Against Politics and Finance in Accounting

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An old joke says every financial crisis needs an accounting culprit to blame. The current crisis may be attributable instead to the dominance of modern finance theory and subordination of traditional accounting principles. Two generations of finance theorists—in business and law schools—developed elaborate models to measure and manage risk in a theoretical world of efficient markets where accounting is not relevant.

Yet two strange twists have arisen—one showing the intellectual limits of the finance story and the other the dark art of making accounting into a political issue. Both concern debate over how to measure financial assets on a balance sheet—the so-called fair value debate.

First, for decades, proponents of modern finance theory urged standard setters to direct asset measurements using fair value rather than applying traditional accounting conventions. The prescription was based on assertions that emphasized the reliability of efficient markets to reveal relevant values. Proponents said traditional accounting conventions, using acquisition cost adjusted over time, were comparatively impoverished.

Amid the crisis, those same people shift their stance, now saying fair value measures in stressful markets are either misleading or put downward pressure on values that could render owners of impaired assets, especially banks, insolvent. On its face, this is an admission about the limits of markets to reveal reliable asset values, that modern finance theory is impoverished.

Second, without opining on the merits of measuring assets at fair value or using historical cost accounting conventions, this issue, once again, is turning accounting standard setting into a political expression rather than a professional one. Politicians in Congress, under heavy bank lobbying, pressured the US standard setter [the Financial Accounting Standards Board] to adopt bank-friendly approaches to asset measurement.   Now, Congressional bills  (here, for example, and noted here) contemplate empowering politicians and/or a new federal agency to oversee US accounting standard setting, equipping them with veto rights over any accounting standards the political power consensus disfavors.

Such politicization of accounting, a recurrent threat in the United States that generally is recurrently defeated, is dangerous, as Bill Bratton has explored. Injecting politics into accounting standard setting would not only turn our accounting system into a version of the politically-pockmarked and incomprehensible US tax code, it would diminish the hard-won emphasis on investors as the primary constituent for which accounting standards are adopted.

Examples of hard-won investor focus, and successful resistance to campaigns to make accounting a political product in the US, include (a) accounting for oil companies during the energy crisis of the 1970s, (b) accounting for mergers in the takeover wave of the 1980s, (c) accounting for pensions and employee benefits in the late 1980s after these proliferated and (d) accounting for stock options in the late 1990s and early 2000s after these mushroomed.

In all those contexts, lobbyists got politicians to pressure the independent accounting standard to steer it off its intended course. In each case, however, eventually the standard setter won, retained its position and achieved adoption of accounting standards focused on the needs of investors, rather than parochial interests of managers.

In the current context, the legislative talk is going much further, to create political watch-dog power to oversee the independent standard setter, even giving the federal agency power to veto any standard it does not like. This is a dangerous proposal that should be rejected out of hand.

There is no accounting culprit in the current crisis, a crisis more a product of modern finance theories. Politicians ought to focus on those theories that failed rather than exploit a period of chaos and confusion to alter practices that have succeeded.

Above all, modern finance theories seduce belief that markets, not accounting, matter. Yet the intense and costly political lobbying about what accounting should be also shows that real-world participants know that finance theory’s intellectual elegance masks important drivers of capital allocation.

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