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Financial Statement Insurance (FSI)

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Financial Statement Insurance (FSI) is a proposal to ensure auditor independence.[1] Under FSI, corporations would buy financial statement insurance instead of privately hiring external auditors.[2] Instead, the auditors would be hired by the insurer; at the same time, the insured corporation would publicize, i.e., make common knowledge, the amount of coverage and the premium for the forthcoming year’s insurance.[3] This would provide an economic incentive to auditors to exert optimal effort in conducting their audit and to managers to ensure a high quality financial reporting system.[4][5] Hence, this proposal would enable market participants to best evaluate financial statement quality to be impounded into the market prices of securities.[6]

Overview[edit]

The concept of FSI originated with Joshua Ronen, a professor of accounting at New York University Leonard N. Stern School of Business.[7][8] It is a market-based solution that proposes that corporations buy financial statement insurance instead of hiring external auditors.[9][10] The insurance carrier would retain and pay an auditor of its choice.[11] Investors and creditors would receive financial compensation for any corporation misrepresentations or omissions in financial statements.[12][13] Corporations would make a payment to the carrier that covers both the insurance premium and cost of the audit; this information would be made public in advance of the fiscal year insured and audited.[14]

Argued Benefits of Proposal[edit]

It is argued that the FSI proposal would have several benefits: first, once the carrier has underwritten the policy, its objective would be to minimize the cost of claims, which means minimizing the probability of misrepresentations and omissions in the financial statements that could give rise to such claims.[15][16] As such, it would be aligned with the interests of investors.[17] Second, since the carrier hires and structures the compensation of the auditor, it would be able to induce the auditor to exert best effort in conducting the audit so as to minimize the probability of misrepresentations.[18][19] Third, since coverage and premium are publicized in advance, investors would impound the signals provided into market prices of securities: higher premium implies lower quality.[20] Fourth, anticipating higher premiums would lower prices of securities issued and hence increase the cost of capital.[21] Managers would then be incentivized to improve the quality of financial statements in order to both pay a lower premium and to obtain higher prices for securities they issue.[22][23] Fifth, by obtaining independent signals on the prospects of the corporation, predicted earnings and cash flows, as well as the quality of the information and hence the reliability of such predictions, the market would become more complete in the sense that securities’ prices would reflect both expected cash flows and the degree to which they can be predicted reliably.[24][25]

Governmental Response[edit]

Senator Elizabeth Dole (R-NC) supported this proposal and made it part of her election platform.[26][27] During her run for U.S. Senate in 2002, she urged that the Securities and Exchange Commission require publicly-traded companies to use FSI.[28] At a Senate Banking Committee confirmation hearing, she argued that, under FSI, “the insurance company has every incentive to hire the most competent auditor, and the auditor has every reason to ensure an accurate audit. Under such a system, the loyalty is to accuracy, not to the corporation being audited."[29][30]

References[edit]

  1. Ronen, Joshua (2006). "A proposed corporate governance reform: Financial statements insurance". Journal of Engineering and Technology Management. 23: 130.
  2. Cherny, Julius; Ronen, Joshua (June 2004). "Financial Statements Insurance Enhances Corporate Governance in a Sarbanes-Oxley Environment". International Journal of Governance. 1 (3).
  3. Ronen, Joshua (October 2002). "Editorial: Policy reforms in the aftermath of accounting scandals". Journal of Accounting and Public Policy. JPP 6094.
  4. Dontoh, Alex; Ronen, Joshhua; Sarath, Bharat (November 2008). "Financial Statements Insurance". Abacus. 49 (3).
  5. Murali, D. "Insurance route to eliminate the perverse incentives of gatekeepers". The Hindu Business Line.
  6. Sterlicchi, John. "The idea the SEC missed". Financial Director.
  7. Ronen, Joshua. "Accounting: progress may lie in insurance". Financial World.
  8. Leone, Marie. "Fresh Ideas on Auditor Independence".
  9. Lee, Susan. "The Dismal Science: A Market Remedy For Our Nasty Accounting Virus".
  10. Nocera, Joseph. "How to Be a Better Bean Counter". The New York Times.
  11. Ronen, Joshua. "A Market Solution to the Accounting Crisis".
  12. Ronen, Joshua; Sagat, Kenneth A. (Summer 2007). "The Public Auditor as an Explicit Insurer of Client Restatements: A Proposal to Promote Market Efficiency". Journal of Accounting, Auditing, & Finance. 22 (3): 511.
  13. Haheshbon, Roeh (September 2006). "Financial Statements Insurance". Institute of Public Accountants in Israel.
  14. Ronen, Joshua (December-January 2006). "Is Financial Statement Insurance a Viable Alternative to the Not-so-Independent Audit?". Securities Litigation Report. 3 (1): 13. Check date values in: |date= (help)
  15. Ronen, Joshua. "Restructuring the auditing market". Witness.
  16. Ronen, Joshua (March 2006). "Is Financial Statement Insurance a Viable Alternative to the Not-so-Independent Audit?". The M&A Lawyer. 10 (3): 1.
  17. Gross, Daniel. "What's the best way to prevent future accounting scandals? Audit insurance". Slate.
  18. Plender, John. "What price virtue?" (PDF). Financial Times.
  19. Ronen, Joshua; Berman, Arnold (July 1, 2004). "TRACKS: Musings on Post-Enron Reforms". Journal of Accounting, Auditing, & Finance. 19 (3): 331.
  20. Ronen, Joshua (January–June 2003). "Financial Statement Insurance". Journal of Forensic Accounting. 4 (1).CS1 maint: Date format (link)
  21. Wan Hussin, Wan Nordin. "My Say: Transforming the audit business". The Edge Weekly.
  22. "Letters to the Editor: How to Keep 'Em Honest While Auditing". Wall Street Journal. July 18, 2002.
  23. Ronen, Joshua; Cherny, Julius. "A Restructuring of the Market for Audit Services". NYS Society of CPAs.
  24. Ronen, Joshua. "Financial Statement Insurance Will Best Ensure Auditor Independence".
  25. Ronen, Joshua (2014). "3". Post-Enron Reform: Financial Statement Insurance, and GAAP Re-Visited. New York, NY: Springer. p. 31. Search this book on
  26. Brewer, Mary Brown. "Elizabeth Dole Applauds Senate Approval of Corporate Accountability Bill; Urges More to Change Incentives for Auditors".
  27. Christensen, Rob; Bonner, Lynn. "Corporate links color Senate Race" (DOC).
  28. Corporate Fianncing Week. "Dole Asks SEC to Require 'Financial Statement Insurance'".
  29. "Nomination of William H. Donaldson to be Chairman of the Securities and Exchange Committee" (DOC). Federal News Service.
  30. Berry, Kate. "Number Crunchers in Chastened Posture as New Rules Take Hold".

Financial Statement Insurance (FSI)[edit]


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