Rethinking the Structure of Accounting and Auditing

1
Rethinking the Structure of Accounting and
Auditing

• Shyam Sunder
• Yale University
• Sixth International Conference of IAARF, Kolkata,
  January 11, 2003

2
Corporate Governance and the Agency Problem

• The Dutch and the British East India Companies
  chartered as joint stock companies four centuries
  ago to gather large amounts of capital for trade
  with the East
• The agency problem money of some people managed
  by others risks shirking and malfeasance
• Recent major corporate failures highlight the
  imperfections of our governance system
• Rethink our system of corporate
  governanceespecially accounting, and auditing

3
Accounting and Audit Elements of the US Corporate
Governance

• Accounting rules
• Organization to set accounting rules
• Audit requirement with oversight of audit quality
• Involvement of the board of directors in audit
  and financial reporting
• A fifth related element executive compensation

4
Accounting Rules

• The law requires publicly held corporations to
  prepare and publish financial reports
• Much of content of format is voluntary
• Law requires internal controls and accounting
  system
• Minimum standards of disclosure, detail,
  definitions, and measurementcollectively
  referred to as accounting rules

5
Organization to Set Accounting Rules

• The statutory authority lies with the Securities
  and Exchange Commission (SEC)
• The SEC delegates the task to privately finance
  Financial Accounting Standards Board, retaining
  the right to overrule the Board
• All public corporations are required to comply
  with these accounting rules
• International Accounting Standards Board is
  knocking at the doorkept out so far

6
The Audit Requirement

• SEC requires the publicly-held corporations to
  obtain a certificate from a CPA on fair
  representation of their financial performance and
  status
• Auditors held liable to shareholders and third
  parties for negligence in certification
• American Institute of CPAs audit standards
• July 2002 law to set up a new oversight board

7
Directors and Executive Compensation

• New York Stock Exchange requires its listed
  companies to have a majority of the members of
  the board to be independent
• Audit and compensation committees must consist of
  independent directors
• Significant parts of executive compensation are
  made to be contingent on financial performance as
  measured by accounting and stock prices,
  especially stock options

8
Accounting as a Natural Language

• Generally accepted accounting principles as
  dominant paradigm in accounting till 1972
• Accounting as natural language
• Evolution by usage and consensus over time
• Multiplicity of meaning and words
• Flexibility and limitless variability
• Authority derives from acceptance not power
• No known natural language designed by man

9
Accounting as Designed Artifact

• Designing rules through deliberation
• Replacement of suggestive nature of research
  bulletins and opinions by standards and the power
  to punish any deviations
• FASB large budget, staff no greater wisdom,
  less modesty in ability to devise better rules
• Multiple criteria without aggregation function
• Cost of capital missing as a criterion for rules
• Consultative process but monopoly deprived it of
  natural selection necessary for evolution

10
Standards Become the Targets

• FASB and its standards became the excuse for
  auditors to abandon their judgment, CEOs to
  demand to see the rule, and for both to demand
  additional clarifications
• Bankers and managers, often with the help from
  auditors, devised transactions to go around the
  rules to frustrate their intent
• Given time and money, IASB rules will catch up
  with the FASB rules in their detail

11
The World Improvises on the US Model

• US model has been widely adopted, with
  adjustments, in various parts of the world
• IASB is the most important imitation
• A thick rulebook has come to be seen as a sign of
  advanced financial reporting system
• Standard setters have a difficult task
• No obvious criteria, trade offs among criteria,
  and assessment of consequences of a given rule
• Receive mostly self-serving advice
• Monopoly makes it difficult to gather evidence
  from the field

12
Standard Setting Approach

• Advantage Like a fire brigade, the board stands
  ready to deploy its expert resources to promptly
  address any reporting abuses
• Disadvantages cannot know the consequences of
  its proposed solutions
• Difficult to anticipate the action-reaction
  sequence and the ultimate result
• Poor correspondence between the intent and the
  consequences
• Game theoretic analyses of motives, options and
  strategies is precluded by its public
  unacceptability

13
Permanent Rule Making Establishments

• Encourage managers and auditors to demand more
  clarifications, instead of exercising their best
  judgment
• No rational basis for denying clarifications
• A permanent establishment needs demands for
  clarifications, or go out of business
• Judgment about the overall fairness gets buried
  under the weight of compliance with the letter of
  detailed rules
• No permanent establishment can promote rules over
  principles

14
GAAP Regime is Hard Work

• Developing and sustaining GAAP requires judgment
  and discipline from managers, accountants,
  bankers, lawyers, analysts, etc.
• It requires creativity, living with uncertainty
• Respect for judgment and expertise, not authority
• Natural languages are unmatched as means of
  communication
• Comparison with common law vs. statutory law

15
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?

