Challenges and Considerations in Regulatory Cooperation and Competition
Protecting consumers and investors through effective regulation of accounting and corporate financial reporting is crucial. Regulatory cooperation offers benefits like simplifying the regulatory environment and enforcing best practices. However, regulatory competition can uncover limits and the advantages of diverse regulatory approaches that may be necessary in a complex and evolving financial landscape.
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ShyamSunder Yale School of Management The Office of the Director General of Internal Markets and Services European Commission Brussels, November 20, 2008 REGULATION OF ACCOUNTING
Protecting Consumers and Investors Protection of consumers and investors from unfair or misleading practices is the common goal of regulation The question worth discussing: How do we achieve this goal? We do not wish to fail to protect the interests of consumers and investors Or promote unwise regulation that may bring more harm than good I would like to concentrate these remarks on regulation of corporate financial reporting which has gained in urgency in light of the recent events
Regulatory Cooperation and Coordination Regulatory cooperation yields many advantages Simplifying the environment Clear communication of the regulatory regime Better and cooperative enforcement among jurisdictions Adoption and use of best practices Avoidance of race to the bottom An appearance and sense of control (until things go wrong) Closing the cracks between the adjacent regulatory domains, etc. The recent decades have seen gradual expansion of regulatory cooperation which has yielded many of these benefits (and revealed some weaknesses) However, as in most matters of social policy, there always the other side of the coin to be considered: regulatory competition
Regulatory Competition In pursuit of the obvious advantages of regulatory cooperation, it is easy to overlook its limits and the advantages of alternatives Regulatory uniformity and cooperation works fine in a world were regulatory alternatives and their respective properties are already known and well-understood Such extensive knowledge a Cartesian universe is highly desirable, but often unachievable by any one As recently as 18 months ago, US regulators sincerely defended their hands-off approach to the derivatives market They were neither incompetent nor Machiavellian Few people knew the consequences of those regulatory policies until much damage had been done In fact, most of the time, we live in a world where properties of regulatory policies, and indeed the alternatives themselves, must be discovered through trial-and-error through experience
Regulatory Humility There is a case to be made for regulatory humility often we do not know the consequences of policy alternatives until we try them out In contrast to the Cartesian mindset of regulatory uniformity through top-down design with complete knowledge of the system, regulatory competition suggests a Darwinian mindset The consequences of changes in social policy involve reactions of millions of people adjusting to the policy in their own diverse and ingenious ways We cannot be sure of the consequences of a policy until we try it out and see what happens We could try to find a balance between the cooperative and the competitive approaches
Extraction and Generation of Benefits of Innovation EU s single market initiative is an example of an effort to make sure the benefits of innovation are enjoyed to the maximum extent by lowering barriers to free movement Making the markets more perfect by removing frictions clearly helps this goal But there is the other side of the innovation coin generation of innovation Entrepreneurs innovate to make private profits by differentiating their products and thus creating local imperfections which tend to be eliminated only over time through competition Blocking innovation to prevent profit making through differentiation would kill the golden goose of prosperity Patent law as an example of the struggle for this balance
Financial Reporting: Some Commonly-held Beliefs
1. Universal Standards Universal standards of financial reporting applied across time, economies, industries and corporate size and organizational forms best serve the constituent interests Standardization does save costs and effort, (electrical plugs, clothing, cars, street grids, commercial codes) Becomes counterproductive beyond certain limits How do we know where to stop? Few industries have universal standards, and no professions have them Rhetoric of universal accounting standards and universal language 8 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
2. The Static Ideal There exists a set of financial reporting standards that, once discovered and implemented, will induce corporations and their auditors to prepare the best attainable financial reports Dynamics of the game between managers and standard setters makes any such static ideal all but impossible Standards is only a (small) part of the problem 9 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
3. People or Structure If we select knowledgeable, experienced, self-less, public-spirited, and wise individuals to constitute bodies that devise accounting standards through deliberation and due process, we can improve financial reporting Individuals stand where they sit Much emphasis on the quality of individuals, too little attention to the structure of game they are asked to play 10 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
4. Engineering Standards through Deliberation It is possible to construct or discover better financial reporting standards through deliberation in properly organized corporate entities (such as the IASB, the FASB, etc.). Assumes that such bodies can know the consequences of their actions History does not support the proposition 11 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
5. Specialization in Setting Standards Specialist standard setting bodies, standing ready to address new problems, inquiries and requests for clarifications help improve financial reporting Their existence encourages a new clarification game targeted at them They must keep a full agenda (performance) Revenue and budget pressures Over time, their output must accumulate to a thick rule book 12 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
