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A perspective on Solomons' quest for credibility in financial reporting
REVIEW ESSAY
A Perspective on Solomons’ Quest for Credibility in Financial Reporting Steven B. Johnson
David Solomons’ 1986 book, Making Accounting Policy: The Quest for Credibility in Financial Reporting, as an intellectual screening mechanism
This paper evaluates
operating in the market for accounting ideas. Such a mechanism is evaluated in terms of its ability to screen out high- from low-quality theories, beliefs, and opinions; to be perceived as credible for such an undertaking by both purveyors and consumers of such theories, beliefs, and opinions; and to contribute something different from or not redundant with that of other mechanisms already available. The evaluation suggests that, although the contribution of Solomons’ analysis will ultimately be decided in the market for accounting ideas, this book has the potential to make a significant contribution toward helping to sort out many of the prevailing notions as to the nature, role, and propriety of accounting standard setting.
I. Introduction The state of thought in a discipline
like accounting tends to advance, most often, not by the introduction of radical new ideas or by flashes of prophetic insight, but rather by means of a careful sifting and winnowing from among the existing inventory of theories, beliefs, and opinions. Viewed from this perspective, such theories, beliefs, and opinions are like experiments, few of which will succeed and exert a lasting impact on the discipline. In the final analysis, the quality of thought in any discipline depends as much on the collective wisdom of those who help to screen out faddish and fallacious ideas as on the quality of the available stock of ideas itself. It is in this important intellectual tradition that David Solomons, in his 1986 book Making Accounting Policy: The Quest for Credibility in Financial Reporting, analyzes and assesses the soundness of many of the current theories, beliefs, and opinions concerning the nature, role, and propriety of accounting standard setting. Although the book is characterized by such literary virtues as a
Address reprint requests to Professor Steven B. Johnson, Graduate School of Business, Columbia University. New York, NY 10027. Journal of Accounting
0
1988 Elsevier
and Public Policy, 7. 137-154 Science Publishing Co.. Inc.
(1988;
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balanced analysis of alternative points of views, well-documented reasoning, and an expository style that clarifies, rather than confounds, the essential issues considered, these attributes are, by themselves, necessary, but not sufficient, in order for such a work to fulfill its function as an intellectual screening mechanism. Therefore, this paper seeks to evaluate Solomons’ work not merely as a literary offering, but as an intellectual screening mechanism. ’ The remainder of this essay is organized as follows. Section II discusses the nature and function of intellectual screening mechanisms and suggects an approach for evaluating their performance. Section III reviews some of the more salient aspects of Solomons’ analysis. Section IV evaluates Solomons’ effort on the basis of its efficiency, credibility, and contribution as an intellectual screening mechanism. Some additional thoughts and observations concerning intellectual screening mechanisms and the approach used in this article are provided in the final section.
II. Intellectual
Screening Mechanisms
In an intellectually open society the ultimate acceptance or particular theory, belief, or opinion is determined in the market win acceptance in such a market, an idea must evolve and mature enable it to meet the demands placed upon it at both an esoteric level. As Stigler (1955, p. 301) has so aptly pointed out:
rejection of a for ideas. ’ To sufficiently to and pragmatic
A new idea does not come forth in its mature scientific form. It contains logical ambiguities or errors; the evidence on which it rests is incomplete or indecisive; and its domain of applicability is exaggerated in certain directions and overlooked in others. These deficiencies are gradually diminished by a peculiar scientific ageing process, which consists of having the theory “worked over” from many directions by many men. Each of the individuals that “works over” a particular theory, belief, or opinion in this sense serves as an intellectual screening mechanism that can profoundly affect its ultimate form, interpretation, and acceptability. In order to appreciate the critical role played by the intellectual screening mechanisms that operate within a market for ideas, it is useful to consider what might happen to the state of knowledge in a particular discipline in the absence of ’ For a general discussion (1973), here.
Arrow
* This
(1973).
assertion
does not, however,
of screening mechanisms
and Stiglitz
(1975).
that the market for ideas determines trivialize
cal and other scientific
the role of epistomological
considerations
out“
than, say, the market for cornflakes,
its ability to win and maintain credibility line see Stigler (1955).
the acceptability
fallacious
of a particular
theory,
considerations.
impact on the acceptability
or faddish notions.
the acceptability
(1970),
the basis for the assessment
and other scientific
can exert a significant
ideas and. in that manner, help to “screen differently
and their role in markets see, e.g., Akerlof
It is this paradigm that forms
While
belief,
Clearly
Space
presented or opinion
epistomologi-
of accounting and other
the market for ideas operates
of an idea in accounting or elsewhere
in the face of constant challenge. For an interesting
discussion
depends on along this
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efficient screening mechanisms. Although such markets are constantly bombarded with new theories, beliefs, and opinions, it is generally infeasible for most academicians, practitioners, and other market participants to differentiate singlehandedly potentially insightful ideas from those that are misleading. Therefore, if efficient mechanisms do not evolve to help screen out misleading ideas, a type of intellectual gridlock or market failure will occur and some potentially insightful ideas will be overlooked or rejected without extracting their residue of truth and some misleading ideas will be accepted in their place. To consider the possible consequences of a market for ideas in which the existing intellectual screening mechanisms are either biased or inoperative, the reader is referred to Figure 1. Quality distribution A represents the density function that corresponds to the potential insightfulness or quality of all possible theories, beliefs, and opinions that could be introduced into the market for ideas within a particular time frame, with pl being the ex ante probability of a particular idea being accepted or rejected. Since the introduction of a rejected idea imposes reputational and other costs on the party or parties with whom it is identified, in a market characterized by biased or inoperative intellectual screening mechanisms the purveyors of high-quality ideas face a higher expected reputational cost from rejection than purveyors of low-quality ideas.3 As a result, while purveyors of low-quality ideas may be willing to introduce their theories, beliefs, and opinions into the market, purveyors of high-quality ideas may tend to withhold or suppress them. 4 At this point, only low-quality ideas may be introduced and the quality distribution shrinks from distribution A to distribution B. Since the market is unable to differentiate the above-averagequality ideas in distribution B from the below-average ideas, and the ex ante probability of being accepted or rejected is now ,uz , only below-average-quality ideas will be introduced and the quality distribution again shrinks and the average quality of ideas introduced deteriorates even further. It is this iterative process that, if not corrected, may cause the market for ideas to operate inefficiently or fail and lead to intellectual gridlock in a particular discipline. In a well-functioning market for ideas, however, there are intellectual screening mechanisms in place that serve to differentiate high- from low-quality theories, beliefs, and opinions and, thus, help to avert this sort of breakdown. In the market for ideas that serves accounting, for example, there are established academic journals that, much like powerful corporate entities, have acquired an
’ This from
assertion
rejection
from low-quality
that, in such a market,
than purveyors
ideas, the probability
idea; and(b) high-quality potential quality
reputational
of high-quality
ideas face a higher expected reputational
ideas assumes that: (a) since the market cannot differentiate
of rejection
of a high-quality
theory,
who introduces
Formally
belief,
of superior
stated. this assumes first-order
or opinion
and the superiority
theories
of natural
insight,
stochastic
of the intellectual
and hence with greater dominance between the
capital possessed
by the
it to the market.
’ As an anecdotal example of this tendency, consider the actions of Charles his
cost high-
idea is at least as great as that of a low-quality
ideas are more apt to emanate from individuals
capital at risk.
of a particular
individual
purveyors
of low-quality
selection
until
many years
evidence. The biasedness of the intellectual are well documented in the literature
(Kuhn
after
screening mechanisms 1962, Chapter
Darwin
they were originally 12).
implicit
who withheld
formulated
publication
of
and documented
by
in the market for ideas faced by Darwin
.__
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-
.”
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QUALITY OF IDEAS
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“,
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iilGl!l
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_>
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^
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_
-
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-
(Potentially Insightful Theories, Beliefs, and Opinions)
Figure 1. Distribution of the quality of ideas and the adverse selection phenomenon.
(Misleading
Theories, Beliefs, and Opinions)
q
. . .
