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  1. 1. Standards for Corporate Financial Reporting: Regulatory Competition Within and Across National Boundaries Shyam Sunder, Yale University Illinois International Accounting Symposium University of Illinois and Universität Göttingen Urbana-Champaign, March 14-16, 2002
  2. 2. Overview <ul><li>Perhaps it is bad judgment to argue for market solutions in the wake of Enron </li></ul><ul><li>But that is what I am going to do </li></ul><ul><li>I believe that we have ignored market forces and market solutions for far too long in accounting to our collective disadvantage </li></ul><ul><li>Regulatory competition is no panacea for financial reporting standards </li></ul><ul><li>But it is better than the status quo, and better than the alternatives I know </li></ul>
  3. 3. Status Quo and Prospects <ul><li>With the SEC’s blessing, the FASB has exclusive jurisdiction over accounting rules in the U.S. </li></ul><ul><li>With the European Commission’s blessing, the IASB may soon have exclusive jurisdiction in the European Union </li></ul><ul><li>They are still competing in Asia and elsewhere </li></ul><ul><li>IASB seems ahead in the race for a world monopoly over accounting standards (except in U.S.) </li></ul><ul><li>Uniform accounting rules across the world! Wouldn’t that be a relief? </li></ul>
  4. 4. Virtues of Uniformity <ul><li>Comparability of financial statements across firms and across countries </li></ul><ul><li>Daimler-Benz AG of Germany’s results for January-June 1993: </li></ul><ul><ul><li>DM 168 million profit under German GAAP </li></ul></ul><ul><ul><li>DM 949 million loss under U.S. GAAP </li></ul></ul><ul><li>The difference attributable to variation in accounting standards </li></ul><ul><li>Increasing demand for international harmonization of financial reporting standards with increased flow of capital across national boundaries </li></ul><ul><li>Better investor decisions </li></ul><ul><li>Social value of efficient allocation of scarce capital to more productive firms </li></ul><ul><li>Hardly seems rational to object to uniformity of accounting rules </li></ul>
  5. 5. Two Problems <ul><li>Uniformity/comparability is a seductive argument </li></ul><ul><li>But it is without substance and misleading </li></ul><ul><li>It has little to do with what rule makers actually do </li></ul><ul><li>To review what rule makers actually do, we ask </li></ul><ul><li>What do we mean by uniform rules </li></ul><ul><li>How do you know which rules are better? </li></ul><ul><li>This will take us back to Hayek </li></ul>
  6. 6. Uniformity is Simple? <ul><li>Treat similar events and transactions alike </li></ul><ul><li>Treat dissimilar events and transactions different </li></ul><ul><li>This works perfectly well if we are interested in classifying events and transactions by a single attribute only </li></ul><ul><li>It breaks down if we consider two or more attributes? </li></ul>
  7. 7. Classify These Four Balls
  8. 8. Rule 1: Big versus Small
  9. 9. Rule 2: Black versus White
  10. 10. Rules 3: Classify by Color and Size
  11. 11. Rule 4: Treat Them All Alike
  12. 12. Demands from Uniformity <ul><li>Treat two objects that are similar in an attribute alike, and </li></ul><ul><li>Treat two objects that are dissimilar in an attribute different </li></ul><ul><li>We can satisfy both these criteria if the objects we classify have only a single attribute of interest </li></ul><ul><li>Otherwise, making a classification system more uniform in one respect is less uniform in another </li></ul><ul><li>Chimera of uniformity does not help the rule makers—in accounting or elsewhere </li></ul><ul><li>Even if we all agree to buy identical cars, it hardly solves the problem of deciding what model we should buy </li></ul><ul><li>What could some other criteria for choosing accounting rules be? </li></ul>
  13. 13. Transparency <ul><li>The current favorite—does not help the rule makers </li></ul><ul><li>Unlike uniformity, transparency is easy to achieve—open books, open offices </li></ul><ul><li>Competitors will thank the firm </li></ul><ul><li>An open business will fail—no profit </li></ul><ul><li>Without confidentiality, a firm can’t earn money for the shareholders </li></ul><ul><li>Without transparency, shareholders can’t tell how much money the firm makes or will make </li></ul><ul><li>Tough part of rule making—knowing the balance between transparency and confidentiality </li></ul>
  14. 14. Help Investor Decisions <ul><li>Touchstone of rule makers—good PR </li></ul><ul><li>How would rule makers know what helps the investors? </li></ul><ul><li>Ease of understanding versus precision and detail </li></ul><ul><li>Investor sophistication ranges from day traders to rocket scientists </li></ul><ul><li>Is an information (or misinformation) system that maximizes value of shares the best? </li></ul><ul><li>Or is it one that generates the “right” stock price, given the prospects of the firm </li></ul><ul><li>“ Right” stock price may be the answer, but we reward the managers for “high” stock prices </li></ul><ul><li>Does a stockholder want a financial reporting system that generates the “right” or the “high” price? When did Enron employees complain? </li></ul>
