Presentation (PPT)

Solving the Problem of Setting Efficient Accounting Standards and

Increasing Complexity through Regulatory Competition

Shyam Sunder, Yale UniversityChinese Accounting Professors Association Annual Conference

Wuhan, China, July 14, 2007

Twenty Commonly-Held Beliefs about Financial Reporting

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1. Universal Standards

• Universal standards of financial reporting applied across time, economies, industries and corporate size and organizational forms best serve the constituent interests

– Standardization does save costs and effort, (electrical plugs, clothing, cars, street grids, commercial codes)

– Becomes counterproductive beyond certain limits– How do we know where to stop?– Financial reports are a joint outcome of accounting

standards and the business-economic environment – Rhetoric of universal accounting standards and

universal language (Esperanto)

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2. The Static Ideal

• There exists a set of financial reporting standards that, once discovered and implemented, will induce corporations and their auditors to prepare the best attainable financial reports

– Dynamics of the game between managers and standard setters makes any such static ideal all but impossible

– Standards address only a (small) part of the financial reporting problem

– Standards create new problems of their own: imagine a day when we succeed in closing all doors to accounting manipulation, what would unscrupulous managers turn to next—manipulation of real decisions

– Which is the greater problem for shareholders: to learn less about what is in the pot or to have less in the pot?

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3. People or Structure

• If we select knowledgeable, experienced, self-less, public-spirited, wise and foresighted individuals to constitute bodies to devise accounting standards through deliberation and due process, we can improve financial reporting

– Individuals stand where they sit– Much emphasis on the quality of individuals, too

little attention to the structure of game they are asked to play

– Research shows that outcomes of social institutions are driven more by their structure, and less by the behavior of individuals who participate in them

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4. Engineering Standards through Rational Deliberation

• It is possible to construct or discover better financial reporting standards through deliberation in properly organized corporate entities (such as the IASB, the FASB, etc.).

– Assumes that such bodies can know the consequences of their actions

– History does not support the proposition– Cartesian versus Hayekian perspective on

society

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5. Specialist Bodies to Set Standards

• Specialist standard setting bodies, standing ready to address new problems, inquiries and requests for clarifications help improve financial reporting

– Their existence encourages a new “clarification” game targeted at them

– They must keep a full agenda (performance)– Revenue and budget pressures– Over time, their output necessarily

accumulates to a thick rule book

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6. What Standards are Good or Bad?

• Standard setters can tell which standards are better and why.

– Little evidence that they know, or can know– Cost-of-capital is the result of complex interactions

among many factors (including accounting)– Not even clear if higher or lower cost-of-capital

serves society better– These influences cannot be sorted out by ex ante

analysis– Ex post analysis of data to assess the impact on

cost of capital may be possible, albeit difficult

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7. Standards Monopolies

• Granting monopoly power in a given jurisdiction to standards written by a given body can help improve corporate financial reporting– Informational disadvantage of a monopoly– No opportunity for experimentation– No opportunity to learn from the experience of

alternatives– No pressure to do better, or to correct errors

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8. Competition and Race to the Bottom

• A regime that encourages reporting entities to choose among the standards written by competing organizations (and paying them a royalty for the privilege) induces a “race to the bottom” to devise less demanding standards

– Counter examples (stock exchanges, bond rating services, appliance standards, college accreditation, bank regulation, corporate charters across U.S. states, etc.)

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9. Greater Force Means Greater Effectiveness

• Increase in the power of enforcement behind authoritative standards improves compliance and quality of financial reporting

– Increased enforcement also increases resources devoted to evasion

– Draconian punishments do not necessarily induce better behavior

– Examples: tax collection, crime, alcohol and drug abuse

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10. Statutory Approach Better than Common Law

• The quasi-statutory approach to setting accounting standards dominates a common law approach to financial reporting

– Evidence?– Constitution (U.K., U.S., Europe)– Role of common law in society– Accountants’ attempt to put “statutes” at the

heart of accounting

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11. Written Standards Dominate Social Norms

• Written standards backed by power of enforcement work better than unwritten social norms backed only by internal and external informal sanctions

– Social norms govern great parts of our lives including many aspects of law

– Insider trading– Guilty beyond reasonable doubt– Private commercial codes (cotton, diamond

trades)

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12. Who defends the middle ground?

