Is Financial Statement Insurance a Viable Alternative to the Not-so-Independent Audit?
by Joshua Ronen

The cascade of recent audit failures has given rise to the Sarbanes-Oxley Act and to an ever-growing commentary on “corporate governance.” A major theme of both the statute and the commentary is the role of “gatekeepers” and, in particular, of auditors. For example, in his book, Take on the Street, former SEC Chairman Arthur Levitt complains:

More and more, it became clear that the auditors didn’t want to do anything to rock the boat with clients, potentially jeopardizing their chief source of income. Consulting contracts were turning accounting firms into extensions of management—even cheerleaders at times. Some firms even paid their auditors on how many non-audit services they sold to their clients.¹

The crisis of confidence created by the accounting scandals is clearly exacerbated by the failure of auditors to enforce accurate reporting of companies’ true performance. Many of the companies that failed spectacularly had clean audit opinions prior to their collapse. This damaged auditors’ reputations and compromised their role as independent experts. That’s a problem, because independence from management—both real and perceived—is crucial to ensuring the auditor’s opinion is relevant and reliable. The issue of auditor independence (or its absence) has occupied a major place in the debate over the failure of corporate governance.

This article discusses the circumstances that can diminish or even negate auditor independence, and offers a possible solution to the problem.

The Sarbanes-Oxley Act and the Impact of Regulation

Sarbanes-Oxley seeks to address the problem of lax accounting gatekeepers by increasing regulation and penalties, empowering audit committees, and curtailing the auditor’s involvement with the client. Among the major reforms Sarbanes-Oxley introduced in the area of accounting and auditing are provisions that address specific deficiencies identified by Congress in reviewing the problems at Enron, WorldCom, and others, such as:

• Preventing officers from improperly influencing the auditing process;
• Changing the oversight of auditing firms; and
• Entrusting a higher level of financial review to independent audit committees.

A primary instrument for accomplishing these objectives was the establishment of the Public Company Accounting Oversight Board (PCAOB), which has regulatory authority over private audit firms. The PCAOB is empowered to “protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports” for investors in publicly traded companies.”² The PCAOB is responsible for registering³ and inspecting public accounting firms and for establishing or adopting auditing, quality control, ethics, independence, and other standards pertinent to the conduct of audits. The PCAOB also is authorized to conduct investigations of auditing firms and disciplinary actions over auditors. Even with the existing system of peer review, Sarbanes-Oxley subjects firms with a record of regularly auditing more than 100 issuers to annual inspection by the PCAOB. Failure to meet the stipulated standards for quality control systems can subject a firm to sanctions.

Can this additional layer of regulatory oversight accomplish what the SEC, endowed with great authority, has failed to do over all these years? There is no reason to expect it would. All regulatory mechanisms impose penalties after the wrongdoing is detected. Ex-post mechanisms are nowhere near as effective as systems that provide incentives for ethical conduct.

Consider how regulation functions. Regulatory mechanisms prohibit certain acts while mandating others. The means of enforcement are penalties imposed when regulators discover that prohibited acts were committed or mandated actions were not taken. There is rarely, if ever, a reward for doing the right thing. Sarbanes-Oxley, for example, prohibits accounting firms from providing some non-audit services,⁴ requires that audit committee members be independent,⁵ and directs auditors to disclose to the issuer’s audit committee “all alternative treatments that have been discussed with management officials of the issuer . . . ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the [audit] firm.”⁶ How well can the PCAOB implement these stipulations?

It is doubtful that these lofty regulatory goals can be accomplished effectively. Successful implementation requires a willingness to enforce the regulations. However, the objectives of the regulators are not necessarily congruent with the interests of the investing public. Regulators’ incentives are determined and formulated within a barter system wherein political favors or threats are exchanged. The incentives generated in such a market are shaped by groups with interests that likely diverge from those of investors. Witness, for example, the SEC’s backtracking on the requirement that lawyers resign and blow the whistle on securities law violations (influenced by the lawyers’ lobby) and on the barring of tax shelter planning by auditors (targeted by the accountants’ lobby). Moreover, with the exception of those with a high measure of integrity—a rare commodity in these days—regulators seek entrenchment in bureaucratic power and the preservation of their ability to exchange political favors so as to facilitate post-regulatory career marketability. This quest requires the goodwill and cooperation of interest groups with goals that are not aligned with those of investors.

