Social Norms vs. Standardization in Accounting

If you have ever seen me go on and on about how modern accounting departments are more concerned about keeping with the "letter of the law" than the "spirit of the law," well, now a Yale School of Management professor is making a similar argument.

The spate of accounting and auditing failures of the recent years raise questions about the wisdom of this transition from norms to standards. Many aspects of family, local, professional, social, national and international behaviors continue to be governed by mechanisms in which norms play an important role. It is possible that the pendulum of standardization in accounting may have swung too far, and it may be time to allow for a greater role for social norms in the practice of corporate financial reporting.

Then there is this gem from the paper itself.

The consequences of rule making bodies went beyond the behavior of corporations and auditors. Investment bankers would call the rule makers and try to obtain assurance about the transaction they had devised with the goal of evading one or another aspect of fair representation would pass the muster. If they could get an affirmative answer, they could collect fat fees from their clients; otherwise it was back to the drawing board for minimal modifications that might clear the bar. The rule book of the accountants thus became a road map for evasion from fair representation. Given their intent, the Wall Street financial engineers calling the FASB to clear their plans, is analogous to a thief calling a homeowner to ask when he plans to leave for work.

I mean, come on, next they will be asking what the definition of "is" is.

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Most people don't realize there are grey areas in accounting, but there are. For example, how much variance is considered material? A client about to get written up will give you a different answer than the auditor that figured out the variance.

I ran this by Mrs. Businesspundit (aka CPA, MBA, Valedictorian, auditor extraordinaire etc. so you should believe her) and she said it depends. So I gave her an example. Assume you are auditing a large company that has lots of complex contracts. They explain their revenue recognition policy to you, but if you apply the policy, it appears they have recognized 4% more revenue this year than they should have. Is that material?She said "it depends."

So I said "what if they just happened to barely make their quarterly numbers, reported last week? Doesn't that mean the variance was problemably intentional?"

She said, "it depends" and pointed me to FASB Statement of Financial Accounting Concepts no. 2, which basically says it is a judgement call.

The point is that accounting is not as simple as debits and credits. And what financial engineers do is figure out all kinds of complex ways to meet what FASB says without really accomplishing the goal that FASB was trying to accomplish by establishing the standard.

Overall the paper is pretty interesting, and you don't have to know that much accounting to follow it. So, go read it. You'll be a better investor or a better manager by learning not to trust the financial engineers.