Is Insurance A Solution To The Auditing Dilemma?

Is Insurance A Solution To The Auditing Dilemma?

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Audit failures, like stars exploding in the sky, occur all the time, but only the large ones catch our attention.

The alleged Enron and WorldCom audit failures are only the latest and seemingly greatest ones to cross the business sky.

The dearth of constructive suggestions for reforming the audit profession is perplexing. While the accounting firms themselves and Washington legislators have offered some solutions, an overlooked, and perhaps more workable solution beckons from the property-casualty insurance industry.

A proposed solution offered by most of the big accounting firms, fearful of governmental “takeover” and anxious to redeem their bruised reputation, came when they announced they would shed their consulting practices.

Is this enough?

Even without the consulting, a consistent stream of hefty audit fees doled out by the management of the very companies to whose financials the auditors attest is enticing. Is it any wonder that audit firms may indulge the occasional buccaneering client and allow scope to beautify the financials? Auditors wont bite the hand that feeds them.

Solution: redirect the auditors loyalty to the shareholders, creditors and employees whose interests auditors are supposed to serve.

How can this be done?

Government intervention to try to remove improprieties from the audit function does not hold allure.

Harvey L. Pitt, the chairman of the Securities & Exchange Commission, has dismissed the prospect of the SEC taking over responsibility for the audit profession as not viable. He rightly pointed out in his address before the Securities Regulation Institute: “My principal concern with giving government the direct responsibility is that the process will not work as well. It will be slower, of necessity, more bound up in process, and less flexible.”

The now-debated U.S. Senate bill authored by Paul Sarbanes, D-Md., proposing to take the authority to set auditing standards away from the industry and give it to an independent board that would also discipline firms that fail to meet the standard, offers nothing that would alleviate Pitts valid concerns.

Past oversight boards, albeit not controlled directly by the Congress, have obviously failed to bring about effective reforms.

Another proposed Standards Board, controlled by the audit industry, also holds little promise of accomplishing what similar past attempts by the industry failed to achieve. Such a board was proposed in the Republican-backed bill authored by Michael Oxley, R-Ohio, which was already passed by the House.

We need to look for other solutions.

As befitting the free market philosophy of our country, a market-based solution will be preferable. Here is one.

Instead of companies appointing and paying auditors, let them have available the option of purchasing financial statements insurance (FSI), which would provide coverage to investors against losses suffered as a result of misrepresented reports of false profits or misstated assets. Let the presence of insurance coverage that companies are able to obtain become public knowledge, along with the premiums paid for the coverage. And let the insurance carriers appoint–and pay–the auditors that attest to accuracy of the financial statements of the prospective insurance clients.

Those who can announce the higher limits of coverage and the smaller premiums will distinguish themselves in the eyes of the investors from their lesser brethren–the sinners. Every company will be eager to get the coverage lest it be identified as the latter.

A reversal of the dynamics of Greshams Law (which says that bad money or bad practices drive out the good) will be set in operation, resulting in a flight to quality.

Under the current failing arrangement, two issues complicate the task of auditors and accountants: perspective and verifiability.

The client produces the data and prepares the financial statements, and the auditor tests the data for accuracy and evaluates the financial statements for their compliance with Generally Accepted Accounting Standards. The recent rash of disclosed audit failures and restatements seem to suggest that the problem was not that the data was inaccurate, but that it was “misclassified,” producing financial statements that are not in accordance with GAAP.

Why does this happen?

A phenomenon akin to a “Stockholm Syndrome,” wherein the captive identifies with his or her captor, is in display. Since the client selects the GAAP through which the financial statements are cast, the auditor almost certainly adopts the clients perspective.

What prompts the auditor to go along with the client?

The answer lies in the fact that even though the financial statements are claimed to be based on historical transactions, nevertheless, more often than not, a large proportion of these transactions play themselves out in the future. The evaluation of these forward-looking events requires that they be screened through assumptions that are either based on past experience, such as the collection of accounts receivables, or formal and informal models that forecast the probability of a given outcome.

In stable situations, these models can be valid in terms of their forecasts; in unstable (volatile or changing) environments, they can be misleading. Consequently, verifiability becomes an issue.

An auditor adopting the perspective of outside stakeholders–the insurance company providing FSI, shareholders and creditors–would demand a higher degree of verifiability than that which he or she currently is willing to accept.

Having undertaken forward-looking types of transactions, management will argue the validity of its underlying assumptions until proven wrong, which at the time of the audit, almost assuredly in the current arrangement, causes the auditor to give the client the benefit of the doubt.

In the insurance arrangement discussed below, the auditor, because of the incentive structure that inheres in the arrangement, is predisposed to insist on a greater degree of verifiable evidence before he or she would buy into managements position.

From an accounting point of view, this tension may result in burdening the current period and benefiting future periods. The ensuing tension may cause management to be less willing to undertake forward-looking types of transactions and to exhibit greater risk aversion.

From a societal point of view, this may retard progress. However, we believe that, over time, the system as described below will result in an optimal balance between risk taking and the needs of financial statement users.

In our suggested solution, the auditors perspective perforce is changed. The new perspective looks at the financial statements from the outside–in that the auditor now identifies with persons or entities that would suffer a loss in the event of an audit failure.

It is our position that FSI achieves the desired results. The critical elements of FSI are as follows: