Auditors As Underwriters

Blackwell Publishing Ltd.Oxford, UK and Malden, USAIJAUInternational Journal of Auditing1090-67382005 Blackwell Publishing Ltd.
March 200591119Auditors as Underwriters: An Alternative FrameworkSudip Bhattacharjee et al.
International Journal of Auditing

Int. J. Audit. 9: 119 (2005)
Auditors as Underwriters:
An Alternative Framework
Sudip Bhattacharjee,1 Kimberly Moreno2 and
James Yardley1
1
Virginia Polytechnic Institute and State University

University of Massachusetts Amherst
In the United States, auditors are required to examine clients

financial statements in compliance with generally accepted
auditing standards (GAAS) and provide an audit opinion to
assure investors that the statements are free of material
misstatements. Since investors must trust the auditor in order
for them to gain assurance from the audit report, we reason
based on prior literature that the current process of regulation
is based on a trust framework. However, given the current
crisis in confidence resulting from recent accounting scandals,
we argue that an institutional system based on trust must be
rethought. In this paper, we propose an alternative framework
for auditing that would meet investors needs to reduce or even
eliminate information risk while transforming this trust
framework. In this model, the need for a traditional financial
statement audit leading to an audit opinion would be
eliminated since regulators could require that public
companies purchase insurance from insurance companies
to indemnify their financial statements against material
misstatement. The insurance company would hire an auditor
to act as an underwriter to assess the risk of material
misstatements in the financial statements. The auditor, in
the capacity of underwriter, would assess the risk to determine
the amount of the insurance coverage and premium. We
believe that the proposed model will allow the SEC and the
stock markets to more effectively accomplish their goal of
eliminating or significantly reducing investors information
risk, while restoring investors confidence and trust in financial
reporting.
Key words: Investor trust, regulatory environment, independence, conflict of interests, insurance
Correspondence to: Kimberly Moreno, Associate Professor,

Department of Accounting & Information Systems, Isenberg
School of Management Room 343, University of
Massachusetts, Amherst, MA 01003-4915, USA. Email:
kmoreno@som.umass.edu
SUMMARY
In the United States, auditors are required to
examine clients financial statements in compliance
with generally accepted auditing standards
ISSN 1090-6738
Blackwell Publishing Ltd 2005. Published by Blackwell Publishing, 9600 Garsington
Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
(GAAS) adopted by the USs PCAOB, and provide

an audit opinion to assure investors that the
statements are free of material misstatements.
Investors are expected to incur investment risk, but
not information risk. We refer to this process as
the assurance model. While the assurance model
is the basis for current SEC and stock exchange
regulations over auditors, we identify two
problems with the existing model.
First, in the assurance model, an audits value
depends on the assurance provided to investors.
Trust is a necessary element in the assurance
process since investors must trust that the auditor
is capable and willing to provide this information
assurance (Kinney, 2001). A lack of trust in
the financial information may result in an
unwillingness by investors to take investment risks
(Seal & Vincent-Jones, 1997). However, in the light
of Enron and other recent accounting scandals,
the publics perception of the auditor acting in
their best interest has been questioned. As SEC
Chairman Pitt recently stated, We are in a crisis
of confidence. In effect, public confidence in
the financial reporting/attestation process is
low (Revsine, 2002). Therefore, we argue that
an institutional system based on trust must be
rethought.
A second problem with the assurance model
is that the auditor is not held liable for providing
the product desired by the regulators. That is,
while the regulatory objective of an audit is to
provide assurance to the investor by eliminating
information risk, the professional standards and
courts focus on the audit process and compliance
with a GAAS audit. The problem is that
compliance with GAAS (or any other predefined
set of standards) does not eliminate or sometimes
even substantially reduce information risk. In
effect, the financial statement audit falls short of
meeting the regulators goals.
We propose that these rule-makers can
substantially reduce, or even eliminate, a markets
information risk and resolve these problems with
the assurance model by restructuring their
requirements. Rather than mandate that auditors
provide a financial statement audit opinion that
may or may not assure investors regarding
information reliability, the SEC could require that
companies indemnify their financial statements
against material misstatements. We refer to this
process as the underwriter model for auditing. In
this framework, the need for a traditional financial
statement audit that provides an opinion would be
Blackwell Publishing Ltd 2005
Sudip Bhattacharjee et al.
eliminated since regulators would require public

companies to contract with insurance companies
to indemnify their financial statements against any
material misstatements. Public companies would
purchase insurance to protect themselves from
losses arising from any material misstatements
in their financial statements. The insurer would
determine a premium, write a policy, and pay
any damages that result. To determine the risk
associated with a policy, an insurer would contract
with an auditor who would act as an underwriter
(i.e., assess and classify the applicants for
insurance). The auditor would assess the risk that
the financial statements of the insured company
contain material misstatements and receive a fee
for their underwriting services directly from the
insurance companies. Our model differs from
recent work by Ronen (2002) in that it draws upon
the trust literature to make the auditor the
centerpiece of the audit and suggests the need to
eliminate the traditional financial statement audit
to help restore investors trust in the auditors. We
believe maintaining the requirement of providing
an audit opinion would continue to put pressure
on the auditor to support company-preferred
reporting methods. Moreover, an audit opinion
adds an unnecessary mixed signal to investors
in the proposed model since now the mix of
insurance premium and coverage will provide the
signal on financial reporting quality.
This model protects investors by providing
public companies with insurance coverage to draw
upon and pay out in case the financial statements
are materially misstated. Investors would receive
greater benefits since they would be protected from
information risk by having the legal right to claim
recourse for losses against the public company
due to materially misstated financial statements.
This would restore investors trust in the capital
markets and auditors. We believe that the
proposed model will allow the SEC and the stock
markets to more effectively accomplish their
goal of significantly reducing or even eliminating
investors information risk, while restoring
investors confidence in financial reporting.
We believe that the proposed models benefits
outweigh its potential costs. While there will be
insurance regulatory costs at the state level as well
as administrative costs for all players involved
(e.g., public companies and external auditors),
these costs may replace existing costs in the current
assurance model. Therefore, many of the costs for
the proposed insurance model are either initial
Int. J. Audit. 9: 119 (2005)
Auditors as Underwriters: An Alternative Framework
administrative costs or replacement costs under

the current assurance model. When compared to
the potential benefits which include restoring
investor confidence in the financial reporting
system, the benefits of the proposed model appear
to outweigh the costs associated with it.
INTRODUCTION
Stock markets function efficiently when
information is fully and fairly available to all
participants. In the United States, the SEC and the
stock exchanges create rules to ensure efficient
operation, including a mandate that financial
statement information is audited each year.
Auditors conduct an examination of the financial
statements in compliance with US generally
accepted auditing standards (GAAS) and issue
an opinion on whether the financial statements
materially conform with US generally accepted
accounting principles (GAAP). The purpose of the
audit is to assure investors that the financial
statements are free of material misstatements, and
the information is full and fair; investors are
expected to incur investment risk, but not
information risk. We refer to this process as the
assurance model for auditing.
While the assurance model is the basis for
current SEC and stock exchange regulations over
auditors, we identify two problems with the
existing model. First, in the assurance model, an
audits value depends on the assurance provided
to investors. Trust is a necessary element in the
assurance process since investors must trust that
the auditor is capable and willing to provide this
information assurance (Kinney, 2001). A lack of
trust in the financial information may result in an
unwillingness by investors to take investment
risks (Seal & Vincent-Jones, 1997). As Levitt (2000)
noted, Trust in the judgment of the public
accountant has helped lay the foundation for the
most vibrant and resilient capital markets in the
world.
To feel trust, investors must perceive that the
auditor possesses benevolence, integrity and
ability, three critical components of trust (Mayer
et al., 1995). In auditing terms, benevolence is the
extent to which the auditor is perceived to act in
the best interests of investors, while integrity
entails, in part, the investors perceptions that
the auditor adheres to a set of principles that
they find acceptable. The auditor must maintain
independence in fact and in appearance and adhere
to professional standards. However, in the light

