Arnold Kling  

Accounting and Financial Crises

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Two From Mark Thoma... Just Try It; or, Nudge for Kid...

Hernando de Soto writes,


Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: "economic facts."

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts...Governments have allowed shadow markets to develop and reach a size beyond comprehension. Mortgages have been granted and recorded with such inattention that homeowners and banks often don't know and can't prove who owns their homes. In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.

Pointer found in commentary from Barry Ritholtz, which was spotted by Tyler Cowen.

In a way, this strikes me as overstated. Yes, there were many bad lending practices. Yes, one problem with securitization is that the ownership of the mortgage cash flows get traded quickly while the noteholder of record changes slowly. But I don't think that one can put the entire financial crisis into the category of property-rights fiasco.

De Soto emphasizes accounting shenanigans, most notably the off-balance sheet activities of banks that were not really off balance sheet. He describes ways that Greece used accounting tricks to hide some of its problems.

I have some fundamental questions about accounting, because it seems as if every crisis exposes an accounting scandal. The S&L Crisis exposed book-value accounting. This crisis exposed various ways in which financial institutions deceived regulators (and probably themselves) about their risk positions.

Does accounting go through cycles of accuracy and inaccuracy? Or is it always inaccurate? There is a saying that "You only see who is swimming naked when the tide goes out," and maybe the exposure of accounting problems during a downturn is an instance of that.


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COMMENTS (15 to date)
Lance writes:

Arnold,

what do you mean by 'accounting'? Do you mean accounting standards as understood to be represented by GAAP, as written by FASB, and implemented by the AICPA? Accounting rules, with various changes at the margins (especially with respect to leases and the accounting treatment of investments), have been relatively consistent since the 1970s.

If I recall correctly, most S&L's were not using GAAP accounting due to exemptions granted by the Federal Home Loan Bank. If anything, the S&L crisis was an affirmation of accounting standards and deviation reflected political realities.

Accounting is an imprecise tool. Coupled with the mismatch between expectations and abilities, accountants are always going to be viewed as 'late to the party'. Every public company now goes through extensive review with respect to their holdings of illiquid securities (Lehman Bros. securities, e,g.) and other issues of material concern.

As for off-balance sheet activities, these have been covered by FAS 46, which was later amended by FAS 167 in wake of the crisis. Accountants may be slow, but the general framework is there.

Methinks writes:

I've always found that most accounting is as accurate as it can be. Certainly, we constantly strive for accuracy in our business and we are always questioning whether our accounting methods not only adhere to the rules but also paint an accurate picture of our firm's economic reality.

However, since accounting is the language used to communicate the underlying economic reality, it (like every language) can quite easily be used to lie. It's always the lies, self-deceptions and simple mistakes that make the news. When was the last time you read a headline screaming that a particular company's accounting methods were completely above board?

some commenter guy writes:

Hernando de Soto is so far off the mark on this issue that it's caused me to wonder if there aren't huge flaws in his more well known research about private property rights in third world countries.

The problem in our financial system isn't that ownership rights are often unclear. The problem is that it's hard to figure out how much risk there is, who really has the risk, and de facto, ultimate risk often unfairly falls on the taxpayer in the end. Property rights usually remain pretty clear through and through.

some commenter guy writes:

I should add that the foreclosure shenanigans are nothing more than a problem of sloppy paperwork and process, mostly due to a brainless factory-style approach to clearing the backlog of foreclosures. The guys who are getting into trouble are cutting corners in MAJOR ways, and they know it. If they followed standard practice that prevailed a few years ago (and still prevails in many companies), they would have spent at most a couple hundred more bucks per case typically, and sometimes have had to wait a couple of weeks longer to complete the cases.

Securitization surely makes this process a little more expensive and slower, but in most cases the hit is not that bad compared to the total amounts at stake. The amount it costs to do the process right is usually small compared to the risks of pissing off judges, and it's almost always relatively small compared to the overall loss a bank takes on a typical foreclosure. I think the problem here is that a lot of banks and servicers couldn't figure out how to deal with the flood, and some of them put low-integrity individuals in charge of figuring out how to make it work (and I am glad to see those individuals get nailed to the wall). It's just growing pains, as there has never been a foreclosure mess this big and the major players don't have enough experience to guide them to avoid the pitfalls.

