ACCY 405 Chap.3 Demand for Assurance and Who Pays the Verifier
Demand for Assurance and Who Pays the Verifier
The law of assurance
The third class draws a rule out of the market game. The probability of trade increases as buyers bid more and as sellers ask less, so a narrow bid-ask spread signals a likely trade and a smaller information gap.
Assurance can add value only if its fee is less than the benefit it brings and less than the current spread, and the class example shows the fee must be below the difference between the two. In the class's used-car illustration, the maximum fee is the amount by which the buyer's new valuation exceeds the asking price.
Who hires the attester
The class links payment to the nature of the claim.
A standardised assertion of interest to many similar decision makers, cheap to disseminate credibly, is usually paid for by the promiser, which is why companies hire their own financial statement auditors.
A non-standard assertion that matters to a few decision makers with different needs, or that is costly to disseminate credibly, is usually paid for by the trusters, as with transaction services.
Endogenous and exogenous demand
Demand that arises inside the economy is endogenous; demand imposed from outside, for example by the securities acts, the Sarbanes-Oxley Act of 2002 or drug regulation, is exogenous.
Because a legal requirement hides what would happen without it, the course asks whether companies would still be audited if the SEC did not require it.
Arguments that they would include that attestation predates regulation and that many organisations buy audits and other assurance voluntarily.
Four reasons and some evidence
The course gives four conceptual reasons for endogenous demand: signalling against adverse selection, monitoring against moral hazard, reducing information risk, and insurance.
It then turns to the assigned study by Minnis on private firms and bank debt, which tests whether audited firms borrow more cheaply, whether lenders rely more on audited ratios and whether audited earnings better predict future cash flows.
What the class wants you to take away
The session closes with four takeaways: the demand for assurance arises inside the market, the kind of engagement decides who pays, assurance is worthwhile only when its price is below what it adds, and audits do add value.
Each is a claim you should be able to support with an example from the game, a reason for demand, or a finding from the assigned research.
What this chapter covers
- 01
The law of assurance and the fee test
- 02
Promiser-paid and truster-paid engagements
- 03
Endogenous and exogenous demand
- 04
Signalling and adverse selection
- 05
Monitoring and moral hazard
- 06
Information risk and insurance
- 07
Evidence from debt financing
Worked example · free
Apply the fee test to a home inspection
- 1Compute the current spread.
- 1Compute the increase in the buyer's value.
- 2Derive the maximum fee and test a quoted price.
- 2Reason about who pays.
Key terms
- Law of Assurance
- The course's rule that trade becomes more likely as the bid-ask spread narrows and that assurance adds value only when its fee is below the gap it closes.
- Bid-Ask Spread
- The difference between what a seller asks and what a buyer is willing to pay.
- Endogenous Demand
- Demand for assurance that arises within the economy without outside intervention.
- Exogenous Demand
- Demand for assurance imposed from outside the market, typically by legislation or regulation.
- Moral Hazard
- The risk that an agent who cannot be observed acts in its own interest at the principal's expense.
- Information Risk
- The chance that the information behind a business decision is wrong, whether through bias or through poor recording.
Demand for Assurance and Who Pays the Verifier FAQ
When is assurance not worth buying?
When its fee exceeds the extra value it creates for the truster less the existing gap between asking price and bid. In that case the trade still fails, so paying for the report only adds cost.
Why do companies pay for their own audits?
Financial statements are a standardised claim read by many similar investors and creditors, and one audit can serve all of them cheaply. Managers also benefit, because credible statements lower the cost of capital and ease monitoring concerns.
Would companies be audited if the law did not require it?
The course presents arguments that many would: attestation existed before regulation, private companies often buy audits voluntarily, and evidence from bank lending suggests audited firms borrow more cheaply.
Is an audit a kind of insurance?
The course raises the question rather than equating the two. Trusters may recover losses from a company or an insurer after a failure, and large settlements show that auditors can end up bearing losses, but assurance's main role is improving information.
What did the Minnis study examine?
It examined private firms that choose whether to be audited, testing whether audits lower the interest rate on debt, strengthen the link between ratios and loan pricing, and improve how well earnings predict next year's cash flows.
Exam move
Make a two-column sheet: one column for the four reasons for demand, one for a real situation where each applies. Then practise the fee test with numbers of your own until you can derive the maximum fee without looking at a formula.
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