How do the perspectives and motives of the manager and absentee owner differ?
Agent Relationship Leading to the Demand for Auditing
F I G U R E 1 – 1
Auditor gathers evidence to evaluate fairness of agent’s financial reports. Auditor issues audit opinion to accompany agent’s financial reports, adding credibility to the reports and reducing principal’s information risk.
Principal provides capital and hires agent to manage resources.
Information asymmetry and conflicts of interest lead to information risk
for the principal.
Agent is accountable to principal; provides financial reports. Agent hires auditor
to report on the fairness of agent’s
financial reports. Agent pays auditor
to reduce principal’s information risk.
Auditor
Agent (Manager)
Principal (Absentee Owner)
Practice I N S I G H T
At the heart of a capital-market economy is the flow of reliable information, which investors, credi- tors, and regulators use to make informed decisions. Chief Justice Warren Burger gave his view of the significance of the audit function in a 1984 Supreme Court decision:
By certifying the public reports that collectively depict a corporation’s financial status, the indepen- dent auditor assumes a public responsibility transcending any employment relationship with the cli- ent. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public.
More than 30 years later, the message is the same—users of financial statements rely on the external auditor to act with honor and integrity in protecting the public interest.
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8 Part 1 Introduction to Assurance and Financial Statement Auditing
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In summary, auditing is demanded because it plays a valuable role in monitoring the contractual relationships between the entity and its stockholders, managers, employees, and debt holders. Certified public accountants have been charged with providing audit services because of their traditional reputation of competence, independence, objectivity, and concern for the public interest. As a result, they are able to add credibility to information produced and reported by management to outside parties. The role of the Certified Public Accountant is discussed in more detail in Chapter 2.
Before we discuss financial statement auditors further, let’s illustrate the concepts we’ve just covered using an analogy: buying a home. In the purchase of an existing house, informa- tion asymmetry usually is present because the seller typically has more information about the house than does the buyer. There is also a natural conflict of interest between the buyer and the seller. Sellers generally prefer a higher selling price and may be motivated to overstate the positive characteristics and understate or remain silent about the negative characteristics of the property they have for sale. In other words, there is information risk to the buyer.
Seller Assertions, Information Asymmetry, and Inspector Characteristics To support the asking price, sellers typically make assertions about their property. For instance, the seller of an older home might declare that the roof doesn’t leak, that the founda- tion is sound, that there is no rot or pest damage, and that the plumbing and electrical systems are in good working order. Fortunately, many sellers are honest and forthcoming, but this is not always the case. The problem is that the buyer often does not know if she or he is dealing with an honest seller or if the seller has the necessary expertise to evaluate all the structural or mechanical aspects of the property. Lacking the necessary expertise to validate the seller’s assertions, the buyer can logically reduce information risk by hiring a house inspector.