Agency Theory

Agency Theory

An agency relationship means the shareholders (owners) hire directors and management to run the company for them. 

The problem is, management has the power, makes the decisions, and controls the financial information, while shareholders just have to trust what they’re told. This can lead to abuse, like hiding bad results or taking benefits for themselves. 

An external audit helps protect shareholders because an independent auditor checks the financial statements and confirms whether they’re true and fair. That makes management more accountable and gives shareholders confidence that they’re not being misled.

In short

1. Owners (shareholders) hire managers to run company.
2. Problem → Managers have more info, may not always act in owners’ best interest (conflict of interest).
3. Solution → Audit ensures managers’ reports are correct.

Why audit is needed

• Audit gives independent verification of the financial statements.
• It reduces the risk that management is hiding errors or fraud.
• It protects shareholders by increasing accountability and reliability of the reported results.

Agency Theory and the importance of an independent audit in reducing the information risks

1. An agency relationship arises when one or more principals, for example, an owner, engage another person as their agent to perform a service on their behalf. Agents are likely to have different motives than principals.
2. They may be influenced by factors such as financial rewards, labor market opportunities, and relationships with other parties that are not directly relevant to principals. As a result of these differing interests, agents may have an incentive to bias information flows and create information asymmetries.
3. Principals may also express concerns about information asymmetries where agents are in possession of information to which principals do not have access.
4. An audit provides an independent check on the work of agents and of the information provided by an agent, which helps to maintain confidence and trust.
5. Independent audits provide assurance that the financial statements are free from material misstatement. This increases users’ confidence in the reliability of the information.