Arnold Kling  

Accounting Standards

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I have been following, but not writing about the Lehman accounting scandal. Simon Johnson brings up a past scandal (Enron) and a future scandal (Greece). He points out the role of investment banks in designing and/or executing transactions that are done solely to cook the books.

I saw a lot of this during the S&L crisis, with Freddie Mac and investment banks "helping" underwater thrifts play accounting games, with the thrifts' regulator cheering us on (I say "us" because I worked for Freddie, although not on these transactions). The incentive of the regulator was to hide the problem until somebody else was in office.

I do not have much useful to say here, except to note that the worst accounting scams tend to come from government agencies and from regulated financial institutions. And as Andrew Ross Sorkin's column points out in the case of Lehman, the regulator typically knows and seemingly approves of the way that the bank games the system. If the government does not apply honest accounting to itself or insist on honest accounting at regulated/insured institutions, what is the point of accounting standards?

UPDATE: See Jennifer S. Taub on the rule change that spurred the growth in repo financing of mortgage securities.


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COMMENTS (6 to date)
Sam writes:

"What is the point of accounting standards?"

To discourage entrepreneurship by making it seem incomprehensibly difficult to legally start/run a business? Nah, too cynical.

Brian writes:

For the benefit of investors. It allows investors to have better information than they otherwise would have to make investment decisions. For me with Lehman’s sight improvement in their leverage ratio thru Repo 105 would not have affected my purchase/selling behavior to much. However, the manipulation of their liquidity would of had major impacts. That is where I think mark to market values as a footnote by asset type (not as the official balance sheet measurement) would be useful. That way an investor could catch the distortion.

The goal of accounting rules should be to increase the transparency of the firms, and to make it harder to massage the books to drastically from what they should so as to fool everyone verse only fooling the uninformed.

david writes:

Canada! Singapore! Sweden!

Anybody interested in regulation as a topic already knows how the rest of the argument goes. A quick summary: international comparison suggests regulations and regulators can be effective; American regulators have an excessively deferential attitude towards business - which are fundamentally political entities at this size - and the legitimization of this deference is likely to continue to be damaging. Effective regulation requires that the regulators suspect that their charges are trying to game the system (an attitude which culturally liberal nations are not short of), and appropriately treat them with some hostile skepticism.

Ultimately the only solution is a shift in policymaker attitudes, albeit in the exact opposite direction that our host Arnold favors.

I note that the Simon Johnson link suggests even further restriction.

Floccina writes:

David,
Sweden had a banking crisis in 1992 and so are not due for another for 20 to 30 more years. :-)

I am sure what you are expressing is bad verses good regulation/enforcement, still it is worth a note that Canadian banks have been less regulated than USA banks.

Doc Merlin writes:

David,

American regulators are not "more deferential" rather their incentives are messed up, because they combine policing powers and regulatory powers. They have an incentive to assist in the cover up, because the crime makes the regulators look bad. A separation between policing and regulators on the other hand, means the ones with policing powers have incentive to uncover bad behavior instead of having incentives to hide it.

Les writes:

There are several parts to the accounting standards issue:

1) Government agencies grossly violate the most basic accounting standards. For example, (a) the Social Security Trust Fund is diverted and commingled to pay for non-Social Security purposes, (b) several government agencies cannot track their revenues, expenses, assets or liabilities even within a billion dollars, (c) our federal government has run large budget deficits year after year, with only a rare surplus once in a great while, (d)several major government programs, such as Medicare, are rife with fraud, and bankrupt on paper.

2) Financial regulatory agencies have proven ineffective many times over. For example, (a) the regulator of Fannie Mae and Freddie Mac gave no warning of their total collapse into massive bankruptcy, (b) the SEC was tipped off repeatedly in full detail about Bernie Madoff's greatest ever Ponzi scheme, but did nothing at all to stop his fraud for years, (c) bank regulators did nothing to stop, or even warn of, their impending bankruptcy even though they were "too big to fail."

3) Unlike government agencies, public corporations are required by law to publish quarterly financial statements conforming to generally accepted accounting principles.

So the major issue is who, if anyone, is regulating the regulators?

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