THE UNIVERSITY OF

CHENAB

By….

Anum Younas

Assignment
In

Master of Philosophy (accounting and finance)

THE UNIVERSITY OF CHENAB

Gujrat, Pakistan

2023

AUDIT and assurance theory and assumption

1
 Presented to
THE UNIVERSITY OF CHENAB, Gujrat, Pakistan

In partial fulfillment of the 1st semester of

Master of Philosophy (Accounting and finance)

By
Anum Younas
12215005
To
Dr. Zeeshan

2023

2
 In the name of ALLAH,
The Most Beneficial,
The Most Merciful

TABLE OF CONTENTS

 What Is Agency Theory?

 Understanding Agency Theory

3
  Areas of Dispute in Agency Theory
 Reducing Agency Loss
 Question related to Agency.

1-What Is Agency Theory?

Agency theory is a principle that is used to explain and resolve issues in the
relationship between business principals and their agents. Most commonly, that
relationship is between shareholders, principals, company executives, and agents.
Agency theory contends that internal auditing, in common with other intervention
mechanisms like financial reporting and external audit, helps to maintain cost‐efficient
contracting between owners and managers.
1.2-KEY TAKEAWAYS

 Agency theory attempts to explain and resolve disputes over the respective
priorities between principals and their agents.
 Principals rely on agents to execute certain transactions, which results in a
difference in agreement on priorities and methods.
 The difference in priorities and interests between agents and principals is known
as the principal-agent problem.
 Resolving the differences in expectations is called "reducing agency loss."
 Performance-based compensation is one way that is used to achieve a balance
between principal and agent.
 Common principal-agent relationships include shareholders and management,
financial planners and their clients, and lessees and lessors.

1.3-Understanding Agency Theory

In broad terms, an agency is any relationship between two parties in which one, the
agent, represents the other, the principal, in day-to-day transactions. The principal or
principals have hired the agent to perform a service on their behalf.
Principals delegate decision-making authority  to agents. Because many decisions that
affect the principal financially are made by the agent, differences of opinion, and even
differences in priorities and interests, can arise. Agency theory assumes that the
interests of a principal and an agent are not always in alignment. This is sometimes
referred to as the principal-agent problem.
By definition, an agent is using the resources of a principal. The principal has entrusted
money but has little or no day-to-day input. The agent is the decision-maker but is
incurring little or no risk because any losses will be borne by the principal.

4
Financial planners and portfolio managers are agents on behalf of their principals and
are given responsibility for the principals' assets. A lessee may be in charge of
protecting and safeguarding assets that do not belong to them. Even though the lessee
is tasked with the job of taking care of the assets, the lessee has less interest in
protecting the goods than the actual owners.

1.4-Areas of Dispute in Agency Theory

Agency theory addresses disputes that arise primarily in two key areas: A difference in
goals or a difference in risk aversion.
For example, company executives, with an eye toward short-term profitability and
elevated compensation, may desire to expand a business into new, high-risk markets.
However, this could pose an unjustified risk to shareholders, who are most concerned
with the long-term growth of earnings and share price appreciation.
Another central issue often addressed by agency theory involves incompatible levels
of risk tolerance between a principal and an agent. For example, shareholders in a
bank may object that management has set the bar too low on loan approvals, thus
taking on too great a risk of defaults.

1.5-Reducing Agency Loss

Various proponents of agency theory have proposed ways to resolve disputes between
agents and principals. This is termed "reducing agency loss." Agency loss is the
amount that the principal contends was lost due to the agent acting contrary to the
principal's interests.
Chief among these strategies is offering incentives to corporate managers to maximize
the profits of their principals. The stock options awarded to company executives have
their origin in agency theory. These incentives seek a way to optimize the relationship
between principals and agents. Other practices include tying executive compensation
in part to shareholder returns. These are examples of how agency theory is used in
corporate governance.
These practices have led to concerns that management will endanger long-term
company growth to boost short-term profits and pay. This can often be seen
in budget planning, where management reduces estimates in annual budgets so that
they are guaranteed to meet performance goals. These concerns have led to yet
another compensation scheme in which executive pay is partially deferred and to be
determined according to long-term goals.
These solutions have parallels in other agency relationships. Performance-based
compensation is one example. Another is requiring that a bond is posted to guarantee

