Accounting Leadership in Practice, Education and Research

Accounting Leadership in Practice, Education and Research Shyam Sunder, Yale School of Management Conference on Accounting Leadership National Taipei University and Taiwan Accounting Association November 8, 2007

I have three treasures. Guard them carefully: The first is deep love; it makes one courageous. The second is frugality; it makes one generous. The third is not to try to be ahead of the world, it makes one the leader of the world. The Way of Lao-tzu (604 BC - 531 BC) Leadership Sunder: Accounting Leadership

Opportunities for Leadership in Accounting: An Overview • Practice • Education • Research Sunder: Accounting Leadership

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 • Defending audits on the basis of professional judgments instead of written accounting and auditing standards Sunder: Accounting Leadership

Developing Social Norms of Accounting • Traditionally, financial reporting was largely 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 Sunder: Accounting Leadership

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 • Norms need a broad consensus, not just majority support • Dictionaries become respectable by attracting a following, not by enforced authority Sunder: Accounting Leadership

Balancing Norms and Standards • 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 • What should be the balance between norms and standards in accounting? Sunder: Accounting Leadership

Use of Social Norms in Various Walks of Life • Family • Neighborhood • Professional • Legal • National Sunder: Accounting Leadership

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 Sunder: Accounting Leadership

Standards 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 were largely ignored • There has been little research and debate on merits and consequences of shifting balance between standards and norms Sunder: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

Has the pendulum of standardization has swung too far? • Misunderstanding of the role of social norms in law • Stress generated by popularity/promotion of stock and accounting-based compensation for senior managers • Consequences 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? Sunder: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

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: Accounting Leadership

A Thumbnail Sketch of the Role of Government • 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 Sunder: Accounting Leadership

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 Sunder: Accounting Leadership

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 (Akerlof)—results would be even worse than the consequences of insufficient competition Sunder: Accounting Leadership

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 Sunder: Accounting Leadership

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 Sunder: Accounting Leadership

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 Sunder: Accounting Leadership

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 Sunder: Accounting Leadership

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) Sunder: Accounting Leadership

Generalizability to Auditors? • Unfortunately, this argument, applicable to lawyers and doctors and many other professionals, does not work for 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 Sunder: Accounting Leadership

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 reputations 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 Sunder: Accounting Leadership

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 Sunder: Accounting Leadership

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 Sunder: Accounting Leadership

Sunder: Accounting Leadership

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 the failure of the 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 Sunder: Accounting Leadership

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 Sunder: Accounting Leadership

Number of Settlements of Claims Against Auditors Sunder: Accounting Leadership

Amounts of Settlements Against Auditors Sunder: Accounting Leadership

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 Sunder: Accounting Leadership

Accountants’ Contributions to Political Campaigns Sunder: Accounting Leadership

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) Sunder: Accounting Leadership

New Business Model • The 1995 legislation, with a 1994 Court ruling exempting advisors from liability for aiding and abetting securities fraud, implemented a new business model for 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 Sunder: Accounting Leadership

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 became the perpetrators, the short term beneficiaries and ultimately the victims of the dot-com bubble • The well meaning government policy to encourage competition in the industry pushed it to collapse Sunder: Accounting Leadership

Accounting Leadership in Practice, Education and Research