Is less really better?
By Karim Jamal
Illustration: Mike Constable
Recent corporate scandals give us reason to question what's been gained after seven decades of accounting regulation
The need for financial market regulation is often justified by the potential for market failure arising from the information gap between managers — who possess inside information — and investors (information asymmetry), as well as from misaligned incentives (moral hazard). However, very little attention has been paid to the potential for regulatory failure. After the dot-com bubble, all market agents (directors, auditors, financial analysts, accounting standard setters) can be asked why they failed to prevent the scandals that engulfed companies such as Enron, WorldCom and Tyco. New laws in the US (Sarbanes-Oxley Act) and new Canadian independence rules indicate that the predominant view among legislators is that we need more regulation, more severe penalties, and larger enforcement budgets to protect financial markets from fraud.
However, since financial markets have been regulated for the past 70 years, the same question can be asked of the regulators — why did they fail to protect investors from fraud?
We could be even more impolite and ask whether too much (misguided) regulation is making financial markets more vulnerable to fraud. Regulators could just as likely be the cause of our problems as the solution.
Standardization of accounting
Since the early 1960s, there has been an explosion in the number of accounting and auditing standards issued by government (or quasi-government) standard-setting boards. In the US, this standardization has been accompanied by an extensive codification of very detailed accounting rules. This divergence between US rules-based and Canadian principles-based standard-setting approaches has spawned a debate about the effect of rule specificity on the quality of financial reporting. Do more specific accounting rules, which allow less judgment, lead to a more transparent and better financial reporting system? Do they lead to situations, like the tax system, where the complexity of the rules makes it easy to find loopholes and legally reduce taxes owed, in ways not contemplated by the government?
It is often asserted that the lesson to be learned from Enron and other scandals is that Canadian GAAP is too loose and needs to be more like US GAAP.1 While this is possible, that Canadian GAAP is being trashed due to scandals that occurred under US GAAP and US regulatory structures is too ironic to ignore. Simple logic suggests that we could just as easily argue that Canadian GAAP is superior and the US should adjust its GAAP to become more like ours (principles based).
The recent corporate scandals and the dot-com bubble give us reason to pause and question what we have gained after seven decades of accounting regulation. While it is easy to demand even more regulation, one has to at least ask whether we might be better off by reducing regulation in accounting, just as in other parts of the economy.
Accounting research on regulation
Recent academic research has begun to focus on the effects of regulation, starting from the pre-Securities and Exchange commission era (1920s) through to the 1990s. The main measures used to assess the quality of earnings is the proportion of variability in stock prices explained by earnings and the amount of excess return an agent can earn by having advance access to accounting earnings numbers. For the most part, the key finding is that these regulatory bodies have had no significant effect on the information content of financial statements.2 There is virtually no evidence that the usefulness of financial statements has increased after seven decades of government regulation. The usual academic debate is about how much the information content of financial statements has declined over time.3 While it is clear that regulation has not improved the information content of accounting numbers, an argument could be made that the information content of financial statements would have been impaired even more in the absence of regulation. These studies can also be used to argue that more regulation is needed to improve the information content of financial statements by recognizing intangibles and other items such as stock options expense that are not currently recognized in financial statements.4
Academic research on auditing has begun to focus on why the auditing profession got into trouble, particularly in the 1990s. The collapse of Arthur Andersen and a widespread belief that there was a deterioration of audit quality is the basis for asking questions about what happened in auditing.5 While this research is just starting, it is clear that the actions of regulatory bodies had a major impact leading to the current troubles of the auditing profession. In 1978, the Federal Trade Commission (FTC) in the US demanded the American Institute of Certified Public Accountants remove all its rules on advertising, solicitation, fees and even restrictions on contingent fees. The hollowing out of the code of ethics, together with a demand that audit firms should compete and be more commercialized, is a major precipitating factor in the current problems of the auditing profession. So far no one has demanded accountability from the FTC, or from other bodies regulating securities markets such as the SEC, and the Ontario Securities Commission. Where were these bodies when the code of ethics of the auditing profession was under attack? Why didn't they fulfill their role of protecting investors? The auditing profession appears to be the victim of very misguided regulation. Before we demand reforms from audit firms (which may be required), the entire regulatory structure of the auditing profession needs to be re-examined.
