Managerial Auditing Journal

Agency Theory and the Internal Audit

Michael B. Adams

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Michael B. Adams, (1994),"Agency Theory and the Internal Audit", Managerial Auditing Journal, Vol. 9 Iss 8 pp. 8 - 12
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Agency theory can provide for richer and more

meaningful research in the internal audit
discipline.

Agency Theory
and the
Internal Audit
Michael B. Adams

Managerial Auditing Journal, Vol. 9 No. 8, 1994, pp. 8-12

MCB University Press, 0268-6902

The literature is replete with studies that have used

agency theory to examine the role of the external auditor
in society (for example [1-5]). However, relatively few
researchers have applied agency theory to the internal
auditing function[6]. This article examines how agency
theory can help explain the existence, role and
responsibilities of the internal audit function and also
provide a useful framework for the conduct of further
empirical research. Key research questions which could
be analysed within an agency theory framework are
outlined in Table I.

principals and that this information asymmetry

adversely affects the principals ability to monitor
effectively whether their interests are being properly
served by agents. It also assumes that principals and
agents act rationally and that they will use the
contracting process to maximize their wealth. This
means that because agents have self-seeking motives
they are likely to take the opportunity to act against the
interests of the owners of the firm, for example by
partaking in high levels of perquisite consumption (that
is, perks). Scapens[10] refers to this dilemma as the
moral hazard problem. Another type of agency problem
which arises is adverse selection. This occurs when the
principal/owner(s) does not have access to all available
information at the time a decision is made by a manager
and is thus unable to determine whether managers
actions are in the best interests of the firm. Scapens
argues that a state of efficiency, or pareto-optimality,
exists in the contracting relationship between principal/
owners and agent/managers when neither party can
enhance their wealth at the expense of the other. To
ensure pareto-optimality in the contracting process, both
principals and agents will incur contracting costs. For
instance, to minimize the risk of shirking[11] by agents,
principals will incur monitoring expenditures, for
example the costs of subjecting financial statements to
external audit scrutiny. Agents, on the other hand, incur
bonding costs, for example the cost of internal audit, in
order to signal to principal/owners that they are acting
responsibly and in a manner consistent with their
contract of employment. Such action also helps managers
to secure their positions in the firm and to protect their
salary levels. Indeed, Wallace[1] argues that the
principals expenditures for monitoring agents actions
are reflected in the salary paid to the agent. Therefore, it
is in the agents interest to demand monitoring services,
like internal auditing, in order to reduce the risk of
principals making adverse adjustments to executive
compensation.

Internal Audit: A Contracting Cost

Agency Theory
Agency theory[7] is part of the positivist group of
theories which derives from the financial economics
literature[8]. It postulates that the firm consists of a nexus
of contracts between the owners of economic resources
(the principals) and managers (the agents) who are
charged with using and controlling those resources[9,
p. 308]. Furthermore, agency theory is based on the
premiss that agents have more information than
The author acknowledges the helpful comments of three
colleagues, Hector Perera, Jeff Robertson and Lin Tozer, on
earlier versions of this article. The financial support of Price
Waterhouse is also very much appreciated.

Watts[12, p. 129] suggests that examples of bonding costs

include expenditure on audit committees, non-executive
directors and internal auditors. The role of internal audit
as a bonding function in the contracting process of the
firm is also recognized by other writers. For example,
Sherer and Kent[13] perceive internal auditing to be a
bonding cost borne by the senior managers to satisfy the
demands for accountability made by external
participants, especially shareholders (p. 99). They also
argue that internal audit is an adjunct of the function
performed by external audit, the difference being that
the cost of an internal audit is incurred directly by the
managers (p. 99) and that agent/managers have an
incentive to incur the costs of internal audit if the total
cost of the audit process, both internal and external, is

AGENCY THEORY AND THE INTERNAL AUDIT

Table I. An Agency Theory Framework for Internal Auditing Research

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Some research
questions

Agency theory
Explanations

Predictions

Why do some
organizations have
an internal audit
department, while
others do not?

