1. Do you think that the auditor’s primary responsibility should be to detect deceptive reporting (e.g., earnings manipulation by management)? Yes or no? Discuss in class.

2. What is information risk? List reasons it is important to society to reduce this risk.

3. Name and describe three theories that explain how audits reduce information risk.

The collapse of Enron and other major corporate scandals of the first decade of this century are a prominent milestone, indicating failure of governance, accounting, auditing, and regulation. The aftermath of these scandals continues to influence 21st-century organizations, including accounting standard setters.1 Important new regulators (such as the Public Company Accounting Oversight Board and regulations (arising from the influence of the Sarbanes-Oxley Act [SOX], 2002) have been created to deal with the many grey areas that characterize corporate activities. Consistent with this concern, accounting standard setters have been urged to take stronger account of how accounting standards can provide relevant information yet not be conducive to fraudulent and unethical reporting.2 Rules-based, compliance-based accounting standards seemingly have strong potential to foster misleading reporting in many contexts, including where corporate leadership is dysfunctional and/or criminal. As a consequence, there is an increasing trend to emphasize ethical reporting, which will have a major impact on the audit function and auditors in the future.

In the chapter, we defined auditing as an activity that reduces information risk. This definition follows from the information hypothesis that is used to explain the demand for external audits. Under the information hypothesis, audit services are demanded to reduce the information risk to users of financial statements. Information risk is the risk that user decisions may be based on incorrect information. Thus, using information risk reduction, auditors must reduce losses due to faulty decisions resulting from errors or irregularities in the financial statements. Losses to investors may also arise because of failure by company management to disclose all the facts about a firm. Auditors help assess whether this information asymmetry is alleviated through proper disclosure. Less-accurate information may also deter investment, so auditing may also alleviate underinvestment in the capital markets and result in better resource allocation in the economy.