Since field results are subject to multiple interpretations, recent research conducted at the University of Alberta, in conjunction with research partners at Yale University, has used experiments to get a different understanding of how regulation affects market behaviour. The key findings of this research are:
1) In a field experiment of unregulated e-commerce markets in the US, we found 90% of websites honour their privacy policies and follow good business practices. About 5% engage in aggressive business practices, and about 5% are outright scoundrels.6 When we replicate this study in the UK (governed by stringent EU law and with extensive government enforcement) we find virtually identical results. About 5% of websites in the UK are also scoundrels. In fact, the regulated scoundrels in the UK are even more extreme in their behaviour.7 This is consistent with the fact that the most extreme financial reporting fraud (Enron, WorldCom) happened in the most highly regulated securities market in the world (the US). These results are also consistent with George Benston's critique8 that the extensive US securities market regulation does not actually improve the quality of accounting or disclosure in the US relative to that in other countries such as the UK. Dan Thornton makes a similar argument about the efficacy of US GAAP relative to Canadian GAAP.9
2) In unregulated e-commerce (US) markets, we find that management appears to understand the importance of disclosure and the need to create consumer trust in the integrity of the business. Good disclosure is easy to find, and an attempt is made to make it meaningful for the average reader. In the regulated UK market, we find the opposite. The lawyers take over the disclosure process. They provide as little useful disclosure as possible, and they make it hard to find and understand their disclosures. The UK websites completely lose sight of the customer and the purpose of the disclosure. Now it seems to be just a legal compliance issue. Again the parallel to financial reporting is striking when you read the Enron notes to the financial statements which appear to have been meant to obfuscate rather than inform the reader about the activity of the firm.
3) In interactive computer experiments with senior Canadian financial executives,10 we find that reducing the amount of discretion in accounting rules makes it harder for managers to report a smooth pattern of earnings. Managers who cannot use accounting discretion to smooth need to have foresight about the effects of their operating decisions in order to manage the actual future cash flows of the firm. Reduced accounting discretion causes managers to become more myopic in their operating decisions since they have limited foresight about the future consequences of current actions. Managers also reduce the absolute level of investments they make in their firm. Changes in accounting rules alter how the firm is managed, and a variety of theoretical models11 indicate that attempts to have very specific accounting rules could end up hurting the shareholders. In their zeal for "correct" accounting numbers, regulators could depress investment and employment in the economy.
The research on regulation of accounting and auditing is just starting to amass a body of evidence. To date, the early evidence suggests that poor regulation may be a major cause underlying the malfunctioning of accounting and auditing. So far, no one has directly challenged the regulators and questioned the usefulness of the very high volume of new regulations being issued. The demand by regulators that a variety of soft numbers (e.g., stock option expense, intangibles, fair value reporting) be recognized in financial statements may be the biggest threat to the integrity of financial reporting. The decision to harmonize Canadian GAAP with US GAAP is also more likely to lower, not raise, the quality of accounting in Canada. One has to wonder why there is so little debate in the CA profession while a noticeable deterioration occurs in the quality of both accounting and auditing in Canada.
Karim Jamal, PhD, CA, is the Alexander Hamilton Professor of Business at The University of Alberta. He can be contacted at karim.jamal@ualberta.ca
Technical editor: Michel Magnan, PhD, FCA, associate dean, John Molson School of Business, Concordia, and Lawrence Bloomberg chair in accountancy
References
1. Rosen, Al and Rosen, Mark. "Canada's GAAP not good enough," The National Post, September 17, 2003.
2. Ely, K. and Waymire, G. "Accounting standard setting organizations and earnings relevance: Longitudinal evidence in NYSE common stocks," 1927-93. Journal of Accounting Research, 37:2 (Autumn 1999): 293-317.
3. Lev, B. "On the usefulness of earnings and earnings research: Lessons and directions from two decades of empirical research," Journal of Accounting Research, 27, (Supplement 1989):153-192.
4. Lev, B. and Zarowin, P. "The boundaries of financial reporting and how to extend them," Journal of Accounting Research, Vol 37(2), Autumn 1999: 353-385.
5. Zeff, S. "How the US accounting profession got where it is today," Part I. Accounting Horizons, September 2003.
6. Jamal, K., Maier, M. and Sunder, S. "Privacy in e-commerce: reporting standards, disclosure and assurance services in an unregulated market," Journal of Accounting Research, 41(2), May 2003a: 285-309.
7. Jamal, K., Maier, M. and Sunder, S. "Evolution versus general acceptance: A comparative study of e-commerce privacy disclosure in the US and the UK." Working paper, University of Alberta, Iowa and Yale University. 2003b.
8. Benston, G. J. "The value of SEC's accounting disclosure requirements," The Accounting Review, 44 (July 1969): 515-532.
9. Thornton, D. "The GAAP's in their logic," The National Post, September 25, 2003.
10. Tan, H.C. and Jamal, K. "An experimental investigation of the effect of accounting discretion on the reporting of smooth increasing earnings." Working paper, University of Alberta, 2003.
11. Demski, J. S. "Performance measure manipulation," Contemporary Accounting Research, 15(3), 1998: 261-285.
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