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reassurance to potential victims that there will be a fund to compensate them for their injuries, and to establish a basis for shifting all or part of the risk of audit failures from the auditor to the client through increased fees sufficient to cover PLI premium amounts. These insurance roles are performed at a price, however. Insurance premiums include substantial administrative expenses and profits to insurers.(n302) These additional costs add little if anything to social wealth; rather, most of this "overhead" should be added to the aggregate cost of financial "accidents." Therefore, legal rules that would increase the role of insurance are less efficient than rules that encourage actors to bear risk with less insurance.(n303)

When the ex ante risk assessment is highly uncertain, the use of liability insurance can normally be expected to increase. Such is probably the case with auditors operating under the new relaxed privity rules.(n304) On the other hand, to insulate auditors from liability to foreseeable third party victims by a return to Ultramares would reduce the incentive for auditors to prevent harm to those parties. Because it would presumably require less PLI expenditure, the more efficient rule would hold auditors liable only for their share of responsibility for the total harm caused by undetected misstatements -- so long as third parties will be assured of either full ex post recovery from all the culpable parties or ex ante compensation for the risk that some culpable parties will later prove to be insolvent.

Full protection of third parties from the risk of tortious conduct can be obtained in two ways. First, auditors can be assigned initially, through the joint and several rule, the liability risk of their own negligence plus the risk of their clients' insolvency. They would then be free to negotiate higher audit fees that shift the latter risk back to the client. As we have seen, however, the auditor will have great difficulty in calculating this fee component because the risk of harm to relying third party users is a highly uncertain calculation.(n305) And even if the risk of harm were readily calculable, we shall see in a later section that passing it through fully in fee negotiations is problematic in today's auditing environment.(n306) The second, more efficient approach is to encourage third parties to negotiate ex ante the risk of insolvency with the auditors' clients through the use of the pricing mechanisms of ordinary financial markets.(n307)

Agency Effects, Macroeconomic Uncertainties, and Reduced Candor

Accounting firms face three additional difficulties in assessing the probability and extent of audit failure. The first is calculating the probability that individuals associated with the firm will act negligently. Economic analysis of legal rules generally assumes monolithic actors who respond rationally to the incentives of the rule under analysis. But accounting firms, like most organizations, are composed of individuals with personal agendas that are not always congruent with the interests of the firm. Despite stringent supervision and exemplary training, the acts and omissions of individual accountant employees, partners, and non-professional staff members can produce unexpected derelictions that run counter to the firm's interests. This "agency" problem adds yet another dimension of unpredictability and uncertainty to the firm's risk calculus.(n308)

A second problem flows from the unpredictable effects of events external to the audit task about which the auditor has little knowledge and over which he has no control. For example, the collapse of the petroleum-based economies of Texas and Louisiana was probably as great a factor in those states' savings and loan failures as were the fraud and mismanagement of


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