The Future of Auditing

David Hay

• Publisher: Routledge
• Year: 2019
• eBook ISBN: 9781351105460
• Topic: Business
• Subtopic: Auditing
• Index: Business

The Future of Auditing provides a concise overview of the function of auditing and the future challenges it faces, underpinned with suggestions for future research. It evaluates the key challenges facing the profession, such as quality, competition, and governance, as well as highlighting the under-explored areas of ethics, fraud, and judgement. The emphasis throughout is on the value of audit, and the importance of auditing research.

Providing an original assessment of global versus national auditing, evidence-based auditing standards, and the structure of professional firms, David Hay critically examines the value of auditing from different standpoints. He critically reviews current assumptions about the value of audits of financial statements, and explores research opportunities and priorities to improve understanding of the value of auditing and its future role and function.

This authoritative but accessible guide to the future of auditing and the challenges it faces will be useful not only to auditing researchers, but also to policy makers, standard setters, financial journalists, and auditing professionals seeking an accessible overview of current and future issues in auditing.

1
Overview

The future of auditing

Financial statement auditing is important because financial reporting mis-statements are dangerous. They can lead investors to make bad decisions, cause lenders to take unnecessary risks, and reward managers when they do not deserve to be rewarded. Poor quality accounting and auditing can be bad for a whole country’s economy.

A general definition of auditing is that it is an assurance service which improves the quality of information or its context. In the context of financial statement auditing, which is the type of auditing that I mainly address in this book, financial reporting information is “better” – more credible, more reliable – because an auditor has examined evidence about the assertions making up the financial statements and convinced management to make changes that improve the accuracy and informativeness of financial statements. The assurance provided by an auditor allows financial statement users to better rely on the information. It has been vetted by an auditor whose conclusions are stated in the audit report.

Auditing has economic benefits, some of which are not always immediately obvious, for both the audited company and its management and the national (or global) economy as a whole. To understand auditing, it is necessary to be aware of those benefits.

The book examines the value of auditing, at present and in the future, from several perspectives. The perspectives include examining current understanding of why audits of financial statements are valuable; emerging issues that are important to the future of auditing; research opportunities about the understanding of the value of auditing; and research opportunities about the future of auditing.

Chapter 2 explains how auditing has value, using several different perspectives. Chapter 3 explores issues about its future and how it might change, and Chapter 4 examines research opportunities arising from Chapter 2 and Chapter 3. Chapter 2 and Chapter 4 further develop the material in Chapters 1 and 28 of The Routledge Companion to Auditing, “The function of auditing” and “The future of auditing research” (Hay et al., 2014a; Hay et al., 2014b). The extended format allows me to further develop the discussion of the reasons for auditing and allows for greater links between the theory and suggestions for future research. The new book expands discussion of current issues.

The value of an audit, and the future of auditing research, are topics that are fundamental to auditing. This book is intended to be useful to decision makers who are not familiar with the research in this area, including legislators, policy makers, news media experts, standard setters, and research students. This book provides a single source that will gives a background to these fundamental issues and a source of further references to expand from.

References

Hay, D. C., W. R. Knechel, and M. Willekens. 2014a. Introduction: The Function of Auditing. In The Routledge Companion to Auditing, edited by D. C. Hay, W. R. Knechel, and M. Willekens, 1–10. Abingdon, Oxford: Routledge.

———. 2014b. The Future of Auditing Research. In The Routledge Companion to Auditing, edited by D. C. Hay, W. R. Knechel, and M. Willekens, 351–357. Abingdon, Oxon, UK: Routledge.

2
The value of auditing

Audits are valuable to a surprising range of parties, and some of the explanations for the valuation of auditing are counter-intuitive.¹ We start with a simple explanation of the benefits of auditing provided by Willekens (2007), using the market for used cars as a parallel. Buying a used car is risky. Most car buyers are not experts, and cannot judge whether assertions made by the car salesman are reasonable and reliable. In the same way, shareholders and other stakeholders in a company are not able to find out whether assertions made by the directors are also reliable. In the case of the company, the assertions might be about how much profit the company has made or how liquid is its financial position. Assertions are made through the financial statements.

The used car buyer has the choice of not buying the car and taking the bus to work instead; or they could get an expert to investigate and give an opinion on the assertions made by the seller. To help the deal go through, the seller might even pay for a trustworthy expert to provide a report (e.g., a vehicle history report from CARFAX in the USA). In much the same way, potential investors have the option of not buying shares of a company if they are uncertain about the reliability of the accounts. Or they can rely on an auditor, as the expert on financial statement assertions, to give them a report on management-provided financial information. It might be in management’s interests to engage a respected auditor if that helps investors to decide to commit their funds to the company.

The auditor does not give an opinion of the worth of the company or whether it is a wise investment. Rather, the audit report provides assurance that what management says is reliable.

The used car example is helpful up to a point, but auditing of financial statements takes place in a setting of much greater complexity. It is more complex than buying a used car because of the number of people involved and the ambiguity of financial information. If there are many shareholders and other stakeholders, it is not feasible to allow them all to examine the company’s records in detail. There is also a wide range of parties involved in running the company – directors, audit committee members, management – all with their own self-interest, as well as their own views of what are the company’s best interests. In addition, there is a well-known expectation gap, whereby different users have different ideas of what the auditor can do – compared to what the auditor intends or is able to do. The amounts involved may be very large, and the underlying financial and accounting issues can be very complex. In many cases, there are operations and stakeholders in a variety of different international jurisdictions. And finally, auditing is usually controlled by regulation and professional standards.

