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.

Truth by Fiat: Its Accountants' Turn

In 1897, Indiana General Assembly was persuaded to consider Bill #246 which provided a method for squaring the circle by ruler and compass (millenniums after unsuccessful search, and 15 years after Lindemann proved it to be mathematically impossible), and effectively declaring the value of pi to be rather convenient 3.2. A physician almost succeeded in getting this bill passed by arguing that the state could collect royalties from those who may use this discovery, and was stopped only by arguments of a real mathematician who just happened to be present.

In recent years, the Financial Accounting Standards Board and the International Accounting Standards Board have declared that in corporate financial reporting stock variables (such as assets and liabilities) have priority over flow variables (such as revenues and expenses).

But stocks and flows are related to each other in a way that precludes the idea of dependence of one over the other. Value of asset derives from the benefits that flow to its owner over time; returns on an investment flow out of its value. It makes little more sense to declare one to have priority over the other than to declare that days precede nights, or that chicken came before the egg.

There have been numerous attempts in human history to establish scientific truth through exercise of political, military, or bureaucratic power or fiat. Of these, declaration of primacy of stocks over flows is neither the first, nor the silliest; it is also unlikely to be the last.

Who Do the Accounting Standards Boards Serve?

I was asked to venture out of my ivory tower to attend a user-preparer roundtable as an invited guest in NY yesterday on the subject of insurance contract accounting proposals issued by FASB and IASB--two boards that write accounting rules in US and internationally. Some 90 people, including CFOs of major insurance firms, analysts, and institutional investors attended. A report on the proceedings by one of the attendees this morning is appended below after my own observations and reactions.

Since the Insurance Contract accounting has been on the agenda for some time, and subject to the Boards' "due process", I was surprised at the virtually unanimous, even vehement,  rejection of the proposal by the CFOs of insurance companies and the buy as well as sell-side analysts in the room. It made me wonder if the "due process" is working or the room was full of people who had just landed from mars. I heard some talk about those who criticize the Boards' proposals being lectured to, treated discourteously, or black-listed out of subsequent consultations by members of the Boards or the staff.

The following para is from email from an institutional investor who (I was surprised to learn) had found and read the Bromwich, Macve and Sunder paper in last Fall's issue of Abacus and invited me on June 8 to attend the session (I mention this only as a straw to clutch for those who  are still interested in theory; I did not even know that this project was on the Boards' agendas):

"My only regret that I didn't call out the boards on the issued highlighted in your Hicksian Income paper.  They (i.e., the Boards) have used the complexity and apparent theoretical justification to avoid and preempt debate on this very dubious proposed model.  This model is indeed one of the key investor concerns about the proposal.  Anyone in the industry can intuitively tell that this model is flawed but we need the theoretical insight to prove its wrong.  You can provide that and have indeed in your paper.  Thank you for this.  Without your help, the boards simply will NOT listen or acknowledge this concern."

As some of you know, I am not one who thinks that investors are the only users of corporate financial reports. With the Boards determined to serve the information needs of investors, I  returned home after seeing a roomful of upset institutional investors who have difficulty containing their anger at the proposals intended to serve them better. What is the missing link here? I seek help to figure this out.

I can't help being surprised that someone out there read the turgid prose of our research paper. And not everyone in the world of business thinks that asset-liability-view-driven standards being forced on them are based on sound verified theory, not just ideology or personal preference of who occupies the chair.

Report on Insurance Accounting Roundtable by a Participant

Discussion Takeaways

• A roundtable/panel discussion was held on June 9 debating proposed changes to insurance accounting. Panel members on the debate consisted of industry CFOs from ACE, Hartford, MetLife, Principal, Protective, SunLife and Travelers, an academic from Yale, as well as a number of buy-side and sell-side analysts.
• The overwhelming majority of panel members seemed to have a negative response to the proposed changes to insurance contract accounting, although some constructive feedback was also provided as to how we could make the current U.S. accounting regime better.
• The meeting was well attended by both fixed income and equity investors, as well as members of the IASB and the FASB. Members of the SEC were also on the phone. Some key takeaways from the meeting were as follows:
• Investor surveys conducted by three sell-side equity analysts covering both the P&C and life sector identified a lack of support for the proposed changes to insurance accounting. One of the more interesting data points from these surveys, in our opinion, was that more than 90% of respondents believed the new standards would make insurance financial statements more difficult to understand.
• The academic from Yale provided an interesting historical background on accounting overhauls, including examples of work done that could indicate unintended consequences are a potential outcome of starting from a fresh slate. He also questioned the term "fair value" and its appropriateness, as the potential move to "accounting from markets" as opposed to "accounting for markets" may not prove to be useful for making investing decisions based on the long-term economics of the business.
• Several of the CFOs in the room gave some perspective on the issue, with one for a major life company concerned that the changes could make the life sector "uninvestable." There were also concerns with the IASB and FASB not speaking with one voice and the political fight that has essentially mounted between these two bodies. There were concerns around how this could affect investor confidence as a result.
• Other items for consideration were the concept that life insurers and pension funds are the largest providers of capital for long-term funding needs of the market, and how some of these changes could potentially alter that investing behavior.
• The notion of accounting fatigue for investors and management teams was a valid concern, in our minds, as other changes are being digested at this time. One CFO indicated regulatory and accounting changes are seen as one of the top risks his company is dealing with right now.
• The proposals in their current form also gave some on the panel concerns around the level of adjustments necessary to illustrate the underlying earnings run rate. We've expressed concerns on this issue as well, as it could damage the integrity of operating income, in our opinion. Elevated volatility was also highlighted as a result of the new model, with headline risk potentially weighing on items such as public confidence.
• Other concerns expressed by investors were the even further removal from comparability to other industries following these changes and the struggles portfolio managers may have investing in the sector as a result. There were cost of capital concerns expressed by CFOs on the panel as a result of this view.
• The consensus view seemed to support the notion of leaving the P&C model alone in its current format, although some suggestions for improvement were offered on the disclosure front for this sector. These items included something akin to Schedule P triangles provided in the GAAP statements and better disclosure around PMLs for CAT risk.
• On the life side, some recommendations for improvement focused primarily on FAS 60 and FAS 97, with one investor suggesting that perhaps the life sector should follow what some P&C companies do in performing either an annual or biennial reserve review, with any changes in assumptions flowing through reserves. A clearer allocation/guideline between what is allocated to DAC and reserves was also offered up. Investors should be aware that the same architect who helped develop these items that investors want fixed in the U.S. is also involved in the new proposals.
• Boiling the discussion down to valuation, there was a clear concern about the overhang the proposals could have on trading multiples, while for bondholders we think the proposals could alter the discussion of whether life insurance spreads in particular remain cheap or simply trade wide if the proposals are adopted.