Role of accounting

Role of Accounting in Global Financial Crisis: Research and Open QuestionsShyam Sunder Yale School of Management Accounting Research Symposium Hangzhou, China, Dec... Little Attention to

Role of Accounting in Global Financial Crisis: Research and Open Questions

Shyam Sunder Yale School of Management Accounting Research Symposium Hangzhou, China, Dec 16-17, 2009

An Overview

Some major events and features

− Little attention has been paid to accounting roots

What happened?

What can be done about it?

Open questions

Some Major Recent Events

 Highly volatile stock markets

 Bubbles and bust in real estate prices

 Massive expansion and shrinkage of derivative

transactions

 Freezing of credit markets

 Failures of major financial service firms

 Unprecedented transfer of funds to financial service employees

 Large government bailouts of banks, and stimulus to economy

 But little reform so far that will matter in the long run

Little Attention to the Role of

Accounting

 Through all these major financial events of our life times, discourse in accountants, professors and research have remained remarkably quiet

 It is almost as if we believe that these events have little

to do with what accountants have done, not done, and we have little role and responsibility for fixing the problems

 I would like to argue that important aspects of crisis are rooted in failures of accounting theory, standards,

regulators and practice, and we shall have to act to help fix the problems

What Is Special about the Role of Accounting in Finance

 Accounting often plays varying roles in success or failure of all

businesses, its role in accounting is very special

 The key objects of most industries (airplanes, clothing, computers, buildings, food, etc.) have physical existence independent of

accounting

 However, the key objects of finance (stocks, bonds, deposits,

derivatives) are entirely defined by accounting, and do not exist

independent of their accounting

− Imagine what would be the substance of a share of stock, or a bond, independent of the accounting system of the firm

 These rights and obligations have no existence independent of the accounts

 No accounting  no finance

 Better to clearly understand this link, and their interaction before trying to explore the role of accounting in the financial crisis

Popular Statements of Root

Causes

 Poor risk management, and ignoring systemic risk

 Proprietary trading: keep the winnings, and public pays the losses

 Large cash bonuses to executives to take risk

 Opaque and inconsistent accounting

 Insufficient cash cushion (bank capital)

 Lax regulation

 Although accounting is mentioned only once in this list, it lies

at the heart of all of them

Five Root Accounting Issues

 Which risk are we talking about?

 What is out theory of white collar compensation? What is the rationale for the current practices?

 What kind of accounting is informative? What is transparency and how far can we pursue it?

 Is financial accounting strong enough to discipline the

financial services industry?

 Accounting from markets or accounting for markets?

What Do We Mean by Risk?

 Many definitions but two simple approaches

1 Risk of returns in the sense of objective or subjective

uncertainty—dispersion of outcomes of a process

2 Risk of loss in the sense of possibility of incurring loss

• These two are quite different concepts of risk

• The first is symmetric in losses and gains, and emphasizes

uncertainty of outcomes—used in portfolio theory, reduced through diversification

• The second is concerned only with losses—magnitude and

chances—used in insurance, credit, etc., and reduced through screening, not diversification

Risk of Loss

 In common parlance, when a layperson talks about risk, it is the risk of loss that is being referred to

 Examples: car accident, fire, credit

 This loss is undesirable by definition; greater the magnitude and greater the (subjective or objective) chances of incurring

it, greater this risk

 In this meaning of risk, it is nonsensical to talk about preferring behavior because there cannot be any

risk-− If someone prefers taking risk (i.e., losses in this meaning

of the word), it could not be a loss

Risk of Return

 In portfolio and much of finance theory, risk refers to dispersion of outcomes

 In theory, risk aversion is said to arise when preferences are

concave, and the expectation of a lottery payoffs is less than the payoff of the expected outcome

 Conversely, if preferences were convex, risk-loving attitudes arise

 The value of diversification as well as risk sharing arises from

assuming universally concave preferences

 We do not know whether, in fact, preferences are concave, convex,

or have any other particular shape in general

 In any case, the dispersion interpretation of risk has only limited relevance to the first meaning of risk of loss (law of large numbers used in estimating insurance premiums and credit allowances)

Risk Management in Financial

Services

 During the past quarter century, expansion of derivatives in the financial services industry have been justified as

instruments to better manage and allocate risk

 While a large number of the customers of these instruments might have thought that they were reducing their risk of loss,

in fact they were bearing it in the form of opaque and

complex instruments and structures created for the purpose of hiding it (and making large amounts of money for their

creators who sold them to people who did not understand

what they were buying)

 This disconnect between different meanings of risk and ways

of hiding through financial engineering games with rules of accounting is one major issue we need to deal with

Five Root Issues

• Which risk are we talking about and when?

