Accounting, Organizations and Society. Vol. 5: No. 1, pp. 65-69. Pergamon Press Ltd, 1980. Printed in Great Bntain.

Discussion of Policy Models in Accounting: A Critical Commentary

PAUL A. GRIFFIN

Graduate School of Business, Sanford University

Professor Buckley’s paper is an attempt to explain why the U.S. accounting profession has adopted the so-called “constitutional” approach for evaluating and selecting financial accounting and reporting policies. Today, according to the author, this approach is the one followed by the Financial Accounting Standards Board. It is embodied in the Board’s publications relating to the conceptual framework project (e.g. FASB Statement of Financial Accounting Concepts No. 1, “Objectives of Financial Reporting by Business Enterprises”, November 1978).

Buckley argues that the two major competitors to the constitutional view - the “common law” or “legal” approach and the “scientific” or “empirical” approach - may not adequately protect the interests of the public accounting profession. He concludes that the constitutional approach has been “a rational, reasonable, and probably necessary choice”, but that certain reforms are needed if the approach is to continue to be effective. Reforms are needed that will broaden the constituency and increase the responsiveness of standard setters to all those organizations and individuals to whom they are accountable and responsible.

The paper refers to both standards for accounting and financial reporting and standards or rules to regulate auditing and other services provided by public accountants. While the policy-making processes of the FASB and the AICPA have much in common, and, sometimes may be the same thing (see, for example, FASB Exposure Draft, “Specialized Accounting and Reporting Principles and Practices in AICPA Industry Accounting Guides, Industry Audit Guides, and Statements of Position”, 1 June, 1979), I shall concentrate my remarks on the standard-setting process for financial accounting and reporting. There are several reasons for this.

First, the bulk of the paper is devoted to that topic. Second, I have just recently returned from a one-year appointment with the FASB as academic fellow and research specialist. Third, one project on which I acted as consultant while at the FASB was the Board’s project on criteria for selecting and evaluating financial accounting and reporting policies. This project is intended to be the second major “block” in the Board’s conceptual frame- work. Certain material in this document ties in with Professor Buckley’s remarks.

This leads me to my first point. Professor Buckley is to be congratulated for identifying the need to evaluate the present accounting policy model, and to develop a more rigorous under- standing of that model as it relates to certain alternative approaches or views toward policy formation. Analysis of the kind embodied in this paper has an important role to play in the standard-setting process. I agree with the author that the FASB’s approach as reflected in the Statement on the objectives of financial reporting and the forthcoming proposed Statement on selecting and evaluating financial accounting and reporting policies is basically constitutional in its orientation. But it is well to note that Buckley’s “words of caution”, which emanate from his analysts, are addressed in these conceptual framework documents - especially the Exposure Draft on selecting and evaluating financial accounting and reporting policies. The Exposure Draft should be published in August 1979 with a comment period of 3-4 months. I will explain more of this later.

The remainder of my remarks are divided into two sections. One examines aspects of the methodology used to “test” the principal hypothesis. The other is a commentary on some of the more normative portions of the paper.

How does Professor Buckley demonstrate that

65

66 PAULA.GRIFFIN

the constitutional policy model for “. . . setting accounting standards and regulating practices . .” can be adequately explained in terms of the “ . . market-oriented, self-enhancing propensity of the public accounting industry?” An important element of this research design is to consider whether the group self-interest hypothesis can be justified. In what manner does the author determine whether higher prices exist (achieved by restricting output, increasing demand, or erecting barriers to entry) relative to those that would exist under some benchmark competitive economic system? While several responses by the public accounting profession to the “public” or “collec- tive” good problem are noted (e.g. licensing requirements), the discussion contains little to convince the reader that such collective actions or responses capture net benefits for the profession to the detriment of the public - i.e. are consistent with the self-interest hypothesis.