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almost institutional status in their role as intellectual screening mechanisms. Similarly, there are individual works, like that of Solomons’, that provide an alternative mechanism for screening out potentially insightful ideas from those that are misleading. To the assess the contribution, if any, provided by an individual work like that of Solomons’, it is necessary to consider both the extent to which it displays the properties of an efficient screening mechanism for ideas and the extent to which it provides something beyond that provided by other available mechanisms of this sort. Solomons’ analysis contributes in this sense only if it is an efficient and credible mechanism for screening accounting ideas and provides something different or not redundant with that of other mechanisms. Therefore, before assessing Solomons’ effort in Section IV, both the properties of an efficient and credible screening mechanism and the potential marginal contribution of such a mechanism are considered in this section. An intellectual screening mechanism can effectively assist accountants and others in differentiating high from low-quality theories, beliefs, and opinions only if three essential conditions are satisfied. First, the mechanism must be able to screen out or separate high- from low-quality ideas consistently and reliably. The statistical implications of this condition are demonstrated in Figure 2. In this figure, the vertical axis represents the probability of not being screened out and the horizontal axis represents the quality of a particular theory, belief, or opinion. The ellipse drawn with the solid line represents the envelope of observations or experiences generated by mechanism X, while the ellipse drawn with the broken line represents the corresponding envelope for mechanism Y. Finally, the figure is divided into four quadrants: quadrant I where the probability of not being screened out is high, but the quality of the idea is low; quadrant II where both the probability of not being screened out and quality are high; quadrant III where both the probability of not being screened out and quality are low; and quadrant IV where quality is high, but the probability of not being screened out is low. In order to evaluate the relative screening efficiency of mechanisms X and Y, two aspects of the figure should be noted. First, the observations in quadrant I represent type I (CY)errors committed in screening, while observations in quadrant IV represent type II (P) errors. Second, because the incidence of type I and type II errors is lower for mechanism Y, it can be concluded that mechanism Y has greater screening efficiency than mechanism X. Therefore, although not completely free of occasional type I and type II errors, mechanisms Y screens out or separates low-quality theories, beliefs, and opinions more consistently and reliably, and thus satisfies the first condition better, than mechanism X. A second condition essential for such a mechanism is that the perceived reputational and other costs of having one’s ideas screened out or rejected must be negatively correlated with the quality of the ideas themselves. This condition is necessary to encourage the introduction of high-quality ideas into the market
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’
I
\
\
143
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by those possessed of superior intellectual (and hence, potential reputational) capital. Specifically, satisfaction of this second condition requires that the mechanism must be viewed by potential purveyors of theories, beliefs, and opinions as being efficient enough to make the expected reputational and other effects of screening positive for high-quality ideas and negative for low-quality ideas. This implies that the perceived screening efficiency be sufficient to overcome both the higher reputational and other costs of having a high-quality idea rejected. More formally, the second condition requires that a screening mechanism satisfy the hypothesis that: aH
>
>
aL +PHaH
>
>PL
aL,
where an, aL = the perceived rate of success in avoiding purveyors of high- (low-) quality ideas
screening
or rejection by
p)H, pL = the perceived probability of success in avoiding screening or rejection given the reputation and other observable properties of the screening process by purveyors of high- (low-) quality ideas pHaH, pLaL = the perceived percentage avoid screening or rejection
of high- (low-) quality ideas that
The reader will note that while the first condition requires screening efficiency in fact, the second condition requires that a mechanism must also have a reputation among potential purveyors of accounting ideas for being able to separate highfrom low-quality ideas reliably and consistently. A third condition essential to an efficient and credible intellectual screening mechanism is that it must be viewed by academicians, practitioners, and other consumers in the market for accounting ideas as being both competent and credible for such an undertaking. This condition requires that the mechanism be perceived by the market as a whole, not merely by potential purveyors of accounting theories, beliefs, and opinions, as being a reliable and consistent source of information in differentiating high- from low-quality ideas. Market perception of an intellectual screening mechanism may be dependent on a number of factors, including its reputation for competency and objectivity, its insulation from political influences, and the degree of “due process” implicit in its screening procedures and processes. In addition to being efficient and credible, however, to make a discernible impact on the market for accounting ideas a mechanism must provide something beyond that provided by other existing mechanisms of this sort. There are several screening devices that serve the market for accounting ideas. Academic journals, prizes and awards selection committees, and scholarly works like
Making Accounting PoIicy: The Quest for Credibility in Financial Reporting are among them. From the perspective of the market they may be viewed as
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alternative information systems that generate signals5 that may be costlessly received by academicians, practitioners, and other consumers of accounting ideas. The marginal effect of a mechanism depends on whether the signals it generates are viewed by market agents as informationally superior, inferior, or noncomparable. A mechanism is informationally superior to another if market agents view its signals as: 1) finer (i.e., inclusive of all signals generated by the other mechanisms and providing additional signals as well) and at least as highly correlated with the quality of the ideas it screens; 2) more highly correlated with the quality of the ideas it screens and at least as fine; or 3) both finer and more highly correlated with the quality of the ideas it screens.6 Conversely, a mechanism is informationally inferior to another if market agents view its signals as: 1) less fine and not more highly correlated with the quality of the ideas it screens; 2) not greater in fineness and less highly correlated with the quality of the ideas it screens; or 3) both less fine and highly correlated with the quality of the ideas it screens. Finally, a mechanism is informationally noncomparable to another if market agents view its signals as: 1) noncomparable on the basis of fineness; or 2) noncomparable in terms of correlation with the quality of the ideas it screens. ’ Whereas it is difficult to evaluate the impact of a screening mechanism wilose signals are informationally noncomparable with those of other available mechanisms, signals generated by an informationally superior mechanism will tend to be viewed with greater confidence by market agents. Therefore, since the signals of alternative screening mechanisms act as informational substitutes for one another, an informationally superior mechanism will, over time, tend to exert a greater impact than its rivals on the state of thought in a discipline like accounting. Because of the nature of the market for ideas relevant to accounting, assessment of Solomons’ work in terms of its performance as an intellectual screening mechanism necessarily involves consideration of its ability to differentiate high- from low-quality theories, beliefs, and opinions; its perceived credibility as such; and the extent to which it offers something informationally different from other alternative screening mechanisms. Therefore, after reviewing some of the more salient aspects of his analysis in the next section, in Section IV I will consider his analysis in terms of its contribution toward helping to sort ’ It is important to distinguish between the term “signal” when used as a noun and when used as a verb. When used as a noun. as here, “signal” refers to the data transmmed by an information system (such as a screening mechanism) (Marschak and Radner 1972). When used as a verb, “signal” refers to the act of certifying one’s competency to the market (Spence 1973, 1974. 1976). 6 Although Blackwell’s fineness theorem requires only the generation of “finer” signals m order for one information system to be more valuable than another (Marschak and Radner 1972, pp. 53-59). a screening mechanism must be viewed by market agents as reliable as well in order to be considered informationally superior. Therefore, a screening mechanism is not informationally superior simply because it provides more signals. if the additional signals are viewed by markets agents as noisy or unreliable. ’ “Noncomparability on the basis of fineness” means the signals generated by each of the screening mechanisms involved are different. i.e., the signals of neither contain the signals generated by the other (Marschak and Radner 1972, pp. 53-59). “Noncomparability in terms of correlation with the quality of the ideas its screens” means that market agents cannot determine which mechanism’s signals are more reliable.
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out many of the prevailing accounting standard setting.
notions
as to the nature,
role, and propriety
of
III. Salient Aspects of Solomons’ Analysis Although Solomons examines many issues relevant to accounting and accounting standard setting, the analysis as a whole rests on three critical assertions: 1. Although there is always the potential for abuse implicit in the promulgation of mandatory accounting standards, there is a need for this form of regulation; 2. Accounting standards ought to be selected so as to yield representationally faithful (i.e., neutral or unbiased) disclosures, not because they would produce certain predetermined political/economic consequences; and 3. The primary threat to the credibility of accounting standard setting is posed by the FASB’s adherence to the historical cost model, not by the institutional or other properties of the body itself. Each of these assertions, which appear as recurrent themes generally throughout Solomons’ writings, is considered more fully in the discussion that follows.
The Need for Mandatory Accounting Standards As a starting point for any well-grounded analysis of accounting and accounting standard setting, it is necessary to consider the fundamental, yet controversial, question as to whether there is a need for this form of regulation. Although Solomons defers explicit consideration of this question until Chapter 9, he addresses it by first responding to the arguments of Richard Leftwich,g a critic of mandatory accounting standard setting, and then considering the potential advantages and dangers of such regulation. In arguing against mandatory accounting standard setting, Leftwich relies on three basic lines of laissez-faire argumentation: 1. Accounting information is a private, not public, good and can, therefore, be distributed by means of the market without the need for regulatory intervention; 2. Contracts can be written between shareholders and management to require management to report and reduce the accounting alternatives by which it reports, and private contracts impose more stringent restrictions than those imposed by regulators; and 3. It is not necessarily in the interests of shareholders to require managers always to use the same reporting rules for external reporting regardless of the circumstances facing the firm because flexible reporting rules would 8 Leftwich’s arguments are
presented,amongother places,in
Leftwich (1980)
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Steven B. Johnson
enable managers to choose accounting of the firm.
techniques
that maximize the value
Collectively, Leftwich’s neoclassical economic arguments assert that mandatory accounting standards are an unwarranted interference with the ability of parties to contract and determine how most appropriately to report on their own operations. In responding to Leftwich’s first argument, that accounting information is a private, not public, good, Solomons acknowledges that the line between what is public and what is private is not clear-cut, but this line of argumentation misses the point anyway. Accounting standards, according to Solomons, are like rules of the road for drivers that, although they restrict individual choice somewhat, make financial reporting more useful to investors and other users by enhancing comparability across firms. Further, he adds, merely arguing that regulation does not necessarily insure production of the right type or quantity of information does not provide support for the view that the market can be relied on to do so. It is in this sense that the regulatory failure argument begs the point in the same manner as the market failure argument assailed by Leftwich (Solomons 1986, pp. 184-185). In responding to Lefiwich’s second argument, that contracts can be written to insure adequate reporting by management, Solomons counters that some standardization can be useful in reducing the costs of receiving and interpreting financial reports and in reducing the costs of monitoring (auditing) those reports. He notes, however, that there is an optimum, a balance between the gains and losses from standardization, and therefore too much standardization can be as detrimental as too little. While opinions differ as to just where the optimum is to be found, it is reasonable to assume that at least some degree of standardization is preferable to none (Solomons 1986, p. 185). In responding to Leftwich’s third argument, that flexible reporting rules would enable managers to report so as to maximize the value of the firm, Solomons retorts that there is a strong potential for abuse by managers seeking to confuse and mislead their critics (and their shareholders)-all in the name of maximizing the value of the firm. This antiregulatory assumption that things always work best in the absence of interference by regulators is referred to by Solomons as “Panglossian economics” (Solomons 1986, p. 188). A Panglossian view that the free market will necessarily induce managers to supply the optimal amount of information and do so in an unbiased fashion is not justified (Solomons 1986, p. 189). While the need for mandatory accounting standards is a question on which reasonable men might differ, two important aspects of Solomons’ analysis are worth noting. First, as a means of considering the case against mandatory accounting standards, Solomons focuses on the most defensible arguments offered by opponents of this form of regulation. It is in this sense that Solomons’ analysis is a legitimate intellectual exercise, not merely an attempt to conjure up
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and exorcise arguments that are merely “straw men.” Secondly, in assessing the case against mandatory accounting standards, Solomons’ analysis is balanced in that it looks carefully at both sides of an argument. It is this balance and perspective that enables the reader to appreciate the limitations of many of the arguments offered by both opponents and proponents of mandatory accounting standards and thereby enhances the credibility of Solomons’ analysis.