5
delivery of the desired result. And then there is the last resort, which is simply firing the
agent.
What Disputes Does Agency Theory Address?
Agency theory addresses disputes that arise primarily in two key areas: A difference in
goals or a difference in risk aversion. Management may desire to expand a business
into new markets, focusing on the prospect of short-term profitability and elevated
compensation. However, this may not sit well with a more risk-averse group of
shareholders, who are most concerned with long-term growth of earnings and share
price appreciation.

There could also be incompatible levels of risk tolerance between a principal and an
agent. For example, shareholders in a bank may object that management has set the
bar too low on loan approvals, thus taking on too great a risk of defaults.

What Is the Principal-Agent Problem?

The principal-agent problem is a conflict in priorities between a person or group and
the representative authorized to act on their behalf. An agent may act in a way that is
contrary to the best interests of the principal. The principal-agent problem is as varied
as the possible roles of principal and agent. It can occur in any situation in which the
ownership of an asset, or a principal, delegates direct control over that asset to another
party, or agent. For example, a home buyer may suspect that a realtor is more
interested in a commission than in the buyer's concerns.

What Are Effective Methods of Reducing Agency Loss?

Agency loss is the amount that the principal contends was lost due to the agent acting
contrary to the principal's interests. Chief among the strategies to resolve disputes
between agents and principals is offering incentives to corporate managers to
maximize the profits of their principals. The stock options awarded to company
executives have their origin in agency theory and seek to optimize the relationship
between principals and agents. Other practices include tying exe cutive
compensation in part to shareholder returns.

1.6-Assumption Of Agency Theory

The theory assumes that both the principal and the agent are utility maximizers with
different interests and that because of information asymmetry, the agent will not always
act in the principal's best interests.

Agency theory assumes that there is a principal-agent relationship between the owners
of a company (the principals) and the managers who run the company on their behalf
(the agents). In the context of auditing, agency theory suggests that auditors are the
agents of the shareholders, who are the ultimate owners of the company.

6
Some of the key assumptions of agency theory in the context of auditing include:
 Information asymmetry: Agency theory assumes that there is an information
asymmetry between the principals (shareholders) and the agents (auditors)
because the agents have more information about the company's financial
performance and operations than the principals do.
 Conflicts of interest: Agency theory assumes that there are potential conflicts of
interest between the principals and the agents, because the agents may prioritize
their interests over the interests of the principals.
 Monitoring and control: Agency theory assumes that the principals must monitor
and control the agents to ensure that they are acting in the best interests of the
principals.
 Incentives: Agency theory assumes that the principals must provide appropriate
incentives to the agents to encourage them to act in the best interests of the
principals.
 Risk and uncertainty: Agency theory assumes that there is a risk and uncertainty
associated with the actions of the agents, because the agents may take actions
that are not in the best interests of the principals.

Overall, agency theory suggests that auditors are the agents of the shareholders and
that the shareholders must monitor and control the auditors to ensure that they are
acting in the best interests of the shareholders. The theory also suggests that incentives
and appropriate risk management strategies must be put in place to encourage auditors
to act in the best interests of the shareholders.

2-Shareholder theory
Shareholder theory is a view of corporate social responsibility that holds that the primary
purpose of a corporation is to maximize shareholder value. This view posits that
companies should prioritize the interests of shareholders over those of other
stakeholders, such as employees, customers, and the environment. According to
shareholder theory, the best way for a company to create value for society is to focus on
maximizing profits and creating returns for shareholders. This view is often contrasted
with stakeholder theory, which argues that companies should consider the interests of
all stakeholders, not just shareholders when making decisions. While shareholder
theory has been criticized for its narrow focus on shareholder value, it remains a
popular perspective among many investors and businesses.

