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Capitalism and Accounting Reform.


It has long been recognized that capitalism depends upon the rule of law and property rights. Without the enforcement of these two underpinnings of a free market system, capitalism does not operate efficiently. As Hayek (1960:159) put it: "When we obey laws, in the sense of general abstract rules laid down irrespective of their application to us, we are not subject to another man's will and are therefore free." Nevertheless, as business activities have become more complex, and as business interests have become more politically powerful, the laws and rules that underpin the capitalist economic model have come under increased scrutiny. The public perception is that some of these laws and rules are weak and foster "loophole mining" and a culture of business dishonesty. This is particularly so after the scandals of 2002 when companies such as Enron, WorldCom, and Adelphia were the focus of media attention and government legislation.

During the last century, capital markets became increasingly important for corporate financing and growth, particularly in a rising stock market. Attempts to align owners' goals (greater wealth) with management goals (company expansion/increased market power) led boards of directors to motivate executives with compensation packages tied to corporate stock prices, particularly stock options. Per Levitt (2002:2), "By 2001 some 80% of management compensation was in the form of stock options. But instead of aligning employees' interests with shareholders, options gave executives an incentive to use accounting tricks to boost the share price on which their compensation depended."

These incentives, however, fostered an environment that 1) sacrificed the long-term goals of sustainable company growth for short-term goals of increased profit, and 2) inflated measures used for financial purposes while simultaneously deflating numbers used for income tax purposes. A company might choose to optimize its stock position by being "honest" enough in its financial accounting to be perceived as a high-quality firm, while skewing tax numbers, using as many gray areas as possible, in the company's favor. Some might argue that managing earnings numbers is the best way to produce a favorable financial output on all fronts, thus protecting the investor. Others would say that while all financial statements contain some approximations, presenting extremely diverging stories to the government and stockholders likely prevents at least one of those stories from straying materially from the truth. Practically, the stakes can be high: two diverging stories were told to Enron stockholders and the IRS regarding Enron's 1993 and 1994 income tax returns. In 1998, an unnamed IRS appeals officer concluded that "the report to shareholders 'fooled' both investors and securities regulators about its financial condition" (Johnston, 2003, Section C, page 1). The unnamed appeals officer made strenuous attempts to persuade the IRS to reject Enron's position, asking in a memo "[s]hould the IRS condone this?" The IRS national office overruled the officer protests. (1) Theoretically, auditors should prevent material misstatements before audited financial statements are released, and where there is doubt as to accounting treatment, opt for the more conservative approach. (2) However, the audited companies pay public auditors, and that in itself creates an ethical conflict. Prior to recent scandals, IRS auditors had little incentive to perform beyond the basic level necessary to remain employed, but accounting scandals have highlighted the need for additional attention to the system to ensure complete disclosure.

This paper will identify economic problems with the U.S. capitalist model, propose possible solutions to the external structure, and discuss the pros, cons, and political realities of the proposed solutions.

Characterizing the Problem with the U.S. Capitalist Model

Is there a problem with the U.S. capitalist model? Certainly articles appearing in both the media (3) and in the academic literature appear to say there is. (See the papers in a recent symposium on Enron and conflicts of interest, most notably Healy and Palepu (2003), Lev (2003) and Demski (2003)). The problem appears to be one of skewed incentives and the honest provision of information and has manifested itself in the corporate scandals that first broke with Enron in late 2001.

Economics can identify incentives for both good and bad behavior inherent in financial statement systems, and this applies in particular to problems in the financial statement and accounting system. In economics, asymmetric information problems are classified as either adverse selection or moral hazard. Adverse selection is defined as a problem that occurs before a transaction takes place (e.g., health insurance, used car purchases, bank loans), and is usually characterized by market inefficiency. For example, low health-risk clients, "peach" vehicles, or good-credit customers, respectively, are not recognized as a different segment of the market in contrast to high health risk clients, "lemon" vehicles, or bad-credit customers. The adverse selection problem leads to higher prices being paid by the very customers that companies are anxious to insure or lend to. Akerlof's (1970) Nobel Prize winning paper on the market for second hand vehicles showed how many good second vehicles would not even appear on the market, because their owners might be reluctant to part with them at average market prices. The adverse selection problem can be solved by forced disclosure, using intermediaries (used car dealers, for example), or by screening applicants.

The second type of asymmetric information, known as moral hazard, occurs after the economic transaction has taken place. It is often evident in labor markets (shirking), venture capital transactions (e.g., internet company spending on entertainment), and any situation where the seller of a security may have incentives to hide information and engage in activities that are undesirable for the purchaser of the security. Sometimes moral hazard can be dramatic. Fire insurance may encourage arson, automobile insurance may encourage accidents, and disability insurance may encourage dismemberment.

