Keep Them Accountable.

OPINION: Some Big Five auditors use indemnification agreements to duck liability on mutual client engagements--in contrast to SEC rules for public companies.

The National Association of Mutual Insurance Companies complained to regulators in a National Association of Insurance Commissioners committee late last year that several top-tier accounting firms were requesting or demanding that their mutual audit clients agree to indemnify those firms against any misrepresentations of management. Such indemnification makes mutual clients--rather than their accounting firms-liable for claims and dam ages that may derive from management misrepresenting data that underlie financial statements certified by the auditor.

What NAMIC emphasized to the state regulators is that the Securities and Exchange Commission prohibits such indemnification of the independent auditor by the client. The SEC's jurisdiction does not include the financially massive mutual sector of the insurance industry.

The American Institute of Certified Public Accountants continues to de fend the practice and stresses that indemnification clauses in agreements with audit clients "cover only knowing misrepresentations."

The SEC's prohibition of auditor indemnification for public companies is unequivocal in its Accounting Series Release "Indemnification by Client":

"When an accountant and his client...have entered into an agreement of indemnity which seeks to assure to the accountant immunity from liability for his own negligent acts, whether of omission or commission, one of the major stimuli to objective and unbiased consideration...is removed."

And what of the AICPA's focus on "knowing misrepresentation" in defense of the indemnification sought of nonpublic clients by some AICPA members? Knowing misrepresentation by reckless or dishonest management may simply be far from cut and dried and may pose major questions as to what the auditor should have tested and reasonably detected. Litigation, in other words, may of necessity dwell lengthily on this matter.

No-Man's Land

What seems to exist, then, for the auditor-client relationship in the non public world is a hostile no-man's land between "knowing misrepresentations" by management and the auditor's "own negligent acts." Absent clear cut evidence from either side as to where fault lies, there is raw material for further legal process. The coping mechanism of a number of large accounting firms is to push their mutual clients toward indemnifying them.

What begs to be answered for companies outside the SEC's jurisdiction is whether there is plausible difference between auditors' responsibilities to those who use financial statements. For mutual insurance companies, there may be no share holders, but there are policyholders, regulators, reinsurers, creditors and others who may rely on the mutual companies' financial statements certified by a member of the accounting profession. They do not have privity in an audit engagement agreement, yet they have valid interests in the accuracy of financial statements.

The SEC's rationale for prohibiting auditor indemnification in the public company context seems to have much less to do with the presence or absence of shareholders than with what may functionally compromise the auditor's independence. The SEC's "Indemnification by Client" is directed toward an arm's length relationship between the auditor and the client company. It speaks to basic duties of the auditor and how the coziness of an indemnification agreement may affect the auditor's depth and breadth of inquiry. Finally, it would seem to say that the auditor must examine management's representations, must test and verify.

But the SEC doesn't make the rules for audits of mutual insurance companies. The NAIC, however, can make the rules for such audits. The NAIC's Model Audit Rule would be the vehicle for such governance, and NAMIC has asked the NAIC/AICPA Working Group, the relevant committee for initiation of such action, to install a prohibition against auditor indemnification. Regulators, who often stand in the shoes of policyholders--and who have strong interest in integrity of regulated companies' financial statements-are deliberating on the prohibition sought.

The accounting profession insists that management is made more forth coming with the auditor when indemnification is part of agreements for audit engagements. But users of financial statements, including policyholders and regulators, are better served when the profession's ability to shift risk is curtailed. We see little reason for mutual companies--and not public companies--to be subject to the accounting profession's ethics where those ethics serve the profession rather than users of financial statements.

William Boya, CPA, is financial regulation manager at the National Association of Mutual Insurance Companies.