2.1-EXPLAIN

7
In the context of auditing, shareholder theory can be relevant in determining the
auditor's responsibilities and obligations. If the primary goal of a corporation is to
maximize shareholder value, then the auditor may be expected to assess the
company's financial statements and internal controls to ensure that they are accurate
and reliable. The auditor may also be expected to provide an opinion on the company's
financial statements, which can be used by shareholders to make informed decisions
about their investments. However, the auditor's responsibilities may be limited to the
interests of shareholders, which could conflict with the interests of other stakeholders,
such as employees or the environment. As such, the auditor may need to consider the
broader implications of their work and ensure that they are not neglecting the interests
of other stakeholders in their audit.
From an auditing perspective, an example of a Pakistani company that may be subject
to the principles of shareholder theory is the Oil and Gas Development Company
Limited (OGDCL). As a publicly traded company, OGDCL has a responsibility to its
shareholders to provide accurate and reliable financial information. The auditor of
OGDCL would be expected to assess the company's financial statements and internal
controls to ensure that they are accurate and reliable. The auditor may also be expected
to provide an opinion on the company's financial statements, which can be used by
shareholders to make informed decisions about their investments. However, the
auditor's responsibilities may be limited to the interests of shareholders, which could
conflict with the interests of other stakeholders, such as employees or the environment.
As such, the auditor of OGDCL may need to consider the broader implications of their
work and ensure that they are not neglecting the interests of other stakeholders in their
audit.

2.2-Assumption
In the context of auditing, shareholder theory assumes that the primary goal of a
corporation is to maximize shareholder value. This assumption implies that the
auditor's primary responsibility is to assess the company's financial statements and
internal controls to ensure that they are accurate and reliable. The auditor may also be
expected to provide an opinion on the company's financial statements, which can be
used by shareholders to make informed decisions about their investments. However,
this assumption may conflict with the interests of other stakeholders, such as
employees or the environment. As such, the auditor may need to consider the broader
implications of their work and ensure that they are not neglecting the interests of other
stakeholders in their audit. Additionally, the assumption of shareholder theory may not
fully capture the complexities of corporate social responsibility, which can involve
balancing the interests of multiple stakeholders and creating long-term value for the
company.

8
3-STEWARDSHIP THEORY
Stewardship theory is a perspective that suggests that managers act as stewards of the
company and are motivated to act in the best interests of the company and its
stakeholders, rather than just the shareholders. In the context of auditing, stewardship
theory can be relevant in determining the auditor's responsibilities and obligations. If
managers are acting as responsible stewards of the company, the auditor may be able
to rely on the accuracy and completeness of the financial information provided by the
company. The auditor may also be expected to assess the company's internal controls
and provide an opinion on the company's financial statements. However, the auditor's
responsibilities may be limited to the interests of the company and its stakeholders,
which could conflict with the interests of shareholders. As such, the auditor may need to
consider the broader implications of their work and ensure that they are not neglecting
the interests of shareholders in their audit.
Briefly Explain
Stewardship theory suggests that managers act as stewards of the company and are
motivated to act in the best interests of the company and its stakeholders, rather than
just the shareholders. This theory assumes that managers are intrinsically motivated to
act responsibly and ethically and that they will take actions that benefit the company in
the long term. Under stewardship theory, managers are seen as responsible for the
success or failure of the company and are expected to act in the best interests of the
company and its stakeholders. The theory suggests that when managers are given
autonomy and are trusted to act in the best interests of the company, they are more
likely to act responsibly and ethically. In the context of auditing, stewardship theory can
be relevant in determining the auditor's responsibilities and obligations.
An example of stewardship theory in the context of auditing in Pakistan could involve a
company that is committed to acting as a responsible steward of its resources and
assets. For instance, the company may have implemented strong internal controls to
ensure the accuracy and completeness of its financial information and may have
established policies and procedures to ensure that it is acting in the best interests of its
stakeholders. In this case, the auditor may be able to rely on the accuracy and
completeness of the financial information provided by the company and may be able to
provide an opinion on the company's financial statements. However, the auditor would
also need to consider the broader implications of their work and ensure that they are not
neglecting the interests of shareholders in their audit. The auditor may need to assess
the company's internal controls and management practices to ensure that they are
consistent with the principles of stewardship theory, and may need to provide
recommendations for improvement if necessary. Overall, the auditor would need to
ensure that they are acting in the best interests of all stakeholders and that they are
providing an accurate and reliable assessment of the company's financial performance.

