Financial Statements Insurance

The fact that auditors are paid by the companies they audit creates an inherent conflict of interest. We analyze how the provision of financial statement 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 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 premia that companies pay for the coverage are publicized. The insurers would 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 smaller 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 will be eager to pay smaller premia (for a given level of coverage) resulting in a flight to high audit quality. As a result, when financial statement insurance is available and the insurer hires the auditor, capital is provided to the most efficient firms.

Joshua Ronen is a professor of accounting at New York University Stern School of Business. Professor Ronen teaches courses in managerial accounting, financial accounting, advanced topics in financial accounting and financial statements analysis.

Professor Ronen has been with NYU Stern for nearly 40 years. His primary research areas include capital markets, disclosure, earning management, economic impact of accounting rules and regulations, financial reporting, legal liability of firms, transfer pricing, agency theory, corporate governance, and fair valuation. Professor Ronen has written numerous books including Accounting and Financial Globalization, Off-Balance Sheet Activities, Entrepreneurship, Smoothing Income Numbers: Objectives, Means and Implications, and Earnings Management. He has been published in many academic journals including and publications including The New York Times, The Accounting Review, Journal of Accounting Research, Journal of Accounting, Auditing and Finance, Abacus, Management Science, Journal of Public Economics, Journal of Organizational Behavior and Human Performance, Stanford Journal of Law, Business, and Finance, and Journal of Financial Markets. In addition to his work at NYU Stern, Professor Ronen has lectured at University of Canterbury, Tel-Aviv University, Federal University of Rio de Janeiro, National University of Mexico, University of Toronto, University of Chicago, Hebrew University, and London School of Economics among many others. He has also been a consultant for numerous organizations, including especially law firms as expert witness in the area of securities litigation. His suggestions for reform in the accounting profession have received critical acclaim by legislators and in the media.

Professor Ronen received his Bachelor of Arts in Economics and Accounting at Hebrew University in Israel, and his Doctor of Philosophy from Stanford University. Professor Ronen is also a licensed C.P.A. in Israel.

Paolo Perego

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