The Need for Unbiased Reporting and Independent Assurance
Effective capital markets require quality financial reporting. An organization’s financial statements should reflect a true and fair view of the organization’s financial results. The statements should not favor one user over another. However, the interests of the various users can conflict. Current shareholders might want management to use accounting principles that result in higher levels of reported income, while lending institutions generally prefer a conservative approach to valuation and income recognition. Exhibit 1.2 presents an overview of potential financial statement users and the decisions they make based on the financial reports.
Why do financial statement users need independent assurance about informationprovided by management? Shouldn’t the information provided by management be reliable? The need for independent assurance arises from several factors:
- Potential bias Management has incentives to bias financial information in order to convey a better impression of the financial data than real circumstances might merit. For example, management’s compensation may be tied to profitability or stock price, so managers may be tempted to “bend” GAAP to make the organization’s performance look better.
- Remoteness An organization and the users of its financial information are often remote from each other, both in terms of geographic distance and the extent of information available to the both parties. Most users cannot interview management, tour a company’s plant, or review its financial records firsthand; instead, they must rely on financial statements to communicate the results of management’s performance. This can tempt management to keep information from users or bend GAAP so the organization looks better
- Complexity Transactions, information, and processing systems are often very complex, so it can be difficult to determine their proper presentation. This provides an opportunity for management to deceive users
- Consequences During the past decade, many financial statement users pension funds, private investors, venture capitalists, and banks lost billions of dollars because financial information had become unreliable. As an example, the factors leading up to, and the consequences of, unreliable information can be seen in the subprime mortgage crisis in the United States. Many borrowers did not provide correct information on their loan applications and lenders sometimes did not perform adequate due diligence in making lending decisions. Consequently, various financial statement users and others suffered significant losses. When financial information is not reliable, investors and other users lose a significant source of information that they need to make decisions that have important consequences.
These factors suggest a role for external auditors who are independent. Independence requires objectivity and freedom from bias, and is often referred to as the cornerstone of the auditing profession. Without independence, audits would lack value
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