Accounting for Legitimacy

 
 
New Book: With little scrutiny from the public, industry experts are quietly rewriting accounting rules to benefit their businesses, says Karthik Ramanna in a new book, Political Standards: Corporate Interest, Ideology, and Leadership in the Shaping of Accounting Rules for the Market Economy.
  • Author Interview

Accounting for Legitimacy

Interview by Roberta Holland

Certain critical accounting rules are being subtly shaped to reflect the interests of small groups of informed corporate experts, according to a new book by Harvard Business School accounting and corporate accountability expert Karthik Ramanna.

Those shifting the rules often see their actions as being within the legitimate purview of corporate profit seeking. But over time, the changes can lessen competition and damage the health of the economy.

“Getting accounting rules right is important to the functioning of capital markets and eventually of a market economy”

The relatively unconstrained ability of a few experts to shape the rules by which they operate is due to what Ramanna calls a “thin political market,” a term he coins in his new book Political Standards: Corporate Interest, Ideology, and Leadership in the Shaping of Accounting Rules for the Market Economy.

Two factors in particular define a thin political market: the colocation of experiential expertise and commercial interest among a few; and low awareness of the issues at stake among the general public.

These features, Ramanna says, create a lack of competition in the rulemaking process and allow groups with a vested interest to shape their own standards.

That kind of market capture poses risks to the economy.

“Getting accounting rules right is important to the functioning of capital markets and eventually of a market economy,” Ramanna says. “If those metrics of performance are undermined, then capital is less likely to find its most productive use. The misallocation of capital can adversely impact the health of the economy; it can also impact the distribution of income and wealth within a society.”

Even for those who aren’t substantial investors, this skewing of the system “can come back to bite,” Ramanna says.

Accounting is not the only thin political market. Ramanna points to auditing standards, actuarial standards, and bank governance as other possible thin political markets. But he focuses on the context of accounting rules in his book, culled from a decade of research on the topic.

“The intent of the book was to search for the whole that was greater than the sum of its parts,” Ramanna says. “In the process of trying to integrate across my studies, I came across what would become the central thesis of the book—the notion of thin political markets.”

THE POWER OF ARCANE KNOWLEDGE

Both the experiential expertise and lack of general interest are important factors, he says. If conceptual expertise were enough to craft standards, then academics and other non-special interests could intervene in the process. “But a lot of the expertise that’s necessary to adjudicate in thin political markets is born of what we call tacit knowledge—learning by doing,” Ramanna says. “So we rely on industry experts to provide information and feedback on what would constitute good regulation in this context.”

Low issue salience is also key. Other areas that may be just as technical, like social security and health care, avoid becoming thin political markets because the press or politicians often intervene, reflecting the public’s attention to these issues. “But it’s hard to imagine politicians running for office campaigning on accounting-rule reform. It’s too abstruse a topic. Likewise it’s hard to imagine newspapers routinely focusing on the nitty-gritty of accounting,” Ramanna says. Even financial publications usually write about accounting issues at a general level.

Thin political markets can “thicken” following a major event that causes a spike in public attention, even though the subject matter remains esoteric. He points to accounting rules requiring the effective expensing of stock options. A push to pass those rules failed in the 1990s, but succeeded in the wake of the Enron and WorldCom scandals in 2002.

“Something like the financial crisis can play an important role and, perversely, a beneficial role for the public because it raises issue salience,” Ramanna says.

BORING AND COMPLEX

That spotlight can be fleeting, though.

“It’s hard to imagine that the kind of public interest necessary to prevent capture can be sustained for an extended period of time, because these issues are so complex; they’re so technical,” Ramanna says. “Quite frankly they’re boring issues to the general public.”

Accounting rules have become more complex, which Ramanna attributes to both the general rise in business complexity and efforts by special interests to carve out rules favorable to them. In the case of the latter, Ramanna doubts the “incentives to game the system” have changed much over time.

Ramanna points out that it’s not always the same special interest groups molding accounting rules in their favor. Tech firms get involved when the issue relates to them, likewise for investment banks. When they’re not affected directly, even expert groups step back from the table, likely because the cost of being informed is so high.

“So what happens is you show up when you really have an interest in an issue and that’s also when you likely have the deepest experiential expertise in the issue, which is why the regulators tend to rely on your advice,” he says.

The gaming of the system usually happens not because managers are evil, but because they are behaving as expected in a competitive market, Ramanna says. “They are embodying the spirit of Milton Friedman, ‘The social responsibility of business is to increase its profits.’”

But, Ramanna adds, profit-seeking is legitimized by the premise of competition, and in the absence of competition, as in thin political markets, that legitimacy breaks down. “There are certain rules of the game, as Friedman himself said, that are necessary to get a capitalist system to work. If you get those rules of the game wrong, then you undermine capitalism. What you get might be closer to an oligarchic system.”

