CHAPTER 1 SOLUTIONS
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There is a demand for auditing in a free-market economy because in the agency relationship there is a natural conflict of interest between an absentee owner and a manager and due to the information asymmetry that exists between the owner and manager. As a result, the agent agrees to be monitored as part of his/her employment contract. Auditing appears to be a cost-effective form of monitoring.
The empirical evidence suggests auditing was demanded prior to government regulation such as statutory audit requirements. Additionally, many private companies and other entities not subject to government auditing regulations also purchase various forms of auditing and assurance services.
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There is a natural conflict of interest in the agency relationship between an owner and manager because of differences in the two parties’ goals. For example, the manager may spend funds on excessive personal benefits or favour entity growth at the expense of stockholders values. If both parties seek to maximize their own self-interest, it is likely that the manager will not act in the best interest of the owner and may manipulate the information provided to the owner accordingly.
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Audit risk is defined as the risk that ‘the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated’ (ISA 200).
Materiality: ‘Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.’(ISA 320).
The audit report states that the auditor obtains ‘reasonable assurance’ whether the financial statements are free from ‘material’ misstatement. The term ‘reasonable assurance’ informs the reader that there is some level of risk that the audit did not