1. Norms, Standards and Failures in Accounting and Auditing: Rethinking Practice, Research and Education Shyam Sunder, Yale University Korean Accounting Association Seoul, Korea, February 7, 2007

2. An Overview Roots of accounting and auditing failures –Short, medium and longer term views Pushing competition in market for auditing Transformation of financial reporting from social norm to written standards Consequences for practice, education and research Policy alternatives

3. Roots of Accounting and Auditing Failures: A Rethinking

4. A Short-Term Perspective The immediate causes of failures: beliefs of executives, auditors, lawyers, investment and commercial bankers, and corporate directors that they could default on their duties without bearing the consequences –Compounded by the failure of government to discipline the individual failures Cases are winding their way through the courts Will enforcement of the existing laws remedy the problem? Mixed signs: –Enron’s auditor is out of business but its law firm is not –Qualified people reluctant to serve as the directors; nominating committees reluctant to choose technically qualified but unknown people for boards –More non-employees on audit and compensation committees; but we do not yet know if they would serve the interests of others any better –Stock option grant rates slowed down in 2002, yet the rapid rise in the compensation of senior executives continues, back-dating scandals

5. Medium-Term Perspective Two critical events of the recent decades –U.S. government decided to push competition in the audit industry in 1979 (Sunder 2003) –Rise in performance-contingent compensation for senior corporate executives Policies driven by the dominant economic theories of the moment –Competition was also supported by the U.S. Supreme Court through its decisions (e.g., Bates vs. Bar of the State of Arizona) The general theory (competition promotes economic efficiency) applied to audit industry created a textbook example of a “market for lemons” Price and quality of audit services declined in the early eighties Audit firms try to find alternative sources of revenue (consulting) Audit services become loss leaders for consulting Fall in prices and the quality of audit services, combined with the increased executive temptation to commit accounting fraud (growth of performance- contingent executive compensation, Erickson et al. 2005) Consequences of this combination were played out over two decades until a sharp drop in the economy and the stock market, following the dotcom bust, brought the house down

6. Longer-Term Perspective Over a century, another pattern emerges Since the enactment of the securities laws in the early 1930s, the U.S. has seen a steady shift in financial reporting –From business and professional norms towards legislated written standards enforced by threats of explicit punishment for violators This shift altered virtually all aspects of accounting (including education) The recent collapse can be seen as a logical consequence of the policy decisions of the past seven decades.

7. A Thumbnail Sketch of the Collapse Ninety years of antitrust laws and enforcement These laws were not applied to the professions—including doctors, lawyers, accountants, and dentists They kept anticompetitive clauses in the “Code of Ethics” of their respective professions

8. Professional Codes of Ethics No advertising No solicitation of competitors’ clients or customers No solicitation of employees of competitors Most professions justified such clauses in their rules of membership on the basis that they are necessary for “professional” behavior

9. Economics of Restrictions on Professional Competition There were substantive economic arguments to justify restrictions of professional competition –Quality of professional services difficult to see –Customer/client depends on seller’s recommendation about what he/she should buy –Professional must incur time/effort to find out what the customer/client needs, must charge for it –Markets for professional services are prone to failure under free competition –Market for lemons (Ackerlof)—results would be even worse than the consequences of insufficient competition

10. Theory Makes a Difference Economic arguments for deregulation Stigler: robustness of competition paper Answer to the “market for lemons”: the reputation effect as a counter to the lemons phenomenon Focus on economic efficiency of the system

11. Status Quo Till 1977 This was the status quo of competition in markets for various kinds of professional services in U.S. until the mid-seventies Then came a decision from the U.S. Supreme Court In 1977: U.S. Supreme Court ruling on Bates v. State Bar of Arizona, held that the restrictions on lawyer advertising violated the protections given free speech under the First Amendment to the US Constitution

12. Change in US Policy The Supreme Court decision led to a change in the U.S. government policy on professional competition Under pressure from the Department of Justice and the Federal Trade Commission, most professional associations, including the American Institute of CPAs deleted the anticompetitive provisions from their codes of ethics by the end of the seventies

