Financial Statements Insurance

39 Pages Posted: 30 Sep 2013

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: September 2013

Abstract

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.

Keywords: Agency conflicts, Audit profession, Conflict of interest, Corporate governance, Insurance

Suggested Citation

Dontoh, Alex and Ronen, Joshua and Sarath, Bharat Sarrukai, Financial Statements Insurance (September 2013). Abacus, Vol. 49, Issue 3, pp. 269-307, 2013. Available at SSRN: https://ssrn.com/abstract=2332908 or http://dx.doi.org/10.1111/abac.12012

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

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