Financial Reporting: Roles of Written and
Unwritten Requirements
Shyam Sunder
Yale School of Management
Consultative Committee of the
Autorité des Normes Comptables (ANC)
Paris, France, June 22, 2011
The Ultimate Man-Bites-Dog
News Story
• L. Gordon Crovitz column on Information Age in the
Wall Street Journal, June 20, 2011
• http://online.wsj.com/article/SB10001424052702303635604576
391802026638250.html
• A strange thing happened in Washington earlier this
month: After spending two years studying an issue, a
federal agency published a 475-page report documenting
the problem only to announce that government is not the
solution.
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Internet and Local News
Reporting
The FCC study, "Information Needs of Communities,”
50 percent drop in state and local news reporting and staffs; internet
undermines the advertising-based business model of local
newspapers, role of search engines
"Just because we have identified a problem does not mean we can
solve it," Steven Waldman, the lead researcher for the agency, told
me last week. "We did not feel we had to show some big regulatory
pot of gold at the end of the rainbow to prove this work had value."
Importance of the Problem and
Efficacy of Solutions
• Is the drop in local news reporting an important matter for
a democratic society?
• Should we try to find a solution to the problem?
• What if we are unable to find a solution that has a
reasonable chance of improving the state of affairs?
– Wait until we can find a better solution?
– Go ahead and do what we can even if we know it is unlikely
to solve the problem?
Specifics vs. Structure of Problems
in
Financial
Reporting
• Most debates on accounting standards (including IFRS) are confined
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to merits of specific written standards
In this narrow debate, we assume that a new or revised written
standard will solve the problem
We need to go beyond the confines of specific details of standards
Roles of written and unwritten standards?
Which standards are best left unwritten?
What should be the structure of institutions we create to decide this
Do we have institutions that do not favor writing new standards?
Let us start with examination of
some commonly-held beliefs in
financial reporting
1. Universal Standards
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Universal written standards of financial reporting
applied across time, economies, industries and
corporate size and organizational forms best serve
the constituent interests
Standardization does save costs and effort, (electrical
plugs, clothing, cars, street grids, commercial codes)
Becomes counterproductive beyond certain limits
How do we know where to stop?
Rhetoric of universal accounting standards and universal
language (Esperanto?)
2. The Static Ideal
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There exists a set of written 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 are only a (small) part of the problem
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 of Standards through
Deliberation
It is possible to construct or discover better written
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
No evidence in history to support this proposition
Written standards by authoritative bodies have repeatedly
failed to yield their stated outcomes
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 written output must accumulate to a
thick rule book
6. What is Good and Bad?
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Standard setters can tell which written standards are
better, and why; and what would happen if a rule were
left unwritten
Little evidence that they know, or can know
Cost-of-capital is the result of complex interactions among
many factors (including accounting)
These influences cannot be sorted out by ex ante analysis
Ex post analysis of data to assess the impact on cost of
capital may be possible
7. Standards Monopolies
• Granting monopoly power in a given jurisdiction to
standards written by a given body can help improve
corporate financial reporting
– Informational disadvantage of a monopoly
– No opportunity for experimentation
– No opportunity to learn from the experience of
alternatives; arrogance
– No pressure to do better, or to correct errors
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8. Competition and Race to the
Bottom
A regime that encourages reporting entities to
choose among the standards written by
competing organizations (and paying them a
royalty for the privilege) induces a “race to the
bottom” to devise less demanding standards
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Counter examples (Stock exchanges, bond rating
services, appliance standards, college
accreditation, bank regulation, corporate
charters across 50 states in U.S., etc.)
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 (recent report on failure of
the War on Drugs)
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10. Statutory Approach Dominates
Common Law
The quasi-statutory approach to setting
accounting standards (writing everything down)
dominates a common law approach to financial
reporting (leave significant parts unwritten, and
subject to professional judgment)
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Evidence?
Constitution (U.K., U.S., Europe)
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11. Written Standards Dominate
Social Norms
Written standards backed by power of
enforcement work better than unwritten social
norms backed only by internal and external
informal sanctions
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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)
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 written and unwritten standards may coexist, as they do in many other aspects of life
13. New Problems, New Solutions
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Often assumed that 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 five years of standardization of financial reports
(in U.S.) has helped improve the quality of financial
reporting
Evidence?
Is a thicker rulebook indication of better financial
reporting?
Perfect correlation between accounting and stock returns?
How do we judge if our financial reports are getting
better?
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15. Fewer Alternatives, Better
Reports
Fewer the alternative treatments the
reporting entities are allowed to choose from,
the better the quality of financial reporting
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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
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
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 rule for Special Purpose Entities => Enron
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
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
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
half-a-century ago (“Recommendations on
Accounting Theory” in Baxter and Davidson,
Studies in Accounting Theory, 1st edition).
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 FAS wholesale
– 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
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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
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Difficulty of assessing proposed standards
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 U.S. graduates will be
able to prepare, use, and audit financial reports based on IFRS
– Educational consequences an afterthought at best
– Effect of expansion of written standards on classroom discourse
– Educational capacity: chance to shift to general principles of
accounting
– Place of accounting in the university: medicine or plumbing
The Problem of Setting Efficient
Standards
Criteria
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• Generation of alternatives
• Evaluation of alternatives
• Complex interactions among accounting, capital and labor
markets
• Facilitation of evolution of accounting norms
• Balancing statutory and common law
• Balancing adjustment speed and errors
• No substitute for personal responsibility
• The nanny does not know, but can help
How Can the Nanny Help?
• Government, quasi-government or private sector bodies can play
a positive role in evolution of norms of accounting through
oversight
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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
In Contrast to IASB (FASB) Command
& Control View
• To develop accounting standards:
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A single set (monopoly?)
Of high quality (what does that mean?)
Understandable (to who?)
Enforceable (stick, not norms)
Global (no clientele or diversity)
• Are we ready for an alternative mind set about financial
reporting?
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Whither Accounting: Windows™ or
Open
Systems
Comfort vs. choice
Uniformity and stagnation vs. dynamic change
Predictability vs. some disorder
High prices or the advantages of technological progress
Financial reporting as an eco-system or a machine (garden or a building)
Huxley or Hayek
Nanny or personal responsibility
Role of accounting researchers/professors?
Concluding Remarks
• In the preface to his Dictionary, Johnson wrote about his
“fortuitous and unguided excursions into… the boundless
chaos of a living speech.”
• Can authoritative uniform written standards without
collaboration with (unwritten) 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
Thank You.
Shyam.sunder@yale.edu
www.som.yale.edu\faculty\sunder