norms, standards, and failures in accounting and auditing: rethinking practice, research, and...

Norms, Standards, and Failures in Accounting and Auditing:

Rethinking Practice, Research, and Education

Shyam Sunder, Yale School of Management

Current Accounting Issues Conference Michigan Association of CPAsLansing, MI – May 15, 2008

(c) Shyam Sunder: Norms, Standards and Failures

2

An Overview

• Roots of accounting and auditing failures– Short, medium, and long 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

Rethinking the Roots of Accounting and Auditing

Failures


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 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 are reluctant to serve as directors; nominating

committees are 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 a rapid rise in the compensation of senior executives continues, back-dating scandals


5

Medium-Term Perspective• Two critical events of 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 dot-com bust, brought the house down


6

Long-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 (Akerlof)—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 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 reputations 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


19


20


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 the failure of the 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

0

50

100

150

200

250

300

1960-1964 1965-1969 1970-1974 1975-1979 1980-1984 1985-1989 1990-1995 Unknown

Time Period

Frequency by Time Period


24

Amounts of Settlements Against Auditors

Total Amount of Settlements

0

100,000,000

200,000,000

300,000,000

400,000,000

500,000,000

Year

Am

ou

nt

of

Set

tlem

ents

Total


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


27

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 a new business model for 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 became the perpetrators, the short term beneficiaries and ultimately the victims of the dot-com 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.

• Or 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

From Norms towards Standards of Corporate Financial Reporting:

A Long Term Perspective


33

An Overview• Norms of accounting are important in financial reporting • Federal regulation of securities induced the 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

• 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 used in professional, family, 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?


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, 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, being subjective and incomplete, work in the high stakes, contentious environment of financial reporting?

• They work well in law, including securities law• Lawyers do not replace norms by law• 5,000 word US Constitution, unwritten in UK• 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 by 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, Congress gave the SEC legal authority to regulate financial reporting• The first three decades: mostly codifying the existing practices• Gradually, these efforts shifted from the identification of conventions or social norms

to the 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, social norms have few advocates left, most favor a legislated standards

model (with legal enforcement) 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 the 1960s, accountants have tried to keep the government out of making accounting rules

• Creation of private rule-making institutions• Beliefs about what can and cannot be achieved

by rules• Expanded rulebooks 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 keeps running harder just to keep the government

out, making more detailed standards• Unlike the 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 the 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 the 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 the 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)

• The greater the detail, the 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 patrol– 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 the accounting profession half-a-century ago

• His ideas were largely ignored• There has been little research and debate on the 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 traces 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 in the 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 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 (human rights movement)

• Standards: apparent advantages of clarity, explicitness, and the power of enforcement; but also disadvantages relative to evolutionary social norms


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

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


61

1. The Information Problem• Rule makers’ problem: How to figure out 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 informational disadvantage by

soliciting information from the affected parties • No incentive to report truthfully; strategic responses only muddy the

waters, create the gaming problem, often forcing unintended consequences


62

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 adjusts 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 aggregate 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


63

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


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3. The Gaming Problem• The information problem is 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• The rule makers cannot anticipate all such changes• Therefore, the new rules often lead to unintended consequences• Adjustment of rules sets up new cycle of 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)


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4. The Signaling Problem• The standards approach to financial reporting favors narrowing the

range of options• Intention: promote comparability and consistency, and the value of

financial statements• The argument ignores the signaling value of the choices: choices

reveal 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 readers of the financial reports• Narrowing financial reporting choices also eliminates the ability of

managers to signal information• 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


66

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 be better than relying

on judgment, 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 US 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


67

Drawing Road Maps for Evasion• 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 Wall Street bankers, accountants, and lawyers to design transactions to frustrate the intent of the standards

• Unintentionally, standard setters end up drawing “road maps for evasion” and fair reporting gets lost

• FASB and the IASB, with issuance of new rules as their sole function, end up promoting the tendency to write standards which are “generally accepted” only by fiat of authority

• Should we abolish the rule making monopolies in various jurisdictions, and introduce competition among rule makers?

Policy Alternatives


69

An Agenda for Reforms• The pendulum seems to have swung towards 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 the U.S., Europe (and elsewhere)

– Voluntary audit, insurance solution


70

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 through

discussion and debate within the profession

Thank You

http://www.som.yale.edu/faculty/sunder

[email protected]