There are a number of economic explanations for auditing, and these explanations overlap. They all provide reasonable explanations as to why managers might find it to be in their interests to submit to an audit, which they do implicitly when taking a job in a company that undergoes an audit. In addition, in many cases, auditing is required by law. The regulation of auditing can be explained by legislators looking after the interests of stakeholders who may not be able to influence the decisions of a company directly. It can also be explained in terms of the interests of the legislators. The next section discusses fundamental theories underlying the benefits of auditing.

A Explanations for the value of auditing

Auditing can be seen as having an agency role; an information role; an insurance role; a management control role; a corporate governance role; and a confirmation role. These are the economic explanations for auditing. In all of these explanations, managers might voluntarily submit to being audited because it is in their own interests. In addition, in many settings auditing is compulsory – but the economic explanations for why auditing is desirable still apply, and companies may engage an auditor to carry out something more than the absolute minimum level of audit effort required by auditing standards. The reasons why auditing is often compulsory are also important in understanding the function of auditing, and explanations for compulsory auditing are discussed later.

1 The agency (or monitoring) explanation

Shareholders are aware that managers may act in their own interest, and could report misleading information as a result. Agency relationships apply where one party (the principal) delegates authority, especially control over resources, to another (the agent) (Wallace, 1980, 12–13). When agency relationships apply, there are agency costs. Agents might be self-interested and spend money for their own benefit, or might shirk their duties, or might be diligent but misguided. If nothing is done to avoid these possibilities, then the principal will be less inclined to enter into this relationship. The principal will spend less, or even avoid entering into the transactions altogether, reducing the scope of the agents’ activities or putting them out of work entirely. Investors might discount the information they receive, and pay a lower price for shares than the financial fundamentals would justify if the financial reports could be trusted (if they can be persuaded to invest at all). Agents have the incentive to prevent that from happening by arranging to reduce the costs of monitoring. The agent might appoint an auditor to report on the financial statements in order to give the principal more confidence and reduce monitoring costs. It becomes worthwhile from a manager’s point of view to provide auditing as a form of bonding of the manager, or monitoring on behalf of the shareholders. Agency costs include the costs that arise when otherwise useful activities are not undertaken because the risks are too high that the self-interested agent will take advantage of the situation, or when the principal expends effort in overseeing the agent.

Thus, audits exist because of “price protection.” Price protection means that shareholders (or other stakeholders) might discount the information they receive, and pay a lower price for shares than the financial fundamentals would justify, because they know some managers in some situations might have an incentive to provide misleading information (Jensen and Meckling, 1976, 325; Pincus, Rusbarsky, and Wong, 1989, 243). In 1994, a senior partner in the US firm of KPMG wrote that “auditing adds tremendous value” (Elliott, 1994). Elliott estimates that audits reduce the cost of capital by 1% to 3%. Elliott estimated that a company without an audit might have to pay 1% to 3% more for capital, by which he meant that “for a company with $10 billion in capital, the comparable annual savings would be $100 million to $300 million!” (Elliott, 1994, 74). Empirical studies suggest that this effect is not as large as Elliott thought, although a substantial and statistically significant effect (0.25%) is present (Blackwell, Noland, and Winters, 1998). More evidence in support of each of the explanations is provided in the next section.

A price-protection explanation might apply when the managers of a company are applying for a loan – they can expect a better response, and perhaps a lower interest rate, if they can produce audited financial statements. Where auditing is compulsory, they can reduce agency costs by providing auditing of more than the minimum standard required (for example, an audit by a large accounting firm with an international reputation for high-quality audits). There is research supporting the argument that Big 4 audits are associated with lower cost of capital than non-Big 4 audits (Khurana and Raman, 2004, 488).

Historical evidence shows that audits were sometimes arranged voluntarily, as predicted by the agency explanation, before legislation made them mandatory (Wallace, 1980; Chow, 1982). Monitoring, bonding and other contracting explanations are supported by previous studies that provide evidence that auditing (or similar assurance services) is necessary when there would otherwise be high agency costs, indicated by greater size, higher debt leverage, or lower managerial ownership (Chow, 1982). Voluntary disclosure, voluntary auditing, and voluntary formation of audit committees are all associated with variables representing higher agency costs such as greater size, higher leverage, or lower managerial ownership (Salamon and Dhaliwal, 1980; Chow, 1982; Pincus et al., 1989). There is evidence that Big N audit firms, which are perceived to provide higher quality audits, are able to charge higher audit fees (Simunic, 2014, 36). This finding supports the argument that managers find higher quality audits valuable.

2 The information (or signaling) explanation

Better information leads to better, more informed decisions, by both managers and outsiders. Auditing can be a way both to improve information, and to demonstrate (or “signal”) that it is better. Company managers have better information about the value and quality of the business that they run than do outside investors or stakeholders. But if managers make statements in the financial report that claim that their business is a better investment than others, their claims may not be believed. This imbalance in knowledge about a business is called “information asymmetry.”

One way of overcoming this in...

Table of contents

• Cover
• Half Title
• Series Page
• Title
• Copyright
• Contents
• Acknowledgements
• 1 Overview: the future of auditing
• 2 The value of auditing
• 3 The future of auditing
• 4 Opportunities for auditing research
• Index