Social Theory and Auditing: Role of Social Norms, Culture, Politics, Institutions, and Ideology

In this chapter, the impact of the social norms, culture, politics, and ideology on the evolution and development of auditing theory and practices is discussed.

Globalization of auditing and basic theories of the sources of demand for audits

Auditing has rapidly grown into a global profession dominated by the Big 4 accounting firms, all of which have Anglo-American roots going back to the previous century. Will this dominance continue in the 21st century? One way it could continue is if countries in Asia and Africa continued to be fringe players in the world economy, but this is no longer the case as the fastest-growing economies are now outside North America and Europe. If current trends continue for the next few decades then the largest economies may become those of China and India. Their influence will likely include the setting of global accounting and audit standards. At some point a fifth, sixth, or seventh accounting firm from either of these countries may join the existing Big 4 (e.g., see Deng and Maeve 2018). Whether audit and accounting standards would stay the same as they are now is unlikely as India and China have quite different models of development from that of the West. Thus their rise could significantly impact which events or activities would be considered significant for financial reporting. For example, diverse organizations such as the Institute of Chartered Accountants of Scotland (ICAS) and the Finance Ministry of China, among others, have signed up to the Global Accounting Alliance to reform accounting and auditing toward a principles-based global regime at: www.gaaaccounting.com/chinese-accounting-reform-towards-a-principles-based-global-regime.

In this chapter we briefly review cultural and social factors that can impact how economic events may be perceived and reported. The next section reviews some social and critical theories that have been proposed. However, all of these have come from the West so far—only time will tell whether they will reflect viewpoints in the future. Nevertheless, they do provide different perspectives on auditing that may affect the future direction of auditing.

Auditing is frequently defined as an activity that reduces information risk. This definition follows from the information hypothesis that is used to explain the demand for external audits. Under the information hypothesis, audit services are demanded to reduce the information risk to users of financial statements. Information risk is the risk that user decisions may be based on incorrect information. Thus, using information risk reduction, auditors must reduce losses due to faulty decisions resulting from errors or irregularities in the financial statements. Losses to investors may also arise because of failure by company management to disclose all the relevant facts about a firm. Relevant facts in turn follow from the stated goals of the financial reporting conceptual framework and the verifiability of facts and assumptions. Auditors help assess whether this information asymmetry is alleviated through proper disclosure. Less accurate information may also deter investment, so auditing may also alleviate underinvestment in the capital markets and result in better resource allocation in the economy.

Another hypothesis has been proposed to explain the sources of demand for audits. The monitoring hypothesis is based on the principal—agent framework of economic theory. Agency theory predicts that utility-maximizing agents (the managers), if unchecked, will consume more resources than optimal. However, investors with rational expectations will take such behavior into account in pricing a firm’s securities. As a result, the agents have the incentive to contract for mechanisms to monitor their opportunistic behavior. The hiring of an external auditor is one such mechanism. This theory predicts that management will demand audits whenever the cost of monitoring their activities is less than the wage loss that management suffers without the monitoring. The presumption here is that the owners of the firm will pay managers more with monitoring of their activities than without monitoring.

The insurance hypothesis predicts that auditors are demanded so that they may be sued in case there is a business failure or investors incur losses from inaccuracies in the financial statements. Auditing thus provides investors a form of insurance. If an investor purchases securities on the basis of audited financial statements and subsequently sustains losses, the law provides some degree of recourse against the auditor. In this way, the auditor can, depending on how the court’s reasoning works, function as an indemnifier against investment losses.

Each of these theories helps explain some aspect of the audit environment and some of the reasons audits are demanded. These theories are best viewed as complementary rather than mutually exclusive. They also appear to apply to varying degrees in different countries and different legal systems. For example, in the United States the risk of an auditor being sued has traditionally been about 10 times that in Canada. This suggests that the insurance hypothesis may be a more important explanation of the demand for audits in the U.S. business environment than in the Canadian business environment.

After briefly reviewing the potential of culture, politics, and social norms in auditing theory, we develop a general approach to analyzing audit issues that should be broad enough to incorporate all these factors, at least conceptually. There is no unique solution to identifying the appropriateness of the auditor’s role, only a process for doing so. The process we use in this book is the process of reasoning in the form of arguments supporting a particular conclusion or viewpoint. The ultimate conclusion we are interested in is the audit opinion of the financial statements, and we desire that this opinion be warranted with evidence and reasoning to justify it.

 
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