the Integrity of Financial Statements and the Audit Process
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?
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?
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.
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:
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.
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.
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.
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.
the kicker: The auditor’s report would include information
disclosing the amount of insurance covering the financial
statements and the related premium.
FSI Would Accomplish
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.
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.
always, I welcome your comments on these and other issues.
Kranacher, MBA, CPA, CFE