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


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Title: 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,
An Overview
  • Some major events and features
  • Little attention has been paid to accounting
  • 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
  • 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
  • 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

What Do We Mean by Risk?
  • Many definitions but two simple approaches
  • Risk of returns in the sense of objective or
    subjective uncertaintydispersion 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 outcomesused in
    portfolio theory, reduced through diversification
  • The second is concerned only with
    lossesmagnitude and chancesused in insurance,
    credit, etc., and reduced through screening, not

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
  • 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
  • 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

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

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
  • 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

Decision-Usefulness Theory of Accounting
  • Choose financial reporting in order to better
    inform the investment decisions
  • Certainly, financial reporting should serve this
  • 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

Can Financial Accounting Control Executives
  • Executives control accounting, boards, and
  • 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 reportsmanaged 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
  • 1991 Forced Bush and Brady to ease up on
    valuation of troubled debts to give the benefit
    of doubt
  • 1990s Kept zombie SLs open, increasing cost of
  • 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

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

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
  • 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?

Accounting and Finance as Aspect of Social
  • 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

Objectives in Financial Engineering
  • The Financial Engineering Concentration
    encompasses the design, analysis, and
    construction of financial contracts to meet the
    needs of enterprises. (Cornells 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

Securitization according to International Finance
  • 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

Financial Reporting Standards as Constraints on
Financial Optimization
  • In such optimization, standards of financial
    reporting are treated as constraints
  • Most optimization problems have hard
    constraintstheir 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
  • 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

Redesigning Contracts
  • A manufacturer needs to buy a machine for the
  • 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
    leasemachine is in the factory but no debt on
    balance sheet!
  • FASB writes Standard 13 leases gt90V and gt75T
    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
Redesigning Transactions
  • Depending on the current standards of financial
    reporting, transactions can be redesigned to
    achieve the desired consequences for revenues,
    expenses and taxes

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)?

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
  • 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

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

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.

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

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
  • 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?

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?

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
  • 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?

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
  • When, and where, should we raise such issues?

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

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.

Question of Remedies
  • How to think of financial reporting? Decision
  • Accounting as input for economics and finance, or
  • 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)?

  • 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,
  • 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
Thank You Shyam.sunder_at_yale.
(No Transcript)
  • Accounting to, for, and from the Crisis