1. Research for Accounting Policy Shyam Sunder, Yale University Information, Markets and Organizations Conference, Harvard Business School June 10-11, 2010

2. 6/9/2015Sunder, Research for Accounting Policy 2 An Overview Social sciences as instruments of social engineering (policy) Scope and levels of accounting policy Maintained assumptions of financial reporting policy Instruments of social sciences: what works, what doesn’t? Why and why not? Way forward: accounting policy beyond social sciences?

3. We Could Talk About Social science and social engineering Robustness of findings to their discovery Field data: Causal direction, correlation of hypotheticals Experiments and bench testing Scope and levels of accounting and financial reporting policy Criteria Assumptions Problems of efficient standards and their alternatives Command and control and alternatives Social science as instrument of policy Accounting policy beyond social sciences Challenges for policy research, historical experience Closed or open systems? 6/9/2015Sunder, Research for Accounting Policy 3

4. 6/9/2015Sunder, Research for Accounting Policy 4 Social sciences as instruments of social engineering Social science as the dominant model of business research since mid-20 th century Although engineering originated well before the origins of natural sciences, advances in natural sciences have enabled us to engineer great many artifacts we consider indispensable today Accounting, too, originated well before policy research; but it does not seem unreasonable to think that we can also take advantage of learning from social sciences to make better social policy (maintained assumption of this session)

5. 6/9/2015Sunder, Research for Accounting Policy 5 Limits of Parallels This parallel can take us only so far Natural sciences search for, and identify, laws of nature valid across time and space Validity, replicability, and predictability of these laws confers prestige on sciences But there is another form of scholarship on our campuses--humanities that regard the behavior of sentient beings as infinitely variable; each of character in Iliad, Macbeth, or Ramayana is unique They pursue eternal truths, but admit no laws

6. 6/9/2015Sunder, Research for Accounting Policy 6 What are social sciences? “Social” recognizes that the subject of study are sentient beings (with free will that humanists recognize), not marbles or atoms without will (that scientists study) “Science” seeks the prestige associated with the search for eternal laws Neither sciences nor humanities allow much room for laws of human behavior we seek in social sciences Free will and laws of behavior do not sit well together; we want but can’t have it both ways

7. 6/9/2015Sunder, Research for Accounting Policy 7 Laws of Social Sciences To serve as a basis for social policy, the “laws” of social sciences must have stability (be robust to their own discovery) Since humans learn and adapt, social science findings can alter behavior in ways that tend to invalidate the findings Findings which are robust to such adaptation can be called “laws” of social sciences, and may serve as the basis for social policy

8. 6/9/2015Sunder, Research for Accounting Policy 8 How Robust Are Our Findings? Independent of the method of research we use, robustness of findings (to their own discovery) is a pre-requisite for their use as basis for policy Like unclaimed dollar bills on side-walk, many findings (e.g., small firm and Monday effects) disappear upon being reported There are other findings (e.g., determination of price by intersection of demand and supply) are robust in this sense (not merely statistically) So the first pre-requisite for usefulness of any research findings for policy is this stability Most such laws are properties of institutions, not behavior [1]

9. 6/9/2015Sunder, Research for Accounting Policy 9 Causal Link Policy makers want to know if the manipulation of the policy variable under consideration has a directional (causal) link to the desired objective. Correlation does nothing for them. Yet, the problem of establishing a causal link between two variables on the basis of field data remains largely unsolved due to endogeneity Experimental methods have been presented as an alternative to address this problem, but they, too, have limitations of their own Consider both approaches briefly

10. 6/9/2015Sunder, Research for Accounting Policy 10 Problems of Inference from Field Data: Causal Direction Labeling of correlation as cause is more of a rule than an exception in accounting research journals When correctly labeled as correlation, what can the policy maker do with the finding? To claim that the finding is “consistent” with Hypothesis X fails to point out that –It is also consistent with innumerable other hypotheses not mentioned in the report, and –No hypothesis has been rejected (violating the essence of Neyman-Pearson-Wald framework)