Selection of Standards on the Basis of Representational Faithfulness Essential to the credibility of any accounting standard-setting process is acceptability of the normative criterion (or criteria) used to select and justify the standards selected. In his discussion of the quality of accounting information in Chapter 5, Solomons considers the controversial question of whether accounting standards ought to be selected and justified on the basis of their representational faithfulness/neutrality or on the basis of their political/economic consequences. In addressing this important question, Solomons starts with the assumption that accounting standard setting is defensible only to the extent that it helps to enhance the quality, hence usefulness, of reported information. As seemingly straightforward as this assumption is, it has not been without its critics who, arguing on the basis of the Stigler-Peltzman economic theory of regulation9 contend that accounting standard setting inevitably serves the interests of corporate management-the very parties intended to be regulated. Such critics argue that although accounting standards may be “marketed” to the public on the basis of their representational faithfulness/neutrality or some other criterion, the use of such a justification is merely a “smokescreen” to rationalize the promulgation of standards that are preferred by corporate managers, regardless of whether they enhance the quality, hence usefulness, of the reported information. lo Although in Chapter 5 Solomons carefully presents the case for representational faithfulness/neutrality as the appropriate basis for accounting standard setting, in Chapter 12 he responds to the advocates of this “economic capture” view of accounting regulation. Focusing on a 1978 paper by Watts and Zimmerman that presents evidence in support of this economic capture theory of accounting standard setting, Solomons observes that the evidence they offer is “extremely flimsy” (Solomons 1986, p. 240). Specifically, he notes four serious problems with their reported findings (Solomons 1986, pp. 239-246): 1. Owing to the minuteness of the evidence presented, the theory they offer is, at best, merely an unsupported hypothesis; 2. Other evidence suggests that reporting firms’ FASB lobbying activities cannot be explained solely in terms of their self-interests; 9As originally posited, the Stigler-Peltzman economic theory of regulation was set forth in Stigler (197 I, 1974) and Peltzman (1976). ” Among the papers that offer this line of argumentation, which refers to itself as the positive theory of accounting standard setting, are Watts and Zimmerman (1978, 1979).
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3. Other evidence suggests that, in dealing with the FASB, public accounting firms do not, as Watts and Zimmerman suggest, always take positions in agreement with the perceived interests of their important clients; and 4. Other evidence suggests that, contrary to what Watts and Zimmerman suggest, accounting policy makers do act independently of reporting firms’ expressed preferences in setting standards. Solomons (1986, p. 241) sums up his assessment by concluding that Watts and Zimmerman offer less a “scientific theory” than “a line on which to hang out their intellectual laundry. ” In explaining why representational faithfulness/neutrality, not political/ economic consequences, must ultimately be the basis on which accounting standards are selected and justified, Solomons reemphasizes that the credibility of the standard setting process is dependent on the general acceptability of its pronouncements. He states (pp. 244-245): No standard setting body can enforce a standard for long that does not have wide even a body like the FASB, which has the enforcement powers of the SEC behind it. . . . [Therefore,] the key question to be answered [is]-what qualities must a standard have to make it generally accepted? . Fortunately, although the FASB has shown itself to be sensitive to the views of its constituents, it has had the sense to recognize that the credibility of accounting will be preserved only by providing society with relevant and reliable information about economic events and transactions acceptance-not
This need to provide relevant and reliable information to insure credibility, he concludes, explains why accounting standards must be selected and justified on the basis of their representational faithfulness/neutrality, not their political/ economic consequences (Solomons 1986, p. 246). Although the appropriate criterion (or criteria) for selecting accounting standards is a matter open to debate, two aspects of Solomons’ treatment of this question might be noted. First, in responding to proponents of the “economic view of accounting standard setting, Solomons emphasizes the capture” fundamental scientific precept that strong claims require strong evidence and that the evidence presented by Watts and Zimmerman is simply inadequate to sustain their claims. This response on methodological, not philosophical or ideological, grounds is, perhaps, the only appropriate way of evaluating the validity of a theory alleged to be supported by empirical evidence. Solomons does not dismiss the economic capture theory per se, but merely argues that its proponents have not met the burden of persuasion imposed on them, at least in the accounting field. Secondly, in assessing the question of how accounting standards are actually selected, Solomons exhibits balance and perspective by acknowledging that accounting policy makers are (and should be) sensitive to the political/economic consequences of their pronouncements, but argues that general acceptability over time requires more. It is this balance and perspective that helps to frame the controversy for the reader and adds credibility to Solomons’ analysis of it (Solomons 1986, pp. 239-246).
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The Threat to Credibility Posed by the Historical Cost Model Perhaps the most controversial of Solomons’ basic assertions is that the primary threat to the credibility of accounting standard setting is posed by the FASB’s adherence to the historical cost model, not by the institutional or other properties of the body itself. In Chapters 6-8 Solomons considers the problems inherent in the present historical cost-based accounting structure, the alternative accounting models available, and why a current cost constant purchasing power accounting (CCCPPA) structure would cure many of the problems inherent in the present structure. In assailing the present historical cost-based accounting structure Solomons argues that its primary defect is its lack of generality or robustness (Solomons 1986, p. 165). That is, he argues, the historical cost model should be viewed as a special case of the current cost model that “is appropriate only if prices, in fact, do not change between the data the resources are acquired and the date they are used or the accounting date, if that comes first” (Solomons 1986, p. 165). Since parties are rarely that constant, use of the historical cost model tends to produce measurements that do not accurately reflect the underlying transactions and economic events. To determine whether, in spite of its lack of generality or robustness in the face of changing prices, there may be other redeeming properties of the historical cost model, Solomons considers some of the leading arguments offered by proponents (Solomons 1986, p. 167). One such argument, for example, often advanced by proponents of historical cost accounting is its supposed “objectivity” (Solomons 1986, p. 167) vis-a-vis current cost accounting. This argument suggests that since “historical cost numbers are derived from actual transactions that have been entered into by the enterprise itself rather than (sometimes) from transactions that are being entered into by others in the marketplace” (Solomons 1986, p. 167), the resultant measurements are more objective. This and similar pro-historical cost arguments are, according to Soiomons, “largely spurious” because any objectivity gained in this manner “is lost as soon as resources haved to be carried over from one accounting period to another and costs have to be allocated to reflect these interperiod resource transfers” (Solomons 1986, pp. 167-168). After identifying several other flaws in the arguments offered in support of historical cost accounting, Solomons considers the case for current cost accounting. He observes (Solomons 1986, p. 171):
The adoption of value to the business (current cost or lower recoverable amount) in place of historical cost as the attribute to be used for measuring assets and. if relevant, liabilities would greatly increase the relevance of the information conveyed in financial reports, and it would increase its representational faithfulness. It is important that these improvements be secured without unduly increasing the subjectivity that already surrounds historical cost measurements.
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He adds that subjectivity can be kept to a bare minimum whenever an “asset can be bought or sold in its present condition at a determinable price” and “evidence of that fact can be inferred from a number of transactions of a kind the enterprise might enter into, whether it actually does so or not” (Solomons 1986, p. 171). In other cases, however, “current cost may not be determinable [and] lower recoverable amount-the higher of net realizable value or net present value of future cash flows-must then take over as a measure of value to the business” (Solomons 1986 p. 173). Such a CCCPPA structure would offer several important advantages over the present historical cost accounting structure that is the current basis for financial reporting. Although much of Solomons’ indictment of historical cost accounting is not new, he suggests, almost by innuendo, that it is the FASB’s aherence to this model, not the institutional and other properties of the body itself, that may constitute the primary threat to the credibility of accounting standard setting. If, for example, the much criticized practice of “creative accounting” is merely a response by reporting firms to what they regard as a set of reporting rules that distorts their actual performance, it may be attributable to the historical cost model, not accounting standard setting. If such reporting problems can be eliminated by adopting a more appropriate accounting structure, based on, perhaps, a CCPPA approach, abandoning accounting standard setting, rather than simply the historical cost model, may be equivalent to “throwing out the proverbial baby with the bath water.” Clearly this assertion, that it is the historical cost model, not the institutional and other properties of the FASB itself, that poses the primary threat to the credibility of accounting standard setting, is open to debate. ii The controversial nature of the assertion notwithstanding, however, two features of Solomons’ analysis should be noted. First, the assertion itself is developed in a gradual, yet deliberate, manner by exposing the reader to the underlying thought process on which it is based. Among the elements of this underlying thought process are the nature of the criticisms of financial reporting, the need for mandatory accounting standards, the institutional and other advantages of the current accounting standard setting process, and the inherent deficiencies implicit in the historical cost model. Collectively, the reader is left with the suspicion that it is the historical cost model, not the FASB itself, that is in need of change. Second, perhaps the most intriguing characteristic of Solomons’ analysis is its ability to draw together so many seemingly divergent aspects of the problem in order to extract a plausible and thought-provoking perspective on the credibility issue. It is this ability to connect and reconcile so many seemingly unconnected pieces of the puzzle that may well be the single most impressive aspect of the book as a whole. I’ It might be argued, for example, that the fact that the FASB continues to “legitimize” the historical CObt model seems contradictory to S&mom assertion. Such a line of argumentation assumer, however. that it IS impossible to effectively judge the output of a process separately from its procedural and other features.
