1. International and National Standards and Norms of Financial Reporting: Monopoly or Competitive Coexistence Shyam Sunder, Yale University Accounting Forum, Kobe University January 26, 2008

2. Sunder, Standards and Norms (Kobe) 2 Firm as a Set of Contracts

3. Sunder, Standards and Norms (Kobe) 3 Summary Traditionally, financial reporting was a matter of social norms of society In recent years, financial accounting has shifted from social norms towards national standards, and then towards international standards In US, federal regulation of securities induced transition from norms towards written standards in accounting thought, practice, regulation, instruction, and research; same may happen in EU Generally accepted accounting principles—no longer a description in its plain English meaning of a generally accepted societal norm Capitalized: Generally Accepted Accounting Principles Social norms maintained by internal and external sanctions Standards enforced by authority with power to punish Recent failures; wisdom of transition from norms to standards? Norms in professional, neighborhood, national, legal aspect of life Consequences of transition from norms to national and intl. standards Has the pendulum of standardization has swung too far? What should be the balance between norms and standards in accounting? Example: the consequences of the so-called “fair” value accounting

4. Sunder, Standards and Norms (Kobe) 4 Long Tradition of Social Norms in Financial Reporting

5. Sunder, Standards and Norms (Kobe) 5 Recent Shift from Social Norms towards National Standards and then towards International Standards

6. Sunder, Standards and Norms (Kobe) 6 In US, Securities Regulation induced transition from norms towards written standards in Accounting thought, Practice, Regulation, Instruction, and Research; The same may happen in EU

7. Sunder, Standards and Norms (Kobe) 7 Generally accepted accounting principles No longer a description in its plain English meaning of a generally accepted societal norm Capitalized: Generally Accepted Accounting Principles

8. Sunder, Standards and Norms (Kobe) 8 Social Norms vs. Standards Maintained by internal and external sanctions Standards enforced by authority with power to punish

9. Sunder, Standards and Norms (Kobe) 9 Use of Social Norms in all Walks of Life Professional, Neighborhood, National, Legal, Family

10. Sunder, Standards and Norms (Kobe) 10 Nature of Social Norms Social norms of a group are shared (common knowledge) expectations of its members about the behavior of others –Etiquette, dress, table manners, grammar, language, customary law, private associations. Objective of norms is observable behavior, not unobservable beliefs Must be a consensus, not just majority support Dictionaries become respectable by attracting a following, not by enforced authority

11. Sunder, Standards and Norms (Kobe) 11 Limits of Written Standards Legal scholarship and practice is careful in recognizing the limits of the efficacy of written rules When it is not possible to write a rule that will improve the state of affairs compared to a judgment-based system, the law leaves the judgment in place When a judge asks the jury to determine if the accused is guilty beyond reasonable doubt, lay jurors would want to know how much doubt is reasonable: ten percent, two percent, or one percent? Law does not attempt to codify answers to such questions People who write and practice law understand all too well the consequences of clarifying such questions would be even less desirable than the consequences of leaving the answers to the best judgment, even of lay people The SEC and the U.S. Congress refuse to clarify the definition of insider trading beyond “trading on non-public information” Again, the consequences of clarification are even less desirable than the consequences of leaving such matters to judgment.

12. Sunder, Standards and Norms (Kobe) 12 Example of an Accounting Norm Revenue recognition Inherently subjective Complete specification of conditions both unnecessary as well as infeasible No authoritative source Everybody is free to propose their own norm; they may or may not be accepted Authority derives from general acceptance by the financial community and disapproval of deviations

13. Sunder, Standards and Norms (Kobe) 13 Consequences of Transition from Social Norms to Standards to national, and More recently, international standards Transfer of responsibility

