Question 1: Describe the three theoretical frameworks that have been proposed to
explain why there is a demand for audit and assurance services.
1. Agency theory = When an individual is an owner-manager of their own bu
...
Question 1: Describe the three theoretical frameworks that have been proposed to
explain why there is a demand for audit and assurance services.
1. Agency theory = When an individual is an owner-manager of their own business there are no
competing incentives. The owner (principal) and manager (agent) are one. When an owner
hires a manager to run the business on their behalf, potential conflicts arise. The manager has
an incentive to provide favourable results. If there is one owner, they can more easily monitor
the activities of their manager. When there are several owners (such as shareholders of a large
company) it is difficult for the owners to monitor the activities of the management. Agency
theory tell us that due to the remoteness of the owners from the entity, the complexity of items
included in the financial report and competing incentives between the owners and managers,
the owners (principals) have an incentive to hire an auditor (incur a monitoring costs) to
assess the truth and fairness of the information contained in the financial report prepared by
their managers (agents). Managers also have an incentive to hire an auditor to demonstrate to
their shareholders that they have prepared true and fair financial reports free of fraud and
error.
2. Information hypothesis= Financial report users require access to high quality information to
make a variety of decisions. That information is used to determine whether to hold or sell
shares in the entity, whether to lend money to the entity, what rate if interest to charge the
entity on money lent and so no. The greater the perceived quality of the information contained
in the financial report, the more likely it is relied upon by the users of that information. The
information hypothesis tells us that due to the demand for reliable high-quality information,
various user groups including shareholders, banks and other lenders will demand that
financial reports be audited to aid their decision making.
3. Insurance hypothesis= Investors take on a risk when buying share. If the entity fails, investors
could lose the money invested. According to the insurance hypothesis, an audit is one way for
investors to insure against at least part of their loss should the company they invest in fail. As
auditors are required to take out professional indemnity insurance policies they are seen as
having ‘deep pockets’ (that is access to money), should an investor be able to prove that audit
negligence was to blame, at least in part for their loss. The insurance hypothesis tells us that
investors will demand that financial reports be audited as a way of insuring against some of
their loss should their investment fail.(Legal liability of auditor, sue investors for
compensation for loss suffered from their negligence)
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Auditing Final Exam Question 1
Question 2: What is the audit expectation gap? Give three examples of how this
may be caused and outline two ways that this gap can be reduced.
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