Reflections On The State Of Accounting Research And The Regulation Of Accounting

Michael C. Jensen Harvard Business School MJensen@hbs.edu

Abstract I have two separate but related topics to cover today. The first is a critical appraisal of the state of accounting research, and the second is an analysis of current trends in the regulation of accounting practices and where they are leading us. Research in accounting has been (with one or two notable exceptions) unscientific. Why? Because the focus of this research has been overwhelmingly normative and definitional. As a result, the field has produced remarkably little theory or evidence bearing on positive issues. I am not claiming that accounting lacks theories. Quite the contrary; accountants promulgate "theories" (Edwards and Bell [1961], Sprouse and Moonitz [1962], Chambers [1966], ASOBAT [1966], Ijiri [1967], Sterling [1970]), as rapidly as the SEC increases disclosure requirements. But in accounting the term "theory" has come to mean normative proposition. I do not intend my emphasis here on positive analysis to imply that normative issues regarding what should be are unimportant. Neither academics nor professionals, however, will make significant progress in obtaining answers to the normative questions they continue to ask until they make a more serious attempt to develop a body of positive theory. It is in this sense that I believe much of what is classified as accounting research is useless. The dearth of positive theory explains the almost complete lack of impact of normative accounting research on professional practice. Furthermore, the belief held by many professionals that the new "Professional Schools of Accounting" will somehow improve accounting research, itself implies a disappointment with the payoffs from past accounting research. This failure has not been quite as dramatic in the managerial accounting area where issues such as capital budgeting and transfer pricing have received considerable attention. Stanford Lectures In Accounting: 1976 (Graduate School of Business, Stanford University, Palo Alto, California, 1976), PP. 11-19. Copyright 1976. Michael C. Jensen. All rights reserved.

You may redistribute this document freely, but please do not post the electronic file on the web. I welcome web links to this document at: http://papers.ssrn.com/abstract=321522. I revise my papers regularly, and providing a link to the original ensures that readers will receive the most recent version. Thank you, Michael C. Jensen

Reflections On The State Of Accounting Research And The Regulation Of Accounting

Michael C. Jensen* Harvard Business School MJensen@hbs.edu Stanford Lectures In Accounting: 1976 (Graduate School of Business, Stanford University, Palo Alto, California, 1976), PP. 11-19.

Introduction I feel somewhat uncomfortable speaking to such an august body of professional and academic accountants as this. Though accounting was one of my main interests during my graduate studies at the University of Chicago, since leaving Chicago in 1967 I have been primarily interested in finance and economics. My colleagues at Rochester, however, have helped maintain my involvement in accounting by consolidating many of the weekly Finance and Accounting Workshops. In any case, I apologize in advance for what are sure to be some gaps in my knowledge of the accounting literature. I have two separate but related topics to cover today. The first is a critical appraisal of the state of accounting research, and the second is an analysis of current trends in the regulation of accounting practices and where they are leading us. Much of what I have to say today is the result of insights I have gained from discussions with my colleagues at Rochester: George Benston, Bill

*I am indebted to Jerold Zimmerman, Ross Watts, William Meckling, and Richard Fortner for their comments, criticisms, and su3gestions.

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Meckling, Philip Meyers, Ross Watts, and Jerold Zimmerman. I have borrowed freely from their ideas, and in some sense what I have to say today represents my assessment of what I might immodestly label the emerging Rochester School of Accounting. Ross Watts, in particular, has waited patiently for me to produce my first draft of a paper on the theory of accounting that he and I have been trying to write for several years. Many of the ideas we have discussed appear here. Unfortunately, none of these people can be held responsible for my errors of fact or understanding. Finally, I'm indebted to Price Waterhouse and Stanford University for giving me the opportunity to explore these topics with you. A Critical Appraisal of Accounting Research In my opinion, research in accounting has been (with one or two notable exceptions) unscientific. Why? Because the focus of this research has been overwhelmingly normative and definitional. As a result, the field has produced remarkably little theory or evidence bearing on positive issues. I am not claiming that accounting lacks theories. Quite the contrary; accountants promulgate "theories" (Edwards and Bell [1961], Sprouse and Moonitz [1962], Chambers [1966], ASOBAT [1966], Ijiri [1967], Sterling [1970]), as rapidly as the SEC increases disclosure requirements. But in accounting the term "theory" has come to mean normative proposition. The so-called accounting theory texts are almost entirely devoted to the examination of questions of a "what ought to be done" nature. These theories, of course, are not supposed to explain existing phenomena. Let me illustrate my point in some detail. The accounting literature focuses almost entirely on such questions as: 1) How should leases be treated on the balance sheet?

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2) Should replacement (or liquidation) values be used in the balance sheet and income statements? 3) How should changing price levels be accounted for? 4) How should changes in foreign exchange rates be accounted for by firms with foreign interests? 5) How should inventories be valued? 6) What should be reported in annual financial statements? 7) Should interim financial statements be ~ audited? 8) How should minority interests in subsidiaries be treated in consolidated statements? On the other hand, what is referred to as accounting theory is useless in trying to answer positive questions about accounting practice. For example: 1) There is much discussion in the literature regarding the "needs" of those using accounting reports. Why is there little or no attention paid to the "needs" of the suppliers of accounting reports? What are the supply-side forces, and what impact do they have on accounting practices? 2) Why do most firms continue to allocate overhead charges to performance centers? 3) Why do firms change accounting techniques? 4) Why do firms change auditors? 5) Why has the accounting profession been cursed with a strong authoritative bias - resulting in the establishment of professional bodies such as the CAP, APB and FASB to rule on "generally accepted accounting techniques"? 6) How have court regulation and rulings influenced accounting practice? 7) Why do firms continue to use historical cost depreciation for other than tax purposes? 8) Why are public accounting firms organized as partnerships?