A particular form of moral hazard problem involving two economic entities is known as the principal/agent problem. Here, for example, the owners of equity (the principals) are not the same as the managers of the firm (the agents), so the managers may act in their own interest rather than in the interest of the stockholders. Since larger shareholders might be able to exert pressure on management, there may be an argument to allow a single shareholder to own large blocks of shares, as shareholders with much smaller stakes are at a disadvantage in identifying and correcting financial problems. Principal/agent problems exist only if incentives diverge between principals and agents, so this partially explains the trend toward internalizing the problem in recent decades by negotiating share options as part of the compensation of senior management. The traditional deterrent to the principal-agent problem has been the presence of an effective, independent, outside audit. An internal audit, conducted by company auditors under the direction of management (who can hire and fire them), is not considered a viable deterrent. Management might be able to exert enough pressure on the internal auditors to effect a bias toward management's goals to the detriment of stockholder goals.

Traditional theory asserts that because an external auditor has many clients and sources of income, they are inoculated against, if not immune to, financial pressure exerted by management. However, some assertions, particularly "capture theory," challenge traditional theory. Under capture theory, CPA firms, the legislature, and the Securities and Exchange Commission (SEC) can be swayed by substantial financial incentives, or "captured" by those they are supposed to regulate. Berstein (1955: 74) argues that regulatory agencies begin their mission with enthusiasm but evolve to become at best the protectors of status quo or at worst captives of those they are supposed to regulate. (4) In another paper, Shasti, Withane, and Ward produce evidence that the format promoted by the Statement of Auditing Standards 58 is more closely aligned with auditor preferences than those of the banking and investment industries. The goal of financial statements is to provide information useful to the external users (creditors and investors); the desires of the auditors, who were self-regulated by the accounting industry that writes the auditing standards, should be secondary. In this case, however, the desire of the auditors prevailed over that of the users, consistent with capture theory.

The 2002 Quality of Earnings Conference also produced findings consistent with capture theory. For example, Frankel, Johnson, and Nelson (2002) found that where auditors also received nonaudit fees, they were positively associated with small earnings surprises and the magnitude of discretionary accruals, while audit fees were negatively associated with those two indicators. Plender (2003: 10) makes this assertion regarding the Enron debacle: "[a]nd everyone--including the watchdogs--had been bought by Enron one way or another." The assignment of Sir David Tweedie, head of the International Accounting Standards Board, who is driving toward a worldwide uniform set of standards to improve transparency, comparability, and logic in accounting, is notable in part because of his reputation for independence and resistance to capture. (5) A diagrammatic representation of the U.S. system is shown in Figure 1.


* Role of shareholders in a capitalist system

Stockholders of public corporations have traditionally been relatively uninvolved in the operations of the company. Consequently, they tend to have little individual influence and lack the information available to management. Shareholders do vote on the Board of Directors and ratify management's selection of outside auditors, but a typical ballot leaves the shareholder few, if any alternatives. Absent sufficient checks and balances, the information asymmetry can pose an acute principal and agent hazard to owners. This issue is explored in the corporate governance literature (see Charkham (1994), Prowse (1992), and Chew (1997), for example).

Stockholders have begun taking a more active stance in protecting their investments. Normally, management nominates the board of directors, which is supposed to oversee and approve major management actions. Investor activists are seeking to change this process, proposing that shareholders be allowed to nominate their own candidates without a proxy fight. Recently, Apria opened its nominations process, announcing that anyone owning at least 5% of its common shares for two years can propose two new directors every year. According to Lublin (2003:2), "Apria's action marks the first time that a publicly held U.S. company has made such a move to enhance shareholders' direct involvement in board selection ..."

* Role of management and the board of directors in a capitalist system

Management and to a lesser extent the board of directors are required to respond to government inquiries and hire an outside auditor to protect shareholders. Management prepares financial statements in accordance with U.S. generally accepted accounting practice (GAAP), and separately oversees preparation of the tax return in accordance with the Internal Revenue Code of 1986, as amended (Code). There are wide divergences between GAAP and the Code.

Management may try to maximize its own wealth, as in the principal/agent problem, so compensation is frequently tied to a proxy for shareholders returns--the stock price. Such compensation packages can be an effective tool for aligning shareholder and management goals. However, aggressive management can take this too far by overstating earnings, which will tend to increase the stock price. An effective audit can combat this tendency.

Management has an advantage in audits in that they generally recommend the auditor. The shareholders ratify with a yes/no vote. Often management holds a substantial block of stock resulting from the exercise of stock options. Management typically hires and fires the auditor, negotiates the fees, and makes direct payment of audit fees. Until Sarbanes-Oxley, management also controlled other lucrative nonaudit consulting contracts with the auditing firm, and still indirectly influences CPA firms through its ability to make or withhold recommendation of the CPA firm to potential clients. No rotation of auditors was required, allowing deep, potentially management-favorable relationships to exist. Management also had a history of hiring auditors directly from the CPA firms for lucrative positions. Sarbanes-Oxley should limit management's behavior in some of these areas, as discussed in Appendix 1. Management has less direct control of IRS audits, but while CPA firms must attest to the financial statements of all publicly traded firms, government audits of GAAP books are few. Government audits of tax books are much more frequent, but since tax and GAAP books diverge, problems found in tax are often irrelevant to GAAP (and visa versa), and no detailed disclosure is made of this divergence. The result is that management can tell two wildly differing stories of profitability (high GAAP income, low tax income), with little accountability to shareholders.