 What is out theory of white collar compensation? What is

the rationale for the current practices?

 What kind of accounting is informative? What is transparency and how far can we pursue it?

 Is financial accounting strong enough to discipline the

financial services industry?

 Accounting from markets, or accounting for markets?

Accepted Theory of

Compensation

 People work to earn compensation (money, benefits, status,

power, fame, etc.)

 More compensation is more desirable

 People are averse to taking risk (dispersion)

 To get them to work harder, promise them compensation linked

to their measured work (bonus, stock, options, etc.)

 Asymmetry of information about work of senior executives

creates agency problem with shareholders

 Address the agency problem by giving responsibility for setting the compensation to the board of directors

Does This Theory Work for White Collar Work?

 How do we pay painters and bricklayers? Salary or piece wage?

Why and why not?

 How do we pay a office cashier or clerk?

 What happens to work when a bonus is added based on measured work?

 What is a senior executive supposed to do in exchange for his/her salary and benefits?

 What is the effect on adding a bonus to compensation? What would he/she do different now?

 Governance structure that sets compensation fails when board is

Five Root Issues

• Which risk are we talking about and when?

• What is out theory of white collar compensation? What is the rationale for the current practices?

 What kind of accounting is informative? What is

transparency and how far can we pursue it?

 Is financial accounting strong enough to discipline the

financial services industry?

 Accounting from markets, or accounting for markets?

Decision-Usefulness Theory of

Accounting

 Choose financial reporting in order to better inform the

investment decisions

 Certainly, financial reporting should serve this purpose

 The question is: how?

 Total transparency not feasible because of management

reactions, and unfavorable consequences for the shareholders

 What about decision makers beyond shareholders

 Whole life and work of managers defined by their accounting environment; they highly sensitive to accounting (a crucial topic I return to later)

 Encouraging them to do the right thing for all stakeholders (to fulfill their respective expectations) is an alternative way of looking at the theory of accounting

Five Root Issues

• Which risk are we talking about and when?

• What is out theory of white collar compensation? What is the rationale for the current practices?

• What kind of accounting is informative? What is transparency and how far can we pursue it?

 Is financial accounting strong enough to discipline the

financial services industry?

 Accounting from markets, or accounting for markets?

Can Financial Accounting

Control Executives

 Executives control accounting, boards, and auditors

 Instruments of accounting control are standards which are words

 The meaning of words can be changed

 Instruments, transactions, and organizations redesigned to ensure that the existing standards yield the desired reports— managed income and debt off their balance-sheets

 If nothing else works, pressure the standard setters, and the politicians (with money if necessary, a small fraction of a single CEO's bonus buys a lot of influence)

History of Banks' Position on

Asset Valuation

 1938: pressure on Fed chair Eccles, Treasury secretary Morgnthau for

infamous Uniform Agreement to force FDIC, OCC and Fed to substitute

“intrinsic” for market values

 Mid-1970s: Forced SEC to back down on market-based valuation of

distressed REITs

 Late 1970: Forced FASB to back down to troubled restructuring

 1991: Forced Bush and Brady to ease up on valuation of troubled debts to give the “benefit of doubt”

 1990s: Kept zombie S&Ls open, increasing cost of bailouts

 FAS 157 and IFRS39 for mark-to-market accounting under the guise of fair values when markets were going up

 2009: Forced FASB/IASB to back down from mark-to-market when market prices went down

 What is your guess on ability of governments to regulate banks?

Five Root Issues

• Which risk are we talking about and when?

• What is out theory of white collar compensation? What is the rationale for the current practices?

 What kind of accounting is informative? What is transparency

and how far can we pursue it?

 Is financial accounting strong enough to discipline the

financial services industry?

 Accounting from markets, or accounting for markets?

