1. Solving the Problem of Setting Efficient Accounting Standards and Increasing Complexity through Regulatory Competition
Shyam Sunder, Yale University
Chinese Accounting Professors Association Annual Conference
Wuhan, China, July 14, 2007

2. Twenty Commonly-Held Beliefs about Financial Reporting

3. Sunder, Setting Efficient Standards
1. Universal Standards
Universal 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?
Financial reports are a joint outcome of accounting standards and the business-economic environment
Rhetoric of universal accounting standards and universal language (Esperanto)
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4. Sunder, Setting Efficient Standards
2. The Static Ideal
There exists a set of financial reporting standards that, once discovered and implemented, will induce corporations and their auditors to prepare the best attainable financial reports
Dynamics of the game between managers and standard setters makes any such static ideal all but impossible
Standards address only a (small) part of the financial reporting problem
Standards create new problems of their own: imagine a day when we succeed in closing all doors to accounting manipulation, what would unscrupulous managers turn to next—manipulation of real decisions
Which is the greater problem for shareholders: to learn less about what is in the pot or to have less in the pot?
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5. Sunder, Setting Efficient Standards
3. People or Structure
If we select knowledgeable, experienced, self-less, public-spirited, wise and foresighted individuals to constitute bodies to devise accounting standards through deliberation and due process, we can improve financial reporting
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
Research shows that outcomes of social institutions are driven more by their structure, and less by the behavior of individuals who participate in them
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6. 4. Engineering Standards through Rational Deliberation
It is possible to construct or discover better financial reporting standards through deliberation in properly organized corporate entities (such as the IASB, the FASB, etc.).
Assumes that such bodies can know the consequences of their actions
History does not support the proposition
Cartesian versus Hayekian perspective on society
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7. 5. Specialist Bodies to Set Standards
Specialist standard setting bodies, standing ready to address new problems, inquiries and requests for clarifications help improve financial reporting
Their existence encourages a new “clarification” game targeted at them
They must keep a full agenda (performance)
Revenue and budget pressures
Over time, their output necessarily accumulates to a thick rule book
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8. 6. What Standards are Good or Bad?
Standard setters can tell which standards are better and why.
Little evidence that they know, or can know
Cost-of-capital is the result of complex interactions among many factors (including accounting)
Not even clear if higher or lower cost-of-capital serves society better
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, albeit difficult
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9. Sunder, Setting Efficient Standards
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
No pressure to do better, or to correct errors
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10. 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
Counter examples (stock exchanges, bond rating services, appliance standards, college accreditation, bank regulation, corporate charters across U.S. states, etc.)
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11. 9. Greater Force Means Greater Effectiveness
Increase in the power of enforcement behind authoritative standards improves compliance and quality of financial reporting
Increased enforcement also increases resources devoted to evasion
Draconian punishments do not necessarily induce better behavior
Examples: tax collection, crime, alcohol and drug abuse
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12. 10. Statutory Approach Better than Common Law
The quasi-statutory approach to setting accounting standards dominates a common law approach to financial reporting
Evidence?
Constitution (U.K., U.S., Europe)
Role of common law in society
Accountants’ attempt to put “statutes” at the heart of accounting
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13. 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
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)
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14. 12. Who defends the middle ground?
The ideal accounting regime would consist of all written standards or all social norms
Easier to make the extreme cases for standards or norms alone
Difficulty of defending the middle ground where both may co-exist, as they do in many other aspects of life
Attempts to drive common law out of accounting are misconceived
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15. 13. New Problems, New Solutions
Financial reporting and governance problems originated in the 20th century
History tells us otherwise
Governance problems of the East India Company
Clive, Hastings, and the Company’s Court of Directors
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16. 14. Financial Reporting is Getting Better
Seventy 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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17. 15. Fewer Alternatives, Better Reports
Fewer the alternative treatments the reporting entities are allowed to choose from, the better the quality of financial reporting
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
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18. 16. Auditor’s Bargaining Power
Well-specified standards enhance the bargaining power of the auditor vis-à-vis the client
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
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19. 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 SPEs => Enron
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20. 18. Individual responsibility
Written financial reporting standards strengthen the individual responsibility of managers, auditors, and investment bankers for fair representation
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
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21. Sunder, Setting Efficient Standards
19. Education
Written standards make it easier to educate better accountants and attract talent to the profession
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
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22. 20. Nothing’s New under the Sun
Have I said something new?
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).
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23. The Problem of Setting Efficient Standards
Criteria (lower cost of capital?)
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 (regulator) does not know, but can help
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24. Sunder, Setting Efficient Standards
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
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
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25. In Contrast to IASB (FASB) Command & Control View
To develop accounting standards:
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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26. 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
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27. Shyam.sunder@yale.edu www.som.yale.edu/faculty/sunder
Thank You!