of Enron and other recent accounting scandals, the
publics perception of the auditor acting in their
best interest has been questioned. For example,
research has shown that when information about
either the integrity or quality of Andersens audit
of Enron was questioned, Andersens other clients
experienced a statistically negative market reaction
(Chaney & Philipich, 2002). This suggests that
when Andersens reputation was damaged by the
Enron audit, investors downgraded the quality of
the audits of other clients performed by Andersen.
As the former SEC Chairman Pitt recently stated,
We are in a crisis of confidence. In effect, public
confidence in the financial reporting/attestation
process is low (Revsine, 2002).1 Therefore, we
argue that these first two components of trust,
benevolence and integrity, may be lacking in the
current environment. The final component of trust,
ability, means that the auditor is able to acquire,
and does acquire, the knowledge necessary to issue
a meaningful opinion. The problem is that, in
todays environment, the actions necessary to
acquire sufficient knowledge of an auditees
businesses and systems (e.g., retention of an audit
client for many years or providing non-audit
services) are the same actions that create an
apparent lack of independence. We propose that
the conflict in these components of trust weakens
this frameworks effectiveness for financial
reporting.
A second problem with the assurance model
is that the auditor is not held liable for providing
the product desired by the regulators. That is,
while the regulatory objective of an audit is to
provide assurance to the investor by eliminating
information risk, the professional standards and
courts focus on the audit process and compliance
with a GAAS audit. The problem is that
compliance with GAAS (or any other predefined
set of standards) does not eliminate or sometimes
even substantially reduce information risk. In
effect, the financial statement audit falls short of
meeting the regulators goals. In the United States,
this situation is further complicated by the fact
that investors are unknown, non-contractual third
parties who are not in privity with the auditor.2
Due to these three party contracts, auditors may be
held liable to parties who are not in privity with
them, and this varies across jurisdictions. These
factors make audit litigation extremely subjective
and complex. In addition, auditors face a greater
likelihood of litigation when a public company
Int. J. Audit. 9: 119 (2005)
files for bankruptcy without a prior going-concern

modified opinion (Geiger & Raghunandan,
2001). If a public company files bankruptcy then
shareholders are often left with nothing after
creditors recover their losses, and the auditor is
their only source for recovery of damages.
However, since an auditor is only responsible for a
GAAS audit and it is often unclear to whom the
auditor is responsible, audit litigation is imperfect
in protecting investors from information risk.
We propose that these rule-makers can
substantially reduce, or even eliminate, a markets
information risk and resolve these problems
with the assurance model by restructuring their
requirements. Rather than mandate audited
financial statements that assure investors regarding
information reliability, the SEC could require that
against material misstatements. We refer to this
process as the underwriter model for auditing.3 In
this framework, regulators would require public
companies to contract with insurance companies
to indemnify their financial statements against
any material misstatements. Companies would
purchase insurance to protect themselves from
losses arising from any material misstatements
in their financial statements. The insurer would
determine a premium, write a policy, and pay
any damages that result. To determine the risk
associated with a policy, an insurer would contract
with an auditor who would act as an underwriter
(i.e., assess and classify the applicants for
insurance). The auditor would assess the risk that
the financial statements of the insured company
contain material misstatements and receive a fee
for their underwriting services directly from the
insurance companies.
Recently a similar model has been proposed by
Ronen (2002) that also suggests the need for
financial statement insurance (also see Ronen &
Cherny, 2003). While the basic steps of our model
are similar to Ronen (2002), we believe that our
underwriter model differs in two important
aspects that make it both more efficient and
effective at addressing the current assurance
models problems. First, unlike Ronen (2002), we
draw upon the trust literature and argue that
investors lack trust in the auditor in the current
assurance model framework. As a result, the
auditor is the centerpiece of our underwriter
model. Second, we suggest that in order to restore
investor trust, the traditional financial statement
audit opinion should be eliminated. We believe
that maintaining this requirement would continue

to make auditors susceptible to pressures to
support company-preferred reporting methods
(Hackenbrack & Nelson, 1996; DeZoort & Lord,
1997). That is, since the audit opinion forces the
auditor to make a dichotomous judgment that can
have severe consequences, auditors will continue
to face conflicts of interest as long as they have
to make this type of judgment. Therefore,
maintaining the requirement of providing an audit
opinion would continue to undermine investor
trust in the auditor that is lacking in the current
environment. In addition, the need for an audit
opinion is eliminated since the insurance company
needs the auditor to perform underwriting services
that result in risk assessment evaluations in order
to determine the mix of insurance premiums and
coverage for the insurance client (i.e., the public
company) rather than a dichotomous opinion.
Moreover, since different public companies will
have different material misstatement risk, if an
audit opinion is required, it is likely that many
companies will receive an unqualified opinion as
well as varied risk assessment evaluations. This
adds an unnecessary and confusing mixed signal
to investors when assessing the financial reporting
quality of public companies.
By eliminating the need for an audit opinion,
our underwriter model creates a framework where
trust is restored since investors would feel that
auditors now have the benevolence, integrity, and
ability to do their job free of any conflicts of
interest. This model also protects investors from
information risk by giving them the legal right
to claim recourse for losses against the public
company due to materially misstated financial
statements.4 In addition, since auditors would now
have the role of underwriter, auditors would be
relieved of legal liability concerns with parties who
are not in privity with them. Instead, investors
would have recourse for losses directly from
the public company. Overall, this model would
enhance the trustworthiness of financial
statements by aligning the interests of all parties
involved.
Whenever a new model is proposed, the costs
of the new model must be considered against
the potential benefits. Insurance regulation costs at
the state level as well as costs to coordinate state
insurance regulation with federal securities
regulation are some start-up costs associated
with the proposed model. While there will be
administrative costs for all players involved (e.g.,
Int. J. Audit. 9: 119 (2005)
public companies and external auditors), these

costs may replace existing costs in the current
assurance model. Therefore, many of the costs for
the proposed insurance model are either initial
administrative costs or replacement costs under
the current assurance model. When compared to
the potential benefits which include restoring
investor confidence in the financial reporting
system, the benefits of the proposed model appear
to outweigh the costs associated with it. The
remainder of this paper discusses the assurance
model and its limitations within a trust framework,
then describes the underwriter model, and finally
elaborates on the need for eliminating the financial
statement audit leading to an audit opinion (as
proposed by our underwriter model) to restore
trust in the auditors.
THE ASSURANCE MODEL

The role of trust
Companies prepare and disseminate financial
statement information to raise capital from
investors. However, investors face the risk of
possible loss due to misinformation provided by
the companies. As a result, companies hire auditors
to perform a financial statement audit, and
investors rely on auditors to provide assurance that
the financial information is credible (see Figure
1 for the basic assurance model). Since the SEC
was established, the external auditors report has
become the primary source of confidence in
financial reporting for investors (Abdel-Khalik,
2002). Assurance is an investors perception that
Company
Prepares financial statements
Provides financial statements to
users (investors)
Purchases audit
increases their confidence in the information. Trust

of the auditor by the investor is a necessary
condition in the assurance function (Kinney, 2001).
Trust forms a basis of confidence between partners
in any relationship that contains risk and
interdependence which are two characteristics of
the assurance function (Bateson, 1988; Garbarino &
Johnson, 1999; Rousseau et al., 1998). Risk is the
decision makers perceived probability of loss; in
the assurance function, it is the investors potential
loss due to information risk. Interdependence
exists when the interests of one party cannot be
achieved without reliance upon another; investors
rely on auditors to eliminate or substantially
reduce their information risk. In effect, trust is an
alternative when a decision maker does not have
full information and implies that the decision
maker is willing to adopt a belief without complete
information (Tomkins, 2001).
Based upon a comprehensive review of the
literature, Mayer et al. (1995) developed a
theoretical model of trust. They suggest that
benevolence, integrity and ability recur frequently
in the literature as critical factors of trustworthiness
(see also Ganesan, 1994; Kumar et al., 1995) (see
Figure 2 incorporating trust in the assurance
model). Although these three components may not
be independent, first we discuss each and then
discuss the potential conflicts between them in the
current auditing environment.
Benevolence and integrity

Benevolence is acting in the best interests of the
trusting party. It is the perception of a positive
Capital
Users (Investors)
Use financial statements to make
capital allocation decisions
Audited Financial
Statements
Audit
Report
Pays for Financial

Statement Audit
Auditor
Issues audit report
based on GAAS audit
Figure 1: The basic assurance model.

Int. J. Audit. 9: 119 (2005)
Company
users (investors)
Purchases audit
Capital
Audited Financial
Statements
Audit
Report
Users (Investors)
Trust that the auditor can reduce
information risk by acting in their
best interests
Pays for Financial

Statement Audit
Provides assurance that
financial statement
information is reliable
Auditor
Issues audit report based on GAAS
audit
Adheres to professional and
independence standards
Perceived to have integrity,
benevolence and ability to perform
a financial statement audit
Figure 2: Trust in the assurance model.
orientation toward the trusting party. Integrity is

defined as the perception that the trustee adheres
to a set of principles that the trusting party finds
acceptable. In an audit framework, professional
standards seek to maintain the perception of
auditors integrity, while independence standards
support the perception of benevolent actions.
The AICPAs code of professional conduct
requires that auditors must maintain a state of
independence in fact and in appearance when
providing audits and other attestation services (AU
section 220.01). Independence, in fact, means that
auditors are mentally objective when obtaining,
examining, and reporting information. That is,
the auditor truly is trustworthy. Independence in
appearance means that a reasonable outside
observer would believe that the auditor is
independent.
Since trust and assurance are perceptions, the
SEC requires that auditors maintain independence
in both fact and appearance (Levitt, 2000; Rockness
et al., 2001). In effect, the ability of investors to
assess the reliability of financial reporting rests
to a large degree on the reputation of the auditor
(Chaney & Philipich, 2002). Therefore, the current
institutional arrangement is based on the premise
that the investor can trust that the auditor has their
best interests in mind. While in theory auditors
are agents of the shareholders, in practice
management is often referred to as the audit client

(Abdel-Khalik, 2002). In addition, given the recent
audit failures, public confidence is understandably
low, and investor trust in the auditor has been
weakened. Therefore, it appears that these critical
components of the trust framework are weakened
in the current audit environment.
Ability
While someone must be perceived as acting with
benevolence and integrity to be trustworthy, a
minimum level of ability is also necessary to gain
trust. Ability is the group of skills, competencies,
and characteristics that allow a party to have
influence within a domain (Mayer & Davis, 1999).
A number of theorists have considered ability or
competence as an essential element of trust (Cook
& Wall, 1980; Butler, 1991; Butler & Cantrell, 1984).
To inspire trust, the domain of ability should be
in a specific area, like a trustee who is highly
competent in some technical area (Jones et al., 1975;
Sitkin & Roth, 1993). In an audit framework, even
if an auditor is deemed to have high integrity or
maintain independence from the client, the auditor
may or may not have the minimum level of
knowledge and capabilities to do the job.
Independence alone will not make an auditor
trustworthy.
Int. J. Audit. 9: 119 (2005)
Developments in the information economy

have led to dramatic changes in an auditors ability
to acquire necessary audit knowledge in the
traditional manner. The complexity and
interdependencies of business organizations
operating within the current global economy
demand new approaches to auditing. In todays
dynamic environment, auditors must gain
knowledge of the nature of the clients business
activities and related business risks, its
organizational structure and internal environment,
and its relationships and interactions with the
external environment to provide assurance on
financial information (e.g., Ballou & Heitger, 2002).
Moreover, in the United States, compliance with
Rule 404 of the Sarbanes-Oxley Act requires the
auditor to have a complete understanding of
the public companys internal control system to
provide assurance on managements internal
control assertions. As a result, in order to audit
todays complex clients effectively, auditors must
have the ability to gain a whole system
representation of how the client organization fits
within the broader economic environment (e.g.,
Bell et al., 1997; Eilifsen et al., 2001).
Conflicts among benevolence, integrity, and ability

in the current auditing environment
A problem arises since the activities that auditors
perform in the current environment to gain
knowledge may reduce their believability.
Consider that one way for auditors to gain a
system representation of their clients is to associate
themselves with a client for many years. However,
familiarity may be perceived to result in overinvolvement with and empathy for managements
worldview, rather than increased knowledge
(Benston & Hartgraves, 2002). Additionally,
performing value-added services for clients,
including tax and some systems consulting, can
enable auditors to gain a greater knowledge of
a clients business processes and systems. With
growing demand for the provision and analysis
of information in the new economy, auditors find
themselves to be part of organizations that offer
a variety of audit and non-audit services (Walker,
1999). Again, while many in the profession
recognize that these changes provide opportunities
to generate additional revenues and to gain a
better understanding of audit clients (e.g., Firth,
1997; Craig, 1999), these services may conflict
with investors views of auditors integrity and
benevolence (Sutton, 1997; Kinney, 1999; Public

Oversight Board, 1999). That is, in the current
environment that includes the assurance model
for auditing, auditors confront a trade-off between
ability, benevolence, and integrity. Possession of
ability assures that the auditor is able to acquire
the knowledge necessary to issue a meaningful
opinion of financial statements. However, the
combination of integrity, benevolence, and ability
assures that the auditor will acquire that
knowledge and use it in the best interests of the
investor, and that the investor perceives this
assurance. The impact of these current conflicts on
trust and assurance is ambivalent.
Legal liability
A second problem with the assurance model is
the potentially differing objectives of regulators,
the profession, and the courts. Regulators want
an audit to provide a product (i.e., assurance to
investors that the financial statements are free from
material misstatements by eliminating information
risk). However, in the professional standards, the
objective of an audit is to issue an opinion that
is based on the auditors reasonable assurance
that the financial statements are free of material
misstatements reducing information risk (see
Figure 3 for auditors legal liability in the assurance
model). Auditors reasonable assurance results
from compliance with GAAS which primarily
entails performing an appropriate audit process.
Similarly, courts hold auditors liable for varying
degrees of negligence on their work during the
audit. For example, third parties turn to the
independent auditor for compensation through
litigation, arguing that had the audit been
conducted properly, the companys financial
problems would have been uncovered and they
would not have suffered losses (Siliciano, 1997).
Since the focus of the profession and the courts is
on the appropriateness of the audit process, audit
failure is not defined by the courts or the profession
as a failure to provide assurance to investors.
Meritorious litigation against independent
auditors includes both substandard financial
statements and substandard audits (Kinney, 1993;
Palmrose, 1997). In fact, in 80% of the cases
involving SEC enforcement actions against
auditors in the period 1987 to 1997, the most
commonly cited problem was the auditors failure
to gather sufficient audit evidence, and in 71%
Int. J. Audit. 9: 119 (2005)
Company
users (investors)
Purchases audit
Capital
Audited Financial
Statements
Audit
Report
Pays for Financial

Statement Audit
Users (Investors)
Trust that the auditor can reduce
information risk by acting in their
best interests
Have recourse to auditor if audit
malpractice occurs
Litigation
based on
due care
Auditor
Issues audit report based on GAAS
audit
Adheres to professional and
independence standards
Perceived to have integrity,
benevolence and ability to perform
a financial statement audit
Provides assurance that

financial statement
information is reliable
Figure 3: Auditors legal liability in the assurance model.
of these cases, auditors failed to exercise due

professional care (Beasley et al., 2001).
The profession and the courts focus on the
audit process rather than the audit product because
the audit product (i.e., assurance to investors)
is subjective. In particular, the maintenance of
trust, which is necessary to provide assurance
to investors, depends on the appearance of
independence. In fact, some accounting researchers
have questioned the practicality of maintaining the
appearance of independence. For example, Kinney
(1999) questioned if any standard-setting body
could possibly prescribe effective standards for all
possible appearances of circumstances. Elliott and
Jacobson (1998) concluded that it is more important
to have a system in place that provides assurance
about the fact of independence than to worry about
subjective appearances.
The complexity of auditors legal liability is
substantially increased by the fact that they are
accountable to unknown third parties (i.e., external
users) who are not privity to any contract. That
is, auditor litigation involves unknown noncontractual third parties. Since the basis of common
law for auditors liability to unknown third parties
varies across jurisdictions, this contributes to
the subjectivity of auditors responsibilities.5 In
addition, there may be a greater likelihood that the
auditor will face litigation when a public company

files for bankruptcy without a prior going-concern
modified opinion (Geiger & Raghunandan, 2001).
In effect, auditors are the last resort for investors
to recover losses since creditors are first in line in
a bankruptcy. However, audit litigation falls short
of eliminating or sometimes even substantially
reducing information risk for shareholders, since
auditors are only responsible for the performance
of an appropriate GAAS audit and there is
ambiguity as to when non-contractual third parties
can recover.
In summary, if GAAS cannot be adequately
specified to achieve information assurance, the
goal of regulation is not accomplished by holding
auditors responsible for compliance with GAAS.
In the assurance model for auditing, the purpose
of the audit is not to perform the audit process.
The regulatory purpose is to eliminate investors
information risk. Performance of the audit in
compliance with GAAS may be a poor surrogate
for investor assurance and information risk
reduction or elimination. In the following section,
we propose a new model for auditing that
potentially eliminates both problems with the
existing assurance model: the lack of investor trust
in the current audit environment and the emphasis
on the audit process rather than the product.
Int. J. Audit. 9: 119 (2005)
THE UNDERWRITER MODEL