14. Sunder, Standards and Norms (Kobe) 14 Standards as Progress Accountants shifted their allegiance from norms to authoritative promulgation Profession now views standardization as a measure of progress (our rule book is thicker than yours!) Most research refers to standards with respect, if not approval –“By the outset of the 1970s, an energetic and ambitious plan was in operation.” Zeff on attempts of the English Institute in Lectures on Forging Accounting Principles in Five Countries Baxter analyzed the corrosive effect of authority on accounting profession half-a-century ago Those ideas were largely ignored There has been little research and debate on merits and consequences of standardization Consider the example of so-called “fair value” accounting

15. Sunder, Standards and Norms (Kobe) 15 Clear Rules or Road Maps for Evasion A law or rule must strive for clarity and enforceability without being a road map for evasion –Documents for entering a country –Schedules and routes of border petrol –Bright line accounting standards (3% SPEs, etc.) remove the uncertainty for financial engineers Many clarifications facilitate financial fraud Standard-writing agencies become unwitting accomplices of evaders

16. Sunder, Standards and Norms (Kobe) 16 Structural Weakness of a Standard Setting Body A permanent rule-making bureaucracy must make rules to justify its budget and existence –FASB (until recently) depended on revenues from sale of its publications; IASB’s revenue model? –Challenge to publish-or-perish very real –Inevitably, rulebook must get thicker over time

17. Sunder, Standards and Norms (Kobe) 17 Incentives Created by Private Rule Making Institutions Existence of rule making institution encourages requests for “clarifications” –Lower resistance to client requests –General principles are questioned: Yes, it says “Thou Shalt Not Steal,” but I only borrowed the car –Competition among auditors makes it worse –After the change in auditors’ code of ethics, partners rewarded for rainmaking, not their technical mastery or professional judgment

18. Sunder, Standards and Norms (Kobe) 18 Effect of Rule Makers on Behavior of Auditors Pushed by clients to cite line and verse to support their positions Calls to FASB/IASB: the rule is not clear Inability of FASB/IASB to respond in timely fashion becomes basis for client to have his way Absent rule making agency, the auditor would have had to worry about the fair representation requirement under the security laws Existence of FASB/IASB as an unwitting supporter of the attitude: “if it is not proscribed, it must be OK”

19. Sunder, Standards and Norms (Kobe) 19 Hide-and-Seek at the Wall Street Investment banker calls the FASB/IASB Financial engineering to get around the rules Reasonable body of rule might be devised to deal with a given set of transactions No rules can be devised when transactions are continually redesigned to get around a slowly adapting body of rules Minimal changes to get over the bar Wall Street/City of London calls to FASB/IASB can have the character of the thief asking when you plan to be away from home

20. Sunder, Standards and Norms (Kobe) 20 Rule-Making Monopolies Monopolies in US and EU deprive the economies and rule makers of the benefits of observation from experimentation with alternatives Difficulty of discovering efficient rules Cost-of-capital consequences unclear Self-serving arguments by constituents Why deny ourselves the benefits of information derived from competition

21. Sunder, Standards and Norms (Kobe) 21 Recent Accounting Failures Questions about the wisdom of transition from norms to standards?

22. Sunder, Standards and Norms (Kobe) 22 Has the pendulum of standardization has swung too far? Misunderstanding of the role of social norms in law Popularity/promotion of stock and accounting-based compensation for senior managers Promotion of competition in the market for audit services Creation of full-time private rule making agencies Has this shift gone too far? How do we know and decide? What should be the balance between norms and standards in accounting?

23. Sunder, Standards and Norms (Kobe) 23 Example: the consequences of the so-called “fair” value accounting

24. Sunder, Standards and Norms (Kobe) 24 Labels Matter What is common to: –Unified Budget Act (1964, Lyndon B. Johnson) –Patriot Act (2002, George W. Bush) –Fair Values (1999, FASB/IASB)

25. Sunder, Standards and Norms (Kobe) 25 “Pernicious changes with deceptively reassuring titles” Choose labels to put potential opponents on defensive before the debate begins Oldest trick in the book of policy rhetoric –Johnson wanted to use the social security surpluses to finance increased spending on Great Society programs and the Vietnam War (who can argue for non-unified budget?) –Bush wanted to fight the war on terror (who is against patriotism?) –FASB wants to use current values (who can be against fair values in accounting?) “Fair” is a personal judgment, not a fact To avoid misuse of language, put the rhetoric of “fair” aside, and talk about current values of which generations of accountants and researchers have thought and written about

