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:

The auditor is retained by the FSI insurance carrier that issues the policy.

The amount of insurance and related premium, which are made public, are reflective of the organizations riskiness.

There are two forms of FSI–in-surance and ex-surance.

In-surance addresses the difference between the financial statements on which the auditor has rendered an opinion and what the “true” financial statements are for that date. In-surance is applicable to both private and public companies.

Ex-surance addresses the losses that holders of the potential insureds publicly held securities, stock and bonds, suffer from an audit failure.

In what follows, we will lay out the FSI process in the public company case.

The FSI underwriting procedure starts with a review of the potential insured. The review is performed, on behalf of the FSI carrier, by experts who investigate the nature of conditions such as the following:

The nature, stability, degree of competition and general economic health of the industries in which the potential insured operates.

The potential insureds managements reputation, integrity, operating philosophy, financial state and prior operating results.

The nature, age, size and operating structure of the potential insured.

The potential insureds control environment, and significant management and accounting policies, practices and methods.

The potential insureds accounting system and control procedures.

The FSI process might proceed as follows:

Step 1–Potential insured requests an insurance proposal from the FSI carrier.

The proposal contains, at a minimum, the maximum amount of insurance being offered and the related premium. The proposal request is made prior to the preparation of the potential insureds shareholders proxy on the basis of the underwriting review described above. The reviewer can be the same auditor who will eventually audit the financial statements.

Step 2–The proxy contains the following alternatives to be voted on:

The maximum amount of insurance and related premium as offered in the insurance proposal.

The amount of insurance and related premium recommended by management.

No insurance.

Step 3–If either of the insurance options set forth in Step 2 is approved, then the reviewer and the auditor cooperatively plan the scope and depth of the audit, which the auditor has to satisfy.

Step 4–If, after the audit, the auditor is in the position of rendering a “clean opinion” and the reviewer signs off as well, the policy is issued.

(The carrier would pay the auditor regardless of whether a clean or qualified opinion is issued. Furthermore, the carrier would ask for reimbursement from the company and this would provide additional incentive for the company to maximize the probability of a clean opinion by improving its internal controls and the quality of its financial statements.)

Step 5–The auditors opinion will contain a paragraph disclosing the amount of insurance that covers the accompanying financial statements and the associated premium.

The FSI concept also contemplates an expeditious claims settlement process.

The FSI carrier and potential insured cooperatively select a fiduciary organization whose responsibility is to represent the financial statement users when an audit failure claim is made. Part of the fiduciarys responsibility is the assessment of claims before notifying the FSI carrier.

After the fiduciary notifies the FSI carrier of a claim, the FSI carrier and fiduciary mutually select an independent expert to render a report as to whether there was an audit failure and if it did give rise to the amount of losses that resulted. Within a short period of time after receiving the experts report, the FSI carrier compensates the fiduciary up to the face amount of the policy for the damages.

Under this proposed arrangement, insurance carriers will be happy to supply the coverage. Why shy away from lucrative new business?

But they will want to properly gauge the risk they face. Should they extend the coverage? How much premium should they charge?

The carriers will now find it useful to engage–and pay–the auditors to opine on the financials of the insurance seekers. The opinion, publicized along with the financial statements, will help the carrier more sagely to decide on coverage and premium. (The originally proposed coverage and premium will be binding on the insurance carrier if the auditors opinion turns out to be clean. If the auditors opinion is qualified, the company can then negotiate different terms with the insurer, which would depend on the auditors findings and reasons for qualification.)

Consider the benefits for the shareholders and creditors. By knowing the amount of insurance coverage (or its absence) that comes with the securities they buy, investors will be able to tell which public companies are the “golden geese” and which the “ugly ducklings.” Moreover, the conflict of interest of the auditors–so heatedly denunciated in the aftermath of Enron–will plague no more. By changing the hand that feeds the auditor, everybody will be better fed.

And finally, the auditor could go about his or her work free of apparent conflict of interest and client pressure to present “the best accounting face.”

FSI is a positive sum game for all.

Joshua Ronen (left) is a professor of accounting. He can be reached at jronen@stern.nyu.edu. Julius Cherny is an adjunct professor of accounting at the Stern School of Business of New York University.


Reproduced from National Underwriter Life & Health/Financial Services Edition, August 12, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.