Description of the model
Under the proposed model, the SEC would
mandate that all publicly traded companies (the
insured) contract with insurance companies (the
insurers) to indemnify the external financial
statements for losses arising from misstatements.
Failure to obtain a minimum level of insurance
mandated by the SEC would disallow a public
company from raising funds in the public capital
markets (i.e., delisted).6 Similar to automobile
insurance in the United States, the insurer would
provide third-party liability coverage to
compensate the insured for any losses arising from
misstated financial statements. As is the case in
most liability insurance, the insurer undertakes to
assume the obligations imposed on the negligent
party. The financial statement users will have no
direct claim against the insurer. The direct claim
would be against the insured. The insurer would
agree to pay the insured partys losses up to the
limit of the insurance, when such obligations are
due to the acts of the insured and are within the
defined coverage (Vaughan & Vaughan, 2001). A
key aspect of this model is that the auditors role
would be to act as an underwriter for the insurance
company and assess the risk that the financial
statements of the public company are materially
misstated. Therefore, the need for the auditor to
perform the traditional financial statement audit
leading to an opinion would be eliminated. As
mentioned earlier, the basic steps of this proposed
model are similar to Ronen (2002). However, our
model differs in that it draws upon the trust
literature to make the auditor the centerpiece of
the audit and suggests the need to eliminate the
traditional financial statement audit to help restore
the trust in the auditors.
The auditor would now be contracted by the
insurance company to evaluate the public
company and to assist in the underwriting process.
The process of underwriting requires the selection
of the prospective insured according the insurers
underwriting standards (Harrington & Niehaus,
1999). Therefore, the auditor and the insurer would
have to agree on standards for selecting only those
companies whose actual loss experience would
not be above a certain threshold. Next, the insurer
with the assistance of the auditors would select a
portfolio of insured companies such that the risk
profile of the portfolio is financially viable. As is
the case in contemporary underwriting, companies

would be classified into pools or classes of
exposure units and the insured companies would
pay premiums according to their risk profile. Since
the auditors central task would be to perform an
investigation to assess accurately the risk that
the financial statements of the public company are
materially misstated, this would eliminate the need
for a traditional financial statement audit leading
to an opinion.
By using the insurance industry as a framework,
the underwriter model is using an industry that is
both highly competitive and regulated (Cummins
et al., 2001). Currently, in nearly all states, vigorous
competition exists among hundreds of property/
casualty insurers on price and product (Cleasby
& Schroeder, 2000). Moreover, the competition in
the industry is increasing from numerous fronts,
including new integrated financial institutions,
electronic commerce, and continued entry into
the US market by global competitors (Cleasby
& Schroeder, 2000). Furthermore, insurance
regulators are continually using their power to
provide licenses to the insurance companies to
maintain competition in the industry. Given these
trends, there appears to be little risk that the
business of insuring financial statements can be
monopolized by a few companies, thus providing
a marketplace that will remain competitive.
Under the underwriting model, insurance
companies get an opportunity to enter a previously
untapped, lucrative market of indemnifying
companies financial statements against material
misstatement. Although this may seem to be a
departure from the traditional services provided
by the insurance industry, given increased
competition, insurers are now providing several
innovative services which are closely related to
our proposed model. For example, insurance
companies sell a relatively new professional
liability insurance product that provides coverage
to a potential buyer in a merger or acquisition
from assets of questionable value or a breach of
warranty (Lenckus, 2000). This has been designed
to facilitate mergers and acquisitions, since the
buyers can close the deal without holding back the
customary percentage of the purchase price for any
future risk. Similarly, insurers have entered the
environmental impairment liability market where
companies involved in mergers and acquisitions
can purchase pollution insurance (Conley, 2000).
This is important since environmental concerns
can often be a deal-breaker in such transactions.
Int. J. Audit. 9: 119 (2005)
10
Insurers also provide coverage for the threat of

litigation and class actions against board directors,
and for political risks associated with a merger
(Amore, 2000). In all these situations the insurers
are, in effect, selling insurance for information risk
in the financial statements at the time of the
merger.
The model would allow investors to have legal
right to claim recourse for losses against the
insured due to materially misstated financial
statements. Such a claim could result in an out-ofcourt settlement, and, if successful, the investors
would be compensated for losses.7 The insured
could then get reimbursed for such successful
claims from the insurer to the extent that the
insurance coverage applies. Under the proposed
model, investors would be compensated for losses
if the financial statements are materially misstated.
This removes the ambiguity that currently exists
in the assurance model since audit litigation is
often based on whether an appropriate GAAS
audit has been performed. In addition, in the
case of bankruptcy, investors are currently left
unprotected since all assets of a public company in
bankruptcy are paid to creditors, with investors
able to share in the residual assets only. This often
results in auditors getting sued due to their deep
pockets. Under the proposed framework, the
relationship between the investors and public
company would be governed by the laws of twoparty contracts, and the investors could sue the
bankruptcy executors for the losses. In other
words, rather than looking to the auditors deep
pockets for compensation, investors would have
access to the insurance coverage. However, this
would require some changes to current regulation
to ensure that money from the insurance coverage
is protected in the case of bankruptcy. The new
rules would need to mandate that creditors could
not claim the insurance coverage available to
investors since they will be covered by existing
bankruptcy laws.
The public company would contract with an
insurer or several insurers by considering the
financial strength of the insurer, the risk
management services provided, and the cost and
terms of the protection.8 This insurance coverage
will be restricted to the claims against the public
company since company officers are often covered
under separate directors and officers (D & O)
liability insurance given the risks associated
with complying with the Sarbanes-Oxley Act
(Vishneski, 2003). The insurer would negotiate the
terms of the insurance contract taking into account

the public companys risk characteristics and the
provisions of the insurance contract. The insurer
would follow the same procedures for providing
coverage as with any other insurance. That is, the
insurer would ultimately be responsible for the
rate setting, sales and marketing activities, claims
settlement, reinsurance, and investment (Rejda,
1998). However, we propose that the insurer could
outsource the underwriting policy (i.e., the process
of selecting and classifying the applicants for
insurance) by hiring the services of an expert
underwriter (such as the auditor).9
In the United States, the insurance industry
is presently regulated through the three basic
branches of the state governments: legislative,
judicial, and executive (Vaughan, 1986). Each state
enacts laws that govern the conduct of the
insurance industry within its boundaries. The
judicial branch exercises control over the insurance
industry through the courts by rendering rulings
on the constitutionality of state insurance laws
and the actions of the administrators. The central
figure in the regulation of the insurance industry
in each state is the Commissioner of Insurance. The
commissioner frequently makes rulings that have
a binding force of law and exercises judicial power
in interpreting and enforcing the insurance code.
In addition, the commissioner judges the adequacy
of insurance companies capital and surplus and
their competence and experience in the industry.
All state insurance commissioners belong to the
National Association of Insurance Commissioners
(NAIC), which provides a forum for the
commissioners to exchange information and ideas
and to coordinate regulatory activities.
The states require insurance companies to
establish reserves to recognize explicitly their
obligations to policyholders and claimants. In the
United States, the insurance code of most states
specifies the manner in which the reserves must
be computed. Since the primary concern of the
insurance regulators is on the early detection of
potential insolvencies of insurance companies and
prevention of consumer suffering, the claimants
would be protected from losses due to unpaid
claims. Furthermore, the periodic inspection made
by the commissioners office of each insurance
company conducting business in a state would
scrutinize the conduct of the insurance companies.
Therefore, financial statement users would get two
safeguards that they do not have under the current
system. First, unlike the current system where
Int. J. Audit. 9: 119 (2005)
shareholders typically only receive residual

interest during a bankruptcy, investors would be
paid out of an insurance pool which would be
protected in the case of bankruptcy. Second, the
regulatory framework of the insurance industry
would ensure that the insurance company would
be solvent to make any necessary payouts.
The regulatory mechanism and the contract
law protections present in the current insurance
environment ensure that the public will retain
confidence in the insurance companys ability to
make the necessary payments. Given the amount
of regulation in the industry, an insurance
transaction is vested in the publics interest since
the government effectively becomes a party to
insurance contracts (Stark, 1999). In fact, the
industry is often viewed as a quasi-public utility
with the insurance regulator assuring the financial
solvency of each insurance entity and the fair
treatment of the claimants.10 For the underwriter
model, this not only provides the investors the
protection that they require, but it can also help
maintain the publics confidence in the insurance
companys ability to ultimately pay their
claimants. Trust in the financial statements and
capital markets would be restored.
In addition, various market mechanisms exist
that would allow the investor to judge the quality
of the insurance companies. The public can use
private sector insurance ratings services to
investigate the financial stability of the insurance
companies, or get information on the track record
of specific insurers from state insurance
departments. Various private rating agencies such
as Alfred M. Best Co., Standard and Poors Corp.,
and Moodys Investor Services provide ratings for
insurance companies. These ratings are of great
value to investors, regulators, and consumers,
since they have consequences for the insurers
(Schwartz, 1994; Pottier & Sommer, 1999;
Moodys, 1998). For instance, strong financial
ratings give insurers better access to capital
markets, and lower ratings force insurers to sell
their policies at low prices compared to higher
rated firms (Doherty & Tinic, 1981; Berger et al.,
1992). Therefore, the insurance companies have a
vested interest in maintaining their ratings. The
insurance coverage provided by the companies
would free investors to make their capital
allocation decisions with the comfort of knowing
that they are protected from losses arising from
inadequate disclosures or inappropriate choices of
accounting standards (obviously, investors will
11
continue to incur all investment risks associated

