IFRS Monopoly: The Pied Piper of Financial Reporting Shyam Sunder Yale University University of Sao Paulo Sao Paulo, Brazil, March 12, 2013

The Legend of the Pied Piper In the German legend the Pied Piper enchanted the children of the village with his music, and they followed him to their doom, never to return.

An Overview Arguments for international financial reporting standards Costs and dangers of excessive standardization Role of IFRS in the Global Financial Crisis What is a prudent way forward? Conclusions 3

Why Standardize Financial Reporting? Global trade/investment Weights and measures analogy Improve coordination Improve quality 4

Expansion of International investment and Trade Past century has seen a great expansion of investment and trade across national boundaries. 5

Standard Weights and Measures One of the oldest functions of the state Economies of the metric system for example But weights and measures deal with inanimate commodities Financial reporting is a game among people, not against nature 6

7 Co-ordination through Standards

Advantages of Standardization If financial reporting were standardized in all or most national jurisdictions, some economies in training of accountants and analysts, preparation and audit of financial reports, writing of rules of financial reporting, and perhaps their enforcement world-wide could be achieved. 8

9 Quality through Standards

Quality Standards Food quality standards are a good example Safety of food in restaurants by standards of quality and hygiene

Costs and Disadvantages of Making IFRS a World Monopoly? Unintended consequences Firms, industries and economies are different, and one size does not fit all “Same” accounting rules do not yield similar financial reports Consequences of monopoly without competition in standard setting Frozen world of financial reporting with no evolution

Promise of Uniform Currency in Europe

Ten Years Later

What Could be the Reasons for Not Making IFRS a World Monopoly? Firms are different Industries are different Countries and economies are different “Same” accounting rules do not yield similar financial reports

No Two Firms are Alike Every firm is unique in many important respects Business model, capital structure, products, markets, strategy, management, ownership, future prospects cannot be captured in a single set of rules 15

No Two Industries are Alike: Can One Size Fit All? Manufacturing, banking, software, real estate, mining and film industries are so different, that different accounting standards are proposed for them Large multinationals are so different from small and medium-sized firms Information that investors, analysts and other parties seek about them is also different

No Two Countries/Economies are Alike Even individual countries have difficulty defending their single set of domestic standards. Less plausible that a single set of world-wide standards can offer an efficient solution.

Rules and Social Norms

Do Standard Rules Yield Comparable Results? 19

A single set of standards do not leave any room to learn from trial-and-error experimentation From cross-border comparisons Risk freezing and fossilizing financial reporting into an inefficient system of reporting.

21 Example of Getting Frozen into a Bad Standard

These Are Just the Principles Without competition, risk of excessive authority Creation of International Accounting Standards Committee and its successor International Accounting Standards Board which has produced about 3,000 pages (and counting) of International Financial Reporting Standards (IFRS). 22

Risk of Rule Making Authority Poor performance of IFRS in the global financial crisis Doubts in U.S., China, Japan, India, and even EU about the wisdom of the standards monopoly Time for the emerging economies to rethink the balance between for international and local standards and between written rules and social norms

Role of IFRS in the Global Financial Crisis The so-called “fair value” accounting Delay in bad-debt recognition Executive bonuses from unearned profits Insufficient capital for banks

Marketing Push to Make IFRS a World Monopoly Since the 1990s, these standards have been intensively marketed around the world in an attempt to get them enforced everywhere, replacing indigenous practices and rules used in various countries. EU was bagged in 2005.

What is a prudent way forward? 26

27 Promotion by Interested Parties

28 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

33 Adaptability

Fit in the legal, economic and business systems

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

Conclusions 39

Countries Can’t be Wrong

41 Thank You.