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Social Norms vs. Standards of Accounting

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Title: Social Norms vs. Standards of Accounting


1
Social Norms vs. Standards of Accounting
  • Shyam Sunder
  • Yale University
  • Norwegian School of Economics
  • Bergen, June 3, 2005

2
Summary
  • Norms of accounting important in financial
    reporting
  • Federal regulation of securities, norms
    progressively replaced by written standards in
    accounting thought, practice, regulation,
    instruction, and research
  • Generally accepted accounting principlesno
    longer a description in its plain English
    meaning of a generally accepted societal norm
  • Capitalized Accepted Accounting Principles
  • Social norms maintained by internal and external
    sanctions
  • Standards enforced by authority with power to
    punish
  • Recent failures wisdom of transition from norms
    to standards?
  • Norms in professional, neighborhood, national,
    legal aspect of life
  • Has the pendulum of standardization has swung too
    far?
  • What should be the balance between norms and
    standards in accounting?

3
Institutionalization of Rule Making
  • Since 1960s, accountants occupation with
    keeping the government out of making accounting
    rules
  • Creation of private rule-making institutions
  • Beliefs about what can and cannot be achieved by
    rules
  • Expanded rule books serve as road maps of evasion
    for the unscrupulous
  • Instead of promoting fair representation of the
    big picture, they frustrate the intent of the
    rule makers

4
Keeping the Government Out
  • Four decades of accounting emphasis on keeping
    the government out of rule making
  • Based on a general dislike of government rules
    that might constrain business
  • But many government rules benefit businesses
  • Road traffic, aviation, health and sanitation,
    environment, safety
  • SEC already has the statutory authority to set
    the rules
  • FASB just keeps running harder just to keep the
    government out, making more detailed standards
  • Unlike cotton and diamond trades, accountants
    have not developed a comprehensive private
    mechanism to substitute government mechanisms

5
Structural Weakness
  • Few agencies have rule making as their only
    function
  • A permanent rule-making bureaucracy must make
    rules to justify its budget and existence
  • FASB (until recently) depended on revenues from
    sale of its publications
  • Challenge to publish-or-perish very real
  • Inevitably, rulebook must get thicker over time

6
Incentives Created by Private Rule Making
Institutions
  • Existence of rule making institution encourages
    requests for clarifications
  • Lower resistance to client requests
  • General principles are questioned Yes, it says
    Thou Shalt Not Steal, but I only borrowed the
    car
  • Competition among auditors makes it worse
  • After the change in auditors code of ethics,
    partners rewarded for rainmaking, not their
    technical mastery or professional judgment

7
Effect of Rule Makers on Behavior of Auditors
  • Pushed by clients to cite line and verse to
    support their positions
  • Calls to FASB the rule is not clear
  • Inability of FASB to respond in timely fashion
    becomes basis for client to have his way
  • Absent rule making agency, the auditor would have
    had to worry about the fair representation
    requirement under the security laws
  • Existence of FASB as an unwitting supporter of
    the attitude if it is not proscribed, it must
    be OK

8
Hide-and-Seek at the Wall Street
  • Investment banker calls the FASB
  • Financial engineering to get around the rules
  • Reasonable body of rule might be devised to deal
    with a given set of transactions
  • No rules can be devised when transactions are
    continually redesigned to get around a slowly
    adapting body of rules
  • Minimal changes to get over the bar
  • Wall Street calls to FASB can have the character
    of the thief asking when you plan to be away from
    home

9
Rule-Making Monopolies
  • Monopolies in US (and EU) deprive the economies
    and rule makers of the benefits of observation
    from experimentation with alternatives
  • Difficulty of discovering efficient rules
  • Cost-of-capital consequences unclear
  • Self-serving arguments by constituents
  • Why deny ourselves the benefits of information
    derived from competition

10
Why the Shift from Norms to Written Prescriptive
Standards
  • Misunderstanding of the role of social norms in
    law
  • Popularity/promotion of stock and
    accounting-based compensation for senior managers
  • Promotion of competition in the market for audit
    services
  • Creation of full-time private rule making
    agencies
  • Has this shift gone too far? How do we know and
    decide?