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9) Why is fund accounting so different from corporate accounting? 10) What impact has the CPA certification procedure had on the practice of accounting and on research in accounting? 11) What have been the effects on the focus of research of accounting educational programs which require faculty to expend substantial effort teaching institutionally oriented material aimed at the CPA exam? 12) Why does the accounting field place an emphasis on "professionalism" and "professional ethics"? Exceptions to this fixation on normative issues are to be found mainly in the efficient market related studies of Benston [1967, 1973], Beaver [1968], Ball and Brown [1968], Kaplan and Roll [1972], Gonedes and Dopuch [1974], and others dealing with the effects of various disclosure rules and financial reporting on security prices. Further exceptions are found in the work on properties of the time series behavior of accounting earnings (Beaver [1970], Ball and Watts [1972], Watts [1975]), as well as in some scattered work on the usefulness of accounting data for predicting such. events as failure (Beaver [1966]), and in a small amount of material dealing with the determinants of a firm's choice of accounting methods (Gordon, Horowitz, and Meyers [1966], Gagnon [1967, 1971], and Watts and Zimmerman [1976]) and the choice of auditor (Burton and Roberts [1967]). This research been the most useful of that done in accounting and none of my criticisms are directed at it. I shall not, however, spend my time today summarizing it, although I mention in passing that at the present time the marginal value of additional research in the efficient market related area seems to be quite low relative to many other areas. Much of the behavioral research in accounting could be classified as positive. That is, it addresses issues such as the effect which provision of variant quantities of data has on certain decisions made by students, questionnaire respondents. or other laboratory subjects. In many ways these studies are similar to the physiological studies which

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measure such things as the effect of alcohol consumption on reaction time; they are similar also in the sense that they are as relevant to accounting issues as these physiological studies. I do not intend my emphasis on positive analysis to imply that normative issues regarding what should be are unimportant. Neither academics nor professionals, however, will make significant progress in obtaining answers to the normative questions they continue to ask until they make a more serious attempt to develop a body of positive theory. It is in this sense that I believe much of what is classified as accounting research is useless. The dearth of positive theory explains the almost complete lack of impact of normative accounting research on professional practice. Furthermore, the belief held by many professionals that the new "Professional Schools of Accounting" will somehow improve accounting research, itself implies a disappointment with the payoffs from past accounting research. This failure has not been quite as dramatic in the managerial accounting area where issues such as capital budgeting and transfer pricing have received considerable attention. Today, however, the majority of my remarks are leveled at financial accounting. The History of Progress in Finance A review of the recent history of finance illustrates the importance of positive theory in the development of answers to normative questions. Prior to 1958 finance was in much the same state as accounting is today. Ad hoc theories filled the literature (as well as practice). Institutional details and definitions filled the textbooks, and little or no valid evidence existed. The theory of finance was riddled with logical inconsistencies and was almost totally prescriptive, that is, normatively oriented. The major concerns of the field were with optimality issues associated with dividend, investment, capital structure, and working capital policies. Little attention was paid to markets, individual incentives, or the nature of equilibrium in the analytical finance setting.

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Then, around 1958, came the Modigliani-Miller propositions, the Theory of Random Walks, and Markowitz's portfolio theory. The orientation of the first two was solidly positive, the third was totally normative. Several years later, however, the meanvariance portfolio theory was turned on its head to generate a positive theory of the pricing of assets under conditions of uncertainty (Sharp [1964] , Lintner [1965]). In 1973 the Black-Scholes option pricing model was published, and more recently the growing normative literature on the theory of agency has been used by Bill Meckling and myself [1967a] to address many positive problems in the theory of the firm and corporate finance. In the dozen years between 1958 and 1970, finance research at the leading universities had little to do with the practice of financial managers. We took a sojourn into a highly artificial world of perfect markets, no transactions costs, etc., and we were able to generate a whole set of "don't count theorems." Most of us, I think, felt somewhat uncomfortable trying to teach students what to do in practice, and some were even slightly antagonistic to the notion of dealing with the "real" problems of the corporate financial manager. But suddenly, in the last five years finance theory has become rich enough to enable us to address all sorts of practical issues, including: 1) the factors determining the indenture provisions in bond contracts, 2) the effects of bankruptcy and bankruptcy costs, 3) procedures for optimal utilization of information in portfolio selection, 4) evaluation of portfolio performance, 5) capital budgeting under uncertainty, 6) the determinants of an optimal capital structure, 7) rights versus underwriting arrangements for new issues, 8) optimal pension funding policies, 9) the theoretical and empirical effects of mergers.

