Content area
Full Text
The literature is replete with studies that have used agency theory to examine the role of the external auditor in society (for example [1-5]). However, relatively few researchers have applied agency theory to the internal auditing function[6]. This article examines how agency theory can help explain the existence, role and responsibilities of the internal audit function and also provide a useful framework for the conduct of further empirical research. Key research questions which could be analysed within an agency theory framework are outlined in Table I. (Table I omitted)
Agency Theory
Agency theory[7] is part of the positivist group of theories which derives from the financial economics literature[8]. It postulates that the firm consists of a nexus of contracts between the owners of economic resources (the principals) and managers (the agents) who are charged with using and controlling those resources[9, p. 308]. Furthermore, agency theory is based on the premiss that agents have more information than principals and that this information asymmetry adversely affects the principals' ability to monitor effectively whether their interests are being properly served by agents. It also assumes that principals and agents act rationally and that they will use the contracting process to maximize their wealth. This means that because agents have self-seeking motives they are likely to take the opportunity to act against the interests of the owners of the firm, for example by partaking in high levels of perquisite consumption (that is, perks). Scapens[10] refers to this dilemma as the "moral hazard" problem. Another type of agency problem which arises is "adverse selection". This occurs when the principal/owner(s) does not have access to all available information at the time a decision is made by a manager and is thus unable to determine whether managers' actions are in the best interests of the firm. Scapens argues that a state of efficiency, or "pareto-optimality", exists in the contracting relationship between principal/owners and agent/managers when neither party can enhance their wealth at the expense of the other. To ensure pareto-optimality in the contracting process, both principals and agents will incur contracting costs. For instance, to minimize the risk of shirking[11] by agents, principals will incur monitoring expenditures, for example the costs of subjecting financial statements to external audit scrutiny. Agents, on the...