11
Errors of Inclusion and Exclusion in
Classification Schemes
  • Detail should not be confused with precision (ten
    Commandments or 100)
  • Greater the detail, greater the errors of
    exclusion and fewer the errors of inclusion
    (Sunder 1984)
  • In classifying multi-attribute objects (e.g.,
    transactions) exclusion and inclusion errors
    cannot be avoided, only balanced

12
Basic Records Approach
  • Goetz and Schmalenbach proposed making basic
    accounting records available for alternative
    aggregations by users (later popularized as
    events approach by George Sorter
  • Database technology exists, but its use would
    involve reallocation of property rights in
    information and of rents

13
Clear Rules or Road Maps for Evasion
  • A law or rule must strive for clarity and
    enforceability without being a road map for
    evasion
  • Documents for entering a country
  • Schedules and routes of border petrol
  • Bright line accounting standards (3 SPEs, etc.)
    remove the uncertainty for financial engineers
  • Many clarifications facilitate financial fraud
  • Standard-writing agencies become unwitting
    accomplices of evaders

14
Nature of Social Norms
  • Social norms of a group are shared (common
    knowledge) expectations of its members about the
    behavior of others
  • Etiquette, dress, table manners, grammar,
    language, customary law, private associations.
  • Objective of norms is observable behavior, not
    unobservable beliefs
  • Must be a consensus, not just majority support
  • Dictionaries become respectable by attracting a
    following, not by enforced authority

15
Example of an Accounting Norm
  • Revenue recognition
  • Inherently subjective
  • Complete specification of conditions both
    unnecessary as well as infeasible
  • No authoritative source
  • Everybody is free to propose their own norm they
    may or may not be accepted
  • Authority derives from general acceptance by the
    financial community and disapproval of deviations

16
How Do Norms Work?
  • Can social norms, subjective, incomplete work in
    high stakes contentious environment of financial
    reporting?
  • The work well in law, including securities law
  • Lawyers do not replace norms by law
  • 5,000 word US constitution, unwritten in U.K.
  • Juries guilty beyond reasonable doubt
  • Try to pick unbiased juries, may be isolated
  • Insider trading definition non-public
    information
  • Role of authority and procedure in ill-defined
    settings

17
Norms in Accounting
  • Interactions among managers, accountants and
    regulators, absence of procedural rigidities and
    ultimate authority made financial reporting
    unfriendly to norms
  • Solving agency problem by links of compensation
    to accounting measures made it less feasible to
    use incompletely specified norms for financial
    reporting
  • Outside audit was the control but it has its own
    conflict of interest, made worse by encouragement
    of competition among auditors
  • Final authority no second guessing of jury
    decision
  • Given conflict of interest, second guessing is
    inevitable unless accounting is entrusted to an
    insulated bureaucracy

18
Dictionary and Inventory of Accounting
  • GAAP changed from codification in the sense of
    organization of existing practice (dictionary) to
    normative prescription
  • Kohlers Dictionary of Accounting
  • Paul Gradys Inventory of GAAP
  • Not to discover new accounting principles
  • Principles and practices regarded essential
  • To supply explanatory and connecting language
  • AICPA Special Committee written expression of
    GAAP for guidance, narrow difference and
    inconsistency persuasion, not compulsion
  • More than Miss Manners, short of Academie
    Francaise
  • How did financial reporting fall into the trap of
    prescriptive standards?

19
Beliefs about Enforcement and Effectiveness
  • Dentists apply only gradual pressure on braces
  • Criminal law does not prescribe maximum possible
    punishment (cut off the hands of thieves) induces
    more evasion
  • Progressive increase in powers of enforcement
    behind accounting standards
  • Does greater enforcement raise compliance or
    lower the professionals personal responsibility
    for fair representation
  • What evidence do we have on the effectiveness of
    stronger enforcement in financial reporting

20
Possible Reforms
  • Removing or weakening performance-contingent
    executive compensation
  • Missing evidence on link of compensation to work
    and performance
  • Take the control of accounting and reporting
    functions away from managers
  • Scale back on support of auditor competition
  • Moral compass for social norms ultimate judgment
    on fair representation in the hands of accounting
    courts (Leonard Spaceks proposal)
  • Competitive among bodies that set accounting
    standards (What is cost of capital?)
  • Current movement in support of accounting
    monopolies
  • Effectiveness of Sarbanes-Oxley Act of 2002
    unclear

21
Thank You.
  • Shyam.sunder_at_yale.edu
  • www.som.yale.edu/faculty/sunder

22
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23
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24
Outline
  • Why such widespread accounting abuses?
  • Short, medium and long-term perspectives
  • Accounting by norms
  • Regulation and the age of standards
  • Evidence for other social phenomena
  • Failures of markets, and of regulation
  • Standards as road maps for evasion
  • What could we do?

