Discussant's response to "The Acme Financial Statement Insurance Company Inc.: A case study";

              Discussant's Response to "The Acme Financial Statement Insurance Company Inc.: A Case Study"
Dan A. Simunic
The University of British Columbia
Before commenting on the Acme Case, it is useful to summarize the basic argu­ments
Steve Aldersley makes in his paper, as I understand it.
Summary of Main Arguments
• The legal liability costs incurred by auditors are becoming so onerous - at least 11 percent of revenues and growing - that the business may soon become uneco­nomic.
That is, the supply price will exceed the maximum amount buyers are willing to pay at all possible market quantities of the service.
• While auditors are doing good work - Steve cites evidence on the relative frequency of litigation developed by Palmrose (1988) - they are constantly being harassed in court to demonstrate their due diligence (lack of ordinary negligence). Auditors find this annoying.
• In addition, courts are seemingly holding auditors liable even in cases where residual audit risk has been reduced to an acceptably low level. That is, although reasonable assurance that the financial statements are free of material misstatement has been obtained, auditors are often held liable for losses suffered by investors, creditors, etc. In effect, courts are imposing de facto strict liability on auditors (i.e. demonstrating due diligence is no defense).
• Given this state of affairs, it would be better for all concerned if the "rules of the game" were clarified by acknowledging that auditors are really selling an insurance policy indemnifying financial statement users against losses incurred on account of reliance on materially misleading financial information.
• Therefore, let's set up a business form - an insurance company - which can:
1. Contract with (somebody) to offer such insurance.
2. Only insure against losses arising from unintentional financial statement errors as the base case, with policy riders available to cover misstatements arising from management fraud and/or business failure (inadequate disclosure, etc. of a business's going concern problems).
3. Set specific policy limits (a liability cap).
• Finally, the paper seems to suggest that this insurance company will probably undercut the prices charged by public accounting firms and drive them out of business.
Overall Reaction
My initial reaction on reading Steve's paper was that the Acme Financial Statement Insurance Company was as much (perhaps more) a public accounting firm than an insurance company. That is, it could not set an appropriate insurance premium without performing an extensive investigation of the "client's" accounting system and finan­cial
statement assertions (more on this point later). The major difference, it seems to me, is that Acme is strictly liable for losses, while at the same time Acme can "pick
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