Political Standards

Corporate Interest, Ideology, and Leadership in the Shaping of Accounting Rules for the Market Economy

Karthik Ramanna

• Editorial: University of Chicago Press
• Año: 2015
• ISBN:
  9780226210889
• Categoría: Negocios y empresa
• Categoría: Negocios en general

Prudent, verifiable, and timely corporate accounting is a bedrock of our modern capitalist system. In recent years, however, the rules that govern corporate accounting have been subtly changed in ways that compromise these core principles, to the detriment of the economy at large. These changes have been driven by the private agendas of certain corporate special interests, aided selectively—and sometimes unwittingly—by arguments from business academiaWith Political Standards, Karthik Ramanna develops the notion of "thin political markets" to describe a key problem facing technical rule-making in corporate accounting and beyond. When standard-setting boards attempt to regulate the accounting practices of corporations, they must draw on a small pool of qualified experts—but those experts almost always have strong commercial interests in the outcome. Meanwhile, standard setting rarely enjoys much attention from the general public. This absence of accountability, Ramanna argues, allows corporate managers to game the system. In the profit-maximization framework of modern capitalism, the only practicable solution is to reframe managerial norms when participating in thin political markets. Political Standards will be an essential resource for understanding how the rules of the game are set, whom they inevitably favor, and how the process can be changed for a better capitalism.

1

Introduction

When I first conceived the idea for this book, I imagined it would focus exclusively on making an assessment of the accounting rule-making process for corporations in the United States and beyond. Corporate accounting rules are a critical institution in modern market capitalism, essential to mitigating collusion and information asymmetry and to promoting the efficient allocation of capital across diverse competing projects. I have been studying this process for several years, so a comprehensive report on that investigation seemed appropriate and timely. And indeed, a substantial portion of this book (chapters 2–7) presents such a report.

But the book goes beyond an assessment of the state of accounting rule-making. As I started to put this book together—and reflect on my findings, searching for the “whole” that would integrate the numerous distinct studies I have conducted in this area—I came to realize that the book ought to be much broader. Because the accounting rule-making process offers a window into a central aspect of the functioning of market capitalism: the nature and challenge of what I define as “thin political markets.” By this I mean a political process of designing essential technical rules of the game in areas where substantive expertise lies with vested interests and where the general interest is usually not involved. Beyond accounting rule-making, areas such as banking supervision, insurance regulation, and standards for auditing and actuaries can be thin political markets.

Thin political markets present a paradox. There is nothing explicitly illegal about constituents lobbying in the accounting rule-making process for outcomes that are likely to increase their own reported profits. These constituents’ actions, as I document in this book, essentially embody the capitalist spirit, as Milton Friedman famously argued: “The social responsibility of business . . . is to increase its profits.”1 But the “invisible hand” that usually aggregates and equilibrates self-interested profit-seeking behavior in markets into a collective prosperity that legitimizes capitalism does not manifest itself in the thin political market of accounting rule-making. By their very nature, thin political markets are one-sided and unrestrained vis-à-vis the general interest. In this sense, they are distinct from “thick” political processes, where the general public is engaged (either directly or through intermediaries) or where expertise for regulation does not necessarily reside largely with vested interests.2

Toward the end of the book I introduce in more detail the notion of thin political markets and offer an inductive definition that I hope future research will expand upon and refine. Then I begin to outline a solution to the challenge of thin political markets. I note that in pursuing profit-increasing behavior in the conduct of commerce, managers are acting in the context of the ethical framework that legitimizes capitalism. Without this framework—which lays out the logic for how the individual pursuit of profit aggregates to a collective good—profit-seeking behavior is morally empty. What makes profit-seeking “a social responsibility” (in Milton Friedman’s words) is the very sound reasoning at the heart of capitalism—a reasoning powerfully articulated by Adam Smith and, more recently, by economic Nobelists as ideologically diverse as Kenneth Arrow, Friedrich Hayek, Paul Samuelson, and Amartya Sen.3 This is not to say that corporate managers are not self-interested or that absent some ethical grant made by capitalism, corporate managers would not pursue their own profit but rather that were it not morally virtuous and ethically sound, the pursuit of self-interest would not be so overt and unabashed.

The logic of profit-increasing behavior is the logic of competitive markets. As the empirical evidence in this book will demonstrate, this logic breaks down in thin political markets. Here, the distinction between thin and thick political markets is also germane. In a thick political market (e.g., the political market for universal health care)—with a vibrant, deliberative process, diverse views well represented, and expertise dispersed across interest groups—the profit-seeking approach to lobbying might indeed be ethically tenable. But the absence of competent opposition in a thin political market obviates the ethical foundations for profit seeking. In this specific context, the capitalist spirit of “rent extraction” is no longer virtuous.