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Most of these issues have strong normative content, that is, they imply policy prescriptions. Let me add that we still do not have all the answers to these questions nor, indeed, answers to all normative issues in finance. For instance, we still don't understand why firms pay dividends, and therefore we have little notion of what constitutes an optimal dividend policy. Today in most of the major centers of financial research in the U.S., I believe there is almost as much effort being devoted to the study of pragmatic corporate financial problems as to the advancement of the frontiers of pure theory. So we have come full circle back to the normative issues, but armed with a tool kit which is rich in positive theory and evidence. We are, I believe, in a much better position to understand the complexities of these problems, and the subtleties of the nature of equilibrium in the market setting in which corporate and public policy decisions are made. Why a Positive Theory of Accounting? The development of a positive theory of accounting will explain why accounting is what it is, why accountants do what they do, and what effects these phenomena have on people and resource utilization. Such a positive theory is a precondition for answering the normative questions which interest us. Our experience in finance is consistent with this. Accounting practices and the ways in which they change are the result of a complex system in which the divergent interests of many different parties are brought into equilibrium. Ross Watts [1974] has begun to provide some analysis of the conflicting interests of various parties and how they interact. Obviously, some of these parties are easily identifiable as corporate management, internal accounting staffs, stockholders, creditors, regulators, security analysts and other users of financial statements, and auditors. But until we better understand the

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interactions of the effected parties and identify other interested groups, progress on normative accounting issues will be virtually nonexistent. William Beaver's [1973] article on "What Should Be the FASB's Objectives" is a very good illustration of two of the points I wish to make. Bill brilliantly summarizes the positive theory of efficient markets, and the theory and evidence on how disclosure, accounting techniques, and changes in these techniques effect security prices. He then marshals these results in a very effective way to address the normative question: What should the FASB do? His article, therefore, is a premier example of what I mean when I say that useful answers to normative questions can be obtained only after we have a solid body of positive theory and consistent evidence. On the other hand, Bill's article represents a good example of the second point I'm trying to make. Neither he nor anyone else I know of has a decent positive theory to explain how the conflicting forces which bear on such bodies as the FASB are brought into equilibrium. The development of such a theory requires something akin to a theory of regulation, which is only just beginning to develop. Given this fact, neither Bill, nor I, nor anyone else has any worthwhile suggestions to make regarding the implementation of a positive program which would have any chance of bringing his suggestions to fruition. To do this we would have to devise changes in the institutional structure which will cause the equilibrium we observe to shift in a desired direction. Without such a theory I fully expect his suggestions to fall on deaf ears. Articles by Horngren [1973], and Meckling and Zimmerman [1976] represent very interesting attempts to provide a positive analysis of some aspects of the system, and to develop a theory which would help us to implement some of Beaver's suggestions. Horngren's article on "The Marketing of Accounting Standards" is an important first step in considering the forces which impinge on

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the behavior of the FASB and I commend it to you all. It lacks, unfortunately, explicit consideration of the objectives and incentives of the individual members of the FASB, the SEC, public accounting firms, etc., as well as a theory of the political process. I shall expand on this in a moment. The Meckling-Zimmerman article focuses on the current movement to establish new and separate "Professional Schools of Accounting." They analyze the forces behind this movement and the likely implications of the establishment of such schools for the quality of accounting training and research, the welfare of public accounting firms and business schools, and social welfare in general. Interestingly enough, the Journal of Accountancy, which has its own objectives, refused to publish their article because it was "untimely." The influence of politics and self-interest extend to more than just the SEC and FASB, and the sooner we recognize that fact, the better we will be able to understand the complex system with which we are dealing. Normative research in accounting now takes the form of attempts to find answers to questions which are phrased in an absolute sense regarding what is "right" and what is "wrong," or what are the informational "needs" of investors and how can accountants meet these "needs." The only way we will obtain useful insight into these issues is to rephrase them in the following way: What kinds of institutional changes will change the incentives facing the interacting parties so to move the equilibrium solution in a "preferred" direction? Simplistic calls to arms will not, in and of themselves, be successful. Obviously, the word preferred implies tile existence of an objective function and it is here that we must be careful to distinguish the viewpoint we are taking. Are we talking about optimal policy from the point of view of the corporate owner, or creditor, or

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auditor, or "society"? These viewpoints will not, in general be consistent, and yet it is often unclear in the debates over what accountants should do just exactly what viewpoint is being taken. Instead, we commonly observe an empty amalgam of conflicting objectives. Consider the following statement in Hendriksen's [1972, p. 2] Accounting Theory text: The major emphasis in this book is on the development of financial accounting theory based on the objectives of reporting to stockholders, investors, creditors, and other outside interests, although the objectives of reporting to management are taken into consideration in specific instances where the objectives overlap. Consideration is also given to meeting the objectives of general social and economic interests of a nation or geographic area. There is simply no way in which all these objectives can be simultaneously satisfied. It astonishes me how the unending discussions regarding what accounting should be can be carried on without the words Pareto Optimality ever being mentioned, much less used in any substantive sense, even though there are often references to the interests of society. Instead, the discussion is couched in terms such as "usefulness" which are essentially empty of content. The only way these issues can in fact ever be answered is in terms of choices based on the real effects of various alternative actions on people, their behavior, their wealth, and their utilization of resources. The only segment of the accounting literature I know of in which the Pareto Optimality notion plays a role is the recent state preference related literature on information production and disclosure which is receiving fairly intense attention here on the West Coast. Unfortunately, most of that literature has little or nothing to do with substantive accounting problems, even though it has pretensions in that direction. Most of it amounts to the generation of "possibility theorems"; as, for example, the delineation of