  15. 15. Just Tell the Simple Truth <ul><li>Truth is not necessarily simple (Enron’s 3,000 special purpose entities will take more than a telephone book to report) </li></ul><ul><li>What is simple may be misleading or insufficient </li></ul><ul><li>I have a lottery ticket which has 60 percent chance of winning $10. How much money do I have? </li></ul><ul><li>Rule maker has to make tough choices between simplicity and detail, between threshold and statistical approach to reporting </li></ul><ul><li>Once the rule is chosen, transactions are revised to manage their appearance under the rule </li></ul><ul><li>Financial reporting is not a passive hidden camera in the sky; it is a closed loop system in which transactions respond to rules </li></ul><ul><li>It is no longer clear what the truth is </li></ul>
  16. 16. What About the Other Stakeholders? <ul><li>Shareholders are not the only relevant party to be considered by rule makers </li></ul><ul><li>Other stakeholders (e.g., employees, customers, vendors, etc.) </li></ul><ul><li>Need a decision criterion that covers the welfare of society at large </li></ul><ul><li>Lowering of the Cost of Capital (CoC) as a criterion for financial reporting rules </li></ul>
  17. 17. Choose Accounting Rules to Minimize the Cost of Capital <ul><li>Cost of capital (CoC) is the return security holders expect on their investments in the firm </li></ul><ul><li>Accounting important for control of managers and information for investors </li></ul><ul><li>Better control and information reduces risk to investors and the return they demand </li></ul><ul><li>Cost of capital minimizing accounting standards are efficient—serve the interests of investors as well as others </li></ul><ul><li>CoC is the result of complex interactions among many organization decisions and market forces, not easily manipulated </li></ul><ul><li>Fits economic theory well </li></ul><ul><li>Lower cost of capital benefits all legitimate agents </li></ul><ul><li>How would the rule maker know which rule will reduce the CoC? </li></ul>
  18. 18. Monopolist’s Problem <ul><li>It is the only game in town </li></ul><ul><li>Cannot learn from the market: what would have happened to CoC if … </li></ul><ul><li>Experimentation with mutations necessary for evolution by natural selection </li></ul><ul><li>A monopoly regime freezes itself in status quo for long periods of time </li></ul><ul><li>It cannot get market signals to adjust rules to changing environment </li></ul><ul><li>Imagine if the IASB rules were implemented in the whole world, what would it take to change a bad rule? </li></ul><ul><li>Rule maker would have no information about the effect of any alternatives on CoC </li></ul><ul><li>Wisdom, diligence and sincerity of the members of the rule making boards is no substitute for information </li></ul>
  19. 19. Hayek’s Information Machine <ul><li>Markets dominate central planning because the they are giant information aggregating machines, more efficient than any computer possible </li></ul><ul><li>If uniformity, transparency, simple truth and due process testimony cannot provide useful guidance to rule makers; perhaps this machine may help </li></ul><ul><li>Not unless the alternatives are out there in the market so we can gather data from the field </li></ul><ul><li>E.g., Leuz’s data from German field competition among alternative standards </li></ul>
  20. 20. Enter: Competition Among Sets of Accounting Standards <ul><li>Let each government (e.g., SEC, European Commission) choose two or three sets of standards for firms in its jurisdiction </li></ul><ul><li>Allow each reporting firm to choose one set of standards (in entirety) </li></ul><ul><li>Issue audited reports clearly labeled with the chosen standard </li></ul><ul><li>Reporting firm pays a royalty to the rule maker </li></ul>
  21. 21. Regulatory Competition <ul><li>Corporate charters among fifty states (Delaware) </li></ul><ul><li>Stock exchanges (NYSE-NASDAQ, Toronto-Vancouver) </li></ul><ul><li>State and local governments for business </li></ul><ul><li>Standard and Poor’s and Moody’s </li></ul><ul><li>Environmental laws across countries </li></ul><ul><li>Underwriters Lab and Good Housekeeping Seal </li></ul><ul><li>Privacy standards, disclosure and practices in e-commerce </li></ul><ul><li>State, federal, offshore regulatory mechanisms for banks </li></ul><ul><li>Maritime regulations across countries (Panama, Liberia) </li></ul>
  22. 22. What Are the Benefits? <ul><li>Efficient accounting standards </li></ul><ul><ul><li>Lowering CoC as the relevant criterion </li></ul></ul><ul><ul><li>Market feedback of better information into the rule making process </li></ul></ul><ul><ul><li>Giving investors an effective voice </li></ul></ul><ul><ul><li>Benefit from innovation anywhere in the world </li></ul></ul><ul><ul><li>Opportunity to specialize, develop clienteles </li></ul></ul><ul><ul><li>Protecting industry from the burden of rules generated as bureaucratic imperatives—aligning incentives </li></ul></ul><ul><ul><li>Greater objectivity and lower susceptibility to lobbying pressure from well-organized groups and threats from politicians </li></ul></ul>
