Accounting for Policy in
Accounting Economics and Law
Shyam Sunder, Yale University
Accounting for Accounting in Economics
Laboratory for Aggregate Economics and
Finance
University of Santa Barbara, Nov. 8-9, 2013
An Overview
• Robustness of what we think we know
• Optimization as a structural principle
• Examples
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LIFO-FIFO accounting, taxation and securities
Security price indeterminacy
Corporate employee options
Attempts at policy relevant research
Endogeneity of transactions
Endogeneity of standards
Regulation and policy
• Tax-Financial reporting conformity
• Audit profession
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How Robust are Our Laws in Social Sciences
• To serve as a basis for social policy, the “laws” of social sciences
must have stability (be robust to their own discovery)
• Since humans learn and adapt, social science findings can alter
behavior in ways that tend to invalidate the findings
– Something like le Chatelier’s Principle in chemistry, though in social
sciences we have examples of both counteraction as well as cases of
cascading
• Findings which are robust to such adaptation can be called “laws”
of social sciences, and may serve as the basis for social policy
• Both economics and accounting have suffered from premature
claims of discovery of “laws” which turn out not to have the
necessary robustness property
• If we were more careful in our claims, perhaps there would not be
such flurry of theorization after our models turn out out to be wrong
spectacularly, e.g. in the financial crises that occur after agents
adjust their behavior to the wisdom of our received theories.
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Problem of Building a Theory of Choice
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This challenge of social sciences is exemplified in difficulties of building a
theory of choice
From the science end: axiomatization of human choice as a function of
innate preferences: people choose what they prefer
How do we know what they prefer? Look at what they choose and reveal
The circularity between preferences and choice might be avoided if there
were some permanency and consistency in preference-choice relationship
across diverse contexts
One could observe choice in one context, tentatively infer the preferences
from these observations, and assuming consistent preferences, predict
choice in other contexts
Unfortunately, half-a-century of research has yielded little predictability of
choice from inferred preferences across contexts (Friedman, Isaac, James
and Sunder 2014 forthcoming book)
Individual human behavior appears to be unmanageably rowdy to capture in
a stable set of laws
Humanists can hardly be surprised (if they pay any attention at all to choice
theory)
But all is not lost
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Optimization as a Structural Principle:
Physics
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Optimization as a Structural Principle:
Biology
• “At multiple hierarchical levels--brain, ganglion, and
individual cell—physical placement of neural
components appears consistent with a single, simple
goal: minimize cost of connections among the
components. The most dramatic instance of this "save
wire" organizing principle is reported for adjacencies
among ganglia in the nematode nervous system; among
about 40,000,000 alternative layout orderings, the actual
ganglion placement in fact requires the least total
connection length. In addition, evidence supports a
component placement optimization hypothesis for
positioning of individual neurons in the nematode, and
also for positioning of mammalian cortical areas.”
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Optimization as a Structural Principle:
Insects
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Optimization as a Structural Principle
• Is it applicable to humans?
• When humans tend to optimize, should we see it
structurally, or cognitively?
• It gets wrapped up in debates about cognitive
abilities, and our own self-image
• If we interpret it cognitively, how do we explain
the movement of ants, neurons, and photons
• Is the optimization principle applicable to social
systems including economics?
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Smith (1962) Chart 1
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Laws with Predictive Content in
Social Sciences
• Simple economic theory: point of intersection of demand
and supply determines price and allocations
• Economists’ have had deep faith in theory, nobody
knew for sure that it works
• Until Vernon Smith’s (1962) experiment in his classroom
(where motivated students traded) double auction
provided the evidence that the law of supply and
demand has reasonable predictive power
• Predictive power at aggregate level, although individual
behavior is not predictable
• But does the result arise from human intelligence and
striving, or is an aggregate level property of the market
mechanism?
