1. Accounting Standards: An Overview
Shyam Sunder
Yale School of Management
Director Education Program
July 19, 2002
11/16/2018
© Shyam Sunder

2. Outline What are accounting standards?
National and international standards
Benefits and costs of using standards
Problem of finding and setting better standards
Regulatory competition in accounting
Rethinking for policy makers
Rethinking for directors
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© Shyam Sunder

3. What are accounting standards?
Complements to professional expertise and judgment
Can easily become substitutes for judgment with unpleasant consequences
An invention of the last thirty years
In U.S. and U.K., a shift from common law towards codification
Initial demand from utilities and bank regulation
Internal Revenue Act (1913) led to wider use of depreciation
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© Shyam Sunder

4. Brief History (in U.S.)
Early attempts by the New York Stock Exchange following Securities and Exchange Act (1933)
43 Accounting Research Bulletins by Committee on Accounting Procedure ( )
31 Opinions by Accounting Principles Board ( )
145 Standards by Financial Accounting Standards Board (1973- ) plus interpretations, guides, etc.
41 Standards by International Accounting Standards Committee and Board (1973- )
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5. IAS vs. FAS Claims to use principles, reduce loopholes
Interest: operating, financing or investing cash flow
Development costs: must be capitalized
Claims to be more rigorous, precise, case by case instructions
Interest: must be treated as operating cash flow
Development costs: must be expensed
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6. Principle Vs. Rule-Based Standards
IAS 2 (Inventories)
Inventories should be measured at the lower of cost and net realisable value. Net realisable value is selling price less cost to complete the inventory and sell it.
IAS 41 (Agriculture, effective Jan. 1, 2003)
Biological assets should be measured at their fair value less estimated point-of-sale costs, except where fair value cannot be measured reliably.
This Standard does not deal with processing of agricultural produce after harvest. IAS 2: Inventories …should be applied in accounting for agricultural produce after the point of harvest;
Propaganda war without principles : FASB vs. IASB, best ignored
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© Shyam Sunder

7. Evidence on Differences
Leuz (2001): German New Market firms, no difference in bid/ask spreads and turnover
Hail (2001): 73 Swiss nonfinancial firms, CoC of higher disclosure firms is about 2 percent lower
Bhattacharya et al. (2002): 34 countries, less opacity, lower cost of capital by about 3 percent
Alford, Jones, Leftwich, Zmijewski (1993): Correlation between earnings and stock price changes, higher in Australia, France, Netherlands and UK, lower in Denmark, Germany, Italy, Singapore, and Sweden, inconclusive for Belgium, Canada, Hong Kong, Ireland, Japan, Norway, South Africa, Switzerland compared to U.S.
Amir, Harris, Venuti (1993): 449 foreign firms’ F-20 earnings and equity (reconciled to U.S. GAAP) are better correlated with U.S. prices, mostly due to asset revaluations and goodwill, meaning is uncertain
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8. Are They Really Different?
Propaganda war without principles : FASB vs. IASB, best ignored
Political problem: U.S. versus international
Staff and Funding: Give IASB a few more years to write rules, and enforcement power behind the FAS, and they will get very close to FAS
They are already trying very hard to harmonize
Is harmonization a good idea?
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© Shyam Sunder

9. Four Main Types of Standards
Explanation of accounting policies (explain what you did to arrive at the financial statements)
Layout and presentation (rare in U.S. and U.K., more prevalent in France and Germany)
Disclosure standards (information you must disclose, to be processed by reader’s own judgment)
Measurement standards (how to get the numbers?)
Approved concepts for asset valuation and income assessment
Depreciation methods, inventory values, deferred tax, and foreign exchange
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10. Benefits of Standards
Comparability of financial statements across firms, time, and countries
Network externality: each additional phone in the city makes my own phone more valuable; economy of using one set of rules
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 international flow of capital
Better investor decisions, especially small (unsophisticated) investors
Social value of efficient allocation of scarce capital to more productive firms
Hardly seems rational to object to uniformity of accounting rules
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© Shyam Sunder

11. Objections to Standards
Rules as substitutes for thinking, judgment, responsibility
At what point can the bird be deemed to have left the bush and reached the hand ? (Baxter)
Is there one right method of mechanically arriving at the right answer in all of the myriad circumstances of the bird’s flight?
Increase in demand for standards from auditors
Increase in demand for “show me where it says I can’t do this” from audit clients
Momentum for standards becomes unstoppable and even reasonable people begin to think that better standards will somehow solve the problems of financial reporting
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© Shyam Sunder

