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Reasons for auditing

Published on March 31, 2026   9 min

A selection of talks on Finance, Accounting & Economics

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0:00
This is David Hay presenting Talk Number 2, which is the reasons why we have auditing. We talked in the first talk about the auditing world. Let's talk about why auditing exists.
0:12
What's the importance of auditing? And why do we have it? Why do companies get audits? The most obvious reason is that they have to. Every country has some kind of regulation that requires auditors for some countries to be audited. But despite all the variations around the world and differences in country legislation, auditing seems to be much of the same. And not only that, before there was legislation, companies already had audits. So, audit developed voluntarily, and later became compulsory. So what's the economic reason for it? And why do we ask? Well, it helps us to understand why auditing exists in the first place and what kinds of things are important about it? And we find that the value of auditing is different for different parties. So there are a lot of people who rely on audits, shareholders, managers, lenders, customers, employees. They all have different needs, different uses of the financial reports, and the audit report might be important to them for different reasons. So that's why we have these different explanations, six explanations for auditing.
1:11
So the six are agency, signaling, insurance, management, governance, and confirmation. Agency is the most important one and the most widely referred to.
1:23
The idea of agency theory is that anytime somebody else is looking after something on your behalf, you might want some kind of accountability of what they do. So in this case, shareholders have an interest in a company, but they've handed their company over to managers. Managers are managing the company. Managers are preparing financial reports. But the financial report is just the managers' story about what's going on. So to make the financial statements more reliable, we have audits. So, as you can see in the picture, the auditors have got access to the management. They can talk to management in ways that shareholders can't. They can examine the financial statements as an expert, and they can prepare their report to the users of the financial statements. So one reason for auditing is for the agency theory, where the manager gets an audit. Audit is actually getting an opinion on the financial statements. And it's been very useful to those kinds of users. So that's a simple explanation of agency theory, principals and agents, where the principals are the shareholders and the agents are the managers. But it's a little bit more complicated than that. Because in practice, the shareholders generally have very little power. If you're a shareholder in a major corporation, you don't have much opportunity to decide whether they're going to be audited or not, or who the auditors are, but the managers do. So agency theory somehow turns around on itself, and it shows that the managers have an interest in being audited. If the managers are managing a company and they don't have an audit, that's not a good look to the marketplace. It will result in lower share prices, or if the company borrowed money, say from a bank, the same kind of thing applies. The bank will charge a higher interest rate for a company that doesn't have financial reports. So managers can see that, and it's then in their interest to try and reduce those costs, and they'll try and do that by appointing an auditor. So that's called price protection. The managers can see that it's going to cost the company more, higher interest rates or a lower share price, and they're trying to get a better deal for the company by having an audit. So one thing managers will do is make sure that the company is audited. That's the agency theory of explanation of auditing. And the price protection, the managers are trying to look after the company by making sure that happens. So that's explanation Number 1.

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