Insuring the Integrity of Financial Statements and the Audit Process

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NOVEMBER 2006 - During the past few months, while updating the NYSSCPA’s ethics course, I’ve had opportunity to critically consider the Code of Professional Conduct. The code consists of principles and rules that provide professional guidelines for members in the practice of public accountancy. One of the main premises of the Code of Professional Conduct is independence. Simply stated, it requires that the CPA be independent from the client “in fact” and “in appearance” when providing auditing or other attestation services. But can CPAs be truly independent of those who hire and pay them?

Some will argue that the shareholders vote on the hiring of external auditors, but in reality the shareholders generally follow the recommendation of upper management. Furthermore, the auditors depend on the support of the same company’s management to recommend their continued engagement. Does anyone sense an inherent conflict of interest?

For several years, the idea of inserting a third-party intermediary, such as an insurance carrier, between an auditor and company management has been bantered about but it has never quite gone anywhere. Perhaps the time has come to begin a serious dialogue about whether, and how, the current arrangement of who engages the auditor should be changed.

Financial Statement Insurance

The effects of this fundamental conflict of interest cannot be eliminated through regulation, legislation, or litigation. Instead, appropriately structuring the relationships among the involved parties is critical to improving the credibility of the audit. Consider the following scenario:

An insurance carrier is contacted by a company (the proposed insured) to provide financial statement insurance (FSI). The proposed insured is then reviewed by an expert risk assessor chosen by the insurance carrier according to underwriting procedures. Risk assessment might include:

  • Evaluation of the industry in which the company operates, such as the industry’s overall economic health, the degree of competition, the nature and stability of the industry, and its outlook for the future; and
  • Evaluation of the company’s control environment, its significant accounting and management policies and practices, its reputation within the industry, and its current and prior reported operating results.

The FSI carrier would subsequently submit a proposal to the proposed insured that contains the maximum amount of insurance offered and the corresponding premium. A proxy would be prepared for a vote, presenting the shareholders three possible choices: 1) accept the maximum amount of insurance offered in the proposal at the stated premium; 2) accept a lesser amount of insurance recommended by management at a reduced premium; or 3) decline to carry any FSI.

If either of the first two choices was selected, the insurance carrier would engage the audit services of an independent CPA firm. This firm could be the same “expert” that conducted the initial risk assessment review.

If the proposed insured receives an unqualified opinion from the auditor, the maximum value of the policy may be issued. If, however, a qualified opinion is rendered, a new maximum level of FSI and revised premium would need to be negotiated between the insurance carrier and the proposed insured.

Here’s the kicker: The auditor’s report would include information disclosing the amount of insurance covering the financial statements and the related premium.

What FSI Would Accomplish

FSI would protect a company (i.e., the shareholders) against the risk of material misstatement of the financial statements, whether caused by error or by fraud. Losses due to a material misstatement would be the trigger for payment of a claim. In addition, users of the financial statements would be able to determine, from the level of insurance obtained and the premium paid, the relative quality of the financial statements: the lower the level of coverage or the higher the premium, the greater the risk. To prevent abuse, the policy would function similarly to directors and officers (D&O) liability insurance in that private companies would be excluded from collecting on a claim that involved one insured against another.

More important, changes in the configuration of the relationship between the auditor and the company being audited could furnish greater independence for auditors in the execution of their professional responsibilities. Admittedly, this idea is a significant departure from the status quo, but serious issues deserve serious solutions.

As always, I welcome your comments on these and other issues.

Mary-Jo Kranacher, MBA, CPA, CFE





















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