Norms, Standards and Failures in
Accounting and Auditing:
Rethinking Practice, Research and Education
Shyam Sunder, Yale University
Peking University
July 12, 2007
An Overview
• Roots of accounting and auditing failures
– Short, medium and longer term views
• Pushing competition in market for auditing
• Transformation of financial reporting from
social norm to written standards
• Consequences for practice, education and
research
• Policy alternatives
Roots of Accounting and
Auditing Failures: A Rethinking
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:
– Enron’s 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, back-dating scandals
Medium-Term Perspective
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Two critical events of the recent decades
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Policies driven by the dominant economic theories of the moment
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U.S. government decided to push competition in the audit industry in 1979 (Sunder 2003)
Rise in performance-contingent compensation for senior corporate executives
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 performancecontingent 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
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.
A Thumbnail Sketch of the
Collapse
• Ninety years of antitrust laws and
enforcement
• These laws were not applied to the
professions—including doctors, lawyers,
accountants, and dentists
• They kept anticompetitive clauses in the
“Code of Ethics” of their respective
professions
Professional Codes of Ethics
• No advertising
• No solicitation of competitors’ clients or
customers
• No solicitation of employees of
competitors
• Most professions justified such clauses in
their rules of membership on the basis that
they are necessary for “professional”
behavior
Economics of Restrictions on
Professional Competition
• There were substantive economic arguments to
justify restrictions of professional competition
– Quality of professional services difficult to see
– Customer/client depends on seller’s recommendation
about what he/she should buy
– Professional must incur time/effort to find out what the
customer/client needs, must charge for it
– Markets for professional services are prone to failure
under free competition
– Market for lemons (Ackerlof)—results would be even
worse than the consequences of insufficient
competition
Theory Makes a Difference
• Economic arguments for deregulation
• Stigler: robustness of competition paper
• Answer to the “market for lemons”: the
reputation effect as a counter to the
lemons phenomenon
• Focus on economic efficiency of the
system
Status Quo Till 1977
• This was the status quo of competition in
markets for various kinds of professional
services in U.S. until the mid-seventies
• Then came a decision from the U.S. Supreme
Court
• In 1977: U.S. Supreme Court ruling on Bates v.
State Bar of Arizona, held that the restrictions on
lawyer advertising violated the protections given
free speech under the First Amendment to the
US Constitution
Change in US Policy
• The Supreme Court decision led to a change in
the U.S. government policy on professional
competition
• Under pressure from the Department of Justice
and the Federal Trade Commission, most
professional associations, including the
American Institute of CPAs deleted the
anticompetitive provisions from their codes of
ethics by the end of the seventies
Good Intentions, Bad Decisions
• The intent behind this change in the government policy (and
the Supreme Court decision) had been to obtain for the public
the presumed benefits of competition among professions
• The Court accepted the argument that, the risks of failure in
the market for professional services are adequately
counterbalanced by the tendency of the professionals to
develop a reputation for the quality of services they provide
• Over time, customer and clients learn about the reputation of
the professionals, as the basis of those they choose to
patronize
• Reputation prevents market failure
Does Reputation Work?
• In the case of doctors, at least the patient (or his
family) know, after the treatment, whether the
patient got better (even survived)
• In the case of lawyers, at least the client knows,
after the trial, whether the case was won or lost
• These ex post observations are reasonably prompt
and have at least a proximate correlation with
performance They enable the doctors/lawyers to
develop a more or less precise reputation with their
patients/clients that serve as the basis of their own
(and their acquaintances’ future decisions)
Generalizability to Auditors?