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IV. Solomons’ Contribution
151
Analysis: Screening Efficiency,
Credibility, and
As discussed in Section II, in order for Solomons’ treatise to contribute as an intellectual screening mechanism it must be able to screen out or separate highfrom low-quality ideas consistently and reliably and be perceived as able to do so by both potential purveyors and consumers of theories, beliefs, and opinions in the market for accounting ideas. In addition, it must provide something different or not redundant with that provided by other such mechanisms already available. Although any assessment of Solomons’ ability to screen out or separate highfrom low-quality theories, beliefs, and opinions concerning accounting and accounting standard setting would, prior to completion of the scientific aging process, be premature at best, it is possible to draw certain circumstantially based inferences from the nature of the analysis itself and the rather considerable reputation of the author. Further, assessment is facilitated by the fact that many of the issues considered are not new and have therefore already been “worked over” (Stigler 1955, p. 301) somewhat in the market for accounting ideas. To provide greater focus to the assessment, it is useful to reconsider Solomons’ screening of ideas relevant to each of the three basic assertions discussed in the previous section. As to his screening of ideas relevant to the first assertion, the need for mandatory accounting standards, Solomons evaluates alternative ideas in terms of their compatibility with the proposition that there is a balance between the gains and losses from standardization, and therefore too much standardization can be as detrimental as too little. Given this intuitively appealing proposition, it is easy to see why theories, beliefs, and opinions that take extreme positions for or against standardization, while providing the basis for an interesting intellectual discourse, may well be inherently flawed. Therefore, since Solomons restricts his screening to such extreme positions, his rejection of intellectually pure but pragmatically questionable ideas may well be borne out by the scientific aging process. In his screening of ideas relevant to the second assertion, that accounting standards ought to be selected on the basis of representational faithfulness, not economic or political consequences, Solomons evaluates alternative theories, beliefs, and opinions in terms of their compatibility with the proposition that only accounting standards that can gain and retain wide acceptance will be sustained over time. It follows, he posits, that selection on the basis of a scientifically credible criterion, such as representational faithfulness, is necessary for a standard to pass this test. His dismissal of economic or political consequences as a normative selection criterion is based on the intuitively appealing view that a standard selected on such a basis would be hard-pressed to gain such wide acceptance and may raise serious concerns as to the legitimacy of the standard-setting process itself. Therefore, since Solomons rejects or questions theories, beliefs, or opinions that are incompatible with the need for
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the wide acceptability of accounting standards, there is reason to believe that his screening of ideas along this line may also be borne out by the scientific aging process. It is Solomons’ screening of ideas relevant to the third assertion, that adherence to the historical cost model, not the institutional and other properties of the rulemaking body itself, poses the primary threat to the credibility of accounting standard setting, that is, perhaps, the most difficult to evaluate. The difficulty in evaluating this assertion comes from the nagging suspicion that there may be something inherently wrong with a standard setting body that is unable to extricate itself from the clutches of a model that is so flawed. While at first blush this suspicion may have considerable appeal, on closer examination it appears that there may be merit in Solomons’ contention that it is possible to abandon the historical cost model without also abandoning the standard setting body that has, heretofore, clung to it. The resolution of this question depends, to a large degree, on whether or not the FASB is robust enough to accomodate such a change without giving up the base of support on which its authority and acceptability depends. If such a separability is both appropriate and plausible, critics that attack accounting standard setting in general, and the FASB in particular, because of deficiencies in the historical cost model may, as Solomons suggests, be committing a guilt by association fallacy. While the jury is still out on this question, it may well be that Solomons’ screening of theories, beliefs, and opinions along this line will also stand up over time (Solomons 1986, Chapter 8). This tendency to give Solomons the benefit of the doubt on these and the other lines of screening in his book is prompted by the recognition that over the course of his distinguished academic career he has demonstrated a remarkable proclivity to put things into perspective and identify faddish and fallacious ideas well ahead of others. It is this track record, as well as the balance and clarity of the analysis presented, that adds credibility to Solomons’ work. In addition to being both an efficient and credible vehicle for differentiating high- from low-quality accounting ideas, to be a bona fide intellectual screening mechanism Solomons’ effort must also provide something different or not redundant with that provided by other mechanisms already available. While many of the assessments of individual ideas presented are not new, it is the overall perspective provided by the analysis as a whole that is, perhaps, Solomons’ greatest contribution. It is this ability to draw together so many seemingly divergent aspects of the problem in order to extract a plausible, thought-provoking, and highly readable perspective on the credibility issue that distinguishes Solomons’ analysis from those provided by other mechanisms already available. One does not, of course, have to agree with all aspects of Solomons’ analysis to recognize that this work is more than just another well-written literary offering. Although the actual efficiency with which Solomons has been able to differentiate high- from low-quality accounting theories, beliefs, and opinions
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can be definitively assessed only after the scientific aging process has been completed, there is reason to believe that Making Accounting Policy: The Quest for Credibility in Financial Reporting is an intellectual screening mechanism that will have a positive long-run impact on the market for accounting ideas.
V. Conclusion This essay has evaluated Solomons’ analysis in terms of its ability to contribute to the market for accounting ideas as an intellectual screening mechanism. Having concluded that his treatise possesses the requisites to contribute in such a capacity, it is perhaps, appropriate to consider briefly the usefulness of this paradigmatic framework and how it has been applied in this paper. Simply stated, assessment of a work like Solomons’ in terms of the signaling/ screening paradigm offers at least two potential advantages over more traditional approaches. First, this paradigmatic structure suggests specific criteria that can be used to evaluate the potential contribution, if any, to the market for accounting ideas. Such a structure forces the evaluator to assess the screening characteristics of a work of this type and go beyond its mere literary virtues to more substansive considerations. Secondly, this paradigmatic structure suggests that the perceived credibility of the author(s) of a work of this type may be just as important as the substantive quality of the analysis itself. It forces the evaluator to consider the extent to which the market for ideas may discount such a work because of the perceived biases of the author(s). Although, as the evaluation presented in this paper demonstrates, it is easier to specify the criteria of screening efficiency, credibility, and contribution than it is to apply them in assessing a particular work, the structure and perspective provided by such an approach may well compensate for such initial implementation problems. In evaluating the application of the signaling/screening approach in the current paper, at least two considerations should be noted. First, the application of such a structured approach may well be particularly appropriate in cases, such as the current one, where the relationship between the evaluator and author of the work being evaluated might be perceived as less than arm’s length. In such cases the imposition of criteria that force the evaluator to ask the “hard questions” may be necessary to provide the requisite level of scholarly detachment essential to the credibility of the evaluation. Secondly, in assessing such factors as the perceived credibility of the author of the work, the evaluator has been forced to draw upon insights gained beyond the context of the book itself. This need suggests that the assessment of any work of this type may require more than merely that it should be read. In closing, it seems appropriate to reemphasize that, ultimately, the contribution of Solomons’ book will be decided in the market for accounting ideas, not by the tenor of an evaluation such as this. The early returns suggest, however, that this book is likely to make a significant contribution in helping to
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sort out many of the prevailing accounting standard setting.
notions as to the nature,
role, and propriety
of
The author acknowledges the helpful suggestions provided by two anonymous referees and the guidance and encouragement provided by the editors. Any remaining errors or misstatements are the sole responsibility of the author.
References Akerlof, G. Aug. 1970. The market for “lemons”: Quality uncertainty and the market Mechanism. Quarterly Journal of Economics 84(3):488-500. Arrow, K. July 1973. Higher education as a filter. Journal of Public Economics 2: 193216. Kuhn, T. 1962. The Structure
of Scientific Revolutions.
Chicago;
University
of
Chicago Press.
Journal of and Economics 2(3): 193-221. Marschak, J. and Radner, R. 1972, Economic Theory of Teams, New Haven, Conn.: Leftwich, R. Dec. 1980. Market failure fallacies and accounting information.
Accounting
Yale University
Press.
Journal of Law 19(2):21 l-240. Solomons, D. 1986. Making Accounting Policy: The Quest for Credibility in Financial Reporting. Wharton Executive Library Series, New York: Oxford Peltzman,
S. Aug. 1976. Toward a more general theory of regulation.
and Economics
University Spence,
Press.
M. Aug.
1973. Job market
Quarterly Journal of Economics.
signaling.
