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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/27449
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| Title: | Financial Statements Insurance |
| Authors: | Dontoh, Alex
Ronen, Joshua
Sarath, Bharat |
| Keywords: | Financial statements
insurance
auditor liability
1934 Securities Act |
| Issue Date: | 17-Aug-2004 |
| Series/Report no.: | Alex Dontoh-2 |
| Abstract: | The largest corporate bankruptcy filed in the U.S., that of Enron in
2001, was preceded by a string of disclosures about errors in and
corrections to their financial statements. The presence of such errors
creates uncertainty about the quality of the financial statements, can
lead to pricing distortions, and inefficient market allocations. Several
causes have been suggested for the current state of affairs. Most
important, perhaps, are managers' tendency to inflate stock prices for
personal gain through deceit, "cooking the Books" -
misrepresentations in financial reporting - and other unethical
behavioral practices, and auditors' failure to fulfill their role as
independent gatekeepers. Currently, the incentives driving auditors'
behavior may not elicit unbiased reports. Auditors are paid by the
companies they audit which creates an inherent conflict of interest that
is endemic to the relation between the firm (the principal) and the
auditor (the agent). Unfortunately, remedying these problems is not
simple. Prosecution and punishment may not adequately deter wrongdoing,
as intentional misrepresentation is difficult to discover or prove.
Overhauling the regulatory structure and adding layers of supervision
and monitoring by the government would be inefficient and socially
wasteful. In addition, little can be done in the short run to cultivate
ethical personalities. Rather, the solution lies in market mechanisms
that eliminate the perverse incentives of gatekeepers, most notably the
auditors. We present a financial statement insurance institutional
mechanism that eliminates the conflict of interest auditors face and
properly aligns their incentives with those of shareholders. We show
analytically that the introduction of financial statement insurance can
significantly mitigate market inefficiencies arising from uncertainty
regarding the quality of financial statements. The basic structure of
Financial Statement Insurance (FSI) can be described as follows. Instead
of appointing and paying auditors, companies would purchase financial
statement insurance that provides coverage to investors against losses
suffered as a result of misrepresentation in financial reports. The
insurance coverage that the companies are able to obtain is publicized,
as are the premiums paid for that coverage. The insurance carriers would
then appoint and pay the auditors who attest to the accuracy of the
financial statements of the prospective insurance clients. Those firms
announcing higher limits of coverage and smaller premiums would
distinguish themselves in the eyes of the investors as companies with
higher quality financial statements. In contrast, those with smaller or
no coverage or higher premiums will reveal themselves as those with
lower quality financial statements. Every company will be eager to get
higher coverage and pay smaller premiums lest it be identified as the
latter. A sort of Gresham's law in reverse would be set in operation,
resulting in a flight to quality. |
| URI: | http://hdl.handle.net/2451/27449 |
| Appears in Collections: | Accounting Working Papers
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