The agency theory explains the relationship between agents and principals by asserting that the agent, as representatives of the principal, is expected to act in the best interests of the principle without being influenced by self-interest. In a business environment, the agent is expected to represent the best interests of the principle during business transactions. As such, agents are often employed by principals to perform a task on the behalf of the principals and therefore agents are accountable to their principals while the successful completion of the task is dependent on the existence of a healthy agent/principal relationship. In a business setting, the corporate management is separate from the ownership of businesses as a way of enhancing corporate governance (Filatotchev & Wright, 2011). The owners of business enterprises include families, initial founders, directors, shareholders, other corporations and government entities while the agents comprise of the management of the firms. The agency theory is relevant in a business setting when it posits that the shareholders/owners of a business enterprise engage managers to act on their behalf and expect that the actions of the managers are not driven by self-interest.
In this regard, the agency theory helps explain the contractual relationships between the agents and the principals, assuming that the two are rational economic entities that are driven solely by their self-interests. The mutually agreed-upon contract stipulates the rights and responsibilities of the agents and the principles with the agents being charged with the responsibility to make decisions on the behalf of the principals although the decision choices of the agents affect the agents and the principals as well. In a business setting, contractual agreements exist between the board of directors and the company’s top executives, between the board of directors and the shareholders and between the company’s top executives and their subordinates with the former acting as the principal while the latter acts as the agent (Filatotchev & Wright, 2011).
However, humans driven by self-interest primarily and therefore agents may act in their own self-interests as opposed to the interests of the principles, which can precipitate into agency problems or conflicts (Islam et al., 2010). Conflicts in the agent/principal relationship may occur because the principal does not participate in control and decision-making undertaken by the management since ownership of the firm is separated from its management. The principal may be ignorant of the detailed activities of the agent due to information asymmetry, the risk behaviours of the agent and the principle may be incongruent, the earning of the agent may be fixed and predetermined while the principal claims the residual earnings, and the agent may spent less time in the company compared to the principal. To ensure that the contractual obligations between the principal and the agent are met, controls are necessary as part of good corporate governance.
Agency costs result when the principal/agent relationship is plagued by moral hazards. Controls facilitate the reigning-in of self-interested and opportunistic agents who are likely to act contrary to the interests of the principal, prevent the violation of the separation of ownership from management, and help reduce agency costs (Minghui, 2009). For instance, the dominance of block holders or family owners can be a source of agency conflicts and agency costs.
In the same vein, dominance of the management can be a source of agency conflicts and agency costs as well. Powerful managers can withhold vital information from and misrepresent information to the owners, shareholders, and boards of governors in a firm, which leads to information asymmetry between the principal and the agent (Bosse & Phillips, 2016). Usually, powerful managers are a regular source of financial misinformation because they are able to pursue their self-interests unchecked an easily violate the principal/agent contractual obligations.
Consequently, this would eliminate the issuance of misstatements, which would enhance the trust from the shareholders and firm owners in the financial reports generated by the company and as such improve the reputation of the company while enhancing its value.
This study focuses on the quality of the auditors as the indicator of the quality of auditing and the occurrence of misstatements.
5.3 Independent variable proxy measures
The auditor quality features that are treated as independent variables in this study include i) brand name of the audit firm, ii) industry specialisation of the audit firm, iii) independence of the auditor, and iii) competence of the auditor. Notably, the scoring of each of these variables are denoted as either one (1) or zero (0) for the auditing firm j and the period of audit j.
With these specifications, the brand name of the auditing firm is captured as an independent variable, which is denoted as Big4 j,t in the regression analysis equation. These auditing firms include Ernst & Young (EY), Deloitte Touché Tohmatsu (DT), PricewaterhouseCoopers (PWC) and KPMG, which are considered the four largest auditing firms in the world. The auditing firm j is scored as (1) in a duration of time t if the firm engaged is an external auditor is a Big4 firm, that is if it is either Ernst & Young (EY), Deloitte Touché Tohmatsu (DT), PricewaterhouseCoopers (PWC) or KPMG. In addition, the industry specialisation of the audit firm is captured as an independent variable that is denoted as Specialization j,tin the regression analysis equation. The industry specialisation of the audit firm is based on its market share, which is determined from the amounts of its client sales revenues. In this regard, the definition of the firm as being an industry specialist is based the quantity of its supply in the given industry sector. Also considered is that the first supplier should differ from the second supplier by a market share of 15 % (Balsam et al., 2003; Mayhew & Wilkins, 2003). In this regard, the firm j is scored one (1) and the audit period t is scored one (1) for this variable if the external auditor conforms to the definition of and industry specialist as specified in the description; otherwise, that scores of the firm j in the audit duration time t is scored zero (0). Further, the independence of the auditor is captures as an independent variable that is denoted by Independence j,t in the regression analysis equation. In this case, the independence variable is given by the ratio of non-audit fees to the total fees paid to the external audit firm. Likewise, for this variable, the score of one (1) if given to the firm j in the time period t if the ratio exceeds 1; otherwise the firm j for the audit period t is scored zero (0). Finally, the competence of the auditor in completing the external audit is also captured as an independent variable that is denoted by Delay j,t in the regression analysis equation. This variable is quantified as the number of days it takes for the firm to deliver the audit report expressed at period t, which begins with the signing of the audit report of the firm j and ends with the termination of the financial year for the form j.
Ownership of the company (Owni,t), family ownership (FAMi,t), cross listing of company shares in the capital market (CROSSi,t ), issuance of shares in the capital market (ISSUEi,t), performance of the company (PERFORMANCEi,t-1) and age of the company (AGEi,t) among others that are included in the regression analysis equation.
Balsam, S., Krishnan, J., & Yang, J. S. (2003). Auditor industry specialization and earnings quality. Auditing: A journal of practice & Theory, 22(2), 71-97.
Bosse, D. A., & Phillips, R. A. (2016). Agency theory and bounded self-interest. Academy of Management Review, 41(2), 276-297.
Filatotchev, I., & Wright, M. (2011). Agency perspectives on corporate governance of multinational enterprises. Journal of Management Studies, 48(2), 471-486.
Islam, M. Z., Islam, M. N., Bhattacharjee, S., & Islam, A. K. M. Z. (2010). Agency problem and the role of audit committee: Implications for corporate sector in Bangladesh. International journal of Economics and Finance, 2(3), 177-188.
Mayhew, B. W., & Wilkins, M. S. (2003). Audit firm industry specialization as a differentiation strategy: Evidence from fees charged to firms going public. Auditing: A Journal of Practice & Theory, 22(2), 33-52.
Minghui, L. I. (2009). Ownership Structure, Corporate Governance and Agency Cost of Equity. Journal of Financial Research, (2), 14.