Judgement and Constraint

With respect to financial accounting standards, there is an ongoing debate as to how “tight” or “loose” such standards should be. Loose standards (or no standards) leaving much room for professional judgement, while tight standards provide bright lines or traffic lights, depending on the analogy, that thereby are represented to limit the exercise of professional judgement.

In the background is theory and evidence in relation to pervasive self-interest. Managers don’t act to maximize shareholder wealth as much as to maximize their own economic interests, which are generally not aligned with shareholder interests. It is the so-termed agency problem. Even if managers are also potential shareholders of a corporation, through either direct stock acquisition or stock options, their self-interest looks to much shorter term gains than many shareholders. If, on the other hand, both managers and shareholders have similar short-term interests in the corporation–and there is some evidence of shorter-term interests on the part of many shareholder types–the corporation would appear to become similar to a vessel to be looted. Wealth is created in as rapid a time as possible, in order to strip it away. The short-term and longer-term social costs of such corporate evisceration are generally not part of the equation.

Among those who believe that shareholder interests, more often than not, will diverge from those of managers, some believe that managerial self-interest is best controlled by contract. Correspondence in shareholder and manager incentives involves imprecise outcomes. So contractual restrictions on managers are suggested, involving such terms as “conditional predictability” and “hardness”. The managers know exactly what outcome will occur as a result of certain managerial actions, and the terms of benefit are unambiguous. Assuming that either or both dimensions are capable of being operationalized contractually.

In other words, the same “bright lines” or “stop lights” that are eschewed in favour of professional judgement in accounting standards become instead the basis of contractual constraints to the exercise of such judgement.

Full circle.

Or empty balloon.


About brucelarochelle

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