Acme Financial Statement Insurance Company Inc.: A case study;

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The Acme Financial Statement Insurance Company Inc.: A Case Study
Stephen J. Aldersley
Ernst & Young (Canada)
Prologue
At the 1992 Kansas Symposium I made some serious judgmental errors, particu­larly
during the discussion of Jerry Sullivan's article on Litigation Risk Broadly Considered. I made the silly observation that in this quagmire of auditor litigation, there was a business opportunity. It seemed to me that the auditing profession was running an insurance business while not really having any idea as to what the loss ratio was. Why not form an insurance company to offer financial statement insurance rather than audit opinions? After all, the market seemed to want someone to pay for their losses and the auditor was apparently the only party left with any money in a financial failure.
It seems when I open my mouth I often get something caught in it. Almost a year ago, Raj Srivastava asked me to develop the idea more formally and present it at the 1994 Symposium. I accepted the invitation. So much for common sense. Well, here is the result of that analysis, a case study built around a business plan for a financial statement insurance company.
If one considers the number of audits performed on an annual basis, one can only conclude that auditors actually make very few mistakes. In fact, as reported by Palmrose (1988) in her studies of auditor litigation the actual rate at which auditors fail in such way as to cause financial loss is extremely low, much less than one percent of the time. Notwithstanding this remarkable performance, the costs of auditor litiga­tion,
including direct payments, legal costs, and liability insurance premiums (when available), have risen to amounts that are now very significant costs for public accounting firms. As reported by Mednick in a speech at the American Accounting Association's 1993 Annual Meeting, the litigation costs of major U.S. auditing firms have risen to 11 percent of revenues in 1992 and continues to trend upward. This cost does not include the costs that are being added to each and every audit as audit firms react to the increasing exposure by seeking increasingly burdensome auditing stan­dards
and by following defensive auditing strategies.
Should auditor legal costs continue to grow, it will probably not be long before auditing becomes uneconomic. What will evolve to replace the existing framework? Before attempting to answer that question, it is important to recognize that the current litigation environment and the public's expectation of auditors do not exist in a vacuum but as part of society's evolution. In the past, auditor litigation often led the evolution of the audit both in technical terms but more importantly in terms of what should be expected of an audit. While the auditing profession's attempts at bridging the expectation gap are highly worthwhile, they may reveal a more fundamental issue, and that may be a need that the existing framework cannot satisfy.
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