* Role of external auditors in a capitalist system

Auditors are supposed to be independent in appearance and fact, and audit the books on a GAAP basis. Under Sarbanes-Oxley, firms continue to be responsible for establishing and maintaining quality control standards. Until Sarbanes-Oxley, the audit industry was self-regulated, undergoing a periodic peer review to assess any potential differences in a firm's quality control structure or work product.

The Sarbanes-Oxley Act of 2002 now prohibits auditors from also performing previously sanctioned accounting activities, including bookkeeping, information systems design and implementation, valuation services, management functions, and legal and investment services. Tax services may still be performed in conjunction with an audit. The Act also adds additional levels of self-regulation. Firms are now required to have a second partner review and approve audit reports, and the primary audit partner must rotate off the audit every five years. Self-regulation has come under fire as being potentially ineffective, as illustrated by the 1997 discovery that the audit staff of Coopers & Lybrand (6) owned stocks in the companies they audited. In that incident, the SEC subsequently uncovered approximately 8,000 violations involving about half the firm partners (Levitt, 2002).

An auditor, while motivated to provide a quality audit, is also motivated to be profitable, which means not upsetting clients. So, there is pressure to acquiesce to management treatment of questionable accounting practices. For example, McDonnell (2003:76) eludes to this pressure with the following advice, "[a]n auditor who spots a questionable accounting practice must not let the client coerce or intimidate him with a threat of losing the business; must inform the boss and explain the concerns; must keep blowing the whistle until the issue is objectively resolved."

* Role of regulators in a capitalist system

While the SEC can take credit for administering the investigation of Coopers & Lybrand, it was not prompted by an SEC discovery but rather by an anonymous letter. The SEC can now prohibit the appointment of a corporate officer for violating [section]10(b) of the 1934 Securities Act.

The Sarbanes-Oxley Act of 2002 has provided a new regulator, the Public Company Accounting Oversight Board, (7) to oversee the previously self-regulated auditing profession. This board consists of five members who will serve five-year terms. Two members must have been CPAs, the other three cannot have been CPAs, but must be financially literate. The chairman of the board cannot have been a practicing CPA for the prior five years. Board members are prohibited from receiving any payments other than fixed continuing payments (e.g., retirement benefits) from a public accounting firm.

The new board's responsibilities include adopting rules for auditing, quality control, ethics, and independence, and the inspection of, investigation of, and disciplinary proceedings for accounting firms (AICPA, 2002a). The SEC will oversee this board and final sanctions imposed by the board are subject to SEC review. The SEC is subject to Congressional inquiry, and the president nominates the head of the SEC, currently former Wall Street executive, William Donaldson. The International Federation of Accountants' influence, however, continues to support self-regulation through the Forum of Firms, Transnational Auditors Committee, (8) Compliance Committee, Public Oversight Board, International Auditing and Assurance Standards Board (IAASB), and Public Sector Committee. Another separate branch of oversight in the U.S. is the IRS. The IRS is unpopular, and its oversight is strictly confined to the tax arena. At this agency, however, there are established checks and balances for eliciting compliance from firms. One complaint about the IRS is that the revenue agents still have some incentive to overstate income to increase tax collections. Management also has an incentive to overstate earnings, but that incentive would diminish where the higher earnings also produce higher taxes.

CPA firms and governmental agencies that perform outside audits are effective barriers to the principal/agent problem only to the extent that they are not captured. The manager/auditor relationship is subject to collusion if both find common incentives or it can be one of asymmetric information where management hides material information from the auditor. Collusion may result if the manager has substantial influence over hiring or firing the auditor, controls the timing or amount of auditor pay, or controls alternative auditor income streams (e.g., other consulting revenue). Factors inhibiting asymmetric information include: management's retention, promotion, pay and benefits scales, and an independent, external audit for likely asymmetric information effects.

Potential Solutions

* Potential solutions--internal structure Evaluating the potential solutions to the internal structure is not the focus of this paper, but U.S. model revisions are currently stumbling, presenting an opportunity for aggressively compliant companies to market their virtue by quickly adopting public solutions under consideration. Appendix 2 is for companies that want to use their company's integrity for leadership or marketing before changes to the auditing system become final.

