Demand for Auditing

Question 1

What is information asymmetry?

Answer 1

When one party has information that the other party lacks.

Question 2

What is adverse selection and when does it happen?

Answer 2

A market outcome where a “bad” product or service is at greater risk of selection

Happens when you can’t tell the difference between good and bad products (people cannot be trusted to share information)

Question 3

What is moral hazard?

Answer 3

The taking of risks or actions after an agreed upon contract that place the other party at risk of loss.

Ex: driving riskier after you get your car insured

• taker of risk does not bear the full cost

Question 4

Corporate Example

Answer 4

• a company wants to sell stock to the public
• some IPOs will not be good investment (and managers cannot be trusted to share all information) (adverse selection)
• after the IPO, some managers will cash in and not worry about managing the company, or take big risks, or consume perks (moral hazard)

Question 5

What happens if we do not fix the problem?

Answer 5

• Market for lemons
• Investory reponse to informatio asymmetry is price protection (price protection by paying less or voting with their feet by not buying at all)
• Consequences for the firm are a lower stock price and less funds for investment
• Consequences for society: less investment than economically optimal, good projects do not get funded, bad projects do get funded, lower overall standard of living)

Question 6

How do we remove information asymmetry?

Answer 6

By hiring auditors.

• the third party must be independent of management but have access to management’s information
• reliable third party can give credibility to management’s reports (investors can trust and then pay higher prices, also less bad projects are funded)

Question 7

What are keys to auditing as the solution (3)?

Answer 7

• Investors must perceive the auditor as more trustworthy than management
• Auditor must have the skill to evaluate the information and determine its veracity
• Auditor must be willing to report the resultsto investors

Question 8

Problems with Auditing as a Solution (3)

Answer 8

• Auditor has his/her own objectives/incentives
• Who hires and fires the auditor - management, investors, or bank
• Who pays the auditor? The source of the money is not as important as who decides the amount

Question 9

What were the results from the Audit Experiment?

Answer 9

• greater auditor accuracy produces higher bids from buyers for high/agree reports
• buyers take price protection against low accuracy, but with high accuracy they relax that protection
• higher accuracy maps into higher investment
• the market CAN recover with a high quality auditor (Verifier #4, the government)