16
Audit Requirement

• Legal requirement to get the financial reports
  certified by an independent auditor
• The audit franchise granted exclusively to the
  members of AICPA
• Many corporations furnished audited financial
  reports before audit was required
• Does the legal requirement create a better
  informed market, or better managed firm?

17
Voluntary Audit

• Benefits convincing the shareholders, creditors
  and tax collector of the reliability of
  representations made in financial reports
• Costs auditor fee, managerial cooperation,
  potential modifications in reports, even
  embarrassment, constraints of behavior
• Managers and directors commissioned audits when
  advantages outweighed the costs
• Voluntary audit is a valuable signal to outsiders
• Contrary to its intent, statutory requirement
  shuts this signal off, thus leaving the outsiders
  less informed

18
Auditor Independence

• Recent attention on the infringement of
  consulting on audit independence
• Major audit firms have been forced to divest
  themselves of their consulting operations
• But audit revenues also raise similar questions
  about auditor independence
• Alternatives audits by federal or state
  governments or stock exchanges, competition among
  states or exchanges
• Firms choose to be incorporated/listed as an
  audited or unaudited corporation, letting
  shareholders discount

19
Independence and Competition in the Audit Industry

• 1970s intense scrutiny of competition
• Insufficient appreciation of links between
  competition and independence responsible for at
  least some of the recent problems
• Two levels of analysis of their relationship
• At one level, a mechanical relationship
• A small number of larger firms are more
  independent and less competitive
• A larger number of small firms are more
  competitive but less independent of their clients

20
On Way to Pursuit of Competition

• After a quarter century long pursuit of
  competition, the US audit industry is down to
  only four major firms and weaker competition, and
  questionable independence
• How did this come about?

21
A Thumbnail Sketch of the Collapse

• Ninety years of antitrust laws and enforcement
• These laws were not applied to the
  professionsincluding doctors, lawyers,
  accountants, and dentists
• They kept anticompetitive clauses in the Code of
  Ethics of their respective professions

22
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

23
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 sellers
  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

24
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

25
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

26
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

27
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

28
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)

29
Generalizability to Auditors?

• Unfortunately, this argument, applicable to
  lawyers and doctors and many other professionals,
  does not work for the auditors
• The auditors customersthe shareholders and
  other third partiescannot 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
• Firms decisions on hiring the auditor are made
  by managers who are the subject of the audit

30
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 downa market for lemons

31
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

32
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

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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

36
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

37
Number of Settlements of Claims Against Auditors
38
Amounts of Settlements Against Auditors
39
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

40
Accountants Contributions to Political Campaigns
41
Accountants Contributions to Political Campaigns
42
Accountants Contributions to Political Campaigns
43
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 Clintons eight year
  presidency when his veto was overturned by the
  Congress (election financing)

44
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

45
The Happy Days

• 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

46
Executive Compensation

• Aligning the interests of managers with the
  interests of shareholders is a fundamental
  challenge of corporate governance
• Since managerial contributions to the firm cannot
  be observed, and managers control the resources
  and information of the firm, there is
  ever-present moral hazard
• Accounting reports were designed to measure
  corporate performance to evaluate
  managerscontingent rewards
• But accounting measures have well-known
  weaknesses
• Solution use market-based measures

47
Assumptions Behind Market-Based Compensation

• Markets are efficient (not subject to
  manipulation by managers)
• In spite of the support it enjoys in accounting
  academia, the assumption is false
• Financial reports are hard, based on unique
  accounting standards and incorruptible auditing
• Again, a false assumption
• Governance mechanism to grant equity-based
  compensation is beyond manipulation
• Yet another false assumption

48
How Did Executive Compensation Soar?

• Directors compensation committees controlled by
  executives
• Annual survey techniques of executive
  compensation consulting firms
• Flexible accounting standards (not bad with
  vigilant analysts and investors)
• Auditor under pressure, controlled by managers
• Highly leveraged options, one-sided
• Skewed accounting for stock options
• Result top to bottom ratio changed from 40 to 500

49
Incentives to Manipulate

• With increased compensation, and increased
  dependence of compensation on accounting and
  market measures, incentives to manipulate
  accounting and stock prices rose
• If the governance, accounting and auditing were
  rock solid links, it would not matter
• But they are not beyond manipulation
• Attempts to better align manager and shareholder
  interests also resulted in more manipulation by
  managers

50
Accounting Standards

• Uniformity and comparability of accounting
  standards has become sacred
• Monopoly of standards in U.S. and many other
  jurisdictions
• Elimination of signaling function of accounting
  in a world of flexible standards
• Standardized financial reports give more
  information in one sense, but less information in
  another

51
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

52
What Are We Doing?

• Sarbanes-Oxley Act, 2002
• Creates a Public Company Accounting Oversight
  Board (there is little reason to think that this
  regulatory body would not, over time, be captured
  by the industry it is supposed to regulate)
• Prohibits auditors from providing certain
  non-audit services to their audit clients (the
  Act incorrectly assumes that such services were
  the cause, not the consequence, of audit market
  failure)
• Requires audit partner rotation every five years
  (will rotated partners be more or less vigilant?
  Collusive?)