* Potential solutions--external structure

To achieve uniform quality across publicly traded companies, relying on changes to internal structure has proven insufficient in a minority of cases. Changes to external structure are indicated, and the current public discussion focuses on what changes are necessary and desirable. The first recent changes required by companies traded on U.S. exchanges came in the Sarbanes-Oxley Act.
 Sarbanes-Oxley: the status quo revised
 As discussed, the Sarbanes-Oxley Act made
 several changes to responsibilities of auditors
 and management, including personal management
 certification of financial statements,
 limits on consulting engagements, and mandatory
 rotation for the partner in charge of an
 audit. While addressing some of the principal/
 agent problems identified in this paper, the
 solution leaves other principal/agent and
 nearly all capture theory solutions un-addressed.
 The advantage of maintaining the
 status quo is that it will provide for gradual
 change, which may be less costly than more
 radical changes. The disadvantage is that
 many problems remain unsolved, as illustrated
 by the New York Times article suggesting
 that Sarbanes-Oxley is already being
 watered down by what may be a "captured"
 SEC. Per Lynn Turner, former chief accountant
 of the SEC, "[we've] had the most tumultuous
 year ever in corporate America. And
 despite all of that, the commission is softening
 rather than toughening the rules in favor of
 the attorneys and auditors to the great detriment
 of investors" Labaton and Glator,

 Solving other principal/agent and capture
 theory problems

 Principal/agent problems can be solved by
 restoring the neutrality of auditors. The profession
 recognizes the need for neutrality, for
 example, in the Statement on Auditing Standards
 (SAS) No. 99, effective for all audits
 after December 15, 2002 (AICPA 2002c). The
 statement emphasizes the need for professional
 skepticism when considering the risk of
 material misstatement due to fraud. However,
 professional skepticism has long been part of
 the due professional care requirement of SAS
 No. 1, so it is unlikely that pronouncements
 alone have restored adequate neutrality. Capture
 theory problems can be solved by removing
 managements' ability to hire and fire and
 influence auditor pay. Additionally, more
 worker representation and greater alignment
 of GAAP and tax books might subdue the
 effects of capture theory. These ideas are
 summarized in Table 1. Specifically, these
 provisions might include:

 * Bonus to CPAs for uncovering bad

 Currently, auditors have an economic interest
 in satisfied clients (companies they audit).
 This interest could be offset in part if rewards
 or bonuses were offered to auditors who
 uncover bad accounting practices. Such bonuses
 could be funded by additional fees
 assessed to the audited or the public companies.

 * Random or systemic selection by SEC

 Similar to the suggested change to internal
 structure proposed in Appendix 1, outside
 selection of auditors (e.g., by the SEC) would
 eliminate managerial leverage to hire and fire
 auditors. Selection by the SEC must take into
 consideration contracts already in place between
 potential auditors and the audited
 company to ensure that conflicts of interest do
 not exist. This solution also reduces the ability
 of management to exert indirect influence by
 recommending CPA firms to other potential

 * Shift payment of auditors

 Management leverage would be reduced if
 management did not pay auditors. Fees could
 be pre paid to an independent intermediary
 (independent trust or government function)
 that would be responsible for paying auditors.

 * Rotating auditors

 When auditors and companies work closely
 together for an extended period, an overly
 close relationship or complacency may develop
 between them. Limiting the length of
 contracts retards these negative effects.
 The Sarbanes-Oxley Act addresses this
 issue indirectly by requiring mandatory
 partner-in-charge rotation every five years.
 However, the Act is only effective to the
 extent a relationship exists between the one
 partner-in-charge and the audited company.

 * Institute SEC auditor ratings

 Complaints against auditors are currently filed
 through the SEC, state boards, and soon
 through the Public Company Accounting
 Oversight Board. Each individually records
 and processes complaints, although they may
 communicate with one another on complex or
 overlapping cases. Thus, higher-quality audit
 firms can distinguish themselves from competitors,
 providing an indirect disincentive of
 complying with questionable management
 requests. A high-quality audit also implies
 higher audit fees.

 * Auditing the accountants

 Currently, auditors undergo mandatory peer
 review, where another CPA firm reviews the
 auditing work papers of the auditor. Some
 companies that have changed auditors have
 elected to undergo a re-audit of prior-period
 financial statements. Per McConnell and
 Banks, "[corporate] executives and boards of
 directors view re-audits in conjunction with
 an auditor change as a way to prove due
 diligence ..." (2003, p. 39). Whether required
 or elected, a re-audit provides a random check
 on auditor work in a real-time setting based
 on original documents, rather than the auditors'
 interpretation of original documents,
 which may be tainted by omission or misunderstanding.

 * Reduce ability of CPA to work for

 Currently, CPAs can leave their public firm to
 work for a governmental agency. For example,
 Harvey Pitt, who played an active role
 in softening the effects of Sarbanes-Oxley,
 previously represented accounting firms
 during a battle with former SEC chair Arthur
 Levitt (Labaton and Glater, 2003). A reduction
 in the ability of industry advocates to work for
 industry regulators would reduce the opportunity
 and appearance of key governmental
 officials being captured by the management of
 big companies.

 * Increased accountability for auditors

 Auditors could be held accountable for individual
 redesign of audit programs to identify
 weaknesses created specifically by management
 incentive structures. To do this, auditors
 would be required to assume that control risk
 is at a maximum for these items (that is, no
 effective internal control system exists), and
 would substantively test whether weaknesses
 would result in financial statement misstatement.

 For example, executive compensation can
 be solely base pay or include a performance-based
 component. Base pay separates shareholders'
 interest from managements' interest
 because management is best off by working
 as little as possible to retain or attain their
 desired job. Performance pay, however, is
 subject to asymmetric information and manipulation
 of performance measurements.

