Audit Theory Evaluation In Audit Industry

This essay will critically discuss and evaluate auditing theory in relation to the audit industry by paying particular attention to Flint’s postulate; “the essential distinguishing characteristics of audit are the independence of its status and its freedom from investigatory and reporting constraints” . Primarily this essay will investigate how this postulate is linked to the agency theory alongside the lending credibility theory and how when auditor independence is compromised, the credibility of their opinion is lost. We start by looking at a couple of basic definitions. Theory itself is defined as “a supposition or a system of ideas intended to explain something, especially one based on general principles independent of the thing to be explained.” Auditing theory therefore explains what the purpose of auditing is whilst also showing why the auditing postulates are so important. Agency theory attempts to portray the principle-agent relationship, where due to information asymmetries and conflicting self-interest, agents cannot be considered trustworthy by the principle. By the use of mechanisms, the principle is able to align the interests of the agent with the principle including risk and reduce the opportunity for opportunistic behaviour. Within auditing, the stakeholders are considered the principle, management are considered the agent and the mechanisms relate to the use of an audit firm. This theory goes hand in hand with the lending creditability theory which demonstrates how “audited financial statements are used by management to enhance stakeholders’ faith in management’s stewardship”. By linking these theories to auditing we are able to understand the significance of Flint’s postulate of audit independence.

First, we discuss how auditor independence is linked to agency theory. Agency theory discusses the relationship between stakeholders and management, and how this relationship creates a principle-agent problem. The use of an audit firm aims to reduce this principle-agent problem and therefore the independence of management. However, the use of an audit firm creates a new principle-agent problem between stakeholders and the audit firm. If the audit team is not independent from management then they cannot be trusted by stakeholders and the original principle-agent problem between stakeholders and management persist. Stakeholders cannot trust an audit firm that is not independent from management as they may be manipulated by, influenced by or in collusion with management in order to fulfil their own professional and personal self-interests. There are many reasons why management may not be considered trustworthy, such as their own financial reward, job security or relationships with third parties who are not relevant to the principle. Auditors too have many incentives to act unprofessionally and therefore ignore the independent requirement of the auditing role, these include the large audit fees paid for by management and the threat of losing employment by the audit client or company. A 2016 survey revealed that the average audit fee for public companies was $7.4 million. The International Federation of Accountants lists the main threats to auditor independence alongside an additional threat listed by the Auditing Practices Board. This is an example of the existing problems presented by the principle-agent relationship within audits.

Next, we discuss how auditor independence is linked to the lending credibility theory. Within auditing, auditors give their opinion on the truth and fairness of financial statements prepared by management. Lending credibility theory suggests that by auditing these financial statements, it adds credibility to them, therefore increasing stakeholder’s confidence in management. The perceived increase in reliable information leads to improved quality investments by stakeholders. However, if we consider the threats to independence discussed above which lead to a lack of independence between management and the audit firm, we can assume that no extra credibility is gained by auditing these financial statements. This is why Flint describes independence as a ‘distinguishing characteristics’ of the audit and why it must always be present in order to improve the credibility of the reports for the benefit of the users. Today, creditability consists of five fundamental principles; integrity, objectivity, professional competence and due care, confidentiality and professional behaviour. By focusing on independence, we can see how easy it is for the fundamental principles such as integrity and objectivity to be neglected as a result of independence being compromised, leading to overall creditability decreasing at a detrimental rate.

Having looked at of these two theories in detail, we can begin to understand their relevance to the modern-day audit and the potential downfalls in the theories. Both of these theories make the assumption that management has a certain level of corporate governance, in which financial statements are kept. It is not always the case that companies have financial statements that are readily available to be audited for stakeholders to use as a mechanisms to improve the credibility of managements stewardship. They also assume that agents are always untrustworthy, this is also not always the case. In the case of management, stakeholders may have already used other mechanisms, such as payment in the form of shares, in order to align their interests. In this case the use of an audit would not add the same level of credibility that it added before, meaning that if the cost of the audit was greater than the benefits achieved from the audit, it would not be beneficial to audit the financial statements. Furthermore, it may be that the agents are simply trustworthy and that there is no need for mechanisms as they have pride in what they do which means their interests have already been aligned with those of the principle. However, even though it is important to look at the other end of the spectrum, this proposition is almost impossible as any uncertainty about the agent’s trustworthiness is likely to call for the use of mechanisms in order to cover any of the doubts had by stakeholders. Lastly, it is important to note that audit firms are not always brought into solve the original principle-agent relationship where the principle doesn’t trust the agent. Audit firms may also be brought in due to legal requirements, or alternatively because the agent wants to prove to the principle that they are trustworthy and not the other way around.

