Agency theory is an important aspect of auditing. To be effective, auditors must understand shareholders and the board of director’s relationships. The concept also implies the stewardship and accountability concept in the audit. Let us deep-dive into this.
Meaning of Agency Concept
Generally, the agency theory is a relationship between a person or group of people, who are called the agents, and their principal. The principal provides either capital or goods to the agent. The agent sells the goods or uses the capital to make a profit on behalf of the principal.
In auditing, the theory of agency is the relationship between shareholders (the principal) and the board of directors (the agent). Earlier we have mentioned that both parties have a fiduciary relationship. A relationship of being truthful and managing the resources of the shareholders with utmost care.
The relationship involved agent and principal. The agent is the board of directors. The principal is the shareholders. It is expected that the board members do not betray the trust of the shareholders. Also, the board should carry out their job with due care. This means that they should not undermine risks that could bring the business down.
The relationship involved accountability. The agency’s relationship is between both parties. And it involves accountability on the part of the board of directors. The board must therefore report to the owners how the resources in their trust were utilized. This is done by preparing an annual report. Also, a member of the board may be asked to explain why things do not go the way they should. For example, the chief executive officer may be asked why the entity makes a loss in the year under review.
The relationship involves stewardship. Also, the concept of agency implies that the directors must be responsible for how the business is managed. This is referred to as stewardship. They should be ready to accept any failure that arises from the management of the business. Moreover, they are responsible for the success of the business. In most cases, the board is rewarded with an additional commission for making more profit for the company.
The board members can be shareholders. In many cases, if not in all cases, the board members are also shareholders. The majority shareholder may be the Chief Executive Officer (CEO) of the company. This results in role conflict. As the shareholder, who is a board member, will try to protect his interest which may affect the board’s interest. If a board member has shared more than 50 percent of the total share capital, it could control the decision of the entity’s directors.
How Agency theory affect Auditing
Understanding the concept of agency is paramount to the auditor in many aspects. Aside from understanding the external environment of the company under examination, the auditor should know the relationship between the board members and the shareholders.
The agency concept is legally binding on both parties. This means that any of the parties can sue or be sued for breach of contract. Auditors should ensure that there is evidence of board meetings. They should ensure that what was discussed was in the best interest of the company. Since the auditor reports to the shareholders, it must examine if the board has gone against the principle of agency.
Finally, the concept of agency implies a legal duty to act in the best interest of the shareholders and must be accountable to them. The auditor needs to examine if the board members comply with agency principles. He or she should report in white and black the stewardship and accountability of the board of directors.