Even if the individuals within a regulatory structure are diligent, enforcement is costly and requires budget authorization. But the availability of the requisite funds depends on political priorities that may lie outside the domain of corporate governance reforms. Competing demands for money can arise unexpectedly, such as when wars or tax cuts are imminent. Also, political agendas can shift over time and, in periods of complacency, corporate governance reforms may be accorded low priority.

Consider also the incentives of the would-be wrongdoers. Regulatory penalties are effective only if agents expect their misdeeds to be detected. If the probability of detection is perceived to be small, the errant will not be deterred. Rational wrongdoers would reasonably expect regulatory hesitance and backtracking and hence are quite likely to perceive a small probability that regulators will detect their transgressions. Suppose that to offset small probabilities of detection, draconian penalties are imposed when the wrongdoing is discovered. Can corporations then staff their boards of directors and audit committees with able members who might face such heightened risks?

Even if transgressions ultimately are detected and penalized, the rendering of justice typically will come too late to properly rectify the wrongs, compensate investors for their losses, or restore their confidence. Punishments that loom in the distant horizon cannot function as effective deterrents.

Beyond all these impediments, there is the question of feasibility. Are the Sarbanes-Oxley mandates workable in principle? Consider, for example, the requirement that audit committee members be independent. Is that possible?

Can Directors or Audit Committee Members Really Be Independent?

Independence is an unobservable state of mind. While independence may be legislated, it cannot be made to happen easily. Even a cursory analysis of directors’ (including audit committee members) incentives and motivations suggests that they are subject to an agency problem: Directors and audit committee members wish to be re-appointed to their board positions. The pay is good,⁷ and good relations with the CEO also bestow valuable benefits, including social connections, prestige, and increased likelihood of becoming a member on other companies’ boards.

The first impediment to director independence is the nominating process. Board elections are by slate, and dissidents face substantial impediments when they attempt to put forward a competing slate. Hence, the management-proposed slate of directors is the only one that typically ends up being offered. As a result, the CEO and his or her team dominate the nominating process, and directors wishing to be re-nominated feel compelled to acquiesce to the CEO’s wishes in a host of matters.

Also militating against genuine independence for directors and audit committee members is the directors’ pay structure. If well paid, the directors would have little incentive, if any, to oppose the CEO’s pay or policies; there would be de facto dependence on management. Alternatively, if not well paid, the directors would have little interest, if any, in bringing an independent perspective to bear on real policy issues: They are not paid enough to make it worth their effort, nor would the directors want to risk relations with the management they need to work with. And while heightened personal liability concerns may somewhat “curb their enthusiasm” for cooperation with mendacious management, the small perceived probability of detection and enforcement over time would limit whatever deterrent effect enhanced liabilities may offer.

Moreover, directors typically have only nominal equity interests in the company. But even if directors owned a significant share of the equity, as long as they are not restricted from disposing of their equity interest, they still would have incentives to overlook attempts by management to inflate earnings or engage in other questionable accounting measures; this will only help them sell their stock at higher prices! Even if directors hold restricted stock with lock provisions that bar them from selling before a certain date, they would have the perverse incentive to encourage (and certainly not discourage) management to “cook the books” so as to inflate the price immediately prior to the expiration of the lockup.⁸

Can Auditors Be Independent?

One of the causes suspected of contributing to the current state of financial disarray is the failure of the auditing profession to fulfill its role as independent gatekeepers. Currently, the incentives driving auditors’ behavior may not elicit unbiased reports. Auditors are paid by the companies they audit and thus depend on CEOs and CFOs, who effectively decide on their employment and compensation. This creates an inherent conflict of interest.