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Audit fees also demonstrate a huge role in auditing theory. Audit fees are a type of agency cost, this is the internal cost of an agent working on behalf of the principle. As mentioned above, audit fees are paid for by management to the audit firm to give an opinion on the truth and fairness of the financial reports. A large agency cost can be associated with a large agency risk, however this is not a useful indication of a managements trustworthiness as different companies require more substantial auditing procedures resulting in varying costs. This may be a limitation of the theories as the cost of using mechanisms doesn’t translate into a direct representation of the credibility gained. Additionally, due to the current payment nature of audit fees, true independence can never be met. This could only be resolved by using a third party completely independent from the principle and the agents in this relationship. Yet, this is unlikely to happen as no one would be willing to pay for such a procedure if they were not able to gain directly from this investment so that their benefits were greater than their costs. For this reason, true independence can never be met, this is further exacerbated by the audit of public sector companies in a situation where the auditor becomes a stakeholder creating bias. In this case, although independence has not been directly compromised, a complicated web of inter-connectedness has caused independence to be compromised. This application of the theory is not limited to public companies, as companies that are considered systemic and possess the ability to have detrimental effects on the economy, may also cause the auditor to become a stakeholder, and therefore cause his interests to be compromised at the principles expense. Remember, a stakeholder is anyone with an interest of concern in the company.

Next, we look at how these theories have become dated due to the introduction of new technologies and how they must seek modernisation. Technologies such as artificial intelligence and blockchain have had a significant impact on auditing, they allow for continuing and automatic audit processes to occur, these come at a much smaller cost then traditional auditing methods and mean stakeholders can constantly monitor management without the need for a physical audit firm. This constant monitoring reduces the threat of auditor independence discussed in Flint’s postulate as these technologies allow for data to be collected openly at any time reducing the scope for manipulation through fraud or error. This evolution in technology will cause a shift in the role of auditors so that they look less towards the truth and fairness of financial reports and more towards the way the reports are recorded in accordance with regulation. With the aid of technology and the potential future role of auditors, the impact a non-independent auditor could make by manipulating reports is significantly reduced and therefore directly increases credibility of any audited reports. This causes Flint’s postulate to become increasing less important, but nonetheless, it is unlikely to become completely redundant as human intervention is always likely to be necessary.

By looking at the Grant Thornton case, the auditors at the time of Nichols Plc and the University of Salford, we see how the independent nature of audit was compromised over the course of four years with respect to eight audits. This case relates to a former senior partner joining the internal Audit Committees’ of Nichols and the University despite continuing to work for Grant Thornton under a consultancy agreement after retirement. This behaviour, that was described as ‘reckless’ lead to serious familiarity and self-interest threats due to the close working nature with both agents. This caused Grant Thornton to receive a severe reprimand and a fine of £4,000,000 along other fines for particular individuals. Sanctions of this stature are common within the modern-day as regulators clamp down on the very prevalent issue of independence, these seem sufficient enough to warn other’s from taking similar risks relating to independence. This is a prime example of how the agency theory and lending credibility theory become dysfunctional as soon as auditor independence is compromised. Originally in this case, the principle, being the stakeholders, did not trust that Nichols Plc and the University were operating within the principle’s best interests. As a result, the audit firm was employed in order to resolve this principle-agent problem, however due to the former senior partners new roles at Nichols Plc and the University the auditor’s independence has been compromised as they have an indirect relationship through the former senior partner with potential to create bias. Any audited financial reports have therefore lost credibility and the principle is back to his original problem with the extra expense of the ineffective audit firm. If at any point the auditor is manipulated by, influenced by or is in collusion with management it creates a bias towards management, which means the opinion of the audit firm cannot be trusted by stakeholders.

In conclusion, it is clear there is a main theme of trust within flints postulate of independence, and that if everyone could be trusted, there would be no need for third party auditors. Auditors independence was mainly first enforced by the Companies Act in only 1985 which is evident, as the threats to independence are ever so present, proven by the continued growing and evolution of audit regulations such as audit firm rotation and audit fees. It is true that it may be impossible to ever be completely independent as an auditor due to the sheer number of stakeholders. This could imply that Flint’s postulate only modestly represents an ongoing fight to maximise auditor independence due to its significance towards producing an unbiased opinion. Furthermore, it is clear that technology is having a huge impact on this postulate, diminishing the traditional role of an auditor by reducing the need for independence as a result of easy and open information. This also causes the agency theory and lending credibility theory to require modernisation within their meanings as traditional credibility gained by the use of an audit may already exist through technology. Generally, it is clear that this postulate and these theories are extremely relevant to the current modern-day audit as they represent the reasons behind the need for an audit and why when they work together, they ensure credibility to stakeholders about managements stewardship.