1. 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.

2. 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).

3. 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.

4. 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 risk Interest rate on the loan

5. 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.

6. 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.