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Research in Accounting Regulation ■■ (2017) ■■–■■

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Research in Accounting Regulation

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Research Note

Learning from ecology: Financial reporting as a ‘commons’

Thomas A. King *
Case Western Reserve University, Cleveland, OH 44106, USA

A R T I C L E I N F O A B S T R A C T

Article history: This note explores how the financial reporting environment for listed companies is a common
Available online good put at risk by participants with incentives to extract benefits at the cost of the in-
vesting public. Disclosure of misleading financial information confers economic gain for a
Keywords: few but pollutes the environment and reduces its usefulness for all. After showing how a
Ecology variant of the prisoner’s dilemma may explain Enron-era scandals, the note discusses how
Financial reporting
U.S. government intervention was the only practical solution to repair damage to the fi-
Common good
nancial reporting Commons. The implication of this note is that government involvement
Prisoner’s dilemma
in financial reporting is here to stay.
© 2017 Elsevier Ltd. All rights reserved.

Introduction of the prisoner’s dilemma to describe behavior of certain

Ecologist Garrett Hardin uses the term tragedy of the
commons to describe how self-interested individuals can ruin
a shared resource (Hardin, 1968). In his metaphor, village
residents let their cows over-graze on common land and ul-
timately deplete grass available for all members of the
community. There is no easy solution because benefits of
over-grazing accrue to individual farmers while costs of
worn-out land are borne by all village residents. Rational
actors have little incentive to show restraint. When private
benefits are extracted at the expense of public costs on a
large scale, a Commons problem may end in disaster (Hardin,
1985). Examining the Enron-era financial reporting envi-
ronment through Hardin’s lens may be instructive to readers
interested in accounting regulation.
The thesis of this note is that financial reporting by listed
firms (i.e., publicly traded companies with widely held
shares) is a common good put at risk from incentives faced
by capital markets participants. Disclosure of misleading in-
formation pollutes the financial reporting Commons and
reduces its usefulness for all others. The purpose of this note
is to encourage borrowing ideas from ecologists as we search
for ways to avoid another accounting meltdown. This paper
begins with a discussion of common goods, invokes a version
* E-mail address: tak30@case.edu.
stakeholders, and examines how the U.S. government in-
tervened with Sarbanes–Oxley (SOX) legislation to repair
damage to the financial reporting Commons. The implica-
tion is that government regulation of financial reporting is
not going away soon.
Common goods
Financial reporting is part of society’s efforts to allo-
cate scarce resources. IBM, Coca Cola, and American Electric
Power operate in different product markets but disclose ac-
counting information in efforts to attract capital from similar
investors. For purposes of this paper, the term preparer is
used to describe company managers who disclose account-
ing information and investor to describe those who use this
information to value and trade corporate securities.
Financial reporting is a common good due to its non-
exclusive, rivalrous nature. Non-exclusive means preparers may
disseminate accounting information at any time. In the absence
of selective disclosure, all investors have access to account-
ing disclosures. Rival use arises because investors trade
securities based on new information, so its value diminishes
as security prices change to reflect recent buying and selling
decisions. A healthy financial reporting environment re-
quires firms to replenish the Commons with new, accurate
information as economic events continue to unfold. Consump-
tion of disclosed information without replenishment degrades

http://dx.doi.org/10.1016/j.racreg.2017.04.008
1052-0457/© 2017 Elsevier Ltd. All rights reserved.

