An Assurance Analogy: The Case of the House Inspector
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Chapter 1 An Introduction to Assurance and Financial Statement Auditing 9
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services must focus on the assertions that are most important, and they must be conducted in a timely and cost-effective manner. Some assertions are more important than others because of their potential risk or cost. For example, a house inspector should recognize the signs that indicate an increased risk of a leaky roof. If those signs are present, he or she should investi- gate further, because damage caused by a leaky roof can be very expensive to repair. At the same time, just because the seller asserts that he or she recently lubricated all the door and window hinges doesn’t mean it would be wise to pay the inspector to validate this assertion.
Stop and Think: How might a house inspection be similar to a financial statement audit?
Relating the House Inspection Analogy to Financial Statement Auditing Now that we have discussed some of the basic characteristics of house inspectors and their services, let’s consider how these relate to financial statement auditors. As noted previously, the demand for the assurance provided by a house inspector comes from information asym- metry and conflicts of interest between the buyer and the seller. Information asymmetry and conflicts of interest also exist between managers of companies and potential investors. For example, if managers are overly optimistic or if they wish to inflate their bonus compensa- tion, they may unintentionally or intentionally overstate the company’s earnings and assets (e.g., by understating the allowance for doubtful accounts or by claiming to have more cash than they really have). One important difference between our house inspector example and financial statement auditing is that the buyer of a home typically hires the inspector. In other words, the buyer identifies and hires the inspector rather than hiring someone that the seller recommends—presumably because by hiring an inspector directly, they increase the likeli- hood that the inspector will be objective and independent.
However, as was discussed previously, the companies selling stocks or bonds to the pub- lic typically hire and pay the auditor, rather than the other way around. To raise capital in the marketplace, companies often sell many small parcels of stocks and bonds to a large number of investors. Suppose a financial statement audit of a given company would cost $500,000. Under such circumstances, it obviously doesn’t make sense for each individual investor to pay for an audit. Instead, the company hires and pays for the auditor because a reputable indepen- dent auditor’s opinion can provide assurance to thousands of potential investors. In addition, recall from our previous discussion that the initial demand for auditing comes not from the principal but from the agent. By purchasing the assurance provided by an audit, the company can sell its stocks and bonds to prospective owners and creditors at more favorable prices,