with any security).
This model should not lead to increased
litigation since as a practical matter only two
percent of insurance liability claims in the United
States are settled by court verdicts. Insurers realize
that the best interests of all concerned are served
if an out-of-court settlement can be reached with
the injured party. Most liability policies reserve
the right of the insurer to seek out-of-court
mechanisms for resolving disagreements, and the
insurance industry has several alternative dispute
resolution mechanisms which are used to settle
claims (Hicks, 2000). Consequently, only those
cases in which the facts and issues are debatable
reach the courts, and these constitute a relatively
small percentage of the total claims. Given the
track record of the insurance industry, the
concerned parties may use alternative dispute
resolution mechanisms which are seldom currently
available in financial misstatement cases. This
could provide the added advantage of reducing
overall litigation costs.
The proposed underwriter model can enhance
the quality of reported numbers. Currently, due
to the pressures facing auditors in the assurance
model (Houston, 1999; Carcello & Neal, 2000,
2003), auditors have an incentive to conceal
prior period irregularities. Our proposed model,
however, changes the existing culture and the
relationship between the auditor and the client and
therefore makes the auditors more vigilant in
uncovering prior and current irregularities. In
fact, additional features of the proposed model
will make it more likely that misstatements
from previous periods are detected and disclosed.
Unlike auditors in the current model, insurance
companies are in the business of assessing risks,
collecting premiums, and routinely paying claims.
Therefore, once any past irregularities are
uncovered by the auditors, insurance companies
would realize the inevitable public discovery of
accounting irregularities. That is, as actuaries,
insurance companies recognize that the longer the
disclosure of accounting irregularities is deferred,
the greater the snowballing effect, and the larger
the exposure to loss payouts. Therefore, we believe
that insurance companies will have a greater
incentive to voluntarily disclose past errors than
auditors in the current model. In addition, under
the proposed model, insurance premiums are
based on auditors risk assessment and will reflect
the risk of the current years as well as the previous
Int. J. Audit. 9: 119 (2005)
12
years financial statements, whether or not any

prior irregularities were disclosed previously.
Therefore, any year-to-year changes in insurance
premium can provide investors with an additional
signal of increased risk due to prior irregularities.
The proposed underwriter model has the
potential to overcome many of the drawbacks of
the assurance model and restore the trust of the
various players in the capital markets. Since the
insurance company would hire the auditor, this
would eliminate the auditors dependence on
audit clients for audit fees. This would reduce the
pressures that auditors face from client retention
issues. The reduction of such pressures would
substantially alter the investors view of auditors
integrity and benevolence, restoring trust in the
marketplace. As auditors assess the risk associated
with the clients financial statements on behalf on
the insurers, it would be in their best interest to
assess the risk accurately. Failure to do so would
hurt the long-term business opportunities for the
auditor. In this way, the best interests of the auditor
are aligned with the best interests of the investors.
When investors become aware of this arrangement,
the perception that the auditor is willing to act in
their best interests, and that the auditor is adhering
to a set of principles that they find acceptable
(i.e., benevolence and integrity) would be greatly
enhanced. In addition, under the proposed new
framework, auditors competitive strength in the
marketplace would be derived from their ability
to perform the risk assessment and underwriting
tasks effectively and efficiently. Thus, auditors
should be able to take all necessary action (e.g.,
non-audit services) to improve their ability to
perform these risk assessment tasks without any
concerns that such actions would compromise
their work. Therefore, the three key components of
trust (benevolence, integrity, and ability) that were
in conflict with one another under the assurance
model become streamlined to improve investors
trust in the underwriter model. The trust and
confidence of regulators would also be enhanced
since investors would have a direct, contractually
enforceable legal right to claim damages against
the public company for losses arising from
misstated financial statements, and because
auditors would be relieved of legal liability
concerns with parties who are not in privity with
them (Maroney et al., 2000) (see Figure 4 for the
underwriter model).
The proposed underwriter model is designed
to restore confidence in the capital markets
and improve the quality of financial reporting.

However, whenever a new model is proposed, the
costs of the new model must be considered against
the potential benefits. Certainly, the novelty of the
model poses challenges for its implementation.
For example, since the insurance industry is the
centerpiece of the model, there will be insurance
regulation costs at the state level. In addition,
initial costs will be incurred to coordinate the
efforts of insurance regulation at the state level and
securities regulation at the federal level. While
there will be administrative costs for all players
involved, these costs may replace existing costs in
the current assurance model. For example, public
companies will replace their current audit costs
with the costs of acquiring insurance. Auditors will
replace their current external audit costs with
insurance risk assessment costs. Finally, insurance
companies will incur costs to enter a new market
area under the presumption that this will be a
profitable line of business. Insurance companies
will also incur normal costs of doing business
including underwriter fees paid to the auditor
which should be recouped through the premiums
paid by public companies. Therefore, many of the
costs for the proposed insurance model are either
initial start-up costs or replacement costs under the
current assurance model. When compared to the
potential benefits which include restoring investor
confidence in the financial reporting system, the
benefits of the proposed model appear to outweigh
the costs associated with it.
ELIMINATING THE NEED FOR AN

AUDIT OPINION TO RESTORE TRUST
As suggested by our underwriter model, the
traditional financial statement audit opinion
would be eliminated in order to restore investor
trust in the auditors. Auditors will continue to
perform an audit to assess the financial statement
risk when contracted by the insurance company
to assist in the underwriting process. Currently,
the audit opinion compels the auditor to
make a dichotomous decision that has severe
consequences on the public company. As a result,
auditors face pressures from a variety of sources
when making this decision. These include
pressures from the client such as fee pressure and
the pressure for client retention (Houston, 1999;
Levitt, 2000). For example, recent research suggests
that when affiliated directors dominate the audit
committee, management often pressures its
Int. J. Audit. 9: 119 (2005)
13
Capital
Public Company
Provides financial statements
to users (investors)
Purchases insurance
Has ability to recover
successful claims by
investors from insurance
companies
Insured financial
statements
Users (Investors)
Have recourse for losses to public
company if financial statements are
misstated
Seek Damages
Payment
Insurance
Premium
Claim
Insurance Company
Writes policy for financial statement information
Determines premium
Pays claims
Evaluates underwriter (auditor)
Underwriting
Report
Assesses
Financial
Statement Risk
Payment
Underwriter/Auditor
Serves as underwriter
Assesses risk of misstatement in financial
statements and provides risk assessment to
insurance company
Figure 4: The underwriter model.
auditor to issue an unmodified report despite

going-concern issues, and dismiss the auditor if the
auditor refuses to issue an unmodified report
(Carcello & Neal, 2000, 2003). Additional research
also indicates that auditors are pressured by media
reports when providing audit opinions (Joe, 2004).
These findings suggest that the audit opinion
process is susceptible to various pressures which
can greatly diminish the trust that financial
statement users have in the ability of auditors to
provide an objective opinion. Therefore, persisting
with the need to issue an audit opinion (e.g.,
Ronen, 2002) does not address the fundamental
aspect of the current assurance model that is
responsible for undermining the confidence of
investors.
In addition, the insurance company, rather than
the public company, is now the auditors client. To
determine the mix of insurance premiums and
coverage required for the insurance clients (i.e.,
public companies), the insurance company would
need the auditor to perform underwriting services
that result in risk assessment evaluations rather

than dichotomous audit opinions. Therefore, an
audit opinion would be of little use to an insurance
company who is trying to determine whether and
how much insurance to provide to insurance
clients. In addition, under the proposed insurance
model, the existence of insurance, as well as the
mix of insurance premiums and coverage, would
provide a signal to investors on the quality of a
public companys financial reporting. To provide
this type of information to investors, the external
auditor would need only to provide a risk
assessment on the financial statements in the
capacity of underwriter. An audit opinion is not
required and adds an unnecessary level of
complexity. As noted above, eliminating the need
for an audit opinion relieves the auditor of
pressure to make a dichotomous decision that
has severe consequences to public companies. In
addition, since different public companies will
have different material misstatement risk, auditors
will ultimately provide a range of risk assessment
Int. J. Audit. 9: 119 (2005)
14
evaluations in their underwriting capacity.

