rely on a third party, the audit firm, to assist them in assessing the quality of fi- nancial information, or accept the quality of the financial data in good faith. The committee (American Accounting Association 1973) considered that these four conditions interact in such a way that as they increase in intensity they form the demand for auditing. Conditions 2–4 are based on the theory of rational ex- pectations. The concept of rational expectations assumes that people take into account all available information that influences the outcome of their decisions. Further, it expects people to utilize their information intelligently and therefore they do not systematically make mistakes (i.e. they learn from the past). This means that principals will not be consistently misled by agents. (Wallace 1980) The implication of rational expectations theory for agents is that principals will: 1. expect agents’ self-interests to diverge from the principals’ interests 2. be able to estimate the effect of such divergence 3. adjust prices (e.g. compensation offered) to reflect the related costs of the agents’ expected activities. The ability of principals to protect themselves through an adjustment of prices generates the agents’ demand for monitoring activities. The agents rather than the
Proceedings of the University of Vaasa. Teaching Aid Series 33 principals can be seen as the source of demand for monitoring. Principals are ba- sically unconcerned, because they can protect themselves from the risk of loss by reducing compensation for the agent’s services. Agents demand monitoring in order to avoid the downward adjustment of their compensation. (Wallace 1980) The committee of the American Accounting Association (1973) concluded that it becomes increasingly important that an informed, independent conclusion is reached by the user as to the quality of the accounting information received. Fur- thermore, it is increasingly difficult for the user of the information to reach an informed, independent conclusion without outside assistance (American Account- ing Association 1973). 5.2 Evidence on factors affecting the demand for auditing The monitoring of an agent can assume a variety of forms: owner-manager in- volvement, contingent compensation or bonus plans, periodic reports on perform- ance etc. (Wallace 1980). Beaver (1989) suggests that one means to align the in- terests of management and shareholders is to use profit-sharing agreements or stock options as incentive contracts. The primary means for continuous perform- ance reporting is a set of a company's financial statements (Wallace 1980). Sub- stantial evidence exists that earnings announcements by companies result in stock price adjustments (Ball and Brown 1968) or that accounting information is related to the market value of a corporation's shares (Beaver 1968), and that accounting ratios can be used to estimate the probability of bankruptcy (Beaver 1966) and the risk of owning a company's stock (Beaver, Kettler and Scholes 1970).
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