Auditing I

Professor Mark Peecher

Module 4: The Value of Audits

Table of Contents
Module 4: The Value of Audits ............................................................................................... 1
Lesson 4-0: Module 4 Overview ......................................................................................................2
Module 4 Overview ...............................................................................................................................................2

Lesson 4-1.1 So You Want a Used Car ..............................................................................................3

Lesson 4-2.1 So You Want a Used Car that Works Part I ...................................................................8
So You Want a Used Car that Works Part I ...........................................................................................................8

Lesson 4-2.2 So You Want a Used Car that Works Part II ................................................................ 13
So You Want a Used Car that Works Part II ........................................................................................................13

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 Auditing I
Professor Mark Peecher

Lesson 4-0: Module 4 Overview

Module 4 Overview

Well welcome back auditing learners, it's good to have you back for another session. I want to
talk to you a little bit about the value of audits. And I want to try to convince you that, you know,
even if a governmental agency were to change the rules in the United States and elsewhere
and say, you know we don't require public companies to get a financial statement audit
anymore. Would that mean that all of a sudden firms would quit getting audits?

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Lesson 4-1.1 So You Want a Used Car

So You Want a Used Car

So, let's think about what drives the value of audits in a simple context, an everyday context,
that you want to buy a new car and in particular, you're keen on getting a 1999 Porsche 911
Turbo. That's a nice looking vehicle in that picture.

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And the problem is you're not really sure if the car that is in that picture is exactly the car you're
going to get, and so when you start looking in the market for these 911s, let's suppose that
about 60% of these cars are of great quality, of a quality you would expect, and that'll satisfy
you. And if that's the case, you should expect to pay $15,000 for that car, and we're making this
very very simple. The other 40% are not reliable. In fact, they are what you might call lemons.
Lemons is a phrase that you often see in the car market and in fact, if you were to go to a car
dealer, you would find that sometimes even on the windows is when they're describing the
options on that car, you will even see an allusion to that state's lemon law. It gives you a right as
a purchaser of a car in states to bring cars back if you can show that it truly is a lemon, and
that's if you're talking to a dealer on a lot. But not everyone from whom you're buying cars is
going to be a dealer. Not that all dealers can be trusted either. But most dealers have a
substantial amount of money invested in their reputation and so they're going to be guarding
that, one hopes.

So, let's think about this a little bit and how would you as someone who wants this car think
about making an offer for the car? So how much would the owner of a 1999 ask for it? So you
have your offering price, that you have, and then you have the owner of a 1999 Porsche Turbo
911 trying to figure out what the asking price is. And in this situation, one very good question to
ask is, does the owner even know what kind of car that he or she has? Is this a good, excellent
condition Porsche 911, or is it a lemon? The other thing you have to worry about is that even if
the owner of that car knew or thought it was a lemon, would that owner be constrained by that
knowledge?

Now you'd like to think, and most people in the world are worthy of trust, you'd like to think you
can trust owners. But unfortunately, some owners would try to sell you the car probably even
with the knowledge that it is a lemon and they'd like to sell you the car without any returns
possible for the price that you would expect to pay for a high quality car. So, in a world in which

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you cannot really revise your beliefs very much about the quality of the car based on the
owner's asking price, that's a world in which you don't pay $15,000 for a car, right? How much
would you pay? So, if you cannot believe the owner at all, when they represent that they have a
high quality car, then you would back away from the owner's asking price and you would come
to a calculation.

A calculation if you were risk neutral, is that you would just take the expected value into
consideration. The expected value would be 60% times $15,000 plus 40% times $5,000, those
coming together to be $11,000. Now, where did I get that? The 60%, it just goes back to that
part of the pie graph where over half of the cars in that market are of high quality, and slightly
less than half is the 40%, are of low quality. And the 15 and then 5 come from the value we are
assuming a high quality car has and a low quality car has in this market. And that's if you're risk
neutral. If you are averse to risk, would you pay higher or lower?