53
Sarbanes-Oxley Act, 2002

• Auditor reports to the audit committee
• Audit committee of independent directors with at
  least one expert
• Corporate responsibility for financial reports
• Forfeiture of bonuses/profits
• Disclosures of adjustments, OBSF, SPE
• Personal loans to executives

54
The New Act

• Disclosure of trades within 2 days (why not
  advance notice of one week?)
• Conflict of interest rules for financial analysts
• Increased appropriations for SEC
• Minimum standards for attorneys
• Audit work papers for 5 years
• Whistle blower protection
• White collar crime penalty enhancements
• SEC annual and quarterly reports in 60-45 days

55
Effectiveness of New Measures

• It is doubtful if any of these measures, aside
  from the promise of adequate staffing of SEC and
  enforcement of existing laws, will have any
  significant impact on the auditing and accounting
  problems
• These fixes do not deal with the root causes
• What are the root causes?

56
Areas of Concern

• Financial reporting standards monopoly versus
  competition
• Market for audit services breakdown under
  pressure of competition
• Insurance approach to audit market
• Corporate governance and qualifications of
  directors
• Control principle choose rules to bring expected
  behavior in line with self interest

57
Financial Reporting Standards

• U.S. monopoly of FASB, spreading to Europe and
  elsewhere
• Difficulty of assessing what is a good rule
• Cost of capital criterion
• Use market competition among standards to
  determine which rules lower the cost of capital
  of the firm empirically

58
Regulatory Competition in Accounting Rules

• Each jurisdiction permits two or three sets of
  accounting standards
• Each firm chooses one set of standards
• Pays a fee to the standard-setting body
• Standard setting bodies compete like the stock
  exchanges, university accreditation, and
  appliance certification bodies do
• Will result in better standards which will lower
  the cost of capital

59
Market for Audit Services

• Cannot bear the burden of full competition
• Choose one of two solutions
• Allow auditors relief from antitrust laws (no
  advertising, solicitation, etc. politically
  difficult
• Combine audit and insurance into one packet

60
An Insurance Solution

• Each public firm is free to buy (or not buy) any
  amount of financial misrepresentation insurance,
  and indicate the amount of coverage bought in its
  report
• The insurer examines the financial reports and
  charges a premium
• The firm adjusts how much insurance to buy
• Investors adjust how they process the information
  based on how much insurance is provided

61
Pros and Cons of the Insurance Solution

• Quality of audit services internalized by the
  insurance firm
• No external regulation necessary to monitor audit
  quality which is difficult anyway
• Will need an accounting court to settle insurance
  claimswhether the financial reports made a fair
  representation
• Audit will be driven by economic, not regulatory
  considerations

62
Corporate Governance and Directors

• Recent emphasis on independence
• Also need competence, industry knowledge,
  contacts, and managements trust
• Criteria are often in conflict with one another
• How do we find directors who will have all these
  qualifications
• College professors? Unfortunately not

63
Minority Directors

• Instead of framing it as a problem of
  independence, frame it as directors to represent
  the minority shareholders
• Have separate slate selected only by the minority
  holders
• More nominations than slots to make it a real
  election
• Better information to shareholders about the
  behavior of directors when they serve on the board

64
Executive Compensation

• Giving incentives to corporate managers to work
  hard, and aligning their incentives with
  shareholders does not come for free
• It has its own cost
• Agency theory we can only get a second best
  solution, not the first best solutions
• Scale back on incentives towards more fixed pay
• Fire those who do not measure up

65
Summary

• The recent collapse of accounting and auditing
  requires careful analysis of root causes
• Bad people or bad policies?
• Need to think of alternative solutions, e.g.,
• Competition for accounting standards
• Reduce competition in audit market or bundle with
  insurance
• Minority directors with real elections and better
  information for shareholders about directors
• Scale back on performance-contingent managerial
  compensation
• Think of even better alternative approaches

66
Thank You

• http//www.som.yale.edu/faculty/sunder/research.ht
  ml
• Shyam.sunder_at_yale.edu