25
Accounting Abuses
  • U.S. Accounting abuses and their consequences
  • Response overhaul of accounting and auditing
    regimes
  • Additional powers to the Securities and Exchange
    Commission (SEC)
  • Additional requirements on the certification of
    internal controls
  • Public Company Accounting Oversight Board (PCAOB)
    to oversee audits of public firms, write auditing
    rules, and to monitor audit firms and the
    industry
  • Effectiveness of these measures an open question
  • Failures unusual, unexpected, undesirable, and
    unacceptable
  • Frequencies of restatements of financial reports,
    SEC enforcement actions, court cases, and
    out-of-court settlementsall rose sharply
  • More than a case of self-perpetuated media frenzy
  • Little anticipation in the nineties of this
    deluge of failures
  • Diagnose the problem short and medium-term
    issues, and then the longer term issues

26
Exhibit 1 Financial Reports Restatements in U.S.
in 1990-2002(Sources Financial Executives
International and General Accounting Office)
27
A Short-Term Perspective
  • The immediate causes of failures beliefs of
    executives, auditors, lawyers, investment and
    commercial bankers, and corporate directors that
    they could default on their duties without
    bearing the consequences
  • Compounded by the failure of government to
    discipline the individual failures
  • Cases are winding their way through the courts
  • Will enforcement of the existing laws remedy the
    problem?
  • Mixed signs so far
  • Enrons auditor is out of business but its law
    firm is not
  • Qualified people reluctant to serve as the
    directors nominating committees reluctant to
    choose technically qualified but unknown people
    for boards
  • More non-employees on audit and compensation
    committees but we do not yet know if they would
    serve the interests of others any better
  • Stock option grant rates slowed down in 2002, yet
    the rapid rise in the compensation of senior
    executives continues
  • Stiff resistance to Donaldsons proposals from
    business and Wall Street

28
Medium-Term Perspective
  • Two critical events of the recent decades
  • U.S. government decided to push competition in
    the audit industry in 1979 (Sunder 2003)
  • Rise in performance-contingent compensation for
    senior corporate executives
  • Policies driven by the dominant economic theories
    of the moment
  • Competition was also supported by the U.S.
    Supreme Court through its decisions (e.g., Bates
    vs. Bar of the State of Arizona)
  • The general theory (competition promotes economic
    efficiency) applied to audit industry created a
    textbook example of a market for lemons
  • Price and quality of audit services declined in
    the early eighties
  • Audit firms try to find alternative sources of
    revenue (consulting)
  • Audit services become loss leaders for consulting
  • Fall in prices and the quality of audit services,
    combined with the increased executive temptation
    to commit accounting fraud (growth of
    performance-contingent executive compensation,
    Erickson et al. 2005)
  • Consequences of this combination were played out
    over two decades until a sharp drop in the
    economy and the stock market, following the
    dotcom bust, brought the house down

29
Longer-Term Perspective
  • Over a century, another pattern emerges
  • Since the enactment of the securities laws in the
    early 1930s, the U.S. has seen a steady shift in
    financial reporting
  • From business and professional norms towards
    legislated written standards enforced by threats
    of explicit punishment for violators
  • This shift altered virtually all aspects of
    accounting (including education)
  • The recent collapse can be seen as a logical
    consequence of the policy decisions of the past
    seven decades.

30
Accounting by Norms
  • The early twentieth century predominance of norms
  • The charge the American Association of Public
    Accountants gave to a Special Committee on
    Accounting Terminology in April 1909
  • to collate and arrange accounting words and
    phrases and show in connection with each the
    varying usages to which they are put. This
    committee will not attempt to determine the
    correct or even the preferable usage where more
    than one is in existence (Zeff 1971, p. 112).
  • In 1918, a memorandum on auditing procedures,
    prepared by the American Institute of
    Accountants, and approved by the Federal Trade
    Commission (FTC), and originally published in the
    Federal Reserve Bulletin, labeled A Tentative
    Proposal Submitted by the Federal Reserve Board
    for the Consideration of Banks, Bankers, and
    Banking Associations Merchants, Manufacturers,
    and Associations of Manufacturers Auditors,
    Accountants, and Associations of Accountants.
  • The intent was to coordinate the evolution of
    norms, and not to impose a standard.