11. 6/9/2015Sunder, Research for Accounting Policy 11 Problems of Inference from Field Data: Hypotheticals and Efficiency Our attempt to produce policy-relevant research often take the following form: Info. Sys. 1  Price system 1 Info. Sys. 2  Price system 2 Suppose information system 1 and price function 1 are the status quo and the policy maker wants to know the consequences of changing the information system from 1 to 2

12. 6/9/2015Sunder, Research for Accounting Policy 12 Problems of Inference from Field Data: Hypotheticals and Efficiency We can gather data on accounting numbers and prices under status quo and estimate their statistical relationship, R(1) In many situations, we can also calculate (or reasonably estimate) what the accounting numbers would have been under the policy alternative (the hypothetical) If we could observe prices that would be generated under the policy alternative, we could also estimate the statistical relationship R(2) Does a comparison of R(1) and R(2) help the policy makers? If stronger R(2) implies preference for the policy alternative, it is trivially simple to push R(2) to the upper limit by simply using prices for accounting

13. 6/9/2015Sunder, Research for Accounting Policy 13 Problems of Inference from Field Data: Hypotheticals and Efficiency Of course, we are rarely so lucky as to be able to observe P(2) An oft-used practice is to estimate the statistical relationship between the hypothetical I(2) and actually observed P(1), and then compare this R(2)* with R(1) and suggest that a stronger R(2)* implies the alternative to be preferred policy Info. Sys. 1  Price system 1 Info. Sys. 2  Price system 1

14. 6/9/2015Sunder, Research for Accounting Policy 14 Logic of Inference Reporting System 1 Reporting System 2Price System 2 Price System 1

15. 6/9/2015Sunder, Research for Accounting Policy 15 Logic of Inference Reporting System 1 Reporting System 2Price System 2 Price System 1

16. 6/9/2015Sunder, Research for Accounting Policy 16 Logic of Inference and Policy This type of inference from field data does not help the policy makers We like them to give us a nod to acknowledge our work, and perhaps even support it But the logical foundations of such inference, and its implications for policy remain to be worked out

17. 6/9/2015Sunder, Research for Accounting Policy 17 What about Lab Experiments? Lab methods allow us to address the causality problem with greater confidence But they also raise new challenges for use of findings in making of accounting policy Accounting is highly institutionalized (complex interactions, expectations), like engineering Experimental methods were developed for social sciences where a single simple example can support a general proposition about existence, or otherwise Simpler experiments suffice for basic disciplines such as economics, psychology and physics, but not for accounting policy or bridge design

18. 6/9/2015Sunder, Research for Accounting Policy 18 Bench Testing of Policy Bench testing of an accounting policy alternative calls for far greater complexity in design of the lab experiment than in case of testing economic theory More complex decisions, larger choice space, need more time (order of magnitude) Compare choice of a point on a function with choice of a function

19. Scope and levels of accounting policy: alphabet soup Financial reporting: FASB, IASB, SEC, etc. Audit: PCAOB, ASB, IAuSB, AICPA Internal Audit: IIA Cost accounting: CASB? Government: GASB, MFOA, OMB, GAO, Congressional committees Education: AACSB, NASBA, IAESB, AICPA, CFA, IMA 6/9/2015Sunder, Research for Accounting Policy 19

20. Macro Policy in Accounting Taxation and collection National income Monetary policy Banking regulation Securities regulation Employment, wages, retirement, unions Wealth generation Wealth distribution Government budgets and financial management Government accounting (control of deficits) Cost of legislative proposals 6/9/2015Sunder, Research for Accounting Policy 20