26. Sunder, Standards and Norms (Kobe) 26 The Proposal The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date –Orderly transaction, not forced liquidation or a distressed sale –From eyes of a market participant, no entity specific assumptions –Highest and best use framework from the perspective of market participants even if the acquirer has different plans

27. Sunder, Standards and Norms (Kobe) 27 The Valuation Debates Relevance to investment decisions Relevance to stewardship, management of enterprise resources, and contract enforcement Other criteria for evaluation: reliability, bias, timeliness, representational faithfulness, cost of implementation

28. Sunder, Standards and Norms (Kobe) 28 Qualitative versus Quantitative Valuation debates have been largely been about qualitative characteristics of rules Without a framework for quantified comparison, debates can go on for ever –People don’t change their minds –Theories are supposed to die only with their proponents (“science advances funeral by funeral”) –Even that is not true in case of fair values –Resurrection of current values under the new label after an interval of almost 70 years How do we bring an element of quantified rationality to this debate?

29. Sunder, Standards and Norms (Kobe) 29 Econometrics Great achievements of econometrics arise from our willingness to –Postulate an underlying structure and unknown parameters of the problem –Characterize the properties of alternative estimators (e.g., OLS, GLS, 2SLS, etc.) as a function of the underlying environment –Choose an estimator appropriate to the postulated environment –Use data to estimate the unknown parameters, holding the structure constant –Examine propositions about the underlying parameter on the basis of estimates –Use alternative datasets of examine the propriety of assumed structure –When found inappropriate, change the assumed structure

30. Sunder, Standards and Norms (Kobe) 30 Econometrics of Valuation Can we use a similar strategy for documenting the properties of valuation rules in various environments? It may not entirely get rid of judgments But still, will move the debates among valuation rules from the domain of opinion into data Let me explain, starting with one postulated structure Remember, we can always change the postulated structure if we find a better one later For now, let us focus on thinking about choice of valuation rules as we think about choice of econometric estimators

31. Sunder, Standards and Norms (Kobe) 31 Postulated Structure There are many resources in the economy (vector ω) Each firm is a special bundle of some or all of these resources--a vector of proportions (vector w) Current values of resources are subject to change over time: relative changes have a given mean vector (μ) and covariance matrix (Σ) Historical costs of resources in the bundle are known Relative changes in current values of the resources are observed with an (unbiased) error term (vector ε) which has covariance matrix (Δ)

32. Sunder, Standards and Norms (Kobe) 32 Two Sources of Error in Valuation Consider two sources of error in valuation of a bundle of resources –Values change over time but the valuation rule ignores these changes (price movement errors) –Current values we use to revalue the bundle are prone to errors due to imperfection and incompleteness of markets (measurement errors)

33. Sunder, Standards and Norms (Kobe) 33 Choose a Metric and Magnitude of Errors of Valuation Rules Let us focus on the expected mean squared error as the metric of errors (used in most econometrics; we could also use bias or other metrics) Magnitudes of the errors depend on –Parameters (Δ, Σ, μ, and ω), and –Valuation rule used to adjust historical to current values The space of valuation rules is very large; even linear subject is huge; let us just focus on the three elements of this subset (historical cost, general price level and current value)

34. Sunder, Standards and Norms (Kobe) 34 Historical Valuation Has price movement errors because it ignores changes in prices from the time of acquisition to present The size this error (MSE) depends on parameters of the economy: –The mean of the vector of relative price changes (μ), and –The covariance matrix of the vector of relative price changes, (Σ) Greater the “magnitude” of these two parameters, greater is the movement error associated with historical valuation Since historical valuation ignores changes in prices, it is free of measurement errors