Well if you said lower, you're right. The risk averse is someone who doesn't want to play even a
fair gamble. A risk averse person, if you had them flip a coin and it was a fair coin and you
would say you would get $10 if it lands head and $0 if it lands tails, they would not play the
game for $5. And risk neutral person would play that game repeatedly for $5. It wouldn't be very
exciting for them because the $5 is exactly equal to the expected value. They don't expect to
make money by playing that game, but $5 is a good price to pay for such a game for risk
neutral. Now, if you were a risk taker, maybe you would pay a little bit more. But most people
are not going to be risk takers in a used car market. So let's suppose you are risk neutral and
that would mean you are really indifferent between paying $11,000 and having the car, versus
keeping all of your money and not having the car. Well this is not very satisfactory to the owners
of cars who think that they have good cars, right? And if that's the case, they are not going to
continue to be in that market.

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Sellers who are certain and not even just certain, but people who are quite knowledgeable and
they think they have a good car. What are they going to do? They are not going to be willing to
give up a car that's worth $14,000 or $15,000 in exchange for what buyers are willing to pay,
which is only...risk-neutral buyers, which is only $11,000. So, what does that tell you about the
kind of the cars that are on the market? It should tell you something about the quality of the
cars. You either have a situation where sellers who think they have a good car have to consider
selling the car at some discount. Something less than they believe it is truly worth and probably
something less than it is worth, okay? Or they'll pull out of the market. So you have these two
types of sellers. They know they have a high quality car, they think they have a high quality car,
but the risk averse and risk neutral buyer alike will not pay, certainly not $15,000, and they're
not going to pay any more than $11,000. It's gonna be hard to get some of these buyers to pay
in between $11,000 and $15,000, say something like $12,500. So what you have here with this
market where there's asymmetric information about the quality of the cars, you have a market
that is favoring in terms of what kind of cars are supplied. The kind of cars that are supplied are
going to be the lemons.

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So again, risk neutral buyers are only willing to spend $11,000 therefore, what are the only cars
that will be there, or the preponderance of the cars? They're going to be these lemons. Only
lemons are gonna be offered for sale, but buyers on the market are going to figure this out and
of course $11,000 is going to be way too much to spend for a lemon, because a lemon is worth
only $5,000. So let's think about the market for the used cars. And the procession of thinking
that went through that whole process. You have a market in which over half of the cars are of
high quality, 60%. But because the buyers can't really trust the sellers to accurately represent
that quality, what's ultimately going to be supplied in that market, more often than not, is the low
quality car and when it's a low quality car, the sellers are going to have asking prices still well in
excess of $5,000, probably in the neighborhood of $11,000. Buyers are not going to pay
anywhere close to $11,000 for a car that they now expect to be much higher than 40% likely to
be a lemon. And in fact, if you just do the pure math and you assume that buyers cannot trust
sellers, only lemons would be offered. So, the market then would collapse. What's that do? It
sets the table for the value of an audit.

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Lesson 4-2.1 So You Want a Used Car that Works Part I

So You Want a Used Car that Works Part I

So welcome back audit learners. I want to continue with the used car example because what we
have done in the prior lesson is set the table for the value of an audit. You don't want a used
car, you want a used car that works. And that comes down to let's make this market function
again. Let's make them market such that sellers who have high quality cars are in the market,
so that you as a buyer can go in and buy the car, the kind you want. So what do we need to
happen? Well we need the bid-ask spread to get smaller on the high quality cars. Remember
from the last lesson, that the risk neutral value of the car was $11,000, but the sellers who know
they have a high quality car are asking $15,000. And that difference between the $15,000
asking price and the bid of $11,000, that $4,000 difference, is creating too much friction in the
market. So we need a market where at least one or more buyers bids overlap with the lowest
asking prices and we can think about ways to make the market function again, by bringing in
independent third party assurance.

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Now there's a lot of different varieties of that in the car market. We probably don't call them
auditors all the time, but they function that way. So one thing you can do is go to an auditor. If
you are buying the car, you might ask the seller, hey do you care if I take the car for a spin and
during that time swing by a trusted mechanic. Now this is a mechanic that you would hire, which
is actually sort of different than the financial statement auditing environment and they would
come in... he or she would come in, and look at the car or you might even ask the seller, can I
take this car for an examination by a mechanic? The whole point here, is that the mechanic is
going to be able to offer you a report about the quality of the car and really probably about some
things that need to be repaired on the car to help you with your negotiations.