 For example, if the performance measure
 used to determine a significant component of
 executive compensation is sales, then the
 audit program should emphasize and report to
 the board of directors any items that would
 artificially increase sales. If, on the other
 hand, the compensation performance measure
 used is net (operating) income, then the audit
 program should emphasize items that would
 artificially inflate sales, deflate deductions, or
 change tax venues. If the relevant performance
 measure is EPS (earnings per share),
 then the audit program should measure bottom
 line above and audit for any reduction in
 the number of shares or change in measurement
 of shares. (9) If performance compensation
 is based on market share, the audit program
 should emphasize items that would artificially
 increase sales and deflate or remeasure market
 size. Other performance-based criteria might
 include timely completion of a major project,
 merger, or acquisition, performance relative to
 budget, government approval of specific
 innovative products, etc.

 * Increased disclosure to public

 Astute public attention provides yet another
 check on the accounting system. Currently,
 GAAP requires disclosure of key accounting
 policies, methods, and additional information
 that might be relevant to the financial aspects
 of the public company. Off-balance sheet
 items and tax situations, however, have only
 general, limited disclosure. Per Al Anderson,
 senior vice president-member and public
 interest, "[our] current financial reporting
 model, although a solid foundation from
 which to start, is neither complete nor timely"
 (AICPA 2002b: 1)

 As noted, it is generally in the best interest
 of management to optimize these results,
 contrary to that same management's motivation
 to understate results for tax purposes. In
 effect, management can often tell different
 stories to different interested users. By viewing
 both sides of the story, (potential) investors
 and creditors have more information with
 which to make decisions. This information
 could be disclosed in one of two easy formats:
 releasing the half-page, M-1 section of the tax
 return with supporting statements, which
 reconciles tax and book net income, and
 allowing public access to all tax returns for
 companies traded on a U.S. public exchange.
 With Web technology, both disclosures would
 increase the availability of information to
 (potential) stakeholders at little additional

 * More closely align tax and GAAP

 Currently, diverging financial and tax accounting
 theories are used to generate financial
 statements. For financial statement
 purposes, management is not harmed, and
 often directly benefits from, maximizing net
 income. The reverse is true for tax purposes.
 Theoretically, however, employing GAAP
 conservatively would understate net income
 for financial statement purposes, aligning the
 results with tax accounting. But because the
 two methods do not automatically converge in
 practice, wide discrepancies can exist between
 net income for tax and book purposes.

 In one case, lawmakers instituted a precautionary
 measure, restricting the use of LIFO
 accounting for inventories for tax purposes to
 companies that adopt LIFO for financial
 statement purposes. Many U.S. companies
 that are not natural candidates for LIFO (e.g.,
 Kroger grocers whose inventory costs more
 naturally follow FIFO) have adopted this
 approach because in times of rising prices, the
 cost of goods sold is higher under LIFO, so
 net income (and income tax) is lower. Internationally,
 allowing LIFO for inventories is less

 Closer alignment of GAAP and tax books
 has wide but diminishing acceptance worldwide.
 For example, most countries with a
 German-based financial heritage will employ
 the Massgeblichkeitprinzip, or determination
 principle. Under this principle, whatever
 method is used to determine book income is
 also used for determining taxable income.
 Table 2 summarizes countries that have chosen
 to align tax and book definitions of income
 more closely. Table 3 notes countries
 that diverge widely, consistent with traditional
 U.S. treatments.

 * Increase worker influence

 European countries, such as Germany, routinely
 have representatives of worker groups
 on the board. Extra scrutiny by workers can
 act as a deterrent to management-driven
 policies. However, it is conceivable that
 workers might be another target for management
 capture, and once captured, reinforce
 management's position in the division between
 management and shareholders interests.

Discussion: Potential of the Above Options to Solve Asymmetric Information and Capture Problems

Regarding the options for reform just cited, there are clearly variations in effectiveness and the extent to which any of them addresses the principal/agent problem or the capture issue. The first seven largely address the capture problem as they pertain only to the appointment of auditors and not to an entire overhaul of the system. The last four partially address the principal/ agent problem and, to a degree, also the capture problem. Clearly, in terms of implementing policies to solve both the principal/agent and capture problems there is no perfect solution for several reasons. First, it is likely that a combination of these options would be more effective than any single one. For example, in the German capitalist system the last two lessen the principal/agent problem but capture is not fully addressed by either. Second, since some of these options have not been tested in an international context, experience with rules-based systems has shown that new rules can introduce different incentives from those originally intended by lawmakers, and loopholes can induce greater problems than problems the policies or rules were introduced to address.

Some of these proposals appear to contradict others on their surface. For example, random assignment of auditors implies that auditor quality is homogenous, whereas an SEC ranking of auditors implies that auditor quality is heterogeneous. Also, generally speaking, re-audits are a costly option that might best be used only when there is concern about the adequacy of the original CPA or its particular audit opinion.