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the conditions under which the production or disclosure of "information" will make all investors better off, worse off, or some better and some worse off. Little or no attention is paid to the question of what institutional arrangements, if any, would induce the maximizing individuals involved to produce or provide the "socially optimal" information. The analysis has policy implications oil), if one assumes there exists some deus ex machina which will bring about the desired results. In all the cases I've seen so far there are no institutional arrangements which will induce "optimal" behavior on the part of individuals. The analysis is a good example of the Nirvana fallacy. The other major thrust of this analysis is in the delineation of the set assumptions which must be made on the farm of individual utility functions, distribution of resources, etc., in order to draw some specified set of implications. But this work is little more than the rigorous manipulation of toy logical structures which entirely lack empirical content. It leads to no new understanding of the workings of the world. To this I ask: Why do we care? I hasten to add that there is much work in finance of a similar nature, and it is subject to the same criticisms. Developing a positive accounting theory is not going to be an easy task. It will not arise full blown out of the work of any single individualthe problems are too big for that. I expect that it will take at least ten to fifteen years far us to generate a substantial body of results. Furthermore, I am not so naive as to believe that my suggestions today will be received with much enthusiasm from either the professional or academic arms of the profession. Understandably, the professionals will not be intrigued by the prospect of having the best minds in the profession diverted from currently pressing issues and devoted to such long range questions as I have raised. I do not expect anything other than a small minority of academic accountants to find my suggestions attractive. Why? Simply because the training and background of the majority of academics leaves them ill-equipped to address these positive issues. No one wants to find himself obsoleteleast of all an academician. Furthermore, it is totally

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unreasonable to expect him to contribute to his own demise. Analysis of these positive issues is at least as much an economic as an accounting problem, and will require knowledge of the theory of finance, the theory of the firm, organization theory, decision theory, the theory of regulation, and political theory. The requisite decision theory and theory of finance are well along in their development. Political theory, the economic theory of the firm, and the theory of regulation are only now receiving real attention and they have a long way to go in their development. Little of that which has been bequeathed to us by the behavioral sciences passing for "organization theory" deserves the appellation "theory." As far as I can tell, it is empty of general positive propositions which are both internally consistent and supported by evidence. There is, however, increasing interest in these problems now in evidence in the economics literature. I believe we will begin to see significant progress made towards the achievement of some fundamental knowledge of organizational problems in the future. The development of a body of accounting theory will not only draw upon these results but will also, I believe, contribute some substantial advances of its own towards a legitimate theory of organizations. Some Guidelines for Change Some major changes must occur in accounting research if a positive theory of accounting is to be developed. One of these I have already mentioned: Accountants must start asking the right questions. Why do we observe what we observe? What are the equilibrating mechanisms and the associated incentives in the system? But merely asking the right questions is not enough. There must be considerably more attention paid to the implicit models of' man that lie at the heart of such analysis. All too often individuals are conceptualized in accounting theories as being incapable or uninterested in caring for themselves. This leads to a very scrawny, undernourished body

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of theory which in no way captures tile vital and robust character of the world. A much richer set of hypotheses will be generated if we correct this error. Bill Meckling and I commend to you the notion of the individual as a Resourceful, Evaluative, Maximizing Man, or as we have labeled trim, REMM. (I apologize for the chauvinistic character of REMM, but somehow REMP does not seem to roil off the tongue in quite tile right fashion.) Our REMM is "Resourceful in that lie `reasons' about the consequences of changes in his environment and in his own behavior [and he is creative] he is an Evaluator, he has preferences [about almost everything and substitutes among alternative ends in all dimensions] , and, finally, lie is a Maximizer, lie acts so as to achieve the highest level of `good' as lie perceives it." (A more detailed discussion of RE:MM and his uses is available in Meckling [1976] .) REMM is to be distinguished from: Sociological Man , who is almost entirely the product of his cultural environment, a role player like an ant or a bee who does not evaluate. His behavior is by and large independent of the incentives he faces. Psychological Man, who is resourceful and who evaluates hut whose wants are not comparable to one another. He therefore does not substitute among goods; i.e., he makes no tradeoffs. His "needs" are arranged in a hierarchical order. Economic Man, a short run money Maximizer with limited resourcefulness. Political Mart, who is in a certain sense an evaluator and a maximizer, but lie is not REMM. He is an altruist who is assumed to he always attempting to maximize the "public good." lie has no individual wants or desires other than this "public good." I'm sure you will, upon reflection, see that all these notions of man are frequently used in all the social sciences and especially in accounting. For instance, the accountant is

