Question

Diamond Corporation has an existing loan in the amount of $ 5 million with an annual interest rate of 5.4 %. The company provides an internal​ company-prepared financial statement to the bank under the loan agreement. Two competing banks have offered to replace Diamond ​Corporation's existing loan agreement with a new one. First Capital Bank has offered to loan Diamond $ 5 million at a rate of 4.1 % but requires Diamond to provide financial statements that have been reviewed by a CPA firm. Money Tree Bank has offered to loan Diamond $ 5 million at a rate of 3.1 % but requires Diamond to provide financial statements that have been audited by a CPA firm. Diamond ​Corporation's controller approached a CPA firm and was given an estimated cost of $ 27 comma 000 to perform a review and $ 62 comma 000 to perform an audit.

A. Explain why the interest rate for the loan that requires a review report is lower than that for the loan that did not require a review. Explain why the interest rate for the loan that requires an audit report is lower than the interest rate for the other two loans.

The interest rate for the loan that requires a review report is___ the loan that did not require a review because of the ___information risk. A review report provides ___assurance to financial statement users. Compared to a review​ report, an audit provides ___assurance and thus___information risk. As a​ result, the interest rate is ___ or the loan with the audit report.

Answer 1

Answer:

The interest rate for the loan that requires review of financial statements by a CPA firm is less than for the loan that does not require a review because of the low information risk.A review report provides moderate level of assurance to the financial statement users which leads to low information related risks.Compared to a review report: an audit provides more assurance and thus least information risk.As a result the interest rate is lowest on the loan with the audit report.

Information Risk for the financial statement users refers to the rises that arises on account of not having relevant information that may impact a company's financial performance and thereby impact their decisions.

For financial statements that do not have any external review or audit and are done only by the internal company :there is high information risk as the company may not disclose relevant information or may manipulate information for their own benefits so as to counter this risk a higher interest rate is charged.

A review of Financial Statements by CPA ensures to some extent that the company does not manipulate information or has not disclosed relevant information and hence the information risk is lower than an un-reviewed one and subsequently the interest rate is lower.

An Audited Financial Statement almost totally ensures that the company does not manipulate information or not disclose relevant information and hence it has the least information risk and hence the lowest interest rate.