However, if an audit opinion is required, it is likely
that many companies could receive an unqualified
opinion with varied risk assessment evaluations.
This adds an unnecessary and mixed signal for
investors when assessing the financial reporting
quality of public companies, while making
auditors susceptible to pressure from public
companies.
By proposing to eliminate the need for auditors
to provide an opinion, our model is able to address
the fundamental weakness of the current assurance
model. Since the auditor would now be contracted
by the insurance company to assess the risk of the
public companys financial statements and assist
in the underwriting process, they will not need to
provide the type of dichotomous decision that
ultimately puts pressure on them. In fact, auditors
would be valued and evaluated by their ability to
assist in the risk management process of the
insurer. As the insurer is free to contract with the
auditor, the quality of the underwriting services
will be the primary determinant of the continuing
association between the auditor and the insurer.
Since we are proposing a free market solution,
quality and cost will be the driving determinants
of the two-party relationship between the auditor
and the insurer.
Several characteristics of auditors activities give
them the unique skills to provide the underwriting
services. For example, current GAAS audits
require auditors to obtain an in-depth knowledge
of the audited entity including knowledge of the
organization and operating characteristics, types
of products and services, and capital structure.
Therefore, auditors are already required to obtain
comprehensive business knowledge in relation
to each audit client. Further, it is common for
individual audit practitioners to serve several
audit clients at any given time. This gives auditors
comprehensive business knowledge of several
different business entities in a number of different
industries. Therefore, auditors are uniquely
qualified to provide underwriting services to
insurance companies on an advisory basis.
The underwriter model can also alleviate some
of the auditors legal liability concerns. Currently,
audit failure and the accompanying legal liability
are often determined by the appropriateness of
the audit process. Since the proposed model
changes the role of auditors to underwriters with
no requirement to provide an opinion and also
indemnifies the financial statement users for
potential losses, the auditors legal liability

exposure to unknown parties is minimized.11 Since
standard-setting bodies are unable to prescribe
effective standards for all possible circumstances
(Kinney, 1999), auditors currently have to worry
about providing assurance about the facts, as well
as subjective appearances, to protect themselves
from legal liability. The proposed model will allow
auditors to focus on their product (i.e., information
risk assessment), rather than worry about
subjective considerations regarding the audit
process. In addition, investors trust will be
restored since the current complex auditor
litigation environment will not be their only
recourse for seeking damages. Therefore, this
model creates a framework where trust is restored
since investors would feel that auditors now have
the benevolence, integrity, and ability to do their
job free of any conflicts of interest.
CONCLUSION
The value of an audit arises from its role in
addressing inherent conflicts between those
seeking capital in the marketplace and those
providing capital. While those seeking capital want
to raise it on the most favorable terms, those
providing capital want to make allocation
decisions based on reliable information. The
conflict arises because capital seekers generally
possess inside information about the issuing
company, and also have the ability to mislead
capital providers about the issuers prospects for
future success (Lambert, 2001). Therefore, capital
providers are inherently disadvantaged in their
ability to control, negotiate, or evaluate the terms
of offerings and the trading prices of securities. In
the current framework (i.e., the assurance model),
auditors can only add value to capital markets and
protect the interests of capital providers by being
independent of capital seekers in both fact and
appearance (Johnstone et al., 2001). However, given
recent events, we argue that a lack of trust has
developed with investors perceiving that auditors
are acting in their own self-interest instead of
providing assurance to financial statement users.
In this paper, we propose an alternative
framework to alleviate some of the problems
with the assurance model by restructuring the
requirements of regulators. We propose that rather
than mandate an audited financial statement
opinion that assures investors regarding
information reliability, regulators could require that
Int. J. Audit. 9: 119 (2005)

against material misstatement. A fundamental and
distinguishing feature of our model is that it calls
for the elimination of the financial statement audit
opinion. Eliminating the need for an audit opinion
relieves the auditor of pressure to make a
dichotomous decision that has severe consequences
to public companies. In addition, an audit opinion
is not required since the insurance company, who
is now the auditors client, needs the auditor to
perform underwriting services that result in risk
assessment evaluations rather than dichotomous
audit opinions. Furthermore, since different public
companies
will
have
different
material
misstatement risk, if an audit opinion is required,
it is likely that many companies will receive
an unqualified opinion as well as varied risk
assessment evaluations. This adds an unnecessary
and confusing signal for investors when assessing
the financial reporting quality of public companies.
All parties would benefit from the proposed
model. For example, auditors would be alleviated
of their legal liability concerns with parties who
are not in privity with them, and the insurance
companies could expand into a new market with
an expert underwriter available for hire. The SEC
and the stock markets would accomplish their goal
of eliminating or significantly reducing investors
information risk. Investors would have the legal
right to recover losses due to materially misstated
financial statements, while public companies could
be protected from these losses with insurance
coverage. Taken together, the proposed model can
align the self-interests of all parties involved and
thereby enhance the trustworthiness of financial
statements. We believe that the proposed models
benefits outweigh its potential costs. While there
will be insurance regulatory costs at the state level
as well as administrative costs for all players
involved (e.g., public companies and external
auditors), these costs may replace existing costs
in the current assurance model. Therefore, many of
the costs for the proposed insurance model are
either initial administrative costs or replacement
costs under the current assurance model. When
compared to the potential benefits which include
restoring investor confidence in the financial
reporting system, the benefits of the proposed
model appear to outweigh the costs associated
with it.
With rapid changes in technology and the capital
markets, the business of auditing is itself in a
state of flux. Among other things, auditors are
15
embracing multidisciplinary practices that include

legal practice (Frank et al., 2001), providing
assurance on subject matters other than financial
statements (e.g., ASB, 2001). These transformations
will continue to put additional pressures on the
traditional attestation function such that the value
of the audit may itself be called into question
(Levitt, 2000). As pressures increase in light of the
Enron scandal, a rethinking of the traditional
framework may be useful. Currently, analysis
of the value of the audit and role of the auditor
is often intertwined with issues such as
independence and legal liability. This paper makes
an attempt to change the structure of the audit
environment, thereby removing some of the
existing constraints. While additional research
needs to provide a more detailed account of the
role of the various parties in the proposed
underwriter model, research that seeks to look at
the existing audit structure through a different lens
can contribute to the current debate facing the
profession.
ACKNOWLEDGEMENTS
We thank Laurie Pant and Lew Shaw for their
helpful comments and suggestions. All authors
made equal contributions to this project.
NOTES
1. While there have been calls for reform in the
past, thus far no radical change has occurred.
However, public confidence in the financial
reporting/attestation process is low, and many
individuals, including former SEC Chairman
Pitt, have argued that we are indeed in a crisis
of confidence. Therefore, the magnitude of the
frauds and investor losses experienced in the
past few years is indicative that change may be
likely. In addition, the passing of the SarbanesOxley legislation is an indication that investors
and Congress want change.
2. Auditors have a contractual relationship only
with the public company they are hired to
audit.
3. Our proposal is distinct from the insurance
hypothesis that exists under the assurance
model (Chow et al., 1998). In the insurance
hypothesis, investors believe that the role of
the audit is the elimination of information risk.
As a result, auditors are liable, like insurers,
when an unqualified opinion accompanies
Int. J. Audit. 9: 119 (2005)
16
4.
5.
6.
7.
materially misstated financial statements. In

other words, auditors are held liable for
investors losses regardless of due care since
they are viewed as insurers. However, many in
the profession reject the notion of auditors
being viewed as insurers. For example, Elliott
(2001) proposed and rejected the concept of an
auditor providing insurance in the current
environment. We concur with Elliot and do not
conceive of auditors as insurance providers. In
fact, under the proposed underwriter model,
insurance companies are the insurers and
auditors serve as underwriters.
The insurance coverage will only protect
investors from losses arising from inadequate
disclosure or material misstatement of
financial statements. Investors will continue
to incur investment risks associated with
the price fluctuations of securities.
Investors can also sue auditors under securities
laws. In an attempt to reduce the amount of
frivolous class action lawsuits under the
securities laws, Congress passed The Private
Securities Litigation Reform Act of 1995.
However, a report released by the National
Economic Research Association found both
that the proportion of federal class action suits
against auditors has not declined since the
enactment of the Reform Act and that more
plaintiffs are suing auditors in state court
(Public Accounting Report, 1996).
Since the insurance coverage will be
compulsory, public companies who fail to get
coverage will not be allowed to list their
securities in the capital markets. They may
elect to go to the private equity market to get
capital as do companies that currently get
delisted from stock markets for lack of an
audit. Alternatively, public companies can take
steps to reduce their risk so that they are able
to obtain insurance coverage at a price they
can afford. Our model assumes that the free
market mechanism will dictate which public
companies receive insurance coverage.
Therefore, no specific guarantee fund will
cover cases where the insurer is insolvent or if
the insurance is invalid. Rather, we assume
that regulatory and other safeguards currently
existing in the insurance industry will be
maintained and would seek to prevent such
eventualities.
The insurance industry is already involved in
helping settle shareholder litigation costs and
awards. However, currently seeking insurance