87(3):355-374. Spence, M. 1974. Market Signaling: Informational Transfer in Hiring and Related Screening Processes. Cambridge, Mass. Harvard University Press. Spence,
M. Nov.
1976. Informational
aspects
of market structure:
An introduction.
Quarterly Journal of Economics 90~591-597. Stigler,
G. Nov.
1955. The nature
and role of originality
in scientific
progress,
Economica 22(4):293-302. Stigler, G. Spring 1971. Theory of economic
regulation.
BeN Journal of Economics
2(1):3-21. Stigler, G. Autumn 1974. Free riders and collective action: An appendix to theories of economic regulation. Bell Journal of Economics 5(2):359-365. education, Stiglitz, J. June 1975. The theory of “screening,” income. American Economic Review 65(3):283-300.
Watts, R. and Zimmerman, of accounting standards.
and the distribution
of
J. Jan. 1978. Towards a positive theory of the determination Review 53(l): 112-134.
The Accounting
Watts, R. and Zimmerman, J. April 1979. The demand for and supply of accounting theories: The market for excuses. The Accounting Review 54(2):272-305.
A Perspective on Solomons’ Quest for Credibility in Financial Reporting Steven B. Johnson
David Solomons’ 1986 book, Making Accounting Policy: The Quest for Credibility in Financial Reporting, as an intellectual screening mechanism
This paper evaluates
operating in the market for accounting ideas. Such a mechanism is evaluated in terms of its ability to screen out high- from low-quality theories, beliefs, and opinions; to be perceived as credible for such an undertaking by both purveyors and consumers of such theories, beliefs, and opinions; and to contribute something different from or not redundant with that of other mechanisms already available. The evaluation suggests that, although the contribution of Solomons’ analysis will ultimately be decided in the market for accounting ideas, this book has the potential to make a significant contribution toward helping to sort out many of the prevailing notions as to the nature, role, and propriety of accounting standard setting.
I. Introduction The state of thought in a discipline
like accounting tends to advance, most often, not by the introduction of radical new ideas or by flashes of prophetic insight, but rather by means of a careful sifting and winnowing from among the existing inventory of theories, beliefs, and opinions. Viewed from this perspective, such theories, beliefs, and opinions are like experiments, few of which will succeed and exert a lasting impact on the discipline. In the final analysis, the quality of thought in any discipline depends as much on the collective wisdom of those who help to screen out faddish and fallacious ideas as on the quality of the available stock of ideas itself. It is in this important intellectual tradition that David Solomons, in his 1986 book Making Accounting Policy: The Quest for Credibility in Financial Reporting, analyzes and assesses the soundness of many of the current theories, beliefs, and opinions concerning the nature, role, and propriety of accounting standard setting. Although the book is characterized by such literary virtues as a
Address reprint requests to Professor Steven B. Johnson, Graduate School of Business, Columbia University. New York, NY 10027. Journal of Accounting
0
1988 Elsevier
and Public Policy, 7. 137-154 Science Publishing Co.. Inc.
(1988;
137 02784254/88/$03.50
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Steven B. Johnson
balanced analysis of alternative points of views, well-documented reasoning, and an expository style that clarifies, rather than confounds, the essential issues considered, these attributes are, by themselves, necessary, but not sufficient, in order for such a work to fulfill its function as an intellectual screening mechanism. Therefore, this paper seeks to evaluate Solomons’ work not merely as a literary offering, but as an intellectual screening mechanism. ’ The remainder of this essay is organized as follows. Section II discusses the nature and function of intellectual screening mechanisms and suggects an approach for evaluating their performance. Section III reviews some of the more salient aspects of Solomons’ analysis. Section IV evaluates Solomons’ effort on the basis of its efficiency, credibility, and contribution as an intellectual screening mechanism. Some additional thoughts and observations concerning intellectual screening mechanisms and the approach used in this article are provided in the final section.
II. Intellectual
Screening Mechanisms
In an intellectually open society the ultimate acceptance or particular theory, belief, or opinion is determined in the market win acceptance in such a market, an idea must evolve and mature enable it to meet the demands placed upon it at both an esoteric level. As Stigler (1955, p. 301) has so aptly pointed out:
rejection of a for ideas. ’ To sufficiently to and pragmatic
A new idea does not come forth in its mature scientific form. It contains logical ambiguities or errors; the evidence on which it rests is incomplete or indecisive; and its domain of applicability is exaggerated in certain directions and overlooked in others. These deficiencies are gradually diminished by a peculiar scientific ageing process, which consists of having the theory “worked over” from many directions by many men. Each of the individuals that “works over” a particular theory, belief, or opinion in this sense serves as an intellectual screening mechanism that can profoundly affect its ultimate form, interpretation, and acceptability. In order to appreciate the critical role played by the intellectual screening mechanisms that operate within a market for ideas, it is useful to consider what might happen to the state of knowledge in a particular discipline in the absence of ’ For a general discussion (1973), here.
Arrow
* This
(1973).
assertion
does not, however,
of screening mechanisms
and Stiglitz
(1975).
that the market for ideas determines trivialize
cal and other scientific
the role of epistomological
considerations
out“
than, say, the market for cornflakes,
its ability to win and maintain credibility line see Stigler (1955).
the acceptability
fallacious
of a particular
theory,
considerations.
impact on the acceptability
or faddish notions.
the acceptability
(1970),
the basis for the assessment
and other scientific
can exert a significant
ideas and. in that manner, help to “screen differently
and their role in markets see, e.g., Akerlof
It is this paradigm that forms
While
belief,
Clearly
Space
presented or opinion
epistomologi-
of accounting and other
the market for ideas operates
of an idea in accounting or elsewhere
in the face of constant challenge. For an interesting
discussion
depends on along this
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139
efficient screening mechanisms. Although such markets are constantly bombarded with new theories, beliefs, and opinions, it is generally infeasible for most academicians, practitioners, and other market participants to differentiate singlehandedly potentially insightful ideas from those that are misleading. Therefore, if efficient mechanisms do not evolve to help screen out misleading ideas, a type of intellectual gridlock or market failure will occur and some potentially insightful ideas will be overlooked or rejected without extracting their residue of truth and some misleading ideas will be accepted in their place. To consider the possible consequences of a market for ideas in which the existing intellectual screening mechanisms are either biased or inoperative, the reader is referred to Figure 1. Quality distribution A represents the density function that corresponds to the potential insightfulness or quality of all possible theories, beliefs, and opinions that could be introduced into the market for ideas within a particular time frame, with pl being the ex ante probability of a particular idea being accepted or rejected. Since the introduction of a rejected idea imposes reputational and other costs on the party or parties with whom it is identified, in a market characterized by biased or inoperative intellectual screening mechanisms the purveyors of high-quality ideas face a higher expected reputational cost from rejection than purveyors of low-quality ideas.3 As a result, while purveyors of low-quality ideas may be willing to introduce their theories, beliefs, and opinions into the market, purveyors of high-quality ideas may tend to withhold or suppress them. 4 At this point, only low-quality ideas may be introduced and the quality distribution shrinks from distribution A to distribution B. Since the market is unable to differentiate the above-averagequality ideas in distribution B from the below-average ideas, and the ex ante probability of being accepted or rejected is now ,uz , only below-average-quality ideas will be introduced and the quality distribution again shrinks and the average quality of ideas introduced deteriorates even further. It is this iterative process that, if not corrected, may cause the market for ideas to operate inefficiently or fail and lead to intellectual gridlock in a particular discipline. In a well-functioning market for ideas, however, there are intellectual screening mechanisms in place that serve to differentiate high- from low-quality theories, beliefs, and opinions and, thus, help to avert this sort of breakdown. In the market for ideas that serves accounting, for example, there are established academic journals that, much like powerful corporate entities, have acquired an
’ This from
assertion
rejection
from low-quality
that, in such a market,
than purveyors
ideas, the probability
idea; and(b) high-quality potential quality
reputational
of high-quality
ideas face a higher expected reputational
ideas assumes that: (a) since the market cannot differentiate
of rejection
of a high-quality
theory,
who introduces
Formally
belief,
of superior
stated. this assumes first-order
or opinion
and the superiority
theories
of natural
insight,
stochastic
of the intellectual
and hence with greater dominance between the
capital possessed
by the
it to the market.
’ As an anecdotal example of this tendency, consider the actions of Charles his
cost high-
idea is at least as great as that of a low-quality
ideas are more apt to emanate from individuals
capital at risk.
of a particular
individual
purveyors
of low-quality
selection
until
many years
evidence. The biasedness of the intellectual are well documented in the literature
(Kuhn
after
screening mechanisms 1962, Chapter
Darwin
they were originally 12).
implicit
who withheld
formulated
publication
of
and documented
by
in the market for ideas faced by Darwin
.__
-_r
_..~”
-
.”
__^.
QUALITY OF IDEAS
__I__^
_
nl
“,
I”
__
,”
“.
I
iilGl!l
_
_>
2
^
_
1
d
_
-
_
-
(Potentially Insightful Theories, Beliefs, and Opinions)
Figure 1. Distribution of the quality of ideas and the adverse selection phenomenon.
(Misleading
Theories, Beliefs, and Opinions)
q
. . .
