BASIC PURPOSE OF AN “AUDIT”

• One party (for example, management) asserts.• A self-report.• Motivation to misrepresent?

• CPA attests to that assertion.• What does the auditor add? Credibility.

• Expertise.• Independence.• Reputations to protect.

• Audit protects against error and fraud.

THREE “CREDIBILITY” SERVICES

• All require independence from the client.• Assurance Services – improve information for decision

makers.– Information Technology (WebTrust).– Other services (ElderCare).

• Attestation Services – expressing a conclusion about the reliability of another’s assertions.

• Auditing - systematic process to gather evidence to attest to the correspondence between another’s assertion of financial activity and an established criteria. – Reviews of Financial Statements (independence needed).– Compilation of Financial Statements (independence is not

required).

GENERAL TYPES OF AUDITS

• Financial statement audit – are F/S in accordance with generally accepted accounting principles (GAAP)?

• CPA must be independent from client.• Exclusive franchise of CPAs.

• Compliance audit – are rules, regulations, policies, etc. being followed?

• Operational audit – are activities effective and efficient?• Forensic audit – did a fraud occur?

• Forensic = pertaining to a legal dispute.

ECONOMIC RATIONALE FOR AN AUDIT

Assume a business is seeking a 20-year, $1,000,000 loan. (Interest is paid annually with a lump-sum repayment for the principal due in 20 years.)

The lender must determine the appropriate interest rate to charge:

Risk-free interest rate+ Business risk+ Information riskInterest rate on the loan

INFORMATION RISK

• Causes of information risk:• Remoteness of information.• Voluminous data.• Complex exchange transactions.• Biases of provider.

• Means to reduce information risk:• Lender verifies information.• Lender imposes some of the risk on management.• Information is audited.

OPTIONS FOR BORROWER(the lender offers these options)

Option 1: No audit required but interest rate is 6%.

Present value of a $60,000 per year annuity for 20 years = $688,195. (Discount rate = 6%)

Option 2: Audit required but interest rate is lowered to 5.5%.

Present value of a $55,000 per year annuity for 20 years = $630,846. (Discount rate = 6%)

Maximum value of the audit: $57,349.