Financial Reporting Standards
Reconsidering the Top-Down Push
APRIL 2007 -
Arguments for developing and enforcing uniform international standards
for financial reporting have been eloquently articulated elsewhere,
and I shall not repeat them at length here. The European Union and
many other countries are on their way to adopting, implementing,
and enforcing the International Financial Reporting Standards (IFRS).
Indeed, the question today is not the desirability of uniform
worldwide standards, but how we might implement them.
The core arguments for
uniform standards are as follows:
serve as a coordinating device, saving time and effort, just
as the rules of the road speed up traffic and reduce accidents;
policy should be made through a well-defined, transparent process
with clear outcomes; and
make auditing easier and are useful to auditors in their negotiations
with their clients.
Although these are valid arguments, to provide a more balanced
perspective on which to base public policy, we should examine
both sides of the issue.
The benefits of uniform standards are clear, concrete, and immediate.
The arguments on the other side are diffuse, hypothetical, and
their consequences lie mostly in the future. It is easy to ignore
the hypothetical in favor of the concrete. Many would concede,
however, that hypothetical opportunity costs are often a better
basis for making decisions than concrete historical costs.
a system of supervised competition among multiple sets of standards
written by independent bodies such as the IASB, FASB, or accounting
firms. Investors, companies, and auditors could then choose from
a set of competing standards. It is possible, through market competition,
for one set of standards to win out over the others, or for several
sets to coexist, each attracting its own clientele without government
enforcement. This bottom-up alternative to “standards monopoly”
offers several advantages.
Language of Business
is the language of business. As with any other language, it derives
its vibrancy from the changing dynamic of the meanings of words.
The value of the Oxford English Dictionary arises from the encyclopedic
collection of the various ways in which a word may be used, not
in recommending or enforcing its opinion. The power of the English
language derives, not from authority, but from the freedom with
which it permits us to communicate. Many natural languages have
been, and some continue to be, strangled by the over-jealous advocates
of their purity, determined to force uniformity of usage. No language,
including accounting, can flourish under the protective umbrella
of punitive authoritative regulations.
is part of complex social phenomena. The tendency to set standards
that are enforceable through the punitive power of the state is
rooted in the Cartesian world view. This perspective presumes
that we have enough rational understanding of the world and enough
knowledge of designing social structures to achieve the desired
ends. There is no evidence, especially in accounting, that our
existing or potential knowledge justifies the Cartesian view of
the world of business and accounting.
As an alternative
to this command-and-control perspective, consider a Darwinian
world where complex phenomena emerge through unpredictable events
and their poorly understood interactions. Information in our economy
is inherently dispersed. It is impossible for any centralized
authority—no matter how wise and benign its intent—to
possess the necessary knowledge to design social systems to effectively
address all possible issues.
to standardize accounting from the top, using command-and-control,
the accounting profession seems to have learned nothing from the
mistakes of central planning. Must we lose another hundred years
in making mistakes we can call our own, before we learn?
of social systems is far more complex than that of physical systems
because the elements of social design—human beings—react
to the choices and adjust their behavior. People affected by standards
take little time to adjust their behavior and redesign their transactions
to get around the intent of the slow-moving standards setters.
This dynamic game between economic agents and standards setters
is a losing battle for the latter.
standards have been of great value in certain systems, such as
computer operating systems and Internet protocol. Yet, absent
competition between Apple and IBM PCs, we might still be running
the Microsoft DOS of the early 1980s.
has interesting qualities. Standards setters may think they can
improve the usefulness of financial statements by reducing the
number of permissible accounting alternatives. But the choices
we make reveal our secrets. A company that chooses the accelerated
over the straight-line method of depreciation reveals the higher
degree of confidence its managers have in the future of the company.
How else could it credibly reveal such information to investors?
The uniformity dogma in financial reporting ignores the signaling
value of the choices people make.
have shifted the focus of accounting education from preparing
professionals to think about the best way to deal with any given
event or transaction, to telling professionals what the rulebook
says. Can we attract talented youth to study a discipline that
consists largely of memorizing a fixed set of rules? When written
standards define financial reporting, professional judgment is
discounted and replaced with a “cover your assets”
mentality. When we consider the effect of standards on the attitudes
of corporate managers and auditors, standardization runs counter
to making difficult judgments after considering the relevant facts.
