Shyam Sunder
Yale School of Management
Krakow University of Economics
Krakow, Poland
May 21, 2009
REGULATION OF ACCOUNTING
Protecting Consumers and
Investors
 Protection of consumers and investors from unfair or
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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
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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
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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
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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
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Universal standards of financial reporting
applied across time, economies, industries and
corporate size and organizational forms best
serve the constituent interests
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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
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2. The Static Ideal
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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
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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
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3. People or Structure
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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
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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
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4. Engineering Standards
through Deliberation
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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.).
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Assumes that such bodies can know the
consequences of their actions
History does not support the proposition
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5. Specialization in Setting
Standards
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Specialist standard setting bodies, standing
ready to address new problems, inquiries
and requests for clarifications help improve
financial reporting
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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 book
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6. What is High Quality
Standard in Accounting?
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Standard setters can tell which standards
are better and why.
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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
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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
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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
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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. Force and Effectiveness
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Increase in the power of enforcement
behind authoritative standards improves
compliance and quality of financial
reporting
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Increased enforcement also increases resources
devoted to evasion
Draconian punishments do not necessarily
induce better behavior
Crime, alcohol and drug abuse
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10. Statutory Approach
Dominates Common Law
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The quasi-statutory approach to setting
accounting standards dominates a common
law approach to financial reporting
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Evidence?
Constitution (U.K., U.S., Europe)
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11. Written Standards Dominate
Social Norms
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Written standards backed by power of
enforcement work better than unwritten
social norms backed only by internal and
external informal sanctions
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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?
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The ideal accounting regime would consist
of all written standards or all social norms
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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
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13. New Problems, New
Solutions
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Financial reporting and governance
problems originated in the 20th century
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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
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Seventy years of standardization of financial
reports (in U.S.) has helped improve the
quality of financial reporting
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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
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Fewer the alternative treatments the
reporting entities are allowed to choose
from, the better the quality of financial
reporting
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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
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Well-specified standards enhance the
bargaining power of the auditor vis-à-vis the
client
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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
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Written financial reporting standards
strengthen the individual responsibility of
managers, auditors, and investment bankers
for fair representation
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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
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Written standards make it easier to educate
better accountants and attract talent to the
profession
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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
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Have I said something new?
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I wish. William T. Baxter (Professor Emeritus,
LSE), made many of these arguments over halfa-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
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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
Accounting Consensus 2
 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
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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?
Accounting Consensus 3
 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
Accounting Consensus 4
 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
Accounting Consensus 5
 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
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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 help
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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
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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
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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?
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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
Shyam.sunder@yale.edu
www.som.yale.edu\faculty\sunder
THANK YOU.