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141
almost institutional status in their role as intellectual screening mechanisms. Similarly, there are individual works, like that of Solomons’, that provide an alternative mechanism for screening out potentially insightful ideas from those that are misleading. To the assess the contribution, if any, provided by an individual work like that of Solomons’, it is necessary to consider both the extent to which it displays the properties of an efficient screening mechanism for ideas and the extent to which it provides something beyond that provided by other available mechanisms of this sort. Solomons’ analysis contributes in this sense only if it is an efficient and credible mechanism for screening accounting ideas and provides something different or not redundant with that of other mechanisms. Therefore, before assessing Solomons’ effort in Section IV, both the properties of an efficient and credible screening mechanism and the potential marginal contribution of such a mechanism are considered in this section. An intellectual screening mechanism can effectively assist accountants and others in differentiating high from low-quality theories, beliefs, and opinions only if three essential conditions are satisfied. First, the mechanism must be able to screen out or separate high- from low-quality ideas consistently and reliably. The statistical implications of this condition are demonstrated in Figure 2. In this figure, the vertical axis represents the probability of not being screened out and the horizontal axis represents the quality of a particular theory, belief, or opinion. The ellipse drawn with the solid line represents the envelope of observations or experiences generated by mechanism X, while the ellipse drawn with the broken line represents the corresponding envelope for mechanism Y. Finally, the figure is divided into four quadrants: quadrant I where the probability of not being screened out is high, but the quality of the idea is low; quadrant II where both the probability of not being screened out and quality are high; quadrant III where both the probability of not being screened out and quality are low; and quadrant IV where quality is high, but the probability of not being screened out is low. In order to evaluate the relative screening efficiency of mechanisms X and Y, two aspects of the figure should be noted. First, the observations in quadrant I represent type I (CY)errors committed in screening, while observations in quadrant IV represent type II (P) errors. Second, because the incidence of type I and type II errors is lower for mechanism Y, it can be concluded that mechanism Y has greater screening efficiency than mechanism X. Therefore, although not completely free of occasional type I and type II errors, mechanisms Y screens out or separates low-quality theories, beliefs, and opinions more consistently and reliably, and thus satisfies the first condition better, than mechanism X. A second condition essential for such a mechanism is that the perceived reputational and other costs of having one’s ideas screened out or rejected must be negatively correlated with the quality of the ideas themselves. This condition is necessary to encourage the introduction of high-quality ideas into the market
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Steven B. Johnson
’
I
\
\
143
Review Essay
by those possessed of superior intellectual (and hence, potential reputational) capital. Specifically, satisfaction of this second condition requires that the mechanism must be viewed by potential purveyors of theories, beliefs, and opinions as being efficient enough to make the expected reputational and other effects of screening positive for high-quality ideas and negative for low-quality ideas. This implies that the perceived screening efficiency be sufficient to overcome both the higher reputational and other costs of having a high-quality idea rejected. More formally, the second condition requires that a screening mechanism satisfy the hypothesis that: aH
>
>
aL +PHaH
>
>PL
aL,
where an, aL = the perceived rate of success in avoiding purveyors of high- (low-) quality ideas
screening
or rejection by
p)H, pL = the perceived probability of success in avoiding screening or rejection given the reputation and other observable properties of the screening process by purveyors of high- (low-) quality ideas pHaH, pLaL = the perceived percentage avoid screening or rejection
of high- (low-) quality ideas that
The reader will note that while the first condition requires screening efficiency in fact, the second condition requires that a mechanism must also have a reputation among potential purveyors of accounting ideas for being able to separate highfrom low-quality ideas reliably and consistently. A third condition essential to an efficient and credible intellectual screening mechanism is that it must be viewed by academicians, practitioners, and other consumers in the market for accounting ideas as being both competent and credible for such an undertaking. This condition requires that the mechanism be perceived by the market as a whole, not merely by potential purveyors of accounting theories, beliefs, and opinions, as being a reliable and consistent source of information in differentiating high- from low-quality ideas. Market perception of an intellectual screening mechanism may be dependent on a number of factors, including its reputation for competency and objectivity, its insulation from political influences, and the degree of “due process” implicit in its screening procedures and processes. In addition to being efficient and credible, however, to make a discernible impact on the market for accounting ideas a mechanism must provide something beyond that provided by other existing mechanisms of this sort. There are several screening devices that serve the market for accounting ideas. Academic journals, prizes and awards selection committees, and scholarly works like
Making Accounting PoIicy: The Quest for Credibility in Financial Reporting are among them. From the perspective of the market they may be viewed as
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Steven B. Johnson
alternative information systems that generate signals5 that may be costlessly received by academicians, practitioners, and other consumers of accounting ideas. The marginal effect of a mechanism depends on whether the signals it generates are viewed by market agents as informationally superior, inferior, or noncomparable. A mechanism is informationally superior to another if market agents view its signals as: 1) finer (i.e., inclusive of all signals generated by the other mechanisms and providing additional signals as well) and at least as highly correlated with the quality of the ideas it screens; 2) more highly correlated with the quality of the ideas it screens and at least as fine; or 3) both finer and more highly correlated with the quality of the ideas it screens.6 Conversely, a mechanism is informationally inferior to another if market agents view its signals as: 1) less fine and not more highly correlated with the quality of the ideas it screens; 2) not greater in fineness and less highly correlated with the quality of the ideas it screens; or 3) both less fine and highly correlated with the quality of the ideas it screens. Finally, a mechanism is informationally noncomparable to another if market agents view its signals as: 1) noncomparable on the basis of fineness; or 2) noncomparable in terms of correlation with the quality of the ideas it screens. ’ Whereas it is difficult to evaluate the impact of a screening mechanism wilose signals are informationally noncomparable with those of other available mechanisms, signals generated by an informationally superior mechanism will tend to be viewed with greater confidence by market agents. Therefore, since the signals of alternative screening mechanisms act as informational substitutes for one another, an informationally superior mechanism will, over time, tend to exert a greater impact than its rivals on the state of thought in a discipline like accounting. Because of the nature of the market for ideas relevant to accounting, assessment of Solomons’ work in terms of its performance as an intellectual screening mechanism necessarily involves consideration of its ability to differentiate high- from low-quality theories, beliefs, and opinions; its perceived credibility as such; and the extent to which it offers something informationally different from other alternative screening mechanisms. Therefore, after reviewing some of the more salient aspects of his analysis in the next section, in Section IV I will consider his analysis in terms of its contribution toward helping to sort ’ It is important to distinguish between the term “signal” when used as a noun and when used as a verb. When used as a noun. as here, “signal” refers to the data transmmed by an information system (such as a screening mechanism) (Marschak and Radner 1972). When used as a verb, “signal” refers to the act of certifying one’s competency to the market (Spence 1973, 1974. 1976). 6 Although Blackwell’s fineness theorem requires only the generation of “finer” signals m order for one information system to be more valuable than another (Marschak and Radner 1972, pp. 53-59). a screening mechanism must be viewed by market agents as reliable as well in order to be considered informationally superior. Therefore, a screening mechanism is not informationally superior simply because it provides more signals. if the additional signals are viewed by markets agents as noisy or unreliable. ’ “Noncomparability on the basis of fineness” means the signals generated by each of the screening mechanisms involved are different. i.e., the signals of neither contain the signals generated by the other (Marschak and Radner 1972, pp. 53-59). “Noncomparability in terms of correlation with the quality of the ideas its screens” means that market agents cannot determine which mechanism’s signals are more reliable.
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out many of the prevailing accounting standard setting.
notions
as to the nature,
role, and propriety
of
III. Salient Aspects of Solomons’ Analysis Although Solomons examines many issues relevant to accounting and accounting standard setting, the analysis as a whole rests on three critical assertions: 1. Although there is always the potential for abuse implicit in the promulgation of mandatory accounting standards, there is a need for this form of regulation; 2. Accounting standards ought to be selected so as to yield representationally faithful (i.e., neutral or unbiased) disclosures, not because they would produce certain predetermined political/economic consequences; and 3. The primary threat to the credibility of accounting standard setting is posed by the FASB’s adherence to the historical cost model, not by the institutional or other properties of the body itself. Each of these assertions, which appear as recurrent themes generally throughout Solomons’ writings, is considered more fully in the discussion that follows.
The Need for Mandatory Accounting Standards As a starting point for any well-grounded analysis of accounting and accounting standard setting, it is necessary to consider the fundamental, yet controversial, question as to whether there is a need for this form of regulation. Although Solomons defers explicit consideration of this question until Chapter 9, he addresses it by first responding to the arguments of Richard Leftwich,g a critic of mandatory accounting standard setting, and then considering the potential advantages and dangers of such regulation. In arguing against mandatory accounting standard setting, Leftwich relies on three basic lines of laissez-faire argumentation: 1. Accounting information is a private, not public, good and can, therefore, be distributed by means of the market without the need for regulatory intervention; 2. Contracts can be written between shareholders and management to require management to report and reduce the accounting alternatives by which it reports, and private contracts impose more stringent restrictions than those imposed by regulators; and 3. It is not necessarily in the interests of shareholders to require managers always to use the same reporting rules for external reporting regardless of the circumstances facing the firm because flexible reporting rules would 8 Leftwich’s arguments are
presented,amongother places,in
Leftwich (1980)
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Steven B. Johnson
enable managers to choose accounting of the firm.