13. Good Intentions, Bad Decisions The intent behind this change in the government policy (and the Supreme Court decision) had been to obtain for the public the presumed benefits of competition among professions The Court accepted the argument that, the risks of failure in the market for professional services are adequately counterbalanced by the tendency of the professionals to develop a reputation for the quality of services they provide Over time, customer and clients learn about the reputation of the professionals, as the basis of those they choose to patronize Reputation prevents market failure

14. Does Reputation Work? In the case of doctors, at least the patient (or his family) know, after the treatment, whether the patient got better (even survived) In the case of lawyers, at least the client knows, after the trial, whether the case was won or lost These ex post observations are reasonably prompt and have at least a proximate correlation with performance They enable the doctors/lawyers to develop a more or less precise reputation with their patients/clients that serve as the basis of their own (and their acquaintances’ future decisions)

15. Generalizability to Auditors? Unfortunately, this argument, applicable to lawyers and doctors and many other professionals, does not work for the auditors The auditors’ customers—the shareholders and other third parties—cannot tell, even after the fact, if the auditor provided quality services for three reasons: –The rate of audit failure is less than 1 percent –The customers never see the auditor do their work –Firm’s decisions on hiring the auditor are made by managers who are the subject of the audit

16. The Fatal Flaw Application of the reputation argument as the justification for competition in the market for auditing was fatally flawed With very low failure rate, and absence of direct contact and observability by the customers, it is not possible for auditors to develop meaningful, and accurate reputation with the shareholders in any reasonable length of time Under the pressure of free competition, the market for auditing broke down—a market for lemons

17. Audit Market Breakdown Clients actively played audit firms against one another to lower their audit fees The amount and quality of the work done by the auditors was not observable to the clients Competition for audit services would not sustain a price to make auditing self- supporting Auditors responded by a new business model to survive in this cut rate environment

18. Revised Business Model of Audit Firms Aggressive pricing of audit services Cut labor intensive substantive testing, and replace it by cheaper analytical reviews Use audit service as “foot in the clients’ door,” to sell consulting services Share consulting revenue with audit partners Use consulting revenue to pay for any additional audit liability coverage arising from reduced substantive testing Reduce the pay for fresh graduates

21. Consulting: A Consequence, Not the Cause of Failure In the debate on consulting services over the past decade, they have often been portrayed as the cause of failure of audit market by depriving auditors of their independence Instead, auditors turned to consulting services to earn a living when they found that they could not do so from audit services

22. Large Liabilities The strategy of de-emphasizing substantive testing led to some spectacular audit failures, especially in the savings and loan banking industry in the mid-eighties Audit firms paid large court judgments or out-of- court settlements Drop in number and quality of students going into accounting majors Mid-course correction was needed to restore profitability

23. Number of Settlements of Claims Against Auditors

24. Amounts of Settlements Against Auditors

25. Joint and Several versus Proportional Liability The auditor liability had been joint and several; if other defendants could not pay, auditors had to pay their share A political strategy to change the law to proportional liability Financing of elections as the lawyers and doctors had done for many years to advance their interests Payoff: Private Securities Litigation Reform Act, 1995

26. Accountants’ Contributions to Political Campaigns

28. 1995 Legislation For auditors: switch from joint and several to proportional liability –Reduced and less uncertain liability For corporate management: forward looking statements under safe harbor rule –Freedom to issue unverified (unverifiable) information in financial statements as long as it was marked forward looking The only instance during Clinton’s eight year presidency when his veto was overturned by the Congress (election financing)

29. New Business Model The 1995 legislation, with a 1994 Court ruling exempting advisors from liability for aiding and abetting securities fraud, implemented the new business model of auditors –Key elements: intense competition, low audit fees to get in, fast growing high margin consulting business for profits Audits discarded in favor of “assurance services” Audit partners pressured to sell consulting services –Many old time auditors quit, instead of selling consulting Internal reorganization of power and responsibilities –E.g., Arthur Andersen transferred the final authority on accounting matters from headquarters specialists to the local partners

30. The Happy Days End In 1999, the Securities and Exchange Commission saw the adverse consequences, but wrongly identified consulting services as the culprit, and tried to stop consulting Audit industry beat back the effort with political help from the Congress (settled for disclosure of consulting fees) Extensive failures of corporate audits are the results of this 25-year chain of events Auditors had become the perpetrators, the short term beneficiaries and ultimately the victims of the dotcom bubble The well meaning government policy to encourage competition in the industry pushed it to collapse