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What Makes the Difference
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Why Equilibrium without Individual
Optimization
• Why do the markets populated with simple
budget-constrained random bid/ask strategies
converge close to Walrasian prediction in price
and achieve close to 100% allocative efficiency
• No memory, learning, adaptation, maximization,
even bounded rationality
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Inference
• The structure, not the behavior of participants, accounts
for the first order magnitude of outcomes in competitive
settings
• Computers and experiments with simple agents opened
a new window into a previously inaccessible aspect of
economics
• Ironically, it was not through computers’ celebrated
optimization capability
• Instead, through deconstruction of human behavior
– Isolating the aggregate (social) level consequences of simple or
arbitrarily chosen classes of individual behavior
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Properties of Accounting
Systems
• It has not been shown yet,
• But it would be useful for us to study the
aggregate level properties of accounting
systems, not just of the individuals who
populate the world of accounting, and not
just of each component of the accounting
system
• Properties of the whole are not the same
as the properties of the components
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Some Examples
• LIFO-FIFO accounting, taxation and
securities
• Security price indeterminacy
• Corporate employee options
• Attempts at policy relevant research
• Endogeneity of transactions
• Endogeneity of standards
• Regulation of auditing profession
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What happens to stock price
earnings and cash flow in conflict?
• LIFO accounting for inventories
• In periods of inflation and non-decreasing
inventories, accounting earnings are lower
• But cash flows are higher
• Sunder 1973: Look at a sample of firms
which adopted LIFO and gave up LIFO
over about 20 years
• Set aside other problems of self-selection
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•
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Did that Settle the Issue?
• WSJ: “Market Smart of Dumb??
• Followed by 100’s of phone calls from corporate CFOs,
wanting to know the results of my dissertation
• In spite of the great advantages of cash flow, most NYSE
firms in fact had not adopt LIFO
• The Murphy question posed for stock options hanged in the
air for LIFO: What is keeping them from saving a bundle of
cash?
• From scores of their letters and phone calls, it seemed clear
that all CFOs seemed to be afraid that if they adopted LIFO to
conserve cash, the hit to their reported earnings will lower
their stock price
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Relax the Common Knowledge
Assumption of Rationality
• Amershi and Sunder 1987: What if we relax the
assumption is common knowledge without
giving up on rationality of anyone
• If managers believe (which they apparently do)
that the shareholders will follow the earnings not
cash flows, you can end up in an equilibrium
where it is best for managers (even if they are
compensated based to stock prices) to maximize
earnings, not cash flows.
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Some Examples
• LIFO-FIFO accounting, taxation and
securities
• Security price indeterminacy
• Corporate employee options
• Attempts at policy relevant research
• Endogeneity of transactions
• Endogeneity of standards
• Regulation of auditing profession
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Bubbles and Price
Indeterminacy in Asset Markets
• Hirota and Sunder 2006 JEDC
• We use PV model for fundamental valuation
using common knowledge assumption
• That is unlikely to hold, especially in markets
with short term investment horizon traders
• Relax the common knowledge assumption
• Without common knowledge assumption, there
is no reason for prices to tend towards the
common knowledge fundamental value
• And that is what we see in the prices
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Long-term Horizon Session
Period 1
Period 15
(Trade)
D
Single terminal dividend at the end of period 15.
An investor’s time horizon is equal to the
security’s maturity.
Prediction: Pt = D
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Figure 4: Stock Prices and Efficiency of Allocations for Session 4
(Exogenous Terminal Payoff Session)
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Short-term Horizon Session
Period 1
Period x
(Trade)
Period 30
Ex (Px+1)
D
Single terminal dividend at the end of period 30.
The session will “likely” be terminated earlier.
If terminated earlier, the stock is liquidated at the
following period predicted price.
An investor’s time horizon is shorter than the
maturity and it is difficult to backward induct.
Prediction: Pt  D
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Figure 10: Stock Prices and Efficiency of Allocations for Session 8
(Endogenous Terminal Payoff Session)
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What About Decision Making with
and without CK of Cash Flows?
• We examine the data to see which model
fits best
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Models of Expectations
• Backward induction (Fundamental) Model: 0 <   1:
Et ( Pt 1 )  Pt   ( D  Pt )
• Forward induction (1): Adaptive model, 0 <   1:
Et ( Pt 1 )  Et 1 ( Pt )   ( Pt  Et 1 ( Pt ))
• Forward induction (2): Trend model,   0 :
Et (Pt 1 )  Pt   (Pt  Pt 1 )
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Price Expectation Model Estimates:
Long-Horizon Sessions
Dependent Variable: Et (Pt+1) - Pt
Model
Const.
