Presentation by Joshua Ronen

1. Presentation by Joshua Ronen Financial Services Research Initiative Toronto, Canada– 12 December, 2008 Joshua Ronen, Stern school of Business

2. fair values under FAS 157 • Consistent with the asset-liability approach • Consistent with the principle-based approach to the setting of standards • Relies on exit values from the perspective of external, hypothetical markets • Three levels of measurement Joshua Ronen, Stern school of Business

3. The assets-liability approach • Earnings are not informative about future earnings • An income statement approach helps predict value added Joshua Ronen, Stern school of Business

4. FAS 157 exit values • Reliability of levels two and three are an issue • Hypothetical market-based Exit values do not help in predicting enterprise cash flows • Market bubbles would be transplanted into the income statement. • But exit values may help assess aspects of risk and opportunity costs • We ultimately need both exit values and management's forecasts of use values Joshua Ronen, Stern school of Business

5. A comprehensive accounting framework • Reports management’s present value of subjectively predicted cash flows Discounted at a general market risk-determined rate • Reports exit values as a measure of downside risk (abandonment value) and opportunity cost • Specific advantage and specific residual • Reporting past realizations and de-realizations distinguishing between the expected and the unexpected Joshua Ronen, Stern school of Business

6. The reports • Balance sheet: historical cost, exit values, and specific advantage • costs and benefits statement: Expected cash and changes in risk • Income statement: Expected and unexpected historical and economic income • Change in assets composition statement: realizations and de-realizations Joshua Ronen, Stern school of Business

7. Moral hazard and misrepresentation • Managers may misrepresent their expectations • It is however possible to elicit truth through a revelation mechanism • But this may not be in the interest of short-horizon shareholders • Hence we need reform in the gate keeping function Joshua Ronen, Stern school of Business

8. The Failures by Auditors to Perform The Gate-keeping Function is one of the main culprits in the recent debacles. Joshua Ronen, Stern school of Business

9. The reason for this Corporate Governance failure is the inherent conflict of interest that exists because of the cozy relation between auditors and the managements of their clients who hire their services. Joshua Ronen, Stern school of Business

10. The Sanbanes Oxley Act of 2002 sought to offer a partial remedy by prohibiting some non-audit services. But an indefinite stream of future audit engagement is a potent temptation. Joshua Ronen, Stern school of Business

11. The conflict of interest is endemic to the relation between Management (Principal) and auditor (agent). The Principal structures the contractual relation so that the agent does what the Principal wishes. The Principal’s (Management) interests are not aligned with those of the investors. Management wishes to maximize the value of its options and other compensation - derived wealth. Joshua Ronen, Stern school of Business

12. Proposal: change the identity of the Principal from client’s management to a Principal whose interests would be aligned with those of investors. A good candidate for such a role would be an insuring body. It could be an existing insurance corporation, the auditor himself, an investment banker, or a government corporation. Joshua Ronen, Stern school of Business

13. Figure 1 The FSI Process FSI Carrier (Insurer) Company (Insured) Requests FSI proposal Underwriting Review Maximum Coverage Insured’s Management Premium Disclosures In Proxy Maxi. Coverage & Associated Premium Management’s recommended coverage No insurance Auditor Coordinates Plan with Risk assessor Shareholders’ vote  Decision is publicized If clean opinion, voted-on coverage becomes effective If opinion is qualified No insurance Renegotiation of policy terms OR Joshua Ronen, Stern school of Business

14. The FSI Settlement • The FSI concept contemplates an expeditious claims settlement process • FSI carrier and the potential insured cooperatively select a fiduciary organization • Whose responsibility is to represent the financial statement users when a claim is made • Part of the fiduciary’s responsibility is the assessment of claims before notifying the FSI carrier • After the fiduciary notifies the FSI carrier of a claim, the FSI carrier and the fiduciary mutually select an independent expert to • render a report as to whether there was an omission / misrepresentation and • whether it did give rises to the amount of losses that resulted • Within a short period of time after receiving the expert’s report, the FSI carrier compensates the fiduciary up to the face amount of the policy for the damages Joshua Ronen, Stern school of Business

15. Premium Coverage Capital Market Published Audit Report If clean opinion, Voted-on coverage becomes effective Risk Assessment Audit Fees Payment Auditor Risk Assessor Equity and Debt Proceeds for Equity and Debt Securities Figure 2Relationship Among the Parties Insurer Company- Insured Legend: Solid lines indicate actual flows / Fuzzy lines indicate information flows Joshua Ronen, Stern school of Business

16. Formal Analysis - Main focus • To show that a public disclosure of the insurance premium charged on the financial statement increases the efficiency of capital allocation • To show that switching the audit employment contract to the insurer in addition to disclosing the premium increases both the quality of financial reporting and the efficiency of capital allocation. Joshua Ronen, Stern school of Business

17. A Modified FSI • Auditor is Explicit Insurer of losses caused by restatements (as a first experimental step). • Satisfy eligible claims by paying into an SEC Fair Fund up to 10%, 5.3% median settlement amount adjusted upward for strict liability (to be adjusted for peers) of the average daily decline of the stock price over (-60, +60) times the non-insider float. Joshua Ronen, Stern school of Business

18. Modified FSI continued • Premium paid is the expected contribution to the Fair Fund in the case of the restatement: contribution multiplied by the probability of a restatement (for example, 2% average long-term loss times 10% cap times 6.8% probability of restatement times float of $5 billion equals $680,000). Joshua Ronen, Stern school of Business

19. Modified FSI continued • ARI would be immune from liability under the securities laws. • Client and its directors and officers would have immunity from securities laws liability arising from the restatement, but not otherwise. Joshua Ronen, Stern school of Business

20. Modified FSI continued • 100% percent reserving tax shelter against risk premium. • Limited offset of risks through reinsurance. • Permitted to provide non-audit services. • Experimental transition period. Joshua Ronen, Stern school of Business

21. Restructuring of compensation arrangements • Managers periodically purchase stock or are granted restricted stock at a price randomly chosen ex-post at the end of the period. • Sales of stock would be restricted till some time after exit • Management will be induced to create value over the long run while not inflating value over the short run in order to pay less for the purchased stock • This scheme may have to be mandated because it is not incentive compatible Joshua Ronen, Stern school of Business

22. Let there be a market maker • The CEO, CFO or an informed member of the Board of Directors can be charged with the task of making a market in the firm's stock. Dishonest bid or ask quotes would penalize him or her. • Correlation between quotes and financial statements content would be a useful check on the quality of the latter Joshua Ronen, Stern school of Business