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

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 • Risk of returns in the sense of objective or subjective uncertainty—dispersion of outcomes of a process • 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 risk-preferring 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 • 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

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

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?

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? 23

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 24

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 25

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 26

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 27

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 Reporting 28

Redesigning Transactions • Depending on the current standards of financial reporting, transactions can be redesigned to achieve the desired consequences for revenues, expenses and taxes 29

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)‏ 30

Asymmetric Game • Note that financial reporting standards neither have, nor can have, any say in any of these “business” decisions of the management • The role of the accountant and auditor is limited to preparing financial reports given all these decisions • While these decisions clearly consider what the accounting standards are, accountants have little freedom to take into account how and why these decisions were taken in the first place • There is great asymmetry between the freedom available to the business decision makers and constraints on the accountant who must abide by relatively rigid written standards 31

The Net Effect • The decision to write an accounting standard is a matter of social policy that calls for a deliberative due process; it typically takes years to determine which rules might best serve investors and others. Inevitably, these standards are written on the assumption that the current forms of contracts, transactions, and organizations will continue to be used in the future when these standards are applied • The decision to change contracts, transactions and organization is an individual decision that may be taken within days if not hours. Further, the scope of these decisions is virtually unbounded (except by the imagination of the businessmen). Soon after the standards are issued, the environment to which they are applied changes relative to the what the standards were written for • The net effect: Financial reporting standards serve as relatively weak constraints (if at all) on what businesses can do 32

Three Major Classes of Derivatives • Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. • Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option ( European vs. American options)‏ • Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. 33

Six Types of Underlying Assets • Interest rate derivatives (the largest)‏ • Foreign Exchange derivatives • Credit Derivatives • Equity derivatives • Commodity derivatives • Weather derivatives 34

Why Is It So Difficult to Write Standards for Derivatives Accounting? • Some derivatives are designed to get around the intent (provision of information) of the extant financial reporting standards • How does one write standards for these instruments? • Is it possible to have an equilibrium between design of such instruments and standards for reporting them? • The problem seems to have gone largely unnoticed in the flurry of proposals on financial reforms now on the table • The question is: Are the optimization in financial engineering (relative to prevailing reporting standards), and search for standards that provide useful information to investors mutually consistent goals? 35

Social Norms of Accounting and Finance • I personally doubt that a non-cooperative game between financial engineers and accountants has led us to a socially efficient outcome • Accountants have, over the past eight decades, increasingly come to rely on written rules as opposed to their judgment and social norms of their profession • Financial engineers, on the other hand consider it their own professional duty to design whatever instruments/transactions/organizations will best serve the immediate interests of their clients under the prevailing written standards of financial reporting • Social norms play a diminishing, if any, role on either side • Is it possible that some part of the blame for the systemic failures of the recent years may be linked to this diminishing role? 36

Ethics and Moral Code in Business Programs • Shiller: “Many schools now offer a course in business ethics, and some even try to integrate business ethics into their other courses. But nowhere is ethics seen as the centerpiece or even integral part of the curriculum. And even when business students do take an ethics course, the theoretical framework of the core courses tends to be so devoid of any moral content that the discussion of ethics must seem like some side order of overcooked vegetable”. • If the role of ethics in curriculum is minimal, what is the role of ethics (i.e., social consequences of our work) in choosing the substantive topics of our research • Identifying mis-pricing of securities, for example, may help move prices to more efficient levels • What about identifying a way of redesigning a transaction so a financial obligation will not show up on the balance sheet under the prevailing reporting standards? 37

Ethics and Moral Code in Research Programs • In some recent theoretical and experimental work, we find that the constraints imposed by financial and social institutions (e.g., bankruptcy laws, commercial code, accounting) can help resolve otherwise mathematically intractable problem of multiplicity of equilibria in economy. Could this also apply to interaction between financial engineering and reporting? • Which one of us would refuse to work on either an optimal transaction design or accounting standardization problem on ethical (social consequences) grounds? • If I were a locksmith, and published the locking codes for the university doors, I might bear some moral culpability • What should a locksmith do if a thief asks him to make a key for the neighbor's house? • Is, or should, there be any moral culpability associated with devising a way around a standard of financial reporting intended to provide better information? • When, and where, should we raise such issues? 38

Roles of Accounting and Finance Research • Progressive “micronization” of research • Progressive shift in research attention to better explanatory power through additional variables • This process is understandable, but does not create a micro-macro issues balance • Discarding of details, standing back, to allow a big picture to emerge is just as important • What is the big picture of corporate financial reporting and engineering today? • Accounting researchers have become so focused on examining the things are that little attention is being paid to what, if anything, can be done to make them better 39

Accounting and Finance • Accounting and finance originated as a single discipline have increasingly diverged in the recent decades • Interaction of financial reporting standards on one hand and financial engineering on the other has created a newer kind of interaction between them with its own special consequences • What, if any thing, should we, and can we do about this? • Are there some alternatives to bringing in a sense of social responsibility for the consequences of our research agendas? If so, let us explore them. 40

Question of Remedies • How to think of financial reporting? Decision usefulness? • Accounting as input for economics and finance, or reverse? • Accounting from markets or for markets? • Accounting as imperfect masonry walls (Lower-of-cost-or-market) or perfect jello walls (Fair value)? • Focus on responding to financial engineering by accounting engineering or by building stable institutional structures • Accounting as rules of the game • Accounting defines rules of the game, and should be evaluated as such • How do we evaluate the rules of a game? Efficiency and social norms • Focus on better methods, or on better institutions of accounting (regulatory competition, evolution, monopoly)‏

References • Hans J. Blommestein, “The Financial Crisis as a symbol of failure of academic finance (a methodological digression), The Journal of Financial Transformation, Fall 2009. • G. Gorton and N. Souleles, “Special Purpose Vehicles and Securitization,” FRB Philadelphia Working Paper, 2005. • Henry, David, Heather Timmons, Steve Rosenbush, and Michael Arndt (2002), “Who else is hiding debt?,” Business Week (January 28), 36-37. • J. Huber, M. Shubik, and S. Sunder, “Default penalty as disciplinary and selection mechanism in presence of multiple equilibria,” Cowles Foundation Working Paper 1730, October 2009. • K. Klee and B. Butler, “Asset-Backed Securitization, Special Purpose Vehicles • and Other Securitization Issues,” Uniform Commercial Code Law Journal 35 (2002), 23-67. • J. Mason, E. Higgins and A. Mordel, “Asset Sales, Recourse, and Investor Reactions to Initial Securitizations: Evidence Why Off-balance Sheet Accounting Treatment Does not Remove On-balance Sheet Financial Risk” LSU Working Paper, 2009. • Robert J. Shiller, “How Wall Street learns to look the other way,” The New York Times, Feb. 8, 2005. • Shyam Sunder. Theory of Accounting and Control. Southwestern Publishing, 1997. • Shyam Sunder, “Determinants of Economic Interaction: Behavior or Structure.” Journal of Economic Interaction and Coordination 1, no. 1 (May 2006): 21-32. • Shyam Sunder, “’True and Fair’ as the Moral Compass of Financial Reporting,” in Cynthia Jeffrey, ed., Research in Professional Responsibility and Ethics in Accounting (Forthcoming 2009). Sunder: Financial Engineering and Reporting 42

Thank You www.som.yale.edu/faculty/sunder Shyam.sunder@yale.edu

Accounting: to, for, and from the Crisis

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