Internal audit, together with other

mechanisms, e.g. audit committees, bonds the
contractual relationship between principals
and agents
Internal audit can also help principals to
overcome the information assymetry problem
and to monitor the activities of agents
cost-efficiently

Complex business
H1:The existence, or
environments, e.g. insurance
otherwise, of an
organizations, are more likely
internal audit unit
to employ internal auditors
varies across business
than are entities which are
sector
less complex, e.g. small
businesses

Why does the nature

and form of internal
audit units (e.g. in
terms of size) vary
between
organizations?

The agency relationship in a firm is a function

of the ownership and control structure of the
entity. For example, less cohesive ownershipcontrol structures, such as mutual companies,
will have a different type of internal audit unit
(e.g. in terms of skill mix) than stock
companies

The nature and form of

internal audit will vary
between firms of different
corporate form, even when
such firms operate in the
same industry, e.g. mutual
and stock companies in
insurance markets

Why do internal
auditing practices
differ between
organizations?

Internal auditing practices may vary between

organizations because principals/agents have
different incentives. For example, in stock
insurance companies which have profit-share
schemes it is in the interest of owners,
managers and internal auditors to perform
activities which increase firm value

Internal auditors in publicly H3:Internal auditing

listed companies are more
practice varies
likely to perform financial
between firms of
audits, fraud investigations
different ownershipand internal control
control status
compliance tests than in nonpublicly listed companies

Why does
organizational
change affect internal
audit departments
different
ways?

Information asymmetry varies between

organizations depending on the nature and
complexity of the entity and its business.
This means that the cost of maintaining the
contractual relationship between principalagent will depend on how severe the problem
of information asymmetry is in the organization

In organizations with severe H4:Internal audit units in

information asymmetry
complex business
internal audit units will be
environments will be
less affected by organizational
unaffected by major
change
changes affecting the
organization

less than the perceived cost of external auditing on its

own. For example, cost savings may arise as a result of
internal auditors specific industry knowledge and
expertise in systems and operational audits.
Furthermore, Sherer and Kent[13] believe that internal
audit is a
feedback mechanism with the result that management
has the ability to remedy any weaknesses in procedures
before they have a significant effect on the overall internal
control system and the financial condition of the
organization (p. 103).

As previously mentioned, the cost of internal audit can

also be judged to be a monitoring expenditure which is
incurred by principal/owners to protect their economic
interests. Indeed, the Institute of Internal Auditors
Statement of Responsibilities[14] defines internal auditing
as an independent appraisal activity established within
an organisation as a service to the organisation

Possible test hypotheses

H2:The characteristics of
internal audit units
differ between firms
in the same industrial/
business sector

(emphasis added). Moxey[15] argues that the worldwide

shift in focus of responsibility of corporate internal
audit from an arm of management to an independent
organizational appraisal function stems from the US
Foreign Corrupt Practices Act 1977. As Moxey remarks,
this Act placed an increased emphasis on the
independence of internal auditors to assure managements integrity in its internal reporting (p. 48).
The effect of government regulation on the contracting
process of the firm is well established in the accounting
literature. For example, Watts and Zimmerman[16]
argues that regulation is often supplied by Government in
response to demand derived from the needs of interest
groups such as investors and consumers. Often the
demand for regulation and/or legislation is instigated in
response to some crisis in the industry, such as the
insolvency of a major company. Government regulation,
for example taxation, is sometimes costly to owners of the

10

MANAGERIAL AUDITING JOURNAL 9,8

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firm and as such they will attempt to minimize the impact

of political intervention on the firm. For example, they
may employ discretionary accounting techniques, such as
manipulation of depreciation and bad debt provisions, to
reduce reported earnings and to minimize the effect of
taxation.
However, regulators can also benefit owners by acting as
surrogate monitors of agent/managers activities. The
statutory requirement for certain types of organization to
have sound internal controls and/or internal audit
functions may be perceived as beneficial regulation
which protects the interests of ownership groups. For
example, in the UK, the Building Societies Act 1986
imposes a statutory responsibility on building societies to
maintain sound systems of internal control. This 1986
Act was motivated by the Governments desire to protect
building society members following serious corporate
fraud and failure in the industry[17].