Les writes:

Comments such as "Does accounting go through cycles of accuracy and inaccuracy? Or is it always inaccurate? There is a saying that "You only see who is swimming naked when the tide goes out," and maybe the exposure of accounting problems during a downturn is an instance of that" reveal a basic misconception about accounting.

Like law, accounting has two separate aspects:
1) The rules, such as GAAP (just like laws), and
2) Crooks who break the rules, such as larcenous CEO's and auditors (just like bank robbers who rob banks although they know its against the law).

So don't blame the rules of accounting when crooks break the rules. The law is no better than how effectively it is enforced - and there is always a potential illicit gain for those willing to take the risk of breaking the rules.

J Oxman writes:

The nonsense about off-balance-sheet liabilities is especially misguided. It's as if those speaking about reporting have never read a 10-K. A great deal of normal business transactions are off-balance-sheet, but that doesn't mean they are not reported. The notes to the financial statements are usually more important than the statements themselves, because that's where all the off-balance-sheet stuff is reported.

Those who complain about off-balance-sheet liabilities are either bad analysts or don't know what they're talking about. I have yet to analyze a company where I didn't have to rework the balance sheet to get a more accurate reflection of the company's true financial position.

OneEyedMan writes:

Les's framework distinguishing between what the rules requires and what people do is a helpful one. Even so, accounting isn't chemistry. There is no exact protocol to follow that if followed by independent skilled workers will give identical results. Discretion enters with differences of opinion on materiality, useful life, interpretations on the tax code for deductions, and I'm sure many other places. That ensures that there is some level of inaccuracy that is always with us. However, if you have a simple business with little financial assets, cash sales, well understood liabilities (equity, loans, and debt), and both capital and inventory with a long and well understood useful life, that inaccuracy will be small except in the presence of malfeasance.

Yancey Ward writes:

What Les said.

The problem isn't accounting per se, but the fact that someone can always concoct a new accounting ledger to show you, if he wants to. Even within the letter of the law, this is possible.

Costard writes:

These accounting scandals have generally come about because good sense mandates one thing - sound lending and a solid balance sheet - while political expediency requires another: cheap credit and banks with a blind eye to risk. Something the Chinese understand very well is that facts are not so important when you have "mandates". What makes a spectacle of our current situation is that the accounting rules themselves have been changed, or suspended, in order to accommodate a policy that Washington is bent upon preserving -- even in the wake of the crisis.

David N writes:

I guess Hernando de Soto never heard of the county recorder's office.

Brian Clendinen writes:

Lesson 1: Only the cash flow statement has any meaning because it can be trusted.

Lesson 2: Although it is better than having no information the various info on 10-k related to risk should be read with extreme prejudice.

I could write a book on the issues with accounting rules and the relevance of how accurate much of accounting is as a performance metric.

The two professor I had who were executives directly reporting to the CFO’s of fortune 100 firms taught me not to trust financial statements (however, they were not financial firms). In my experience as an analysis who actually has help make some cost accounting policies, I would be of this camp now even if I had been taught this before hand.

Now that is not to say accounting does not have uses and in the long term it does not allow a firm to hide major issues (with the exception of long term assets such are real property, loans, ect). However, the movement of FASB to economic value verse historical value is distorting the books even worse. I have no problems with footnote notes calculating economic value to help analyzing the firm. However, there are relatively few people in a company who are equipped to do a decent job of providing this information on specific subject matters. Auditors are at a total loss in understanding the issues let alone auditing the methodology. So I would take much of this with a grain of salt. However, in the end it is an analysis’s job to determine economic value not the corporate accountants who have huge conflicts of interest. Although I am a diehard contrarian investor, I realize the extreme informational distortion financial statements have and the limited value. This is partly why investing in stocks is so much like poker. Financials statements are like tells, and knowing the history of how someone plays poker.

fundamentalist writes:

Accounting is just a tool. Using a tool well requires common sense. The tool can no more substitute for common sense than buying a hammer can substitute for training in being a carpenter.