When lobbying in a thin political market, corporate managers assume an agency responsibility for the market system as a whole and, eventually, for the citizens in whose interests market capitalism must function virtuously. So just as there is widespread recognition among managers of their agency responsibility to corporations and shareholders—a recognition that is imbued in them via business schools and corporate codes as a moral duty (in addition to being a legal duty; in fact, it is a legal duty because it is moral)—so too must we create a recognition for managerial agency of the system when lobbying in thin political markets. This is a key takeaway from the book.

What comes next is a detailed introduction to the book. I begin with an example from the area of accounting rule-making for corporate mergers and acquisitions (M&A). The example illustrates the phenomenon at the core of the evidence and analysis in this book: the problem of thin political markets. Later in the introduction, I provide an outline of the chapters that follow.

*

Mergers and acquisitions between and across companies are a critical institution of our modern market-capitalist economy. They allow companies to fold into each other to unleash synergies that can sustain and grow the economy. Furthermore, they constitute a core element of the “market for corporate control”—the process by which floundering companies and their managements are held to account by the rigors of the marketplace, embodying the creative destruction at the heart of capitalism. From 1980 to 2012, M&A activity in the United States totaled roughly $44 trillion, about 15 percent of U.S. gross domestic product (GDP) over that period.4 The central issue in M&A is the price to be paid in an acquisition; decades of academic research has revealed that managers often overpay in M&A, perhaps because they are overconfident in their ability to realize synergies or because they are unreasonably driven to build scale into their existing organizations.5

Given that M&A can either generate value for shareholders and society or, alternatively, be misused by “empire-building” management teams, it is important to hold managers to account for their M&A activities, particularly for an acquisition’s purchase price. This is largely accomplished through corporate financial reporting. Without financial reporting that matches the costs of an acquisition to its benefits, investors could be led to reward managers who increase the scale of their companies but decrease their value through overpriced acquisitions. As such, accounting rules for M&A are a key accountability institution in capital markets. A particularly relevant area of M&A accounting—relevant to the purchase price of an acquisition—is “goodwill accounting.”

Goodwill is the excess of the purchase price in an acquisition over the current value of all purchased assets less the current value of all assumed liabilities. In other words, goodwill is premium paid over the verifiable value of the acquired firm. It generally represents the conjectural “future profits” that an acquiring manager hopes to realize through an acquisition. Research has shown that, on average, acquiring CEOs overestimate on the date of acquisition the amount of goodwill than can be realized.6 How goodwill is accounted for is thus critical to the accountability of M&A transactions.

Since 2001, the formal rules or Generally Accepted Accounting Principles (GAAP) in the United States that govern goodwill accounting have compromised this accountability role in subtle ways. To see this requires a brief plunge into accounting principles. “Income” in accounting is defined as revenues minus expenses. A core principle underlying traditional historic-cost accounting income is to match expenses to their associated revenues. In other words, to get a useful income number for a given year, we want the year’s revenues to be matched with the costs—including investments from previous years—that were needed to generate those revenues. In the case of measuring income from an M&A deal, the revenues are those generated when imagined synergies become real sales to customers. The corresponding costs are numerous, but they include the value of goodwill acquired—that is, the premium paid in the M&A. Since the revenues from actualized synergies can occur over many years following an M&A in a process that is not measurable with any certainty, the traditional historic-cost way to account for M&A is to take a predetermined proportion of a firm’s goodwill balance and treat it as a cost each year (e.g., one-tenth of the goodwill balance each year for ten years). In fact, this was the rule that defined goodwill accounting in several cases prior to 2001—a process known as goodwill amortization (the maximum allowed goodwill amortization period was forty years).