Several of these proposals are complementary and can be forged into one working model for discussion purposes. For example, assume that publicly traded companies pay fee based on last year's audit cost to the SEC instead of to the auditor. The SEC would contract directly with independent, licensed, eligible auditors interested in bidding on an audit for that company. The SEC might solicit bids for bundles of multiple company audits, possibly achieving market efficiencies and economies of scale. The SEC would assign auditors, weighing the following factors: frequent auditor rotation, SEC auditor rating, results of re-audit work, if any, CPA proposed audit program, price, firm experience, and firm availability. A program for SEC payment of bonuses to CPAs for uncovering bad practices could also be administered by the SEC, although similar programs (e.g., within the IRS) exist with relatively few funds actually being paid out to whistleblowers.

This model would not conflict with the remaining solutions: reducing the ability of CPAs to work for government, increased disclosure to the public, closer alignment of tax and GAAP, or increased worker influence. Some proposals depend on legislative action as opposed to the exercise of powers already granted. Therefore, this model is likely to be a long-run rather than short-term solution. Increased public disclosure is relatively low-cost, while trying to align financial and tax methods interact with other U.S. governmental policy objectives like balanced budget provisions. Worker influence, touted highly in Germany, might be either helpful or may be just another target to be captured.

Another issue that pertains to the implementation of reforms is whether it is best to use rules-based or discretion-based reforms. The current system is a mix of rules and discretion: for example, accountancy practices are rule-based, but choice of members for a board of directors is discretion-based. Clearly, an option such as bonuses for uncovering accounting malpractices would be discretion-based, but legislating employee board members would be rule-based.

Presumably, the Sarbanes-Oxley reforms are a mix of both rule and discretion-based changes and are an attempt to solve both the capture and principal/agent problems. But given our analysis, the contents of the Act are unlikely to have any more than a minor effect on these issues. Something more radical is needed if these issues are to be effectively addressed.


The dominant economic system in the world today is capitalism, yet the various hybrids that continue to exist in different countries suggest that although convergence is happening to some extent, none of the models adequately solves all the system's problems. In this paper, the problems of asymmetric information and capture are presented in the context of the governance and auditing practices currently used in the U.S. capitalist model. Our initial findings are that both principal/agent and capture problems are present in many instances in our system. Several solutions to some of these problems were suggested and an evaluation of these options that assumed the possibility of changing the relevant laws was presented.

In the U.S. version of the system, recent scandals pertaining to principal/agent problems and issues of audit capture have prompted lawmakers to act to try and "fix" the model. Sarbanes-Oxley, although better than nothing, is inadequate in our view, given the problems we have identified in this paper. Also Sarbanes-Oxley clearly tries to fix the immediate problems in the system without looking at problems in the context of the system as a whole. External changes are called for but may not be sufficient without additional internal changes to corporate structure. Unless all the problems are simultaneously and adequately addressed, we predict further and perhaps more serious problems in the future.

Future research might include an extensive discussion of potential internal changes to the structure of corporations, how to market those changes to the investor community, and suggestions as to further changes to develop the Sarbanes-Oxley model and the collective economic effects on the U.S. capitalist system. A further avenue for research would be to compare and contrast developments in terms of the relative costs and benefits of the proposed solutions in the U.S. and other countries.

Appendix 1: Additional Management Responsibilities from the Sarbanes-Oxley Act

Changes to Management Responsibilities Under the Sarbanes-Oxley Act of 2002, companies are prohibited from extending credit to any director or officer of their company. Officers are no longer permitted to sell stock during blackout periods, and, directors and officers (and 10% owners) must report allowable stock sales within two business days following the transaction. The

company's audit firm cannot have employed CEOs, CFOs, controllers, and chief accounting officers during the year preceding the audit.

Auditors must now attest to the assessment of internal controls made by management. Management must implement, maintain, and evaluate internal controls, and disclose to the auditor any material weakness, fraud, or changes in the controls.

Internal controls within a company must be strengthened to include an independent (10) audit committee as a subdivision of the board of directors. The audit committee is to be responsible for appointing, compensating, and overseeing the work of the public accounting firm, receive and address accounting, auditing, and internal control complaints, and pre-approval of non-audit services performed by auditing firms.

Appendix 2: An Example of Possible Changes to Internal Structure to Resolve Principal/Agent and Capture Theory Problems

Currently, management hires the auditors in consultation with the board of directors' audit committee. The powers to hire, fire, and withhold payment from auditors, addressed elsewhere in the paper, provide potentially dangerous leverage for management where opinions on accounting treatment differ. A company's voluntary elimination of this leverage, if carefully and sincerely marketed, could provide an appearance of above-average virtue and an intent to provide financial statements of above-average reliability and below-average business risk.

How changes to internal structure can bridge the gap through changes in external structure This situation calls for innovation because there is no existing model. To begin discussion and provide initial practical guidance, the authors suggest that the innovative company change the way auditors are hired to be similar to one way that CPAs hire their auditors (peer reviewers).

