Hayes et al. (2005) (cited in Ittonen (2010), summarized four main theoretical bases for auditing that requires substantial investigation as follows: Agency Theory, Stakeholder theory (Inspired Confidence Theory), The Police Man Theory and Lending Credibility Theory. Below discussed those theoretical views of demand for audit.
2.2.1. Agency Theory
Agency theory has traditionally been accepted as the dominant theory behind the demand for audit (Adams, 1994). This theory dwells on the knowledge of the agency relationship between those charged with governance and management – as agents of their principal – the shareholders of a company (Ittonen, 2010). Since shareholders do not participate in the functions of those charged with governance and management of the company, it is assumed that the agent has a considerable advantage over their principals in terms of valuable
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information for decision making (Mihret, 2014). This situation is referred to as information asymmetry and agency cost (DeFond & Zhang, 2014). This is a reason for the speculation that organizational actions are driven by individual Director’s pursuit of self-interest when it comes to governance of contracts bordering on the interests between management or the employee on one side and shareholders on the other side (Mihret, 2014). Thus, differences in risk tolerances can lead to principal and agent being inclined to take different and goal-incongruous actions each (DeFond & Zhang, 2014). Accordingly, the agency theory of auditing argues that audit and the independent review of internal control mechanisms are introduced by management to create a signalling effect to shareholders that management is properly in place and to assure shareholders that those charged with governance and management are discharging their responsibility in good faith for the maximization of their interests (Jensen, 2002).
2.2.2. Stakeholder theory (Inspired Confidence Theory)
Criticisms raised by various corporate governance writers of the agency theory propose stakeholder theory as alternative perspectives of the demand for audit (Mihret, 2014).
Proponents of stakeholder theory criticize agency theory on its neglect of the firm’s responsibility to a broad range of interested parties or stakeholders other than shareholders of the entity as well as its failure to adequately explain how IT auditing or internal auditing fits into the control framework of capitalist firms. The stakeholder theory suggests that an audit is required based on a tripartite arrangement in stakeholder theory underlying every economic system. The tripartite theory posits that the world of business consists of different groups that are affected by, or participate in, the decisions, behaviour and reporting of a business entity. They include shareholders, managers, creditors, customers, suppliers, employees, government and regulatory agencies (Jensen, 2002). With varying power and interest different stakeholder group can influence decision, behaviour or reporting to the detriment of others (Ramirez, 1999). The stakeholder theory of demand for audit, therefore, says Directors and managers, because of their extensive power to change the behaviour and reporting by their decisions, should consider the interests of all identifiable stakeholders to the firm (Jensen, 2002). Audit and assurance remains the only option for other groups of stakeholders to obtain an independent opinion on the stated plans by those in charged decision making, organisational behaviour and reporting (Nehinbe & Adebayo, 2011; Clas, 2008). Demand for audit in the information age, therefore, is for audit professionals to
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evaluate the extent to which management decisions, behaviour and reporting processes deliver value to all groups of interested parties. Internal and IT auditing, for instance, are demanded to provide the assurance that risks of unfairness on unassuming interested party or regulatory compliance failures by those in charge of decision are put in check (Rahman et al., 2014).
2.2.3. Lending Credibility Theory
Lending credibility theory has close relationship with inspired confidence theory. According to the lending credibility theory, investors and lenders face significant risk in doing business in recent years; therefore, auditors are required to primarily function to add appropriate credibility to the financial statements (Ittonen, 2010). Lending and investments involve complex and risky agreements and contracts. According to Baylis et al. (2015) auditors owe an obligation to lenders in terms of predictability associated with evolving market variables that assist contracting parties without regulatory intervention. It is widely acknowledged that high-quality audits directly benefit businesses and indirectly benefit the economy and society in general by assisting in minimizing risk of losses to lenders through ‘due diligence’
assignments. Independent audit is an important service for providing users with assurance on entities historical financial statements and other risks (Mahzan & Hassan, 2015). An Audit report of a company has significant influence on investment decisions since they are integral to investor confidence and are vital to the effective functioning of capital markets.
IT audit is a highly valued service since it provides insights into the level of enterprise risks and the extent of ‘due care’ exercised by management to make a real difference to their entity’ operations (Marcello et al, 2017).
2.2.4. The Policeman Theory
The policeman theory says that since those entrusted with governance and control often abuse their privilege. To safeguard assets, therefore, audit is demanded because the expectation is that audit has an enormous role to play in the detection and prevention of fraud (Ittonen, 2010). The policeman theory is one problematic area in auditing where there is existence of an audit expectation gap (Chandler, 2014) because traditional auditing has maintained a passive philosophy towards their responsibility for fraud detection or prevention (Rahaman, 2010). The foundation of this phenomenon is traceable to the famous English case law – re Kingston Cotton Mill Company (1896) in which it was held that an auditor is not bound to be a detective, or … to approach his work with suspicion, or with a
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foregone conclusion that there is something wrong. He, therefore, is a watchdog, not a bloodhound (Chandler, & Edwards. Eds., 2014). According to the Policeman theory attempts to correct this traditional impression. Recent standards on auditing require practitioners to search, discover and prevent fraud in the organization through the investigation of the financial transactions, the financial statement as well as other information (COSO, 2017).
The approach to it has, however, continued to attract academic debate among academics and professionals in the field (Omonuk & Oni, 2015; Ebimobowei et al., 2011).