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often represented as sociological man he dues what he does because he has been educated to do so, indoctrinated with professional ethics, and directed by the rules of' "generally accepted accounting principles." He has no personal wants or creativity and does not respond to incentives presented to him by his environment. Mr. Burton, who shares the podium here today, explicitly expressed his view of the accountant as sociological man in his speech on "The Need for Professional Accounting Education." This position is usually only implicit in accounting research; he put it as follows: Business schools tend to emphasize an approach geared substantially to profit maximization in a competitive environment. Accountants on the other hand need a different approach. They need what might be called the dispassionate professional approach. Alone among the professions the accountant achieves his social purpose by being independent of his client rather than serving the client's interest to the exclusion of others or following his own profit maximizing interest. These approaches are not necessarily mutually exclusive, but the fundamental objective of the public accountant is one of independence. This approach needs to be instilled at an early stage. I suggest that a number of the problems which the accounting profession is having today arise because this fundamental approach has not been sufficiently ingrained (Burton [1975, pp. 6, 7] ). The user of financial statements is often characterized as psychological man he "needs" objectivity and is unwilling to sacrifice any of' it to obtain anything else (such as unbiasedness); he makes no tradeoffs. The member of the APB, or FASB, or regulatory bodies such as the SEC is generally thought of as political man he is an altruist, solely interested in discovering what is "right." lie pursues truth with total disregard for his own personal interests. Many

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people, in the comfort and secrecy of their own homes, allow themselves to think of these men as REMM's individuals with personal interests and drives who are more likely to lake a given action, whatever its consequences for the "public good," if the private benefits to themselves are larger. This heresy, however, seldom finds its way into print in the accounting literature and never into accounting theory, although Watts [1974] and Watts-Zimrnerman [1976] are exceptions. Gentlemen, I submit to you that Mr. Burton, just like you and me, is better understood as a REMM than as a political man. So, too, I might add, is the auditor, the manager, the banker, etc., and any other bureaucrat I don't mean to pick on Mr. Burton personally. The sooner we recognize that all these individuals are REMM's and we incorporate formal analysis of their maximizing behavior in our models, the sooner we will develop positive theories which will give us some fundamental understanding about why the system reaches the equilibrium it does, why the professional boards seem to continually fail, why Mr. Burton does what he dues, and what we can do to stop him. Once we begin to think of each individual in the system under study as a REMM we are then led quite naturally to inquire into the characteristics of the incentives he faces in order to explain his behavior. That is, we are naturally led to a positive theory of accounting. We want to understand, for instance, the costs and the benefits generated by alternative disclosure actions on all parties and how individual REMM's will react. With this accomplished, we will be able to understand how the system operates and to make predictions. And eventually, we will be able to make normative statements. Purely positive research cannot be accomplished without some consideration of some normative issues. However, there is a subtle but important difference between such normative considerations and what usually goes on in accounting. When we construct positive theories we endow our REMM's with objectives. We take a normative approach to each of the REMM's decision problems and solve for the optimal policies. Then we assume that all the REMM's in our problem behave according to our optimal policies and

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investigate the characteristics of the resulting equilibrium. Given this description of the equilibrium, we can then address the normative public policy issues. This, I maintain, is very different from the normal procedures followed in accounting, which amount to standing in a hole contemplating Mount Olympus and trying to figure out how to jump over it without first climbing out of the hole. Looking at the methodological problem in this "bootstrapping" way also suggests that I may have been a bit too hard in my blanket criticisms of accounting research. Some of that research is directed at determining what effects alternative accounting policies have on various reported measures such as income, etc. There is little doubt that some knowledge of these effects will play an important role in the development of a positive theory. To date, however, that research does not aid in answering any normative questions. Without a theory which is well founded in maximizing behavior by individuals we don't know what measures (reported or not) are important. Furthermore, we don't know what effects, if any, these alternative accounting techniques have on individual behavior or resource utilization. I wish I understood better why accounting researchers have avoided developing positive theories and why the concept of REMM has played such a small role in accounting research. (Notice that answers to both these questions themselves require positive theories.) One simplistic hypothesis is that the continuing pressure of the regulatory climate over the past decades has confronted accountants with the ever present (and real) spectre of constraints and control. This has played a large role in focusing the professional and academic debates and research on superficial questions of the "right" way to do things in some undefined and absolute moral sense. The current debates surrounding the euphemism "sensitive payments" and the legal liability of auditors to disclose these payments as well as management fraud are good examples of this focus. There has been almost no attention paid to the positive effects of various policies on the involved parties such as stockholders and auditors. In practice, the debate has centered on

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moral issues. This is not at all unusual and is, I think, about par for what we can expect out of the political sector. It simply doesn't pay for REMM's, like Mr. Burton, to pay a great deal of attention to the real effects of the actions of the SEC. It is not, I believe, in his (or any other bureaucrat's) interest to maximize the "public good." This brings me to the last set of thoughts I would like !a leave with you today. Regulation of Accounting Standards and Disclosure and the Attack on Corporations Since Mr. Burton took office as the Chief Accountant of the SEC in 1972, that body has played an increasingly strong role in the establishment of accounting and disclosure standards. Great concern has arisen in the accounting profession that the establishment of such standards is being usurped from the private sector. Although the SEC has for 40 years had the statutory authority to set such standards, it had previously allowed this function to remain in the private sector with the CAP and its successor, the APB. The creation of the FASB was due in part to a desire to keep the authority for setting standards in the private sector. Even with the FASB, however, the SEC continues to play a stronger role in the setting of standards. Its recent requirements for disclosure of replacement costs of productive capacity and inventories are only a small example. The question regarding why the SEC voluntarily limited its standard setting activities for 40 years, even though it had the legal authority to mandate accounting practices, is another fascinating question worthy of study. If we knew why this occurred and why the recent changes in policy have come about, we would be in a much better position to understand the future of accounting. I do not believe, incidentally, that the simplistic hypothesis that the change was solely due to the appointment of a new Chief Accountant will stand the test of time and analysis. I do not believe that it was merely an accident that an "activist" was appointed to succeed Mr. Barr, the former Chief Accountant for 33 years.