31. Perspective on Events of 2002 We can choose to view the events of 2002 as bad behavior by some individual managers, auditors, directors, lawyers, investment bankers, bankers, politicians, etc. Alternatively, we can see them as a chain a related events, arising from bad policy We pushed competition into a market that is not able to sustain competition because of ex ante or ex post unobservability of the quality of service provided

32. From Norms towards Standards of Corporate Financial Reporting: A Long Term Perspective

33. Summary Norms of accounting are important in financial reporting Federal regulation of securities induced transition from norms towards written standards in accounting thought, practice, regulation, instruction, and research Generally accepted accounting principles—no longer a description in its plain English meaning of a generally accepted societal norm Capitalized: 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 standards Has the pendulum of standardization has swung too far? What should be the balance between norms and standards in accounting?

34. 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

35. Common Law Approach Development in England through custom, acceptance and judicial precedent From people, not experts Their force arises from usage Progressive replacement of common law by statutory thinking in financial reporting Time to reconsider the merits of common elements Would introduction of limited competition among alternative sets of accounting rules help?

36. Accounting by Norms The early twentieth century predominance of norms The charge the American Association of Public Accountants gave to a Special Committee on Accounting Terminology in April 1909 –to collate and arrange accounting words and phrases and show in connection with each the varying usages to which they are put. … This committee will not attempt to determine the correct or even the preferable usage where more than one is in existence (Zeff 1971, p. 112). In 1918, a memorandum on auditing procedures, prepared by the American Institute of Accountants, and approved by the Federal Trade Commission (FTC), and originally published in the Federal Reserve Bulletin, labeled “A Tentative Proposal Submitted by the Federal Reserve Board for the Consideration of Banks, Bankers, and Banking Associations; Merchants, Manufacturers, and Associations of Manufacturers; Auditors, Accountants, and Associations of Accountants.” The intent was to coordinate the evolution of norms, and not to impose a standard.

37. Dictionary and Inventory of Accounting GAAP changed from codification in the sense of organization of existing practice (dictionary) to normative prescription Kohler’s Dictionary of Accounting Paul Grady’s Inventory of GAAP –Not to discover new accounting principles –Principles and practices regarded essential –To supply explanatory and connecting language AICPA Special Committee: written expression of GAAP for guidance, narrow difference and inconsistency; persuasion, not compulsion More than Miss Manners, short of Academie Francaise How did financial reporting fall into the trap of prescriptive standards?

38. 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

39. How Do Norms Work? Can social norms, subjective, incomplete work in high stakes contentious environment of financial reporting? The work well in law, including securities law Lawyers do not replace norms by law 5,000 word US constitution, unwritten in U.K. Juries: guilty beyond reasonable doubt Try to pick unbiased juries, may be isolated Insider trading definition: non-public information Role of authority and procedure in ill-defined settings

40. Beliefs about Enforcement and Effectiveness Dentists apply only gradual pressure on braces Criminal law does not prescribe maximum possible punishment (cut off the hands of thieves) induces more evasion Progressive increase in powers of enforcement behind accounting standards Does greater enforcement raise compliance or lower the professionals’ personal responsibility for fair representation What evidence do we have on the effectiveness of stronger enforcement in financial reporting

41. Facilitating Evolution of Norms In 1918, the American Institute of Accountants appointed a Special Committee on Interest in Relation to Cost to address a lively controversy on imputed interest as part of the cost of production The Committee’s recommendation against inclusion of imputed interest in cost of production, approved at the annual meeting of the Institute, does not become accepted as an accounting norm The Institute appoints a special committee on the standardization of accounting procedure “to consider all questions of procedure brought before it, and to make recommendations from time to time on vexed questions in the hope that ultimately there may be established something approaching uniformity of procedure throughout the country” The charge suggests facilitation to form norms, not legislation of standards. During its eleven-year tenure (1918-1929), the Committee produced six reports, and none was submitted for an official stamp of approval of the membership

