Agency Theory and Auditing

An agency relationship arises whenever one or more individuals called principals use other people or individual/s called agents to perform some services on their behalf.

The principals delegate decision making authority to the agents. In case of public limited company, agency relationship may take two forms:

  • Agency Relationship Between Shareholders and The Management
  • Between shareholders and Creditors

More often than not conflicts may arise between the principals and agents. Public companies are owned shareholders but are managed directors who in turn employ the top management to manage the affairs of the company on their behalf. The shareholders and other stakeholders are interested in knowing whether their hard earned resources are managed in more transparent and profitable manner. The management reports the affairs of the business through financial statements such as:

  1. Income statement
  2.  Cash flow statement and
  3.  Statement of financial position

The authenticity of these financial statements must ascertained an independent and qualified party. This party happens to be the auditor.

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