Please cite this article in press as: Thomas A. King, Learning from ecology: Financial reporting as a ‘commons’, Research in Accounting Regulation (2017), doi:
10.1016/j.racreg.2017.04.008
 ARTICLE IN PRESS
2 T.A. King / Research in Accounting Regulation ■■ (2017) ■■–■■
the usefulness of the financial reporting environment. This
“subtractability” makes accounting information a common
good rather than a public good (Ostrom, 2009).
The U.S. government, benefiting from wealth creation and
tax revenue that follow efficient capital allocation, has made
healthy financial reporting a priority. To promote replen-
ishment, Congress passed the Securities Exchange Act of
1934. The ’34 Act created the Securities and Exchange Com-
mission (SEC) and requires publicly traded firms to issue
periodic financial statements audited by independent ac-
countants. Criminal prosecution may be brought against
preparers who fail to disclose accurate financial informa-
tion (SEC Rule 10b-5) and auditors who sign off on
misleading statements (United States v. Simon, 425 F.2d 796).
Two threats to fair reporting emerged in the 1990s. To
encourage trading among its clients, brokerage firms hire
security analysts to write research reports that include fore-
casts of earnings per share (EPS) for listed companies. By
the late ‘90s, most public U.S. firms were covered by secu-
rity analysts (Berenson, 2003). The average of published EPS
forecasts becomes the consensus estimate for the compa-
ny’s next accounting period. Every time a public firm reports
results, some investors compare actual performance with
analyst expectations to determine whether reported EPS
missed, met or beat analyst expectations. Earnings sur-
prises, where reported EPS differ from consensus estimates,
have stock price consequences.
Contemporary research finds a stock market reward for
firms that meet (Kasznik & McNichols, 2002) or beat ex-
pectations (Lopez & Rees, 2002) and a penalty for firms that
miss (Skinner & Sloan, 2002). Such stock market behavior
motivated executives to nudge accounting balances to avoid
earnings misses.
The second threat came from a 1993 revision to the In-
ternal Revenue Code. In response to criticism about high
corporate pay, Congress disallowed tax deductions for sala-
ries greater than $1 million per year paid to certain
executives at publicly traded firms. However, the law allows
an exception for performance-based pay (Section 162m).
Company boards of directors then substituted equity awards
for cash salaries to compensate senior corporate execu-
tives. Since executive pay packages were influenced by short-
term stock price movements, some managers had an
economic incentive to misreport performance to spark tem-
porary boosts to share prices. Executives at these shirking
firms extracted private gains (higher compensation through
inflated share prices) at the cost of public losses (degrada-
tion in the quality of accounting information released into
the Commons).
Evidence of a problem with 1990s financial reporting is
the landmark speech given by SEC chair Arthur Levitt, who
decried a game of winks and nods among preparers and au-
ditors as firms modified earnings calculations to meet analyst
earnings estimates and project smooth earnings paths (Levitt,
1998).
Prisoner’s dilemma
Ostrom argues that the health of a Commons turns on
a community’s ability to keep self-interest at bay. Partici-
pants may guard against ruin through creation of rules,
Please cite this article in press as: Thomas A. King, Learning from ecology: Financial reporting as a ‘commons’, Research in Accounting Regulation (2017), doi:
10.1016/j.racreg.2017.04.008
Auditors
Cooperate Defect
Preparers
Cooperate Reward, Reward Sucker's Payoff, Temptation
Defect Temptation, Sucker's Payoff Punishment, Punishment
Note: Each of the four cells presents an ordered pair of payoffs, where the first label
describes the payoff to financial statement preparers on the left and the second applies to
independent financial statement auditors at the top.
Fig. 1. Payoff matrix for a prisoner’s dilemma game.
monitoring tools, sanctions, and conflict-resolution mecha-
nisms (Ostrom, 1990). Such measures are not available on
security exchanges because the anonymous nature of se-
curity trading impedes cooperation among participants.
Ostrom further argues that if a Commons is open-access with
no limit on who can appropriate resources, use of the
Commons leads to a prisoner’s dilemma game (Ostrom,
1990). The prisoner’s dilemma, discussed in most intro-
ductory economics textbooks, describes situations where
rational, self-interested individuals fail to cooperate, even
when it is in their mutual interest to do so. The following
analysis presents a variant of this metaphor.
The ’34 Act, as modified, encourages two stakeholders
