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«Corporate Audits and How to Fix Them Joshua Ronen A uditors are supposed to be watchdogs, but in the last decade or so, they sometimes looked like ...»

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Stock Exchanges Hiring Auditors Healy and Palepu (2003, p. 76) argue that stock exchanges, wanting to signal their reputations in competition for listing fees, have incentives to ensure that listed companies provide high-quality information to investors. They therefore suggest that the exchanges hire the audit firms, negotiate their fees, and oversee the outcome of the audits themselves. The exchanges could cover the audit fees through an increase in stock-trading fees, through additional listing fees, or a combination of the two.

While this proposal is intriguing, it’s concerning to note that the exchanges do not have “skin in the game.” They are not liable for damages suffered by investors Joshua Ronen 203 relying on misleading information. The interests of stock exchanges are not closely aligned with those of investors; indeed, executives at stock exchanges may prefer pleasing their listed members to safeguarding the interests of long-horizon investors.

Increased Liability Auditors typically face legal liability under tort law (Talley, 2006). The empirical literature offers some evidence that auditors increase effort and become more conservative in response to litigation risk, which imposes both direct costs and reputation costs (see, for example, Davis and Simon, 1992).10 Perhaps some movement along these lines is worthwhile. But the current sanctions under the Sarbanes–Oxley act are quite extensive. At some point, high standards of liability will push auditors mainly to protect themselves against that liability, which may not be the same as providing the most accurate audit. Too high a level of legal liability could also cause a reduction in the number of firms in the market.

Could changes to liability rules strike a better balance in the incentives for auditors to provide high-quality audits, without risking undesired outcomes? In their review of the theoretical research on whether litigation risk improves audit quality, Latham and Linville (1998) stress that liability is an effective deterrent to poor audits only if meritorious suits against auditors are more successful than nonmeritorious ones. Whether this condition holds is difficult to establish, especially because suits against auditors rarely reach trial (Palmrose, 1997). A proposed reform (Partnoy, 2004) that advocates raising the stakes auditors face for audit failure by imposing “strict” liability for some share of losses regardless of fault is fraught with the difficulty of establishing an appropriate formula.

For other reasons, it is questionable whether increased liability will increase quality to a sufficient degree. First, expected liability costs depend on the perceived probability of detection and enforcement by the regulators and on the effectiveness of civil litigation. With respect to the former, if the past performance of the SEC and other regulatory agencies is any indication, detection and enforcement seem to be doubtful and distant (consider Enron and Bernard Madoff as two cases in point). Such shortcomings may not be surprising where regulators’ budgets are buffeted by shifting political priorities and where their incentives may be more aligned toward potential future employment in the industries they are supposed to regulate rather than with investors. As to civil litigation, except for the very few A series of legislative changes and court decisions in the 1990s served to protect auditors from liability. These changes instituted proportional damages reflecting culpability under the Private Securities Litigation Reform Act of 1995 (PSLRA); barred recovery of treble damages from auditors under RICO in securities fraud cases (under the same act); shortened the statute of limitations in federal securities fraud cases (Lampf, PLeva, Lipkind, Prupis & Petigrow v. Gilberston, 501 U.S. 350 [1991]); eliminated private lawsuits against auditors for aiding and abetting issuer fraud (Central Bank of Denver v.

First Interstate Bancorp Denver, 511 U.S. 164 (1994); heightened pleading standards to allege securities fraud (PSLRA § 101); and outlawed state court class actions alleging securities fraud in the Securities Litigation Uniform Standards Act of 1998. Following these changes, the number of lawsuits against auditors fell sharply (Cunningham, 2007; Coffee, 2004; Talley, 2006).

204 Journal of Economic Perspectives massive cases like Enron and WorldCom, the estimated auditor litigation rate for all public clients is 3 percent, and suits against auditors rarely reach trial (Palmrose, 1997). Moreover, if auditors pass litigation costs on to their clients, their incentives to increase effort would be commensurately lessened.

Moving from Rule-Oriented to Principle-Based Accounting Many corporate accounting scandals seem to share the property that managers, with the consent of their auditors, structured transactions that complied with “bright line” accounting rules but obfuscated revenues or earnings (Maines, Bartov, Fairfield, Hirst, Iannaconi, Mallett, Schrand, and Vincent, 2003). Thus, a common proposal is that the regulations governing financial reporting might shift from being clear rules, which can be manipulated, to broader statements of principle, which offer more discretion to an enforcement agency like a regulator or a court. For example, after Enron was able to avoid treating certain “special purpose entities” as part of Enron because outside equity holders owned at least 3 percent of those entities, this “bright line” rule was recently changed to the principle that a company that most significantly affects the economic performance of a special purpose entity should treat that entity as part of the firm. Canadian accounting standards are more principle-based than U.S. standards, and Thornton and Webster (2004) find better accrual quality (in the sense of smaller abnormal accruals) in statements of cross-listed Canadian firms reporting under both Canadian and U.S. generally accepted accounting principles.





Indeed, some claim that litigation risk may have induced auditors to lobby for “rule-oriented” rather than “principles-based” accounting and auditing standards, because rules afford better protection against liability—although overly strict adherence to rules emphasizes form rather than substance and can lead to a reduction in transparency (Benston, 2003; Harris, 2005; Coffee, 2003; Sunder, 2003;

Wyatt, 2003). Some move toward principle-based regulations may make sense, but it is no panacea. After all, principle-based regulations that do not spell out rules in specific detail can also offer scope for eliding unpleasant truths.

