Shyam Sunder Yale University

Does Competition Offer a Way to Resolve the GAAP versus IAS Controversy?
Shyam Sunder Yale University Luncheon Address, American Enterprise Institute Conference: Is GAAP Accounting Worth Fighting For? Washington D.C. March 13, 2002

Copyright 2001, Regulatory Competition in Accounting
Overview Perhaps it is bad judgment to argue for market solutions in Washington in March 2002 But that is what I am going to do I hope you would give my argument a hearing before you make up your minds Regulatory competition is no panacea for financial reporting standards But it is better than the status quo, and better than the alternatives I know 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Status Quo and Prospects
With the SEC’s blessing, the FASB has exclusive jurisdiction over accounting rules in the U.S. With the European Commission’s blessing, the IASB may soon have exclusive jurisdiction in the European Union They are still competing in Asia and elsewhere IASB seems ahead in the race for a world monopoly over accounting standards (except in U.S.) Uniform accounting rules across the world! Wouldn’t that be a relief? 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Virtues of Uniformity Comparability of financial statements across firms and across countries Daimler-Benz AG of Germany’s results for January-June 1993: DM 168 million profit under German GAAP DM 949 million loss under U.S. GAAP The difference attributable to variation in accounting standards Increasing demand for international harmonization of financial reporting standards with increased flow of capital across national boundaries Better investor decisions Social value of efficient allocation of scarce capital to more productive firms Hardly seems rational to object to uniformity of accounting rules 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Two Problems What do you mean by uniform rules? No semantics please! Bear with me, it is important How do you know which rules are better? This will take us back to Hayek Let us consider each 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Uniformity is Simple? Treat similar events and transactions alike Treat dissimilar events and transactions different This works perfectly well if we are interested in classifying events and transactions by a single attribute only It breaks down if we consider two or more attributes? 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Classify These Four Balls
5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Rule 2: Black versus White

Rules 3: Classify by Color and Size

Rule 4: Treat Them All Alike

Demands from Uniformity
Treat two objects that are similar in an attribute alike, and Treat two objects that are dissimilar in an attribute different We can satisfy both these criteria if the objects we classify have only a single attribute of interest Otherwise, making a classification system more uniform in one respect is less uniform in another Chimera of uniformity does not help the rule makers—in accounting or elsewhere Even if we all agree to buy identical cars, it hardly solves the problem of deciding what model we should buy What could some other criteria for choosing accounting rules be? 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Transparency The current favorite—does not help the rule makers Unlike uniformity, transparency is easy to achieve—open books, open offices Competitors will thank the firm An open business will fail—no profit Without confidentiality, a firm can’t earn money for the shareholders Without transparency, shareholders can’t tell how much money the firm makes or will make Tough part of rule making—knowing the balance between transparency and confidentiality 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Help Investor Decisions
Touchstone of rule makers—good PR How would rule makers know what helps the investors? Ease of understanding versus precision and detail Investor sophistication ranges from day traders to rocket scientists Is an information (or misinformation) system that maximizes value of shares the best? Or is it one that generates the “right” stock price, given the prospects of the firm “Right” stock price may be the answer, but we reward the managers for “high” stock prices Does a stockholder want a financial reporting system that generates the “right” or the “high” price? When did Enron employees complain? 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Just Tell the Simple Truth
Truth is not necessarily simple (Enron’s 3,000 special purpose entities will take more than a telephone book to report) What is simple may be misleading or insufficient I have a lottery ticket which has 60 percent chance of winning $10. How much money do I have? Rule maker has to make tough choices between simplicity and detail, between threshold and statistical approach to reporting Once the rule is chosen, transactions are revised to manage their appearance under the rule Financial reporting is not a passive hidden camera in the sky; it is a closed loop system in which transactions respond to rules It is no longer clear what the truth is 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

What About the Other Stakeholders?
Shareholders are not the only relevant party to be considered by rule makers Other stakeholders (e.g., employees, customers, vendors, etc.) Need a decision criterion that covers the welfare of society at large Lowering of the Cost of Capital (CoC) as a criterion for financial reporting rules 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Choose Accounting Rules to Minimize the Cost of Capital
Cost of capital (CoC) 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 CoC is the result of complex interactions among many organization decisions and market forces, not easily manipulated Fits economic theory well Lower cost of capital benefits all legitimate agents How would the rule maker know which rule will reduce the CoC? 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Monopolist’s Problem It is the only game in town Cannot learn from the market: what would have happened to CoC if … Experimentation with mutations necessary for evolution by natural selection A monopoly regime freezes itself in status quo for long periods of time It cannot get market signals to adjust rules to changing environment Imagine if the IASB rules were implemented in the whole world, what would it take to change a bad rule? Rule maker would have no information about the effect of any alternatives on CoC Wisdom, diligence and sincerity of the members of the rule making boards is no substitute for information 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Hayek’s Information Machine
Markets dominate central planning because the they are giant information aggregating machines, more efficient than any computer possible If uniformity, transparency, simple truth and due process testimony cannot provide useful guidance to rule makers; perhaps this machine may help Not unless the alternatives are out there in the market so we can gather data from the field E.g., Leuz’s data from German field competition among alternative standards 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Enter: Competition Among Sets of Accounting Standards
Let each government (e.g., SEC, European Commission) choose two or three sets of standards for firms in its jurisdiction Allow each reporting firm to choose one set of standards (in entirety) Issue audited reports clearly labeled with the chosen standard Reporting firm pays a royalty to the rule maker 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Regulatory Competition
Corporate charters among fifty states (Delaware) Stock exchanges (NYSE-NASDAQ, Toronto-Vancouver) State and local governments for business Standard and Poor’s and Moody’s Environmental laws across countries Underwriters Lab and Good Housekeeping Seal Privacy standards, disclosure and practices in e-commerce State, federal, offshore regulatory mechanisms for banks Maritime regulations across countries (Panama, Liberia) 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

