Transcript Does Competition Offer a Way to Resolve the GAAP versus IAS Controversy? Shyam Sunder Yale University Luncheon Address, American Enterprise Institute Conference: Is GAAP Accounting.

Does Competition Offer a Way to Resolve
the GAAP versus IAS Controversy?
Shyam Sunder
Yale University
Luncheon Address, American Enterprise Institute
Conference: Is GAAP Accounting Worth Fighting For?
Washington D.C. March 13, 2002
Overview
• Perhaps it is bad judgment to argue for market
solutions in Washington in March 2002
• But that is what I am going to do
• I hope you would give my argument a hearing
before you make up your minds
• Regulatory competition is no panacea for financial
reporting standards
• But it is better than the status quo, and better than
the alternatives I know
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Status Quo and Prospects
• With the SEC’s blessing, the FASB has exclusive
jurisdiction over accounting rules in the U.S.
• With the European Commission’s blessing, the IASB may
soon have exclusive jurisdiction in the European Union
• They are still competing in Asia and elsewhere
• IASB seems ahead in the race for a world monopoly over
accounting standards (except in U.S.)
• Uniform accounting rules across the world! Wouldn’t that
be a relief?
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Virtues of Uniformity
• Comparability of financial statements across firms and across countries
• Daimler-Benz AG of Germany’s results for January-June 1993:
– DM 168 million profit under German GAAP
– DM 949 million loss under U.S. GAAP
• The difference attributable to variation in accounting standards
• Increasing demand for international harmonization of financial
reporting standards with increased flow of capital across national
boundaries
• Better investor decisions
• Social value of efficient allocation of scarce capital to more productive
firms
• Hardly seems rational to object to uniformity of accounting rules
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Two Problems
• What do you mean by uniform rules?
– No semantics please!
– Bear with me, it is important
• How do you know which rules are better?
– This will take us back to Hayek
• Let us consider each
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Uniformity is Simple?
• Treat similar events and transactions alike
• Treat dissimilar events and transactions
different
• This works perfectly well if we are
interested in classifying events and
transactions by a single attribute only
• It breaks down if we consider two or more
attributes?
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Classify These Four Balls
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Rule 1: Big versus Small
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Rule 2: Black versus White
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Rules 3: Classify by Color and
Size
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Rule 4: Treat Them All Alike
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Demands from Uniformity
• Treat two objects that are similar in an attribute alike, and
• Treat two objects that are dissimilar in an attribute different
• We can satisfy both these criteria if the objects we classify have only a
single attribute of interest
• Otherwise, making a classification system more uniform in one respect
is less uniform in another
• Chimera of uniformity does not help the rule makers—in accounting or
elsewhere
• Even if we all agree to buy identical cars, it hardly solves the problem
of deciding what model we should buy
• What could some other criteria for choosing accounting rules be?
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Transparency
• The current favorite—does not help the rule makers
• Unlike uniformity, transparency is easy to achieve—open
books, open offices
• Competitors will thank the firm
• An open business will fail—no profit
• Without confidentiality, a firm can’t earn money for the
shareholders
• Without transparency, shareholders can’t tell how much
money the firm makes or will make
• Tough part of rule making—knowing the balance between
transparency and confidentiality
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Help Investor Decisions
•
•
•
•
•
Touchstone of rule makers—good PR
How would rule makers know what helps the investors?
Ease of understanding versus precision and detail
Investor sophistication ranges from day traders to rocket scientists
Is an information (or misinformation) system that maximizes value of
shares the best?
• Or is it one that generates the “right” stock price, given the prospects
of the firm
• “Right” stock price may be the answer, but we reward the managers
for “high” stock prices
• Does a stockholder want a financial reporting system that generates the
“right” or the “high” price? When did Enron employees complain?
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Just Tell the Simple Truth
• Truth is not necessarily simple (Enron’s 3,000 special purpose
entities will take more than a telephone book to report)
• What is simple may be misleading or insufficient
• I have a lottery ticket which has 60 percent chance of winning
$10. How much money do I have?
• Rule maker has to make tough choices between simplicity and
detail, between threshold and statistical approach to reporting
• Once the rule is chosen, transactions are revised to manage their
appearance under the rule
• Financial reporting is not a passive hidden camera in the sky; it
is a closed loop system in which transactions respond to rules
• It is no longer clear what the truth is
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What About the Other
Stakeholders?
• Shareholders are not the only relevant party
to be considered by rule makers
• Other stakeholders (e.g., employees,
customers, vendors, etc.)
