1. Accounting for Policy in Accounting Economics and Law Shyam Sunder, Yale University Accounting for Accounting in Economics Laboratory for Aggregate Economics and Finance University of Santa Barbara, Nov. 8-9, 2013

2. An Overview Robustness of what we think we know Optimization as a structural principle Examples –LIFO-FIFO accounting, taxation and securities –Security price indeterminacy –Corporate employee options –Attempts at policy relevant research –Endogeneity of transactions –Endogeneity of standards –Regulation and policy Tax-Financial reporting conformity Audit profession 10/23/2015Sunder, Research for Accounting Policy 2

3. 10/23/2015Sunder, Research for Accounting Policy 3 How Robust are Our Laws in 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 –Something like le Chatelier’s Principle in chemistry, though in social sciences we have examples of both counteraction as well as cases of cascading Findings which are robust to such adaptation can be called “laws” of social sciences, and may serve as the basis for social policy Both economics and accounting have suffered from premature claims of discovery of “laws” which turn out not to have the necessary robustness property If we were more careful in our claims, perhaps there would not be such flurry of theorization after our models turn out out to be wrong spectacularly, e.g. in the financial crises that occur after agents adjust their behavior to the wisdom of our received theories.

4. 10/23/2015Sunder, Structure and Behavior4 Problem of Building a Theory of Choice This challenge of social sciences is exemplified in difficulties of building a theory of choice From the science end: axiomatization of human choice as a function of innate preferences: people choose what they prefer How do we know what they prefer? Look at what they choose and reveal The circularity between preferences and choice might be avoided if there were some permanency and consistency in preference-choice relationship across diverse contexts One could observe choice in one context, tentatively infer the preferences from these observations, and assuming consistent preferences, predict choice in other contexts Unfortunately, half-a-century of research has yielded little predictability of choice from inferred preferences across contexts (Friedman, Isaac, James and Sunder 2014 forthcoming book) Individual human behavior appears to be unmanageably rowdy to capture in a stable set of laws Humanists can hardly be surprised (if they pay any attention at all to choice theory) But all is not lost

5. Optimization as a Structural Principle: Physics 10/23/2015Sunder, Research for Accounting Policy 5

6. Optimization as a Structural Principle: Biology “At multiple hierarchical levels--brain, ganglion, and individual cell—physical placement of neural components appears consistent with a single, simple goal: minimize cost of connections among the components. The most dramatic instance of this "save wire" organizing principle is reported for adjacencies among ganglia in the nematode nervous system; among about 40,000,000 alternative layout orderings, the actual ganglion placement in fact requires the least total connection length. In addition, evidence supports a component placement optimization hypothesis for positioning of individual neurons in the nematode, and also for positioning of mammalian cortical areas.” 10/23/2015Sunder, Research for Accounting Policy 6

7. Optimization as a Structural Principle: Insects 10/23/2015Sunder, Research for Accounting Policy 7

8. Optimization as a Structural Principle Is it applicable to humans? When humans tend to optimize, should we see it structurally, or cognitively? It gets wrapped up in debates about cognitive abilities, and our own self-image If we interpret it cognitively, how do we explain the movement of ants, neurons, and photons Is the optimization principle applicable to social systems including economics? 10/23/2015Sunder, Research for Accounting Policy 8

9. 10/23/2015Sunder, Structure and Behavior9 Smith (1962) Chart 1

10. 10/23/2015Sunder, Structure and Behavior10 Laws with Predictive Content in Social Sciences Simple economic theory: point of intersection of demand and supply determines price and allocations Economists’ have had deep faith in theory, nobody knew for sure that it works Until Vernon Smith’s (1962) experiment in his classroom (where motivated students traded) double auction provided the evidence that the law of supply and demand has reasonable predictive power Predictive power at aggregate level, although individual behavior is not predictable But does the result arise from human intelligence and striving, or is an aggregate level property of the market mechanism?

11. 10/23/2015Sunder, Structure and Behavior11 What Makes the Difference

12. 10/23/2015Sunder, Structure and Behavior12 Why Equilibrium without Individual Optimization Why do the markets populated with simple budget-constrained random bid/ask strategies converge close to Walrasian prediction in price and achieve close to 100% allocative efficiency No memory, learning, adaptation, maximization, even bounded rationality

13. 10/23/2015Sunder, Structure and Behavior13 Inference The structure, not the behavior of participants, accounts for the first order magnitude of outcomes in competitive settings Computers and experiments with simple agents opened a new window into a previously inaccessible aspect of economics Ironically, it was not through computers’ celebrated optimization capability Instead, through deconstruction of human behavior –Isolating the aggregate (social) level consequences of simple or arbitrarily chosen classes of individual behavior

14. Properties of Accounting Systems It has not been shown yet, But it would be useful for us to study the aggregate level properties of accounting systems, not just of the individuals who populate the world of accounting, and not just of each component of the accounting system Properties of the whole are not the same as the properties of the components 10/23/2015Sunder, Research for Accounting Policy 14

