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Rev. Confirming Pages
Chapter 1 An Introduction to Assurance and Financial Statement Auditing 7
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adds credibility to the report and reduces information risk, or the risk that information cir- culated by a company’s management will be false or misleading. Reducing information risk potentially benefits both the owner and the manager. Figure 1–1 provides an overview of this agency relationship.
While the setting we’ve outlined is very simple, understanding the basics of the owner– manager relationship is helpful in understanding the demand for auditing. The principal– agent model is a powerful conceptual tool that can be extrapolated to much more complex employment and other contractual arrangements. For example, how can a lender prevent management from taking the borrowed funds and using them inappropriately? One way is to place restrictive covenants in the debt agreement with which the entity and its management must comply. Again, this arrangement gives rise to a demand for the auditing of information reported by management to the lender.
Overview of the Principal–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.