NCPA - National Center for Policy Analysis

Removing The Conflict of Interest Auditors Face

July 10, 2002

Auditing firms have a tremendous incentive to please the corporations they audit. Is there a way to insulate them from pressure to approve or overlook a cooking of the books?

Joshua Ronen, an accounting professor at New York University's Stern School of Business, has come up with a plan to do it by utilizing the free market while avoiding additional layers of regulation.

Ronen calls his approach Financial Statement Insurance and here is how it would work:

  • Corporations would buy insurance from carriers -- in much the same way they now purchase directors-and-officers insurance.
  • But the main difference would be that auditors would be selected by, and work for, the insurance companies.
  • Insurance companies, armed with their own auditor's assessment of the risk that a company was not forthcoming -- either by misrepresenting financial data, omitting data or otherwise engaging in dubious practices -- would then determine how much coverage to offer and at what premium.
  • Risky companies would pay higher premiums than less risky ones, and insurance companies might even decline to provide as much coverage as a company wants.

Both the amount of coverage and the size of premiums would be publicly disclosed so investors would be alerted to companies that have a small amount of coverage at a high premium. Investors would automatically be alerted to situations of high risk; they would shun purchases of such stocks; the stocks would decline in value; and the riskier firms unmasked would find increases in their capital borrowing costs.

The plan brings market discipline into corporate accounting via stock prices. It avoids more government regulation by harnessing the free market's natural system of checks and balances.

Source: Susan Lee, "A Market Remedy For Our Nasty Accounting Virus," Wall Street Journal, July 10, 2002.


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