Financial Statements Insurance

40 Pages Posted: 8 Oct 2008 Last revised: 2 Dec 2008

See all articles by Alex Dontoh

Alex Dontoh

New York University (NYU) - Department of Accounting

Joshua Ronen

New York University (NYU) - Department of Accounting

Bharat Sarath

Rutgers, The State University of New Jersey - Accounting

Multiple version iconThere are 3 versions of this paper

Date Written: November 28, 2008

Abstract

The fact that auditors are paid by the companies they audit creates an inherent conflict of interest with investors who rely on the audit report in their capital allocation decisions. We analyze how the provision of financial statement insurance could eliminate this conflict of interest and properly aligns 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 cash flows from firms are improperly identified and firms which 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 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 insurers would appoint and pay the auditors who attest to the accuracy of the financial statements of the prospective insurance clients. 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 would be set in operation, resulting in a flight to quality. As a result, when financial statement insurance is available, capital is generally provided to the most efficient firms.

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

Suggested Citation

Dontoh, Alex and Ronen, Joshua and Sarath, Bharat Sarrukai, Financial Statements Insurance (November 28, 2008). NYU Working Paper No. 2451/27449. Available at SSRN: https://ssrn.com/abstract=1280670

Alex Dontoh (Contact Author)

New York University (NYU) - Department of Accounting ( email )

40 West 4th Street, Suite 400
Suite 10-180
New York, NY 10012-1118
United States
212-998-0064 (Phone)
212-995-4004 (Fax)

Joshua Ronen

New York University (NYU) - Department of Accounting ( email )

40 West 4th Street, Suite 400
Suite 10-180
New York, NY 10012-1118
United States
212-998-4144 (Phone)
212-995-4599 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~jronen/

Bharat Sarrukai Sarath

Rutgers, The State University of New Jersey - Accounting ( email )

94 Rockafeller Road
Piscataway, NJ 08854
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
325
rank
11,245
Abstract Views
1,904
PlumX Metrics