An Alternative Model for Auditing: Financial Statements Insurance

Financial statements insurance is a proposal for a market mechanism that offers significant changes in the structure and incentives of the auditing profession in such a way as to align auditors’ and managers’ incentives with those of investors. The results should be to ensure better quality audits, better quality financial statements, and fewer omissions and misrepresentations in the financial statements. Moreover, audit firms would compete along the dimension of quality rather than price.

Here’s how financial statements insurance would work. Companies that choose to do so would begin by soliciting from insurance carriers offers of insurance coverage for their securities holders against losses caused by omissions and Corporate Audits and How to Fix Them 205 misrepresentations in financial statements that occur during the covered year.11 The insurance carriers would hire an underwriting reviewer to assess the risk of omissions and misrepresentations by examining a company’s internal controls and management incentive structures, its history and competitive environment, and other relevant factors. This underwriting reviewer might be an independent private organization to be created, or an external firm. Based on these reports, insurance carriers would decide whether to offer coverage, and if so, under what conditions—perhaps offering a schedule of possible coverage amounts and premia.

Managers of firms would decide whether to purchase such coverage, and if they did, the coverage and premium would be publicized. Companies that opted for zero coverage would revert to the existing auditing regime. Companies would select an external auditor from a list of audit firms approved by their insurance carrier.

The auditor would be hired and paid by the insurance carrier, but the audit fees would be reimbursed by the insured and separately publicized. Audit firms would also be rated by an independent organization (likely the same as the independent private organization that conducted the underwriting review) to be financed by fees collected from the audit profession.

The financial statements insurance coverage would become effective only if the auditor issued an unqualified opinion on year t’s financial statements somes time in year t + 1. If the opinion was not unqualified there would be no coverage, or the policy terms would be renegotiated and the renegotiated terms would be publicized. For companies with effective coverage, investors’ claims for recovery for losses caused by omissions and misrepresentations that occurred during the covered year would be settled through an expedited judicial process that could involve either a de novo institution created for this purpose or existing arbitrators agreed upon in advance by both the insured and the insurer.

Cunningham (2004b) describes in detail a model act for financial statements insurance. A financial statements insurance product is yet to be created in the market place; a reluctance on the part of the auditors to be hired by insurers seems the main impediment to the attempt to implement this scheme.

By insuring financial statements instead of auditors, fi nancial statements insurance is based on a specific investigation of the underlying risk of misrepresentation, rather than on pooling and diversification. In this sense, it is akin to title insurance, rather than to liability or casualty insurance (Jerry, 2002). While ( Jerry, the existing “directors and officers insurance” product bears certain similarities to the financial statements insurance described here, it is different in substantial aspects: 1) directors and officers insurance insures directors and officers against Under existing law, shareholders who sell stock at inflated prices resulting from misrepresentations cannot be made to surrender their gains to partially offset losses by shareholder who retained the stock until after a curative disclosure (revealing the truth) has occurred. This asymmetry, which would not be cured in the absence of legislative or regulatory action, creates incentives for short-horizon shareholders to induce (via boards of directors’ appropriately designed compensation schemes) manager-initiated omissions or misrepresentations that inflate prices (Ronen and Yaari, 2002). The financial statement insurance mechanism discussed here would dampen the effects of such perverse incentives.

206 Journal of Economic Perspectives liability for omissions and misrepresentations rather than insuring investors;

2) directors and officers insurance covers only the year in which claims are made and not the year during which misrepresentations were made; 3) the premiums for directors and officers insurance are not based on a thorough underwriting review; and 4) coverage and premiums for directors and officers insurance are not publicized.

The insurance industry will have the capacity to pay claims made under financial statements insurance in part because—unlike property and casualty insurance for example—the decreases in the valuation of companies resulting from omissions and misrepresentations in the financial statements that are insured against can be hedged in the capital markets. Specifically, the insurer can buy a special put option to be created with a duration that corresponds to the period covered under the policy. The put would be exercisable upon a stock price decline of the insured that was determined by the judiciary body discussed above to have resulted from omissions and misrepresentations in the insured’s financial statements. Investment funds (including pension funds, mutual funds, and the like) would be willing to sell these puts for less than the price of general puts (which are not conditional on omissions and misrepresentations) and would thus enable the insurer to reinsure any portion of the coverage as desired (Ronen, 2002). Regulators would have to impose limits on the extent of hedging so that the insurers would retain incentives for minimizing investors’ losses.12 Let’s summarize how financial statements insurance affects the incentives of the main parties. Once an insurer has underwritten a financial statement insurance policy, the insurer’s objective would be to minimize the cost of claims against the policy—that is, the insurer’s incentives would be aligned with those of investors. Towards meeting this objective, the insurer would provide incentives to its hired auditor to exert optimal effort, improving the financial statement’s quality in the process. The insurer will charge neither too high a premium (to avoid losing market share) nor too low a premium (to avoid bankruptcy).

Managers of companies with high-quality financial statements will likely wish to buy financial statements insurance and pay small premia relative to other companies to credibly signal their higher quality, which should drive companies to race to a higher quality of financial statements. Auditors, having been hired by the insurers, would want to build reputations for high quality. Their independence, both real and perceived, would be enhanced. Finally, investors and financial markets would benefit from a higher quality of information. Not only will audits be more accurate, but the public information on premiums and coverage for financial statements insurance constitutes a quality or reliability index for investors.

Derivatives such as credit default swaps can be also used to price risk, but that would be a different risk: namely the risk of default. But while default is observable and hence contractible, there exist no satisfactory observable proxies on either audit quality or the probability of omissions and misrepresentations; under the existing institutional arrangements, these constitute private information.



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