42. Norms as an Attitude The absence of authoritative standards of accounting did not mean that the world of accounting had less order in the early twentieth century than in the early twenty-first Active mechanisms the accountants used to identify the norms of their profession –Journal of Accountancy and the CPA Journal served as forums for active, even feisty debates on accounting and auditing; a function largely abandoned by the accounting journals over the past quarter century when authoritative standards pushed the norms out –During 1920-29, the Librarian of the Institute issued 33 “special bulletins” on topics referred to them, without the authority of the Institute. –In 1931, the Institute published a 126-page book Accounting Terminology, a compilation of accounting terms and their definitions as a matter of advice, not authority. –(See Kitchen’s (1954) Costing Terminology, a cogent argument for resisting the temptation to issue authoritative definitions, especially in accounting) –Throughout the 1920s and into 1930s, a committee of the Institute worked in close cooperation with a committee of Robert Morris Associates, an organization of bank loan officers, to respond to inquiries submitted to them.

43. Norms Not Enough: An Era Ends Role of fair value accounting in the “roaring twenties” The stock market crash of 1929 Severe economic depression that followed, precipitated another crash Loss of credibility of norms of accounting, and the formal or informal mechanisms by which these norms evolved and were sustained Too many had lost wealth, livelihoods, even lives Financial reporting transgressions were far too many, people lost trust in the social contract It was time to identify and punish—at least constrain—the guilty Politicians responded the only way they could and introduced securities laws and regulations. In the following seven decades, accounting and audit failures have been interpreted as evidence that norms do not work; Norms were gradually shifted to the back burner, and legislated accounting standards rose to dominate accounting Have the standards achieved, and can they achieve, their purported goal?

44. Federal Securities Regulation In 1933-34, U.S. Congress give SEC the legal authority to regulate financial reporting The first three decades: mostly codifying the existing practices Gradually, these efforts shifted from identification of conventions or social norms to promulgation of legally enforceable standards Increasingly assertive nomenclature of the three private sector organizations to write accounting rules –The Committee on Accounting Procedure’s Accounting Research Bulletins (1948-59) –The Accounting Principles Board’s Opinions (1959-73) –The FASB’s Financial Accounting Standards (1973 to present). (IASB’s International Financial Reporting Standards being the latest addition to this trend) By 2000, the social norms have few advocates left, most favor legislated standards (with legal enforcement) model for financial reporting Yet, the evidence that formal standards do any better than social norms of financial reporting remains elusive The case for the efficacy of enforced standards remains to be made In the absence of evidence, should the benefit of doubt go to the government or the market? Thoreau’s motto: “that government is best which governs least.”

45. Institutionalization of Rule Making Since 1960’s, accountants’ occupation with keeping the government out of making accounting rules Creation of private rule-making institutions Beliefs about what can and cannot be achieved by rules Expanded rule books serve as road maps of evasion for the unscrupulous Instead of promoting fair representation of the “big picture,” they frustrate the intent of the rule makers

46. Trying to Keep the Government Out Four decades of accounting emphasis on keeping the government out of rule making Based on a general dislike of government rules that might constrain business But many government rules benefit businesses –Road traffic, aviation, health and sanitation, environment, safety SEC already has the statutory authority to set the rules FASB just keeps running harder just to keep the government out, making more detailed standards Unlike cotton and diamond trades, accountants have not developed a comprehensive private mechanism to substitute government mechanisms

47. Structural Weakness Few agencies have rule making as their only function 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 –Challenge to publish-or-perish very real –Inevitably, rulebook must get thicker over time

48. 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

49. Effect of Rule Makers on Behavior of Auditors Pushed by clients to cite line and verse to support their positions Calls to FASB: the rule is not clear Inability of FASB 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 as an unwitting supporter of the attitude: “if it is not proscribed, it must be OK”

50. 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

51. Why the Shift from Norms to Written Prescriptive Standards 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?

52. Errors of Inclusion and Exclusion in Classification Schemes Detail should not be confused with precision (ten Commandments or 100) Greater the detail, greater the errors of exclusion and fewer the errors of inclusion (Sunder 1984) In classifying multi-attribute objects (e.g., transactions) exclusion and inclusion errors cannot be avoided, only balanced