Standards provide a cover from having to take personal responsibility
for one’s judgments. The scandals of recent years have made
it clear that, after 30 years of intensive pursuit of the “gold
standard” for accounting, we have discovered fool’s
past seven decades, standards have progressively become roadmaps
for evasion. It has been suggested that standards should be based
on principles, not rules. However, “rules versus principles”
is a misleading debate. No standards setter sets out with a preference
for rules over principles. The standards setters’ monopoly
existence with their sole duty to develop standards forces them
to “clarify” their principles, and that ultimately
degenerates into rulemaking. Financial accounting standards are
more detailed only because FASB has had more time and a larger
budget. Twenty years from now, the IASB’s rulebook will
probably be just as voluminous. Its processes are similar, and
so will be the outcomes.
Essence of a Learned Profession
of our lives exclude social norms and depend so exclusively on
written standards to the degree being attempted by accountants.
No other learned profession relies on standards as accountants
are being asked to do. Not doctors, not lawyers, not dentists,
not actuaries. Judgment, not a written standard, is the essence
of a learned profession. If we do not stop chasing the mirage
of uniformity and comparability now, we may soon destroy our profession
and any value society places on its services.
who agree with these arguments may ask: What do we do? Isn’t
it too late to stop the speeding train of standardization of financial
reporting? As to the first question, I do not suggest a free-for-all
in accounting. Some experts in the field have argued, not against
standards and definitions, but merely against those written by
authority. I suggest moderating the power of the SEC that stands
behind FASB and the PCAOB, and the power of the European Union
and the increasing number of other governments that stand behind
jurisdiction, the appropriate authority could choose at least
two, perhaps three or four, bodies whose standards would be acceptable.
Every company in that jurisdiction would be allowed to choose
the set of standards it wishes to follow. These bodies would be
financed exclusively by the royalties they collect from the firms
that use their standards.
setters would effectively compete with each other for these royalty
fees, and would be forced to make difficult choices which might
possibly reduce the cost of capital of the companies that use
may or may not emerge from this bottom-up competition. Such competition
occurs in many regulated fields, including stock exchanges, bond
raters, and university accreditation. There is no evidence that
competition would reduce quality.
Is it too
late to try to stop the speeding train of standardization for
financial accounting? Not if we are convinced that reversing policy
is in our best interest.
In the true spirit of open debate on matters of public policy,
I realize that many readers may strongly incline toward the pro-standardization
case we have heard over recent decades from the distinguished
proponents of uniform, enforced standards. I request only that
you withhold judgment until we have developed, heard, and weighed
both sides of the argument on both sides of the Atlantic.
remarks be regarded as an attack on IFRS, Statements of Financial
Accounting Standards, or their creators, allow me to quote from
the late Professor William T. Baxter of the London School of Economics:
It is not unusual in human affairs for a thing to be started with
the best intentions, and yet to develop aspects that threaten
harm. My plea is that we should now review the good and bad alike,
and see whether we cannot guide future growth in directions that
are wholly good.
from his article “Recommendations on Accounting Theory,”
were published in The Accountant in October 1953. Perhaps
it is time the debate begins.
and the dynamic, cross-sectional variation in meanings attached
to words are the essence of any language; the same is true of
are disadvantages to a Cartesian top-down design, command-and-control,
central planning perspective when compared to a Darwinian-Hayekian
evolution [Ed.: named for Friedrich Hayek, a renowed 20th-century
economist and political philosopher], and an emergence from
markets and a social processes perspective.
setters will always be too slow to respond effectively to evasive
maneuvers of unscrupulous companies.
dogma ignores signaling the value of choice.
- The degradation
of accounting education and training, and the unattractiveness
of such a profession to talented youth.
as alternatives to social norms and personal responsibility,
become roadmaps for evasion.
jurisdiction would permit two or more competing sets of standards,
company decides which set of standards to use in its reports
(i.e., investors react to choice).
setters would be financed by royalties collected from companies
using their standards, and would compete for royalties.
would be forced to make difficult choices in the hope of identifying
better standards through market feedback.
Convergence may or may not occur in this bottom-up approach driven
by the market.
Sunder, PhD, is the James L. Frank Professor of Accounting,
Economics and Finance in the Yale School of Management, New Haven,
Conn. He is the current president of the American Accounting Association
(AAA). The views expressed here are his own.