“True and Fair” as the Moral Compass of Financial Reporting

1. “True and Fair” as the Moral Compass of Financial Reporting Shyam Sunder Yale University 2009 Ethics Symposium of the American Accounting Association New York, August 2, 2009

2. Leadership Challenges in Practice • Developing social norms of accounting to balance reliance on written standards • Restoring the role of accountant as a professional with self-discipline and responsibilities that extend beyond business • “True and Fair” as the moral compass of accounting Sunder: True and Fair

3. Developing Social Norms of Accounting • Traditionally, financial reporting was largely a matter of social norms of society • In recent decades, 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 Sunder: True and Fair

4. Nature of Social Norms • Social norms of a group are shared 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 • Norms need a broad consensus, not just majority support • Dictionaries earn their respect by attracting a following, not by enforced their authority Sunder: True and Fair

5. Balancing Norms and Standards • Social norms maintained by internal and external sanctions • Standards enforced by authority with power to punish • Recent failures raise questions about the wisdom of transition from norms to standards • Widespread use of norms in professional, neighborhood, national, legal aspect of life • What should be the balance between norms and standards in accounting? Sunder: True and Fair

6. 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 community disapproval of deviations Sunder: True and Fair

7. Standards Viewed as Progress • 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 • Baxter analyzed the corrosive effect of authority on accounting profession half-a-century ago • Those ideas are largely forgotten • There has been little research and debate on merits and consequences of shifting balance between standards and norms Sunder: True and Fair

8. 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? Sunder: True and Fair

9. Norms in Law • 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. Sunder: True and Fair

10. 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 Sunder: True and Fair

11. 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 Sunder: True and Fair

12. 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 Sunder: True and Fair

13. 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” Sunder: True and Fair

14. 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 Sunder: True and Fair

15. 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 Sunder: True and Fair

16. Dependence on Rules Undermines Accountant as a Professional • What is a profession? • Is being an accountant a profession? If not, should accountant change and become one? • If yes, how can accountant be a better professional? Sunder: True and Fair

17. Professions • A professional is one whose loyalties extend beyond self (business) interest to the discipline and customer/clients • For example, a physician who pursued his business interests without regard to allegiance to his oath is not considered a professional Sunder: True and Fair

18. Traditional Hippocratic Oath • I swear by Apollo Physician and Asciepius and Hygieia and Panaceia and all the gods and goddesses, making them my witnesses, that I will fulfill according to my ability and judgment this oath and this covenant: • To hold him who has taught me this art as equal to my parents and to live my life in partnership with him, and if he is in need of money to give him a share of mine, and to regard his offspring as equal to my brothers in male lineage and to teach them this art—if they desire to learn it—without fee and covenant; to give a share of precepts and oral instruction and all the other learning to my sons and to the sons of him who has instructed me and to pupils who have signed the covenant and have taken an oath according to the medical law, but to no one else. • I will apply dietetic measures for the benefit of the sick according to my ability and judgment; I will keep them from harm and injustice. Sunder: True and Fair

19. Traditional Hippocratic Oath (Contd.) • I will neither give a deadly drug to anybody if asked for it, nor will I make a suggestion to this effect. Similarly I will not give to a woman an abortive remedy. In purity and holiness I will guard my life and my art. • I will not use the knife, not even on sufferers from stone, but will withdraw in favor of such men as are engaged in this work. • Whatever houses I may visit, I will come for the benefit of the sick, remaining free of all intentional injustice, of all mischief and in particular of sexual relations with both female and male persons, be they free or slaves. • What I may see or hear in the course of the treatment or even outside of the treatment in regard to the life of men, which on no account one must spread abroad, I will keep to myself holding such things shameful to be spoken about. • If I fulfill this oath and do not violate it, may it be granted to me to enjoy life and art, being honored with fame among all men for all time to come; if I transgress it and swear falsely, may the opposite of all this be my lot. Sunder: True and Fair

20. Yale 2003 Version of Hippocratic Oath • In the tradition of Hippocrates and all the other great physicians who have come before me in the ancient field of medicine, I will fulfill, according to my ability and judgment, this pledge: • I will be just and generous to those who have taught me this art, holding them in highest esteem, and will give guidance and instruction freely to all those who wish to follow in this path. • I will strive to correct the knowledge that I have acquired and to extend its domain, while remembering that medicine is more than science, and that warmth, sympathy, and understanding may heal as well as the surgeon’s knife or the chemist’s drug. • I will practice my art solely for the benefit of my patients, knowing that at times I must put their interests before my own. May I never see in my patient anything but a fellow human in pain. My goal will be to help, or at least to do no harm. • I will remain free of all intentional injustice, practicing with integrity and honor, and will not exploit my privileged role in the lives of my patients. What is revealed to me in confidence, I will keep inviolably secret. I will use my skills to serve all in need, with openness of spirit and without bias. • In the presence of my teachers, my family, and my friends, I make this pledge freely and upon my honor. I am ready for my vocation and now I turn unto my calling. Sunder: True and Fair