In my view, the one or two shreds of available evidence suggest something different. The public accounting profession appears reasonably competitive and, if anything, prices in real terms are more likely to have remained fairly stable in recent years, rather than increased. The benefits of such pricing decisions would seem to be accruing largely to the users of such services. This trend has apparently been exacerbated by the new rules of the AICPA which permit certain forms of advertising [see, for example, Bernstein (1978) and Anreder (1979)] . More recently, analysis of the pricing of audit services by Simunic (1979) leads to a similar conclusion - that the market is competitive. At least the null hypothesis could not be rejected. Simunic adds that the Big Eight public accounting firms may enjoy scale economies which, potentially, are passed onto clients in the form of lower prices.

On a much less well-documented basis, I offer some additional observations. First, possibly increased barriers to entry do not seem to have diminished the numbers obtaining professional qualification. Students’ willingness to invest large sums in an accounting (and business) education seem more widespread than ever. Second, certain services provided by accounting firms have expanded rather than diminished. This is especially the case in the management services division of the profession where, according to a recent Business Week (1979) survey, the growth by accounting firms has far outstripped the growth by many of the traditional specialist management consulting

firms. A third situation is the concern of the pro- fession to ease costly regulatory burdens for pre- parers and users of accounting services who are involved with small and/or closely-held business operations, despite the potential for diminished revenues from such clients. Already the profession is well along in defining what should constitute generally accepted accounting principles and report- ing standards for small and/or closely-held business enterprises.

Additionally, in the area of supplementary disclosure, an evolving concept of limited auditor review may be seen as another example of consideration by the profession not for its members but for the ultimate users of accounting information and the public in general. Of course, given a potential for increased risk when auditing data such as current cost information, one could counter-argue that the concept of limited auditor review is also consistent with the self-interest hypothesis. Only detailed empirical analysis will, of course, help decide which view is to prevail.

The next step is that, even if one accepts that the public accounting profession has restricted entry, restrained supply, or otherwise acted in a way so as not to confer net benefits on the public, a link must be established between the accounting firm’s characteristic of self-interest and its choice of the constitutional view in preference for some other approach to policy decision making. A key question is whether the self-interest hypothesis is a necessary condition - one that must be present if the constitutional approach is utilized.

Consider Buckley’s arguments in favor of the constitutional approach. He states that the needs for power by auditors and for control over accounting policy have “biased much of the ‘theoretical’ effort in the direction of their interests”. Why is this? From Buckley’s perspective, it appears that the legal or common law alternative is unacceptable for reasons such as courtroom histrionics, loss of accounting influence to the legal profession, increased use of common sense by the lay jurist, and the need to apply social cost vs social benefit calculus. Further, the scientific or empirical approach is unacceptable due to a possible loss of accounting influence to outside academics and potentially increased costs of audits which are the results of the application of new scientific discoveries. Buckley then discards these two alternatives to leave a third - the constitutional approach - as the appropriate selection of a policy model.

DISCUSSIONOF POLICYMODELSINACCOUNTING:ACRITICALCOMMENTARY 67

Apart from what I believe to be a less-than- complete analysis of the pros and cons of the various approaches, the salient issue in my judgment is that Professor Buckley does not establish the self-interest proposition as a necessary and sufficient condition. To elaborate, it does not seem too difficult to conceive of a legal rule-making process that is capable of maintaining or increasing accountants’ interests just as some groups in society are supposedly advantaged by the present judicial process. The same could be said of the scientific approach. Certain work pertaining to the stock market impact of FAST Statement No. 19 was sponsored by those who supported the continued use of full cost accounting in the oil and gas industry. Additionally, during the hearings of the SEC during March and April 1978 much effort was made by supporters of the full cost method to question other independent studies on the issue of capital market impact. The point is that scenarios can probably be constructed wherein each of the policy approaches are consistent with self- interested group behavior. Conversely, behavior that is oriented to the interests of the public (not the private interests of auditors) can also be viewed as consistent with the constitutional approach. Indeed, such behavior or activity might best characterize the standard-setting process for accounting and financial reporting as we observe it today.