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At the same time that the SEC has played an increasingly strong role in dictating standards, it, along with the courts, has been moving to bring about substantial changes in the function of the auditors as I'm sure you are all aware. Auditors are increasingly being pressured by both the SEC and the courts to accept liability for failure to disclose "material items" and management fraud. I have seen estimates of pending class action lawsuits against auditors ranging from 200 to 1,000 such cases for which damage claims run into hundreds of millions of dollars. There are also pressures building to bring auditors into the certification of interim statements, financial press releases, line of business reporting, and, in a recent bill proposed by the SEC, for evaluation and certification of corporate internal control systems. I believe that these events and others which are causing substantial consternation in the accounting profession today are not unique to your profession. They are, in fact, additional manifestations of a major and continuing attack on the corporation as an organizational form. Large corporations are being forced by law and by threat of law (euphemistically called "social responsibility") to serve as a vehicle for effecting all sorts of social reform - from the alleviation of discrimination and poverty, to the establishment of training and pollution programs. The motivating force behind this is the fact that corporations represent large visible blocks of wealth which are particularly vulnerable to expropriation by special interest groups and the political sector. Politicians, bureaucrats, and special interest groups are using the notion of social responsibility- and the power of the political sector to effect wealth transfers from corporate owners, creditors, and the consumers of the corporation's product to others in society. This phenomenon is not limited to the corporation alone. In its most general form, it amounts to a continuing process in which the political sector is gradually destroying private rights to property and private contracting rights by transferring these rights to the public sector.

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I do not use the term "rights" in any ethical or moral sense, but simply mean it to refer to actions which the law allows specific individuals (owners) to take, including writing contracts with others. In another paper [1976] I have outlined the general magnitude of this problem, and Bill Meckling and I in a joint paper [1976b] have analyzed the forces at work and their implications for the future of the corporation in some detail. Our conclusion is that the corporation is being destroyed as a viable form of organization. Unfortunately, we see no way to halt the process. I do not have the time today to go into a detailed analysis of this problem. It arises out of a fundamental conflict between our form of political democracy and the market system. The government. which possesses ultimate authority over the use of violence, plays two very different roles. It has the responsibility for protecting the rights of individuals and for enforcing contracts. But it also has the power through legislation and through court decisions to alter individual rights. The use of this latter power by politicians, bureaucrats, and various special interest groups to increase their own welfare at the expense of others is the basic source of the inconsistency between a political democracy as we know it and the market system. I indicated earlier that it is not in the personal interest of politicians or bureaucrats (including Mr. Burton) to maximize the "public good." The reason is that they are, as individuals, no different than the rest of us. As REMM's. they prefer more rights to less and they have the same interest as the rest of us in expanding the set of rights from which they benefit. Since stability in private rights is by its very nature a constraint on what government (i.e., bureaucrats and politicians) can do, they have a strong interest in breaking down the system of private rights. To the extent that they succeed in this, they extend the market for their services. They use the rhetoric of crises to justify the revocation and abrogation of private rights which is the currency in which they deal. By doing so they can expand their staffs, their power, and ultimately their own welfare.

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Two weeks ago, for example, at a conference in Rochester I listened to an SEC representative explain that the SEC could not spell out precisely what corporations should disclose in the realm of so-called "sensitive payments." That position is nonsense. The reason the SEC does not now articulate such guidelines is that doing so would restrict their discretionary authority. Guidelines would constrain their power to take future disciplinary action against various parties; actions which they now perceive they might want to take at that time. They have little, if any, real interest in sacrificing such power. If you doubt what I say about the transfer of rights, I ask you to contemplate the outcomes of all the recent so-called "crises" over civil rights, energy, "sensitive payments," and various disclosure issues in your own field. I defy you to find even one instance in which the "solution" has not involved the elimination of some private rights and the expansion of the power of the political sector. I can think of none except the move to the volunteer army and the elimination of the mandatory seat belt interlock system. With the elimination of private rights comes, of course, more governmental control, more regulation, larger bureaucracies, etc. The Implications of Current Trends for the Accounting Profession Let me return now to some of the current problems facing the accounting profession. One of the positive questions which I raised earlier was: Why have the professional standard setting boards persisted for so long in accounting and what have been their effects? One simple hypothesis to explain their existence is that more uniform accounting techniques lower the user's information costs in interpreting the reports of any given company. Once such a board is established as a rule maker, however, it is subject to many of the same pressures applied to the governmental rule makers at large. It is then worth the while of special interest groups to expend resources to influence the decisions of the rule making board to make themselves better off at the expense of others. I think

