Handout #2 Demand for Auditing PDF

Handout #2: What is Auditing? Demand for Auditing What is Auditing? Competing Definitions 1. Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspo...

Handout #2: What is Auditing? Demand for Auditing What is Auditing? Competing Definitions 1. Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between the assertions and established criteria and communicating the results to interested users (Louwers et al. 2021). 2. Auditing is the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established crtiteria. Auditing should be done by a competent, independent person (Arens et al. 2017). 3. Auditing is a type of attestation, which is a type of assurance service. Assurance services are independent professional services that improve the quality of information for decision makers. Example: The Audit Bureau of Circulations (ABC) provides assurance services (see article in supplement). – YM magazine reported newsstand sales May 2001: 621,000 copies – ABC reported newsstand sales: 299,635 (report issued Dec. 2002) – YM over-reported sales by 40% on 2 other issues within 6 months Attestation services are assurance services where a practitioner (i.e., CPA) issues a report on the reliability of an assertion made by another party Examples: – Audits of F/Ss – Reviews of F/Ss – Attestation over Internal Control over Financial Reporting (i.e., “ICFR” or “§404 audits”) – Other Attest Services ACCY 401 Auditing 1 of 8 What is Auditing? The AICPA’s universe of services: Accounting & auditing are closely related, but not the same  Accounting o Collection, classification, summarization, and communication of financial data as they affect and represent a given entity  Auditing o Review the measurements and communications of accounting for propriety o Analytical, not constructive o Critical and investigative, concerned with the basis of accounting measurements and assertions o Based on logic and proof Accounting Subtopic Intended Audience ACCY 401 Auditing 2 of 8 Demand for Auditing Recall our previous discussion about information asymmetry—the preparer/provider of information knows more than the intended audience Think back to the curtain scene in The Wizard of Oz. If demand for assurance arises within the economy itself, with no outside intervention, the demand is endogenous. If demand for assurance is imposed a result of outside intervention the demand is exogenous. Exogenous Assurance Demand Government legislation could require that commodity quality always be subjected to attest engagements. Financial statement audits—SEC Acts. For prescription drugs—FDA rules. For meat – USDA inspections. Problem: Once legislation exists, inferring what would happen in its absence is troublesome. Reasons Audit Demand is Endogenous Despite Regulation: Attestation predates regulation Organizations not required to, often purchase financial-statement audits o and other attest services (e.g., internal controls, terms in contractual agreements) o and non-attest assurance services (e.g., improve information display) ACCY 401 Auditing 3 of 8 Demand for Auditing Key Players in the Economy Producers Consumers Capital Providers And…Assurance Providers? Key attributes in our economy Complexity quality sometimes is not easy to observe Consequence success is rewarded failure is penalized Asymmetric information One party to transaction has more/different information than other Conflicting interests Seller wants to make profit; buyer wants low price Conceptual Reasons for Endogenous Demand 1. Signaling 2. Monitoring 3. Information-risk reduction 4. Insurance hypothesis ACCY 401 Auditing 4 of 8 Demand for Auditing Signaling Example: a producer is selling a gold substance. She asserts that it is real gold worth $420 per ounce. The buyer is worried that the gold is actually fool’s gold that is worth only $10 per ounce. He offers to pay only $10. Producers believe their commodity is high quality Want information asymmetry reduced But, consumers can’t observe quality Assurance is next best thing Result: sell commodity at higher prices Assurance provides a method of credibly signaling the quality of the commodity to the consumer Monitoring – Principal-Agent Model Example: Mary hires John to run her store in Oxford. Mary lives in Memphis. Mary knows that if business is good and John works hard, the store makes a monthly profit of $3000; If it is a bad month or John does not work hard, the store’s profit is $2000. Producers are agents of capital providers Capital providers are principals Assume that Everyone maximizes their own self interest and people prefer: o less work to more, and o more compensation to less Everyone has “rational expectations” o People learn from past, so can’t cheat/be cheated repeatedly ACCY 401 Auditing 5 of 8 Demand for Auditing Monitoring (cont’d) Producer agents require compensation to work hard Producer agents tend to shirk because principals cannot readily monitor their work levels. Anticipating agents’ shirking, principals propose to reduce the amount of compensation given to agents. Anticipating principals’ compensation reduction, agents make assertions (about their quality) and hire assurance providers. ACCY 401 Auditing 6 of 8 Demand for Auditing Information Risk Reduction Information Risk: The possibility that the information upon which a business decision was made was inaccurate. Cost of information risk is a factor in Cost of Capital: o Cost of Capital (say 13%) composed of 3 elements: o Risk-free rate of return (5.5%) o Economic risk prem (business risk-3.5%) o Information risk premium (4.0%) Causes of Information Risk 1-Remoteness of Information: cannot have first-hand knowledge about organizations do business with Information provided by others must be relied upon This increases the likelihood of it being intentionally or unintentionally misstated 2- Biases and Motives of the Provider: Inconsistent goals of information provider and user may bias the information in favor of the provider Could be due to: o Honest optimism o Intentional: designed to influence info users 3- Voluminous Data: large organizations have many transactions As volume increases, the likelihood of improperly recorded information increases. As transactions between entities become more complex, the likelihood of these transactions being recorded incorrectly increases. ACCY 401 Auditing 7 of 8 Demand for Auditing Three Ways to Reduce Information Risk User Verifies Information: This may be too costly. User Shares Information Risk with Management: Management is responsible for providing reliable information to users. Provide Audited F/S: The most common way to reduce information risk. Example: Net value of audit for Home Depot Market capitalization 8-11-2006 68.77B BV of LTD (1st qtr 2006 – investment grade) 6.67B Audit fee FY 2005 (clean F/S and ICFR opinions) 3.67M Financial statement audit value: Equities (.0048 * 68.77B) 330M Debt (.0036 * 6.67B) 24M Internal control audit value: Equities (.00583 * 68.77B) 401M Total savings due to audit 755M Less: audit fee 3.67M Net savings 751.33M Average audit value is 32 – 36 times audit fees Source: Kinney, Botosan, and Palmrose (2006) Insurance Hypothesis Assurance professionals “make whole” injured parties Injured parties can be: o Investors who relied on audited financial statements can sue auditors who are negligent and who have deep pockets o Politicians who would be blamed for a company failure – allows SEC to point the finger at auditors and avoid blame ACCY 401 Auditing 8 of 8