Role of accounting

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
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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 riskpreferring behavior because there cannot be any

− 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
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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
picked by executives
 No evidence on the effect of bonus compensation on senior
executive productivity?
 Large amounts of money transferred to executives by encouraging
them to take risky bets at tax payers' or stockholders' expense

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
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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
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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
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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
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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
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What is the relationship of the FR to the world it report on?
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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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Objectives in Financial
Engineering
 “The Financial Engineering Concentration encompasses the design,
analysis, and construction of financial contracts to meet the needs
of enterprises.” (Cornell’s ORIE M.S. concentration in financial
engineering)
− 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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