Financial Statements Insurance

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