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So, what else can you do if you don't go...but notice that that mechanic is an auditor. What else
can we do to make the market function again? So, what I want you to do as I talk about each of
these possibilities, is to think about what would be the analogs to these things in the market for
audit services for financial statements. Well one thing you can do, briefly alluded to this even in
lesson one of this module, is that you can abandon the private market, the want ads in
newspapers and online and you could go to a dealer, and you could buy retail with a reputable
dealer. But one thing you will get is, for sure, you're going to have to pay more.

What are you buying though from that dealer? You're certainly buying more than just the car,
aren't you? Because you could buy a car in the private market. What you're buying from the
dealer is not just the car, but also the assurance that that car is going to work as advertised. The
dealer has an investment in his or her reputation. That investment and reputation is partially due
to huge amounts of money they spend on advertising and maybe they even contract with third
parties themselves to get a warranty. Sometimes dealers have their own mechanics, there on
site, other times they will buy for a fleet of their cars warranties basically trying to make the
buyers less worried about the working power, working ability of that car.

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So a really good question for this course is, how much would you be willing to pay for
assurance? Well it depends on how much the mechanic changes your beliefs about the value of
the car, after you get the mechanic's report. Let's assume that you go to a good mechanic and
that mechanic's report moves the probability that the car is good from 60% to 80%. Now I want
you to think for a moment about how much you would pay. Well one thing you should think
about doing is asking yourself, how has the market changed for this car? Now if you're the only
one who has this mechanic's report, you have more information than anyone else, right? If the
seller got the mechanic's report, from an independent mechanic, then anyone who transacts
with that seller would now have a basis to believe it's 80% likely that that car is a good car.

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So let's think about how much buyers would be willing to pay for assurance if they were risk-
neutral. Now, one thing that is important to do is not to forget to include the cost of the
assurance in the full acquisition price of the car. So, if you think about this particular example,
we have a car, that prior to the assurance being provided had an expected value of $11,000.
The mechanic's report moves you from 60% likely to 80% likely that it's high quality. The value
of high quality car, $15,000. If you take that $15,000 times .8 and add to that now 20%
probability times 5,000, you will find that the new expected value of the car is $13,000. But you
wouldn't want to pay $13,000 for the car, because you would be paying that price plus any price
to the auditor and then you would be in a situation where you're paying more than the expected
value.

So, let's suppose the assurance report the mechanic gives you is, well for $200 I'll look at the
car. Well then, what you need to do as a risk-neutral buyer is not elevate the price you're willing
to pay to $13,000 but you stop short of that to $12,800, okay? That's kind of a law of assurance.
You want to make sure that your out-of-pocket cost when you pay for that assurance, plus the
service or the product you're getting after transacting for that assurance together, that expected
value is acceptable to you as a buyer.

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Lesson 4-2.2 So You Want a Used Car that Works Part II

So You Want a Used Car that Works Part II

Now the value of assurance in the used car market is so prolific that one of the most common
ways one sees used cars sold today is certified pre-owned. This is where individuals maybe
take their Porsches or their BMWs or Hondas back to a dealer. They maybe want to get a new
car, or purchase it or lease it, but they went in to give...trade in their car. Rather than just sitting
that car on the lot and putting it for sale, what has been proven to be value, as a valuable
business proposition, is for these dealers to subject these cars to a battery of tests so that you
can put in the window that this is a certified pre-owned car. And the price that you'll have to pay
for a certified pre-owned car is higher than a used car that hasn't been subjected to this audit.
Okay? The same thing is true in financial statement context. Now, in the used car market, there
are couple of other things that you can look at to protect yourself as a buyer.

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One of them, of course, there's this third party organization called the Kelley Blue Book, you
may or may not be familiar with this organization. But they purport, and I think they are pretty
good at being independent, but they purport to give buyers ranges of prices that they should
expect to pay for cars that have different characteristics. Good condition, excellent condition,
bad condition. But what I want to show you here from this particular slide, is that the fair market
range of certified pre-owned cars are higher than the fair market range for a purchase from a
private party. And that's kind of the point of this exercise, because the certified pre-owned is the
auditor. It's actually very, very popular option for automobile purchases.