The Rationale for Internal Audit

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.
A proposed agency theory framework for internal
auditing research is outlined in Table I. As illustrated in
Table I, agency theory may not only help to explain the
existence of internal audit in organizations but can also
help explain some of the characteristics of the internal
audit department, for example, its size, and the scope of
its activities, such as financial versus operational
auditing. Agency theory can be employed to test
empirically whether cross-sectional variations between
internal auditing practices reflect the different
contracting relationships emanating from differences in
organizational form. The insurance industry provides a
test environment within which to examine this
proposition.
The insurance industry is dominated by entities which
are either stock companies, owned by shareholders, or
mutual companies, owned by policyholders. Mayers and
Smith[18] consider that policyholders in mutual
companies find it more difficult than shareholders in
stock companies to monitor and control the activities of
agent/managers effectively because they are a less
cohesive and heterogeneous ownership group than
shareholders.
To counteract the possibility of loss of policyholders
wealth as a result of a looser ownership-control structure
within the firm, agency theory predicts that mutual
insurance companies are more likely than stock
insurance companies to employ internal monitoring

mechanisms such as internal auditors and non-executive

directors and to use the services of an audit committee.
Furthermore, to prevent agents from taking advantage of
the incohesive ownership-control structure and adversely
influencing these monitoring mechanisms to suit their
self-interests, agency theory predicts that mutual
insurance companies may introduce additional control
mechanisms. For example, mutual insurance companies
can try to prevent managers from curtailing the scope of
the internal audit function and/or ignoring internal
auditors recommendations by ensuring that the role and
responsibilities of internal audit are mandated in an audit
charter, and that the head of internal audit reports
directly, and in an unrestricted way, to the board of
directors and/or audit committee. In addition, the
corporate reputation and independence of internal audit
can be promoted through the appointment of qualified
and experienced staff and adequate financial provision
for staff development and training. As in the case of UK
building societies, previously mentioned, the Government
may also seek to protect the interests of a heterogeneous,
and potentially vulnerable, ownership group by
introducing legislation such as that requiring firms to
maintain adequate systems of internal control.
In stock insurance companies internal auditors may be
inextricably bound to the interests of shareholders and
managers, for example through employee share
ownership schemes. Arguably this shared interest lowers
internal auditing independence and also affects the nature
and scope of internal auditing activities. For example,
agency theory predicts that, to ensure high share prices,
stock companies may wish to signal to capital markets
that they have achieved above average annual financial
performance and that management systems in the
company are sound. Consequently, stock companies will
endeavour to achieve an unqualified audit report and they
may even disclose details of sound internal control
systems in their annual report and accounts[19]. To help
achieve these objectives it is possible that the focus of
internal audit activity in stock insurance companies will
be geared towards financial audit, fraud prevention and
internal control compliance work rather than operational
reviews and management audits.

Agency Theory and Prior Research

Three areas of current interest to the internal auditing
profession which could benefit from an agency theory
interpretation are explored briefly in this section as
follows:
(1) internal-external auditor relationships;
(2) internal audit outsourcing;
(3) the internal auditor in organizational
rationalization.

AGENCY THEORY AND THE INTERNAL AUDIT

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Internal-External Auditor Relationships

