Internal auditors will not always return good new to their companies in these audits, so to avoid any misinformation being inseminated in the reports, auditors work independent of everyone in the company, almost as though they were an outside consultant. This allows the auditor to be as critical as necessary of the company (Vrettos, 2010).

The final role played is that of regulatory monitoring. This purpose is considered the primary motive of corporations for keeping an auditor on staff. This process involves the auditor reviewing individual departments within a business and pointing out all non-compliance and criminal activity. The purpose is to save the company money and liability should any of the actions be questioned publicly (Vrettos, 2010).

Legal Implications and the Need for Auditing

One painful fact in the business world is that businesses exist to make profit and successful companies take risks in order to maximize that profit. Under modern corporate law, those risks are considered legal, so long as they are prudent. This vague legal term is the reason that auditors exist. It is impossible for a board or in more serious cases, a court, to determine prudent actions without numerical evidence. Auditors create that numerical evidence for the decision makers before a risk is ever taken. Should the auditor consider the action too risky and unwise, the auditor's report will say so (Eisenhardt, 1989). In other words, the true final decision maker in modern business is not the CEO, but rather the auditor.

It is for this reason that legal entities have gone a step further and now regulate not only businesses but also auditors. Auditors must pass a rigorous exam and take an oath before being properly licensed to practice. Additionally, auditors are expected to remain disinterested in the affairs of a business and their analysis must remain unbiased. Should a decision be found to have been imprudent, and the auditor had some interest in the decision, they will be punished for their actions (Eisenhardt, 1989).

Modern Audit Quality

Within the confines of classic statistical auditing is the conjunction that audits must be of sound quality. The reason is that the higher the audit's quality and the less mistakes within an audit, the more likely a company is to accept the audit and implement the recommended changes. The greater the errors within the audit, the more likely the audit's advice will be rejected.

This is especially seen in modern government audits. Unlike private business audits where the auditor reports to the CEO of the business, government audits are presented to the congress's supervisory panel and the recommendations determine changes within the law. This is one area where auditing mistakes are often reported in the public media and entire agencies are placed into investigations. It is these forms of tension that lead to the next area of consideration, agency theory.

Agency Cost

While the modern role of the auditor appears of its face to be advantageous to both the public and businesses, there are many who argue that the regulations come at too high a cost for free trade within the business world. Within this argument are two camps of thought, each will be discussed within this section. The first camp is those in favor of government regulation and the other camp is opposed to government interference within businesses.

Government Interference Supporters

The first camp argues that Sarbanes-Oxley is helpful to the business world in that the corporate governance keeps businesses honest. The premise cited for this conclusion is the destruction caused by the Enron case. The damage when the company went bankrupt was much farther reaching then simply the company itself. Rather, thousands of workers lost their retirement funds and were now unemployed. Furthermore, the collapse resulted in what was considered highly profitable and safe stock becoming worthless overnight (Healy, Paul, 2003).

The reason that this camp argues that further regulation is beneficial in preventing these ills is that auditors are now free to do their jobs as needed. Under previous law, auditors could only report their findings as far as the board of a company and then must stop. The concept behind this action was referred to as release of privileged information. Any accountant who went outside of the company with the information could be sued by the company at a later time for releasing the information. This very idea was the reason that Enron collapsed. According to the Congressional Investigation report on the incident, the auditors knew about the questionable accounting practices an entire decade before the collapse of the company. What's more, the auditors reported these non-compliant practices to the board in a full report detailing how risky the practice was and what the results would likely be for the company. The response of the board to this extensive report by the auditors was to ignore their advice and continue reporting the finances as being much higher and more substantial than the situation actually was. In the words of the corporate council during a meeting, "the firm intended to convey to the Audit Committee that Enron's use of highly structured transactions, with multiple special purpose entities and complex overlapping transactions, ran the risk that, if one element failed, the entire structure might fail and cause the company to fall into noncompliance." (The Role, 2002).

Under this camp of thought, the company auditors, whose entire purpose was to supervise the company's compliance with the law and integrity of their financial situation had failed. The reason it failed was a basic legal technicality within the business world placing the freedom and discretion of the business's board above those of the good of the company allowing the board the freedom to increase the company's profits. The result of this failure was the proceeding bankruptcy and criminal charges brought against the board members and attorney.

The solution, according to this camp of thought under Sarbanes-Oxley allows for the auditors to report any ignored findings to the government resulting in a formal investigation. This camp's argument is that the investigation would result in the necessary board members being replaced and charged criminally leaving the company in tact.

Government Interference Opposition

There is a second camp of thought on this issue that is in complete disagreement with the above stated argument. This camp, while entirely in favor of auditing within a company, is opposed to auditors being required to report outside of the company. The reason for their opposition stems back to the market freedom idea that is central to American business practice and structure.

According to this camp of thought, requiring auditors to answer to a higher agency outside of the companies creates a serious tension between the auditors and the business. Where once, auditors had full disclosure and cooperation of businesses, modern auditors are fought and their audits questioned with greater scrutiny by businesses (Ahmed, Hameed, 2005).

This tension has led to yet another problem within companies, that of the board-auditor survivalist issue. Where once, neither board nor auditors were held criminally liable in the event that a risk should prove to be flawed, modernly, both parties could face serious criminal charges. The board members can be charged for making irresponsible decisions and the auditors could be criminally charged for failing to report the board's poor decision to the SEC and halt that decision. With both sets of hands completely tied, the result has now been seen in these recent recession years. Businesses no longer take the high risks that grow the business as a whole and increase profitability.

Agency Theory

Agency theory dictates that it is an unrealistic perception to assume that an agent of a business can remain neutral and purely informative. The reason is that the agent reports to a specific hiring authority and their performance within the company determines their overall pay and longevity with that company.

The principle of agency theory can be best described through a linear model: wages=a+b (e+x+gy). A is the standard wage given to an employee. B is the incentive offered by the company for an agreeable performance. The factors of e, x, g, and y are all determinative variants unseen by the company that play a role in a final outcome. In general, the more unseen time that is spent working, the higher the reward outcome will be. This is true in the case of most professionals, but not necessarily the case with auditors and this is where agency theory deflates.

An auditor will spend countless hours reviewing records and procedures to draft a short memo advising the CEO of what to do in a particular situation. Typically the two people work otherwise independent of one another with the CEO seeing only the reports from the auditor. So, the CEO is unaware of the work that the auditor did to complete the requested memo or the sincerity of that memo.

Over time and being absent of recognition, many auditors become stagnant in their investigations. This results in sloppier work and sub-quality audits. Once this happens, it is only a matter of time before the auditor makes a serious mistake.

The Solution: Or so it Would Seem

Naturally in the business world, one would think that the solution to such a problem is to offer the auditor an increased incentive for their work. What better motivator to gain a flawless audit then to reward perfection with added compensatory rewards.

This was, in fact, attempted by many companies during the 1980's (Webster 2010). In this period, businesses would offer their auditors a share in the company's stock for their services. The auditors were then shareholders within the company and would receive financial payments whenever the company gave a payout. Some of the auditors would take the stock and reinvest any payouts, adding to their interest within the company. All and all, it seemed like an excellent incentive plan for the auditors.