To summarize, Buckley presents an interesting and provocative hypothesis. I am not convinced, however, that the constitutional approach and the accounting profession’s self-interested behavior are linked in the manner he describes. This is not to say that a positive theory cannot be developed to explain the active involvement of public accountants (and corporate management) in the standard-setting process. Sunder (1979) for instance, argues that a group will seek to either encourage accounting changes or maintain the status quo only when the cost of transfer from one group to another is high and the particular accounting issue has potentially significant wealth effects. An observation that accountants do not move into other groups given significant wealth effects would be consistent with the views of Sunder. But many would regard the accountant’s skills and experience as valued highly outside public accounting. Especially at the lower ranks, public accounting firms are plagued with high rates of turnover.

As I mentioned earlier, the FASB is placing the finishing touches on its Exposure Draft, “Criteria for Selecting and Evaluating Financial and Reporting Policies”. This document is intended to portray a policy model, to give guidance to the Board, financial statement preparers, auditors, and others who must choose between available alternatives. The policy alternatives covered by the Exposure Draft include choosing the attributes of assets and ,liabilities to be measured, selecting methods of cost allocation, and deciding on levels of disaggregation and formats for disclosure. The document, implicitly, views the FASB as a social choice institution with a due process mechanism that allows for participation by a diverse constituency of preparers, auditors, users, govern- ment, academics and members of the general public.

Qualities of useful information and the criteria for choice that they imply are set forth in detail. The Exposure Draft notes that the “. . . criteria, however, cannot always be expected to produce agreement on a preferred choice. The Board must try to balance the needs of all members of its constituency, yet the preferences of different individuals and groups will not always coincide. Individual or private interests will, therefore, at times have to be sacrificed in selecting that accounting or reporting policy most useful to all”

(P. vi, with emphasis added). A hierarchy of informational qualities is defined with decision usefulness at its head. The other (lower level) criteria include relevance, reliability, timeliness, understandability, verifiability, representational faithfulness, materiality, comparability and cost vs benefit.

In a nutshell, this Exposure Draft, together with Concepts Statement No. 1 and the due process procedures of the FASB, would seem to have pre-empted much of Professor Buckley’s call for reform. Certainly, the FASB seeks input from a very broad constituency which extends well beyond auditors and public accountants. A detailed analysis and review of due process may be found in the “Report of the Structure Committee of the Financial Accounting Foundation”, April 1977 and the more recent “Interim Review of the FASB and FASAC”, issued by the same Committee in May 1979.

There are two other matters on which I should comment. The first is Buckley’s view that the present constitutional approach may be threatened by scientific or empirical findings. The second is

68 PAUL A. GRIFFIN

that the constitutional approach may be ineffective in dealing with political realities.

First, I believe that empirical evidence is becoming an increasingly recognized and accepted element of the standard-setting process at the FASB. Since 1977, the Board has engaged in a major effort to assess the economic consequences of its standards. Moreover, several of the FASB Research Reports have employed modern capital market research techniques to assess investor response to proposed standards. Similar future studies are planned. Another trend at the FASB is an interest in adequately documenting and understanding users’ needs for financial information. In part, the initial phases of the conceptual framework carry a distinct and important research responsibility. Alexander (1979) has described this responsibility as a desire to “. . . identify and relate to the stated objectives of financial reporting (and hence the standard- setting process) those items of financial information that groups within society (1) demand by nature of their decision-making relationship with the enterprise, (2) supply as managers of the enterprise, and (3) are willing to verify as auditors”. This users’ needs focus would seem to suggest a rich set of research questions and issues of economic consequence.

As a further commitment to the importance of research methodology and research findings, the FASB in July 1978 created the position of research specialist. As the first appointment to this position, I consulted with all project managers on questions of research input, its evaluation and analysis, and its relationship to the policy decision. A good deal of time was spent on examining research that pertained to the project to evaluate FASB Statements Nos. l-12. For a description of some of the evidence on economic consequences that was brought to bear upon the policy process regarding FASB Statement No. 8 see Griffin (1979). In short, the evaluation of empirical research forms a vital component of the activity which precedes the issuance of an FASB document (e.g. a discussion memorandum, exposure draft, statement, etc.).

