Source acknowledgements 1
Introduction
Before getting into the details of providing auditing and assurance services, we need to pause and ask ourselves: why do companies have audits?
“Why do companies have audits?”
In this case, we will discuss the role of the audit and assurance both historically and in today’s heavily regulated environment. At a high level, we will consider auditing and assurance as an economic service and seek to understand the sources of demand for audit and assurance services. To complete this case, each group will examine one private company headquartered in the Seattle metropolitan, Greater Seattle area, or Washington State. There are many large well-known private companies including SaltChuk, Darigold, REI, Intellectual Ventures, Bartell Drugs and many others in this region, pick a company that interests your team. For each of these companies, consider the information they disclose publicly and whether you expect them to employ an external audit firm, if yes, why, and if no, why not? By asking these questions we can better understand the economic theory that has shaped the modern provision of audit and assurance services.2
Conflicts of interest
Consequence
Complexity
Remoteness
There are four general economic conditions that create a demand for auditing and assurance services. (1) In many business environments there are conflicts of interest between a preparer of information preparer and the user of that information. This can result in the production of biased information. (2) Information, especially financial information, can have substantial economic consequences to a user of that information especially when making important economic decisions. (3) Information can be complex and often expertise is required both for the preparation and the verification of information. (4) The users of information are often unable to directly assess the quality of the information.
These four conditions provide the foundations into two theories that explain the demand for auditing and assurance services. They can be considered as the demand to improve the stewardship of the firm and the demand to improve the information quality released by the firm.
A brief history lesson
Auditing dates to at least as early as 500 to 300 BCE with auditing and assurance practices in Athens, where three state accountants verified state revenues and expenditures. In the United States, prior to the passage of the Securities Acts in 1933 and 1934, which mandated audits for public companies, auditing was common practice. As early as the 1880s and 1890s sufficiently many companies were engaging audit and assurance services that the professionals providing this service self-organized to what is now known as the American Institute of Certified Public Accountants (AICPA) was formed in 1886.
Despite the mandatory nature of audits today this significant historical evidence of demand for voluntary audits is consistent with equity holders valuing audits. This begs the question, what features of the audit and assurance product are valued?
Improving Stewardship
It has long been recognized that most public companies have an agency relationship between the managers and the providers of capital (such as lenders and equity investors). An agency relationship can be defined as a contract under which one or more providers of capital (often called principals) engage another person as their steward or manager (often call an agent) to perform some service (such as manage a company) on their behalf.3 In general, the operation of the entity requires both the delegation of significant decision-making authority to the manager, and the delegation of measurement and reporting of performance to the manager.
What’s the problem? Often the phrase agency conflict or agency problem is used to refer to the possible negative side-effects of the agency contract (often called negative externalities). Put simply, if we assume that both the providers of capital and the managers they hire are both interested in maximizing their own wealth, and the providers of capital cannot perfectly monitor the manager’s performance, then a self-interested manager may not always act in the best interests of the providers of capital. Why not? Because sometimes human nature gets the better of us.
Why can’t the providers of capital perfectly monitor the manager? If the providers of capital had the ability to perfectly monitor the manager’s performance, that is, how the manager used the capital provided to them, then there would be no agency problem. But it isn’t rational for a capital provider to delegate responsibility to a manager and monitor every action that the manager undertakes, they would instead manage the company themselves (why incur the cost of hiring a manager if you oversee and correct all their actions).4 Partial monitoring of the manager can include the provision of periodic performance reports from the manager to the provider(s) of capital. With partial monitoring, the provider of capital faces a different problem, often called an information asymmetry problem, in that the manager has access to more information that the summaries of performance that they are asked to provide to the capital provider.
Where does the auditor fit in? As the providers of capital consider where to invest their capital, and when to liquidate their investment, they rely on the summary of the firm’s performance that was measured and disclosed by the manager. Clearly, the provision of a performance measure alone doesn’t always remove the agency problem between the providers of capital and managers, as the manager can choose how to measure and report their performance. To the provider of capital, this means that the reported performance may not be an accurate reflection of the achieved performance; increasing the risk associated with their investment. The capital provider would then rationally either lower the amount of capital they provide to the manager (increasing the cost of raising capital from the manager’s perspective) or they would lower the compensation paid to the manager (decreasing the reward from running the firm to the manager). Both actions are costly to the manager, so the manager will agree to a less costly option – to provide evidence that the reported performance has been measured carefully to avoid accidental error and is free of material errors or omissions. The product which provides this assurance to the capital provider, is the independent audit.5
Improving information quality
An additional theory relating to the value from auditing is the argument that investors demand audited financial statements because they improve the quality of the information derived from financial statements. It has long been recognized that investors require timely information about the financial prospects of an investment to make purchasing decisions.
