Motives of agents that causing information imbalance (agency problems)

 Motives of agents → information imbalance (agency problems)

• Bonus/stock-price incentives → earnings management, smoothing, selective disclosure.
• Job security/career concerns → hide losses, delay bad news, bias estimates (provisions, impairments).
• Perks & private benefits → perquisite consumption, related-party deals, tunnelling.
• Empire building → value-destroying acquisitions, overinvestment; optimistic projections.
• Short-termism → cut R&D/maintenance to “make the numbers”; misstate cut-off.
• Risk shifting (limited downside, upside to management) → off-balance-sheet exposure, inadequate risk disclosure.
• Debt/contract constraints → manipulate ratios to avoid covenant breach.
• Information monopoly → complex reporting, opacity, cherry-picked KPIs.

How the auditor restores trust between principal & agent

Core role: provide independent, reasonable assurance that the financial statements are free of material misstatement (fraud or error), reducing information asymmetry.

Mechanisms

• Independence & ethics: follow professional code (independence in mind/appearance), rotation, safeguards.
• Risk-based audit: assess business, control environment, fraud risks (ISA 240), design focused procedures.
• Evidence gathering: tests of controls & substantive tests; external confirmations, recalculation, inspection, analytical procedures, cut-off/valuation tests.
• Judgement challenge: scrutinise management estimates (impairment, fair value, ECL), going concern (ISA 570), related-party transactions.
• Internal control insights: evaluate controls; communicate deficiencies to Those Charged with Governance (TCWG) via management letters.
• Transparent reporting: clear audit opinion (unmodified/modified), KAMs (ISA 701) explaining significant auditor judgements, EM/OM paragraphs where relevant.
• Quality management: firm-level ISQM/ISA compliance, engagement quality reviews.

Outputs that rebuild confidence

• Credible audit report → increases reliability of numbers used by shareholders, lenders, regulators.
• Governance dialogue with the board/Audit Committee → disciplines management behaviour.
• Deterrence effect → higher chance of detection reduces opportunism.

Quick map (memorize)

• Motive: bonus/price pressure → Risk: earnings management → Audit: analytics, cut-off, journal-entry testing, estimate challenge, KAM.
• Motive: related-party benefits → Risk: undisclosed RPTs → Audit: inquiries, minutes review, confirmations, disclosure checks.
• Motive: covenant pressure → Risk: classification/liquidity misstatements → Audit: debt confirmations, subsequent-events review, reclassification testing.
• Motive: going-concern avoidance → Risk: conceal distress → Audit: cash-flow forecasts scrutiny, sensitivities, GC conclusion & emphasis/modified opinion.

Limitations (state in exams)

• Reasonable, not absolute assurance; materiality; collusion/override may evade detection; time/cost constraints.

One-liner conclusion

Agents may bias or conceal information to serve self-interest; an independent auditor, via a risk-based, evidence-driven audit and transparent reporting to shareholders and TCWG, reduces information asymmetry and rebuilds trust.