  23. 23. Effective Voice to Investors <ul><li>Investor role in accounting rule-making is weak (mostly accountants and managers) </li></ul><ul><li>Investors vote with their feet </li></ul><ul><li>In a monopoly regime there is little opportunity for investors to indicate their preferences by choosing between standards </li></ul><ul><li>Competitive regime will give a real voice to investors in choice of accounting standards </li></ul><ul><li>Firms using poorly regarded standards may find few buyers for their shares (I.e., higher cost of capital) </li></ul>
  24. 24. Innovation and Learning <ul><li>In a single-standard regime </li></ul><ul><ul><li>Little room for innovation </li></ul></ul><ul><ul><li>Comparison of consequences of different standards is difficult and unreliable </li></ul></ul><ul><ul><li>No opportunity to benefit from the experience of others </li></ul></ul><ul><ul><li>Once a standard is adopted internationally, it will become almost impossible to gather evidence to support a change </li></ul></ul><ul><ul><li>Rigidity and inability to adjust to change </li></ul></ul><ul><li>Competitive regime more flexible and innovative </li></ul>
  25. 25. Differentiation by Clientele <ul><li>Competitive regimes may develop different clienteles by </li></ul><ul><ul><li>Size of firms </li></ul></ul><ul><ul><li>Industries </li></ul></ul><ul><ul><li>Economic development </li></ul></ul><ul><ul><li>Local economic institutions </li></ul></ul><ul><li>Compare: NASDAQ stock exchange in U.S. differentiated itself from NYSE to become attractive for high technology companies </li></ul><ul><ul><li>No differentiation without competition </li></ul></ul>
  26. 26. Aligning Rule Maker Incentives to Investor Interests <ul><li>Rule makers are susceptible bureaucratic incentives </li></ul><ul><ul><li>Making rules is the only output of the organization </li></ul></ul><ul><ul><li>Must remain busy (publish new rules or perish) </li></ul></ul><ul><ul><li>Auditors demand increasingly specific rules as support for their arguments with managers </li></ul></ul><ul><li>Investor interests may be buried under day-to-day pressures on rule makers </li></ul><ul><li>Competitive regime highlights investor interest </li></ul><ul><li>If standards are not attractive to firms and their investors means less revenues to the rule-maker </li></ul>
  27. 27. Less Interest Group Pressure <ul><li>Rule makers often subjected to strong pressures from interest groups </li></ul><ul><ul><li>e.g. accounting for employee stock options </li></ul></ul><ul><li>Competitive regime will ease interest group pressures </li></ul><ul><li>Those who do not like one set of rules can be asked choose another, if they so prefer </li></ul><ul><li>Each rule maker is free to use its own best judgment about what standards will lower the cost of capital </li></ul>
  28. 28. Objections to Competition <ul><li>Race to the bottom among rule makers </li></ul><ul><li>What happens to comparability of reports? </li></ul><ul><li>We do it better than them </li></ul><ul><li>What about the confusion for small investor </li></ul><ul><li>Cost of experimentation and multiple rule makers </li></ul>
  29. 29. Rules Race to the Bottom <ul><li>Popular argument from rule makers </li></ul><ul><ul><li>We would never do such a thing, but what about them (not much faith in their brethren) </li></ul></ul><ul><li>But at least we now are talking economics </li></ul><ul><ul><li>Incentives of rule making </li></ul></ul><ul><ul><li>Rule makers as economic agents </li></ul></ul><ul><li>Let us look at evidence </li></ul><ul><li>Has regulatory competition generated a race to the bottom in other fields? </li></ul>
  30. 30. Why No Evidence of Market Failure? <ul><li>We do not see the bottom when </li></ul><ul><ul><li>The race is not in the interest of the parties </li></ul></ul><ul><ul><li>Consequences of agent actions are visible to others </li></ul></ul><ul><ul><li>The race is subject to adult supervision </li></ul></ul><ul><li>SEC will have an active role in deciding which sets of standards U.S. firms can choose from </li></ul><ul><li>Investors will demand higher risk premium from firms choosing less desirable standards </li></ul><ul><li>Firms and their management are keen on lowering CoC </li></ul><ul><ul><li>Daimler-Benz AG came to U.S. capital markets to lower its CoC </li></ul></ul>
  31. 31. What About Comparability of Reports? <ul><li>Financial analysts use computer worksheets to infer DCF from financial reports and other industry and firm specific data </li></ul><ul><li>Once a worksheet for one set of financial reports is prepared, marginal cost of its use for another firm is virtually zero </li></ul><ul><li>Most of the cost of competition is one time set up cost of a second worksheet </li></ul><ul><li>This additional cost is trivial compared to the benefits of competition </li></ul>