The perception of auditors’ conflict of interest (lack of independence) started with a host of highprofile, highly publicized corporate failures and near failures, such as Enron and WorldCom. Among the (probably false) premises for the culpability of the auditor was the belief that the problem could have been avoided if the auditing firm had not also provided lucrative consulting services to the audit client. In other words, many argued that had auditors not been enticed by the lure of large fees, they would have done the right thing. Unfortunately, the prohibition against an auditor providing consulting services results in the auditor acquiring less knowledge of the client’s systems and operations even when, because of great changes in record-keeping technology and increased sophistication of the client’s operations, more knowledge is critical.

While providing multiple services can generate economies of scale and scope, it allegedly creates two potential sources of conflict of interest. First, there is the potential to pressure individual auditors to bias their judgments and opinions in exchange for more (or continued) nonaudit work. The second is that auditors often evaluate systems that were put in place by their own non-audit colleagues (consider, for example, the off-balance sheet special-purpose entities marketed by Arthur Andersen to Enron and other clients). In spite of these concerns, however, the empirical evidence does not reveal a systematic pattern of these conflicts creating obvious biases. Even so, regulators’ concerns about threats to auditors’ independence grew dramatically in the late 1990s, along with the growth in the share of the non-audit services relative to the auditors’ total revenue and profits.

In fact, one does not need to resort to identifying non-audit services as the villain responsible for the conflict of interest and the lower quality of the audit. An indefinite stream of future audit fees to be received for being continually engaged as auditor supplies all the necessary incentives for complying with management’s wishes or, at the very least, the grounds for being perceived as dependent on management. This conflict of interest has been intensified by changes in the business and audit environment over the few last decades. To see why this happened, we need to consider the audit process. It comprises two components: the validation of data (GAAS) and the validation of measures of financial statement items (GAAP). GAAS is designed to verify the appropriateness, completeness, accuracy, and timelines of the accounting data. GAAP involves the reasonableness of the values presented in the financial statements (for example, the quantification of inventory at cost or market, or the net realizable values of accounts receivable after write-offs and allowances for uncollectible debts).

While the recent spate of “audit failures” is not unusual when viewed over, let us say, the last fifty years—in this period “audit failures” happened all the time—the failures become more noticeable in a weak economy and in an environment of stock price declines, and particularly where the failures are so visibly enormous. Indeed, the visibility, frequency, and magnitude of audit failures have increased substantially over the last few decades. Reasons for this possibly include a more aggressive plaintiff ’s bar coupled with increased demands on the auditor in light of more sophisticated and complex business contracts and transactions. Also noteworthy is the fact that an overwhelming number of visible audit failures were associated with the largest and best audit firms. What are the likely causes of this astonishing phenomenon?

One likely explanation lies in the movement from an industrial economy to an information economy. In the industrial economy of fifty years ago, the primary focus of the auditor was the validation of data, through extensive counting of inventory and confirming accounts receivable and payable with external parties. In addition, other than long-term assets (for example, plant and equipment), and long-term debt (such as bonds), the rest of the balance sheet had, by the time the auditor completed the necessary fieldwork, generally completed its cycle. Most of the inventory turned over, most of the receivables were collected, and most of the payables were settled. Auditors could look back and further validate their assessment of the data and valuations as of the statement date.

At least two major changes have had a significant impact on the auditor: the computer and the change in the nature of assets and liabilities. While the computer has substantially expanded the amount and quality of data available, auditors also became dependent on the data processing systems. In addition, the movement from tangible to intangible assets with very long lives, and from liabilities whose principal and terms are known and specified to liabilities whose principal and terms are legally related to and dependent on other factors (such as found in derivatives), has substantially reduced the auditor’s ability to validate the values presented in the financial statements.

