Research Paper: Audit Quality and Agency

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[. . .] 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… [END OF PREVIEW]

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