This course provides an intensive conceptual and applied introduction to auditing in society. It focuses on concepts and applications related to financial-statement auditors’ professional responsibilities as well as major facets of the audit process including risk assessment and audit reporting. In the U.S. financial-statement audits and related services generally are provided by Certified Public Accountants (CPAs). To succeed in this course, you should anticipate engaging in critical thinking and thoughtful communication about audit professionals' decision environments, decision processes, and deliverables. Additionally, you should understand the macro-level learning objectives in each of the course's weekly modules.
So You Want a Used Car
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Из курса от партнера University of Illinois at Urbana-Champaign
Auditing I: Conceptual Foundations of Auditing
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Mark E. Peecher, PhD, CPAAssociate Dean of Faculty and Deloitte Professor of Accountancy
Department of Accountancy
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.
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 percent of these cars are of great quality,
of a quality you would expect,
and that'll satisfy you.
If that's the case,
you should expect to pay $15,000 for that car but,
and we're making this very very simple.
The other 40 percent 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 states 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 what 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 that 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 you can not 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.
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 owners 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 percent times $15,000 plus
40 percent times $5,000 those coming together to be $11,000.
Now, where did I get that? The 60 percent,
this 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 percent,
are of low quality and the 15 and then five 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's
a fair coin and you would say you would get $10 if
it lands head and zero dollars if it lands tails,
they would not play the game for five dollars.
Risk neutral person would play that game repeatedly for five dollars.
It wouldn't be very exciting for them because
the five dollars is exactly equal to the expected value.
They don't expect to make money by playing that game,
but five dollars 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?
If that's the case,
they are not going to continue to be in that market.
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,
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 going to 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.
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 going to 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 percent.
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 percent likely to be a lemon.
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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