• Need a decision criterion that covers the
welfare of society at large
• Lowering of the Cost of Capital (CoC) as a
criterion for financial reporting rules
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Choose Accounting Rules to
Minimize the Cost of Capital
• Cost of capital (CoC) is the return security holders expect on their
investments in the firm
• Accounting important for control of managers and information for
investors
• Better control and information reduces risk to investors and the return
they demand
• Cost of capital minimizing accounting standards are efficient—serve
the interests of investors as well as others
• CoC is the result of complex interactions among many organization
decisions and market forces, not easily manipulated
• Fits economic theory well
• Lower cost of capital benefits all legitimate agents
• How would the rule maker know which rule will reduce the CoC?
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Monopolist’s Problem
• It is the only game in town
• Cannot learn from the market: what would have happened to CoC if
…
• Experimentation with mutations necessary for evolution by natural
selection
• A monopoly regime freezes itself in status quo for long periods of time
• It cannot get market signals to adjust rules to changing environment
• Imagine if the IASB rules were implemented in the whole world, what
would it take to change a bad rule?
• Rule maker would have no information about the effect of any
alternatives on CoC
• Wisdom, diligence and sincerity of the members of the rule making
boards is no substitute for information
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Hayek’s Information Machine
• Markets dominate central planning because the
they are giant information aggregating machines,
more efficient than any computer possible
• If uniformity, transparency, simple truth and due
process testimony cannot provide useful guidance
to rule makers; perhaps this machine may help
• Not unless the alternatives are out there in the
market so we can gather data from the field
• E.g., Leuz’s data from German field competition
among alternative standards
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Enter: Competition Among Sets
of Accounting Standards
• Let each government (e.g., SEC, European
Commission) choose two or three sets of standards
for firms in its jurisdiction
• Allow each reporting firm to choose one set of
standards (in entirety)
• Issue audited reports clearly labeled with the
chosen standard
• Reporting firm pays a royalty to the rule maker
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Regulatory Competition
•
•
•
•
•
•
•
•
•
Corporate charters among fifty states (Delaware)
Stock exchanges (NYSE-NASDAQ, Toronto-Vancouver)
State and local governments for business
Standard and Poor’s and Moody’s
Environmental laws across countries
Underwriters Lab and Good Housekeeping Seal
Privacy standards, disclosure and practices in e-commerce
State, federal, offshore regulatory mechanisms for banks
Maritime regulations across countries (Panama, Liberia)
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What Are the Benefits?
• Efficient accounting standards
–
–
–
–
–
–
Lowering CoC as the relevant criterion
Market feedback of better information into the rule making process
Giving investors an effective voice
Benefit from innovation anywhere in the world
Opportunity to specialize, develop clienteles
Protecting industry from the burden of rules generated as
bureaucratic imperatives—aligning incentives
– Greater objectivity and lower susceptibility to lobbying pressure
from well-organized groups and threats from politicians
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Effective Voice to Investors
• Investor role in accounting rule-making is weak (mostly
accountants and managers)
• Investors vote with their feet
• In a monopoly regime there is little opportunity for
investors to indicate their preferences by choosing between
standards
• Competitive regime will give a real voice to investors in
choice of accounting standards
• Firms using poorly regarded standards may find few
buyers for their shares (I.e., higher cost of capital)
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Innovation and Learning
• In a single-standard regime
– Little room for innovation
– Comparison of consequences of different standards is
difficult and unreliable
– No opportunity to benefit from the experience of others
– Once a standard is adopted internationally, it will
become almost impossible to gather evidence to support
a change
– Rigidity and inability to adjust to change
• Competitive regime more flexible and innovative
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Differentiation by Clientele
• Competitive regimes may develop different
clienteles by
–
–
–
–
Size of firms
Industries
Economic development
Local economic institutions
• Compare: NASDAQ stock exchange in U.S.
differentiated itself from NYSE to become
attractive for high technology companies
– No differentiation without competition
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Aligning Rule Maker
Incentives to Investor Interests
• Rule makers are susceptible bureaucratic incentives
– Making rules is the only output of the organization
– Must remain busy (publish new rules or perish)
– Auditors demand increasingly specific rules as support
for their arguments with managers
• Investor interests may be buried under day-to-day
pressures on rule makers
• Competitive regime highlights investor interest
• If standards are not attractive to firms and their
investors means less revenues to the rule-maker
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Less Interest Group Pressure
• Rule makers often subjected to strong pressures
from interest groups
– e.g. accounting for employee stock options
• Competitive regime will ease interest group
pressures
• Those who do not like one set of rules can be
asked choose another, if they so prefer
• Each rule maker is free to use its own best
judgment about what standards will lower the cost
of capital
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Objections to Competition
•
•
•
•
•
Race to the bottom among rule makers
What happens to comparability of reports?
We do it better than them
What about the confusion for small investor
Cost of experimentation and multiple rule
makers
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Rules Race to the Bottom
• Popular argument from rule makers
– We would never do such a thing, but what about them
(not much faith in their brethren)
• But at least we now are talking economics
– Incentives of rule making
– Rule makers as economic agents
• Let us look at evidence
• Has regulatory competition generated a race to the
bottom in other fields?
