Accounting for Legitimacy

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.”