15. Some Examples LIFO-FIFO accounting, taxation and securities Security price indeterminacy Corporate employee options Attempts at policy relevant research Endogeneity of transactions Endogeneity of standards Regulation of auditing profession 10/23/2015Sunder, Research for Accounting Policy 15

16. What happens to stock price earnings and cash flow in conflict? LIFO accounting for inventories In periods of inflation and non-decreasing inventories, accounting earnings are lower But cash flows are higher Sunder 1973: Look at a sample of firms which adopted LIFO and gave up LIFO over about 20 years Set aside other problems of self-selection 10/23/2015Sunder, Research for Accounting Policy 16

17. 10/23/2015Sunder, Research for Accounting Policy 17

18. Did that Settle the Issue? WSJ: “Market Smart of Dumb?? Followed by 100’s of phone calls from corporate CFOs, wanting to know the results of my dissertation In spite of the great advantages of cash flow, most NYSE firms in fact had not adopt LIFO The Murphy question posed for stock options hanged in the air for LIFO: What is keeping them from saving a bundle of cash? From scores of their letters and phone calls, it seemed clear that all CFOs seemed to be afraid that if they adopted LIFO to conserve cash, the hit to their reported earnings will lower their stock price 10/23/2015Sunder, Research for Accounting Policy 18

19. Relax the Common Knowledge Assumption of Rationality Amershi and Sunder 1987: What if we relax the assumption is common knowledge without giving up on rationality of anyone If managers believe (which they apparently do) that the shareholders will follow the earnings not cash flows, you can end up in an equilibrium where it is best for managers (even if they are compensated based to stock prices) to maximize earnings, not cash flows. 10/23/2015Sunder, Research for Accounting Policy 19

20. Some Examples LIFO-FIFO accounting, taxation and securities Security price indeterminacy Corporate employee options Attempts at policy relevant research Endogeneity of transactions Endogeneity of standards Regulation of auditing profession 10/23/2015Sunder, Research for Accounting Policy 20

21. Bubbles and Price Indeterminacy in Asset Markets Hirota and Sunder 2006 JEDC We use PV model for fundamental valuation using common knowledge assumption That is unlikely to hold, especially in markets with short term investment horizon traders Relax the common knowledge assumption Without common knowledge assumption, there is no reason for prices to tend towards the common knowledge fundamental value And that is what we see in the prices 10/23/2015Sunder, Research for Accounting Policy 21

22. 22 Long-term Horizon Session Single terminal dividend at the end of period 15. An investor’s time horizon is equal to the security’s maturity. Prediction: P t = D Period 1Period 15 D (Trade)

23. 23 Figure 4: Stock Prices and Efficiency of Allocations for Session 4 (Exogenous Terminal Payoff Session)

24. 24 Short-term Horizon Session Single terminal dividend at the end of period 30. The session will “likely” be terminated earlier. If terminated earlier, the stock is liquidated at the following period predicted price. An investor’s time horizon is shorter than the maturity and it is difficult to backward induct. Prediction: P t  D Period 1 Period xPeriod 30 DE x (P x+1 ) (Trade)

25. 25 Figure 10: Stock Prices and Efficiency of Allocations for Session 8 (Endogenous Terminal Payoff Session)

26. What About Decision Making with and without CK of Cash Flows? We examine the data to see which model fits best 10/23/2015Sunder, Research for Accounting Policy 26

27. 27 Models of Expectations Backward induction (Fundamental) Model: 0 <   1: Forward induction (1): Adaptive model, 0 <   1: Forward induction (2): Trend model,   0 :

28. 28 Price Expectation Model Estimates: Long-Horizon Sessions Dependent Variable: E t (P t+1 ) - P t

29. 29 Price Expectation Model Estimates: Short-Horizon Sessions Dependent Variable: E t (P t+1 ) - P t

30. Using Historical Data for Forward Induction Traders use historical data to project the future because in absence of CK about the future they have no alternative What is the rationale for depriving them of that anchor? 10/23/2015Sunder, Research for Accounting Policy 30

31. Some Examples LIFO-FIFO accounting, taxation and securities Security price indeterminacy Corporate employee options Attempts at policy relevant research Endogeneity of transactions Endogeneity of standards Regulation of auditing profession 10/23/2015Sunder, Research for Accounting Policy 31

32. Some Examples LIFO-FIFO accounting, taxation and securities Security price indeterminacy Corporate employee options Attempts at policy relevant research Endogeneity of transactions Endogeneity of standards Regulation of auditing profession 10/23/2015Sunder, Research for Accounting Policy 32

33. 10/23/2015Sunder, Research for Accounting Policy 33 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

34. 10/23/2015Sunder, Research for Accounting Policy 34 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

35. 10/23/2015Sunder, Research for Accounting Policy 35 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

36. 10/23/2015Sunder, Research for Accounting Policy 36 Logic of Inference Reporting System 1 Reporting System 2Price System 2 Price System 1

37. 10/23/2015Sunder, Research for Accounting Policy 37 Logic of Inference Reporting System 1 Reporting System 2Price System 2 Price System 1

38. 10/23/2015Sunder, Research for Accounting Policy 38 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