What’s the problem? Investors gain three main benefits from access to information: (1) the risk of their investment decreases as they receive higher quality information, (2) information improves decision-making, and (3) these features combined increase investors’ expected wealth.
As investors will typically avoid taking on higher risk (in economics this is referred to as risk-aversion), one way of viewing the value of auditing is from increasing an investor’s view of the risk of errors in the financial reports.
Keep in mind that auditing became mandatory when the SEC was established. The SEC followed the 1929 stock crash, that fueled one of the worst depressions in U.S. history. The apparent extension of auditors’ responsibilities from a voluntary to mandatory service was in part justified by claims that "adequate disclosures" would preclude future stock market crashes. At the time there was no evidence that inadequate disclosure practices caused the crash. You will notice, however, that in almost all major historical crashes, there is inevitably discussion of problems with accounting disclosures and auditing!
An auditor can improve performance measurement either explicitly by finding errors or implicitly by making employees more careful in preparing records in anticipation of an audit. For the modern audit, the integration of internal control testing within the audit product, often referred to as the integrated audit, allows for the audit to improve performance measurement by finding weaknesses in internal company processes that can be improved. These processes can be both operational processes (such as supply chain and inventory management systems), and processes within the financial reporting function (such as not having appropriate reconciliation processes for major accounts). Thus, the modern audit adds value to the company which has a positive side-effect of creating more accurate data for internal decision making in areas such as budgeting and forecasting (as a basis for production and pricing decisions), that can lead to operational efficiencies in inventory management and supply chain decisions.
Application and analysis
How well do these theories help us understand the demand for audit in the modern environment? Above, the theory suggests that the audit provides value to the company receiving it. We also know that prior to the audit becoming mandatory in the 1930s, many companies voluntarily undertook an audit.6 Intuitively, this means that there is a cost-benefit trade-off to the audit, and if the audit was voluntary, we would expect companies to choose to be audited when the cost is lower than the value received from the audit. The cost of the audit, or audit fee, is the amount paid by the company to the audit firm.7
Why might one company pay more for their audit than another company? Consider Apple and Microsoft, what are the similarities and differences between their business models? 
Why would one company pay more for the audit than the other?
Economics suggests that in a competitive equilibrium, audit fees should reflect the expected costs of auditor business (or engagement) risk. In the modern business environment, the audit fee will reflect (i) a base level of
inherent risk associated with the audit, and (ii) the contracting firm’s assessment about the additional risks of the company. Intuitively, the inherent audit risk in the company reflects the work associated with obtaining reasonable assurance for a company. As such, the size of the firm is a logical determinant of audit fees as the size of the firm will determine the base level of work hours needed to audit the transactions and accounts of a firm. The complexity of the firm, as well as the potential for agency conflicts, increases the additional audit hours required to obtain reasonable assurance.
In addition, if the demand for audit services increases, then the amount of audit fees paid by each company is expected to increase. For example, when the regulator increases the required amount of disclosure in public filings (like the number of items required in 10-Ks and 10-Qs), then the demand for audit services increases.
References
Abdel-Khalik, A. R. 1993. Why Do Private Companies Demand Auditing? A Case for Organizational Loss of Control. Journal of Accounting, Auditing & Finance 8 (1):31-52.
Carey, P., R. Simnett, and G. Tanewski. 2000. Voluntary Demand for Internal and External Auditing by Family Businesses. AUDITING: A Journal of Practice & Theory 19 (s-1):37-51.
Lennox, C. S., and J. A. Pittman. 2011. Voluntary Audits versus Mandatory Audits. The Accounting Review 86 (5):1655-1678.
Rennie, M., D. Senkow, R. Rennie, and J. Wong. 2003. DEREGULATION OF THE PRIVATE CORPORATION AUDIT IN CANADA: JUSTIFICATION, LOBBYING, AND OUTCOMES. Research in Accounting Regulation 16 (Supplement C):227-241.
Wallace, W. 1980. The economic role of the audit in free and regulated markets.