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Why No Evidence of Market
Failure?
• We do not see the bottom when
– The race is not in the interest of the parties
– Consequences of agent actions are visible to others
– The race is subject to adult supervision
• SEC will have an active role in deciding which sets of
standards U.S. firms can choose from
• Investors will demand higher risk premium from firms
choosing less desirable standards
• Firms and their management are keen on lowering CoC
– Daimler-Benz AG came to U.S. capital markets to
lower its CoC
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What About Comparability of
Reports?
• Financial analysts use computer worksheets to
infer DCF from financial reports and other
industry and firm specific data
• Once a worksheet for one set of financial reports
is prepared, marginal cost of its use for another
firm is virtually zero
• Most of the cost of competition is one time set up
cost of a second worksheet
• This additional cost is trivial compared to the
benefits of competition
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We Do It Better Than Them
• This argument has been used in U.S. over recent years in
making comparisons with the IASB
• Given the structure of rule making, FASB has probably done as
good a job as possible
• The questions we need to address are:
– Could it be done better?
– What do we do to keep the cost of capital lowest possible in
U.S. markets?
– Most economies of the world benefited from U.S.
accounting standards. Should we claim the benefits of any
good ideas from overseas, or reject what is not-invented-here
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What About the Non-Expert
Investors
• Benefits of lower cost of capital under competitive regime
will be shared by all investors, including non-experts
• Majority of U.S. equities are professionally managed
• Present financial reports are already inaccessible to nonexperts
• Neither the US nor the international GAAP presently
specify a unique set of accounting rules
• Price of developing lower cost of capital accounting rules
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Cost of Experimentation and
Multiple Rule Makers
• Supporting multiple rule makers and experimentation with
rules is costly
• Yes it is. Other than experimentation, what other reliable
method of choosing lower cost of capital accounting rules
do we have?
• Cost of running multiple rule-making agencies is
minuscule compared to savings from even 0.1 percent
reduction in cost of capital ($12 billion for NYSE)
• Empirical evidence: disclosure practices may affect the
cost of capital by as much as 1 percent
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Implementing a Competitive
Regime
• Each national security regulator selects two or more competing sets of
standards available for companies in its jurisdiction (Food and Drug
Administration model)
• Security regulators coordinate and share information on the oversight
of rule making with other members of IOSCO
• Security regulators coordinate and share the oversight of auditors with
members of IOSCO and list the auditors permitted to practice before
them
• Security regulators oversee financial reports for fairness, and
question/discipline auditors and registrants about deviations
• IOSCO and rule making agencies maintain a staff to address the
queries from national security regulators
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Consequences of Regulatory
Competition
Governance: Firms will tend to choose standards that will
lower their cost of capital which is observable
– If they don’t, market for corporate control can remove
or punish the management
Incentives: Standard setters will compete for corporate
following, and tend to develop efficient standards
– If they don’t, they will go out of business
Innovation: A system of dual standards will introduce best
practices at suitable rate to local economies
Globalization: Help the cross-border organizations by letting
them choose between local or imported practices
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Open Research Questions
• Why have we depended on regulatory monopolies
in accounting for so long?
• Will the benefits of competition at a global scale
overcome national rivalries and pride?
• Are we prepared for true globalization—global
competition among the rules of the game without
local or international monopolies?
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Thank You
• This Powerpoint presentation is available for
download from
• http://www.som.yale.edu/faculty/sunder/Regulator
y/AEIPresentation.ppt
• Two related papers(one by Dye and Sunder,
Accounting Horizons, September 2001; and the
other by Sunder) are available at
• http://www.som.yale.edu/faculty/sunder/research/
• http://papers.ssrn.com/
• Or send email to: [email protected]
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The Rule Maker’s Problem:
Information
• Need information about the effect of alternative rules on
CoC
• CoC is an overall social welfare criterion rooted in
equilibrium concept
• Its distributive effects vary from rule to rule
• No single class of agents benefits consistently from CoClowering accounting rules
• Information from the FASB/IASB “due process”
submissions and testimonies protect respective interests of
managers, auditors, financial analysts, even investors
• Who argues on the basis of evidence about the effect on
CoC
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Who Will Audit Them?
• SEC oversees the U.S. regulatory regime
for public accountants
• Many of these firms are international, with
in-house expertise in financial standards of
the countries where they do business
• Others will acquire this expertise when
there is money to be made from it
– They acquired consulting expertise
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Our Law Does Not Permit This
• I don’t know if it does, or not
• We have to ask: how do we develop and
apply good accounting rules?
• If we find that the existing laws stand in the
way of doing things better, laws can be and
should be changed
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