July 22 Article in “National Underwriter”:

Can Insurance Solve The Auditing Dilemma?

By Joshua Ronen and Julius Cherny

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 won't bite the hand that feeds them.

Solution: redirect the auditor's 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 Chairman Pitt's

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 Gresham's 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 client's 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 management's 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 auditor's 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 organization's 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 insured's

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 insured's management's reputation, integrity, operating

philosophy, financial state and prior operating results.

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

* The potential insured's control environment, and significant management

and accounting policies, practices and methods.

* The potential insured's 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 insured's 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 auditor's 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 fiduciary's

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

expert's 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 auditor's opinion

turns out to be clean. If the auditor's opinion is qualified, the company

can then negotiate different terms with the insurer, which would depend on

the auditor's 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 is a professor of accounting, and Julius Cherny is an adjunct

professor of accounting at the Stern School of Business of New York

University. Mr. Ronen can be reached at jronen@stern.nyu.edu.