WORKING PAPER - Faculteit Economie en Bedrijfskunde

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point of view, companies can use the model tested in this study to decide on the size of their internal audit function, a question that is highly relevant in today’s business environment (Carcello et al., 2005b). The results of this study confirm the explanatory power of agency variables such as diffusion of ownership, company size and the number of reporting levels. The following section of this paper develops hypotheses for the agency model based on a review of the relevant literature. The third section outlines the methodology of this study. The fourth section shows the empirical results. The paper ends with a summary and discussion of the conclusions. Literature Review and Development of Hypotheses Agency theory postulates that a company 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 (Jensen and Meckling, 1976). Agency theory is based on the idea that agents have more information than principals and that this information asymmetry adversely affects the principals’ ability to monitor whether or not 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 maximise 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 company. Jensen and Meckling (1976) refer to this dilemma as the moral hazard problem. Another type of agency problem is adverse selection. This occurs when the principal does not have access to all available information at the time a decision is made by an agent, and is thus unable to determine whether the agent’s actions are in the best 4
interests of the firm. To ensure the so-called pareto-optimality in the contracting process, both principals and agents will incur contracting costs. Sherer and Kent (1983) and Watts (1988) suggest that internal auditing is a bonding cost borne by agents to satisfy the principals’ demands for accountability. The cost of internal auditing can also be judged to be a monitoring cost which is incurred by principals to protect their economic interests. Agency theory contends that internal auditing, like other intervention mechanisms like financial reporting and external auditing, helps to maintain cost- efficient contracting between owners and managers. Adams (1994) illustrates that agency theory helps to explain the existence of internal auditing in companies but can also help to explain an important characteristic of the internal audit function, namely its size. It is assumed that the more information asymmetry, the greater the need for monitoring to reduce this information asymmetry, resulting in a larger internal audit function. In a larger internal audit function, there will be more staff and, the scope of the internal audit work covered would be greater than in a smaller function (Mat Zain et al., 2006). It is assumed that a larger internal audit function has a broader scope of work and is able to cover more areas where (potential) information asymmetries exist. In the following paragraphs, hypotheses will be developed based on the principal/agent problem that exists between the owners of resources (shareholders and debtholders) and the users of resources (management). Diffusion of Ownership Based on studies done by DeFond (1992) and Francis and Wilson (1988), explaining the implications of the separation of ownership and control, it can be argued that the more diffused the ownership of the company, the higher the divergence in preferences of the owners and managers and the lower the observability and control of management’s actions by 5
Page 1 and 2: FACULTEIT ECONOMIE EN BEDRIJFSKUNDE
Page 3: Introduction Despite all of the rec
Page 7 and 8: will need monitoring through auditi
Page 9 and 10: levels in the company increases, th
Page 11 and 12: after an intensive follow-up by e-m
Page 13 and 14: e reasonably expected that these co
Page 15 and 16: Descriptive Statistics and Correlat
Page 17 and 18: lowest operating unit, the larger t
Page 19 and 20: external auditing in this agency co
Page 21 and 22: have more reporting levels and a wi
Page 23 and 24: Francis, J.R. and Wilson, E.R. (198
Page 25 and 26: Exhibit 1: Relationship between age
Page 27 and 28: Table 2: Descriptive Statistics for
Page 29 and 30: Table 4: OLS Regression Analysis (n

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