• Unfortunately, this argument, applicable to
lawyers and doctors and many other
professionals, does not work for the auditors
• The auditors’ customers—the shareholders and
other third parties—cannot tell, even after the
fact, if the auditor provided quality services for
three reasons:
– The rate of audit failure is less than 1 percent
– The customers never see the auditor do their work
– Firm’s decisions on hiring the auditor are made by
managers who are the subject of the audit
The Fatal Flaw
• Application of the reputation argument as the
justification for competition in the market for
auditing was fatally flawed
• With very low failure rate, and absence of direct
contact and observability by the customers, it is
not possible for auditors to develop meaningful,
and accurate reputation with the shareholders in
any reasonable length of time
• Under the pressure of free competition, the
market for auditing broke down—a market for
lemons
Audit Market Breakdown
• Clients actively played audit firms against one
another to lower their audit fees
• The amount and quality of the work done by
the auditors was not observable to the clients
• Competition for audit services would not
sustain a price to make auditing selfsupporting
• Auditors responded by a new business model
to survive in this cut rate environment
Revised Business Model of
Audit Firms
• Aggressive pricing of audit services
• Cut labor intensive substantive testing, and
replace it by cheaper analytical reviews
• Use audit service as “foot in the clients’ door,” to
sell consulting services
• Share consulting revenue with audit partners
• Use consulting revenue to pay for any additional
audit liability coverage arising from reduced
substantive testing
• Reduce the pay for fresh graduates
Consulting: A Consequence,
Not the Cause of Failure
• In the debate on consulting services over
the past decade, they have often been
portrayed as the cause of failure of audit
market by depriving auditors of their
independence
• Instead, auditors turned to consulting
services to earn a living when they found
that they could not do so from audit
services
Large Liabilities
• The strategy of de-emphasizing substantive
testing led to some spectacular audit failures,
especially in the savings and loan banking
industry in the mid-eighties
• Audit firms paid large court judgments or out-ofcourt settlements
• Drop in number and quality of students going
into accounting majors
• Mid-course correction was needed to restore
profitability
Number of Settlements of
Claims Against Auditors
Frequency by Time Period
300
250
200
150
100
50
0
1960-1964 1965-1969
1970-1974
1975-1979
1980-1984
Time Period
1985-1989
1990-1995
Unknown
Amounts of Settlements Against
Auditors
500,000,000
400,000,000
300,000,000
Total
200,000,000
100,000,000
0
19
67
19
72
19
75
19
78
19
81
19
84
19
87
19
90
19
93
19
96
Amount of Settlements
Total Amount of Settlements
Year
Joint and Several versus
Proportional Liability
• The auditor liability had been joint and several; if
other defendants could not pay, auditors had to
pay their share
• A political strategy to change the law to
proportional liability
• Financing of elections as the lawyers and
doctors had done for many years to advance
their interests
• Payoff: Private Securities Litigation Reform Act,
1995
Accountants’ Contributions to
Political Campaigns
Accountants’ Contributions to
Political Campaigns
1995 Legislation
• For auditors: switch from joint and several to
proportional liability
– Reduced and less uncertain liability
• For corporate management: forward looking
statements under safe harbor rule
– Freedom to issue unverified (unverifiable) information
in financial statements as long as it was marked
forward looking
• The only instance during Clinton’s eight year
presidency when his veto was overturned by the
Congress (election financing)
New Business Model
• The 1995 legislation, with a 1994 Court ruling exempting
advisors from liability for aiding and abetting securities
fraud, implemented the new business model of auditors
– Key elements: intense competition, low audit fees to get in, fast
growing high margin consulting business for profits
• Audits discarded in favor of “assurance services”
• Audit partners pressured to sell consulting services
– Many old time auditors quit, instead of selling consulting
• Internal reorganization of power and responsibilities
– E.g., Arthur Andersen transferred the final authority on
accounting matters from headquarters specialists to the local
partners
The Happy Days End
• In 1999, the Securities and Exchange Commission saw
the adverse consequences, but wrongly identified
consulting services as the culprit, and tried to stop
consulting
• Audit industry beat back the effort with political help from
the Congress (settled for disclosure of consulting fees)
• Extensive failures of corporate audits are the results of
this 25-year chain of events
• Auditors had become the perpetrators, the short term
beneficiaries and ultimately the victims of the dotcom
bubble
• The well meaning government policy to encourage
competition in the industry pushed it to collapse
Perspective on Events of 2002
• We can choose to view the events of 2002 as
bad behavior by some individual managers,
auditors, directors, lawyers, investment bankers,
bankers, politicians, etc.
