Karthik Ramanna on How a Quilt Of Special Interests Captured Corporate Accounting

Karthik Ramanna is an associate professor at the Harvard Business School.

Karthik Ramanna

Karthik Ramanna

And he has a new book out titled — Political Standards: Corporate Interest, Ideology, and Leadership in the Shaping of Accounting Rules for the Market Economy (University of Chicago Press, 2016).

“Political Standards is an assessment of the rulemaking process in corporate accounting rulemaking — what we call Generally Accepted Accounting Principles (GAAP) — both in the United States, but also worldwide,” Ramanna told Corporate Crime Reporter in an interview last week.

“The core thesis of the book is that these political processes operate in what I call thin political markets. Thin political markets are areas in which some of the most esoteric rules of the market economy are developed. The nature of the knowledge that is necessary to adjudicate the political process is deeply experiential — it’s deeply tactic. It’s knowledge where you rely on experts who are in industry. As a result of this, and perhaps not so surprisingly, the knowledge comes with a tint of special interest.”

“So in subtle, but pretty significant ways, the rules of the game that emerge in corporate accounting are tailored to benefit these expert few. Because the nature of expertise is so highly diversified across different groups of individuals, there is no one unequivocal villain in the story, there is no group or organization who you say — that’s the person or group that is capturing the system. Rather, it is a systemic problem. It’s what I call a quilt of special interests.”

“Different experts show up at the table when they happen to be the ones in the know. And they find that there is no one sitting across from them. And they view this as a competitive process, much like they view their day to day business activities.”

“And so not surprisingly, they color their expert opinion or advice with their self interest and they structure the rules in ways that benefit themselves. This results in a systemic subversion of the rules and detracts from the ability of market participants, retail investors to be able to truly divine the performance of companies — truly divine whether their investment opportunities are doing well. And this creates distortions — in fact, wealth transfers between the managers of these firms and the shareholders and between society and businesses as a whole.”

“This becomes a systemic problem that starts to undermine or subvert capitalism in the eyes of a democratic society — something that we started to see becoming increasingly an issue in this election season. The book develops this notion of thin political markets as a way to alert us to the central paradox of capitalism – where the business leaders who have the capacity to shape the rules of the game are structuring them in ways that are self-interested or self-serving.”

What is a recent example you have found?

“The most recent example I used in an op-ed in the New York Times a couple of weeks ago,” Rammana said. “This is not something in the book — it came after the book was completed.”

“The Financial Accounting Standards Board (FASB) is the organization in charge of accounting rulemaking in the United States. It has a project on improving disclosure. In the course of that project, FASB has taken on this issue of materiality. What constitutes material financial information that merits disclosure?”

“If you look at the direction the world has been moving in terms of technological progress, it has unambiguously been moving in the direction of more transparency rather than less, more disclosure rather than less, in part because technology has made it so easy to sift through large volumes of data so that we can democratize accountability and allow individuals to search for the information they want to find.”

“It was in the context of this environment that FASB made a decision that would actually lower the standards for what would affect material disclosure — therefore reduce the volume of material disclosure. This flies in the face of the tradition and practice and accounting rulemaking being biased toward creating more disclosure and greater accountability. And it contradicts the technological trends.”

“This struck me as especially egregious because it allows corporations to say in certain instances — I don’t need to make this disclosure because the standard of materiality is now different from what it was before. There is now a higher standard of materiality. And it allows companies to be more selective than they are presently in what they disclose.”
Why is the political market so thin in accounting?

“It comes down to two basic forces. The nature of the knowledge that is essential to determining outcomes in these political processes is tacit. It’s not the kind of knowledge that a professor brings to a classroom — and says — the theory of this is x.”

“The kind of knowledge is the knowledge of compliance costs, for example, the knowledge of how you might be able to induce information from large volumes of data. You have to be in the practice of doing this on a day to day basis to be able to supply that knowledge.”

“The second factor is what I call low issue salience. This is to say that there are certain topics like climate change and social security reform that are salient in the minds of the public, that are discussed at cocktail parties. Even if the public does not have the expertise on these issues, there is enough public interest to create an incentive for intermediaries like the press, like politicians to become informed and to advocate for the public interest on these issues.”

“But thin political markets are characterized by low issue salience, which is to say that in these areas, the public considers them boring and the public is generally unaware. And this is not just accounting — there are auditing rules, actuarial standards. Up until 2008, governance standards could have been considered thin political markets as well.”

“Since 2008, we have been able to sustain a level of public attention on bank governance that has been great. It’s been effective for public accountability. We are still making blockbuster movies about the financial crisis and the role of banks — that’s great for public accountability. It keeps the pressure on politicians and media to continue to cover these topics.”

Ramanna says that in thin political markets executives have to show restraint and not lobby for everything they can get.

“When you are sitting in a room and testifying about what the rules of the game should look like, and there is no one sitting across the table from you to cross examine you, you have to realize that you are a steward for the entire system. You are a citizen of the society in which you live — and much more so than you are a manager for the firm that has employed you in that context.”

“And that is the sense of public spiritedness that we have to cultivate. Business leaders are not only employees of their corporations. They are citizens of the society in which they live. And there are times in which that citizenship, that public spiritedness, has to take precedence. That has to be part of a structural solution.”

[For the complete Interview with Karthik Ramanna, see 30 Corporate Crime Reporter 21(13), May 23, 2016, print edition only.]

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