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this fact is commonly realized in the profession, but has never, to my knowledge, been the subject of research, except for the recent Watts Zimmerman [1976] study. Zeff [1972] and Moonitz [1974] provide a fascinating history of the determination of accounting standards for a number of important issues and the roles played by various special interest groups. If a valid theory of this process existed, it would be very helpful in attempting to establish an institutional arrangement such as the FASB in a way such that the undesirable side effects of the process would be reduced. I think there are probably good reasons for why the implicit contract between the auditor and client in the past has not involved the auditor's guarantee of the discovery and disclosure of fraud. Both parties had the right to negotiate such contracts and they didn't, even though one can make arguments that it is in the interests of the corporate owners to do so (Jensen and Meckling [1976a] ). I suspect the reason is that it is too costly to do so, i.e., that the benefits do not justify it. However, since the theory of agency and monitoring from which I draw these conclusions is still in its infancy and little evidence has yet been gathered, we cannot be too confident in them as yet. Nevertheless, current trends are, in fact: changing the system of private rights so as to prevent the auditor and client from explicitly entering into a contract which specifies both that the discovery of fraud is not a purpose of the audit and that certification provides no warranty against such an event. The implications of such changes in contracting rights can be analyzed. Holding auditors liable for undiscovered fraud will increase the cost of audits because additional resources will be spent in discovery attempts. And the potential legal liability for undiscovered fraud will increase the risk and the insurance costs of public accounting firms. Since all auditors will be subject to the same rules, both these increases in cost will be passed on to the corporate clients. I suspect these additional costs will be substantial and will far outweigh any productive benefits. Furthermore, the demand for audits by the individual firm will

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not be affected because of the legal constraints already requiring such services. In a sense, then, the resulting increases in audit fees amount to another special tax on the corporate form of organization, and will be another factor contributing to its demise. These increased costs will ultimately be passed on to consumers. If nationalized firms like Conrail, other public enterprises, or nonprofit organizations are not subject to the same rules of the game (and I do not believe they will be), this will simply add to their competitive advantage vis a vis the private corporate form. Finally, let me say that I think much of the hope that the FASB will succeed in keeping the standard setting function in the private sector is naive. The SEC now holds almost all the cards, and I believe the private sector will lose this power struggle unless it conforms to the SEC's wishes; and if it does, who cares? The only way I can see for the private sector to retain the standard-setting power is to obtain strong support in Congress. But this requires a situation in which the interest of Congress coincides with that of the FASB and the profession, and I don't think it does. As soon as another "crisis" arises (or is manufactured, which is perhaps a better term), the obvious scapegoat will again be the FASB. The only way I can see for the accounting profession to win this fight is by putting together a powerful voting coalition to bring pressure directly on Congress. I don't believe this will happen. Public accounting firms will undoubtedly incur transition costs resulting from unanticipated liabilities, training, etc., that won't in the short run be correctly reflected in fees. Outside of these costs of adapting to the new rules of the game, I don't see why you care about the outcome. I may, however, vastly underestimate these transition costs. In the end, the increased auditing costs will, through increased fees, be imposed on the owners of corporations and the consumers of their products. To the extent that this reduces the demand for your services by

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helping to destroy the corporation, the public accounting profession will, of course, be smaller and this will harm you. But the solution to that problem is fairly obvious: Use the political sector to make sure that your services are required by the substitute organizational forms. Lobby to require the private auditing of all substitute organizations. Make it mandatory that organizations like Conrail, Amtrak, and local governmental bodies be audited. The proposed 1976 SEC amendments require all municipalities with outstanding debt in excess of $50 million to publish audited financial statements. This will offset much of the potential decline in your corporate business for years to come, but I understand it is receiving relatively little interest in Congress. In the long run, I suspect your major competitor and the major threat to your continued viability will be the Governmental Accounting Office. But that's quite a distance in the future. REFERENCES ASOBAT, American Accounting Association, Committee on Basic Accounting "Theory, A Statement of Basic Accounting Theory (American Accounting Association, 1966). Ball, Raymond, and Brown, Philip. "An Empirical Evaluation of Accounting Income Numbers," Journal of Accounting Research, Vol. 6 (Autumn, 1968), pp. 159-77. Ball, Raymond, and Watts, Ross. "Some Time Series Properties of Accounting Income," Journal of Finance (June, 1972, pp. 663-82. Beaver, William H. "What Should be the FASB's Objectives?" Journal of Accountancy (August, 1973), pp. 49-56. Beaver, William H. "The Information Content of Annual Earnings Announcements," Empirical Research in Accounting: Selected Studies, 1968, Supplement to Journal of Accounting Research, Vol. 6 (1968), pp. 67-92. Beaver, William H. "Financial Ratios as Predictors of Failure," Journal of Accounting Research (Autumn, 1966), pp. 71-111.