9
Stewardship theory is based on several key assumptions, including:

 Managers are trustworthy: Stewardship theory assumes that managers are

trustworthy and are motivated to act in the best interests of the company and its
stakeholders. This means that managers are expected to act ethically and
responsibly and to take actions that benefit the company in the long term.
 Managers are intrinsically motivated: Stewardship theory assumes that
managers are intrinsically motivated to act responsibly and ethically and that
they are not solely motivated by financial incentives or external rewards.
 Managers have a long-term perspective: Stewardship theory assumes that
managers have a long-term perspective and are focused on building sustainable
value for the company and its stakeholders, rather than just maximizing short-
term profits.
 Managers have autonomy: Stewardship theory assumes that managers have
autonomy and are trusted to act in the best interests of the company. This
means that managers are given the freedom to make decisions and take actions
that they believe will benefit the company.
 Managers are committed to the company: Stewardship theory assumes that
managers are committed to the company and its success and that they view their
role as a steward of the company's resources and assets.

Overall, stewardship theory assumes that managers are responsible and committed
stewards of the company and that they will act in the best interests of the company and
its stakeholders.

SIGNALING THEORY
Signaling theory in the context of auditing refers to the idea that companies use their
financial statements and other disclosures to signal information to external
stakeholders, such as investors, creditors, and auditors. Specifically, signaling theory
suggests that companies may use their financial statements to communicate
information about their financial health, performance, and prospects and that this
information may be used by stakeholders to make decisions about whether to invest in
or lend to the company.

From an auditing perspective, signaling theory suggests that auditors may need to
consider the broader implications of their work, and to look beyond the financial
statements themselves to understand the context in which they are being presented.
For example, auditors may need to consider factors such as the company's industry,

10
competitive landscape, and regulatory environment to understand the full implications
of the financial statements.
Overall, signaling theory highlights the importance of understanding the broader
context in which financial statements are presented, and of considering the motivations
and incentives of the parties involved in the financial reporting process. By doing so,
auditors can provide a more accurate and reliable assessment of the company's
financial performance and prospects.
An example of signaling theory in the context of auditing might involve a company
that is trying to attract investors by signaling its financial health and performance. The
company might do this by presenting financial statements that show strong revenue
growth, high profitability, and low levels of debt. By doing so, the company is signaling
to potential investors that it is a financially healthy and stable company with strong
growth prospects.
From an auditing perspective, the auditor would need to assess the accuracy and
reliability of the financial statements and consider whether any underlying factors might
affect the company's financial health and prospects. For example, the auditor might
need to consider whether the company is operating in a highly competitive industry,
whether it is facing regulatory or legal challenges, or whether other factors might affect
its long-term prospects.
By considering these factors, the auditor can provide a more accurate and reliable
assessment of the company's financial performance and prospects, and help investors
make informed decisions about whether to invest in the company.