D  Pt
Fundamental
(5)
6.146
(5.603)
0.267 *
(0.102)
Adaptive
(7)
5.305
(6.523)
Trend
(8)
3.330
(5.713)
Hybrid
(9)
7.553
(6.721)
Et-1 (Pt)  Pt
Pt  Pt-1
2
N
0.086
100
0.046
100
0.182
(0.340)
0.001
100
0.270
(0.248)
0.097
100
0.454
(0.446)
0.199 **
(0.072)
0.566
(0.297)
R
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Price Expectation Model Estimates:
Short-Horizon Sessions
Dependent Variable: Et (Pt+1) - Pt
Model
Const.
D  Pt
Fundamental
(5)
3.543
(4.593)
0.077
(0.042)
Adaptive
(7)
19.851 **
(6.869)
Trend
(8)
5.809
(4.411)
Hybrid
(9)
4.808
(3.244)
Et-1 (Pt)  Pt
Pt  Pt-1
2
N
0.092
166
0.010
166
0.467 *
(0.196)
0.349
166
0.829 **
(0.164)
0.506
166
0.113
(0.149)
0.027
(0.027)
0.543 **
(0.179)
R
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Using Historical Data for
Forward Induction
• Traders use historical data to project the
future because in absence of CK about the
future they have no alternative
• What is the rationale for depriving them of
that anchor?
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Some Examples
• LIFO-FIFO accounting, taxation and
securities
• Security price indeterminacy
• Corporate employee options
• Attempts at policy relevant research
• Endogeneity of transactions
• Endogeneity of standards
• Regulation of auditing profession
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Some Examples
• LIFO-FIFO accounting, taxation and
securities
• Security price indeterminacy
• Corporate employee options
• Attempts at policy relevant research
• Endogeneity of transactions
• Endogeneity of standards
• Regulation of auditing profession
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Problems of Inference from Field
Data: Hypotheticals and Efficiency
• Our attempt to produce policy-relevant research
often take the following form:
• Info. Sys. 1

Price system 1
• Info. Sys. 2

Price system 2
• Suppose information system 1 and price function
1 are the status quo and the policy maker wants
to know the consequences of changing the
information system from 1 to 2
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Problems of Inference from Field
Data: Hypotheticals and Efficiency
• We can gather data on accounting numbers and prices
under status quo and estimate their statistical
relationship, R(1)
• In many situations, we can also calculate (or reasonably
estimate) what the accounting numbers would have
been under the policy alternative (the hypothetical)
• If we could observe prices that would be generated
under the policy alternative, we could also estimate the
statistical relationship R(2)
• Does a comparison of R(1) and R(2) help the policy
makers?
• If stronger R(2) implies preference for the policy
alternative, it is trivially simple to push R(2) to the upper
limit by simply using prices for accounting
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Problems of Inference from Field
Data: Hypotheticals and Efficiency
• Of course, we are rarely so lucky as to be able
to observe P(2)
• An oft-used practice is to estimate the statistical
relationship between the hypothetical I(2) and
actually observed P(1), and then compare this
R(2)* with R(1) and suggest that a stronger
R(2)* implies the alternative to be preferred
policy
• Info. Sys. 1

Price system 1
• Info. Sys. 2

Price system 1
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Logic of Inference
Reporting System 1
Reporting System 2
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Price System 1
Price System 2
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Logic of Inference
Reporting System 1
Reporting System 2
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Price System 1
Price System 2
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Logic of Inference and Policy
• This type of inference from field data does
not help the policy makers
• We like them to give us a nod to
acknowledge our work, and perhaps even
support it
• But the logical foundations of such
inference, and its implications for policy
remain to be worked out
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Some Examples
• LIFO-FIFO accounting, taxation and
securities
• Security price indeterminacy
• Corporate employee options
• Attempts at policy relevant research
• Endogeneity of transactions
• Endogeneity of standards
• Regulation of auditing profession
7/29/2017
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Policy
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Some Examples
• LIFO-FIFO accounting, taxation and
securities
• Security price indeterminacy
• Corporate employee options
• Attempts at policy relevant research
• Endogeneity of transactions
• Endogeneity of standards
• Regulation of auditing profession
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Some Examples
•
•
•
•
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•
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LIFO-FIFO accounting, taxation and securities
Security price indeterminacy
Corporate employee options
Attempts at policy relevant research
Endogeneity of transactions
Endogeneity of standards
Policy and Regulation profession
– Conformity of tax and financial reporting
– Auditing Profession
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Chances of Success of Recent
Reforms and Proposals
• I am pessimistic
• None of the fundamental problems have been
addressed
• Nothing structural has been changed
• PCAOB: With all due respect, a few years later,
we shall be looking for the person who can be
blamed for inventing the idea that a few
hundred, or thousand, people can figure out if
auditors are doing their job right
– Can we reduce the number of bank robberies by
appointing watchmen to watch the guards?