12. Once You Set Up a Bureaucracy to Make Rules
Consequences of a rule making bureaucracy
Production targets for rules
Financing by sale of documents
No economically justifiable criterion for choice of standards and choice of topics
Will produce standards whether you want them to or not
Political and business pressures
Wisdom, insight, and sincerity of the members do not necessarily help make better standards
Constant target of criticism and new demands
New standards to deflect attacks
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13. Standards and Education
Presence of standards shifts focus of accounting education from analysis and judgment to memorization of rules
Uncritical obedience to the wisdom of authority imposed with the force of law
Passive attitudes carried from classroom to practice
How were the accountants of Enron and WorldCom educated?
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14. How to Tell Which Standards Are Better
Uniformity/comparability (What does it mean?)
Transparency (Will you still make money?)
Simple truth (what if the truth is complicated?)
Help investors make better decisions (Which investors? Higher stock price or right stock price?)
What about the other stakeholders?
Lower cost of capital as a criterion for choosing standards
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© Shyam Sunder

15. Choose Accounting Rules to Minimize the Cost of Capital
Cost of capital (CoC): 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?
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© Shyam Sunder

16. 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 little information about the effect of any alternatives on CoC, even with “due process”
Wisdom, diligence and sincerity of the members of the rule making boards is no substitute for information
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© Shyam Sunder

17. Competition Among Sets of Accounting Standards
Suppose we 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
Not an accounting free for all, only controlled regulatory competition
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© Shyam Sunder

18. Examples of 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
Educational standards for colleges and universities
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19. What Are the Benefits? Efficient accounting standards
Lowering CoC as the relevant criterion
Market feeds back better information into the rule making process
Gives 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 rule-maker incentives
Greater objectivity and lower susceptibility to lobbying pressure from well-organized groups and threats from politicians
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© Shyam Sunder

20. 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 fewer buyers for their shares (i.e., higher cost of capital)
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© Shyam Sunder

21. 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
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© Shyam Sunder

22. 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
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© Shyam Sunder

23. 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
Standards not attractive to firms and their investors will mean less revenues to the rule-maker
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© Shyam Sunder

24. Easing Interest Group Pressures
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
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© Shyam Sunder

25. Objections to Competition
Race to the bottom among rule makers
What happens to comparability of reports?
Our rules are better than theirs
Small investor will be confused
Cost of experimentation and multiple rule makers
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© Shyam Sunder

26. Rules Race to the Bottom
Popular argument from rule makers
Of course, 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
How often has regulatory competition generated a race to the bottom in other fields?
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© Shyam Sunder

27. 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 (and other security regulators) will decide which sets of standards U.S. firms can choose from (example Food and Drug Administration decides which drugs physicians 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
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© Shyam Sunder

28. 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
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© Shyam Sunder

29. 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, the 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 as low as 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?
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© Shyam Sunder

30. 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
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© Shyam Sunder

31. 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 per year for NYSE)
Empirical evidence: disclosure practices may affect the cost of capital by as much as 1 percent
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© Shyam Sunder

32. 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
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© Shyam Sunder

33. Consequences of Regulatory Competition
Governance: Firms 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
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© Shyam Sunder

34. Rethinking for Policy Makers
Enron, WorldCom, Tyco: greedy people or bad policy?
Is it time to rethink the seventy-year old structure of regulation of security markets?
What other changes we could consider in accounting policy?
Do away with mandatory audit?
Let firms buy financial fraud insurance in any amount they wish to
Eliminate regulation of auditing; let auditing be a function internal to the insurance provider (e.g., physical checkup of the applicant for life insurance policy)?
Establish financial reporting courts to hear the financial reporting fraud cases
Could we use markets for stock option accounting?
Why can’t we let go of regulatory monopoly in accounting?
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© Shyam Sunder

35. Rethinking for Directors
Cost of performance-based incentives includes not only the payment in cash or securities, but also manipulation of accounting which is not hard
Hard accounting is less informative; informative numbers are more manipulable
Accounts are not a satellite photograph, it is the picture of a model who smiles when the camera clicks. Can you tell what the model looks like when the camera is not open?
As soon as a new standard is issued, business transactions are redesigned to adjust the appearances. Would the board stop that? How?
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© Shyam Sunder

36. Thank You
This Powerpoint presentation will be 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:
11/16/2018
© Shyam Sunder