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Rethinking the Structure of
Accounting and Auditing
Shyam Sunder
Yale University
Sixth International Conference of
IAARF, Kolkata, January 11, 2003
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 governance—
especially accounting, and auditing
11/21/2010 Rethinking Accounting and Auditing 2
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
11/21/2010 Rethinking Accounting and Auditing 3
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 measurement—collectively
referred to as accounting rules
11/21/2010 Rethinking Accounting and Auditing 4
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 door—kept out so far
11/21/2010 Rethinking Accounting and Auditing 5
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
11/21/2010 Rethinking Accounting and Auditing 6
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
11/21/2010 Rethinking Accounting and Auditing 7
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
11/21/2010 Rethinking Accounting and Auditing 8
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
11/21/2010 Rethinking Accounting and Auditing 9
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
11/21/2010 Rethinking Accounting and Auditing 10
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
11/21/2010 Rethinking Accounting and Auditing 11
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
11/21/2010 Rethinking Accounting and Auditing 12
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
11/21/2010 Rethinking Accounting and Auditing 13
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
11/21/2010 Rethinking Accounting and Auditing 14
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?
11/21/2010 Rethinking Accounting and Auditing 15
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?
11/21/2010 Rethinking Accounting and Auditing 16
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
11/21/2010 Rethinking Accounting and Auditing 17
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
11/21/2010 Rethinking Accounting and Auditing 18
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
11/21/2010 Rethinking Accounting and Auditing 19
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?
11/21/2010 Rethinking Accounting and Auditing 20
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
11/21/2010 Rethinking Accounting and Auditing 21
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
11/21/2010 Rethinking Accounting and Auditing 22
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 Rethinking Accounting and Auditing
11/21/2010 23
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
11/21/2010 Rethinking Accounting and Auditing 24
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
11/21/2010 Rethinking Accounting and Auditing 25
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
11/21/2010 Rethinking Accounting and Auditing 26
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
11/21/2010 Rethinking Accounting and Auditing 27
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)
11/21/2010 Rethinking Accounting and Auditing 28
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
11/21/2010 Rethinking Accounting and Auditing 29
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
11/21/2010 Rethinking Accounting and Auditing 30
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
11/21/2010 Rethinking Accounting and Auditing 31
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
11/21/2010 Rethinking Accounting and Auditing 32
11/21/2010 Rethinking Accounting and Auditing 33
11/21/2010 Rethinking Accounting and Auditing 34
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
11/21/2010 Rethinking Accounting and Auditing 35
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
11/21/2010 Rethinking Accounting and Auditing 36
Number of Settlements of Claims
Against Auditors
Frequency by Time Period
300
250
200
150
100
50
0
1960-1964 1965-1969 1970-1974 1975-1979 1980-1984 1985-1989 1990-1995 Unknown
Time Period
11/21/2010 Rethinking Accounting and Auditing 37
Amounts of Settlements Against
Auditors
Total Amount of Settlements
Amount of Settlements
500,000,000
400,000,000
300,000,000
Total
200,000,000
100,000,000
0
67
72
75
78
81
84
87
90
93
96
19
19
19
19
19
19
19
19
19
19
Year
11/21/2010 Rethinking Accounting and Auditing 38
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
11/21/2010 Rethinking Accounting and Auditing 39
Accountants‘ Contributions to
Political Campaigns
11/21/2010 Rethinking Accounting and Auditing 40
Accountants‘ Contributions to
Political Campaigns
11/21/2010 Rethinking Accounting and Auditing 41
Accountants‘ Contributions to
Political Campaigns
Contributi Soft Donatio Donation %
Electi Total Contributi % to
Ran ons from Money ns to s to to
on Contribut ons from Rep
k† Individual Contributi Democr Republic De
Cycle ions PACs ub
2002 s ons ats ans m
27
27 72%
* $7,8 $2,2 $3,3 $2,2 $2,1 $5,6 %
39
2000 28 $8,9 61%
$14,8 $7,0 $5,1 $2,6 $5,7 %
39
1998 26 $3,4 61%
$9,4 $4,5 $1,4 $3,6 $5,7 %
41
1996 21 $6,5 59%
$11,2 $5,0 $4,7 $1,5 $4,6 %
50
1994 23 $6,9 $0.6 49%
$2,6 $3,6 $3,4 $3,4 %
54
1992 29 $3,3 $2,9 46%
$6,3 $3,2 $2,4 $0.5 %
50
1990 27 $1,7 N/A $1,5 $1,5 50%
$3,1 $1,3 %
41
27
Total 11/21/2010 $25,6
Rethinking Accounting and Auditing 42 58%
$59,7 $24,9 $9,0 $24,5 $34,8 %
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)
11/21/2010 Rethinking Accounting and Auditing 43
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
11/21/2010 Rethinking Accounting and Auditing 44
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
the industry pushed
competition in Rethinking Accounting and Auditing it to collapse 45
11/21/2010
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 managers—contingent rewards
• But accounting measures have well-known weaknesses
• Solution: use market-based measures
11/21/2010 Rethinking Accounting and Auditing 46
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
11/21/2010 Rethinking Accounting and Auditing 47
How Did Executive
Compensation Soar?
• Director‘s 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 bottomAccounting changed from 40 to 500
11/21/2010 Rethinking
ratio and Auditing 48
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
11/21/2010 Rethinking Accounting and Auditing 49
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
11/21/2010 Rethinking Accounting and Auditing 50
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
11/21/2010 Rethinking Accounting and Auditing 51
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?)
11/21/2010 Rethinking Accounting and Auditing 52
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
11/21/2010 Rethinking Accounting and Auditing 53
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
11/21/2010 Rethinking Accounting and Auditing 54
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?
11/21/2010 Rethinking Accounting and Auditing 55
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
11/21/2010 Rethinking Accounting and Auditing 56
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
11/21/2010 Rethinking Accounting and Auditing 57
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
11/21/2010 Rethinking Accounting and Auditing 58
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
11/21/2010 Rethinking Accounting and Auditing 59
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
11/21/2010 Rethinking Accounting and Auditing 60
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
claims—whether the financial reports made a fair
representation
• Audit will be driven by economic, not regulatory
considerations
11/21/2010 Rethinking Accounting and Auditing 61
Corporate Governance and
Directors
• Recent emphasis on independence
• Also need competence, industry knowledge,
contacts, and management‘s trust
• Criteria are often in conflict with one
another
• How do we find directors who will have all
these qualifications
• College professors? Unfortunately not
11/21/2010 Rethinking Accounting and Auditing 62
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
11/21/2010 Rethinking Accounting and Auditing 63
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
11/21/2010 Rethinking Accounting and Auditing 64
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
11/21/2010 Rethinking Accounting and Auditing 65
Thank You
http://www.som.yale.edu/faculty/sun
der/research.html
Shyam.sunder@yale.edu
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