The Hindu Business Line : Insurance route to eliminate the perverse incentives of gatekeepers

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Insurance route to eliminate the perverse incentives of gatekeepers

When space vehicles and sportspersons can have insurance cover, why not financial statements? Aren't auditors the best insurance for financial statements, you may protest? No, say Alex Dontoh, Joshua Ronen and Bharat Sarath, in a research paper titled Financial Statements Insurance.

Pray, why? Because auditors are paid by the companies they audit, and this creates an inherent conflict of interest, avers the trio. "We present a mechanism that mitigates this whereby companies would purchase financial statement insurance that provides coverage to investors against losses suffered as a result of misrepresentation in financial reports," the authors propose.

"The insurance coverage that the companies are able to obtain is publicised, 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." Thus, the auditor receives the fee from the insurance carrier, and not from the audited company.

How to differentiate between the good and the lemons among financial statements? Those firms that announce higher limits of coverage and smaller premiums would be seen by investors `as companies with higher quality financial statements,' reason the authors. "In contrast, those with smaller or no coverage or higher premiums will reveal themselves as those with lower quality financial statements." How easy to spot the lemons!

Gresham's law in reverse

As a result, "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."

For starters, Gresham's law is "the theory that bad money drives good money out of circulation," as www.wordsmith.org explains. "When both are required to be accepted as legal tender, inferior money remains in circulation while the good money tends to be hoarded or exported." Reverse of that, as the research paper postulates, would mean that the good drive out the bad. If only we were able to do that to our politicians!

"There are worse things in life than death. Have you ever spent an evening with an insurance salesman?" asks Woody Allen. Many would share Allen's view, making insurance-selling a tough job, more so if the product were a cover for financial statements to accountants. For, hasn't one always thought that financial statements are the cover, or more rightly, cover-up, of the truth that lies buried in transactions?

`Current state of affairs' is where, despite the availability of accurate models for projecting cash flows and valuing securities, there is `uncertainty about the quality of the financial statements', leading to `pricing distortions and inefficient market allocations.'

The most important factor contributing to such a dismal state are: "managers' tendency to inflate stock prices for personal gain through deceit, `cooking the books' — misrepresentations in financial reporting — and other unethical behavioural practices, and auditors' failure to fulfil their role as independent gatekeepers," state the authors.

Quality defined

They define quality as "the inverse of the probability of overstatement in financial statements," and state that, on the average, "firms that potentially yield low rate of return (low fundamental value) are over funded, relative to firms characterised by a high rate of return (high fundamental value)."

Until the truth is revealed (such as through SEC investigations) a subset of firms will have stock prices that exceed the fundamental value — a bubble, reads an insight from the paper. Something that would apply with equal force to companies closer home, and the corrective actions by the counterpart of the Securities and Exchange Commission here, the SEBI (Securities and Exchange Board of India).

Yet, regulatory mechanism may not be enough. "Prosecution and punishment may not adequately deter wrongdoing, as intentional misrepresentation is difficult to discover or prove. Overhauling the regulatory structure and adding layers of supervision and monitoring by the government would be inefficient and socially wasteful," reason the authors.

"In addition, little can be done in the short run to cultivate ethical personalities. Rather, the solution lies in market mechanisms that eliminate the perverse incentives of gatekeepers, most notably the auditors."

Such a solution is FSI or financial statement insurance, "an institutional mechanism that eliminates the conflict of interest auditors face and properly align their incentives with those of shareholders."

Google returns nearly 400 finds for the phrase `financial statement insurance'. What comes first is a 2005 paper titled The Financial Statement Insurance Alternative to Auditor Liability, by Lawrence A. Cunningham of Boston College, on www.aals.org, the site of the Association of American Law Schools.

"The FSI concept was pioneered by Josh Ronen, NYU Accounting Professor, who has modelled its economic aspects," mentions the abstract. The reference is to Joshua Ronen, one of the authors of the paper we'd started off with. "Following the proverb `whose bread I eat, his song I sing', when auditors are paid by insurers rather than those they audit, audit quality should improve," writes Cunningham, on the advantages of FSI. "Auditors have greater power to pressure managers to apply accounting policies promoting more reliable financial statements."

An idea whose time has come

Auditors too should benefit from the changes brought about by the FSI concept, hopes Moody, Michael J in Financial statement insurance: an idea whose time has come, on www.looksmartinsurance.com.

"For the most part, the scope and amount of audit work is expected to remain about the same, so the auditors would not have to sacrifice any of their current workload. They will, however, have to get used to working for a new boss, (i.e., the insurance company)."

Moody expects that after shedding the conflict of interest concerns that have followed them for years, auditors "can go back to the original concept of guardian of the public good."

At the time of writing this, http://calsun.canoe.ca has a report `2-hours' old titled Accounting on danger! by Bill Kaufmann of Calgary Sun. "Paper cuts and carpal tunnel syndrome have become the smallest hazards facing accountants," begins the story, and goes on to cite Dean Neu and Duncan Green, the authors of Truth or Profit: The Ethics and Business of Public Accounting. `Fannie Mae identifies new accounting problems,' announces Reuters, in an update `13 hours ago'. It seems that the company found fresh blisters in its books when investigating the $11-billion black hole; and that the restatement process itself is "likely cost more than $800 million this year."

What do the innocent do when the Satan of scam lays siege to the tree of truth? Run for financial statement cover?

http://AccountSpeak.blogspot.com

D. Murali

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