Post-Enron Reform: Financial Statement Insurance, and GAAP Re-Visited

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.