31
Facilitating Evolution of Norms
  • In 1918, the American Institute of Accountants
    appointed a Special Committee on Interest in
    Relation to Cost to address a lively controversy
    on imputed interest as part of the cost of
    production
  • The Committees recommendation against inclusion
    of imputed interest in cost of production,
    approved at the annual meeting of the Institute,
    does not become accepted as an accounting norm
  • The Institute appoints a special committee on the
    standardization of accounting procedure to
    consider all questions of procedure brought
    before it, and to make recommendations from time
    to time on vexed questions in the hope that
    ultimately there may be established something
    approaching uniformity of procedure throughout
    the country
  • The charge suggests facilitation to form norms,
    not legislation of standards. During its
    eleven-year tenure (1918-1929), the Committee
    produced six reports, and none was submitted for
    an official stamp of approval of the membership

32
Norms as an Attitude
  • The absence of authoritative standards of
    accounting did not mean that the world of
    accounting had less order in the early twentieth
    century than in the early twenty-first
  • Active mechanisms the accountants used to
    identify the norms of their profession
  • Journal of Accountancy and the CPA Journal
    served as forums for active, even feisty debates
    on accounting and auditing a function largely
    abandoned by the accounting journals over the
    past quarter century when authoritative standards
    pushed the norms out
  • During 1920-29, the Librarian of the Institute
    issued 33 special bulletins on topics referred
    to them, without the authority of the Institute.
  • In 1931, the Institute published a 126-page book
    Accounting Terminology, a compilation of
    accounting terms and their definitions as a
    matter of advice, not authority.
  • (See Kitchens (1954) Costing Terminology, a
    cogent argument for resisting the temptation to
    issue authoritative definitions, especially in
    accounting)
  • Throughout the 1920s and into 1930s, a committee
    of the Institute worked in close cooperation with
    a committee of Robert Morris Associates, an
    organization of bank loan officers, to respond to
    inquiries submitted to them.

33
Norms Not Enough An Era Ends
  • Role of fair value accounting in the roaring
    twenties
  • The stock market crash of 1929
  • Severe economic depression that followed,
    precipitated another crash
  • Loss of credibility of norms of accounting, and
    the formal or informal mechanisms by which these
    norms evolved and were sustained
  • Too many had lost wealth, livelihoods, even lives
  • Financial reporting transgressions were far too
    many, people lost trust in the social contract
  • It was time to identify and punishat least
    constrainthe guilty
  • Politicians responded the only way they could and
    introduced securities laws and regulations.
  • In the following seven decades, accounting and
    audit failures have been interpreted as evidence
    that norms do not work
  • Norms were gradually shifted to the back burner,
    and legislated accounting standards rose to
    dominate accounting
  • Have the standards achieved, and can they
    achieve, their purported goal?

34
Federal Securities Regulation
  • In 1933-34, U.S. Congress give SEC the legal
    authority to regulate financial reporting
  • The first three decades mostly codifying the
    existing practices
  • Gradually, these efforts shifted from
    identification of conventions or social norms to
    promulgation of legally enforceable standards
  • Increasingly assertive nomenclature of the three
    private sector organizations to write accounting
    rules
  • The Committee on Accounting Procedures
    Accounting Research Bulletins (1948-59)
  • The Accounting Principles Boards Opinions
    (1959-73)
  • The FASBs Financial Accounting Standards (1973
    to present). (IASBs International Financial
    Reporting Standards being the latest addition to
    this trend)
  • By 2000, the social norms have few advocates
    left, most favor legislated standards (with legal
    enforcement) model for financial reporting
  • Yet, the evidence that formal standards do any
    better than social norms of financial reporting
    remains elusive
  • The case for the efficacy of enforced standards
    remains to be made
  • In the absence of evidence, should the benefit of
    doubt go to the government or the market?
  • Thoreaus motto that government is best which
    governs least.