But since 2001, firms have not been required to draw down their goodwill balance each year. Instead, they are required to determine for themselves whether their goodwill is “impaired.” Not surprisingly, a CEO who overpays in an M&A is not particularly keen to publicly acknowledge that overpayment, so instances of firms declaring their goodwill as impaired are rare. What this means is that if an M&A was successful—and the acquiring firm generates the synergies it imagined at acquisition—the firm’s income recognizes the revenues from those synergies but not all of its costs, resulting in a double-counting of sorts. This violates the basic premise of traditional accounting. Alternatively, if an M&A is unsuccessful, and imagined synergies are for naught, investors and other users of accounting information can be left waiting for true accountability from managers; it takes a particularly earnest CEO to admit that he or she overpaid for an acquisition. In fact, research shows that goodwill impairment is more likely to occur under new CEOs, who take a “bath” on their predecessors’ accumulated goodwill balance.7

Why would the goodwill accounting rule change matter if even a few sophisticated investors are able to undo its effects, reconstructing what firms’ income statements and balance sheets would have looked like under the old rules through some accounting analysis? Partly because summary accounting numbers such as net income and net assets—which are both affected by the rule change—are sometimes predictably associated with stock prices, reflecting market inefficiencies.8 And partly because such summary accounting numbers are used in a host of formal commercial contracts, such as executive bonus contracts, debt contracts, and supplier contracts. As a matter of economy, these contracts are generally written on GAAP rules; it is costly for contracting parties to redefine accounting rules on an ad hoc basis.9

Thus one likely consequence of the goodwill accounting rules since 2001 is compromised accountability for M&A. Then a natural follow-up question is: How did the 2001 accounting rules for M&A come to be?

The answer lies in a deeper understanding of the arcane process through which accounting rules are determined. At the heart of this process is the Financial Accounting Standards Board (FASB), the country’s accounting rule-maker. In 1999, the FASB, partly in response to pressure from the U.S. Securities and Exchange Commission (SEC), which oversees the nation’s stock markets and publicly listed securities, decided to reevaluate the accounting rules for M&A. What followed was an unusually long and political process that, importantly, involved the country’s biggest investment banks: Goldman Sachs, Merrill Lynch, and Morgan Stanley. Investment banks, by the nature of their business, have an interest in issues related to M&A, including the accounting rules used by their prospective clients. As the opportunity to revisit these rules came up, the investment banks became key players in the private rule-making process. First, they saw their allies in the U.S. Congress lambast the FASB for its initial proposed replacement to the extant M&A accounting rules. Then representatives from the banks met with the FASB to advance their own proposals. They lobbied for rules that looked very similar to the ones that eventually ended up as the final FASB standard on goodwill accounting—that is, they advocated the abolishment of goodwill amortization and the introduction of the rules for goodwill impairment.

To be sure, the old rule—goodwill amortization—was far from perfect; treating a predetermined portion of a firm’s goodwill balance as an expense each year is arbitrary. Moreover, the SEC had been concerned about abuses of other extant M&A accounting rules (unrelated to goodwill per se), which was part of the impetus for the 2001 rule change. So compromised accountability for M&A under the current goodwill rules is the outcome of complex bargaining that comingled many issues. But given the repercussions of compromised goodwill accountability to the integrity of M&A and capital markets, there is, nevertheless, cause for concern.

How did a handful of special interests shift such a core accounting rule? Why was the shift not bigger news as it happened? Who looks out for the interests of common citizens and retail investors in the political process that determines the accounting rules?

In this book, I address these questions through a broad analysis of the corporate accounting rule-making process in the United States and beyond. Apart from the accounting community, this analysis can be of interest to scholars of the market economy, policy makers, and executives in business more generally. After all, accounting rules are at the heart of measuring corporate performance, securing corporate accountability, and facilitating capital allocation in a market economy.

*

Since the early 1970s, corporate accounting standard setting in the United States has been formally vested in the FASB, a small group of accounting rule-makers, incorporated as part of a private not-for-profit organization, the Financial Accounting Foundation (FAF). But neither the FASB nor the FAF holds a congressional charter to make accounting rules for corporate America. Rather, this authority comes from the SEC, which has been charged by Congress since its establishment in the 1930s with the determination of accounting standards for publicly listed companies in the United States.10 The SEC has for almost all its history relied on private bodies to draft and promulgate accounting standards. This delegation of public responsibility to private interests implicitly recognizes that neither Congress nor the SEC have direct substantive knowledge and experience in the matters that inform accounting standards. The expertise necessary to create accounting rules—familiarity with ever-mutating business practices, their evolving methods of account, and emerging technologies to audit such accounts—resides in the private sector.

But inherent in the idea of private rule-making is the fear that private interests will come to subvert the public’s benefit through opportunistic rule-setting. In fact, two private bodies were delegated the accounting rule-making role prior to the FASB—the Committee on Accounting Procedure (1939–59) and the Accounting Principles Board (1959–73)—and both these bodies met their demise in part because of concerns about their lack of independence from private interests.11 Speaking in 1971 of the need to ...