Andersen, Meet Aetna

What’s the best way to prevent future accounting scandals? Audit insurance.

If the new accounting oversight board ever gets down to business—William Webster will apparently withdraw as chairman even before Wednesday’s first meeting—it probably won’t be bold enough to address the deepest problem in the accounting business: Companies pay for their own audits.

This principal-agent conflict has existed since New Deal-era securities laws first required “independent” audits of public companies. As long as an accounting firm was reasonably competent, it had every incentive to go easy on its clients—even if the public would benefit from more vigilance. Toughness would just encourage the client to replace the auditor with a more pliable firm. The conflict became truly intractable in recent decades, as the tax code grew more complex and accounting firms built massive consulting arms. With audit fees shrinking to a sliver of overall revenues, accountants had even less incentive to ride herd on their clients.

In theory, an auditor’s concern for its own reputation should deter it from signing off on cooked books. But the experience of Arthur Andersen, which presided over a series of accounting debacles before Enron without major client defections, shows that deterrence doesn’t happen in practice. Either companies were too lazy to change accountants, or they were simply oblivious to Andersen’s failures, or they may have wanted the lax treatment for themselves.

So even if Rudolph Giuliani is named to head the accounting oversight board, the misalignment of carrots and sticks will remain in the structure of the industry. Certified public accountants, like lawyers, are licensed by the public to perform certain services. An old-fashioned guild, the accounting industry has a monopoly on the auditing business. Yet the profit motive dictates that CPAs’ highest duty is owed to the paying client rather than to the non-paying investing public.

The key to real accounting reform is to remove the economic incentive for accountants to be halfhearted in their audits. One way would be to make the audit of public companies a federal function. That would guarantee independence, to be sure. But the government’s inability to hire low-skilled airport screeners in a timely fashion doesn’t exactly instill confidence that it could assemble a crack team of accountants. Besides, even if you’ve got an executive branch pushing for accounting strictness—and we certainly don’t have that now—members of Congress have shown an alarming tendency to interfere with the federal agencies charged with setting accounting standards. You can be sure Congress would make life impossible for any federal audit service that went too hard on favored corporations.

But there is a way to use the power of the marketplace—which until now has conspired against good auditing and accounting—to bring corporations to heel. We should require publicly held companies to purchase accounting insurance. Joshua Ronen, a professor of accounting at New York University, floated this idea in a March New York Times op-ed. It makes even more sense today.

Here’s how it would work. Public companies, as a condition of doing business, would be required to buy accounting insurance. Accounting insurance would cover all, or a portion, of damages suffered by investors because of accounting fraud or earnings misstatements, with a certain deductible and a cap.

In order to assess the risk of insuring a company’s books, insurance companies would hire accountants and pay them to conduct annual audits. Since the auditors would be representing their new customers—insurers—not the audited companies, they would have both the freedom and the incentive to be tough and thorough. Meanwhile, accountants could continue to offer their consulting services to public companies, because the conflict of interest created when they both audited and consulted to the same company would disappear.

Signing off on faulty books would be devastating for an accounting firm. Insurance companies are nothing if not risk-averse; mitigating risk is their business. If an accounting firm were to botch one audit or help insiders cook the books, that firm would jeopardize the dozens or hundreds of auditing assignments it got from insurance companies.

The insurance companies would charge premiums based on the perceived risk. That risk would be dictated not simply by the audits but also by the past actions of the company and its executives—the way accident-prone drivers pay higher rates or smokers with a history of accidental fires shell out more for home insurance.

For companies with honest, clean, and transparent books, accounting insurance will be a relatively minor cost of doing business. A company run by Warren Buffett would pay a low premium. For companies or executives with a history of earnings exaggeration, insurance would be more expensive. A company headed by Jeff Skilling would find it very difficult to obtain accounting insurance. Premiums and ratings would be disclosed to investors in financial statements, so they could draw their own conclusions about the accounting risk inherent in a given company.

It would be a challenge for insurers to price the audit coverage at first, but insurers have shown an ability and eagerness to insure everything from the knees of college football players to priceless works of art. And this is a market with sufficient history and sufficient size to quickly develop an orderly pricing regime.

Accounting insurance would have other salutary effects. When honest companies are victimized by fraud—say by an internal bad apple or by a company that they acquire—the litigation and hangover can last for years. Insurance might provide a more rapid settlement and allow new management teams to revive the business faster.

Sure, requiring public companies to purchase accounting insurance would be a coercive government mandate. But we also require drivers to carry auto insurance, and mortgage companies require home buyers to purchase home insurance. These requirements certainly don’t inhibit ownership or the ability to conduct transactions in either market.

The accounting insurance market would work much like the credit market. Companies’ bonds and other debt instruments are rated by outside agencies. Those with lower ratings pay higher interest rates. Investors can make a conclusion about a company’s prospects based on its credit rating and decide if they think the potential reward is worth the risk. This credit risk market is one of the great tools of American capitalism. Audit insurance could be a worthy supplement.