Several key assumptions underpin signaling theory, including:

 Asymmetric information: Signaling theory assumes that there is a difference in

the information available to different parties in a transaction. In the context of
financial reporting, this might mean that companies have more information about
their financial health and prospects than external stakeholders, such as
investors and creditors.
 Rational behavior: Signaling theory assumes that parties in a transaction behave
rationally and that they will use all available information to make informed
decisions. From an auditing perspective, this means that auditors need to
consider the incentives and motivations of the parties involved in the financial
reporting process and assess whether they are behaving rationally.
 Costly signals: Signaling theory assumes that signals are costly to produce and
that the cost of producing a signal is related to the quality of the information
being signaled. In the context of financial reporting, this might mean that

11
 companies that produce more detailed and accurate financial statements are
signaling that they have better financial health and prospects.
 Signaling equilibrium: Signaling theory assumes that there is a point at which the
cost of producing a signal is equal to the benefit of the information being
signaled. At this point, a signaling equilibrium is reached, and the signal
becomes a reliable indicator of the quality of the information being signaled.

Overall, these assumptions highlight the importance of understanding the broader

context in which financial statements are presented, and of considering the motivations
and incentives of the parties involved in the financial reporting process. By doing so,
auditors can provide a more accurate and reliable assessment of the company's
financial performance and prospects.

EFFICIENT MARKET THEORY

The efficient market theory is a financial theory that suggests that financial markets are
"efficient" in the sense that they fully reflect all available information about a security or
asset. According to this theory, it is impossible to consistently achieve returns that are
higher than the market average, because all available information is already reflected
in the market price of the security or asset.
The efficient market theory is based on the idea that many investors in the market are
constantly analyzing and interpreting information about different securities and assets.
As a result, any new information that becomes available is quickly incorporated into the
market price of the security or asset, making it difficult for investors to consistently
achieve returns that are higher than the market average.
From an auditing perspective, efficient market theory has important implications for the
assessment of financial statements. If financial markets are truly efficient, then auditors
need to ensure that financial statements are accurate, reliable, and complete, so that
investors and other stakeholders can make informed decisions based on the available
information. By doing so, auditors can help to promote market efficiency and to ensure
that financial markets are working effectively for all participants.
One example of efficient market theory in action is the stock market. According to
efficient market theory, the market price of a stock should reflect all available
information about the company, including its financial performance, growth prospects,
and any other relevant factors that might affect its value.

For example, if a company announces that it has developed a breakthrough technology

that could revolutionize its industry, the market price of the company's stock should
quickly reflect this news, as investors adjust their expectations about the company's
future growth prospects. Similarly, if a company announces that it has experienced a

12
significant decline in sales or profits, the market price of the company's stock should
also reflect this news, as investors adjust their expectations about the company's future
financial performance.

In an efficient market, it is difficult for investors to consistently achieve returns that are
higher than the market average because all available information is already reflected in
the market price of the stock. This means that investors who try to "beat the market" by
buying and selling stocks based on their analysis and interpretation of information are
unlikely to achieve consistent returns that are higher than the market average over the
long term.

Overall, efficient market theory suggests that financial markets are highly competitive
and that all available information is quickly incorporated into market prices, making it
difficult for investors to consistently achieve returns that are higher than the market
average.
ASSUMPTIONS
The efficient market theory makes several assumptions about financial markets and the
behavior of investors. Some of the key assumptions of the efficient market theory
include:

 Investors are rational and profit-seeking: Efficient market theory assumes that
investors are rational and seek to maximize their returns by making informed
investment decisions based on all available information.
 Information is freely available: Efficient market theory assumes that all investors
have equal access to all available information about a security or asset and that
this information is freely available and widely disseminated.
 Information is quickly incorporated into prices: Efficient market theory assumes
that investors quickly and accurately incorporate all available information into the
market price of a security or asset so that the price always reflects the true
underlying value of the security or asset.
 No one can consistently beat the market: Efficient market theory assumes that
no one can consistently achieve returns that are higher than the market
average, because all available information is already reflected in the market
price of the security or asset.
 Markets are highly competitive: Efficient market theory assumes that financial
markets are highly competitive, with many investors constantly analyzing and
interpreting information about different securities and assets.

13
Overall, the efficient market theory assumes that financial markets are highly efficient
and that all available information is quickly and accurately incorporated into market
prices, making it difficult for investors to consistently achieve returns that are higher
than the market average.

14