35
Standards as Progress
  • Accountants shifted their allegiance from norms
    to authoritative promulgation
  • Profession now views standardization as a measure
    of progress (our rule book is thicker than
    yours!)
  • Most research refers to standards with respect,
    if not approval
  • By the outset of the 1970s, an energetic and
    ambitious plan was in operation. Zeff on
    attempts of the English Institute in Lectures on
    Forging Accounting Principles in Five Countries
  • Baxter analyzed the corrosive effect of authority
    on accounting profession half-a-century ago
  • Those ideas were largely ignored
  • There has been little research and debate on
    merits and consequences of standardization

36
Standards Leave Documents for Historians
  • Easy to identify the history of accounting with
    the organized efforts to produce written rules
  • Such efforts leave documentary tracer for
    historians, norms dont leave much even if they
    are widely accepted, leave nary a footprint,
    except in fiction
  • Lisa Evans paper on textual analysis of two
    novels with respect to accounting and social
    norms during 1923s German hyperinflation

37
The Appeal of Standards
  • Written standards concrete, salient, published,
    easily disseminated, easy to find, specified
    formally with some precision, can be analyzed and
    discussed line and verse
  • They come into existence at a specific time,
    through a known and understood institutional
    process that may allow the participation of the
    constituents
  • When the environment changes, a systematic
    process is available to formulate changes and
    submit them to a well-specified process for
    possible promulgation
  • Democratic appeal of a transparent institutional
    mechanism for setting standards
  • Following accidents and scandals, the rules were
    not clear is a popular defense
  • Let us make the rules clear to allas a response
    to calm the political waters
  • Even George O. May, an influential leader of
    profession and an ardent supporter of norms,
    responded to William Ripleys Stop, Look and
    Listen (1926) by a call for clearer definition
    of authority
  • Formal written standards appeal to our sense of
    good housekeeping
  • Specified processes for enforcement of violations

38
Norms Are Messy
  • Social conventions and norms are rarely well
    defined, vary in time and space, require an
    extended socialization process to learn and
    understand (Coleman 1990)
  • They carry a penumbra of uncertainty about them
  • Substantial but incomplete overlap among the
    beliefs of the individual members of a group
    about its norms
  • Norms evolve in small, almost imperceptible
    steps, by processes that are not well understood
  • This evolution is decentralized, difficult to
    predict the future direction
  • While the evolutionary process is not opaque, the
    lack of definition and our poor understanding of
    how norms evolve make them less transparent
  • Scandals mock the claims of expertise and
    efficiency required to legitimize existing
    institutions
  • During periods of crises, political or
    bureaucratic decision makers feel pressured to
    write new standards rather than continue to rely
    on existing (recently discredited) norms and
    business practices

39
What About Enforcement
  • Formal standards call for formal enforcement
  • Government departments, courts, regulatory
    agencies, industry associations, and private
    sector bureaucracies in national and
    international domains have a stake
  • Formal enforcement of informal social conventions
    is difficult, no assurance of enforcement
  • Word-of-mouth mechanisms in business
    relationships provide feedback damage or enhance
    reputation (cotton and diamond trades, even
    e-commerce), but dont always do so
  • Yet, social norms do work, nationally and
    internationally
  • The human rights movement, even the U.S. yielded
    recently to evolving international norms on the
    death penalty for minor and mentally retarded
    offenders
  • The Texas state anti-sodomy law struck down the
    Court cited values shared with a wider
    civilizationEuropean Court of Human Rights, and
    other nations
  • Standards apparent advantages of clarity,
    explicitness, and the power of enforcement but
    also disadvantages relative to evolutionary
    social norms
  • Consider a recent example of privacy in e-commerce

40
E-Commerce Privacy
  • The U.K. (and the European Union) protect
    individual privacy by legislated standards
    monitored and enforced by government
  • The U.S. allows the privacy policies in
    e-commerce to evolve as norms or conventions of
    e-commerce without legislated standards or a
    punitive enforcement mechanism
  • Jamal, Maier and Sunders (2005) compared the
    performance of these two regimes
  • The frequency of email messages sent to those who
    do (and those who do not) give consent to receive
    such messages, is almost identical under the two
    regimes (Exhibit 2).
  • In providing timely notice of privacy policies
    and obtaining consent, the performance of the
    standards and enforcement regime of the U.K. is
    about the same as that of the evolutionary regime
    of the U.S. (Exhibit 3)
  • In the absence of legislated standards and their
    government enforcement, a market for web
    assurance services, including privacy assurance,
    has arisen in the U.S. but not in U.K.
  • Formal regulation does not provide protection
    from the extreme behavior of a few websites
  • This is consistent with Enron, WorldCom, Fannie
    Mae, and other companies being mired in
    accounting scandals in the most extensively
    regulated financial reporting environment
  • Privacy has fared no better in the U.K. than in
    the unregulated U.S. e-commerce environment