21. 6/9/2015Sunder, Research for Accounting Policy 21 Scope and levels of financial reporting policy Financial reporting policy is made at many levels, with higher levels having broader scope Most common level is the choice of specific accounting methods and disclosures At the other end of the spectrum are institutional and structural decisions usually made by Congress Most research is concentrated at the micro end of the policy spectrum, probably because the high frequency of such decisions, and ex ante availability of data sets from comparable contexts At higher institutional levels of policy making, ex ante data becomes more scarce, leaving us with ex post analyses that come too late to serve as inputs to decisions on policy alternatives

22. 6/9/2015Sunder, Research for Accounting Policy 22 Policy Criteria Research input for policy calls for identifying the policy criteria and including them in research design While accounting policy makers proclaim allegiance to qualitative criteria such as representativeness, timeliness, neutrality, decision usefulness, etc., few of them find their way into our research designs Research on representativeness and neutrality, for example, would require comparison of accounting data with their corresponding principals which are difficult to observe Research on decision usefulness is subsumed into correlation with stock prices, setting aside questions about market efficiency and the interests of non-equity stakeholders

23. 6/9/2015Sunder, Research for Accounting Policy 23 Assumptions of financial reporting policy Subjecting them to investigation, instead of assuming that they hold

24. 6/9/2015Sunder, Research for Accounting Policy 24 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, (coordination vs. efficiency benefits; electrical plugs, clothing, cars, street grids, commercial codes, cell phones, software) –When does standardization become counterproductive –How do we know where to stop? –Rhetoric of universal accounting standards using analogy of weights and measures and universal language

25. 6/9/2015Sunder, Research for Accounting Policy 25 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 financial reporting and financial engineering makes any such a static ideal all but impossible –Consider leases, derivatives, design of transactions

26. 6/9/2015Sunder, Research for Accounting Policy 26 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

27. 6/9/2015Sunder, Research for Accounting Policy 27 4. Design, not Evolution 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 –Balancing Cartesian design vs. Darwinian evolution –Hayek’s spontaneous emergence

28. 6/9/2015Sunder, Research for Accounting Policy 28 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

29. 6/9/2015Sunder, Research for Accounting Policy 29 6. What is Good and 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) –To what extent can we sort these influences by ex ante analysis and research?

30. 6/9/2015Sunder, Research for Accounting Policy 30 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

31. 6/9/2015Sunder, Research for Accounting Policy 31 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.) –Research on tendency of race to the bottom (or top)?

32. 6/9/2015Sunder, Research for Accounting Policy 32 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 –Do draconian punishments induce better behavior –Comparison of evidence from domains of crime, alcohol and drug abuse

33. 6/9/2015Sunder, Research for Accounting Policy 33 10. Effectiveness of Statutory vs. Common Law Approaches The quasi-statutory approach to setting accounting standards dominates a common law approach to financial reporting –Evidence? –Constitution (U.K., U.S., Europe)

34. 6/9/2015Sunder, Research for Accounting Policy 34 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)

35. 6/9/2015Sunder, Research for Accounting Policy 35 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 –Most of our models tend to be linear and monotonic in decision variables

36. 6/9/2015Sunder, Research for Accounting Policy 36 13. What is New?: Historical Analysis Did financial reporting and governance problems originate in the 20th century –History tells us otherwise –E.g., governance problems of the East India Company –Clive, Hastings, and the Company’s Court of Directors –Evolution of internal directives, financial reporting and auditing

37. 6/9/2015Sunder, Research for Accounting Policy 37 14. Financial Reporting is Getting Better Has eighty years of standardization of financial reports (in U.S.) helped improve the quality of financial reporting? –Evidence? –Is a thicker (or thinner) rule book indication of better financial reporting? –Perfect correlation between accounting and stock returns? –How do we judge if our financial reports are getting better?

38. 6/9/2015Sunder, Research for Accounting Policy 38 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 –Spence on signaling

39. 6/9/2015Sunder, Research for Accounting Policy 39 16. Auditor’s Bargaining Power Do well-specified standards enhance the bargaining power of the auditor vis-à-vis the client? Reduce their legal liability? –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

40. 6/9/2015Sunder, Research for Accounting Policy 40 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 –Does codification of GAAP serve as a roadmap for evasion to guide the financial engineers?