Accounting for Markets or from

Markets

 Is financial reporting an input into markets (information,

decision making, liquidity, settlement, etc.)?

 Or is financial reporting better seen as a reflection of market events?

 If 1: what about efficient markets?

 If 2: what purpose does FR serve?

 If both, what could be a reasonable theory of the relationship between FR and security markets

 Perhaps it is fair to say that we have come to think of financial reporting as a reflection of the market events, instead of seeing

it as an input

Neutrality or Reflexivity

 What is the relationship of the FR to the world it report on?

− Neutral observer and reporter (eye-in-the-sky)?

− Active engagement with its “objects” (model and photographer)?

 If neutral, it cannot be concerned with its consequences; what should it be?

 If reflexive, what should the terms of engagement between FR and the executives?

 Perhaps it is fair to say that we have taken a supposedly neutral stance on the role of FR, ignoring this reflexivity

 This way of thinking has had major consequences that I would like to explain with the interaction of accounting and finance

Interaction of Accounting and

Finance

 Objective in corporate financial engineering: to design transactions to optimize from the point of view of the organization, e.g., increase

assessed creditworthiness and lower risk based on facts and

appearances of its financial reports

 Objective of financial reporting: to provide information useful for investment and other decisions by various agents in the economy

 Does the interplay of these two objectives lead to a stable

equilibrium?

 If yes, what is the equilibrium?

 If not, what are the consequences and what, if anything should be

done about it?

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Accounting and Finance as

Aspect of Social Sciences

 Social phenomena are characterized by multiple levels of analysis, e.g., macroeconomic, organizational, and individual

 At each level, and across the levels, social phenomena exhibit

interaction among agents (individuals, organizations, and

government), learning by them, feedback effects, and consequently, pervasive endogeneity

 These features of a social science make it more difficult to identify laws or relationships which are stable relative to their discovery and characterization (e.g., small firm effect)

 What are the interactions between financial reporting and

engineering, and their consequences

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− What are these needs? In at least some cases, these needs

consist of finding ways of

− Reducing indebtedness on the balance sheet, or

− Reducing expense on income statement, or

− Increasing revenue on income statement, or

− Increasing deductions on tax returns

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Securitization according to

International Finance Corporation

 A form of off-balance sheet financing which involves the pooling of financial assets

 Risk transfer mechanism that allows loan originators to optimize balance sheet management

 Allows highly rated securities to be created from less credit worthy assets

 Can be in local or foreign currency, depending on client needs

 A rapidly growing asset class with proven benefit for emerging

market borrowers

 For summaries of prior deals, please visit

www.ifc.org/structuredfinance

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Financial Reporting Standards as

Constraints on Financial Optimization

 In such optimization, standards of financial reporting are treated as constraints

 Most optimization problems have hard constraints—their violation brings well-specified penalties (dual prices)

 With optimization confined by the production possibilities set and other such physical limitations, external constraints make a real

difference to the final actions

 What kind of constraints do accounting standards offer?

 I am going to argue that these standards offer softer constraints

because the forms of contracts, transactions, as well as organizational forms that businessmen can devise and use are beyond the scope of accounting standards

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Redesigning Contracts

 A manufacturer needs to buy a machine for the factory

 Borrowing is an option, but the manufacturer does not want more debt on its balance sheet

 The leasing subsidiary of a bank buys the machine and gives it to the manufacturer on a long term lease—machine is in the factory but no debt on balance sheet!

 FASB writes Standard 13: leases >90%V and >75%T must be

treated as capital leases (debt is back on BS)

 The bank revises the lease to levels below the thresholds specified

in the standard (debt is off the BS)

 FASB goes back to work, and so on … until the rulebook grows to over a 1,000 pages

Sunder: Financial Engineering and

Redesigning the Organization

 When design of contracts and transactions is not sufficient, organizations themselves can be redesigned, or new ones created in order to have the

desired consequences for balance sheets, income statements and tax returns

 Special purpose entities (SPEs and SPVs) are examples of organizations created for this purpose (see Klee and Butler 2002 and Gorton and Souleles 2005)

 “Hundreds of respected U.S companies are ferreting away trillions of

dollars in debt in off-balance sheet subsidiaries, partnerships, and assorted obligations” (Henry et al 2002)

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