How do you stop the books being cooked? A management-control perspective on financial accounting standard setting and the section 404 requirements of the Sarbanes-Oxley Act

Abstract

The recent series of corporate scandals has resulted in an unprecedented crisis in accounting. Investors have lost faith in financial statements on the assumption that ‘cooking the books’ has become a routine practice in corporate America. Restoring the credibility of financial reporting is clearly an urgent priority, as indicated by the passage of the Sarbanes–Oxley Act, which mandates that chief executive officers personally certify the accuracy of their firms' financial statements. The approach being contemplated by the accounting profession itself is a shift away from the rules-based approach to financial accounting standards used by US Generally Accepted Accounting Principles towards the principles-based approach of International Accounting Standards. Both these initiatives draw attention to the fact that accounting standards are only useful and effective if they are actually implemented by firms in the way the standard setter intended. In other words, the need to ensure implementation of accounting standards by managers who have an incentive to beat analysts' earnings forecasts means that accounting standards have a management-control component. In this paper the authors put forward an ex. post perspective on accounting-standard implementation that places the problem clearly within the domain of control theory. That in turn implies that, to ensure compliance by management, standard setters can make use of the powerful tools that control theory provides — the four levers of control: belief, boundary, diagnostic and interactive control systems. The authors' control perspective provides new insights into accounting standard setting, including the need for both belief and boundary controls rather than reliance on one alone. Of even greater potential significance is the implication this management-control perspective has for the Sarbanes–Oxley Act's section 404 requirement for management and auditor assurance on the effectiveness of a firm's internal controls over financial reporting. A management-control perspective can provide a much-needed framework within which the COSO (The Committee of Sponsoring Organizations of the Treadway Commission) standards can be applied, avoiding an excessive focus on the existence and documentation of controls and increasing their efficacy.