Download Presentation

International and National Standards
and Norms of Financial Reporting:
Monopoly or Competitive Coexistence
Shyam Sunder, Yale University
Journée IFRS, CNAM, Paris
September 14, 2007
Summary
•
•
•
•
•
•
•
•
•
•
•
•
•
Traditionally, financial reporting was a matter of social norms of society
In recent years, financial accounting has shifted from social norms towards
national standards, and then towards international standards
In US, federal regulation of securities induced transition from norms towards
written standards in accounting thought, practice, regulation, instruction,
and research; same may happen in EU
Generally accepted accounting principles—no longer a description in its
plain English meaning of a generally accepted societal norm
Capitalized: Generally Accepted Accounting Principles
Social norms maintained by internal and external sanctions
Standards enforced by authority with power to punish
Recent failures; wisdom of transition from norms to standards?
Norms in professional, neighborhood, national, legal aspect of life
Consequences of transition from norms to national and intl. standards
Has the pendulum of standardization has swung too far?
What should be the balance between norms and standards in accounting?
Example: the consequences of the so-called “fair” value accounting
Long Tradition of Social Norms in
Financial Reporting
Recent Shift from Social Norms
towards National Standards
• and then towards International Standards
In US, Securities Regulation
induced transition from norms
towards written standards in
•
•
•
•
•
•
Accounting thought,
Practice,
Regulation,
Instruction, and
Research;
The same may happen in EU
Generally accepted accounting
principles
• No longer a description in its plain English
meaning of a generally accepted societal
norm
Capitalized: Generally Accepted
Accounting Principles
Social Norms vs. Standards
• Maintained by internal and external
sanctions
Standards enforced by authority with
power to punish
Use of Social Norms in all Walks of
Life
•
•
•
•
•
Professional,
Neighborhood,
National,
Legal,
Family
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
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
Consequences of Transition from
Social Norms to Standards
• to national, and
• More recently, international standards
Transfer of responsibility
Standards as Progress
• Accountants shifted their allegiance from norms to authoritative
promulgation
• Profession now views standardization as a measure of progress (our
rule book is thicker than yours!)
• Most research refers to standards with respect, if not approval
– “By the outset of the 1970s, an energetic and ambitious plan was in
operation.” Zeff on attempts of the English Institute in Lectures on
Forging Accounting Principles in Five Countries
• Baxter analyzed the corrosive effect of authority on accounting
profession half-a-century ago
• Those ideas were largely ignored
• There has been little research and debate on merits and
consequences of standardization
• Consider the example of so-called “fair value” accounting
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.
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
Structural Weakness of a Standard
Setting Body
• A permanent rule-making bureaucracy
must make rules to justify its budget and
existence
– FASB (until recently) depended on revenues
from sale of its publications; IASB’s revenue
model?
– Challenge to publish-or-perish very real
– Inevitably, rulebook must get thicker over time
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
Effect of Rule Makers on Behavior
of Auditors
• Pushed by clients to cite line and verse to
support their positions
• Calls to FASB/IASB: the rule is not clear
• Inability of FASB/IASB to respond in timely
fashion becomes basis for client to have his way
• Absent rule making agency, the auditor would
have had to worry about the fair representation
requirement under the security laws
• Existence of FASB/IASB as an unwitting
supporter of the attitude: “if it is not proscribed, it
must be OK”
Hide-and-Seek at the Wall Street
• Investment banker calls the FASB/IASB
• Financial engineering to get around the rules
• Reasonable body of rule might be devised to
deal with a given set of transactions
• No rules can be devised when transactions are
continually redesigned to get around a slowly
adapting body of rules
• Minimal changes to get over the bar
• Wall Street/City of London calls to FASB/IASB
can have the character of the thief asking when
you plan to be away from home
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
Recent Accounting Failures
• Questions about the wisdom of transition
from norms to standards?
Has the pendulum of
standardization has swung too far?
• Misunderstanding of the role of social norms in law
• Popularity/promotion of stock and accounting-based
compensation for senior managers
• Promotion of competition in the market for audit services
• Creation of full-time private rule making agencies
• Has this shift gone too far? How do we know and
decide?
