What negative consequences could information asymmetry have for the absentee owner?
Stop and Think: What negative consequences could information asymmetry have for the absentee owner? How do the perspectives and motives of the manager and absentee owner differ?
Because their goals may not coincide, there is a natural conflict of interest between the manager and the absentee owner. If both parties seek to maximize their self-interest, the man- ager may not always act in the best interests of the owner. For example, the risk exists that a manager may follow the example of Tyco Inc.’s former CEO Dennis Kozlowski, who spent Tyco funds on excessive personal benefits such as $6,000 shower curtains, or Andrew Fastow, the former CFO of Enron, who pleaded guilty to manipulating the reported earnings of Enron in order to inflate the price of the company’s stock so that he could earn larger bonuses and sell his stock holdings at artificially high prices. The owner can attempt to protect him or her- self against the possibility of improper use of resources by reducing the manager’s compensa- tion by the amount of company resources that the owner expects the manager to consume. But rather than accept reduced compensation, the manager may agree to some type of monitoring provisions in his or her employment contract, providing assurance to the owner that he or she will not misuse resources. For example, the two parties may agree that the manager will periodically report on how well he or she has managed the owner’s assets. Of course, a set of criteria is needed to govern the form and content of the manager’s reports. In other words, the reporting of this financial information to the owner must follow some set of agreed-upon principles in holding the manager accountable. As you can see, one primary role of account- ing information is to hold the manager accountable to the owner—hence the word accounting.
The Role of Auditing Of course, reporting in accordance with an agreed-upon set of accounting principles doesn’t solve the problem by itself. Because the manager is responsible for reporting on the results of his or her own actions, which the absentee owner cannot directly observe, the manager is in a position to manipulate the reports. Again, the owner adjusts for this possibility by assum- ing that the manager will manipulate the reports to his or her benefit and by reducing the manager’s compensation accordingly. It is at this point that the demand for auditing arises. If the manager is honest, it may very well be in the manager’s self-interest to hire an auditor to monitor and report to the owner on his or her activities. The owner likely will be willing to invest more in the business and to pay the manager more if the manager can be held account- able for how he or she uses the owner’s invested resources. As the amount of capital involved and the number of potential owners increase, the potential impact of accountability also increases. The auditor’s role is to determine whether the reports prepared by the manager con- form to the contract’s provisions. Thus, the auditor’s verification of the financial information
Final PDF to printer
Chapter 1 An Introduction to Assurance and Financial Statement Auditing 7
mes32502_ch01_001-034.indd 7 09/30/15 02:33 PM
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.