claims from auditors is a tedious process.
Investors must sue auditors and win.
Moreover, since most audit firms are in
insurance pools with other audit firms, there is
a limit to the amount of payoff that investors
can get (e.g., Andersen and Enron). However,
we propose a more simplified system where
investors claims get processed more directly
and are bound by simple two-party contracts.
8. Under the proposed model consideration
should be given to the possibility of a liability
insurance crisis. The liability crisis in the
United States from late 1984 to 1986 was
characterized by limited availability of
insurance coverage and extreme increases in
premiums (Lai et al., 2000). While there is much
disagreement about the causes of the crisis,
increased civil liability, poor underwriting,
and exaggerated estimates of future losses by
insurers are some reasons that have been
discussed (Willard & Perlman, 1986). To avoid
a similar crisis several mechanisms have been
proposed. Tort reform to limit the amount of
awards and liability of insurers, and improved
risk management to avoid poor underwriting
services are ways the insurance industry can
try to balance their risks (Smith, 1987; Ward,
1988). Certainly, these are issues that the
insurance industry would need to consider
when assessing the viability of the proposed
model.
9. While we propose that public companies
get insurers to indemnify financial statements
for losses arising from misstatements, we do
not suggest that the criminal liability of
corporations
for
misleading
financial
statements need to be changed. Recently,
under Sarbanes-Oxley, CEOs and CFOs have
become directly responsible for meeting their
companys financial disclosure requirements.
CEOs and CFOs must personally certify that
the financial information contained in their
companies quarterly and annual reports are
not false or misleading. In addition, stiff
criminal penalties have been proposed for
the destruction, alteration, or falsification of
records during investigations and bankruptcy.
These criminal liabilities will remain in place
in the proposed underwriter model.
10. While we affirm that the insurance industry is
highly regulated, we are not proposing that
the government is going to act as a guarantor
Int. J. Audit. 9: 119 (2005)
and necessarily bail out the industry from

financial distress. Rather, the regulation may
provide early warnings of insurance company
bankruptcy
and
discourage
insurance
companies from taking unwarranted risks.
Ultimately, our solution is still a free market
framework
with
limited
government
intervention.
11. Since we are proposing a two-party contractual
relationship between the insurance company
and auditor, the auditor could be sued for
breach of contract. However, this two-party
contract
framework
greatly
simplifies
auditors current legal liability to unknown
third parties.
REFERENCES
Abdel-Khalik, A. (2002), Reforming corporate
governance post Enron: Shareholders board of
trustees and the auditor, Journal of Accounting and
Public Policy, Vol. 21, pp. 97103.
Amore, J. (2000), Insurance tools for deals interrupted,
Risk Management, Vol. 47, No. 10, pp. 5052.
Auditing Standards Board (ASB) (2001), Statement on
Standards For Attestation Engagements (SSAE) No. 10,
AICPA: New York.
Ballou, B. & Heitger, D. (2002), Potential impacts of
recent developments in audit methodologies on how
audit evidence is gathered, documented and evaluated.
Working Paper, Auburn University.
Bateson, P. (1988). The biological evolution of
cooperation and trust. In Trust, Gambetta, D. G.
(eds). Basil Blackwell: New York.
Beasley, M. S. Carcello, J. V. & Hermanson, D. R.
(2001), Top 10 audit deficiencies, Journal of
Accountancy, Vol. 191, No. 4, p. 63.
Bell, T., Marrs, F., Solomon, I. & Thomas, H. (1997),
Auditing Organizations Through A Strategic-Systems
Lens, KPMG LLP: New York.
Benston, A. I. & Hartgraves, L. (2002), Enron: What
happened and what we can learn from it, Journal of
Accounting and Public Policy, Vol. 21, No. 2, pp. 105
127.
Berger, L. A., Cummins, J. D. & Tennyson, S. (1992),
Reinsurance and the liability insurance crisis,
Journal of Risk and Uncertainty, Vol. 5, pp. 253272.
Butler, J. K. (1991), Toward understanding and
measuring conditions of trust: Evolution of a
conditions of trust inventory, Journal of Management,
Vol. 17, pp. 643663.
Butler, J. K. & Cantrell, R. S. (1984), A behavioral
decision theory approach to modeling dyadic trust
in superiors and subordinates, Psychological Reports,
Vol. 55, pp. 1928.
Carcello, J. V. & Neal, T. L. (2000), Audit committee
composition and auditor reporting, The Accounting
Review, Vol. 75, No. 4, pp. 453467.
17
Carcello, J. V. & Neal, T. L. (2003), Audit committee

characteristics and auditor dismissals following
new going-concern reports, The Accounting Review,
Vol. 78, No. 1, pp. 95117.
Chaney, P. K. & Philipich, K. L. (2002), Shredded
reputation: The cost of audit failure, Journal of
Accounting Research, Vol. 40, No. 4, pp. 12211245.
Chow, C. W., Kramer, L. & Wallace, W. A. (1998), The
environment of auditing. In Research Opportunities
In Auditing: The Second Decade, Abdel-Khalik,
A. R., Soloman, I. (eds), American Accounting
Association: Sarasota, FL.
Cleasby, D. & Schroeder, N. M. (2000), Regulatory
reform: The consequences of baby steps, Journal of
Insurance Regulation, Vol. 18, No. 3, pp. 288298.
Conley, J. (2000), Hidden dangers: Taking the
uncertainty out of mergers & acquisitions, Risk
Management, Vol. 47, No. 4, pp. 1222.
Cook, J. & Wall, T. (1980), New work attitude
measures of trust, organizational commitment,
and personal need nonfulfillment, Journal of
Occupational Psychology, Vol. 53, pp. 3952.
Craig, J. L. (1999), The CPA and independence:
Illusion or reality?, The CPA Journal, Vol. 69, March,
pp. 1423.
Cummins, J. D., Phillips, R. D. & Tennyson, S. (2001),
Regulation, political influence and the price of
automobile insurance, Journal of Insurance
Regulation, Vol. 20, No. 1, pp. 950.
DeZoort, F. T. & Lord, A. T. (1997), A review and
synthesis of pressure effects research in accounting.
Journal of Accounting Literature, Vol. 16, pp. 2885.
Doherty, N. & Tinic, S. (1981), Reinsurance under
conditions of capital market equilibrium, Journal of
Finance, Vol. 36, pp. 949953.
Eilifsen, A. W., Knechel, R. & Wallage, P. (2001),
Application of the business risk audit model: A
field study, Accounting Horizons, Vol. 15, No. 3,
pp. 193208.
Elliott, R. K. (2001), 21st century assurance, Speech at the
AAA Auditing Section Midyear Meeting. Houston,
TX.
Elliott, R. K. & Jacobson, P. D. (1998), In search of
solutions: SEC independence concepts, The CPA
Journal, Vol. 68, No. 4, pp. 1420.
Firth, M. (1997), The provision of nonaudit services by
accounting firms to their audit clients, Contemporary
Accounting Research, Vol. 14, No. 2, pp. 121.
Frank, K. E., Hanson, R. K., Lowe, D. J. & Smith, J. K.
(2001), CPAs perceptions of the emerging multidisciplinary accounting/legal practice, Accounting
Horizons, Vol. 15, No. 1, pp. 3548.
Ganesan, S. (1994), Determinants of long term
orientation in buyer-seller relationships, Journal of
Marketing, Vol. 58, April, pp. 119.
Garbarino, E. & Johnson, M. S. (1999), The different
roles of satisfaction, trust, and commitment in
customer relationships, Journal of Marketing, Vol. 63,
No. 2, pp. 7087.
Geiger, M. A. & Raghunandan, K. (2001),
Bankruptcies, audit reports, and the reform act,
Int. J. Audit. 9: 119 (2005)
18
Auditing: A Journal of Practice and Theory, Vol. 20,

