 Hello and welcome to this session in which we will discuss the purpose of an audit and how does the audit reduce something we call information risk. Now think about if you are a loan officer working at a bank and you're trying to approve a loan for a company or you are an investor deciding whether you should invest or not or you are advising someone with money whether they should invest or not. Let's assume as a loan officer, well your choice whether to grant the loan or not relies on how well the company is doing in the past. You can't see the future just we can't if you see the future that's a great. So you have to rely on their financial statements that's presented to you whether you should give the loan or not and what interest rate you need to provide and when you're determining the interest rate while you would look at the risk-free rate you would say okay well if I need to lend the government I will charge the government five percent the government is risk-free. So I'm going to start with this I'm going to add to this interest rate the customer business risk. What's the customer business risk? How risky is that customer in terms of how well are they doing within their industry? How well they are doing against the competition? How resilient are they to a recession? Well giving these factors I might add a few percentage point on the risk-free rate. So I would say maybe five percent is the risk-free rate and their business risk is equal to eight percent therefore together I'm going to charge them 13 percent. So based on risk-free rate and their business risk you will charge 13 percent but there's a third risk and that risk is called information risk. What is the information risk? The information risk is the risk that the information you are relying on is incorrect so simply put remember you are relying on the financial statement to be to to looking at their past performance to predict the future. How about if those statements themselves are unreliable they are they cannot be relied on that's another information risk and if the information risk is high you may either say you know what I am not going to give you the loan or I'm going to add maybe another seven percent to that 13 percent and I'm going to charge you 20 percent. So you have to compensate for that information risk now how can we reduce information risk? What are the reasons for information risk and how can we reduce the information risk? This is what we will discuss in this session starting with the causes of information risk. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead start your free trial today. There are four reasons why we have information risks. We have to kind of establish that we live in a complex society and the four reasons are the distance information which is the remoteness of information, the provider bias and motivation, three is data overload, four is complex transactions. Now if you know anything about farhat and every time I have a list of items I'm going to go over each item separately to basically explain how does each one of these factors cause lead to what we call the information risk. They're pretty self-explanatory but it's worth looking at each one separately. First one is distant sources. What does that mean? It means in a global economy you're going to be might be investing in a company that's in Asia or in Africa or in the Middle East. So you have to make a decision whether you should invest or not. What do you rely on? You rely on information provided by others unless you can travel over there and go and physically inspect the company, look at how well they are doing, inspect it yourself, otherwise you have to rely on information provided. Well that's the case. That's going to increase the risk of intentional or unintentional misinformation. So there is a distance between you and the company. So imagine if you're a small investor looking to invest in a startup located in another country. Well since you cannot visit the company you rely on the report and a case in point is a company called Wirecard. Maybe you heard of it, maybe not. It's a German fintech. It's similar to PayPal. Obviously they went bust. What they did, they claimed that they were growing by buying more companies in Asia. They're building offices, buying companies in Asia and they were reporting on customers that that customer did not exist for them, did not exist. They were not their actual customers. So what happened to this company? It went bankrupt. But people that invested in this company, they relied on the auditors. They relied on someone else. Also another reason for information risk is provider biases and motivation. Whoever's giving you this information, let's assume you're the bank. Well they have a bias. That bias could be deliberate or simply put optimism. All they can skew the data causing some misrepresentation. For example, a borrower might tweak the financial statements to improve their loan chances. Altering numbers or emitting details, fudging earnings to manipulate the stock. It could take any form. A case in point you're going to be learning in this audit course or in your audit course about a company called Enron. Now the sad part about Enron, which is really not a badge of honor for auditors, is the fraud was committed with the help of the auditor, with the help of Arthur Anderson. So they employed various accounting loopholes, something called Special Purpose Entity. I talk about in details in my advanced accounting course and what they did, they took advantage of those loopholes to do what? To fudge the numbers, to hide billions of dollars in debt. And this is what happened to Enron. So notice here, even with the presence of an auditor, we still committed fraud. The provider, Enron, did not give accurate information for the investors and many people were harmed. Another reason for information risk is data overload. So as the company grows, their transaction grows as well. And this surge could do what? Hightening the risk of inaccuracies. Why? Because you have a lot of transaction. Some incorrect transaction might sneak in into the record without being overlooked. For example, a company might overcompensate a vendor by $2,000 an error, and that error might go unnoticed unless you do what? You have some sort of an internal control system that's going to stop these errors from happening. Another reason for information risk is complex or exchanges or transaction. The complexity of transactions is growing over time because of the use of technology, like a cryptocurrency, blockchain, options, so on and so forth. Also, in a merger, when you have a merger, well, that's going to present its own complex accounting challenges. For example, how do you determine the fair value of assets, the fair value of liabilities? A lot of estimates and judgments go on taking place. That's considered complex transaction, especially in mergers and acquisitions. Also, if you are dealing with financial instrument derivatives, how do you value, correct valuation of these accounts becomes very complex? Therefore, information risk goes up. So how do you reduce information risk? You ask a trusted auditor, a competent, independent, trusted auditor. Again, not Arthur Anderson. That's the exception. We're talking about the norm. The norm is an audit will reduce information risk. So users commonly rely on an independent, competent auditor for trustworthy information. And this is the importance of you as a future CPA, future auditor, that the financial market, the economy is relying on your judgment. Therefore, you have to take your job very seriously. It's not your job. It's your career. It's your mission. Because public and private companies hire auditors to vouch for their financial reliability, their financial statements, because they want to raise money, either by borrowing money or selling stocks or bringing more investors on board. So external stakeholders like stockholders, lenders view the auditor's report as a credibility marker. And this is what we have to be. We cannot be Arthur Anderson. That's not what you should be thinking about. This is the exception. The reason we talk about one rule is to look at the exception. There is one Arthur Anderson and millions of other cases where the auditor helps. But we have to learn from companies like Arthur Anderson. So decision makers trust this information for its assumed accuracy and value the auditor's impartial expertise. So you'll have, you are to be going into a profession that has a lot of integrity. If you don't have integrity right now, don't be an accounting major. Find something else to do because you are going to tarnish the image, the reputation of our profession. Let's take a look at a multiple choice questions from far hat lectures. A correct relationship exists between the auditor, the client and the external users when what? Well, let's take a look at the options and see what that relationship, how do we draw this relationship? Well, the clients provide capital to the external users. Not at all. The client don't provide capital to the external users. The client, the client, it means the company that's being audited provides financial information to the users to make a decision. Therefore, A is out. That's not the correct relationship. The external users can depend on the auditor's report to reduce information risk. I would say yes, we have the external users and we have the auditor and we have the client. And the external users like the creditors and shareholders, they do depend on the auditor's report. B looks like a good candidate, but we don't want to jump the gun yet. Let's go to C. An independent auditor is hired by the audit committee of a private company. Well, yes, but that's not the relationship between auditor, client and external users. This is the relationship between the company and the, which is the audit committee and the independent auditor. There's no client involved here. An independent auditor is hired by management of a public company. The independent auditor, this is incorrect, is hired by the audit committee. That's also incorrect and see it's incorrect because it does not include the client as part of this picture. So, B, the external users depend on the auditor's report to reduce information risk that's coming from the client. So, the answer will be B as in void. What should you do now? Go to far hat lectures, look at additional MCQs through false, that's going to help you in your auditing course. Invest in yourself, invest in your career. Accounting and auditing is a rewarding field. Good luck, study hard and have integrity.