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Benston, George J. "Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act of 1934," American Economic Review (March, 1973), pp. 132-55. Benston, George J. "Published Corporate Accounting Data and Stock Prices," Empirical Research in Accounting. Selected Studies, 1967. Supplement to Journal of Accounting Research, Vol. 5 (1967), pp. 1-14 and 22-54. Black, Fischer, and Scholes, Myron. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, Vol. 81, No. 3 (May-June, 1973). Burton, John C. "The Need for Professional Accounting Education," in Schools of Accountancy: A Look at the Issues, Bizzel, Allen H., and Larson, Kirmit D. (eds.), (New York: AICPA, 1975). Burton, John C. and Roberts; William. "A Study of Auditor Changes," Journal of Accountancy (April, 1967), pp. 31-36. Chambers, R. J. Accounting, Evaluation, and Economic Behavior (Englewood Cliffs, New Jersey: Prentice-Hall, 1966). Edwards, Edgar O., and Bell, Philip W. The Theory and Measurement of Business Income (Berkeley: University of California Press, 1961). Gagnon, Jean-Marie. "Purchase Versus Pooling of Interests: The Search for a Predictor," Empirical Research in Accounting: Selected Studies, 1967 Supplement to Journal of Accounting Research, Vol. 5 (1967), pp. I87-204. Gagnon, Jean-Marie. "The Purchase-Pooling Choice: Some Empirical Evidence," Journal of Accounting Research, Vol. 9 (Spring, 1971), pp. 52-64. Gonedes, Nicholas J., and Dopuch, Nicholas. "Capital Market Equilibrium, Information Production, and Selecting Accounting Techniques: Theoretical Framework and Review of Empirical Work," Studies on Financial Accounting Objectives: 1974, Journal of Accounting Research Supplement, Vol. 12 (1974), pp. 48-129. Gordon, Myron J., Horowitz, B.. and Meyers, P. "Accounting Measurements and Normal Growth of the Firm," in Research in Accounting Measurements, Jaedicke, et al. (eds.), (New York: American Accounting Association, 1966). Hakansson, Nils. "Empirical Research in Accounting, 1960-70: An Appraisal," Accounting Research, 1960-70: A Critical Evaluation, Nicholas Dopuch and L. Revsine (eds.), (Urbana: Center for International Education and Research in Accounting, University of Illinois, 1973), pp. 137-73. Hendriksen, Eldon S. Accounting Theory (Homewood, Illinois; Richard D. Irwin, Inc., 1970).

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Horngren, Charles T. "The Marketing of Accounting Standards," The Journal of Accountancy (October, 1973), pp. 61-66. Ijiri, Yuji. The Foundations of Accounting Measurement: A Mathematical, Economic, and Behavioral Inquiry (Prentice Hall, 1967). Jensen, Michael C. "The Debasement of Contracts and the Decline of Capital Markets" (Center for Research in Government Policy and Business, Public Policy Working Paper Series No. PPS-76-1, University of Rochester, Graduate School of Management, February, 1976). Jensen, Michael C., and Meckling, William H. "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure" (Center for Research in Government Policy and Business, Working Paper Series No. GPB-76-6, University of Rochester, Graduate School of Management, April, 1976a, forthcoming in the Journal of Financial Economics). Jensen, Michael C., and Meckling, William H. "Can the Corporation Survive?" (Center for Research in Government Policy and Business, Public Policy Working Paper Series No. PPS-764, University of Rochester, Graduate School of Management, May, 1976b). Kaplan, Robert S., and Roll, Richard. "Investor Evaluation of Accounting Information: Some Empirical Evidence," Journal of Business (April, 1972), pp. 225-257. Lintner, John. "The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets," Review of Economics and Statistics (February, 1965), pp. 13-37. Markowitz, H. Portfolio Selection: Efficient Diversification of Investments (New York: John Wiley & Sons, 1959). Meckling, William H. "Values and the Choice of the Model of the Individual in the Social Sciences" (Center for Research in Government Policy and Business, Working Paper Series No. GPB-76-5, University of Rochester, Graduate School of Management, February, 1976, forthcoming in Revue Suisse d'Economie Politique et de Statisque, December, 1976). Meckling, W. H.. and Zimmerman, J. L. "What Will the New Schools of Accounting Do for the Profession?" (forthcoming in The CPA Journal, 1976). Modigliani, Franco, and Miller, Merton H. "The Cost of Capital, Corporation Finance, and the Theory of Investment," American Economic Review (June, 1958), pp. 261-97.

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Moonitz, M. Obtaining Agreement on Standards in the Accounting Profession, Studies in Accounting Research, No. 8 (American Accounting Association, 1974). Moonitz, M. The Basic Postulates of Accounting, Accounting Research Study No. 1 (American Institute of CPA's, 1961). Sharpe, W. F. "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk," Journal of Finance (September, 1964), pp. 425-42. Sprouse, K. T., and Moonitz, M. A Tentative Set of Broad Accounting Principles for Business Enterprises, Accounting Research Study No. 3 (American Institute of CPA's, 1962). Sterling, R. R. Theory of the Measurement of Enterprise Income (University Press of Kansas, 1970). Watts, Ross. "The Time Series Behavior of Quarterly Earnings" (unpublished manuscript, Department of Commerce, University of Newcastle, Australia, April, 1975). Watts, Ross. "Accounting Objectives" (Working Paper Series No. 7408, University of Rochester. Graduate School of Management. April, 1974). Watts, Ross, and Zimmerman, Jerold. "Towards a Positive Theory of the Determination of Accounting Standards" (unpublished manuscript, University of Rochester, Graduate School of Management, April, 1976). Zeff, Stephen A. Forging Accounting Principles in Five Countries: A History and Analysis of Trends (Champaign, Illinois: Stepes Publishing Company, 1972).