6. What is High Quality Standard in Accounting? Standard setters can tell which standards are better and why. Little evidence that they know, or can know Cost-of-capital is the result of complex interactions among many factors (including accounting) These influences cannot be sorted out by ex ante analysis Ex post analysis of data to assess the impact on cost of capital may be possible 13 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
7. Standards Monopolies Granting monopoly power in a given jurisdiction to standards written by a given body can help improve corporate financial reporting Informational disadvantage of a monopoly No opportunity for experimentation No opportunity to learn from the experience of alternatives No pressure to do better, or to correct errors 14 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
8. Competition and Race to the Bottom A regime that encourages reporting entities to choose among the standards written by competing organizations (and paying them a royalty for the privilege) induces a race to the bottom to devise less demanding standards Counter examples (Stock exchanges, bond rating services, appliance standards, college accreditation, bank regulation, corporate charters across U.S. states, etc.) 15 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
9. Force and Effectiveness Increase in the power of enforcement behind authoritative standards improves compliance and quality of financial reporting Increased enforcement also increases resources devoted to evasion Draconian punishments do not necessarily induce better behavior Crime, alcohol and drug abuse 16 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
10. Statutory Approach Dominates Common Law The quasi-statutory approach to setting accounting standards dominates a common law approach to financial reporting Evidence? Constitution (U.K., U.S., Europe) 17 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
11. Written Standards Dominate Social Norms Written standards backed by power of enforcement work better than unwritten social norms backed only by internal and external informal sanctions Social norms govern great parts of our lives including many aspects of law Insider trading Guilty beyond reasonable doubt Private commercial codes (cotton, diamond trades) 18 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
12. Who defends the middle ground? The ideal accounting regime would consist of all written standards or all social norms Easier to make the extreme cases for standards or norms alone Difficulty of defending the middle ground where both may co-exist, as they do in many other aspects of life 19 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
13. New Problems, New Solutions Financial reporting and governance problems originated in the 20th century History tells us otherwise Governance problems of the East India Company Clive, Hastings, and the Company s Court of Directors 20 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
14. Financial Reporting is Getting Better Seventy years of standardization of financial reports (in U.S.) has helped improve the quality of financial reporting Evidence? Is a thicker rulebook indication of better financial reporting? Perfect correlation between accounting and stock returns? How do we judge if our financial reports are getting better? 21 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
15. Fewer Alternatives, Better Reports Fewer the alternative treatments the reporting entities are allowed to choose from, the better the quality of financial reporting Fewer alternatives also tie the hands of the management of well-run companies who may wish to signal their confidence, competence and prospects by choosing reporting practices others find difficult to emulate 22 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
16. Auditors Bargaining Power Well-specified standards enhance the bargaining power of the auditor vis- -vis the client Standards also encourage clients to demand: show me the rule Reduced reliance on judgment More detailed the standards, greater the part of accountant s work that can be replaced by a computer, and lower the value of the service 23 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
17. Accounting & Auditing Games Written standards constrain the tendency of managers, auditors and investment bankers to play accounting and auditing games On the contrary, they encourage and facilitate game-playing by reducing uncertainty about what is, and is not, acceptable 3 percent SPEs => Enron 24 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
18. Individual responsibility Written financial reporting standards strengthen the individual responsibility of managers, auditors, and investment bankers for fair representation On the contrary, they undermine individual responsibility for fair representation and the big picture by shifting attention to meeting the letter, not spirit, of the specific provisions and their wording 25 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
19. Education Written standards make it easier to educate better accountants and attract talent to the profession Written standards degrade the class room from reasoning and intellectual debate to rote memorization, reinforce street image of accounting as boring and mechanical They make it less attractive to young talent 26 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
20. Nothings New under the Sun Have I said something new? I wish. William T. Baxter (Professor Emeritus, LSE), made many of these arguments over half- a-century ago ( Recommendations on Accounting Theory in Baxter and Davidson, Studies in Accounting Theory, 1st edition). Kautilya s Arthasastra, the 4th centurt B.C. Sanskrit classic has three chapters on accounting, auditing and control 27 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
Beware of Consensus A different perspective You would be left behind if you do not follow the crowd Washington Consensus Accounting Consensus five main elements
Accounting Consensus 1 The standards developed should be confined to principles, and not become detailed rules Nobody can tell which is which IFRS vs. FAS, yet plans to adopt many of the FAS Fair values: principle or rhetorical device
Accounting Consensus 2 A single set of high quality written standards of financial reporting applied to all companies (at least the publicly traded ones) in the world will improve financial reporting by making financial reports more comparable, and thus assist investors and other users of financial statements make better decisions All prefer high quality, but what is it (Joyce et al.) Principles-comparability contradiction Accounting for research & development costs (FAS 2) Evidence that accounting standards help investors or managers make better decisions?