Wallace, W. A. 2004. THE ECONOMIC ROLE OF THE AUDIT IN FREE AND REGULATED MARKETS: A LOOK BACK AND A LOOK FORWARD. Research in Accounting Regulation 17 (Supplement C):267-298.
Endnotes
Acknowledgements: This case was prepared by Asher Curtis in the Autumn of 2017. Thanks to Andy Kitto and Joe Paperman for suggestions and comments.
↩This case draws heavily from Wallace (1980) and Wallace (2004).
↩Often these contracts will include the terms of compensation, which include bonus pay for meeting a performance target or targets.
↩Abdel-Khalik (1993) provides evidence that private firms use audits to compensate for the manager’s lack of control over the company’s operations. Carey et al. (2000) find similar results for family-owned firms, and find that internal audit of family firms is used as a substitute for an external audit in many cases.
↩Importantly independent audits always come with acknowledged limitations regarding the ability of the independent auditor to discover fraud.
↩In both Canada and the United Kingdom, mandatory audit requirements for private firms have been made voluntary. Rennie et al. (2003) find that around 73% of Canadian private firms continued to undertake an audit after the change. In the UK, Lennox and Pittman (2011) find that the private firms that undertook voluntary audits obtained better credit ratings, consistent with the audit adding value through assurance over the financial reports.
↩Firms also face an economic cost from the audit due to the amount of time that company employees (these days often both in accounting roles and in IT systems roles) deal with requests from the auditor.
↩
Focus Questions
This case will be discussed over two class periods. To prepare for these classes you need to download and activate Tableau. See Canvas for details. In addition, on Canvas you will find the following resources:
A Tableau Packaged Workbook “WA_Private_Firms_List” with basic information about private firms in the Seattle and Greater Seattle region.
Required reading: “Microsoft pays more than Apple for its audit, and why investors should care.” Fortune.
Background readings (additional, not required readings). 1) Wanda Wallace “The Economic Role of the Audit in Free and Regulated Markets” 2) Joe Paperman and Asher Curtis “A summary of your biases in Judgment and Decision Making.”
Preparation
As a team, pick a company from the list of private firms that you can find a website for (which should be most if not all on the list).
REQUIRED: email the company website URL to Asher Curtis (abcurtis@uw.edu) ASAP.
Before moving to any of the questions below what do you expect about this company in terms of the information they provide to the public?
Go to the firm’s website and do background research on the company, note down an answer to as many of the following as you can find:
What industry is the company in?
What is the main product or service that the company engages in?
What is the ownership structure? Is the company backed by venture capitalists? Is it a family-owned firm? Is the founder of the company still running the company?
The next task is to describe the disclosure environment of the firm. As private firms they are not required to provide financial accounting disclosures (income statements and balance sheets) to the public. But that doesn’t mean that the firm will not provide any information. Find out as much as you can about the company’s disclosure of information, such as:
Does the firm disclose any financial information? If so, what?
Does the firm provide any kinds of reports to stakeholders? If so, what is the topic? Do they include metrics in these reports? Pick one or more of the metrics that seem interesting and describe it.
Can you find any information that the firm is being audited by a CPA firm? (hint: if there is nothing obvious on the website, try searching for phrases with the combination of the company name and various CPA firm names).
What reasons do you think drive the firm’s choice to have (or not have) an audit?
In-class Discussion Questions and Activities
Exercise 1
In class you will be asked to split into your teams (please sit together). You will have 20 minutes in class to discuss and prepare your team’s answers to the following questions, which one team member will summarize and report back to the class:
Based on your preparation, did you have any biases relating to the type of information you would expect to find?
Formulate a brief but effective description of the company that covers:
The industry the firm is in and the main products/services it offers.
The information you could obtain from the company.
Finally, choose one metric that the firm reports and discuss the potential flexibility in the metric. Is it something that is easy or difficult to measure? Do managers have flexibility in how they report this measure?
Exercise 2
In class you will be asked to consider making a bet on an uncertain outcome. There will be two versions of this game. We will play the game with real money.
Exercise 3
Remaining in your teams you will have 20 mins in class to discuss and prepare your team’s answer the following questions, which one team member will summarize and report back to the class:
What financial information were you able to find about your firm?
Could you find any evidence that the financial information was audited?
If the information wasn’t audited, how else could you verify the accuracy of the information disclosed on the website?
What additional information you would request if you were planning on purchasing a large equity stake in the firm?
What do you believe would happen if audits were no longer mandatory for publicly listed companies?
**Please note that there are no required submissions for this case.