  32. 32. We Do It Better Than Them <ul><li>This argument has been used in U.S. over recent years in making comparisons with the IASB </li></ul><ul><li>Given the structure of rule making, FASB has probably done as good a job as possible </li></ul><ul><li>The questions we need to address are: </li></ul><ul><ul><li>Could it be done better? </li></ul></ul><ul><ul><li>What do we do to keep the cost of capital lowest possible in U.S. markets? </li></ul></ul><ul><ul><li>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 </li></ul></ul>
  33. 33. What About the Non-Expert Investors <ul><li>Benefits of lower cost of capital under competitive regime will be shared by all investors, including non-experts </li></ul><ul><li>Majority of U.S. equities are professionally managed </li></ul><ul><li>Present financial reports are already inaccessible to non-experts </li></ul><ul><li>Neither the US nor the international GAAP presently specify a unique set of accounting rules </li></ul><ul><li>Price of developing lower cost of capital accounting rules </li></ul>
  34. 34. Cost of Experimentation and Multiple Rule Makers <ul><li>Supporting multiple rule makers and experimentation with rules is costly </li></ul><ul><li>Yes it is. Other than experimentation, what other reliable method of choosing lower cost of capital accounting rules do we have? </li></ul><ul><li>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) </li></ul><ul><li>Empirical evidence: disclosure practices may affect the cost of capital by as much as 1 percent </li></ul>
  35. 35. Implementing a Competitive Regime <ul><li>Each national security regulator selects two or more competing sets of standards available for companies in its jurisdiction (Food and Drug Administration model) </li></ul><ul><li>Security regulators coordinate and share information on the oversight of rule making with other members of IOSCO </li></ul><ul><li>Security regulators coordinate and share the oversight of auditors with members of IOSCO and list the auditors permitted to practice before them </li></ul><ul><li>Security regulators oversee financial reports for fairness, and question/discipline auditors and registrants about deviations </li></ul><ul><li>IOSCO and rule making agencies maintain a staff to address the queries from national security regulators </li></ul>
  36. 36. Consequences of Regulatory Competition <ul><li>Governance : Firms will tend to choose standards that will lower their cost of capital which is observable </li></ul><ul><ul><li>If they don’t, market for corporate control can remove or punish the management </li></ul></ul><ul><li>Incentives : Standard setters will compete for corporate following, and tend to develop efficient standards </li></ul><ul><ul><li>If they don’t, they will go out of business </li></ul></ul><ul><li>Innovation: A system of dual standards will introduce best practices at suitable rate to local economies </li></ul><ul><li>Globalization: H elp the cross-border organizations by letting them choose between local or imported practices </li></ul>
  37. 37. Open Research Questions <ul><li>Why have we depended on regulatory monopolies in accounting for so long? </li></ul><ul><li>Will the benefits of competition at a global scale overcome national rivalries and pride? </li></ul><ul><li>Are we prepared for true globalization—global competition among the rules of the game without local or international monopolies? </li></ul>
  38. 38. Thank You <ul><li>This Powerpoint presentation is available for download from </li></ul><ul><li> </li></ul><ul><li>Two related papers(one by Dye and Sunder, Accounting Horizons , September 2001; and the other by Sunder) are available at </li></ul><ul><li> </li></ul><ul><li> </li></ul><ul><li>Or send email to: [email_address] </li></ul>
  39. 39. The Rule Maker’s Problem: Information <ul><li>Need information about the effect of alternative rules on CoC </li></ul><ul><li>CoC is an overall social welfare criterion rooted in equilibrium concept </li></ul><ul><li>Its distributive effects vary from rule to rule </li></ul><ul><li>No single class of agents benefits consistently from CoC-lowering accounting rules </li></ul><ul><li>Information from the FASB/IASB “due process” submissions and testimonies protect respective interests of managers, auditors, financial analysts, even investors </li></ul><ul><li>Who argues on the basis of evidence about the effect on CoC </li></ul>
  40. 40. Who Will Audit Them? <ul><li>SEC oversees the U.S. regulatory regime for public accountants </li></ul><ul><li>Many of these firms are international, with in-house expertise in financial standards of the countries where they do business </li></ul><ul><li>Others will acquire this expertise when there is money to be made from it </li></ul><ul><ul><li>They acquired consulting expertise </li></ul></ul>
  41. 41. Our Law Does Not Permit This <ul><li>I don’t know if it does, or not </li></ul><ul><li>We have to ask: how do we develop and apply good accounting rules? </li></ul><ul><li>If we find that the existing laws stand in the way of doing things better, laws can be and should be changed </li></ul>