Historically, common sense and conservativism encouraged people to use the lower of the book price or the market price. It worked quite well until some people decided they could make more money by using one exclusively. When the goal is to cheat others, the tool of accounting can’t prevent it. In fact, crooks know how to use the tool very well for their purposes.
At the same time, accounting relies on prices. As Hayek often tried to convince people, but convinced few economists, prices are information. Prices are the only material accounting has to work with.

But if the government distorts prices through intervention, price fixing (as with interest rates), subsidies and massive regulations, then prices convey bad information. Garbage in garbage out. Don’t blame the tool for the garbage. Blaming accounting for the garbage it has to work with is like blaming the computers that crunch the numbers.

OneEyedMan writes:

@Brian Clendinen
Eugene E. Comiskey (author of The Financial Numbers Game: Detecting Creative Accounting Practices) taught a seminar at my work. He said that to the extent that cash flow statements were more trustworthy than income statements, it was only because more people were interested in income statement numbers. He said that the minute people started paying a lot of attention to cash flow statements they would manipulate those numbers too.

I think a simple example is that you currently a firm might offer a special deal to customers who order at the end of the quarter to book the sales in the current quarter. If people watched cash flows then instead they'd offer a deal to firms that paid before the end of the quarter instead. It wouldn't be exactly the same but the same rough potential for mischief exists.

Lance writes:

Brian,

The movement from historical cost to fair value accounting is primarily occuring in investment holdings. There have been some applications to leases, but this has been very limited.

There are very clear guidelines for what constitutes fair value for a given security. Any person with investment management audit experience could tell you how they determine whether or not a security which is fair valued is a fair representation of fair value.

I really don't see the relevance of your point with respect to audit methodology. Having IM audit experience, most firms have to give a detailed explanation of their valuation methodology (usually Black-Scholes), which is then evaluated by a pricing specialist. Then the prices generated by the client in question is then cross-referenced to other securities, or securities of a similar nature, to determine whether or not the pricing is reasonable.

@One Eyed Man,

Basic finance says a company's worth is equivalent to the net present value of the expected stream of cash flow. So, cash flows give insight into a company's worth. Given this, there is already significant incentive to distort cash flow.

Yet, for publicly traded companies, cash is a low-risk item*. There are significant internal controls over cash, generally. More importantly, fraud in cash is hard to hide. Accounting firms will seek to 'prove' the cash flow statement.

However, companies with captive finance companies can distort cash flow statements to some extent. If GMAC loaned money to a local GM dealership to help finance the purchase of a car, cash outflow is recognized as an investing activity, not an operating activity. But, even before the dealer pays back the loan, cash inflow from the sale is recognized as an operating activity.

There are certainly many ways for companies to game FASB accounting rules (securization of receivables, increased capital lease transactions, stretching out payables through the use of a third-party, etc). But, by and large, accounting standards serve as a fairly adequate guideposts for investors.

*For investment management and private equity firms, the risk is nearly non-existent. They hold very little cash as most are put into repurchase agreements/other overnight securities in order to generate returns.

Brian Clendinen writes:

@Lance

My experience in methodology with auditors is in contract accounting, cost accounting standers, and lease accounting.
Cost impact studies are really somewhat a joke. I have done one or two after the fact for a very simple project accounting set-up and I had to guess at and make assumptions which really resulted in it being an approximation. A former boos who was the cost accounting compliance officer for a 2 billion dollar a year defense sector taught me when one does a forward looking cost impact study, it is highly subjective. The importance is how much the auditors trust you and how one presents the data to them.
Trying to explain a delay claim cost impact to an auditor manager that has done construction accounting for years is a nightmare. I could of in some cases could of fairly used two or three different methods. They don’t understand it so the senior partners required the burden of proof to be 75% to 80% instead of 50% which the regulations stipulated.

Valuation methodology of assets, I have never done that for a firm other than read threw some of the FASB rules, but I do know standard valuation methods. It is not that hard to adjust the risk variables to skew the results to how one wants them. The real valuation issue is when one hold assets which have low liquidity. Highly liquid assets using market rates are typically good valuations and I don’t have any issues unless one uses that for reserve requirements.

In the end all this accounting rules and audits reduces the margin of error by maybe half and stops outright glaring lies. This is not a bad thing but my point is one needs to realize there is most likely a 20% margin of error one can get away with. Not low single digit errors rates that auditors and investors seems to think.

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