Whispering in the Ears of Princes Authority and

Whispering in the Ears of Princes: Authority and Academe in Accounting Shyam Sunder Yale University Conference on Critical Perspectives in Accounting, New York, April 26, 2008

Advice on Advice • Advice: blessed are those who give, not receive. Carolyn Wells • Good advice is always certain to be ignored, but that's no reason not to give it. Agatha Christie • I have found the best way to give advice to your children is to find out what they want and then advise them to do it. Harry S. Truman • Too bad that all the people who really know how to run the country are busy driving taxi cabs and cutting hair. George Burns • I have yet to hear a man ask for advice on how to combine marriage and a career. Gloria Steinem • I owe my success to having listened respectfully to the very best advice, and then going away and doing the exact opposite. G. K. Chesterton • The only thing to do with good advice is pass it on. It is never any use to oneself. Oscar Wilde Sunder: Whispering to Princes 2

Whispering to Princes • Roth (1987, 1995) used the metaphor in the context of economics experiments intended to provide advice to policy makers – Roth, A. “Laboratory Experimentation in Economics. ” Advances in Economic Theory, Fifth World Congress. Truman Bewley, ed. Cambridge University Press, 1987. – Roth, A. "Introduction. " The Handbook of Experimental Economics. John Kagel and Alvin Roth, eds. Princeton, NJ: Princeton University Press, 1995. • Perhaps it is appropriate to extend it to accounting research and what accounting academics may sometimes do • In addition to the regulators (the princes of power) that Roth had in mind, we might extend the scope of the term to the princes of commerce and law whose ears may also be receptive to our whispers, or may be sought by us for our own reasons • Let us start with the government and regulators Sunder: Whispering to Princes 3

Government and Regulators • Many aspects of our lives call for collective choice for reasons of efficiency and governments are mechanisms to make such choices in appropriate circumstances • There is no shortage of such arguments, and decisionmaking bodies created in response to such arguments in accounting • Besides general legislative bodies, there exist commissions, boards, councils and committees supported by varying degrees of consent of the governed • What is, and could be, the attitude and role of academics with respect to such bodies? Sunder: Whispering to Princes 4

Regulators’ Problem • Regulators’ major problem is that they do not know what the best course of action in a given situation is • Choosing a course action involves identifying: – – Alternative course of action, The relevant parties Their respective interests How those interests might be affected by the alternative courses of action – �Weighing the interests of and consequences for various parti – And then choosing a course of action – This is a massive amount of information the regulator needs to do this right (even if you assume it has the right incentives) Sunder: Whispering to Princes 5

Difficulty of Finding the Information • In order to concentrate attention on the information problem, let us assume for the moment that the regulator has identified the relevant parties, has an appropriate welfare function for society in its hands, and has the right incentives to choose (i. e. , has not been captured by a group) • It still needs to find out what will be the effect of alternative courses of action on various parties • Why not ask them? • Regulators could, and do, but what are the chances that these parties will disclose their interests, and consequences of proposed alternatives sincerely and non-strategically? • If you ask me, the chances are small Sunder: Whispering to Princes 6

Information in Society is Private and Dispersed • A great deal of information in society (about what individuals want and know) is private to them • There is no way for anyone else (much less an authority) to know this information for sure • Individuals have no incentives to reveal it truthfully except when they think such revelation would serve their own interests • Authority is not trusted to use private information revealed to them in individuals’ best interest • So, authority cannot get it by asking, and may turn to experts for advice Sunder: Whispering to Princes 7

So, the Professor Gets a Call • Could you please advise us on …? (assume that everything is above board and the regulator asks the person it believes knows best) • What do we as experts know that the regulator may not? – – Identity of interested parties? Interests of these parties? Effect of alternatives on the parties? How the interests of various parties should be traded off? • But academics are no more qualified for these tasks than the regulators themselves. This calls for some explanation with respect to the last two items Sunder: Whispering to Princes 8

Do We Know (or Can We Find Out) These Effects? • During the recent decades, it has sometimes been claimed that the effects of proposed or actual regulatory actions on shareholders can be assessed by the change in stock price associated with the action • (Some also claim that the shareholders are the only parties whose interests matter, but we shall not get into that now) • There are two major problems with this approach: assumption of market efficiency and the consequences of market efficiency • Let us talk about each Sunder: Whispering to Princes 9

Assumption of Market Efficiency • That security markets promptly and unbiasedly (and reasonably accurately) reflect the information in the hands of the market participants is a standard assumption in attempts to use the stock market event studies to assess the consequences of financial reporting decisions and events (Sunder 1973) • In other words, using stock market returns to assess financial reports assumes that such reports are irrelevant to how the market reflects information • If informing the markets is one of the presumed functions of financial reporting, this fundamental inconsistency casts doubt on the validity of inferences from event Sunder: Whispering to Princes 10 studies

Consequences of Market Efficiency • Suppose, we set aside the problem of assuming away the effects of financial reports on market efficiency, we are faced with an even more difficulty challenge • Assume the stock markets are perfectly efficient and the regulator announces that it has chosen to implement method A instead of B because it believes that it will raise the stock price. However, being reasonable, the regulator also announces that it will reverse the decision if an event study reveals the action to decrease the stock prices • Will this combination of stock market research and regulatory dependence on it lead to choice of accounting that raises the stock price? The answer is a surprising no. Why? Sunder: Whispering to Princes 11