41
Average Number of E-mail Messages Generated Per
Week(Source Jamal, Maier, and Sunder, 2005)
42
Notifying Visitors Disclosure of Privacy
Policies on U.S. and UK Websites(Source Jamal,
Maier, and Sunder, 2005)
43
Failures of Market and Regulation
  • Regulation often proposed as a solution in case
    of market failure
  • However, regulation, too, is subject to failure
    (see Djankov 2003).
  • Consider four possible reasons why formal
    standards and their enforcement, with all their
    apparent advantages, may not dominate social
    norms in financial reporting
  • The information problem
  • The design problem
  • The gaming problem
  • The signaling problem

44
1. The Information Problem
  • Rule makers problem How to figure which rule is
    better
  • What is a good rule for determining interference
    in soccer? What is a good height of the goal
    posts?
  • Each possible answer changes the game itself
  • Accounting rules affect many members of society
    in diverse ways
  • The direct effect of the rules on people depends
    on their individual circumstances that the rule
    maker knows little about
  • Rules are designed in the hope that they will
    change or constrain the behavior of at least some
    people
  • Changes in the behavior of individuals interact
    in complex ways to generate aggregate
    consequences that are difficult to anticipate
  • The rule maker may try to ameliorate this
    informational disadvantage by soliciting
    information from the parties potentially affected
    by its actions.
  • No incentive to report truthfully strategic
    responses only muddy the waters (Sunder 1997,
    Chapter 11, 2003), create the gaming problem
    discussed below, often forcing the rule maker to
    deal with unintended consequences of the rules.

45
Evolution Incorporates Much Information
  • In social conventions, as in biology, evolution
    proceeds in fits and starts, with no assurance of
    progress
  • Each small or large change in conventions is
    induced by, and induces changes in, individual
    behavior
  • With each change, the social system to a new,
    albeit temporary, expectations equilibrium (see
    Sunder 2002)
  • People get the chance to experience the
    consequences of each change, and adjust their
    behavior to the new circumstances
  • Information in possession of the individuals
    aggregated into these outcomes through market and
    other social processes (Hayek 1945)
  • Evolved social norms tend to incorporate more
    information than the rules made by legislature,
    boards, and other corporate entities.

46
2. The Design Problem
  • Corporate entities for setting standards need
    structure, people, and resources
  • All three needs force compromises in the design
    of the entity
  • Legislative structures emphasize
    representativeness judicial structures emphasize
    impartiality, while bureaucratic structures value
    rules of procedure
  • Not possible to attain representativeness,
    impartiality, and consistency of procedure all at
    once
  • Finding the people to operate the rule-making
    system raises problems
  • The best experts may not be representative or
    impartial
  • Representative bodies may lack substantive
    expertise
  • Financial supporters seek to further their own
    agendas
  • Such inevitable compromises corrupt the ideal
    of standard-setting
  • The gradual evolution of social conventions can
    be said to be free of these weaknesses of
    corporate entities

47
3. The Gaming Problem
  • The information problem compounded by dynamics
    between rules and the behavior the rules are
    intended to influence
  • Each standard alters the decision environments of
    individuals, and potentially alters their
    decisions
  • Induces individuals to search for new
    alternatives, create new opportunities
  • The rule makers cannot anticipate all such
    changes
  • Therefore, the new rules often lead to unintended
    consequences
  • Adjustment of rules sets up yet another cycle of
    new behavior and adjustments
  • Individuals can adjust faster than the rule
    makers can
  • Difficult to make sure that this action-reaction
    sequence converges to a rule and behavior in
    equilibrium
  • Informality and the flexibility of social norms
    can better deal with this gaming problem
  • Evolution is stretched over a long period of
    time, and may get stuck in a rut (e.g., Scapens
    monkeys with bananas)

48
4. The Signaling Problem
  • The standards approach to financial reporting
    favors narrowing the range of options available
    to the reporting entity
  • Intention promote comparability and consistency,
    and the value of financial statements
  • The argument ignores the signaling value of the
    choices made by the reporting entity
  • In choosing from a given set of alternatives, one
    reveals private information
  • Managers reveal their privately held information,
    in part through the financial reporting methods
    they choose (Levine 1996)
  • The use of aggressive or conservative accounting
    gives away valuable information to careful
    readers of the financial reports
  • Narrowing financial reporting choices through
    strict standards also eliminates the ability of
    managers to signal information through their
    choice of financial reporting methods
  • The information, design, gaming and signaling
    problems are ever-present in setting standards
  • They deserve consideration when we weigh the
    roles of standards and norms in financial
    reporting

