Abstract
The fact that auditors are paid by the companies they audit creates an inherent conflict of interest that is endemic to the relation between the firm (the principal) and the auditor (the agent). I analyze a financial statement insurance mechanism that eliminates the conflict of interest auditors face and properly aligns their incentives with those of shareholders thus mitigating market inefficiencies arising from uncertainty regarding the quality of financial statements. 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. 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.
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Notes
- 1.
This Chapter includes a reprinted article first published under the title “Post-Enron Reform: Financial Statement Insurance, and GAAP Re-visited” in the Stanford Journal of Law, Business and Finance in 2002, which is followed by the author’s comments by way of a post script on further developments on the Financial statement insurance based on the original paper presented at the Third International Workshop on Accounting and Regulation in 2004.
- 2.
Greenspan (1996), The Challenge of Central Banking in a Democratic Society, Address at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research (Dec. 5, 1996).
- 3.
Federal Reserve Board’s Semiannual Monetary Policy Report to the Congress Before the US S. Comm. on Banking, Housing., and Urban Affairs, 107th Cong. (2002) (statement of Alan Greenspan, Chairman, Federal Reserve), available at http://www.federalreserve.gov/boarddocs/hh/2002/july/testimony.htm.
- 4.
The SEC has the authority to establish generally accepted accounting and auditing standards, to review the financial statements registered with the SEC by most publicly traded corporations, to discipline CPAs who sign such statements (by rejecting statements they sign or by suspending or barring the CPAs from SEC practice), and to conduct investigations and recommend possible criminal inquiries to the Department of Justice.
- 5.
American Heritage Dictionary of the English Language (4th ed. 2002), available at http://education.yahoo.com/reference/dictionary/index.html.
- 6.
United States v. Arthur Young & Co., 465 U.S. 805, 817–18 (1984).
- 7.
- 8.
Sarbanes–Oxley Act, Pub. L. No. 107-204, 116 Stat. 745 (2002). The Act prohibits auditors from providing most of the traditional nonaudit services, such as bookkeeping, financial information systems design, appraisal services, fairness opinions, actuarial services, internal audit services, management functions, investment banking, legal and other expert services unrelated to the audit, and any other services deemed by the Public Company Accounting Oversight Board to be impermissible. Id. (§ 201). The Act also requires that all services (with some minor exceptions) be preapproved by the audit committee and that such pre- approvals be disclosed in public reports. Id. (§ 201–202).
- 9.
See supra note 5 and accompanying text.
- 10.
Sir Thomas Gresham was a financier born in London, England in 1519. Knighted in 1559, he was for a time the English ambassador at Brussels. “Gresham’s Law” is an economic observation attributed to him: if there are two coins of equal legal exchange value, and one is suspected to be of lower intrinsic value, the “bad” coin will tend to drive the other out of circulation, as people will hoard the “good” coin. See Webster’s World Encyclopedia: The Cambridge Biographical Encyclopedia (Webster’s Millennium 2002 CD-ROM, 2002).
- 11.
For further background information on the FSI mechanism, see Ronen and Cherny (2002) Is Insurance a Solution to the Auditing Dilemma?, Nat’l Underwriter, Life and Health/Fin. Services Edition, Aug. 12, 2002, at 26.
- 12.
How the premium is determined is discussed in the proceeding paragraph.
- 13.
Below I shall argue that for the same coverage the equilibrium magnitude of the premiums paid under my proposed regime would be less than under the existing regime because of the improved audit quality, improved financial statement quality, and hence smaller shareholder losses.
- 14.
A put option is a contract giving its owner the right to sell a fixed number of shares of a specified common stock at a fixed price at any time on or before a given date.
- 15.
What I mean by quality in this context is the combination of effort that the auditor exerts on the job and the level of his objectivity and freedom from bias.
- 16.
Consider, however, the so-called “anomalies,” such as the post-announcement drift, that can be explained within a rational market, as shown by in A. Dontoh et al., On the Rationality of Post-announcement Drift, 8 J. Acct.. Stud. 69–104, 2003.
- 17.
See generally Riley (1979), Informational Equilibrium, 47 Econometrica 331, 333–36 (1979) (discussing the relevant conditions).
- 18.
See Benston and Hartgraves (2002), Enron: What Happened and What We Can Learn From It, 21 J. Acct. and Pub. Pol’y 105, 126 (2002).
- 19.
Wriston (2002), The Solution to Scandals? Simpler Rules, Wall St. J., Aug. 5, 2002, at A10.
- 20.
1 AICPA, Objective of Financial Statements (1973).
- 21.
2 AICPA, Objective of Financial Statements (1974).
- 22.
See supra note 20 and accompanying text.
- 23.
In any case, an overriding GAAP rule is the principle of “substance over form,” by which adherence to the literal rules may violate GAAP. See Qualitative Characteristics of Accounting Information, FASB Concept Statement No. 2 160 (Financial Accounting Standards Bd. 1991).
- 24.
Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities Research and Dev. Arrangements, Statement of Financial Accounting Standards No. 140 (Financial Accounting Standards Bd. 2000).
- 25.
R. Smith, Show Business: A Blockbuster Deal Shows How Enron Overplayed Its Hand, Company Booked Big Profit From Pilot Video Project That Soon Fizzled Out, “I Just Couldn’t Believe It,” Wall St. J., Jan. 17, 2002, at A1.
- 26.
We do encounter sweeping admonitions in the press to the effect that accountants should make sure that “GAAP fairly portrays the underlying economics.” See S. Liesman, SEC Accounting Cop’s Warning: Playing By Rules May Not Ward Off Fraud Issues, Wall St. J., Feb. 12, 2002, at C1 (quoting Michael Young, a defense attorney who specializes in securities fraud).
- 27.
Ronen and Yaari (2002), Incentives for Voluntary Disclosure, 5 J. Fin. Mkts. 349, 362, 372-73 (2002).
- 28.
See infra Part VI.
- 29.
See generally Ronen and Sorter (1972), Relevant Accounting, 45 Bus. 258, 258-282 (1972) (providing a detailed description of how such a financial reporting system can be implemented).
References
Benston, G. J., & Hartgraves, A. L. (2002). Enron: What happened and what we can learn from it. Journal of Accounting and Public Policy, 105, 126.
Greenspan, A. (1996). The challenge of central banking in a democratic society, address at the annual dinner and Francis boyer lecture of the American enterprise institute for public policy research. 5 Dec 1996.
Koford, K., & Penno, M. (1992). Accounting, principal-agent theory, and self-interested behavior. In N. E. Bowie et al. (Eds.), Ethics and agency theory 127.
Riley, J. G. (1979). Informational equilibrium. Econometrica, 331, 333–336.
Ronen, J., & Cherny, J. (2002. Is insurance a solution to the auditing dilemma? Nat’l Underwriter, Life and Health/Fin. Services Edition. 12 Aug 2002 at 26.
Ronen, J., & Sorter, G. H. (1972). Relevant accounting. Bus 45, 258–282.
Ronen, J., & Yaari, V. (2002). Incentives for voluntary disclosure. Journal of Financial Markets, 5(3), 349–373.
Wriston, W. (2002). The solution to scandals? Simpler rules. Wall Street Journal. 5 Aug 5 2002, at A10.
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Ronen, J. (2014). Post-Enron Reform: Financial Statement Insurance, and GAAP Re-Visited. In: Di Pietra, R., McLeay, S., Ronen, J. (eds) Accounting and Regulation. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-8097-6_3
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