Second, with respect to political pressure, the FASB’s standard-setting process is relatively well

shielded from direct intervention. The methods of runding, the openness of Board meetings, the availability of a public record, and the need to weigh the concerns of all members of the constituency provide a fairly thick layer of insulation. But the SEC has oversight power and must use this on occasion in carrying out its legal and congressionally-mandated duties, as it did with FASB Statement No. 19. It is very difficult to argue, however, that the suspension of Statement No. 19 was caused by a disregard for political consequences.

Contrary to Buckley’s assertion regarding political ramifications, the standard-setting process is not oblivious to expected political (and economic aspects) of accounting policy decisions. There is, of course, unanimous agreement that no rules should be designed to achieve national political goals or deliberately benefit one group to the disadvantage of another. Such rules, if enacted, would not be neutral or even-handed and would most likely destroy the credibility of the entire standard-setting process itself. But, even-handed rule-making does not obviate a need to constantly monitor the activities of congressional committees and other law-making groups. The FASB has a Washington office and is officially registered as a lobbyist for this purpose. Sometimes the Board must enter the political arena, especially if the successful implementation of a standard is crucially dependent on a decision by non-SEC branches of government. Presently, the FASB is making every effort to ensure that compliance with the proposed standard for supplementary reporting of the effects of inflation and changing prices will not jeopardize a taxpayer’s election of the LIFO inventory costing technique.

To conclude, then, I have reservations concern- ing Professor Buckley’s self-interest characterization of the public accounting profession, and I am not persuaded by his arguments that such self-interested behavior is necessarily linked to the constitutional approach. Certain of the reforms that Professor Buckley proposes would seem to have already been implemented, particularly as they relate to standard setting for financial accounting and reporting.

DISCUSSION OF POLICY MODELS IN ACCOUNTING: A CRITICAL COMMENTARY 69

BIBLIOGRAPHY

Alexander, M. O., Research for Financial Reporting by Business Enterprises: The Role of the Fiicial Accounting Standards Board. In J. Davies (ed.) Accounting Research Convocation 1978 (University of Alabama, forthcoming, 1979).

Anreder, S. S., Profit or Loss: Price-Cutting is Hitting Accountants in the Bottom Line, Burrons (12 March 1979), pp. 9, 18, 20 and 31.

Bernstein, P. W., Competition Comes to Accounting, Fortune (17 July 1978), pp. 87 -96. Business Week, The New Shape of Management Consulting: A Splintering into Speciality (21 May

1979), pp. 98-104. Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. I, Objectives

of Financial Reporting by Business Enterprises (FASB, November 1978). Financial Accounting Standards Board, Exposure Draft, Specialized Accounting and Reporting

Principles and Practices in AICPA Industry Accounting Guides, Industry Audit Guides, and Statements of Position (FASB, 1 June 1979).

Financial Accounting Standards Board, Exposure Draft, Criteria for Selecting and Evaluating FinanciaI Accounting and Reporting Policies (FASB, forthcoming, 1979).

Griffin, P. A., What Harm Has FASB 8 Actually Done? Harvard Business Review (July-August 1979), pp. 36.

Simunic, D. A., Determinants of Prices of Financial Audit Services, unpublished doctoral dissertation, University of Chicago, 1979, as reported in Nicholas Dopuch and Dan Simunic, “The Nature of Competition in the Auditing Profession”, paper presented at the UCLA Conference on Regulation and the Accounting Profession: An Exploration of the Issues, 24-25 May 1979).

Structure Committee of the Financial Accounting Foundation, The Structure of Establishing Financial Accounting Standards (FAF, April 1977).

Structure Committee of the Financial Accounting Foundation, Inierim Review of rhe FASB and FASAC (FAF, May 1979).

Sunder, S., Towards a Theory of Accounting Choice, unpublished manuscript, Graduate School of Business, University of Chicago (June 1979).