Shyam Sunder, Yale University Korean Accounting Association Seoul, Korea, February 7, 2007

1. Norms, Standards and Failures in Accounting and Auditing: Rethinking Practice, Research and Education Shyam Sunder, Yale University Korean Accounting Association Seoul, Korea, February 7, 2007

2. An Overview • Roots of accounting and auditing failures • Short, medium and longer 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

3. Roots of Accounting and Auditing Failures: A Rethinking

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 the 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 reluctant to serve as the directors; nominating committees 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 the rapid rise in the compensation of senior executives continues, back-dating scandals

5. Medium-Term Perspective • Two critical events of the 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 dotcom bust, brought the house down

6. Longer-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 (Ackerlof)—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 the 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 reputation 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

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 failure of 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

24. Amounts of Settlements Against Auditors

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 the new business model of 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 had become the perpetrators, the short term beneficiaries and ultimately the victims of the dotcom 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. • Alternatively, 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

32. From Norms towards Standards of Corporate Financial Reporting: A Long Term Perspective

33. Summary • Norms of accounting are important in financial reporting • Federal regulation of securities induced 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 • Capitalized: 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 standards • Has the pendulum of standardization has swung too far? • What should be the balance between norms and standards in accounting?

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, and 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, subjective, incomplete work in high stakes contentious environment of financial reporting? • The work well in law, including securities law • Lawyers do not replace norms by law • 5,000 word US constitution, unwritten in U.K. • 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 of 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, U.S. Congress give SEC the legal authority to regulate financial reporting • The first three decades: mostly codifying the existing practices • Gradually, these efforts shifted from identification of conventions or social norms to 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, the social norms have few advocates left, most favor legislated standards (with legal enforcement) model 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 1960’s, accountants’ occupation with keeping the government out of making accounting rules • Creation of private rule-making institutions • Beliefs about what can and cannot be achieved by rules • Expanded rule books 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 just keeps running harder just to keep the government out, making more detailed standards • Unlike 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 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 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 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