shyam sunder yale school of management

Shyam SunderYale School of Management

Krakow University of EconomicsKrakow, PolandMay 21, 2009

Protecting Consumers and Investors Protection of consumers and investors

from unfair or misleading practices is the common goal of regulation

The question worth discussing: How do we achieve this goal?

We do not wish to fail to protect the interests of consumers and investors

Or promote unwise regulation that may bring more harm than good

I would like to concentrate these remarks on regulation of corporate financial reporting which has gained in urgency in light of the recent events

Regulatory Cooperation and Coordination Regulatory cooperation yields many advantages

Simplifying the environment Clear communication of the regulatory regime Better and cooperative enforcement among jurisdictions Adoption and use of best practices Avoidance of race to the bottom An appearance and sense of control (until things go

wrong) Closing the cracks between the adjacent regulatory

domains, etc. The recent decades have seen gradual expansion of

regulatory cooperation which has yielded many of these benefits (and revealed some weaknesses)

However, as in most matters of social policy, there always the other side of the coin to be considered: regulatory competition

Regulatory Competition

In pursuit of the obvious advantages of regulatory cooperation, it is easy to overlook its limits and the advantages of alternatives

Regulatory uniformity and cooperation works fine in a world were regulatory alternatives and their respective properties are already known and well-understood

Such extensive knowledge—a Cartesian universe—is highly desirable, but often unachievable by any one As recently as 18 months ago, US regulators sincerely

defended their hands-off approach to the derivatives market They were neither incompetent nor Machiavellian Few people knew the consequences of those regulatory

policies until much damage had been done In fact, most of the time, we live in a world where

properties of regulatory policies, and indeed the alternatives themselves, must be discovered through trial-and-error through experience

Regulatory Humility

There is a case to be made for regulatory humility—often we do not know the consequences of policy alternatives until we try them out

In contrast to the Cartesian mindset of regulatory uniformity through top-down design with complete knowledge of the system, regulatory competition suggests a Darwinian mindset The consequences of changes in social policy involve

reactions of millions of people adjusting to the policy in their own diverse and ingenious ways

We cannot be sure of the consequences of a policy until we try it out and see what happens

We could try to find a balance between the cooperative and the competitive approaches

Extraction and Generation of Benefits of Innovation EU’s single market initiative is an example of an effort

to make sure the benefits of innovation are enjoyed to the maximum extent by lowering barriers to free movement

Making the markets more perfect by removing frictions clearly helps this goal

But there is the other side of the innovation coin—generation of innovation

Entrepreneurs innovate to make private profits by differentiating their products and thus creating local imperfections which tend to be eliminated only over time through competition

Blocking innovation to prevent profit making through differentiation would kill the golden goose of prosperity

Patent law as an example of the struggle for this balance

Financial Reporting: Some Commonly-held Beliefs

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? Few industries have universal standards, and

no professions have them Rhetoric of universal accounting standards and

universal language

04/08/23(c) 2005 Sunder, Nanny Knows Best 8

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 is only a (small) part of the problem


3. People or Structure

If we select knowledgeable, experienced, self-less, public-spirited, and wise individuals to constitute bodies that 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


4. Engineering Standards through 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


5. Specialization in Setting 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 must accumulate

to a thick rule book04/08/23(c) 2005 Sunder, Nanny Knows Best 12

6. What is High Quality Standard in Accounting? 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)

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


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


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.)


9. Force and 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

Crime, alcohol and drug abuse


10. Statutory Approach Dominates 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)


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)04/08/23(c) 2005 Sunder, Nanny Knows Best 18

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


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


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?04/08/23(c) 2005 Sunder, Nanny Knows Best 21

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


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


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


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


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


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).

Kautilya’s Arthasastra, the 4th centurt B.C. Sanskrit classic has three chapters on accounting, auditing and control


Beware of Consensus

A different perspective You would be left behind if you

do not follow the crowd Washington Consensus Accounting Consensus—five

main elements

Accounting Consensus 1

The standards developed should be confined to principles, and not become detailed rules Nobody can tell which is which IFRS vs. FAS, yet plans to adopt many of

the FAS Fair values: principle or rhetorical device


A single set of high quality written standards of financial reporting applied to all companies (at least the publicly traded ones) in the world will improve financial reporting by making financial reports more comparable, and thus assist investors and other users of financial statements make better decisions All prefer high quality, but what is it (Joyce et al.) Principles-comparability contradiction Accounting for research & development costs (FAS

2) Evidence that accounting standards help investors

or managers make better decisions?


The best way to develop such standards is to create a single deliberative corporate body consisting of appropriate experts with a proper governance structure and legally assured funding, functioning under the oversight of statutory regulatory authorities such as the SEC and the EC Difficulty of assessing proposed standards (no

comparison) Even simple engineering design need field trials Complexity of social institutions, risk of getting boxed

into a wrong standards Division of simplicity and complexity between strategy

and institutions Ecosystem view of financial reporting system Competition with no tax revenues


To this end, the operations of the FASB and the IASB should be gradually merged into one corporate body and one set of standards to be called IFRS From social norms to uniform written

standards Effect of uniformity of education, research

and profession Compare accounting education to

education for other professions


This single set of standards should be practiced in the U.S., EC, and elsewhere, and the U.S. educational system should prepare itself to integrate IFRS into its curricula so university graduates will be able to prepare, use, and audit financial reports based on IFRS Educational consequences an afterthought at best Effect of expansion of written standards on

classroom discourse Educational capacity: chance to shift to general

principles of accounting Place of accounting in the university: medicine or

plumbing

The Problem of Setting Efficient Standards Criteria 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 regulators may not know, but can

help04/08/23(c) 2005 Sunder, Nanny Knows Best 34

How Can the Regulators 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


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?


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 Role of accounting researchers/professors?


Concluding Remarks

In the preface to his Dictionary, Johnson wrote about his “fortuitous and unguided excursions into… the boundless chaos of a living speech." Can authoritative uniform standards without collaboration with social norms bring a semblance of order to the chaos to financial reporting? After seven decades of incessant efforts, the answer stares us in the face

[email protected]\faculty\sunder

shyam sunder yale school of management

Documents

regulatory competition

regulatory alternatives

regulatory regime

regulatory humilityoften

adjacent regulatory

impossible standards

engineering standards

benefits of innovation