To put it more plainly, current financial statements are a blend of largely verifiable, but uninformative, depictions of past transactions, and largely unverifiable, but possibly informative, projections of future outcomes. Under existing GAAP, many of these projections show up in the balance sheets as assets, and even as revenues. Consider the “interest only strip,” shown as an asset in the balance sheets of specialty finance companies under Financial Accounting Standard 140. This asset is simply the present value of a future stream of unrealized income recorded as current income. Its valuation is highly subjective and acutely sensitive to changes in assumptions. It is extremely difficult, even for a well-intentioned auditor, to dispute and reject the projection of a manager wishing to improve the appearance of his or her financial statements. Similarly, for one of its ventures, “Enron assigned the partnership a value of $124.8 million based on its projections of the [venture’s] revenue and earnings potential.”⁹ Such largely unverifiable intangibles make financial statements difficult to audit. They constitute private information that cannot be perfectly verified after the fact. We can only observe whether a manager’s forecasts were accurate; we cannot know whether the manager truly believed the forecasts were accurate when made. Under these circumstances, in equilibrium, and on average, managers’ presentations will not be truthful, in the sense that, at any point in time, a subset of companies will intentionally misinform. ¹⁰ Even detailed standards have not prevented unverifiable intangibles from creeping into the financial statements.

This changed environment puts the auditor in a very difficult position, especially within the extremely competitive market for audit services. Price competition puts the auditor at the mercy of the client. In an uncertain environment marked by the difficulty of verifying valuations that are necessarily soft and subjective, the auditor, who is paid by the potentially prevaricating client, is naturally tempted to adopt the client’s position. Thus, while some audit failures were precipitated by incompetence and corruption, the conditions that created audit uncertainty likely contributed to the failures brought about by auditor malfeasance.

A major flaw, and one that has persisted over time, is that the auditor is effectively retained by the management of the client in the case of public companies, creating a circumstance wherein the auditor is beholden to the client and its management. Theoretically, auditors are the agents of the shareholders. But in practice, it is management that engages the auditor and ultimately pays for audit services and hence determines auditing and consulting fee structures to elicit actions, including opinions and assurances, that it desires from the auditor. Even in the current litigation environment, the anticipation of potential gains from acquiescing to management’s wishes more than offsets the threat of legal liability against auditors from shareholder class action suits. Furthermore, a large portion of shareholder recoveries in omissions and misrepresentation-related class action suits come from the corporation’s own resources. And, on the average, auditors pass costs related to legal settlements on to their corporate clients.

It is tempting to suggest that an increase in the liability exposure of the auditors can deter malpractice, but that theory falls short on three grounds. One, it fails to address the misallocation of risk and resources. Imposing higher litigation penalties on the auditor after the fact does not enhance the ability of society to distinguish, in advance, between firms with intrinsically high returns from the Enrons and WorldComs of the world that have intrinsically low or negative returns but misrepresent themselves as highreturn firms. Two, increasing exposure to liability and instituting high penalties may drive auditors out of the business of auditing altogether. And finally, the penalties and costs of litigation would be passed on to clients in the form of higher audit fees, thus blunting the positive incentive effects that the threat of litigation may otherwise have had.

Financial Statement Insurance

Despite Congress’ intentions, the Sarbanes- Oxley Act does not untie the auditor/management knot. Without realignment of the auditor’s incentives and the establishment of a corporate governance framework, matters will not change.

To address the problem, I propose a financial statement insurance (“FSI”) scheme. FSI is a market mechanism that can bring about significant changes in the structure and incentives of the auditing profession so as to align auditors’ and managers’ incentives with those of shareholders and ensure better quality audits, better quality financial statements, and, derivatively, fewer if any omissions and misrepresentations in the financial statements and smaller shareholder losses resulting from omissions and misrepresentations that do occur. At the same time, securities prices would reflect financial statement quality more accurately, contributing to a more complete market and enhancing allocative efficiency. Also, audit firms would compete along the dimension of quality rather than price, thus enhancing the profession’s reputation for independence and competence.