The antidote for a thin political market is not a sudden embrace of arcane issues. “Nobody grows up wanting to be an accounting professor,” Ramanna jokes. The solution, he believes, is raising awareness of the consequences of using the rules of the game to create competitive advantage. If managers see thin political markets as a competitive opportunity rather than a leadership responsibility, then the market system as a whole can be compromised.

“A place to start is the classroom. When we teach economics, we should also encourage reflection on what makes profit-seeking behavior legitimate; what is the moral philosophy of capitalism,” Ramanna says. “Raising these questions in the minds of students is a step toward a solution. It’s a first step. The nature of thin political markets is such that there isn’t a quick, neat institutional fix. A more robust education in leadership is part of a generational fix.”

  • Book Excerpt

My Own Private Company Council

from: Political Standards: Corporate Interest, Ideology, and Leadership in the Shaping of Accounting Rules for the Market Economy by Karthik Ramanna, taken from Chapter 8, “Political Standards: Lobbying in Thin Political Markets.” © 2015 University of Chicago Press
by Karthik Ramanna

The accounting rule-making process is an esoteric world, ensconced in a shell of specialist knowledge and removed from the eyes of the unschooled public. In this sense, it is largely immune from the dangers of populist policy making (although populism has from time to time been effectively wielded as a weapon in shaping rule-making outcomes, most notably in the case of determining accounting rules for employee stock options). But this technical world is not immune to political dynamics, as the preceding chapters have shown. Put differently, in the United States and beyond, across industrial companies, financial institutions, and audit firms, and over both substantive issues and the design of relevant institutions, the corporate accounting rulemaking process is at once deeply technical and political.

Those with the knowledge to shape accounting rules—corporate managers, defined to include auditors, bankers, and other financial intermediaries—accumulate such knowledge because of their experience and their concentrated economic interests in the outcome of the rule-making process. Conversely, those with dispersed interests—ordinary savers and the average citizen—rarely enjoy the expertise necessary to engage productively in rulemaking; acquiring such expertise is economically unviable given their limited interests. Accordingly, the political process of accounting rule-making is largely attended by a handful of keen special interests and largely ignored by the general interest. And, not surprisingly, the outcomes of this process, in several instances, skew toward the special interests and away from conceptual expectations of what accounting rules should look like.

In their efforts to shape accounting rules, the special interests have been aided from time to time by seemingly independent experts, including academics. For example, chapter 5 introduces evidence that academics who have served on the FASB since the mid-1980s have been unequivocally supportive of fair-value accounting. The overwhelming support for fair values among academics serving on the FASB is in contrast to the more contentious status of fair-value accounting in the wider academic community. The data suggest that academics on the FASB may have been selected for their predisposition to fair-value accounting—to provide conceptual validation to the special-interest groups advancing fair values. This explanation, if true, suggests that the regulatory model of the determination of GAAP is more nuanced than that derived from a straightforward application of capture theory. Rather, the regulatory model can be described as one of “ideological capture,” where prevailing special-interest groups co-opt certain conceptual arguments and associated experts to advance their agendas in the political process.

Furthermore, while a certain special interest might capture the political process in a given instance, there is little evidence of comprehensive capture. On a given issue, those with the strongest incentives and the deepest expertise have the loudest voice and an important say in the outcome. But the portfolio of accounting rules to be determined is broad—spanning all sectors of the economy—and the expertise necessary in each instance is considerable. Thus a special interest on one issue can be part of the general interest on another. Special-interest capture in accounting rule-making appears to be localized; the system itself is not beholden to any one group.

The behavioral model emerging from this description of corporate accounting rule-making is the pursuit of self-interest by participants during the political process. This is true of the corporations and investment banks lobbying on M&A and goodwill accounting in chapter 3, the Big N audit firms protecting themselves from liability in chapter 4, the investment banking and investment management professionals serving on the FASB seeking fair-value accounting rules in chapter 5; the Chinese state-controlled enterprises and the Indian multinational carving out self-serving protections in chapter 6, and the private-company interests pushing for their own regulator in chapter 7. Participants from across the spectrum seek to increase their own profits as they engage in the accounting rule-making game. This behavior is entirely consistent with the competitive spirit that underlies capitalism. Indeed, it embodies the moral imperative of competitive strategy, as Milton Friedman and many others have pointed out.

But capitalism encourages self-interest on the premise of competition; and competition—particularly competition from groups representing ordinary savers and citizens—is uncharacteristic of the accounting rule-making process. Thus the pursuit of profit, which otherwise engineers markets away from iniquitous amassment of wealth and power toward aggregate prosperity, produces a quilt of special-interest concessions in accounting rulemaking. This outcome is what I characterize as “political standards.”

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