Financial Reporting and Financial Engineering

Let me comment first on the relationship between financial reporting and financial engineering, and then on government accounting.

For over seven decades we have worked on the assumption that writing accounting standards improves financial reporting, ignoring financial engineers who make a living out of finding ways around the written accounting standards. It may take them less than three hours to find a way around a standard that may have taken three years for standard setters to prepare. Standards affect only those who are willing to comply with them. This interplay between financial reporting and financial engineering was a fundamental issue in the creation of the financial crisis. For example, much of the securitization of sub-prime mortgages was motivated by desire to get debt off the balance sheet.

We can think of accounting in two quite different ways. One is as a satellite camera - which quietly photographs from a great distance and has no discernible effect on the images it records. The second is as a photographer paired with a model, where the model smiles and poses for the camera. We may want accounting to be like a satellite camera but it has a reflexive relationship with what it records.

There is a large gap between what standard setters can achieve and what they are expected to achieve. Social systems are so complex that it's unrealistic to expect anyone to have the knowledge and ability to design a better system. We need a better balance between the top-down imposition of standards and bottom-up evolution of accounting practice, and between dependence on rules and dependence on judgement. Over the past 70-plus years we have moved from almost total dependence on judgement to almost total dependence on written rules. The British idea of a "˜true and fair' override would help improve financial reporting.

As the crisis has moved on from banks to governments, it is worth thinking about government accounting. Just as it is difficult to stop corporate CFOs from manipulating earnings, civil servants have little power to refuse to manipulate government accounts if they are told to by the politicians. Disciplining sovereign states for poor accounting - think of Greece and its problems - is a major challenge for accounting, and it seems to be a largely unaddressed aspect of the current financial crisis.