What is agency theory in auditing

Requirement 2 Part A

Arthur Andersen failed to fulfil its auditing responsibilities to Enron in 2002 and ultimately destroyed both businesses. The other clients of Arthur Andersen had begun to dismiss the firm as their auditor before the realisation that the business was going to collapse. Three theories that may have caused the clients to leave are the agency theory, information hypothesis and insurance hypothesis.

Agency theory is the incentive to hire an auditor to assess the complexity of the items in the financial reports. Owners of an entity that aren’t included in operations want to assess truth and fairness of financial reports that are produced by the managers. The managers also wish to use an auditor to demonstrate the truth and fairness of the prepared financial reports to the shareholders (owners). Clients of Arthur Andersen may have dropped the auditor due to the reputation of not properly executing audits and fulfilling its auditing responsibilities. The owners of other businesses could not trust the audit completed by Arthur Andersen to assess the truth and fairness of the financial reports which were prepared by managers and could not trust the reports of the managers.

The financial reports of a company need to be high quality to allow users to make decisions. Examples of decisions made by users are buying or selling shares, to lend money, the interest rate charged for money borrowed etc. The information hypothesis is the demand from users such as shareholders and banks for an audit to measure the quality and reliability of the information on financial reports to make decisions. Clients may have dropped Arthur Andersen under this theory due to the reputation for not fulfilling responsibilities and the information provided on the financial reports cannot be trusted to be of high quality or reliable for users to make decisions regarding the entity.

The insurance hypothesis is to provide insurance for investors who purchase shares and are risking their money. An auditor is required to have professional indemnity insurance policies in case of audit negligence that results in a loss for investors. Investors demand an audit of financial reports to insure in case of loss in the investment. Clients may have dropped Arthur Andersen as the investors demand for the truth and fairness of reports to make decisions is affected by the incapability to fulfil responsibilities.

Requirement 1 Four topics of choice There are many factors that influences an accountants’ decision to find a career with either a big 4 or non-big 4 firm. (Bagley, Dalton & Ortegren, 2012) identifies the subjective norms, attitudes and behaviour control that can influence decision regarding careers. An accountant more likely to work at a big 4 firm believe that the larger firms are more prestigious and offer better training. There is a greater perceived level of social pressure on accountants to pursue careers with the Big 4 firms. These factors can also negatively influence an accountant’s decision to work at a Big 4 firm as it is believed to require more working hours, the job is stressful and do not offer desirable workplaces. Accountants also believe they are not qualified enough to pursue these careers. The careers section of KPMG ("Life at KPMG", 2017) highlights the career progression, the clients that they work with, global opportunities, additional learning and development and finally rewards and benefits. Compared to Pitcher Partners career section ("Career development | Pitcher Partners", 2017) that talks about the company and its mission and values, career development, corporate social responsibility and a work life balance.

The audit market share in Australia is considerably different to the market in the United States (Carson, Redmayne & Liao, 2014). The United States Big-4 firms account for approximately 70% of the market share whereas in Australia, the Big-4 firms account for about 43%. The large and medium non-big 4 firms account for roughly the same amount of market share. The largest clients in Australia are predominantly audited by the big-4 firms however the amount of business of small to medium clients has declined and the medium and large non-big 4 firms have collected these clients and increase market share. KPMG services government departments such as the Australian Department of Defence and Department of Environment, Land, Water and Planning. It serves large clients such as nib, AAPT and the Sydney Zoo ("Clients", 2017). Pitcher Partners services smaller businesses such as CFO Cogstate Ltd, Icon Clothing Pty Ltd and Allan Hall Chartered Accountants ("Why Pitcher Partners? | Pitcher Partners", 2017).

The loan spread charged by banks to companies is significantly lower for borrowers who use Big 4 auditors compared to borrowers who use non-Big 4 auditors. (Kim, Song & Tsui, 2012) has concluded through the research the companies using Big-4 auditors have a spread difference of 23 basis points when compared to non-Big 4 audit firms. The clients of KPMG ("Clients", 2017) such as nib, AAPT and the Sydney Zoo are expected to get much lower interest rates from banks on borrowings when compared to clients of Pitcher Partners such as CGO Cogstate Ltd, Icon Clothing Pty Ltd and Allan Hall Chartered Accountants ("Why Pitcher Partners? | Pitcher Partners", 2017).

Investors involved in the equity market trading value audits which come from Big-4 companies which are KPMG, Ernst & Young, PricewaterhouseCoopers and Deloitte when compared to non-big 4 firms such as Pitcher Partners. (Azizkhani, Monroe & Shailer, 2010), investors prefer these audits due to the information quality hypothesis and the insurance hypothesis. Investors believe that big-4 firms are more likely to produce higher quality information and offer significantly larger insurance coverage on audits. KPMG audits would provide more investors compared to Pitcher Partners due to the theories regarding information and insurance for investors.

References

Bagley, P., Dalton, D., & Ortegren, M. (2012). The Factors that Affect Accountants' Decisions to Seek Careers with Big 4 versus Non-Big 4 Accounting Firms. Accounting Horizons, 26(2), 239-264. http://dx.doi.org/10.2308/acch-50123

Life at KPMG. (2017). KPMG. Retrieved 25 September 2017, from https://home.kpmg.com/au/en/home/careers/life-at-kpmg.html

Career development | Pitcher Partners. (2017). Pitcher.com.au. Retrieved 25 September 2017, from http://www.pitcher.com.au/careers/working-at-pitcher-partners/career-development

Carson, E., Redmayne, N., & Liao, L. (2014). Audit Market Structure and Competition in Australia. Australian Accounting Review, 24(4), 298-312. http://dx.doi.org/10.1111/auar.12041

Clients. (2017). KPMG. Retrieved 25 September 2017, from https://home.kpmg.com/au/en/home/about/clients.html

Why Pitcher Partners? | Pitcher Partners. (2017). Pitcher.com.au. Retrieved 25 September 2017, from http://www.pitcher.com.au/about/why-pitcher-partners

Kim, J., Song, B., & Tsui, J. (2012). Auditor size, tenure, and bank loan pricing. Review Of Quantitative Finance And Accounting, 40(1), 75-99. http://dx.doi.org/10.1007/s11156-011-0270-z

Azizkhani, M., Monroe, G., & Shailer, G. (2010). The value of Big 4 audits in Australia. Accounting & Finance, 50(4), 743-766. http://dx.doi.org/10.1111/j.1467-629x.2010.00346.x