Critique of potential IFRS monopoly
I just read an insightful, if not provocative, paper on the shortcomings of a potential IFRS monopoly. The paper entitled, “IFRS Monopoly: The Pied Piper of Financial Reporting,” is written by Shyam Sunder of Yale University, and I recommend it to anyone who wants to form a balanced opinion about whether the US should adopt IFRS as promulgated by the IASB.
The paper is not heavy on data, although it does provide an extensive bibliography for those hungry for data. Instead, the paper critiques the usual arguments made in support of an IFRS monopoly (or exposes those situations where no argument is ever made, but everyone seems to accept the idea as given). Then the paper provides a number of arguments against IFRS as a monopoly along with what I thought were very difficult questions to answer. I’m not saying that I agree with the specific arguments in the paper, but I am persuaded that the arguments should be heard and carefully considered.
I know this topic stirs up lots of emotion among many academics, and responses to this blog are not likely to provide useful input to the FASB per se. However, understanding how standard setters converge standards and how foreign jurisdictions go about adopting and/or endorsing IFRS provides important context within which to understand all other standard setting projects. And at the very least, the SEC is still open to ideas on how to proceed with IFRS in the US, as evidenced by the May 26, 2011 SEC Staff Paper: Exploring A Possible Method of Incorporation of IFRS, and its description of the “condorsement” approach, which seems quite different from pure IFRS adoption. So, take some time to read this paper, and post any reactions you may have here. I look forward to reading them.
Thanks for the post, Jeff, and for the link to Shyam’s paper.
I find it interesting that Shyam (and others) argue that one disadvantage of an IFRS monopoly is that “it eliminates the opportunity to compare alternative practices and learn from them.”
Ironically, a common criticism of attempting to achieve a single set of global financial reporting standards is that the application of IFRS is “so inconsistent [around the world that] it doesn’t result in a single set [of standards].” For more on this latter point, see this article on today’s WSJ.com.
There is a lot in this paper to comment on! For now, I’ll just address this point. Shyam writes (page 16):
The problem with the consumer-farmer example is that it captures a pure exchange economy. The “additional condition” needed is the ability for the firm raising capital to make an investment in real assets that will create value. Being able to raise capital more cheaply allows the firm to invest more in physical, intellectual or human capital, thereby improving social welfare.
By the way, the end of the paper contains abstracts from research papers on IFRS and convergence issues…a very nice resource for anyone interested in the area.
Thank you for the comment.
Neither potato nor corporate economies are “pure exchange” in fact. Pure exchange is a modeling choice or analytical device in which we choose not to analyze the other consequences of the exchange transactions being considered (for the sake of simplicity).
The comment above refers to only one of these “other” consequences of lower price often mentioned in industry and regulatory arguments–corporate investment. It seems to me that welfare analysis of lower prices calls at least for consideration of some other consequences also. In the context of CoC, these include consequences for investors (lower consumption or savings that may follow from lower rates of return); In the context of potato, there are consequences for farmers (lower investment in production) and for consumers (more savings or demand for other goods).
After we analyze these consequences, we may find out if lower prices–of either capital or of potato, or both–are better. Without analysis, we do not know. Simply assuming that lower prices make us better off does not seem prudent.
Thank you for giving me the chance to elaborate on the short paragraph on this subject I included in the paper under reference.
I agree. It is ironic, because:
1. One possibility is that the IFRS project succeeds in its stated goal of making accounting practice uniform/comparable/consistent across the globe. Then, it would no longer be possible to compare the consequences of alternative financial reporting regimes, and to learn from such comparisons to improve accounting practice and standards. This would not be a concern if we could be sure that the standard setters get their standards just right the first time they write them. Recent decades of experience suggests this is unlikely.
2. A second possibility is that the project fails to bring about the hoped for uniformity/comparability/consistency in financial reporting practices, in spite of being adopted in various parts of the world.
I hope there is a third possibility under which the IFRS project may bring about some improvement.
Thanks for the comments, Shyam. I guess my point is that we should either be concerned about alternative methods or we should embrace them, depending on one’s world view. But we should be consistent in our reasoning. Let me explain.
If we think that competitive forces will drive preparers to optimal reporting practices, then allowing diversity in practice (either across standard setting regimes or within a given regime) makes sense. No need for excess regulation here.
If, however, we think that competitive forces will be insufficient to drive preparers to optimal reporting practices, then there may be a role for additional oversight (assuming that one expects standard setters and/or regulators to do a better job than the market).
My point is not which world view is correct. Rather, my main point is this – If we are worried about diversity in practice within a standard setting regime, where transaction costs to changing methods are relatively low, then I would expect even greater concern about diversity in practice across standard setting regimes because the transaction costs involved in switching regimes are so much larger.
By analogy, if we are worried about stock market efficiency when transaction costs and arbitrage opportunities are relatively low, we should surely be worried about market efficiency when those costs are high.
While the cost of capital issue represents a small portion of Shyam’s paper, I think it is very important. I tend to agree with Rob that the cost of capital is more than simply a market clearing price. The most intuitive way for me to express this is in terms of Akerlof’s lemon’s principle (“The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism”. Quarterly Journal of Economics, 1970, 488–500). Akerlof considers how the market for used cars can disintegrate when the sellers have better information about their cars than the buyers. In Akerloff’s stylized example, when the information asymmetry is sufficiently costly, the market can shut down even though by construction, every car in his assumed economy should be sold.
Extend this to an inventor trying to raise capital by selling his latest invention. Suppose he is fairly certain the expected payoff from the invention is $120,000. (For simplicity, assume the time value of money equals zero, meaning a borrower and lender would use an interest rate of zero if both were fully informed). Capital providers have much less precise information than the inventor about the invention, and they fear the inventor is making the invention sound more profitable than it is. So they only offer $100,000.
To me, the inventor is facing a 20% cost of capital. If he accepts, the capital providers will pay $100,000 for something that (with full information) would have been worth $120,000, resulting in an expected return of 20%. This is the premium demanded due to information asymmetry. The inventor may view this cost as too high and decide to dump the project. What would happen if we could reduce the information asymmetry? Capital providers would demand less premium, inventors would be willing to pursue more projects, and social welfare would increase.
Waymire and Basu (“Accounting is an Evolved Economic Institution,” Foundations and Trends in Accounting, Vol 2, Nos 1-2 (2007), pp 1-174 ) discuss evidence of how information affects economic cooperation and how something as simple as bookkeeping can instill trust which reduces transaction costs and improves social welfare. Whether you view the information as reducing information asymmetry or enhancing the ability of the parties to cooperate, the result is the same – change the type of information that exists and you can change the premium demanded by capital providers. Reducing that part of the cost of capital seems to be an unambiguous benefit. If this benefit exceeds the cost of the system being used to improve the information, then I see this as a win-win.