41. 6/9/2015Sunder, Research for Accounting Policy 41 18. Individual responsibility Written financial reporting standards strengthen the individual responsibility of managers, auditors, and investment bankers for fair representation –On the contrary, they may 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 –John C. Burton (1975) on “true and fair” override

42. 6/9/2015Sunder, Research for Accounting Policy 42 19. Education Written standards make it easier to educate better accountants and attract talent to the profession –Written standards may also 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

43. 6/9/2015Sunder, Research for Accounting Policy 43 The Problem of Setting Efficient Standards Calling for Research Criteria Generation of alternatives Evaluation of alternatives Complex interactions among accounting, capital and labor markets financial engineering Facilitation of evolution of accounting norms Balancing statutory and common law Balancing adjustment speed and errors of policy Extent of standards, and consequences for personal responsibility Command-and-control (nanny knows all) or bottom up (laissez faire) or some combination of the two? What combination?

44. 6/9/2015Sunder, Research for Accounting Policy 44 Command & Control Perspective To develop accounting standards: –A single set (monopoly?) –Of high quality (what does that mean?) –Understandable (to who?) –Enforceable (stick, not social norms) –Global (no clientele or diversity) Are we willing to explore alternative mind sets about financial reporting through research?

45. 6/9/2015Sunder, Research for Accounting Policy 45 Instruments of social sciences Analysis of data gathered from the field Analysis of controlled experiments in the lab or the field Abstract mathematical analysis Historical analysis Introspection If accounting research is to contribute to policy, we shall have to use all the tools at our disposal as and when necessary Prior commitment to one or the other tool set is likely to be self-defeating

46. 6/9/2015Sunder, Research for Accounting Policy 46 Way forward: accounting policy beyond social sciences? Accounting policy includes considerations that go beyond the scope of social sciences I do not believe that a stable financial system is feasible without broadly accepted social norms of personal responsibility business and accounting community Our own (academic) community could not function without such norms We should not expect that written codification of accounting standards to be sufficient to create order in the world of financial reporting, no matter how much resources and power is given to the Boards They can only do so much. The rest is up to the community of accountants

47. 6/9/2015Sunder, Research for Accounting Policy 47 The Challenge of Policy for Research If research does not (at least ultimately) lead to better understanding, practice or policy, it will be ignored The methods we have do not always take us in that direction Stick to these methods (because that is what get published) Or, move beyond the methods if they cannot enlighten us Does research affect accounting policy for better? Do standards improve financial reporting? Do we have an honest assessment? History suggests that improving financial reporting and governance is not an easy task

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50. 6/9/2015Sunder, Research for Accounting Policy 50 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 Where does the research community stand? There are many life times of research agendas here if we are willing to consider them

51. 6/9/2015Sunder, Research for Accounting Policy 51 References Gode, D. K. and Shyam Sunder. 1993. “Allocative Efficiency of Markets with Zero Intelligence Traders: Market as a Partial Substitute for Individual Rationality.” The Journal of Political Economy 101, no. 1 (February 1993): 119-137. Sunder, Shyam. “Determinants of Economic Interaction: Behavior or Structure.” Journal of Economic Interaction and Coordination 1, no. 1 (May 2006): 21-32. Sunder, Shyam. “What Have We Learned from Experimental Finance?” In Developments on Experimental Economics: New Approaches to Solving Real-world Problems edited by Sobei H. Oda, 91-100. Lecture Notes in Economics and Mathematical Systems 590. Berlin: Springer, 2007. 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). Sunder, Shyam. 2010. “Was Accounting a Root Cause of the Global Financial Crisis?” Plenary Address to the Annual Meeting of the International Corporate Governance Network, Toronto, June 7.

52. Thank You! Shyam.sunder@yale.edu www.som.yale.edu/faculty/sunder