to work together to replenish the Commons with fresh, ac-
curate financial information. Preparers have a duty to
disclose accurate quarterly results while auditors have a duty
to monitor preparers’ efforts and offer an opinion on the pro-
priety of this reporting.
Each group has a temptation to defect. Preparers who
receive pay tied to stock prices may have an incentive to
adjust accounting balances that would otherwise fall short
of analyst expectations. Auditors, typically hired by a firm’s
Audit Committee for an agreed-upon fee, have discretion
about the scope of efforts used to evaluate the propriety of
a firm’s financial statements as the year progresses. Reduc-
ing an audit’s scope improves the profitability of the
engagement and speeds up its completion. Faster, less in-
vasive audits may also bring happier preparers who may be
more inclined to purchase non-audit services from their in-
dependent accountants.
Fig. 1 shows these relationships in a payoff matrix. Each
stakeholder may choose to cooperate or defect. For preparers,
cooperation means releasing financial statements that
present accounting balances in a fair, unbiased manner. De-
fection means making adjustments to the firm’s accounts
so that managers provide a distorted story to outsiders. For
auditors, cooperation means making good-faith efforts to
verify that reported balances are valid, accurate, and com-
plete. Defection means that auditors do not perform a
sufficient quantity of work, or do not perform work with
sufficient professional skepticism, to reach a valid opinion
on the fairness of the client’s financial statements.
The matrix has four possibilities. If both parties coop-
erate, each receives the reward of cash-based compensation
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T.A. King / Research in Accounting Regulation ■■ (2017) ■■–■■
through salaries or audit fees. If the preparer defects while
the auditor cooperates, the preparer receives the tempta-
tion payoff of a possible temporary boost in the company
stock from unidentified accounting shenanigans while the
cooperating auditor receives the sucker’s payoff from pos-
sible sanctions for failing to identify misreported balances.
If the auditor defects but the preparer cooperates, the auditor
receives the temptation payoff of a more profitable audit
while the preparer receives a sucker’s payoff from a fore-
gone opportunity to manage earnings. If both parties defect,
each receives the punishment payoff of possible criminal
prosecution and securities litigation from permitting dis-
semination of misleading financial reports. The point is that
preparers and auditors each has an economic incentive to
defect rather than to cooperate in efforts to maintain a
healthy financial reporting environment.
Events of the 1990s elevated incentives for both parties
to defect and put the Commons at greater risk of degrada-
tion. The business press focused attention on analyst
earnings estimates, which reinforced investor attention on
whether a firm met or missed its quarterly earnings esti-
mates (Fox, 1997). Firms like General Electric found ways
to report earnings that met expectations for many consec-
utive quarters and enjoyed elevated share valuations (SEC,
2009). For certain executives compensated with rich equity
awards, the professional satisfaction from diligent finan-
cial statement preparation did not match financial rewards
of short-term stock price increases from accounting ma-
nipulation. Some preparers defected and reported earnings
which did not conform to Generally Accepted Accounting
Principles (King, 2006).
The rise of lucrative consulting practices within account-
ing firms changed incentives for partners of CPA firms. By
the 1990s, auditing had become a mature, slow-growing pro-
fessional service (Brewster, 2003). Information technology
consulting assignments offered wider margins and faster
growth prospects. Auditors competed with rival CPA firms
and non-accounting firms to land this business. Should a
rival firm secure a consulting assignment, the auditing
partner might worry that the other firm could influence the
client to purchase additional services from a competitor. It
can also be difficult to sell additional services to a client that
is subjected to an unpleasant, invasive audit. By 2001, de-
fection by auditors brought large-scale audit scandals at firms
such as Enron, Cendant, Sunbeam, Waste Management,
WorldCom, Qwest, Adelphia, HealthSouth, and Global Cross-
ing (King, 2006).
Sarbanes–Oxley legislation
Discovery of misreporting by a select few taints the pub-
lic’s perception of the entire financial reporting space.
Repairing financial reporting can become a significant public
policy goal. Evidence of the importance of this concern is
that George W. Bush gave a speech in New York on July 9,