35. Sunder, Standards and Norms (Kobe) 35 Current Valuation It has price measurement errors arising from assessment of current values Again, the size this error (MSE) also depends on parameters of the economy: –If we assume that the relative changes in current values are measured without bias ( ε = 0), the MSE arising from the mean of measurement errors is zero –The error arises from the covariance matrix of the vector of measurement errors in relative price changes ( Δ ) Greater the “magnitude” of this covariance matrix, greater is the measurement error associated with current valuation Since current valuation takes into account the changes in prices, it is free of price movement errors

36. Sunder, Standards and Norms (Kobe) 36 General Price Level Valuation GPL uses a single price index to adjust historical values towards current values The use of a single price index reduces the price movement error associated with the historical estimator but does not eliminate it The use of a single price index also introduces some measurement error, although it is not as large as the error associated with current value estimator The total error associated with GPL estimator depends on the values of the parameters μ, Σ, Δ and ω. Let us look at the picture as a schematic graph

37. Sunder, Standards and Norms (Kobe) 37 Behavior of Price Movement Error with Respect to Aggregation

38. Sunder, Standards and Norms (Kobe) 38 Behavior of Price Measurement Error with Respect to Aggregation

39. Sunder, Standards and Norms (Kobe) 39 Behavior of Total (Valuation) Error with Respect to Aggregation

40. Sunder, Standards and Norms (Kobe) 40 How Do These Estimators of Value Perform Which estimator of is associated with lower mean squared value It depends on the parameters of the economy With high price volatility and low measurement errors, current value estimator dominates With low price volatility and high measurement errors, GPL, and even historical value estimator may dominate In general, we should not expect that the MSE minimizing estimator will be any of the three we have explicitly considered Instead, it is likely to be some intermediate specific price index estimator of value

41. Sunder, Standards and Norms (Kobe) 41 Testable Implications of Theory Current valuation would be more informative for firms and industries whose –Assets have a large mean rate of price change –Assets have more variability in price changes –Assets are traded in relatively perfect and complete markets (accurately measured CV) Real estate, mineral deposits, films, software, patents have large measurement errors Instead of cross-sectional tests (e.g., Gheyara and Boatsman 1980, Ro 1980), we could benefit from paying more attention to characteristics of assets of firms and industries

42. Sunder, Standards and Norms (Kobe) 42 Testable Implications of Theory Efficient valuation rules would vary across assets, firms and industries Level of aggregation at which current values are chosen has a major impact on the properties of valuation (left open in FASB/IASB’s proposal)

43. Sunder, Standards and Norms (Kobe) 43 What Do We Learn from This Theory? Theories of valuation can be integrated into a framework to facilitate direct comparison of their properties in specified environments When current prices change, and are prone to measurement errors, neither the current nor general price level valuation is necessarily the min(MSE) estimator of the unobserved economic value of assets Generally, min (MSE) estimator is likely to be a specific price index rule If the measurement errors are sufficiently large relative to movement errors, historical cost can be the min (MSE) estimator Which valuation rule has min (MSE) is a matter of econometrics, not theory or principle (depends of relative magnitude of parameters of the economy)

44. Sunder, Standards and Norms (Kobe) 44 An Agenda for Reforms The pendulum seems to have swung too far in the direction of written standards Reconsider a stronger role of social norms and personal and professional responsibility in accounting and business –Reconsider virtues of promoting competition among auditors (a “market for lemons”) –Better use of social norms: “fair representation” as a moral compass of accounting As “guilty beyond reasonable doubt” in criminal law Neither can be captured in written standards Creation of accounting courts to judge “fairly represent” –Assist evolution of accounting norms through competition among multiple accounting rule makers (no collusion, no convergence) –Remove rule-making monopolies in U.S., Europe (and elsewhere)

45. Sunder, Standards and Norms (Kobe) 45 Thank You Please send comments to Shyam.sunder@yale.edu The paper and the presentation will be available at www.som.yale.edu/faculty/sunder/research