Problems of Feedback Loops • The problem lies in the anticipatory nature of security markets • The anticipation that tends the markets towards efficiency, also makes the meaning of event studies highly ambiguous • Suppose the “true” effect of choosing method A over B is to reduce the stock price by $10. In an efficient market, we should expect the price to decline by $10 • However, if the price declines, the traders should anticipate that the regulation will be changed to B, and therefore raise the price back to the original level, in which case, regulation A will stay in place, and so on… • Perhaps there are examples where research has led to better policy. We should identify them Sunder: Whispering to Princes 12

Conceptual Frameworks • There is another potential channel for academic contribution • Development of conceptual frameworks and checks on consistency of rules and regulations • Starting with Moonitz and Sprouse at least, academics have played this role for many decades • Again, let us ask what can we academics bring to the table in this respect Sunder: Whispering to Princes 13

Constructivist Perspective • Academics bring a constructivist perspective to the table • In this perspective, decision makers have enough knowledge of the system to choose the right alternative • Based on a Cartesian view of the world • But this approach to public policy has repeatedly been shown to fail miserably whenever it is taken literally and in isolation Sunder: Whispering to Princes 14

Ecological Perspective • In contrast, ecological perspective views the system to consist of interacting parts which influence one another, evolve over time, and are selected by their fitness • In this Darwinian approach, global or even local consistency is not a prime criterion for survival and acceptance of a policy proposal • Both constructivist and ecological orders can, indeed must, coexist Sunder: Whispering to Princes 15

Coexistence • Constructivist order creates/proposes alternatives which may or may not survive in the ecological order • This is the role played by random mutations in Darwinian evolution • Academics can play a role in the constuctivist order by devising and proposing new alternatives—the social mutations, so to speak Sunder: Whispering to Princes 16

Not Many Academics Do That • Unfortunately, not many academics choose to do that • Instead of using the constructivist perspective to generate new alternatives which could swim or sink on their own merits, we tend to take ourselves and our proposal too seriously, and are overly confident of their superiority over status quo • However, superiority of a social system cannot be established without trial and error through the rough and tumble of experience Sunder: Whispering to Princes 17

“Fair Value” Accounting • As an example of this over-confidence, consider the so-called fair value accounting – I say so-called because it is an old rhetorical device to label the alternative you favor as being good before the debate starts (e. g. , Unified Budget Act 1965, Patriot Act 2002) • It emerged from constructivist order of things • There is nothing wrong with that as long as we take it as a possibility, and not be too confident about its superiority even before it has been tried out • But the regulators and some of their academic advisors were too confident of their ex ante assessments and look at the consequences we are going through at this very moment Sunder: Whispering to Princes 18

Academics Live by Consistency • As instructors and researchers, logical consistency is the coin of our realm • We pursue it in our classes and exams (marking the students down when we catch them in an inconsistency) • We pursue it in our research, workshops and the publications process • This key criterion of the constructivist order occupies most if not all of our attention in academia • It does not leave much space for the messier outcomes that evolve out of the ecological order Sunder: Whispering to Princes 19

GAAP is from Ecological Order • Yet, the very idea of generally accepted accounting principles (GAAP) in financial reporting is from the ecological, not constructivist, order • Components of what is generally accepted rarely show much logical consistency • Look at the products of ecological order we live with: – Social norms, family behavior, natural languages, common law, and GAAP – Contrast with computer languages and the attempts to put a constructive order in the domain (Esperanto died) Sunder: Whispering to Princes 20

Pushing Too Hard • When given the chance to whisper to princes, far too often, academics push their constructivist perspectives or agendas too hard • Looking at accounting as an engineering construction problem (but even engineers and architects build their models and test them out before ordering the bricks) • We tend to ignore the ecological order that we must simultaneously live with • And sooner or later, we are not lent the ears to whisper to Sunder: Whispering to Princes 21

Being on the Table • This happened to the President’s Council of Economic Advisors a couple of decades ago • In the historic events and regulatory changes of the recent years, accounting academics have played bit parts at most • And they are in the process of being dropped from the FASB • May be that is a good thing. We should think about it and discuss it Sunder: Whispering to Princes 22

Going Forward • What can we academics do? • Recognition of the two parallel orders which do, and must coexist: constructivist and ecological • Exclusive reliance on one (creating and implementing new solutions) or the other (things are best the way they happen to develop by themselves without intervention) would not do • Its implications for research (contents of our journals are like unfiltered water, imbibing them directly is risky to your financial health; wiser to wait for a while until ideas get debated and filtered) • And for policy (make proposals, not prescriptions to be tried but not imposed) Sunder: Whispering to Princes 23

Policy Research and Engagement • Policy research in accounting as a dirty word • Need more thinking, writing, research and debate within the larger ecological order of accounting • Academics can play as keepers of conscience of society • Some free thinking, muckraking, investigation, exposure, with passion • Tradition of Briloff (now Sikka) Sunder: Whispering to Princes 24

Summary • Be careful accepting money, lest we censor ourselves • Think the role of academics beyond classroom, journals, internal service and consulting • Perhaps then, our whispers will help create a better world • We shall be heard, even if not listened to Sunder: Whispering to Princes 25

Thank You! Shyam. sunder@yale. edu www. som. yale. edu/faculty/sunder