Financial Statements Insurance

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.

Keywords: Financial statements, insurance, auditor liability, 1934 Securities Act

JEL Classifications: M41, M49, G22, G28

Working Paper Series