CPAs undergoing a mandatory peer review (which is an audit of the quality of their work) pay a fee to the state board of public accountancy for administering the peer review program. A separate audit fee is paid to the peer reviewer. In Texas, for example, CPAs may pick their own peer reviewer (similar to companies hiring their own auditor) or may have one assigned to them. CPAs choosing an assignment have no say and no idea who will be assigned. The state board selects a qualified reviewer based on experience, availability, etc. and notifies the peer review candidate of the assigned auditor. Generally, once a reviewer is assigned, a change cannot be made. In essence, the state board acts as a blind trust to hire a qualified reviewer that cannot easily be dismissed by the CPA.

Converting critical elements of this plan to a business application, the audit committee of a company could pay a set fee to an outside administrator (e.g., a lawyer or CPA not otherwise employed by the firm, a large bank or creditor, etc.) to hire a CPA firm without direct influence from the firm itself. Due to a voluntary company restriction, the ability to hire and fire rests solely with this outside firm, which is paid a set fee for this service (and cannot contractually accept fees from the CPA firm chosen as an auditor). Audit fees are accrued in escrow by this firm to pay the auditor. The CPA firm and outside administrator are both subject to non-renewable term limits. This plan has the advantage of largely eliminating management's leverage resulting from the ability to hire, fire, and withhold payment from the auditor. It may also provide an additional buffer against litigation in that extraordinary steps have been taken to avoid collusion, weakening arguments that management or the board intends to mislead shareholders, or increase public perception that this particular company is less risky in its accounting practices (and therefore a better investment) than other businesses. The disadvantage is the additional cost of hiring an outside administrator.
Table 1: Table of Economic/Political Problems and Potential Solutions

Problem Potential Solutions Sarbanes-Oxle

Principal/ Effective Audit (*)
 Agent CPA bonus for uncovering bad accounting

Capture Theory:

CPA Reduce/eliminate consulting and other fees *
 captured Reduce ability for CPA to work for audit *
 Random selection of CPAs to shift hire/
 fire responsibility and reduce the
 ability to refer other clients.
 Increase accountability of auditors (*)
 Rotate auditors (*)
 Institute SEC auditor ratings
 Random second audit of accounting work
 Shift who directly pays audit fees

SEC Increase voter pressure through additional
 captured disclosure
 Align GAAP with tax law
 Reduce ability for CPA to work for SEC
 Increase worker group influence (e.g.,

Courts Increase voter pressure through additional
 captured disclosure
 Align GAAP with tax law

* Covered by Sarbanes-Oxley; (*) partially covered by Sarbanes-Oxley.

Table 2: International Comparison of Techniques Recently Used to
Address the Economic Problem of Diverging Tax/Book Financial
Statements *

Count Description/Notes

Germany GAAP = tax: "Massgeblichkeitsprinzip"--any
 deduction taken for tax must be taken for books
 (Choi, Frost, & Meek, 2002)

France Revaluations of fixed assets (by management choice)
 allowed if also booked for tax purposes; extra tax
 depreciation is shown as exceptional charge when
 available (Choi, Frost, & Meek, 2002)

Switzerland GAAP = tax (Holt & Hein, 2001)

Brazil GAAP = tax (Holt & Hein, 2001)

Venezuela GAAP similar to tax; tax discloses adjustments for
 inflation (Holt & Hein, 2001)

Islamic Countries No tax, but mandatory alms based on earnings (Holt
 & Hein, 2001)

Netherlands Accounting is a branch of economics; government
 conducts extensive audits of individuals. (Choi,
 Frost, & Meek, 2002) (Holt & Hein, 2001)

Thailand Must submit GAAP statements with tax return (Holt
 & Hein, 2001)

Italy Multiple sets of books reduced; accounting more
 conservative (Radebaugh & Gray, 2002)

Japan Any deduction taken for tax must be taken for books
 (Radebaugh & Gray, 2002)

Sweden GAAP similar to tax (Radebaugh & Gray, 2002)

United States Must use LIFO for book purposes if used for tax

* These techniques normally result in more conservative financial
statements, which better protect the creditors and investors than
aggressive financial statements.

Table 3: Notable Tax/Book Divergences in Other Countries

Count Description

United States Wide divergence, but see Table 1.

Mexico No inventory for tax purposes (Holt & Hein, 2001)

Belgium High tax rates, but liberal exemptions for benefits
 (Holt & Hein, 2001)

Russia Rapidly changing, complex, and confusing tax code
 (Holt & Hein, 2001)

China Taxation once a main concern, but westernizing
 (Radebaugh & Gray, 2002)

Czech Republic German system of accounting, but not tax (Choi, Frost,
 & Meek, 2002)

Taiwan U.S/U.K. system of accounting; e.g., different
 tax/book depreciation methods (Choi, Frost, & Meek,


(1) Indeed, the U.S. Internal Revenue Service (IRS) currently has a duty to protect the privacy of all taxpayers. Whether the privacy of the tax return of publicly traded company does more harm than good is apparently up for debate. The American Taxation Association has formed a committee to investigate whether or not it would be prudent to require these companies to make their tax return available for public inspection (as some not-for-profits make their 990's available to donors on request).

