Financial Statements Insurance

• Published in: Abacus (Sydney) Vol. 49; no. 3; pp. 269 - 307
• Main Authors: Dontoh, Alex, Ronen, Joshua, Sarath, Bharat
• Format: Journal Article
• Language: English
• Published: Sydney Blackwell Publishing Ltd 01-09-2013
• Subjects: Accounting; Agency conflicts; Audit profession; Auditing; Auditors; Business insurance; Companies; Conflict of interest; Conflict of interests; Conflict theory; Conflicts of interest; Corporate governance; Financial reporting; Financial services; Financial statements; Insurance; Insurance coverage; Mathematical models; Studies
• ISSN: 0001-3072; 1467-6281
• DOI: 10.1111/abac.12012

The fact that auditors are paid by the companies they audit creates an inherent conflict of interest. We analyze how the provision of financial statements insurance could eliminate this conflict of interest and properly align the incentives of auditors with those of shareholders. We first show that when the benefits to obtaining funding are sufficiently large, the existing legal and regulatory regime governing financial reporting (and auditing) results in low quality financial statements. Consequently, the financial statements of firms are misleading and firms that yield a low rate‐of‐return (low fundamental value) are over‐funded relative to firms characterized by a high rate‐of‐return (high fundamental value). We present a mechanism whereby companies would purchase financial statements insurance that provides coverage to investors against losses suffered as a result of misrepresentation in financial reports. The insurance premia that companies pay for the coverage would be publicized. The insurers appoint and pay the auditors who attest to the accuracy of the financial statements of the prospective insurance clients. For a given level of coverage firms announcing lower premia would distinguish themselves in the eyes of the investors as companies with higher quality financial statements relative to those with higher premia. Every company would be eager to pay lower premia (for a given level of coverage) resulting in a flight to high audit quality. As a result, when financial statements insurance is available and the insurer hires the auditor, capital is provided to the most efficient firms.