1.3 the importance of auditing

to illustrate the need for auditing, consider the decision of a bank officer in making a loan to a business. this decision will be based on such factors as previous financial relationships with the business and the financial condition of the business as reflected y its financial statements. if the bank makes the loan, it will charge a rate of interest determined primarily by three factors:

risk free interest rate. this is approximately the the rate the bank could earn by investing in U.S. treasury notes for the same length of time as the business loan.

business risk for the customer. this risk reflects the possibility that the business will not be able to repay its loan because of economic or business conditions, such as a recession, poor management decisions, or unexpected competition in the industry.

information risk. information risk reflects the possibility that the information upon which the business risk decision was made was inaccurate. a likely cause of the information risk is the possibility of inaccurate financial statements.