The Audit function and the role of regulation


One of the issues which affects the running of a company is that the owners and managers have different sets of information, with managers generally having more information than owners or investors. Agency theory provides one way to deal with this which we discuss in this chapter. Regulation and rating agencies also help and we discuss these. So too does audit. In this chapter we discuss all of these in the context of governance.

The role of audit

The general definition of an audit is an evaluation but it is normally taken to mean an evaluation of the financial and other records of business and is undertaken on behalf of the owners of a business by some independent experts. The purpose is to ensure that the information presented in the published accounts provides a "true and fair" view of the activities of the business and that the balance sheet provides a realistic assessment of the assets and liabilities of the business. It is undertaken on behalf of owners and investors who tend to need to rely on this information for their assessment.

In the UK, and most countries, audit is a statutory function which must be undertaken by someone appropriately qualified

- either a qualified auditor or a qualified accountant with appropriate experience. Increasingly also other information

- such as environmental impact assessments are subject to audit by appropriately qualified people. This kind of audit is growing in importance but is not yet subject to control such as for financial auditing.

Although auditors are supposedly impartial they are appointed by the Board of Directors of the company and receive remuneration from the company. This has raised questions about their actual independence from the company and this is one important issue as far as governance is concerned. It should be noted also that an impartial assessment is not always arrived at. For example the accounts of Enron were always audited and confirmed, although the auditors - Arthur Andersen - went out of business at the same time as Enron did. But more recently the accounts of Lehman Bros were also audited and confirmed. Thus the role and impartiality of auditors remains an problematic subject

The Audit Committee

Every company must have an audit committee. This is an operating committee of the Board of Directors charged with oversight of financial reporting and disclosure. Committee members are drawn from members of the company's board of directors. It should contain independent directors and at least one member must be qualified as a financial expert. The role of audit committees continues to evolve as a result of the passing of the Sarbanes-Oxley Act 2002.

Responsibilities of the audit committee typically include:

o Overseeing the financial reporting and disclosure process.

o Monitoring choice of accounting policies and principles.

o Overseeing hiring, performance and independence of the external auditors.

o Overseeing regulatory compliance, ethics, and whistleblower hotlines.

o Monitoring the internal control process.

o Overseeing the performance of the internal function.

o Discussing risk management policies and practices with management.

Agency theory and asymmetric power

Agency theory argues that managers merely act as custodians of the organisation and its operational activities and places upon them the burden of managing in the best interest of the owners of that business23. According to agency theory all other stakeholders of the business are largely irrelevant and if they benefit from the business then this is coincidental to the activities of management in running the business to serve shareholders. This focus upon shareholders alone as the intended beneficiaries of a business has been questioned considerably from many perspectives, which argue that it is either not the way in which a business is actually run or that it is a view which does not meet the needs of society in general.

Conversely stakeholder theory argues that there are a whole variety of stakeholders involved in the organisation and each deserves some return for their involvement. According to stakeholder theory therefore benefit is maximised if the business is operated by its management on behalf of all stakeholders and returns are divided appropriately amongst those stakeholders, in some way which is acceptable to all. Unfortunately a mechanism for dividing returns amongst all stakeholders which has universal acceptance does not exist, and stakeholder theory is significantly lacking in suggestions in this respect. Nevertheless this theory has some acceptance and is based upon the premise that operating a business in this manner achieves as one of its outcomes the maximisation of returns to shareholders, as part of the process of maximising returns to all other stakeholders.

These two theories can be regarded as competing explanations of the operations of a firm, which lead to different operational foci and to different implications for the measurement, and reporting of performance. It is significant however that both theories have one feature in common. This is that the management of the firm is believed to be acting on behalf of others, either shareholders or stakeholders more generally. They do so, not because they are the kind of people who behave altruistically, but because they are rewarded appropriately and much effort is therefore devoted to the creation of reward schemes which motivate these managers to achieve the desired ends. This is the subject of Agency Theory.

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