Question

the owner-manager (OM) would sell a part of his/her equity shares to outside investors, mostly because OM (1) needs external funds to finance growth & expansion; (2) wants to reduce the risk of business failure (risk sharing); and (3) enjoys the perks at the expense of outside investors.

(i) Suppose that OM, instead of selling equity shares, decides to sell unsecured long-term debt like debenture (under the firm's name). Would reasonable investors in the financial market be interested in buying the firm's debenture? If not, why not?  

(ii) Do you think the role of auditors to those debenture-holders should be different from that to the equity-holders?

Hint for (i) - In reality, stock IPO (or venture capital) is only a plausible option for initial external financing for OM. So, short answer to the question would be no (because of market failure).

Answer 1

(i) due to initial external financing for OM , reasonable investors wont be interested in buying the firm's debenture because it would have already been a wide distribution of power of management and besides this no major investor would have been standing due to selling his/her part of equity shares. so the investors would not feel safe for investing in this company. So i guess management would have to go for IPO

(ii) In reality the auditor has no responsibility towards the debentureholders. Auditor is responsible for correcctness of financial books of accounts only and to check whether all laws have been complied with, in order to give his opinion to the members(shareholders) of the company.

but yes the role of auditors to those debenture-holders should be different from that to the equity-holders because the debentureholders are interested in knowing whether their investment is safe or not and thet will they get interest payments on time or not and while shareholders are more interested in profit making and growth. Auditor should check how much safe is the investment of debentureholders and whether the entity will be able to fulfill it's obligations towards them or not.

while for shareholders , auditor should check whether management is being done properly or not and whether ther are any chances of profit making or not.