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ふぁっ君特製人参スムージーのレシピを公開してしまおう。ふふっ
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.
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