What Are the Benefits? Efficient accounting standards Lowering CoC as the relevant criterion Market feedback of better information into the rule making process Giving investors an effective voice Benefit from innovation anywhere in the world Opportunity to specialize, develop clienteles Protecting industry from the burden of rules generated as bureaucratic imperatives—aligning incentives Greater objectivity and lower susceptibility to lobbying pressure from well-organized groups and threats from politicians 5/20/2018 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 little 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 (I.e., higher cost of capital) 5/20/2018 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 5/20/2018 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 5/20/2018 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 5/20/2018 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 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Objections to Competition
Race to the bottom among rule makers What happens to comparability of reports? We do it better than them What about the confusion for small investor Cost of experimentation and multiple rule makers 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Rules Race to the Bottom
Popular argument from rule makers We would never do such a thing, but what about them (not much faith in their brethren) But at least we now are talking economics Incentives of rule making Rule makers as economic agents Let us look at evidence Has regulatory competition generated a race to the bottom in other fields? 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Why No Evidence of Market Failure?
We do not see the bottom when The race is not in the interest of the parties Consequences of agent actions are visible to others The race is subject to adult supervision SEC will have an active role in deciding which sets of standards U.S. firms can choose from Investors will demand higher risk premium from firms choosing less desirable standards Firms and their management are keen on lowering CoC Daimler-Benz AG came to U.S. capital markets to lower its CoC 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

What About Comparability of Reports?
Financial analysts use computer worksheets to infer DCF from financial reports and other industry and firm specific data Once a worksheet for one set of financial reports is prepared, marginal cost of its use for another firm is virtually zero Most of the cost of competition is one time set up cost of a second worksheet This additional cost is trivial compared to the benefits of competition 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

We Do It Better Than Them
This argument has been used in U.S. over recent years in making comparisons with the IASB Given the structure of rule making, FASB has probably done as good a job as possible The questions we need to address are: Could it be done better? What do we do to keep the cost of capital lowest possible in U.S. markets? Most economies of the world benefited from U.S. accounting standards. Should we claim the benefits of any good ideas from overseas, or reject what is not-invented-here 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

What About the Non-Expert Investors
Benefits of lower cost of capital under competitive regime will be shared by all investors, including non-experts Majority of U.S. equities are professionally managed Present financial reports are already inaccessible to non-experts Neither the US nor the international GAAP presently specify a unique set of accounting rules Price of developing lower cost of capital accounting rules 5/20/2018 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 5/20/2018 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 (Food and Drug Administration model) 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 oversee 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 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Consequences of Regulatory Competition
Governance: Firms will tend to choose standards that will lower their cost of capital which is observable If they don’t, market for corporate control can remove or punish the management Incentives: Standard setters will compete for corporate following, and tend to develop efficient standards If they don’t, they will go out of business Innovation: A system of dual standards will introduce best practices at suitable rate to local economies Globalization: Help the cross-border organizations by letting them choose between local or imported practices 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Open Research 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? 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Thank You This Powerpoint presentation is available for download from Two related papers(one by Dye and Sunder, Accounting Horizons, September 2001; and the other by Sunder) are available at Or send to: 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

The Rule Maker’s Problem: Information
Need information about the effect of alternative rules on CoC CoC is an overall social welfare criterion rooted in equilibrium concept Its distributive effects vary from rule to rule No single class of agents benefits consistently from CoC-lowering accounting rules Information from the FASB/IASB “due process” submissions and testimonies protect respective interests of managers, auditors, financial analysts, even investors Who argues on the basis of evidence about the effect on CoC 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Who Will Audit Them? SEC oversees the U.S. regulatory regime for public accountants Many of these firms are international, with in-house expertise in financial standards of the countries where they do business Others will acquire this expertise when there is money to be made from it They acquired consulting expertise 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Our Law Does Not Permit This
I don’t know if it does, or not We have to ask: how do we develop and apply good accounting rules? If we find that the existing laws stand in the way of doing things better, laws can be and should be changed 5/20/2018 Copyright 2001, Regulatory Competition in Accounting

Shyam Sunder Yale University

Similar presentations

Presentation on theme: "Shyam Sunder Yale University"— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

Shyam Sunder Yale University

Similar presentations

Presentation on theme: "Shyam Sunder Yale University"— Presentation transcript:

Similar presentations

About project

Feedback