(2) Conservative treatment is defined as erring on the side of understating net assets (assets minus liabilities) and/or understating net income in order to protect the investor (Kieso & Weygandt, p. 51).

(3) See, for example, the Financial Times for December 2, 2002, p13, "What price virtue? The Anglo-US model has gone off the rails because the penalties and rewards are skewed."

(4) Examples include The Civil Aeronautics Board's shielding of established truck carriers by refusing to allow any new airline to approve scheduled service on major routes until the late 1970s, and the Federal Maritime Commission's routine approval of shipping company rates (Shasti, Withane, and Ward, 2000).

(5) See Dini, J. (2002). Can One Good Man Save Accounting? Institutional Investor, 36 (7) 68-76.

(6) Coopers & Lybrand subsequently merged with Price Waterhouse to become PriceWaterhouse Coopers.

(7) This name has unofficially shortened to "Peek-a-boo."


(9) A change in accounting for earnings per share was lobbied for and successfully passed in February 1997 (SFAS No. 128, Earnings per Share).

(10) "Independent" is defined as "not receiving, other than for service on the board, any consulting, advisory, or other compensatory fee for the issuer ..." (AICPA, 2002a).


AICPA. (2002a). Summary of Sarbanes-Oxley Act of 2002. Retrieved October 3, 2002 from

AICPA. (2002b, December). New business reporting model beginning to emerge--Timeliness, reliability, transparency to be improved. The CPA Letter.

AICPA. (2002c). Statement on Auditing Standard No. 99. Retrieved May 14, 2003 from

Akerlof, G. (1970). The market for 'lemons': Quality, uncertainty and the market mechanism." Quarterly Journal of Economics, 84(3), 488-500.

Berstein, M. (1955). Regulating business by independent commission, Princeton, NJ: Princeton University Press.

Charkham, J. (1994). Keeping good company: A study of corporate governance in five countries. New York: Oxford University Press.

Chew, D. H. (Ed.). (1997). Studies in international corporate finance and governance systems. New York: Oxford University Press.

Choi, D.S., Frost, C.A. and Meek G.K. (2002). International accounting, (4th ed.). Prentice Hall.

Demski, J. (2003). Corporate conflicts of interest. Journal of Economic Perspectives, 17(2), 51-72.

Dini, J. (2002). Can one good man save accounting? Institutional Investor, 36(7), 68-76.

Frankel, R.M., Johnson, M.F. and Nelson, K.K. (2002). The relation between auditors' fees for nonaudit services and earnings management. The Accounting Review, 77, 71-105.

Hayek, F. (1960). The constitution of liberty, University of Chicago Press.

Healy, P. and Palepu, K. (2003). The fall of Enron. Journal of Economic Perspectives, 17(2), 3-26.

Holt, P.E., and Hein, C.D. (2001). International accounting, (5th ed.). Dame.

Huang, C. and Litzenberger, R.H. (1988). Foundations for financial economics. Prentice-Hall. Johnston, D.C. (2003, February 14). Wall St. firms are faulted in report on Enron's taxes. The New York Times, C-1.

Kieso, D.E., and Weygandt, J.J. (1998). Intermediate accounting, (9th ed.). John Wiley & Sons, Inc.

Labaton, S. and Glater, J.D. (2003, January 22). Staff of S.E.C. is said to dilute rule changes: Lawyers and auditors lobbied persuasively. The New York Times.

Lev, B. (2003). Corporate earnings: Fact and fiction, Journal of Economic Perspectives, 17(2) 27-50.

Levitt, A. with Dwyer, P. (2002, September 30). Take on the street: What Wall Street and corporate America don't want you to know. What you can do to fight back (Electronic version). Business Week. Retrieved October 3, 2002, from

McConnell, D.K. Jr., and Banks, G.Y. (2003, January). Audit redux. Journal of Accountancy. AICPA, 39-7.

McDonnell, P.J. (2003, January). Maintain excellence, cut risk. Journal of Accountancy, AICPA, 75-78.

Plender, J. (2003, January 28). Casting a shadow on capitalism. Financial Times, 10.

Plender, J. (2003, December 2). What price virtue? The Anglo-US model has gone off the rails because the penalties and rewards are skewed. Financial Times, 13.

Prowse, S. (1992). Institutional investment patterns and corporate financial behavior in the United States and Japan. Journal of Financial Economics, 27, 43-66.

Radebaugh, L. H. and Gray, S.J. (2002). International accounting & multinational enterprises, (5th ed.). John Wiley & Sons.

Shasti, T., Withane, S. and Ward, B.H. (2000). Capture theory and the regulatory process relating to audit and assurance services--Some empirical evidence. Unpublished working Paper, University of Windsor.

Before entering the academic world, Dr. Chambers had over a decade of public accounting experience as owner and managing partner of a CPA firm in Houston focusing on small business. She has published in such journals as Tax Notes and Tax Adviser. Dr. Crowley conducts research on the economics of the EU, international economics, history of economic thought, public finance, and political theory.
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Author:Chambers, Valrie; Crowley, Patrick
Publication:SAM Advanced Management Journal
Date:Jun 22, 2003
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