Saturday, February 11, 2006

Why is Tort Law like Accounting?

Because in both, all probabilities are either zero or one.

I have suffered a million dollar loss for which I think you should be liable. I sue you. If the court concludes that there is a .4 chance that I am right, I get nothing. If it thinks there is a .6 chance, I get a million dollars. All probabilities less than .5 are treated as zero, greater than .5 as one.

Accountants do the same thing. If your accountant thinks the probability of your losing the suit is .4, he doesn't list your expected loss of $400,000 as a liability. He leaves it out entirely, aside from a footnote mentioning the existence of the lawsuit. If he thinks the probability is .6, he puts it in as a million dollar liability.

I suspect the underlying reason is the same in both cases. Both tort law and accounting depend on low quality decision making mechanisms. Nobody designing an automobile or diagnosing an illness would do it by putting the question to 12 laymen. So instead of asking the hard question--what is the probability that the defendant was negligent--we ask a simpler question: Was he probably negligent? If you are not competent to answer a comlicated question, there is much to be said for limiting yourself to simple ones.

An accountant is a more sophisticated decision maker than a jury, but he knows much less about a business than the people running it. And those people frequently have an interest in having the accounts turn out one way instead of another--high equity to boost stock prices or low profit to hold down taxes. One way of making it harder for them to fudge the accounts by the information they give their accountant is to have accountants use simple rules wherever possible. That explains many of the ways in which accounting substitutes a simple answer for a correct one--with the treatment of probability only one example. Other biggies are the preference for cost price over market price and the reluctance to take account of intangibles, even important ones such as brand name reputation.

And this is my last post on accounting. Unless something else interesting occurs to me.


Anonymous said...

I have sometimes read news stories about (usually) negligence suits where the answer was that this party was 70% liable and that one 25% (and these guys on the side 5%), with the result of the award being affected by that. Does "tort" describe only a subset of the cases that can end up in civil court?

David Friedman said...

Response to Monica:

Those are tort suits, but they are conceptualized as partial responsibility, not probability. There are a variety of different negligence rules in tort law in different jurisdictions--I think that one is called "comparative negligence." said...


There is much more about accounting that is worth discussing. I plan to take this up some on my new blog, (go to Blogma - the site is a work in progress).

One other similarity of accounting to tort law is that accounting rules (Generally Accepted Accounting Principles) are created on various levels from those rules set on high by the FASB (Financial Accounting Standards Board) to any number of other accounting organizations. There are subsets of rules and interpretions and it's all very complicated (much like the tort system). This is not the connection I'm referring to, however.

The connection is that accountants frequently encounter questions about how to account for certain transactions despite the existence of rules that exist to guide them on such transactions or because no such rules exist. These questions create problems for management, external auditors, internal accountants and stakeholders. Thus, these groups individually lobby the rule-setters to improve the rules or set new ones. Just like the courts, a rule-setting body like the FASB doesn't want to keep dealing with an inefficient rule. Thus, like the courts, the accounting rule-setting bodies tend to prodce more efficient rules due to inefficient rules creating costs on the bodies. David, I'm trusting you follow what I'm saying here, but if I need to take another stab at it, let me know.

My point is that there are more similarities between accounting and tort law. I probably first saw these connections while attending David Mustard's law/economics class at the Univ. of Georgia back in 2003 - which your book was quite helpful in. Thanks.

I trust you'll write more on accounting should other parts of it pique your interst.

Anonymous said...

All civil, criminal, contract or tort matters result in victories or losses. This is why almost all cases are settled, not just tort cases. The problem is that anyone can sue for any reason in this country. This produces settlements with respect to matters that should be zero's in all cases. Cases that have reasonable merit would go to trial or be settled anyway.

You are correct that accounting rules are too complex. The problem is that more complex rules can produce a more exact accounting because they can be tailored to suit variable situations. Unfortunately, this makes them more susceptible to abuse. For example, portions of Enron's debt were improperly recorded as off balance sheet debts simply by virtue of what types and how many corporate guarantees were present. Some of these guarantees were in separate documents which were not disclosed to the accountants by Enron. These differences can. at times, be subtle, yet produce huge swings in accounting...i.e. either the debt is recorded as a libility or it is a footnote.

Anonymous said...

This, by the way, is why the Enron defendants will argue that the accounting is correct and that they did nothing wrong under the law and the accounting system. After all, if the formal accounting system accounts for a .4 as a zero (i.e., all accounts are either a zero or a 1 - they are fully accounted for or they are not accounted for at all), and Enron reported a libility as a zero, its former executives need only prove that the .4 situation exists to be technically innocent of all charges.

Anonymous said...

There are elements of subjectivity in accounting, including the definitions of assets and liabilities.
In any event, an accountant would not book a $400,000 (expected) loss as a liability, which is what's owed on the balance sheet; instead, it would appear on the income statement as the residual of revenue less expenses.

Anonymous said...

Accountants are learning. The FASB issued a conceptual statement (SFAC 7) which describes the "expected cash flow" method of reporting items, taking into account probability. When applied, a $1 million loss with a .4 probability is booked at $400,000, and one with a .6 probability is recorded at $600,000.

So when does it apply? Currently, it is already required to value loan guarantees (FASB Interpretation 45) and employee stock options (FASB SFAS 123R, when using the recommended binomial distribution method), is utilized to determine when to consolidate variable interest entities (FIN 46R), and I suspect will eventually be applied to the example you gave, contingent liabilities arising from lawsuits (your example was, of course, correct under current GAAP).