39. Some Examples LIFO-FIFO accounting, taxation and securities Security price indeterminacy Corporate employee options Attempts at policy relevant research Endogeneity of transactions Endogeneity of standards Regulation of auditing profession 10/23/2015Sunder, Research for Accounting Policy 39

40. Some Examples LIFO-FIFO accounting, taxation and securities Security price indeterminacy Corporate employee options Attempts at policy relevant research Endogeneity of transactions Endogeneity of standards Regulation of auditing profession 10/23/2015Sunder, Research for Accounting Policy 40

41. Some Examples LIFO-FIFO accounting, taxation and securities Security price indeterminacy Corporate employee options Attempts at policy relevant research Endogeneity of transactions Endogeneity of standards Policy and Regulation profession –Conformity of tax and financial reporting –Auditing Profession 10/23/2015Sunder, Research for Accounting Policy 41

42. (c) Copyright 2004 Shyam Sunder Chances of Success of Recent Reforms and Proposals I am pessimistic None of the fundamental problems have been addressed Nothing structural has been changed PCAOB: With all due respect, a few years later, we shall be looking for the person who can be blamed for inventing the idea that a few hundred, or thousand, people can figure out if auditors are doing their job right –Can we reduce the number of bank robberies by appointing watchmen to watch the guards? Let me move to what can be done

43. (c) Copyright 2004 Shyam Sunder What Can We Do? Solutions need to fundamental, structural and robust One is already on the table: Prof. Ronen –Integrate insurance and audit –Firm decides how much, if any, financial fraud insurance to buy –Insurance firm decides on audit and the premium to charge (insurance and premium are made public) –No need for government oversight, except an accounting court (Leonard Spacek’s idea from more than four decades ago) I shall present a second idea of my own

44. (c) Copyright 2004 Shyam Sunder Tax and Financial Reporting Ninety years of drift between financial and tax reporting Separate optimization: minimize taxes, temptation to boost performance reported to shareholders Increasing audit burden on IRS Increased incentives to lobby Congress for corporate tax breaks Falling effective tax rates for corporations Push, push, push for lower taxes, even as IRS budgets get tighter

45. (c) Copyright 2004 Shyam Sunder Financial Reporting on the Other Hand Push, push, push for better quarterly performance driven by high powered compensation contracts Financial reporting and governance failures Difficulties of auditors faced with managers who might lose millions because the auditor says no Rock bottom audit fees driven by competition do not allow much resources for substantive testing, so “analytical review” would have to do Auditor incentives and independence problems

46. (c) Copyright 2004 Shyam Sunder Management Plays Two Games One to the IRS, who must spend resources it does not have to get the revenue the exchequer deserves The other to the shareholders to persuade them what a great job they have done to deserve a pat on the back and a tidy bonus (stock options) Integrate two games into one Congress could see this in 1947 (LIFO) –Gave that up in the seventies

47. (c) Copyright 2004 Shyam Sunder Tax Return = Income Statement Tax returns of public corporations are public Financial reports = tax return + balance sheet + cash flow statement + management discussion + footnotes Could the two bookends of tax and financial reporting lean on each other to yield outcome which are better? What would happen?

48. (c) Copyright 2004 Shyam Sunder Consequences By managerial choice –Tax returns would be less aggressive –Financial reports would be less aggressive Save on significant auditing costs –By IRS –By independent auditors Less Government regulation in financial reporting Less corporate lobbying on the Hill Scaling down of FASB and SEC Chief Accountant’s Office A smaller auditing profession

49. (c) Copyright 2004 Shyam Sunder Auditing Regulation & Breakdown: Misapplication of Economi cs Antitrust laws and professions –Unobservability of quality, restraint, Akerlof (market for lemons) 1960-70s: the cult of competition, Stigler (robustness of competition), misapplication of economic theory 1977-78: Supreme Court (Bates vs. Arizona Bar) US D of Justice and FTC: new professional codes of ethics for doctors, lawyers, accountants etc. AICPA implements it in 1979

50. Law, Economics and Accounting Failures 1980: sharp drop in audit prices begins, no profit, new business model (analytical review, consulting, internal transfer payments, and wage adjustments for recruits) Consequences played out for two decades Sharp drop in stock market exposes the accumulated skeletons in the closet None of the problems, especially the impossibility of attaining a reasonable market equilibrium in a market where the quality of the service essentially unobservable to the customer has been addressed yet PCAOB has been handed an impossible task People who make laws and policy do not understand accounting, and accountants do not get into policy 10/23/2015Sunder, Research for Accounting Policy 50

51. An Overview Do we think we know things that we don’t? Optimization: behavioral or structural principle Economics and accounting: disciplines with falsifiable propositions about the world, or self-contained logical structures with no empirical implications/imperfections? Some examples –LIFO-FIFO accounting, taxation and securities –Security price indeterminacy –Corporate employee options –Attempts at policy relevant research –Endogeneity of transactions –Endogeneity of standards –Regulation and policy –Tax-Financial reporting conformity –Audit profession 10/23/2015Sunder, Research for Accounting Policy 51

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