Auditors as Underwriters: An Alternative Framework

Abstract

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.

JEL Classification: M41, M49, K22