• What should be the balance between norms and
standards in accounting?
Example: the consequences of the
so-called “fair” value accounting
Labels Matter
• What is common to:
– Unified Budget Act (1964, Lyndon B. Johnson)
– Patriot Act (2002, George W. Bush)
– Fair Values (1999, FASB/IASB)
“Pernicious changes with
deceptively reassuring titles”
• Choose labels to put potential opponents on defensive before
the debate begins
• Oldest trick in the book of policy rhetoric
– Johnson wanted to use the social security surpluses to
finance increased spending on Great Society programs
and the Vietnam War (who can argue for non-unified
budget?)
– Bush wanted to fight the war on terror (who is against
patriotism?)
– FASB wants to use current values (who can be against fair
values in accounting?)
• “Fair” is a personal judgment, not a fact
• To avoid misuse of language, put the rhetoric of “fair” aside,
and talk about current values of which generations of
accountants and researchers have thought and written about
The Proposal
• The price that would be received to sell an asset
or paid to transfer a liability in an orderly
transaction between market participants at the
measurement date
– Orderly transaction, not forced liquidation or a
distressed sale
– From eyes of a market participant, no entity specific
assumptions
– Highest and best use framework from the perspective
of market participants even if the acquirer has
different plans
The Valuation Debates
• Relevance to investment decisions
• Relevance to stewardship, management of
enterprise resources, and contract
enforcement
• Other criteria for evaluation: reliability,
bias, timeliness, representational
faithfulness, cost of implementation
Qualitative versus Quantitative
• Valuation debates have been largely been about
qualitative characteristics of rules
• Without a framework for quantified comparison,
debates can go on for ever
– People don’t change their minds
– Theories are supposed to die only with their
proponents (“science advances funeral by funeral”)
– Even that is not true in case of fair values
– Resurrection of current values under the new label
after an interval of almost 70 years
• How do we bring an element of quantified
rationality to this debate?
Econometrics
• Great achievements of econometrics arise from our
willingness to
– Postulate an underlying structure and unknown parameters of
the problem
– Characterize the properties of alternative estimators (e.g., OLS,
GLS, 2SLS, etc.) as a function of the underlying environment
– Choose an estimator appropriate to the postulated environment
– Use data to estimate the unknown parameters, holding the
structure constant
– Examine propositions about the underlying parameter on the
basis of estimates
– Use alternative datasets of examine the propriety of assumed
structure
– When found inappropriate, change the assumed structure
Econometrics of Valuation
• Can we use a similar strategy for documenting the
properties of valuation rules in various environments?
• It may not entirely get rid of judgments
• But still, will move the debates among valuation rules
from the domain of opinion into data
• Let me explain, starting with one postulated structure
• Remember, we can always change the postulated
structure if we find a better one later
• For now, let us focus on thinking about choice of
valuation rules as we think about choice of econometric
estimators
Postulated Structure
• There are many resources in the economy (vector ω)
• Each firm is a special bundle of some or all of these
resources--a vector of proportions (vector w)
• Current values of resources are subject to change
over time: relative changes have a given mean
vector (μ) and covariance matrix (Σ)
• Historical costs of resources in the bundle are
known
• Relative changes in current values of the resources
are observed with an (unbiased) error term (vector ε)
which has covariance matrix (Δ)
Two Sources of Error in Valuation
• Consider two sources of error in valuation
of a bundle of resources
– Values change over time but the valuation rule
ignores these changes (price movement
errors)
– Current values we use to revalue the bundle
are prone to errors due to imperfection and
incompleteness of markets (measurement
errors)
Choose a Metric and Magnitude of
Errors of Valuation Rules
• Let us focus on the expected mean squared
error as the metric of errors (used in most
econometrics; we could also use bias or other
metrics)
• Magnitudes of the errors depend on
– Parameters (Δ, Σ, μ, and ω), and
– Valuation rule used to adjust historical to current
values
• The space of valuation rules is very large; even
linear subject is huge; let us just focus on the
three elements of this subset (historical cost,
general price level and current value)
Historical Valuation
• Has price movement errors because it ignores changes