In a study of the role of US company internal auditors in
the annual statutory audit, Oliverio and Newman[20]
conclude that there is considerable participation in
external audits by internal auditors [but that]
approximately a third of the respondents hoped for a
different relationship (p 67). Unfortunately, the authors
neither explain why internal auditors participate in the
external audit function in particular organizations nor
why a substantial minority of internal auditors in the
study felt dissatisfied with their allotted role in the
external audit.
Agency theorists could interpret the employment of
internal auditors on the statutory audit as a ploy by
managers to reduce the monitoring cost of the statutory
audit but at the same time signal to owners that the
coverage of the audit is not reduced. In addition, the
executive decision to involve internal auditors in the
external audit may be driven by self-interest motives.
For instance, managers may wish to draw internal
auditors away from operational assignments if there is a
likelihood that evidence of managerial inefficiency and/or
incompetence will be uncovered. In turn, internal
auditors may dislike the switch in assignment, and
become dissatisfied with their subordinated role in the
statutory audit.
Outsourcing
Another issue of relevance to the internal auditing
profession concerns the outsourcing of internal audit
services to public accounting firms. Barr and Chang[21]
point out that the advantages of contracted-in internal
auditors include greater perceived independence, flexibility, cost savings and improved quality. The authors
consider the disadvantages of outsourcing to be the loss
of loyalty and business knowledge and the loss of a
valuable training ground. Notwithstanding that some
organizations, such as UK local authorities, are obliged
by the Local Government Act 1992 to put out professional
services, like internal audit, to compulsory competitive
tender, Barr and Changs[21] study does not address
questions such as which types of organization will
voluntarily contract-out their internal audit function,
and why.
Agency theory may help to explain such research
questions. For instance, agency theory postulates that
there is an information asymmetry problem in the firm
which hinders principals from effectively monitoring the
opportunistic behaviour of agents. In sectors like the
insurance industry, where the activities to be controlled
are acknowledged to be technically specific and complex
[22], the employment of in-house internal auditors with
industry knowledge may be a more cost-efficient
contractual mechanism by which principals can control
shirking by agents, and for agents to signal to principals
that they are acting in a responsible manner. Hence,
agency theory may predict that organizations operating

11

in more complicated business environments are

less likely to contract out their internal auditing function
than entities operating in less complicated business
environments.
Organizational Change
The issue of internal audit outsourcing is also related to
the general question of how internal audit is treated in
corporate restructuring and rationalization programmes.
In a study into the impact of corporate downsizing on
internal audit departments in US companies following a
leveraged buy-out (LBO), Campbell and Mohan[23]
conclude that
contrary to anecdotal evidence, our study indicates that
LBOs do not always lead to a reduction in internal audit
that there is no uniform impact from LBOs on corporate
internal audit functions (p. 9).

This situation could be explained by the different agency

relationships in the organizations covered by the study.
As with decisions concerning the outsourcing of internal
audit, LBO managers may decide to retain, or even
strengthen, internal audit departments in organizations
where an acute information asymmetry problem is
acknowledged to exist. Arguably, the information
asymmetry constraint is likely to be accentuated when
LBO managers are unfamiliar with the idiosyncrasies
and complex business processes of the entity bought out.
Sherris[24] refers to this agency problem as the bounded
rationality constraint which relates to the inability of
owners and managers to solve complex problems due to
imperfect information. Hence, to help them manage
uncertainty in complex and highly competitive business
environments, LBO managers may perceive there to be a
contracting cost advantage in retaining, and even
strengthening, the existing internal audit function.
Indeed, Campbell and Mohan[23] state that
downsizing for competitive reasons may enhance the
usefulness of IA [internal audit] IA may be need more
than ever to check on the maintenance of controls in the
wake of competitive pressures and reduced resources (p. 8).

Summary and Conclusion

This article has outlined how agency theory can provide
for richer and more meaningful research in the internal
audit discipline. Agency theory can help explain the
existence of internal audit, the nature of the internal audit
function and the particular approach adopted by internal
auditors to their work. It can also help to predict how
internal auditors will be affected by organizational
restructuring and rationalization. Further, these
explanatory and predictive qualities can help researchers
and the internal audit profession to gauge the likely
consequences of change better. In this respect, it is
considered that an agency-theory perspective to the
internal audit will have substantive benefits for both
academics and practitioners.