The FSI process begins with companies that choose to do so soliciting from insurance carriers in year T-1 offers of insurance coverage for their shareholders against losses caused by omissions and misrepresentations in financial statements that occur during the covered year (year T). The carriers would engage an underwriting reviewer (that could be either an independent organization or the external auditor), which would assess the risk of omissions and misrepresentations by examining the soliciting companies’ internal controls, management incentive structures, competitive environment, history of past omissions and misrepresentations and earnings surprises, and the market’s responses to such surprises. Detailed underwriting review reports would be the basis for the carriers’ decisions on whether to offer coverage, the maximum amount of such coverage, and the associated required premium (or they may offer a schedule of coverage amounts and premiums).

Based on the insurance offers received, a company would disclose in its proxy management’s recommendation for buying FSI coverage at a given amount and premium (including zero coverage, or no insurance). After the vote, the shareholders’ approved coverage and premium (including possibly zero coverage) would be publicized, becoming common knowledge. Companies that opt for zero coverage and companies that chose not to solicit FSI coverage would revert to the existing regime under which they would hire an external auditor that opines on their statements. Companies whose shareholders approve insurance coverage would select an external auditor from a list of firms approved by their chosen insurance carrier. The selected auditor would be hired and paid by the carrier. Audit firms also would be rated by an independent organization (likely the same as the one that conducted the underwriting review). The selected external auditor would coordinate the audit plan with the underwriting reviewer to adapt it to the findings of the review.

Eventually, the insurance coverage would become effective only if the auditor issues an unqualified opinion on year T’s financial statements (sometime in year T+1). If the opinion is not unqualified there would be no coverage, or perhaps the policy terms would be renegotiated. In either case (no coverage or renegotiated coverage and premium) the renegotiated terms would be publicized. For companies with effective coverage, shareholders’ claims for recovery for losses caused by omissions and misrepresentations that occurred during the covered year would be settled through an expedited process. A judiciary body, agreed upon in advance by both the insured and the insurer, would submit claims upon the detection of omissions and misrepresentations, hire the necessary experts to estimate the damages, and agree on a settlement on behalf of the shareholders within the policy limits with the carrier. (The insurer may hire its own experts to analyze the damages.) To see the benefits of this mechanism, consider the incentives of each of the parties.

Insurers

Once having underwritten an FSI policy, the insurer’s objective would be to minimize the cost of claims. But this is tantamount to minimizing shareholder losses that could be claimed. This means the insurer’s incentives would be aligned with those of shareholders. Insurance industry competition will work to reduce the inclination of any carrier to dispute valid claims. To minimize claim losses, the insurer would incentivize, with a proper combination of rewards, its hired auditor to apply such intensity and quality of audit as would ensure zero or minimal omissions and misrepresentations. That is, audit quality would be optimized for any given coverage and premium. It can be shown that audit quality (effort) would be higher than in the existing regime.

In addition to the premium, the fee paid by the insurer would be reimbursed by the insured and separately publicized. The premium charged would be tailored to the risk assessed by the underwriting reviewer and would credibly signal (accurately) the financial statement quality (risk of omissions and misrepresentations). The insurer will neither charge too high a premium (lest it lose market share in a competitive insurance industry) nor too low a premium (lest it bankrupt itself).

The market

Because the publicized coverage and premium become credible signals of the quality of financial statements, being based on a detailed assessment of the risk of omissions and misrepresentations, investors will pay a higher (lower) price for the securities associated with a lower (higher) premium for a given coverage. As a result, prices, in addition to reflecting expected cash flows, will reflect the information on financial statement quality embedded in the publicized coverage and premium. The markets would become more complete and security prices would become better signals for resource allocation.

The insureds

Anticipating the effect of publicized coverage and premium on the price of their issued securities, and hence on their cost of capital, managers of companies with high quality financial statements will wish to buy insurance. Managers of companies with poor quality financial statements, knowing that with either no insurance or a higher (than their better peers) premium-to-coverage ratio, they will be recognized as poor-qualityfinancial- statements companies (incurring a higher cost of capital), will understand that their only option is to improve the quality of their statements so as to merit a smaller premium-tocoverage ratio. Thus, the FSI arrangement would drive companies to race to top-quality financial statements. With more transparent and truthful financial reports, investors would have more ability to distinguish between companies with low potential returns and those with high potential returns, resulting in improved resource allocation.

