1. Regulation of Accounting
Shyam Sunder
Yale School of Management
Krakow University of Economics
Krakow, Poland
May 21, 2009
Regulation of Accounting

2. Protecting Consumers and Investors
Protection of consumers and investors from unfair or misleading practices is the common goal of regulation
The question worth discussing: How do we achieve this goal?
We do not wish to fail to protect the interests of consumers and investors
Or promote unwise regulation that may bring more harm than good
I would like to concentrate these remarks on regulation of corporate financial reporting which has gained in urgency in light of the recent events

3. Regulatory Cooperation and Coordination
Regulatory cooperation yields many advantages
Simplifying the environment
Clear communication of the regulatory regime
Better and cooperative enforcement among jurisdictions
Adoption and use of best practices
Avoidance of race to the bottom
An appearance and sense of control (until things go wrong)
Closing the cracks between the adjacent regulatory domains, etc.
The recent decades have seen gradual expansion of regulatory cooperation which has yielded many of these benefits (and revealed some weaknesses)
However, as in most matters of social policy, there always the other side of the coin to be considered: regulatory competition

4. Regulatory Competition
In pursuit of the obvious advantages of regulatory cooperation, it is easy to overlook its limits and the advantages of alternatives
Regulatory uniformity and cooperation works fine in a world were regulatory alternatives and their respective properties are already known and well-understood
Such extensive knowledge—a Cartesian universe—is highly desirable, but often unachievable by any one
As recently as 18 months ago, US regulators sincerely defended their hands-off approach to the derivatives market
They were neither incompetent nor Machiavellian
Few people knew the consequences of those regulatory policies until much damage had been done
In fact, most of the time, we live in a world where properties of regulatory policies, and indeed the alternatives themselves, must be discovered through trial-and-error through experience

5. Regulatory Humility
There is a case to be made for regulatory humility—often we do not know the consequences of policy alternatives until we try them out
In contrast to the Cartesian mindset of regulatory uniformity through top-down design with complete knowledge of the system, regulatory competition suggests a Darwinian mindset
The consequences of changes in social policy involve reactions of millions of people adjusting to the policy in their own diverse and ingenious ways
We cannot be sure of the consequences of a policy until we try it out and see what happens
We could try to find a balance between the cooperative and the competitive approaches

6. Extraction and Generation of Benefits of Innovation
EU’s single market initiative is an example of an effort to make sure the benefits of innovation are enjoyed to the maximum extent by lowering barriers to free movement
Making the markets more perfect by removing frictions clearly helps this goal
But there is the other side of the innovation coin— generation of innovation
Entrepreneurs innovate to make private profits by differentiating their products and thus creating local imperfections which tend to be eliminated only over time through competition
Blocking innovation to prevent profit making through differentiation would kill the golden goose of prosperity
Patent law as an example of the struggle for this balance

7. Financial Reporting: Some Commonly-held Beliefs

8. 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?
Few industries have universal standards, and no professions have them
Rhetoric of universal accounting standards and universal language
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

9. 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 is only a (small) part of the problem
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

10. 3. People or Structure
If we select knowledgeable, experienced, self-less, public-spirited, and wise individuals to constitute bodies that 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

11. 4. Engineering Standards through 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

12. 5. Specialization in Setting 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 must accumulate to a thick rule book
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

13. 6. What is High Quality Standard in Accounting?
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)
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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

14. 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

15. 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.)
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

16. 9. Force and 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
Crime, alcohol and drug abuse
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

17. 10. Statutory Approach Dominates 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)
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

18. 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)
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

19. 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

20. 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

21. 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?
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

22. 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

23. 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

24. 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

25. 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

26. 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

27. 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).
Kautilya’s Arthasastra, the 4th centurt B.C. Sanskrit classic has three chapters on accounting, auditing and control
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

28. Beware of Consensus A different perspective
You would be left behind if you do not follow the crowd
Washington Consensus
Accounting Consensus—five main elements

29. Accounting Consensus 1
The standards developed should be confined to principles, and not become detailed rules
Nobody can tell which is which
IFRS vs. FAS, yet plans to adopt many of the FAS
Fair values: principle or rhetorical device

30. Accounting Consensus 2
A single set of high quality written standards of financial reporting applied to all companies (at least the publicly traded ones) in the world will improve financial reporting by making financial reports more comparable, and thus assist investors and other users of financial statements make better decisions
All prefer high quality, but what is it (Joyce et al.)
Principles-comparability contradiction
Accounting for research & development costs (FAS 2)
Evidence that accounting standards help investors or managers make better decisions?

31. Accounting Consensus 3
The best way to develop such standards is to create a single deliberative corporate body consisting of appropriate experts with a proper governance structure and legally assured funding, functioning under the oversight of statutory regulatory authorities such as the SEC and the EC
Difficulty of assessing proposed standards (no comparison)
Even simple engineering design need field trials
Complexity of social institutions, risk of getting boxed into a wrong standards
Division of simplicity and complexity between strategy and institutions
Ecosystem view of financial reporting system
Competition with no tax revenues

32. Accounting Consensus 4
To this end, the operations of the FASB and the IASB should be gradually merged into one corporate body and one set of standards to be called IFRS
From social norms to uniform written standards
Effect of uniformity of education, research and profession
Compare accounting education to education for other professions

33. Accounting Consensus 5
This single set of standards should be practiced in the U.S., EC, and elsewhere, and the U.S. educational system should prepare itself to integrate IFRS into its curricula so university graduates will be able to prepare, use, and audit financial reports based on IFRS
Educational consequences an afterthought at best
Effect of expansion of written standards on classroom discourse
Educational capacity: chance to shift to general principles of accounting
Place of accounting in the university: medicine or plumbing

34. The Problem of Setting Efficient Standards
Criteria
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 regulators may not know, but can help
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

35. How Can the Regulators 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
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

36. 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?
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

37. 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
Role of accounting researchers/professors?
(c) 2005 Sunder, Nanny Knows Best
2/24/2019

38. Concluding Remarks
In the preface to his Dictionary, Johnson wrote about his “fortuitous and unguided excursions into… the boundless chaos of a living speech." Can authoritative uniform standards without collaboration with social norms bring a semblance of order to the chaos to financial reporting? After seven decades of incessant efforts, the answer stares us in the face

39. Shyam.sunder@yale.edu www.som.yale.edu\faculty\sunder
Thank You.