Accounting Consensus 3 The best way to develop such standards is to create a single deliberative corporate body consisting of appropriate experts with a proper governance structure and legally assured funding, functioning under the oversight of statutory regulatory authorities such as the SEC and the EC Difficulty of assessing proposed standards (no comparison) Even simple engineering design need field trials Complexity of social institutions, risk of getting boxed into a wrong standards Division of simplicity and complexity between strategy and institutions Ecosystem view of financial reporting system Competition with no tax revenues
Accounting Consensus 4 To this end, the operations of the FASB and the IASB should be gradually merged into one corporate body and one set of standards to be called IFRS From social norms to uniform written standards Effect of uniformity of education, research and profession Compare accounting education to education for other professions
Accounting Consensus 5 This single set of standards should be practiced in the U.S., EC, and elsewhere, and the U.S. educational system should prepare itself to integrate IFRS into its curricula so university graduates will be able to prepare, use, and audit financial reports based on IFRS Educational consequences an afterthought at best Effect of expansion of written standards on classroom discourse Educational capacity: chance to shift to general principles of accounting Place of accounting in the university: medicine or plumbing
The Problem of Setting Efficient Standards Criteria Generation of alternatives Evaluation of alternatives Complex interactions among accounting, capital and labor markets Facilitation of evolution of accounting norms Balancing statutory and common law Balancing adjustment speed and errors No substitute for personal responsibility The regulators may not know, but can help 34 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
How Can the Regulators Help? Government, quasi-government or private sector bodies can play a positive role in evolution of norms of accounting through oversight No monopoly jurisdiction Competition with alternatives (royalties) Opportunity to experiment Co-existence of multiple sets of standards for different clienteles diversity essential to evolution Excel conversion workbooks (high R-square) Personal responsibility for fair representation Accounting Court: guilty beyond reasonable doubt 35 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
In Contrast to IASB (FASB) Command & Control View To develop accounting standards: A single set (monopoly?) Of high quality (what does that mean?) Understandable (to who?) Enforceable (stick, not norms) Global (no clientele or diversity) Are we ready for an alternative mind set about financial reporting? 36 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
Whither Accounting: Windows or Open Systems Comfort vs. choice Uniformity and stagnation vs. dynamic change Predictability vs. some disorder High prices or the advantages of technological progress Financial reporting as an eco-system or a machine (garden or a building) Huxley or Hayek Nanny or personal responsibility Role of accounting researchers/professors? 37 (c) 2005 Sunder, Nanny Knows Best 9/20/2024
Concluding Remarks In the preface to his Dictionary, Johnson wrote about his fortuitous and unguided excursions into the boundless chaos of a living speech." Can authoritative uniform standards without collaboration with social norms bring a semblance of order to the chaos to financial reporting? After seven decades of incessant efforts, the answer stares us in the face
Shyam.sunder@yale.edu www.som.yale.edu\faculty\sunder THANK YOU.