No. 1, pp. 187195.
Hackenbrack, K. & Nelson, M. W. (1996), Auditors
incentives and their application of financial
accounting standards. The Accounting Review, Vol.
71, January, pp. 4359.
Harrington, S. E. & Niehaus, G. R. (1999), Risk
Management and Insurance, Irwin/McGraw-Hill:
New York.
Hicks, B. (2000), Alternative dispute resolution, Rough
Notes, Vol. 143, No. 8, pp. 9195.
Houston, R. W. (1999), The effects of fee pressure and
client risk on audit seniors time budget decisions,
Auditing: A Journal of Practice and Theory, Vol. 18,
No. 2, pp. 7086.
Joe, J. (2004), Why Press Coverage of a Client
Influences the Audit Opinion?, Journal of Accounting
Research, Vol. 41, No. 1, pp. 109133.
Johnstone, K. M., Sutton, M. H. & Warfield, T. D.
(2001), Antecedents and consequences of
independence risk: Framework for analysis,
Accounting Horizons, Vol. 15, No. 1, pp. 118.
Jones, A. P., James, L. R. & Bruni, J. R. (1975),
Perceived leadership behavior and employee
confidence in the leader as moderated by job
involvement, Journal of Applied Psychology, Vol. 60,
pp. 146149.
Kinney, W. R. (1993), Auditors liability:
Opportunities for research, Journal of Economics &
Management Strategy, Vol. 2, No. 3, pp. 349360.
Kinney, W. R. (1999), Auditor independence: A
burdensome constraint of core value, Accounting
Kinney, W. R. (2001), Accounting scholarship: What
is uniquely ours?, The Accounting Review, Vol. 76,
No. 2, pp. 275284.
Kumar, N., Scheer, L. & Steenkamp, J. E. M. (1995),
The effects of perceived interdependence on dealer
attitudes, Journal of Marketing Research, Vol. 32,
August, pp. 348356.
Lai, G. C., Witt, R. C., Fung, H., MacMinn, R. D. &
Brockett, P. L. (2000), Great (and not so great)
expectations: An endogenous economic explication of insurance cycles and liability crises, The
Journal of Risk and Insurance, Vol. 67, No. 4, pp.
617652.
Lambert, R. (2001), Contracting theory and
accounting, Journal of Accounting and Economics, Vol.
32, No. 1, pp. 387.
Lenckus, D. (2000), Coverage can shift M&A risks,
Business Insurance, Vol. 34, No. 37, p. 36.
Levitt, A. (2000), Speech by SEC Chairman: Renewing the
Covenant with Investors, U.S. Securities & Exchange
Commission: www.sec.gov.
Maroney, P., Pacini, C. & Hillison, W. (2000), Auditor
negligent misrepresentation, Journal of Insurance
Regulation, Vol. 19, No. 1, pp. 2858.
Mayer, R. C. & Davis, J. H. (1999), The effect of the
performance appraisal system on trust for
management: A field quasi-experiment, Journal of
Applied Psychology, Vol. 84, No. 1, pp. 123136.
Mayer, R. C., Davis, J. H. & Schoorman, F. D. (1995),

An integrative model of organizational trust,
Academy of Management Journal, Vol. 20, pp. 709
734.
Moodys (1998), Property and Casualty Insurance and
Reinsurance, Moodys Investors Service: New York.
Palmrose, Z. V. (1997), Audit litigation research: Do
the merits matter: An assessment and direction for
future research, Journal of Accounting and Public
Policy, Vol. 16, pp. 355378.
Pottier, S. W. & Sommer, D. W. (1999), Propertyliability insurance financial strength ratings:
Differences across rating agencies, Journal of Risk
and Insurance, Vol. 66, No. 4, pp. 621642.
Public Accounting Report (1996), Tort Reform, Short
Reform, pp. 15.
Public Oversight Board (POB) (1999), 1999 Annual
Report, Stanford: Connecticut.
Rejda, G. E. (1998), Principles of Risk Management And
Insurance (6th edn), Addison Wesley: Reading,
Mass.
Revsine, L. (2002), Enron: Sad but inevitable, Journal
of Accounting and Public Policy, Vol. 21, pp. 137
145.
Rockness, J., Ivancevich, S. & Keaveny, T. (2001),
Auditor independence: A bit more rope, Financial
Executive, Vol. 17, No. 1, pp. 1822.
Ronen, J. (2002), Post-Enron Reform: Financial
Statement Insurance, and GAAP Re-visited,
Stanford Journal of Law, Business & Finance, Vol. 8,
No. 1, pp. 3968.
Ronen, J. & Cherny, J. (2003), A prognosis for
restructuring the market for audit services, The CPA
Journal, Vol. 73, No. 5, pp. 610.
Rousseau, D. M., Sitkin, S. B., Burt, R. S. & Camerer,
C. (1998), Not so different after all: A cross
discipline view of trust, Academy of Management
Review, Vol. 23, No. 3, pp. 393404.
Schwartz, R. (1994), Good, better, best, ReActions, Vol.
14, pp. 3435.
Seal, W. & Vincent-Jones, P. (1997), Accounting and
trust in the enabling of long-term relations,
Accounting Auditing & Accountability Journal, Vol. 10,
No. 3, pp. 406431.
Siliciano, J. (1997), Trends in independent auditor
liability: The emergence of a sane consensus?,
Journal of Accounting and Public Policy, Vol. 16,
pp. 339353.
Sitkin, S. B. & Roth, N. L. (1993), Explaining the
limited effectiveness of legalistic remedies for
trust/distrust, Organization Science, Vol. 4, pp. 367
392.
Smith, R. (1987), Balancing risks: coping with the
insurance and liability crises, Journal of Property
Management, Vol. 52, No. 2, pp. 710.
Stark, S. J. (1999), Regulatory access to insurer
information, Journal of Insurance Regulation, Vol. 17,
No. 3, pp. 279288.
Sutton, M. H. (1997), Auditor independence: The
challenge of fact and appearance, Accounting
Int. J. Audit. 9: 119 (2005)
Tomkins, C. (2001), Interdependencies trust and

information in relationships, alliances and
networks, Accounting, Organizations and Society, Vol.
26, pp. 161191.
Vaughan, E. (1986), Fundamentals of Risk and Insurance
(4th edn), John Wiley and Sons: New York.
Vaughan, E. & Vaughan, T. M. (2001), Essentials of Risk
Management And Insurance (2nd edn), John Wiley &
Sons: New York.
Vishneski, J. S. (2003), New liabilities created by
Sarbanes-Oxley: are your directors, officers
covered? National Underwriter (Property & casualty/
risk & benefits management edn), Vol. 107, No. 48,
pp. 3840.
Walker, R. H. (1999), The SEC director of enforcement
addresses the importance of being independent.
Auditor independence: The issues, The CPA Journal,
Vol. 69, No. 5, pp. 4450.
Ward, J. O. (1988), Origins of the tort reform
movement, Contemporary Economic Policy, Vol. 6,
No. 3, pp. 97107.
Willard, R. K. & Perlman, P. (1986), The lawsuit crisis:
two perspectives, Insurance Review, Vol. 47, No. 2,
pp. 5862.
AUTHOR PROFILES
Sudip Bhattacharjee is an Assistant Professor of
Accounting at Virginia Tech. He has a Ph.D. in
Accounting from the University of Massachusetts,
19
Amherst. Sudips research interests include

examining decision making in accounting and
auditing contexts using behavioral decision theory.
He has published in the Journal of Accounting
Research, Auditing: A Journal of Practice and Theory,
Journal of Behavioral Decision Making, Accounting
Education: An International Journal, Journal of
Psychology and Financial Markets, and Business
Journal.
Kimberly Moreno earned her Ph.D. at the
University of Massachusetts, Amherst. She is
currently an Associate Professor of Accounting
at the University of Massachusetts Amherst.
Her main research interests are in judgment and
decision making in accounting and auditing
contexts. She has published in Journal of Accounting
Research, Contemporary Accounting Research,
Auditing: A Journal of Practice and Theory, Behavioral
Research in Accounting, and Journal of Behavioral
Decision Making.
James Yardley is an Associate Professor of
Accounting at Virginia Tech. He has a Ph.D. from
University of Illinois at Urbana-Champaign. His
research interests are in auditor decision making,
and he has published in Auditing: A Journal of
Practice and Theory, Journal of Accounting Literature,
and Journal of Accountancy.
Int. J. Audit. 9: 119 (2005)

Auditors As Underwriters

Caricato da

Informazioni sul documento

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Auditors As Underwriters

Caricato da

Copyright:

Formati disponibili

Blackwell Publishing Ltd.Oxford, UK and Malden, USAIJAUInternational Journal of Auditing1090-67382005 Blackwell Publishing Ltd.

March 200591119Auditors as Underwriters: An Alternative FrameworkSudip Bhattacharjee et al.

International Journal of Auditing

Virginia Polytechnic Institute and State University

In the United States, auditors are required to examine clients

Correspondence to: Kimberly Moreno, Associate Professor,

(GAAS) adopted by the USs PCAOB, and provide

Sudip Bhattacharjee et al.

eliminated since regulators would require public