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The idea the SEC missed

External auditors and their clients are facing dozens of rule changes, which are being proposed for discussion by the Securities and Exchange Com-mission in the wake of the Enron, WorldCom and Tyco debacles.

Yet not one of those new rules addresses the basic issue inherent in the relationship between a corporation and its auditors, which is that the corporation pays the external auditors and no matter how much the latter protest their independence there is a clear conflict of interest.

Eliminating this conflict has, for many years, occupied the thoughts of Joshua Rouen, the Professor of Accounting at the Stern School of Business, New York University and he believes he has come up with a workable solution.

He has developed an idea for “Financial Statements Insurance (FSI),” which is a way of changing the employer of the auditors and thereby ending the conflict of interest.

Instead of hiring external auditors, corporations would be obliged by, for instance, the Securities and Exchange Commission to buy FSI, which would indemnify investors against losses suffered because of shenanigans in corporate reporting and auditing.

As with the issuance of any insurance, the carriers would have to gauge the risk posed by each company. Auditors would be hired to assess the risk that financial statements of their prospective clients may contain misrepresentations. This would be followed by the usual external audit and would be co-ordinated with the risk assessment findings.

This will see the end of companies hiring the auditors. Instead their new bosses would be the carriers and auditors would know full well the consequences of forgetting who pays their bills.

For instance, if another Enron came to light and the insurance carrier was suddenly faced with a claim from fuming investors, the auditors might as well uninstall their spreadsheets because no other carrier would ever employ them again.

Professor Rouen’s scenario is that the auditors’ risk assessment report would enable the carriers to decide on the coverage and premium. Both the amount of coverage obtained and its cost would be made public, which would give investors an accurate insight into the corporation.

“By knowing how much insurance coverage comes with the securities they buy, investors would be able to tell which stocks are more reliable and which corporations are more trustworthy. This would also solve the problem of auditors’ having conflicts of interest, since they would not be hired by the companies they audit,” wrote Professor Rouen in an op-ed piece in the New York Times.

That article set in motion a groundswell of interest. He is in fact in the process of explaining FSI to the US insurance industry. The concept caught the attention of many people. He has even discussed FSI informally with a senior official, whom he declined to name, at The Bank of England.

Openly supporting the plan is the senator for North Carolina, Elizabeth Dole. In her “Dole Plan”, which she will take to Congress in January 2003, she said “FSI will ensure loyalty to accuracy, not to corporate interests, by changing the incentives to restore investor confidence.”

Under what is called the Dole FSI proposal, “the Securities and Exchange Commission would require companies to buy FSI, in much the same way they now buy officers and directors insurance, and the insurance company hires the auditor. The insurance company has every reason to hire the best auditor, and the auditor has every reason to guarantee an accurate report.”

Why did Professor Rouen sit on his idea for years before springing it on the world? Through the late 1990s, he said, everyone seemed happy with the status quo. The fallout from Enron and its relationship with Arthur Andersen changed all that.

His main concern is that it may take too long for the plan to work its way through the corridors of power. “If it takes too long complacency will set in,” he warned.

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