techniques
that maximize the value
Collectively, Leftwich’s neoclassical economic arguments assert that mandatory accounting standards are an unwarranted interference with the ability of parties to contract and determine how most appropriately to report on their own operations. In responding to Leftwich’s first argument, that accounting information is a private, not public, good, Solomons acknowledges that the line between what is public and what is private is not clear-cut, but this line of argumentation misses the point anyway. Accounting standards, according to Solomons, are like rules of the road for drivers that, although they restrict individual choice somewhat, make financial reporting more useful to investors and other users by enhancing comparability across firms. Further, he adds, merely arguing that regulation does not necessarily insure production of the right type or quantity of information does not provide support for the view that the market can be relied on to do so. It is in this sense that the regulatory failure argument begs the point in the same manner as the market failure argument assailed by Leftwich (Solomons 1986, pp. 184-185). In responding to Lefiwich’s second argument, that contracts can be written to insure adequate reporting by management, Solomons counters that some standardization can be useful in reducing the costs of receiving and interpreting financial reports and in reducing the costs of monitoring (auditing) those reports. He notes, however, that there is an optimum, a balance between the gains and losses from standardization, and therefore too much standardization can be as detrimental as too little. While opinions differ as to just where the optimum is to be found, it is reasonable to assume that at least some degree of standardization is preferable to none (Solomons 1986, p. 185). In responding to Leftwich’s third argument, that flexible reporting rules would enable managers to report so as to maximize the value of the firm, Solomons retorts that there is a strong potential for abuse by managers seeking to confuse and mislead their critics (and their shareholders)-all in the name of maximizing the value of the firm. This antiregulatory assumption that things always work best in the absence of interference by regulators is referred to by Solomons as “Panglossian economics” (Solomons 1986, p. 188). A Panglossian view that the free market will necessarily induce managers to supply the optimal amount of information and do so in an unbiased fashion is not justified (Solomons 1986, p. 189). While the need for mandatory accounting standards is a question on which reasonable men might differ, two important aspects of Solomons’ analysis are worth noting. First, as a means of considering the case against mandatory accounting standards, Solomons focuses on the most defensible arguments offered by opponents of this form of regulation. It is in this sense that Solomons’ analysis is a legitimate intellectual exercise, not merely an attempt to conjure up
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and exorcise arguments that are merely “straw men.” Secondly, in assessing the case against mandatory accounting standards, Solomons’ analysis is balanced in that it looks carefully at both sides of an argument. It is this balance and perspective that enables the reader to appreciate the limitations of many of the arguments offered by both opponents and proponents of mandatory accounting standards and thereby enhances the credibility of Solomons’ analysis.
Selection of Standards on the Basis of Representational Faithfulness Essential to the credibility of any accounting standard-setting process is acceptability of the normative criterion (or criteria) used to select and justify the standards selected. In his discussion of the quality of accounting information in Chapter 5, Solomons considers the controversial question of whether accounting standards ought to be selected and justified on the basis of their representational faithfulness/neutrality or on the basis of their political/economic consequences. In addressing this important question, Solomons starts with the assumption that accounting standard setting is defensible only to the extent that it helps to enhance the quality, hence usefulness, of reported information. As seemingly straightforward as this assumption is, it has not been without its critics who, arguing on the basis of the Stigler-Peltzman economic theory of regulation9 contend that accounting standard setting inevitably serves the interests of corporate management-the very parties intended to be regulated. Such critics argue that although accounting standards may be “marketed” to the public on the basis of their representational faithfulness/neutrality or some other criterion, the use of such a justification is merely a “smokescreen” to rationalize the promulgation of standards that are preferred by corporate managers, regardless of whether they enhance the quality, hence usefulness, of the reported information. lo Although in Chapter 5 Solomons carefully presents the case for representational faithfulness/neutrality as the appropriate basis for accounting standard setting, in Chapter 12 he responds to the advocates of this “economic capture” view of accounting regulation. Focusing on a 1978 paper by Watts and Zimmerman that presents evidence in support of this economic capture theory of accounting standard setting, Solomons observes that the evidence they offer is “extremely flimsy” (Solomons 1986, p. 240). Specifically, he notes four serious problems with their reported findings (Solomons 1986, pp. 239-246): 1. Owing to the minuteness of the evidence presented, the theory they offer is, at best, merely an unsupported hypothesis; 2. Other evidence suggests that reporting firms’ FASB lobbying activities cannot be explained solely in terms of their self-interests; 9As originally posited, the Stigler-Peltzman economic theory of regulation was set forth in Stigler (197 I, 1974) and Peltzman (1976). ” Among the papers that offer this line of argumentation, which refers to itself as the positive theory of accounting standard setting, are Watts and Zimmerman (1978, 1979).
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3. Other evidence suggests that, in dealing with the FASB, public accounting firms do not, as Watts and Zimmerman suggest, always take positions in agreement with the perceived interests of their important clients; and 4. Other evidence suggests that, contrary to what Watts and Zimmerman suggest, accounting policy makers do act independently of reporting firms’ expressed preferences in setting standards. Solomons (1986, p. 241) sums up his assessment by concluding that Watts and Zimmerman offer less a “scientific theory” than “a line on which to hang out their intellectual laundry. ” In explaining why representational faithfulness/neutrality, not political/ economic consequences, must ultimately be the basis on which accounting standards are selected and justified, Solomons reemphasizes that the credibility of the standard setting process is dependent on the general acceptability of its pronouncements. He states (pp. 244-245): No standard setting body can enforce a standard for long that does not have wide even a body like the FASB, which has the enforcement powers of the SEC behind it. . . . [Therefore,] the key question to be answered [is]-what qualities must a standard have to make it generally accepted? . Fortunately, although the FASB has shown itself to be sensitive to the views of its constituents, it has had the sense to recognize that the credibility of accounting will be preserved only by providing society with relevant and reliable information about economic events and transactions acceptance-not
This need to provide relevant and reliable information to insure credibility, he concludes, explains why accounting standards must be selected and justified on the basis of their representational faithfulness/neutrality, not their political/ economic consequences (Solomons 1986, p. 246). Although the appropriate criterion (or criteria) for selecting accounting standards is a matter open to debate, two aspects of Solomons’ treatment of this question might be noted. First, in responding to proponents of the “economic view of accounting standard setting, Solomons emphasizes the capture” fundamental scientific precept that strong claims require strong evidence and that the evidence presented by Watts and Zimmerman is simply inadequate to sustain their claims. This response on methodological, not philosophical or ideological, grounds is, perhaps, the only appropriate way of evaluating the validity of a theory alleged to be supported by empirical evidence. Solomons does not dismiss the economic capture theory per se, but merely argues that its proponents have not met the burden of persuasion imposed on them, at least in the accounting field. Secondly, in assessing the question of how accounting standards are actually selected, Solomons exhibits balance and perspective by acknowledging that accounting policy makers are (and should be) sensitive to the political/economic consequences of their pronouncements, but argues that general acceptability over time requires more. It is this balance and perspective that helps to frame the controversy for the reader and adds credibility to Solomons’ analysis of it (Solomons 1986, pp. 239-246).
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The Threat to Credibility Posed by the Historical Cost Model Perhaps the most controversial of Solomons’ basic assertions is that the primary threat to the credibility of accounting standard setting is posed by the FASB’s adherence to the historical cost model, not by the institutional or other properties of the body itself. In Chapters 6-8 Solomons considers the problems inherent in the present historical cost-based accounting structure, the alternative accounting models available, and why a current cost constant purchasing power accounting (CCCPPA) structure would cure many of the problems inherent in the present structure. In assailing the present historical cost-based accounting structure Solomons argues that its primary defect is its lack of generality or robustness (Solomons 1986, p. 165). That is, he argues, the historical cost model should be viewed as a special case of the current cost model that “is appropriate only if prices, in fact, do not change between the data the resources are acquired and the date they are used or the accounting date, if that comes first” (Solomons 1986, p. 165). Since parties are rarely that constant, use of the historical cost model tends to produce measurements that do not accurately reflect the underlying transactions and economic events. To determine whether, in spite of its lack of generality or robustness in the face of changing prices, there may be other redeeming properties of the historical cost model, Solomons considers some of the leading arguments offered by proponents (Solomons 1986, p. 167). One such argument, for example, often advanced by proponents of historical cost accounting is its supposed “objectivity” (Solomons 1986, p. 167) vis-a-vis current cost accounting. This argument suggests that since “historical cost numbers are derived from actual transactions that have been entered into by the enterprise itself rather than (sometimes) from transactions that are being entered into by others in the marketplace” (Solomons 1986, p. 167), the resultant measurements are more objective. This and similar pro-historical cost arguments are, according to Soiomons, “largely spurious” because any objectivity gained in this manner “is lost as soon as resources haved to be carried over from one accounting period to another and costs have to be allocated to reflect these interperiod resource transfers” (Solomons 1986, pp. 167-168). After identifying several other flaws in the arguments offered in support of historical cost accounting, Solomons considers the case for current cost accounting. He observes (Solomons 1986, p. 171):
The adoption of value to the business (current cost or lower recoverable amount) in place of historical cost as the attribute to be used for measuring assets and. if relevant, liabilities would greatly increase the relevance of the information conveyed in financial reports, and it would increase its representational faithfulness. It is important that these improvements be secured without unduly increasing the subjectivity that already surrounds historical cost measurements.