2002, promising that his administration would do “every-
thing in our power to end the days of cooking the books and
shading the truth” (Bush, 2002). What’s amazing is that the
President of the United States, dealing with the fallout of
9/11, the invasion of Afghanistan, the Iraqi disarmament
Please cite this article in press as: Thomas A. King, Learning from ecology: Financial reporting as a ‘commons’, Research in Accounting Regulation (2017), doi:
10.1016/j.racreg.2017.04.008
3
crisis, and an anthrax scare, chose to devote administra-
tion time to improving American financial accounting.
Obviously, no single individual is in charge of a Commons.
A useful study of how to foster cooperation when no one
is in charge comes from David Axelrod’s The Evolution of
Cooperation (Axelrod, 1984). The author puts forth five pro-
posals to promote cooperation among individuals in the
absence of central authority.
First, participants could enlarge the shadow of the future
by promoting frequent interactions and durable relation-
ships among stakeholders. Prolonged interaction allows
patterns of cooperation to emerge. Axelrod describes how
small units of opposing, trench-bound troops in World War
I developed behavior patterns to promote mutual safety. This
approach is impractical because the SEC wants preparers
and auditors to maintain a professional distance. Audit
partner rotation rules seek to confound development of such
relationships.
Second, participants could attempt to teach people to care
about each other. For example, parents and schools devote
considerable effort to teaching students to value the well-
being of others. However, an effective auditor must be
emotionally distant from his or her client and willing to put
the goal of fair financial reporting ahead of developing res-
onant relationships with a firm’s management team.
Third, stakeholders within a Commons could teach rec-
iprocity to promote cooperation. Such action involves
rewarding examples of the Golden Rule (do unto others as
you would have them do unto you). Preparers and audi-
tors have little ability to promote high-quality financial
reporting by peers at competitor firms.
Fourth, stakeholders could improve the ability of indi-
viduals to identify those who cooperate and defect. The U.S.
financial reporting system has not developed self-monitoring
mechanisms among preparers or auditors. Private sector or-
ganizations have limited capacity to levy penalties on errant
actors. Whistleblowing systems did not gain prominence
until the global financial crisis in 2008.
Finally, participants could change the payoffs for parties
tempted to defect. Private sector participants within the fi-
nancial reporting Commons have little ability to change
payoffs. However, the federal government has such power.
Congress intervened by passing SOX. This legislation re-
quires public firms’ CEOs and CFOs to certify in writing that
financial statements present fairly the company’s finan-
cial condition and results of operations, with the possibility
of fines or imprisonment for noncompliance. The absence
of a bright line separating fudging from fraud brings career
and legal risks to executives seeking to shade the truth. Au-
ditors are prohibited from selling certain advisory services
to audit clients and are subject to review by the newly
created Public Company Accounting Oversight Board, to
which the SEC has delegated authority to inspect audits and
assess fines and other penalties on auditing firms found
complicit in shoddy work.
By changing payoffs for preparers and auditors, SOX
reduced incentives to defect. The Act’s compliance costs and
harsh penalties were unpopular among preparers and au-
ditors. Yet a review of academic papers finds evidence of
improved financial reporting quality after passage of SOX
(Chambers, Hermanson, & Payne, 2010).
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4 T.A. King / Research in Accounting Regulation ■■ (2017) ■■–■■
Implications
This note argues that the financial reporting environ-
ment is a Commons where financial statement preparers
and auditors each has an incentive to allow disclosure of
misleading accounting information. Such pollution reduces
the Commons’ usefulness for all. As Enron-era accounting
scandals came to a boil in 2001, no practical private-
sector solution emerged to clean up the Commons. The U.S.
government intervened to change payoffs for these two
stakeholders through passage of SOX legislation. If preparers
and auditors seek to keep further government interven-
tion at bay, they must find new ways to cooperate.
Acknowledgments
The author gratefully acknowledges suggestions from
Editor Gary Previts and two anonymous reviewers.
References
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10.1016/j.racreg.2017.04.008
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