21. Accountants • Have struggled with their business and professional motivations • Pressure of legal liabilities • Reluctance to accept responsibility for fraud detection • Accusations of conflict of interest • Reluctance to defend themselves on the basis of professional judgment based on the reasonable amount of evidence that was available at the time • Seeking protection of written accounting and auditing standards • But written standards can go only so far • Beyond a certain level, they begin on encroach on professionalism (box checking physician or lawyer? Sunder: True and Fair

22. Defending Judgment in Auditing • Defending audits on the basis of professional judgments instead of written accounting and auditing standards • It is a difficult thing to do • There is great temptation to think that by writing rules to follow in work, as long as accountants follow these rules, they shall be protected from liability • This is highly defensive mode of thinking • It does not work, and worse • It de-professionalizes the accountants making them appear to be hiding behind the rules • Government policies of the recent decades have not helped Sunder: True and Fair

23. Professional Leadership • Restoring the role of accountant as a professional with self-discipline and responsibilities that extend beyond business • Leadership requires us to reconsider how accountants can remain a profession, and not get reduced to a trade • This cannot be done without a social norm, by dependence on written rules alone • Need a moral compass Sunder: True and Fair

24. Parallels with Law • In law, “guilty beyond reasonable doubt” serves this function • After lawyers have finished they lawyering, the final judgment is a lay decision by members of community untutored in law • This process keeps the statutory and common parts of the law in balance to help maintain order in society • While everyone would not agree with every decision, the general lay acceptance of judgments of the courts is essential • This is where financial reporting has failed Sunder: True and Fair

25. Moral Compass for Accounting • How can accountants earn lay acceptance? • Thousands of pages of written rules will not protect us from wrath of society if the final outcomes are not “true and fair” • This what the President of the U.S. promised the public on July 9, 2002 after Enron-WorldCom: “We're moving corporate accounting out of the shadows, so the investing public will have a true and fair and timely picture of assets and liabilities and income of publicly traded companies.” • In these 7 years, have we gotten closer? • If not, why not? • Increasing dependence on written standards cannot move us closer to, “true and fair” Sunder: True and Fair

26. Thank you www.som.yale.edu/faculty/sunder Shyam.Sunder@yale.edu

27. Leadership Challenges in Education • What we teach in accounting classes • Who is attracted to accounting classes • Building PhD programs as seed farms for the future • Place of accounting programs in the university Sunder: True and Fair

28. What We Teach • Most, if not all, aspects of accounting have come to be dominated by standard writers • Financial reporting • Auditing • Even education (there is something called International Accounting Education Standards Board) • What do we (and what should we) do in our classes? Sunder: True and Fair

29. Teach Students to Think? • Present them with various scenarios and transactions (cases) • Ask them how they think each such case should be accounted for so as to achieve “true and fair” financial reports • Consider and discuss the merits and weaknesses of each proposed method to help students develop their own refined judgment about how to prepare true and fair financial reports • Help them develop a sense of professional norms of what is right and what is wrong • Have our students leave the class with ability to back up their judgments with economic, financial, organizational and legal reasoning Sunder: True and Fair

30. Or, Teach the Rules? • Open the rule books • Teach the rules of financial reporting and auditing • Teach them how to conform to rules so they would not get into “troule” • One right answer to each question (to be found in the rulebooks) • Avoid professional judgment at all costs • There are plenty of textbooks which do just that; they compete on the basis of which edition has the latest rules issued by the authority Sunder: True and Fair

31. Who Will be Attracted to these Two Types of Accounting Classes? • The first kind of accounting class will be attractive to those who like to think for themselves, sharpen their judgment, are willing to exert the effort to explore and understand the economic, financial, organizational and legal consequences of what they do, and apply judgment to difficult circumstances • The second kind of class will be attractive to those who view accounting as a trade in which rote memorization of rules is the primary necessary skill • Look at the street image of accounting and accountants and ask: what kind of people do we think we are attracting to accounting classes, and why? • Should we the educators look at ourselves for leadership? Sunder: True and Fair

