Standards for Corporate Financial Reporting: Regulatory Competition Within and Across National Boundaries Shyam Sunder, Yale University Tenth Conference on Accounting Theory and Practice Soochow University and Taiwan Accounting Association, Taipei, October 27, 2001

Single Accounting Standard Most countries in the world require their business firms to adhere to a single set of accounting standards U.S. Securities and Exchange Commission expects registrants to conform to GAAP as defined by the FASB Similar national standard setting bodies exercise exclusive jurisdiction in most countries 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Global Capital Markets In recent decades capital flows across national boundaries have grown fast Popularity of international diversification of individual investment portfolios leads to interest in foreign equities As multinationals expand operations across national boundaries, they also raise equity and debt capital from markets away from home Result: growth in demand and supply of foreign securities 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Accounting Barriers to Globalization of Capital Markets Daimler-Benz AG of Germany’s results for January-June 1993: DM168 million profit under German GAAP DM949 million loss under U.S. GAAP The difference attributed to accounting standards Demand for international harmonization of financial reporting standards 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Response to Globalization Rise of International Accounting Standards Board to meet this demand Real prospect of a single accounting standard across countries Identical accounting standards used within and across countries will make financial statements more comparable Apparently clear case for international harmonization 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Copyright 2001, Regulatory Competition in Accounting On the Other Hand Two or more competing sets of accounting standards be made available to all firms in each country Each firm has the freedom to choose one set of standards for its financial reports Financial reports are clearly labeled with the standards used to prepare them Standards have to compete for adoption by firms 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Alternatives Deserve Close Consideration Before extending national monopolies in accounting standards to regional or international scale Need serious debate on the merits of single versus multiple (competitive) standards regimes Cases for national and international harmonization have already been made I would like to make a case for competitive national and international accounting regimes 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Advantages of Accounting Competition Developing efficient standards to minimize firms’ cost of capital Learning more about the consequences of proposals Giving investors an effective voice in setting standards Encouraging innovation and experimentation with alternatives Accounting segmentation by clientele Aligning incentives of standard setters with the interests of investors Limiting interest group pressures in standard setting 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Other Competitive Regulatory Regimes Competitive regulatory regimes used extensively in US and Internationally, e.g., Fifty states in US for corporate charters Stock exchanges for listings State and national regulators for banks State and national environmental laws for industry National maritime regulations for ships 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Efficient Standards: Minimizing the Cost of Capital Cost of capital is the return security holders expect on their investments in the firm Accounting important for control of managers and information for investors Better control and information reduces risk to investors and the return they demand Cost of capital minimizing accounting standards are efficient—serve the interests of investors as well as others 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Learning Consequences of Proposals It is difficult for standard setters to assess the economic consequences of proposals Consequences for cost of capital are almost impossible to estimate CoC determined by actions and reactions of various agents in response to the standards Under competitive regime, it is possible evaluate the economic consequences of alternative proposals by gathering data from the field 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Effective Voice to Investors Investor role in accounting rule-making is weak (mostly accountants and managers) Investors vote with their feet In a monopoly regime there is not much opportunity for investors to indicate their preferences by choosing between standards Competitive regime will give a real voice to investors in choice of accounting standards Firms using poorly regarded standards may find few buyers for their shares (higher cost of capital) 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Innovation and Learning In a single-standard regime Little room for innovation Comparison of consequences of different standards is difficult and unreliable No opportunity to benefit from the experience of others Once a standard is adopted internationally, it will become almost impossible to gather evidence to support a change Rigidity and inability to adjust to change Competitive regime more flexible and innovative 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Differentiation by Clientele Competitive regimes may develop different clienteles by Size of firms Industries Economic development Local economic institutions Compare: NASDAQ stock exchange in U.S. differentiated itself from NYSE to become attractive for high technology companies No differentiation without competition 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Aligning Rule Maker Incentives to Investor Interests Rule makers are susceptible bureaucratic incentives Making rules is the only output of the organization Must remain busy (publish new rules or perish) Auditors demand increasingly specific rules as support for their arguments with managers Investor interests may be buried under day-to-day pressures on rule makers Competitive regime highlights investor interest If standards are not attractive to firms and their investors means less revenues to the rule-maker 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Less Interest Group Pressure Rule makers often subjected to strong pressures from interest groups e.g. accounting for employee stock options Competitive regime will ease interest group pressures Those who do not like one set of rules can be asked choose another, if they so prefer Each rule maker is free to use its own best judgment about what standards will lower the cost of capital 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

What About the Quality of Standards? Will competition among rule makers create a “race to the bottom?” Will rule makers try to attract followers by framing less demanding standards? Some will, and others will not Theoretical and empirical evidence from various fields indicates no race to the bottom There is demand for “quality” Majority of shares in U.S. are held by institutions Why push “high quality” (complicated?) rules where investors not sophisticated enough to analyze their output? 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Cost of Experimentation and Multiple Rule Makers Supporting multiple rule makers and experimentation with rules is costly Yes it is. Other than experimentation, what other reliable method of choosing lower cost of capital accounting rules do we have? Cost of running multiple rule-making agencies is minuscule compared to savings from even 0.1 percent reduction in cost of capital ($12 billion for NYSE) Empirical evidence: disclosure practices may affect the cost of capital by as much as 1 percent 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

What About the Non-Expert Investors? Competition will leave the non-expert investors confused: different rules used by different companies But the benefits of lower cost of capital under competitive regime will be shared by all investors alike, including non-experts Financial reports already produced are hardly accessible to non-experts Neither the US nor the international GAAP specify a unique set of accounting rules Price of developing lower cost of capital accounting rules 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Implementing a Competitive Regime Each national security regulator selects two or more competing sets of standards available for companies in its jurisdiction Security regulators coordinate and share information on the oversight of rule making with other members of IOSCO Security regulators coordinate and share the oversight of auditors with members of IOSCO and list the auditors permitted to practice before them Security regulators scrutinize financial reports for fairness, and question/discipline auditors and registrants about deviations IOSCO and rule making agencies maintain a staff to address the queries from national security regulators 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Regulatory Competition as a Guiding Principle Markets can help guide committees, boards and legislative bodies Allow competition between two or more sets of standards in each jurisdiction (e.g., local and international) Let each firm choose one set and clearly label its financial reports accordingly 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Consequences of Regulatory Competition Firms will tend to choose the standards that will lower their cost of capital which is observable If they don’t, market for corporate control can remove the management Standard setters will compete for corporate following, and tend to develop efficient standards If they don’t, they will go out of business A system of dual standards will introduce best practices at suitable rate to local economies It will also help the cross-border organizations by letting them choose between local or imported practices 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Copyright 2001, Regulatory Competition in Accounting Research Question Questions Why have we depended on regulatory monopolies in accounting for so long? Will the benefits of competition at a global scale overcome national rivalries and pride? Are we prepared for true globalization—global competition among the rules of the game without local or international monopolies? 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Text and Slides of This Presentation Available for download from http://www.som.yale.edu/faculty/sunder/research/ A related paper by Dye and Sunder (Accounting Horizons, September 2001) is also available at http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=160390 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

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Copyright 2001, Regulatory Competition in Accounting 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Copyright 2001, Regulatory Competition in Accounting 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Copyright 2001, Regulatory Competition in Accounting 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Copyright 2001, Regulatory Competition in Accounting 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Copyright 2001, Regulatory Competition in Accounting 7/31/2018 Copyright 2001, Regulatory Competition in Accounting

Copyright 2001, Regulatory Competition in Accounting 7/31/2018 Copyright 2001, Regulatory Competition in Accounting