• The ideal accounting regime would consist of all written standards or all social norms

– Easier to make the extreme cases for standards or norms alone

– Difficulty of defending the middle ground where both may co-exist, as they do in many other aspects of life

– Attempts to drive common law out of accounting are misconceived

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13. New Problems, New Solutions

• Financial reporting and governance problems originated in the 20th century

– History tells us otherwise– Governance problems of the East India

Company– Clive, Hastings, and the Company’s Court of

Directors

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14. Financial Reporting is Getting Better

• Seventy years of standardization of financial reports (in U.S.) has helped improve the quality of financial reporting

– Evidence?– Is a thicker rulebook indication of better

financial reporting?– Perfect correlation between accounting and

stock returns?– How do we judge if our financial reports are

getting better?

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15. Fewer Alternatives, Better Reports

• Fewer the alternative treatments the reporting entities are allowed to choose from, the better the quality of financial reporting

– Fewer alternatives also tie the hands of the management of well-run companies who may wish to signal their confidence, competence and prospects by choosing reporting practices others find difficult to emulate

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16. Auditor’s Bargaining Power

• Well-specified standards enhance the bargaining power of the auditor vis-à-vis the client

– Standards also encourage clients to demand: show me the rule

– Reduced reliance on judgment– More detailed the standards, greater the part

of accountant’s work that can be replaced by a computer, and lower the value of the service

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17. Accounting & Auditing Games

• Written standards constrain the tendency of managers, auditors and investment bankers to play accounting and auditing games– On the contrary, they encourage and facilitate

game-playing by reducing uncertainty about what is, and is not, acceptable

– 3 percent SPEs => Enron

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18. Individual responsibility

• Written financial reporting standards strengthen the individual responsibility of managers, auditors, and investment bankers for fair representation

– On the contrary, they undermine individual responsibility for fair representation and the big picture by shifting attention to meeting the letter, not spirit, of the specific provisions and their wording

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19. Education

• Written standards make it easier to educate better accountants and attract talent to the profession

– Written standards degrade the class room from reasoning and intellectual debate to rote memorization, reinforce street image of accounting as boring and mechanical

– They make it less attractive to young talent

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20. Nothing’s New under the Sun

• Have I said something new?– I wish. William T. Baxter (Professor

Emeritus, LSE), made many of these arguments over half-a-century ago (“Recommendations on Accounting Theory” in Baxter and Davidson, Studies in Accounting Theory, 1st edition).

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The Problem of Setting Efficient Standards

• Criteria (lower cost of capital?)• Generation of alternatives• Evaluation of alternatives• Complex interactions among accounting, capital and

labor markets• Facilitation of evolution of accounting norms• Balancing statutory and common law• Balancing adjustment speed and errors• No substitute for personal responsibility• The nanny (regulator) does not know, but can help

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How Can the Nanny Help?

• Government, quasi-government or private sector bodies can play a positive role in evolution of norms of accounting through oversight– No monopoly jurisdiction– Competition with alternatives (royalties)– Opportunity to experiment– Co-existence of multiple sets of standards for different

clienteles—diversity essential to evolution– Excel conversion workbooks (high R-square)– Personal responsibility for fair representation– Accounting Court: guilty beyond reasonable doubt

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In Contrast to IASB (FASB) Command & Control View

• To develop accounting standards:– A single set (monopoly?)– Of high quality (what does that mean?)– Understandable (to who?)– Enforceable (stick, not norms)– Global (no clientele or diversity)

• Are we ready for an alternative mind set about financial reporting?

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Whither Accounting: Windows™ or Open Systems

• Comfort vs. choice• Uniformity and stagnation vs. dynamic change• Predictability vs. some disorder• High prices or the advantages of technological

progress• Financial reporting as an eco-system or a

machine (garden or a building)• Huxley or Hayek• Nanny or personal responsibility

Thank You!

[email protected]

www.som.yale.edu/faculty/sunder