49
Limits of Written Standards
  • Legal scholarship and practice is careful in
    recognizing the limits of the efficacy of written
    rules
  • When it is not possible to write a rule that will
    improve the state of affairs compared to a
    judgment-based system, the law leaves the
    judgment in place
  • When a judge asks the jury to determine if the
    accused is guilty beyond reasonable doubt, lay
    jurors would want to know how much doubt is
    reasonable ten percent, two percent, or one
    percent?
  • Law does not attempt to codify answers to such
    questions
  • People who write and practice law understand all
    too well the consequences of clarifying such
    questions would be even less desirable than the
    consequences of leaving the answers to the best
    judgment, even of lay people
  • The SEC and the U.S. Congress refuse to clarify
    the definition of insider trading beyond trading
    on non-public information
  • Again, the consequences of clarification are even
    less desirable than the consequences of leaving
    such matters to judgment.

50
Drawing Road Maps for Evasion
  • Unfortunately, accountants willing to pursue
    endless clarification of accounting rules to the
    point of defining the percentages that justify
  • Materiality
  • Lease capitalization
  • Consolidation
  • Non-consolidation of special purpose entities,
    etc.
  • With such written standards it is childs play
    for the Wall Street bankers, accountants, and
    lawyers to design transactions to frustrate the
    intent of the standards
  • Contrary to their intent, standard setters end up
    drawing road maps for evasion
  • The Wall Street (and perhaps the City) loves it
    but fair reporting gets lost
  • Setting up accounting institutions such as the
    FASB and the IASB, whose sole function is to
    issue new accounting rules, has contributed to
    the tendency to write standards which are
    generally accepted only by fiat of authority
  • Wisdom from law, abolish the rule making
    monopolies in various jurisdictions, and
    introduce competition among rule makers with each
    financial reporting jurisdiction in order to
    address this problem (Dye and Sunder 2001, Sunder
    2002).

51
Legal Audit Requirement
  • The legal requirement of an independent audit of
    publicly-held firms blocks efficient functioning
    of a market for audit services
  • If independent audit were not a legal
    requirement, firms with sufficient confidence in
    their accounts and in their prospects would spend
    the money to hire reputable independent auditors
    to convince their shareholders about their
    transparency and good prospects
  • Firms without such confidence will not find it
    worthwhile to hire auditors
  • Investors, presented with reports with and
    without auditor certificates will have to make
    their own risk assessments and price the
    securities accordingly
  • Without government regulation, a market for
    certification or audit services would develop
    analogous to the U.S. market for web services in
    e-commerce
  • Evolution and functioning of an audit
    certification service for online comic book and
    other auctions on eBay
  • Instead of allowing such a market to develop
    endogenously, the SEC requires all firms to have
    their reports audited
  • PCAOB has been set up recently to specify the
    standards by which the auditing must be carried
    out
  • Adding watchmen to look after watchmen does not
    help
  • The extensive regulation of audit practice has
    been accompanied by commoditization of the audit,
    and contributed to extensive auditing failures of
    recent years

52
An Agenda for Reforms
  • The pendulum seems to have swung too far in the
    direction of written standards
  • Reconsider a stronger role of social norms and
    personal and professional responsibility in
    accounting and business
  • Performance-contingent executive compensation
  • Transfer control of accounting system
  • Reconsider virtues of promoting competition among
    auditors (a market for lemmons)
  • Better use of social norms fair representation
    as a moral compass of accounting
  • As guilty beyond reasonable doubt in criminal
    law
  • Neither can be captured in written standards
  • Creation of accounting courts to judge fairly
    represent
  • Assist evolution of accounting norms through
    competition among multiple accounting rule makers
    (no collusion, no convergence)
  • Remove rule-making monopolies in U.S., Europe
    (and elsewhere)

53
Thank You
  • Please send comments to
  • Shyam.sunder_at_yale.edu
  • The paper and the presentation will be available
    at
  • www.som.yale.edu/faculty/sunder/research
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