32. Quality and Number of Accounting PhD Programs • Shortage of high caliber students willing to PhD is a problem across disciplines and countries • Economically, it is a public good problem that requires public financing; it is expensive and does not confer direct benefits on universities who educate PhDs • In accounting the problem is especially acute • Opportunity costs of accountants are relatively high • What kind of person is attracted to teach each of the two kinds of accounting classes? • The street image of accounting as a trade discourages talented students from thinking of accounting as a subject of scholarly pursuit Sunder: True and Fair

33. Accounting in University • Universities devote themselves to education and advancement of knowledge • Many skills important to society are not considered suitable for inclusion in university curriculum (plumbing, bricklaying, real estate sales, etc.) • Where does accounting stand in university curriculum and why? • How long can accounting retain its place in university as it is standardized? Sunder: True and Fair

34. Leadership Challenges in Research • Innovation • Policy • Faculty Evaluation • International and National Journals Sunder: True and Fair

35. Innovation • Imagination, creativity, and innovation is the essence of research • How many new ideas did we generate in accounting research journals last year? • For some reason, the number of new ideas in accounting research has fallen to a low level • Of course, method is important, and research has to be properly done to be of any value, but there is no substitute for innovation in accounting research • Academic leadership in research consists of innovation Sunder: True and Fair

36. Policy • For more than three decades, policy research in accounting seems to have fallen out of favor • Returning to the parallel with medicine, abandoning policy research is like abandoning research on finding a treatment for diabetes in favor of only studying who gets diabetes and why • Of course the study of such questions is a prerequisite to finding a cure • But no learned profession can stop at the natural or social science level, without risking its scholarly status Sunder: True and Fair

37. Faculty Evaluation • Teaching-Research-Service formula has considerable following in B-schools • Does this practice yield good teaching, research, and service in a desirable combination • What are the problems associated with current practice • What could be the alternatives? • Where do we go from here? Sunder: True and Fair

38. Another Example • Record of teaching success and productive scholarship supported by substantial publication • Evidence of recognition by peers. • Evaluation of teaching effectiveness before scholarship and professional service • Evaluation of record of publications, by outsiders if necessary • Materials prepared to aid classroom teaching • Administrative and other professional services to the University • External service (professional organizations and community, state, and federal agencies): judgment about the educational or scholarly value of the services rendered Sunder: True and Fair

39. What We Want in Research • Creativity, innovation and thought leadership • Driven by curiosity about the world: How things work and why they don’t? • Contribution to society: how they might be made to work better • Explore new frontiers whose value and consequences may not be known for some (long?) time Sunder: True and Fair

40. How Do We Promote Research? • Research scores weighted by journal ratings (objective?) • Citation counts • Download counts • Criticality of external letters of review (local vs. selection bias?) • Immediacy of assessment (power to editors and referees) Sunder: True and Fair

41. What Do We Get in Research? • Maximization of publication counts • Journal ratings replace reading of research • Dominance of method over substance • Citation networks Sunder: True and Fair

42. Holy Cows of Faculty Evaluation • Judgment vs. objective measurement • History of misuse of judgment • Individual merit vs. social justice • Time horizon of evaluation and decision • Shorter time horizon enables quick corrections of errors • Is more error prone Sunder: True and Fair

43. International and National Journals • Publishing in international journals: blessing or curse of scholarship? • Many universities around the world encourage, even require, their faculty to publish their research in international journals • It helps maintain the “high standards” of research • It carries a stamp of unbiased distant authority behind controversial promotion and tenure decisions Sunder: True and Fair

44. Cost of the Policy • Immense costs of “publish international” policy • Talent diverted away for addressing problems of society • Wastage of scarce financial resources • Under-development of organic research cultures • Critical thinking and discussion • Separation of scholarly critique and personal relationships • Local journals • Diversity of thought and methods • Editing and reviewing skills • End up with research for the sake of research, instead of research for the sake of innovation Sunder: True and Fair

45. Summary • Accounting deserves and needs leadership in • Practice (developing social norms to balance reliance on written standards, professional self-discipline) • Education (what we teach, who is attracted to our classes, seed farms of knowledge, and place of accounting in the university) • Research (innovation, policy research, faculty evaluation, and developing local journals and research cultures) • I am privileged to have had this chance to discuss these challenges for accounting leadership that lie before us • How we tackle each of these challenges will determine the future of accounting Sunder: True and Fair

46. Thank you www.som.yale.edu/faculty/sunder Shyam.Sunder@yale.edu