Just like you would see in a financial statement auditing situation, where you have hundreds of
thousands of companies in the United States that are not a public company. If you talk about
public companies in the United States, and I know many of you may not be residing in United
States, I'm just using it for an example, there are about 10 to 11,000 public companies in the
United States. How many companies do you think there are in the United States? Well if you
were to look at recent census data, you would find that there are over 6 million different
companies. Now some of these are very small, but what you will also find that many of these
private companies get some form of assurance over their financial statements, much like you
see in this car market.

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So let's talk about this in terms of sort of fancy academic jargon. It's always good to know the
jargon for a profession. It gives you an ability to say things in a succinct way and it's a common
way to communicate with other professionals. So what I would like you to know here is that
someone who voluntarily buys an audit, subjects their services or their goods to an audit, what
that does is signal to the market that their quality is legit, that it's a high-quality product. So if
you look across the market and you see some automobile dealers saying, sure, subject it to a
mechanic's look. And others saying, I'm not so sure that's something we want to do. That's a
signal to you. The signal does this to you, it helps you understand which of these sellers actually
have high-quality products. If you're in a market where people are buying audit services, the
sellers, that's going to drive away those people who have low-quality products, who do not want
to buy assurance, because if they were to buy assurance what would happen? Well, it would be
revealed that they're selling low-quality products. When you have the signaling value occur,
when there's money left on the table without the signaling, what happens is that auditing and
here's the fancy term is endogenously demanded, endogenous demand as opposed to
exogenous.

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I understand these are academic terms, but they have a home in economics, that's where they
come from. An endogenous demand is one that bubbles up from within the market. It's one that
exists without a mayor, or a president, or a legislature saying we must have audits. And that's
what you often would see. If you have an audit that is adding value, you would like it to be
demanded endogenously, not just because the government said so.

So real quickly, some of the laws of assurance or the law of assurance we have covered in this
exercise is, are the out-of-pocket costs of assurance less than its benefits? An assurance is
going to potentially add value if the assurance fee is less than the current bid-ask spread. So, in

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our example, remember, the high-quality car was worth $15,000 if you knew for certain, the risk-
neutral buyer is $11,000, it's all he or she will be willing to pay. It's a big bid-ask spread.
Assurance has potential value there, even if it costs as much as $4,000. And of course if it's
$4,000, you can't pay more than $11,000 for the car. That's probably not going to be a workable
solution. But if you can get a seller to agree to some incremental over 11,000, let's say 13,000,
you could afford to pay even $2,000 for that assurance and still be equally well off. You should
understand that the chance of their trading occurring, it increases with increases in the buyer's
bid prices and decreases in the seller's asking prices. But that's just saying that as the bid-ask
spread shrinks, the probability of a transaction increases.

Anytime you look in the market, and it's fun to do this with the Wall Street Journal or New York
Times some big newspaper, you can look at stocks and you can look at their bid-ask spreads.
Stocks that have a larger difference between the bids that buyers are willing to pay and the
asking price is that sellers are asking for, smaller bid-ask spreads tells you that there's lower
information asymmetry. That there's more agreement between buyers and sellers about the
value of that stock or in our case that car.

So, if we were to summarize the two lessons here. So, you want to buy a new car or a used car,
excuse me, and you want to buy a used car that works, what we need to understand is that
information asymmetry can cause market failure. Such that the highest quality service and the
highest quality products are not even offered. The sellers who have these products are scared
away from the market because it can only command prices that are much much lower due to
the presence and threat of low-quality products.

But, the good news is, various kinds of audit related mechanisms bubble up often within the
economy to keep that market functioning. The value of that audit depends, in part, on how much
belief revision occurs as a result of that assurance. Now that last statement is important and it

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can be restated in another way. The value of the assurance depends on the quality of the
assurance. If you have lousy mechanics, they're not going to result in very much belief revision.
But if you have expert mechanics who really understand the Porsche 911, backwards and
forwards, and they are trustworthy, that assurance will be quite valuable indeed.

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