Auditors

Being hired by the insurers, auditors will no longer be subject to the conflicts of interest that afflict their relations with clients under the existing arrangement. Their independence, both real and perceived, would be assured. They would be freed from client pressure to go along with dubious accounting or disclosures; they would be rewarded for better quality rather than for being willing to “fail to detect” material omissions and misrepresentations. Because they will be rewarded for better quality, they will compete on the dimension of quality rather than price or acquiescence to clients’ wishes. The competition over quality would realign the profession, making it possible for smaller firms to compete effectively, not needing to have “deep pockets” to be demanded by the insurers. Also, auditors’ legal liability would decrease on the average, since reduced conflicts of interest will make it more difficult for plaintiffs to prove scienter in fraud cases.

Furthermore, the debate now raging over principles versus rules would have a more clearcut resolution. When the incentives of auditors and managers are not aligned with those of shareholders, principles can be abused, in that clients can use the absence of rules to pressure auditors into accounting treatments or disclosures the managers prefer. With FSI, and the aligned incentives that FSI engenders, a regime of “principles” would become feasible and desirable: no constraining bright line rules would impede the reflection in the financial reports of a “fair view” of the company.

Conclusion

Several causes have been advanced in the media for an accounting meltdown: irrational exuberance, infectious greed, the stock market bubble, moral turpitude of executives, unethical accountants, non-audit services, and related ills. I have argued that the inherent conflict of interest in the auditor-client relationship combined with the unobservability of financial statement quality, together, are likely culprits. Bubbles and exuberance merely magnify the payoffs so that executives are more tempted to “cook the books” and the auditors’ conflict of interest is aggravated.

Financial Statement Insurance provides a market-based solution that acts as an effective check on the issuance of overly-biased financial statements. First, by transferring the auditor hiring decision to the insurer, this scheme eliminates the auditors’ inherent conflict of interest. Second, publicizing the insurance coverage and the premium will credibly signal the quality of the insured’s financial statements and direct investments toward better projects. At the same time, the ability to signal the quality of financial statements will motivate companies to improve theirs. Thus, along with the consequent improvement in audit quality, FSI will result in fewer misrepresentations, and accordingly, in fewer lawsuits and stakeholder losses.

Notes

1. Paula Dwyer and Arthur Levitt, TAKE ON THE STREET: HOW TO FIGHT FOR YOUR FINANCIAL FUTURE, Vintage Books (2003), at 116.

2. Section 101(a) of the Sarbanes-Oxley Act.

3. As of September 16, 2005, 1,540 firms were registered with the PCOAB. See <www.pcaobus.org/Registration/Registered_Firms.pdf>.

4. Section 201(a) of the Sarbanes-Oxley Act.

5. Section 301 of the Sarbanes-Oxley Act.

6. Section 204 of the Sarbanes-Oxley Act.

7. Pearl, Meyer and Partners, a compensation consulting firm, reports average director compensation in the 200 largest U.S. corporations in 2004 to be $176,673. See <www.pearlmeyer.com/registered/DirectorsData2004.pdf>.

8. Randomizing the date at which the lock-up provisions expire would only exacerbate matters. Incentives to inflate the stock price would operate with unabated strength until the random expiration date.

9. Rebecca Smith, “Show Business: A Blockbuster Deal Shows How Enron Overplayed Its Hand,” WALL STREET JOURNAL, Jan. 17, 2002, at A.1.

10. See J. Ronen and V. Yaari, “Incentives for Voluntary Disclosure,” JOURNAL OF FINANCIAL MARKETS 5:349–390 (December, 2002), available at <http://pages.stern.nyu.edu/~jronen/IncentivesVDPDF3-2001.pdf>.

About the Author

Joshua Ronen (jronen@stern.nyu.edu) is a professor at the Stern School of Business at New York University.