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12

MANAGERIAL AUDITING JOURNAL 9,8

Notes and References

1. Wallace, W.A., The Economic Role of the Audit in
Free and Regulated Markets, Graduate School of
Management, University of Rochester, NY, 1980.
2. Antle, R., The Auditor as an Economic Agent, Journal
of Accounting Research, Vol. 20 No. 2 Part II, 1982,
pp. 503-27.
3. Wilson, R., Auditing: Perspectives from Multiperson
Decision Theory, Technical Report No. 385, Institute for
Mathematical Studies in the Social Sciences, Stanford
University, CA, October 1982.
4. Hardman, D.J., Towards a Conceptual Framework for
Government Auditing, Accounting and Finance, Vol. 31
No. 1, 1991, pp. 22-38.
5. Parkash, M. and Venable, C.F., Auditee Incentives for
Auditor Independence: The Case of Audit Services,
The Accounting Review, Vol. 68 No. 1, 1993, pp. 113-33.
6. A study that has utilized agency theory/contingency
theory to examine the role of internal audit in different
organizational control structures is San Miguel, J.G. and
Govindarajan, V., The Contingent Relationship between
the Controller and Internal Audit Functions in Large
Organizations, Accounting, Organizations and Society,
Vol. 9 No. 2, 1984, pp. 179-88.
7. Agency theory is also referred to as contracting cost
theory.
8. Walker, M., The Information Economics Approach to
Financial Reporting, Accounting and Business Research,
Vol. 18 No. 72, 1988, pp. 170-82.
9. Jensen, M.C. and Meckling, W.H., Theory of the Firm:
Management Behaviour, Agency Costs and Ownership
Structure, Journal of Financial Economics, Vol. 3 No. 3,
1976, pp. 305-60.
10. Scapens, R.W., Management Accounting: A Review of
Recent Developments, Macmillan Press Ltd, London,
1985.
11. Kren and Kerr broadly define shirking as action that is
not in the best long-run interests of the firm [such as]
a refusal to engage in convenient travel or other timeconsuming activities (p. 160). See Kren, L. and Kerr, J.L.,
The Effect of Behaviour Monitoring and Uncertainty in
the Use of Performance-contingent Compensation,
Accounting and Business Research, Vol. 23 No. 9, 1993,
pp. 159-68.

12. Watts, R.L., Discussion of Financial Reporting

Standards, Agency Costs, and Shareholder Intervention,
Journal of Accounting Literature, Vol. 7, 1988, pp. 125-32.
13. Sherer, M. and Kent, D., Auditing and Accountability,
Pitman, London, 1983.
14. Institute of Internal Auditors (UK), Standards and
Guidel ines for the Professional Practice of Internal
Auditing, Institute of Internal Auditors, London, 1988.
15. Moxey, D., Audit Committees: What They Should Not
Do, Journal of Contemporary Business, Vol. 8 No. 1,
1979, pp. 43-56.
16. Watts, R.L. and Zimmerman, J.L., Positive Accounting
Theory, Prentice-Hall, Englewood Cliffs, NJ, 1986.
17. The collapse of the UK Grays Building Society in 1978
and the criticism of the external audit function in the
subsequent investigation by the Registrar of Friendly
Societies (1979) led to the Building Society Act 1986.
Under Section 71 of the 1986 Act building societies must
maintain adequate systems of internal control.
18. Mayers, D. and Smith, C.W., Ownership Structure and
Control: The Mutualization of Stock Life Insurance
Companies, Journal of Financial Economics, Vol. 16
No. 1, 1986, pp. 73-98.
19. Studies are reporting that the disclosure of internal
control issues in corporate reports is becoming an
increasingly common activity. For example, see Kintzele,
M.R., Kintzele, P.L. and Kwiatkowski, V.E., Reporting on
Internal Control in Annual Reports, Internal Auditing,
Winter 1993, pp. 3-15.
20. Oliverio, M.E. and Newman, B.H., Internal Auditor
Participation in External Audits, Internal Auditing,
Winter 1991, pp. 57-67.
21. Barr, R.H. and Chang, S.Y., Outsourcing Internal Audits:
A Boon or Bane?, Managerial Auditing Journal, Vol. 8
No. 1, 1993, pp. 14-17.
22. Many writers acknowledge that insurance companies
operate in a particularly complex business environment.
For example, see Meier, K.J., The Politics of Regulation,
The Journal of Risk and Insurance, Vol. 58 No. 4, 1991,
pp. 700-13.
23. Campbell, J.E. and Mohan, N., The Impact of Corporate
Downsizing on Internal Auditing, Internal Auditing,
Spring 1992, pp. 3-9.
24. Sherris, M., The Role of the Actuary and the Theory of
Contracting, Transactions of the Institute of Actuaries in
Australia, Vol. 2, 1987, pp. 1117-42.

Michael B. Adams is a Lecturer in the Department of Accountancy, Massey University, Palmserston North, New Zealand.

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