in prices from the time of acquisition to present
• The size this error (MSE) depends on parameters of the
economy:
– The mean of the vector of relative price changes (μ), and
– The covariance matrix of the vector of relative price
changes, (Σ)
• Greater the “magnitude” of these two parameters,
greater is the movement error associated with historical
valuation
• Since historical valuation ignores changes in prices, it is
free of measurement errors
Current Valuation
• It has price measurement errors arising from
assessment of current values
• Again, the size this error (MSE) also depends on
parameters of the economy:
– If we assume that the relative changes in current values
are measured without bias (ε = 0), the MSE arising from
the mean of measurement errors is zero
– The error arises from the covariance matrix of the vector of
measurement errors in relative price changes (Δ)
• Greater the “magnitude” of this covariance matrix,
greater is the measurement error associated with current
valuation
• Since current valuation takes into account the changes
in prices, it is free of price movement errors
General Price Level Valuation
• GPL uses a single price index to adjust historical values
towards current values
• The use of a single price index reduces the price
movement error associated with the historical estimator
but does not eliminate it
• The use of a single price index also introduces some
measurement error, although it is not as large as the
error associated with current value estimator
• The total error associated with GPL estimator depends
on the values of the parameters μ, Σ, Δ and ω.
• Let us look at the picture as a schematic graph
Behavior of Price Movement Error
with Respect to Aggregation
Behavior of Price Measurement
Error with Respect to Aggregation
Behavior of Total (Valuation) Error
with Respect to Aggregation
How Do These Estimators of Value
Perform
• Which estimator of is associated with lower mean
squared value
• It depends on the parameters of the economy
• With high price volatility and low measurement errors,
current value estimator dominates
• With low price volatility and high measurement errors,
GPL, and even historical value estimator may dominate
• In general, we should not expect that the MSE
minimizing estimator will be any of the three we have
explicitly considered
• Instead, it is likely to be some intermediate specific price
index estimator of value
Testable Implications of Theory
• Current valuation would be more informative for
firms and industries whose
– Assets have a large mean rate of price change
– Assets have more variability in price changes
– Assets are traded in relatively perfect and complete
markets (accurately measured CV)
• Real estate, mineral deposits, films, software,
patents have large measurement errors
• Instead of cross-sectional tests (e.g., Gheyara
and Boatsman 1980, Ro 1980), we could benefit
from paying more attention to characteristics of
assets of firms and industries
Testable Implications of Theory
• Efficient valuation rules would vary across
assets, firms and industries
• Level of aggregation at which current
values are chosen has a major impact on
the properties of valuation (left open in
FASB/IASB’s proposal)
What Do We Learn from This
Theory?
• Theories of valuation can be integrated into a framework
to facilitate direct comparison of their properties in
specified environments
• When current prices change, and are prone to
measurement errors, neither the current nor general
price level valuation is necessarily the min(MSE)
estimator of the unobserved economic value of assets
• Generally, min (MSE) estimator is likely to be a specific
price index rule
• If the measurement errors are sufficiently large relative
to movement errors, historical cost can be the min (MSE)
estimator
• Which valuation rule has min (MSE) is a matter of
econometrics, not theory or principle (depends of relative
magnitude of parameters of the economy)
An Agenda for Reforms
• The pendulum seems to have swung too far in the direction of
written standards
• Reconsider a stronger role of social norms and personal and
professional responsibility in accounting and business
– Reconsider virtues of promoting competition among auditors (a
“market for lemons”)
– Better use of social norms: “fair representation” as a moral
compass of accounting
• As “guilty beyond reasonable doubt” in criminal law
• Neither can be captured in written standards
• Creation of accounting courts to judge “fairly represent”
– Assist evolution of accounting norms through competition among
multiple accounting rule makers (no collusion, no convergence)
– Remove rule-making monopolies in U.S., Europe (and
elsewhere)
Thank You
• Please send comments to
• [email protected]
• The paper and the presentation will be available
at
• www.som.yale.edu/faculty/sunder/research