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He adds that subjectivity can be kept to a bare minimum whenever an “asset can be bought or sold in its present condition at a determinable price” and “evidence of that fact can be inferred from a number of transactions of a kind the enterprise might enter into, whether it actually does so or not” (Solomons 1986, p. 171). In other cases, however, “current cost may not be determinable [and] lower recoverable amount-the higher of net realizable value or net present value of future cash flows-must then take over as a measure of value to the business” (Solomons 1986 p. 173). Such a CCCPPA structure would offer several important advantages over the present historical cost accounting structure that is the current basis for financial reporting. Although much of Solomons’ indictment of historical cost accounting is not new, he suggests, almost by innuendo, that it is the FASB’s aherence to this model, not the institutional and other properties of the body itself, that may constitute the primary threat to the credibility of accounting standard setting. If, for example, the much criticized practice of “creative accounting” is merely a response by reporting firms to what they regard as a set of reporting rules that distorts their actual performance, it may be attributable to the historical cost model, not accounting standard setting. If such reporting problems can be eliminated by adopting a more appropriate accounting structure, based on, perhaps, a CCPPA approach, abandoning accounting standard setting, rather than simply the historical cost model, may be equivalent to “throwing out the proverbial baby with the bath water.” Clearly this assertion, that it is the historical cost model, not the institutional and other properties of the FASB itself, that poses the primary threat to the credibility of accounting standard setting, is open to debate. ii The controversial nature of the assertion notwithstanding, however, two features of Solomons’ analysis should be noted. First, the assertion itself is developed in a gradual, yet deliberate, manner by exposing the reader to the underlying thought process on which it is based. Among the elements of this underlying thought process are the nature of the criticisms of financial reporting, the need for mandatory accounting standards, the institutional and other advantages of the current accounting standard setting process, and the inherent deficiencies implicit in the historical cost model. Collectively, the reader is left with the suspicion that it is the historical cost model, not the FASB itself, that is in need of change. Second, perhaps the most intriguing characteristic of Solomons’ analysis is its ability to draw together so many seemingly divergent aspects of the problem in order to extract a plausible and thought-provoking perspective on the credibility issue. It is this ability to connect and reconcile so many seemingly unconnected pieces of the puzzle that may well be the single most impressive aspect of the book as a whole. I’ It might be argued, for example, that the fact that the FASB continues to “legitimize” the historical CObt model seems contradictory to S&mom assertion. Such a line of argumentation assumer, however. that it IS impossible to effectively judge the output of a process separately from its procedural and other features.
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IV. Solomons’ Contribution
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Analysis: Screening Efficiency,
Credibility, and
As discussed in Section II, in order for Solomons’ treatise to contribute as an intellectual screening mechanism it must be able to screen out or separate highfrom low-quality ideas consistently and reliably and be perceived as able to do so by both potential purveyors and consumers of theories, beliefs, and opinions in the market for accounting ideas. In addition, it must provide something different or not redundant with that provided by other such mechanisms already available. Although any assessment of Solomons’ ability to screen out or separate highfrom low-quality theories, beliefs, and opinions concerning accounting and accounting standard setting would, prior to completion of the scientific aging process, be premature at best, it is possible to draw certain circumstantially based inferences from the nature of the analysis itself and the rather considerable reputation of the author. Further, assessment is facilitated by the fact that many of the issues considered are not new and have therefore already been “worked over” (Stigler 1955, p. 301) somewhat in the market for accounting ideas. To provide greater focus to the assessment, it is useful to reconsider Solomons’ screening of ideas relevant to each of the three basic assertions discussed in the previous section. As to his screening of ideas relevant to the first assertion, the need for mandatory accounting standards, Solomons evaluates alternative ideas in terms of their compatibility with the proposition that there is a balance between the gains and losses from standardization, and therefore too much standardization can be as detrimental as too little. Given this intuitively appealing proposition, it is easy to see why theories, beliefs, and opinions that take extreme positions for or against standardization, while providing the basis for an interesting intellectual discourse, may well be inherently flawed. Therefore, since Solomons restricts his screening to such extreme positions, his rejection of intellectually pure but pragmatically questionable ideas may well be borne out by the scientific aging process. In his screening of ideas relevant to the second assertion, that accounting standards ought to be selected on the basis of representational faithfulness, not economic or political consequences, Solomons evaluates alternative theories, beliefs, and opinions in terms of their compatibility with the proposition that only accounting standards that can gain and retain wide acceptance will be sustained over time. It follows, he posits, that selection on the basis of a scientifically credible criterion, such as representational faithfulness, is necessary for a standard to pass this test. His dismissal of economic or political consequences as a normative selection criterion is based on the intuitively appealing view that a standard selected on such a basis would be hard-pressed to gain such wide acceptance and may raise serious concerns as to the legitimacy of the standard-setting process itself. Therefore, since Solomons rejects or questions theories, beliefs, or opinions that are incompatible with the need for
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the wide acceptability of accounting standards, there is reason to believe that his screening of ideas along this line may also be borne out by the scientific aging process. It is Solomons’ screening of ideas relevant to the third assertion, that adherence to the historical cost model, not the institutional and other properties of the rulemaking body itself, poses the primary threat to the credibility of accounting standard setting, that is, perhaps, the most difficult to evaluate. The difficulty in evaluating this assertion comes from the nagging suspicion that there may be something inherently wrong with a standard setting body that is unable to extricate itself from the clutches of a model that is so flawed. While at first blush this suspicion may have considerable appeal, on closer examination it appears that there may be merit in Solomons’ contention that it is possible to abandon the historical cost model without also abandoning the standard setting body that has, heretofore, clung to it. The resolution of this question depends, to a large degree, on whether or not the FASB is robust enough to accomodate such a change without giving up the base of support on which its authority and acceptability depends. If such a separability is both appropriate and plausible, critics that attack accounting standard setting in general, and the FASB in particular, because of deficiencies in the historical cost model may, as Solomons suggests, be committing a guilt by association fallacy. While the jury is still out on this question, it may well be that Solomons’ screening of theories, beliefs, and opinions along this line will also stand up over time (Solomons 1986, Chapter 8). This tendency to give Solomons the benefit of the doubt on these and the other lines of screening in his book is prompted by the recognition that over the course of his distinguished academic career he has demonstrated a remarkable proclivity to put things into perspective and identify faddish and fallacious ideas well ahead of others. It is this track record, as well as the balance and clarity of the analysis presented, that adds credibility to Solomons’ work. In addition to being both an efficient and credible vehicle for differentiating high- from low-quality accounting ideas, to be a bona fide intellectual screening mechanism Solomons’ effort must also provide something different or not redundant with that provided by other mechanisms already available. While many of the assessments of individual ideas presented are not new, it is the overall perspective provided by the analysis as a whole that is, perhaps, Solomons’ greatest contribution. It is this ability to draw together so many seemingly divergent aspects of the problem in order to extract a plausible, thought-provoking, and highly readable perspective on the credibility issue that distinguishes Solomons’ analysis from those provided by other mechanisms already available. One does not, of course, have to agree with all aspects of Solomons’ analysis to recognize that this work is more than just another well-written literary offering. Although the actual efficiency with which Solomons has been able to differentiate high- from low-quality accounting theories, beliefs, and opinions
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can be definitively assessed only after the scientific aging process has been completed, there is reason to believe that Making Accounting Policy: The Quest for Credibility in Financial Reporting is an intellectual screening mechanism that will have a positive long-run impact on the market for accounting ideas.
V. Conclusion This essay has evaluated Solomons’ analysis in terms of its ability to contribute to the market for accounting ideas as an intellectual screening mechanism. Having concluded that his treatise possesses the requisites to contribute in such a capacity, it is perhaps, appropriate to consider briefly the usefulness of this paradigmatic framework and how it has been applied in this paper. Simply stated, assessment of a work like Solomons’ in terms of the signaling/ screening paradigm offers at least two potential advantages over more traditional approaches. First, this paradigmatic structure suggests specific criteria that can be used to evaluate the potential contribution, if any, to the market for accounting ideas. Such a structure forces the evaluator to assess the screening characteristics of a work of this type and go beyond its mere literary virtues to more substansive considerations. Secondly, this paradigmatic structure suggests that the perceived credibility of the author(s) of a work of this type may be just as important as the substantive quality of the analysis itself. It forces the evaluator to consider the extent to which the market for ideas may discount such a work because of the perceived biases of the author(s). Although, as the evaluation presented in this paper demonstrates, it is easier to specify the criteria of screening efficiency, credibility, and contribution than it is to apply them in assessing a particular work, the structure and perspective provided by such an approach may well compensate for such initial implementation problems. In evaluating the application of the signaling/screening approach in the current paper, at least two considerations should be noted. First, the application of such a structured approach may well be particularly appropriate in cases, such as the current one, where the relationship between the evaluator and author of the work being evaluated might be perceived as less than arm’s length. In such cases the imposition of criteria that force the evaluator to ask the “hard questions” may be necessary to provide the requisite level of scholarly detachment essential to the credibility of the evaluation. Secondly, in assessing such factors as the perceived credibility of the author of the work, the evaluator has been forced to draw upon insights gained beyond the context of the book itself. This need suggests that the assessment of any work of this type may require more than merely that it should be read. In closing, it seems appropriate to reemphasize that, ultimately, the contribution of Solomons’ book will be decided in the market for accounting ideas, not by the tenor of an evaluation such as this. The early returns suggest, however, that this book is likely to make a significant contribution in helping to
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sort out many of the prevailing accounting standard setting.
notions as to the nature,
role, and propriety
of
The author acknowledges the helpful suggestions provided by two anonymous referees and the guidance and encouragement provided by the editors. Any remaining errors or misstatements are the sole responsibility of the author.
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