• Let me move to what can be done
(c) Copyright 2004 Shyam Sunder
What Can We Do?
• Solutions need to fundamental, structural and
robust
• One is already on the table: Prof. Ronen
– Integrate insurance and audit
– Firm decides how much, if any, financial fraud
insurance to buy
– Insurance firm decides on audit and the premium to
charge (insurance and premium are made public)
– No need for government oversight, except an
accounting court (Leonard Spacek’s idea from more
than four decades ago)
• I shall present a second idea of my own
(c) Copyright 2004 Shyam Sunder
Tax and Financial Reporting
• Ninety years of drift between financial and tax
reporting
• Separate optimization: minimize taxes,
temptation to boost performance reported to
shareholders
• Increasing audit burden on IRS
• Increased incentives to lobby Congress for
corporate tax breaks
• Falling effective tax rates for corporations
• Push, push, push for lower taxes, even as IRS
budgets get tighter
(c) Copyright 2004 Shyam Sunder
Financial Reporting on the Other
Hand
• Push, push, push for better quarterly
performance driven by high powered
compensation contracts
• Financial reporting and governance failures
• Difficulties of auditors faced with managers who
might lose millions because the auditor says no
• Rock bottom audit fees driven by competition do
not allow much resources for substantive testing,
so “analytical review” would have to do
• Auditor incentives and independence problems
(c) Copyright 2004 Shyam Sunder
Management Plays Two Games
• One to the IRS, who must spend resources it
does not have to get the revenue the exchequer
deserves
• The other to the shareholders to persuade them
what a great job they have done to deserve a
pat on the back and a tidy bonus (stock options)
• Integrate two games into one
• Congress could see this in 1947 (LIFO)
– Gave that up in the seventies
(c) Copyright 2004 Shyam Sunder
Tax Return = Income Statement
• Tax returns of public corporations are
public
• Financial reports = tax return + balance
sheet + cash flow statement +
management discussion + footnotes
• Could the two bookends of tax and
financial reporting lean on each other to
yield outcome which are better?
• What would happen?
(c) Copyright 2004 Shyam Sunder
Consequences
• By managerial choice
– Tax returns would be less aggressive
– Financial reports would be less aggressive
• Save on significant auditing costs
– By IRS
– By independent auditors
• Less Government regulation in financial reporting
• Less corporate lobbying on the Hill
• Scaling down of FASB and SEC Chief Accountant’s
Office
• A smaller auditing profession
(c) Copyright 2004 Shyam Sunder
Auditing Regulation & Breakdown:
Misapplication of Economics
• Antitrust laws and professions
– Unobservability of quality, restraint, Akerlof
(market for lemons)
• 1960-70s: the cult of competition, Stigler
(robustness of competition), misapplication of
economic theory
• 1977-78: Supreme Court (Bates vs. Arizona Bar)
• US D of Justice and FTC: new professional
codes of ethics for doctors, lawyers, accountants
etc.
• AICPA implements it in 1979
(c) Copyright 2004 Shyam Sunder
Law, Economics and
Accounting Failures
• 1980: sharp drop in audit prices begins, no profit, new
business model (analytical review, consulting, internal
transfer payments, and wage adjustments for recruits)
• Consequences played out for two decades
• Sharp drop in stock market exposes the accumulated
skeletons in the closet
• None of the problems, especially the impossibility of
attaining a reasonable market equilibrium in a market
where the quality of the service essentially unobservable
to the customer has been addressed yet
• PCAOB has been handed an impossible task
• People who make laws and policy do not understand
accounting, and accountants do not get into policy
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An Overview
• Do we think we know things that we don’t?
• Optimization: behavioral or structural principle
• Economics and accounting: disciplines with falsifiable propositions
about the world, or self-contained logical structures with no empirical
implications/imperfections?
• Some examples
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–
–
–
–
–
–
–
–
LIFO-FIFO accounting, taxation and securities
Security price indeterminacy
Corporate employee options
Attempts at policy relevant research
Endogeneity of transactions
Endogeneity of standards
Regulation and policy
Tax-Financial reporting conformity
Audit profession
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Thank You!
[email protected]
www.som.yale.edu/faculty/sunder