53. 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

54. 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

55. Standards Leave Documents for Historians Easy to identify the history of accounting with the organized efforts to produce written rules –Such efforts leave documentary tracer for historians, norms don’t leave much even if they are widely accepted, leave nary a footprint, except in fiction Lisa Evan’s paper on textual analysis of two novels with respect to accounting and social norms during 1923’s German hyperinflation

56. The Appeal of Standards Written standards: concrete, salient, published, easily disseminated, easy to find, specified formally with some precision, can be analyzed and discussed line and verse They come into existence at a specific time, through a known and understood institutional process that may allow the participation of the constituents When the environment changes, a systematic process is available to formulate changes and submit them to a well-specified process for possible promulgation Democratic appeal of a transparent institutional mechanism for setting standards Following accidents and scandals, “the rules were not clear” is a popular defense Let us make the rules clear to all—as a response to calm the political waters Even George O. May, an influential leader of profession and an ardent supporter of norms, responded to William Ripley’s “Stop, Look and Listen” (1926) by a call for clearer definition of authority Formal written standards appeal to our sense of good housekeeping Specified processes for enforcement of violations

57. Norms Are Messy Social conventions and norms are rarely well defined, vary in time and space, require an extended socialization process to learn and understand (Coleman [1990]) They carry a penumbra of uncertainty about them Substantial but incomplete overlap among the beliefs of the individual members of a group about its norms Norms evolve in small, almost imperceptible steps, by processes that are not well understood This evolution is decentralized, difficult to predict the future direction While the evolutionary process is not opaque, the lack of definition and our poor understanding of how norms evolve make them less transparent Scandals mock the claims of expertise and efficiency required to legitimize existing institutions During periods of crises, political or bureaucratic decision makers feel pressured to write new standards rather than continue to rely on existing (recently discredited) norms and business practices

58. What About Enforcement Formal standards call for formal enforcement Government departments, courts, regulatory agencies, industry associations, and private sector bureaucracies in national and international domains have a stake Formal enforcement of informal social conventions is difficult, no assurance of enforcement Word-of-mouth mechanisms in business relationships provide feedback; damage or enhance reputation (cotton and diamond trades, even e- commerce), but don’t always do so Yet, social norms do work, nationally and internationally The human rights movement, even the U.S. yielded recently to evolving international norms on the death penalty for minor and mentally retarded offenders The Texas state anti-sodomy law struck down; the Court cited “values shared with a wider civilization…European Court of Human Rights, and other nations…” Standards: apparent advantages of clarity, explicitness, and the power of enforcement; but also disadvantages relative to evolutionary social norms Consider a recent example of privacy in e-commerce

59. Accounting as a Natural Language Generally accepted accounting principles as dominant paradigm in accounting till 1972 –Accounting as natural language –Evolution by usage and consensus over time –Multiplicity of meaning and words –Flexibility and limitless variability –Authority derives from acceptance not power –No known natural language designed by man

60. Accounting as Designed Artifact Designing rules through deliberation Replacement of suggestive nature of research bulletins and opinions by standards and the power to punish any deviations FASB: large budget, staff; no greater wisdom, less modesty in ability to devise better rules Multiple criteria without aggregation function Cost of capital missing as a criterion for rules Consultative process but monopoly deprived it of natural selection necessary for evolution

61. Failures of Market and Regulation Regulation often proposed as a solution in case of market failure However, regulation, too, is subject to failure (see Djankov [2003]). Consider four possible reasons why formal standards and their enforcement, with all their apparent advantages, may not dominate social norms in financial reporting –The information problem –The design problem –The gaming problem –The signaling problem

62. 1. The Information Problem Rule makers’ problem: How to figure which rule is better What is a good rule for determining interference in soccer? What is a good height of the goal posts? Each possible answer changes the game itself Accounting rules affect many members of society in diverse ways The direct effect of the rules on people depends on their individual circumstances that the rule maker knows little about Rules are designed in the hope that they will change or constrain the behavior of at least some people Changes in the behavior of individuals interact in complex ways to generate aggregate consequences that are difficult to anticipate The rule maker may try to ameliorate this informational disadvantage by soliciting information from the parties potentially affected by its actions. No incentive to report truthfully; strategic responses only muddy the waters (Sunder [1997], Chapter 11, [[2003]), create the gaming problem discussed below, often forcing the rule maker to deal with unintended consequences of the rules.