• Alternatively, we can see them as a chain a
related events, arising from bad policy
• We pushed competition into a market that is not
able to sustain competition because of ex ante
or ex post unobservability of the quality of
service provided
From Norms towards Standards
of Corporate Financial Reporting:
A Long Term Perspective
Summary
• Norms of accounting are important in financial reporting
• Federal regulation of securities induced transition from norms
towards written standards in accounting thought, practice,
regulation, instruction, and research
• Generally accepted accounting principles—no 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
• Consequences of transition from norms to standards
• Has the pendulum of standardization has swung too far?
• What should be the balance between norms and standards in
accounting?
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
Common Law Approach
• Development in England through custom,
acceptance and judicial precedent
• From people, not experts
• Their force arises from usage
• Progressive replacement of common law by
statutory thinking in financial reporting
• Time to reconsider the merits of common
elements
• Would introduction of limited competition among
alternative sets of accounting rules help?
Accounting by Norms
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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).
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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.
Dictionary and Inventory of
Accounting
• GAAP changed from codification in the sense of organization of
existing practice (dictionary) to normative prescription
• Kohler’s Dictionary of Accounting
• Paul Grady’s 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?
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
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
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
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 Committee’s 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
Norms as an Attitude
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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 Kitchen’s (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.
Norms Not Enough: An Era Ends
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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 punish—at least constrain—the 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?
Federal Securities Regulation
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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
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The Committee on Accounting Procedure’s Accounting Research Bulletins (1948-59)
The Accounting Principles Board’s Opinions (1959-73)
The FASB’s Financial Accounting Standards (1973 to present). (IASB’s 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?
Thoreau’s motto: “that government is best which governs least.”
Institutionalization of Rule Making
• Since 1960’s, 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
Trying to Keep 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
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
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
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”
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
Why the Shift from Norms to
Written Prescriptive Standards
• Misunderstanding of the role of social norms in
law
• Popularity/promotion of stock and accountingbased 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?
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
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
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
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 don’t leave much even if they are widely
accepted, leave nary a footprint, except in fiction
• Lisa Evan’s paper on textual analysis of two
novels with respect to accounting and social
norms during 1923’s German hyperinflation
The Appeal of Standards
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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 all—as 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 Ripley’s “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
Norms Are Messy
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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
What About Enforcement
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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 ecommerce), but don’t 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 civilization…European 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
Accounting as a Natural
Language
• Generally accepted accounting principles
as dominant paradigm in accounting till
1972
– Accounting as natural language
– Evolution by usage and consensus over time
– Multiplicity of meaning and words
– Flexibility and limitless variability
– Authority derives from acceptance not power
– No known natural language designed by man
Accounting as Designed Artifact
• Designing rules through deliberation
• Replacement of suggestive nature of research
bulletins and opinions by standards and the
power to punish any deviations
• FASB: large budget, staff; no greater wisdom,
less modesty in ability to devise better rules
• Multiple criteria without aggregation function
• Cost of capital missing as a criterion for rules
• Consultative process but monopoly deprived it of
natural selection necessary for evolution
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
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The information problem
The design problem
The gaming problem
The signaling problem
1. The Information Problem
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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.
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.
2. The Design Problem
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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
3. The Gaming Problem
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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)
4. The Signaling Problem
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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
Limits of Written Standards
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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.
Drawing Road Maps for Evasion
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Unfortunately, accountants willing to pursue endless clarification of accounting rules
to the point of defining the percentages that justify
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Materiality
Lease capitalization
Consolidation
Non-consolidation of special purpose entities, etc.
With such written standards it is child’s 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).
Policy Alternatives
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 lemons”)
– 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)
– Voluntary audit, insurance solution
Summary
• The recent collapse of accounting and auditing requires
careful analysis of its root causes
• Bad people or bad policies?
• Need to think of alternative solutions, e.g.,
– Competition for accounting standards
– Reduce competition in audit market or bundle with
insurance
– Minority directors with real elections and better information
for shareholders about directors
– Scale back on performance-contingent managerial
compensation
• Think of even better alternative approaches
Thank You
http://www.som.yale.edu/faculty/sunder
Shyam.sunder@yale.edu