IFRS Monopoly: Pied Piper of Financial Reporting Shyam Sunder Yale University Waseda University Tokyo, Japan, Feb 3, 2011

Better Society? Better Markets? Better Accounting?

Competition

Competition

IFRS through National Regulators

I was very creative with my accounting, but not creative enough.

Crusade for Fiscal Responsibility David Walker Former Comptroller General of the U.S. Founder, CBI initiative to return to fiscal responsibility

All in One Voice “Single set of high quality principles-based standards for use by all to achieve comparability”

Unintended Consequences

Promise of Uniform Currency

Ten Years Later

One Size Fits All

Quality through Standards

Co-ordination through Standards

Quality and Coordination Standards

Standardization of Financial Reporting Disclosure Format Measurement

Good and Bad Standards

Bases for Deciding Prosperity of society Inclusion of information from all Stability over time Adaptability to changes in environment Robustness against manipulation Resistance to capture Mr. Crenshaw’s proposal was passed by a vote of one-to-six with Mr. Crenshaw casting the deciding vote.

Why Is the FASB Making Too Many Accounting Rules? Shyam Sunder The Wall Street Journal April 21, 1981

Adaptability

Non-Bases for Deciding on IFRS Statistical covariation between accounting and stock market data Promotion by interested parties 120 countries can’t be wrong

Statistical Studies of Accounting and Stock Markets

Stock Market as Objective Evidence on Financial Reporting Alternatives This paper aims at determining the value relevance of financial reporting. …This study aims at explaining likely impact of financial reporting by listed companies on the market prices of their shares. Our study reveals that value relevance of published financial statements, per se, is negligible. … The results of our investigation depict negligible value being added by cash flow reporting. Vishnani and Shah (International Journal of Finance and Economics, 2008)

Two Problems with the Argument Could stock market be the sole or dominant criterion for choosing financial reporting? If it were, does statistical covariation deliver on its promise?

The Status Quo is System A Financial Reporting System A  Price System A

Estimate the Covariation of Accounting and Stock Market Data under the Status Quo Financial Reporting System A  Price System A Financial Reporting System A  Price System A R(A)

Consider Hypothetical Alternative B Financial Reporting System A  Price System A Financial Reporting System A  Price System A R(A) Financial Reporting System B  Price System B

Estimate Covariation R(B) Financial Reporting System A  Price System A Financial Reporting System A  Price System A R(A) Financial Reporting System B  Price System B Financial Reporting System B  Price System B R(B)

Inference? Financial Reporting System A  Price System A R(A) Financial Reporting System B  Price System B R(B) What can we learn about the relative desirability of A versus B from comparing R(A) against R(B)?

“Information Content” Criterion If statistically proximity of accounting and stock market data is to be maximized, it is trivial to achieve nirvana Fire the accountants and report change in market capitalization as income! Accounting from the markets, instead of accounting for the markets Violates the maintained hypothesis of this conference that accounting may be relevant for stock markets

But Things are Much Worse! We do not have stock price data under financial reporting regime B (because it is still being considered). We have no way of estimating R(B) for comparison with R(A) even if that comparison was of any use. What do we do? Here is the trick.

Correlate Accounting B to Price A Financial Reporting System A R(A) Price System A R*(B) Financial Reporting Price System B System B What can comparison of R(A) to R*(B) tell us about the relative desirability of financial reporting systems A and B?

Accounting-Stock Market Covariation Studies It is hard enough to derive a logical inference from comparison of R(A) vs. R(B) Comparison of R(A) to R*(B) might make sense if stock prices were the identical under A and B That is, if financial reporting were irrelevant to stock markets In which case, why bother with these covariation studies

Promotion by Interested Parties

120 Countries Can’t be Wrong

How Do We Learn What is Better? A priori beliefs Derivation from known first principles Controlled experimentation Analysis of data gathered from the field

A Priori Beliefs Truthfulness Timeliness Relevance Unbiasedness, etc. Difficult to compare IFRS has no evident advantage Your head weighs 36 pounds, same as your feet.

Derivation from Known First Principles

Controlled Experimentation

Analysis of Data from the Field

Monopoly: No Requsite Variation for Evolution or Research

Rules and Social Norms

Principles vs. Uniformity Any two transactions which have any similarity should be treated alike. Any two transactions which have any differences should be treated different.

Language and Translation A direct translation may not convey the exact meaning of the original language

Top-Down Design Cartesian view of our world Belief in our knowledge and ability to design social systems to achieve desired ends

Fatal Conceit Friedrich A. Hayek Modern civilization naturally evolved and was not planned. All of its customs and traditions naturally led to the current order and are needed for its continuance. Any fundamental change to the system that tries to control it is doomed to fail since it would be impossible or unsustainable in modern civilization.

Biological Evolution Darwin: Biological evolution through replication, mutation and selection Spenser: Social evolution through Herbert Spencer: evolution of social processes

Fit in the legal, economic and business systems

Criteria for choice of standards Will better standards lower the cost of capital? Will better standards also lower the rate of return to investors If not, what is the difference?

Fortunately, we do not need to select a criterion in bottom-up evolution Bottom up evolution of financial reporting can proceed with light regulatory oversight Use general criterion of investment, growth, GNP, mitigation of fraud Compare institutions across boundaries and imitate better performing ones

Fractal Reality Benoit Mandelbrot (1977) Infinitely detailed No natural limit to additional detail Structure of rules in society No such thing as “perfectly clear” Do not believe in applicability of principles rhetoric Similar processes yield similar outcomes

Dependence and Judgment

Financial Reporting and Financial Engineering Unequal battle Slow, rule bound financial reporting has no chance against agile and free financial engineering Monopoly will make it even worse

Financial reporting as eye-in-the-sky or camera-model

Thank You.