63. Evolution Incorporates Much Information In social conventions, as in biology, evolution proceeds in fits and starts, with no assurance of progress Each small or large change in conventions is induced by, and induces changes in, individual behavior With each change, the social system to a new, albeit temporary, expectations equilibrium (see Sunder [2002]) People get the chance to experience the consequences of each change, and adjust their behavior to the new circumstances Information in possession of the individuals aggregated into these outcomes through market and other social processes (Hayek 1945) Evolved social norms tend to incorporate more information than the rules made by legislature, boards, and other corporate entities.

64. 2. The Design Problem Corporate entities for setting standards need structure, people, and resources All three needs force compromises in the design of the entity Legislative structures emphasize representativeness; judicial structures emphasize impartiality, while bureaucratic structures value rules of procedure Not possible to attain representativeness, impartiality, and consistency of procedure all at once Finding the people to operate the rule-making system raises problems The best experts may not be representative or impartial Representative bodies may lack substantive expertise Financial supporters seek to further their own agendas Such inevitable compromises “corrupt” the ideal of standard-setting The gradual evolution of social conventions can be said to be free of these weaknesses of corporate entities

65. 3. The Gaming Problem The information problem compounded by dynamics between rules and the behavior the rules are intended to influence Each standard alters the decision environments of individuals, and potentially alters their decisions Induces individuals to search for new alternatives, create new opportunities The rule makers cannot anticipate all such changes Therefore, the new rules often lead to unintended consequences Adjustment of rules sets up yet another cycle of new behavior and adjustments Individuals can adjust faster than the rule makers can Difficult to make sure that this action-reaction sequence converges to a rule and behavior in equilibrium Informality and the flexibility of social norms can better deal with this gaming problem Evolution is stretched over a long period of time, and may get stuck in a rut (e.g., Scapens’ monkeys with bananas)

66. 4. The Signaling Problem The standards approach to financial reporting favors narrowing the range of options available to the reporting entity Intention: promote comparability and consistency, and the value of financial statements The argument ignores the signaling value of the choices made by the reporting entity In choosing from a given set of alternatives, one reveals private information Managers reveal their privately held information, in part; through the financial reporting methods they choose (Levine [1996]) The use of aggressive or conservative accounting gives away valuable information to careful readers of the financial reports Narrowing financial reporting choices through strict standards also eliminates the ability of managers to signal information through their choice of financial reporting methods The information, design, gaming and signaling problems are ever-present in setting standards They deserve consideration when we weigh the roles of standards and norms in financial reporting

67. 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.

68. Drawing Road Maps for Evasion Unfortunately, accountants willing to pursue endless clarification of accounting rules to the point of defining the percentages that justify –Materiality –Lease capitalization –Consolidation –Non-consolidation of special purpose entities, etc. With such written standards it is child’s play for the Wall Street bankers, accountants, and lawyers to design transactions to frustrate the intent of the standards Contrary to their intent, standard setters end up drawing “road maps for evasion” The Wall Street (and perhaps the City) loves it; but fair reporting gets lost Setting up accounting institutions such as the FASB and the IASB, whose sole function is to issue new accounting rules, has contributed to the tendency to write standards which are “generally accepted” only by fiat of authority Wisdom from law, abolish the rule making monopolies in various jurisdictions, and introduce competition among rule makers with each financial reporting jurisdiction in order to address this problem (Dye and Sunder 2001, Sunder 2002).

69. Policy Alternatives

70. 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 –Performance-contingent executive compensation –Transfer control of accounting system –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) –Voluntary audit, insurance solution

71. Summary The recent collapse of accounting and auditing requires careful analysis of its root causes Bad people or bad policies? Need to think of alternative solutions, e.g., –Competition for accounting standards –Reduce competition in audit market or bundle with insurance –Minority directors with real elections and better information for shareholders about directors –Scale back on performance-contingent managerial compensation Think of even better alternative approaches

72. Thank You http://www.som.yale.edu/faculty/sunder Shyam.sunder@yale.edu