Finance Theory and Accounting Policy

Amid the financial crisis, considerable debate attends the enduring validity of Modern Finance Theory, including assumptions of capital market efficiency, reliability of recognized risk measurement tools and models of risk reduction through diversification.  There’s little doubt that MFT has had considerable effects on positive law and legal scholarship in the past three generations.  Looming are questions about whether those policies warrant reconsideration given ongoing discoveries of potential deficiencies in those models.

Some of these implications appear in contexts covered by the broad subject called Law and Accounting, topics within securities regulation, corporation law and financial reporting policy. In writing a paper addressing the influence of MFT on L&A, I’m trying to identify the most significant subjects. In outlining a draft, I’ve identified the following as the most consequential, and would be delighted to hear, through comment or email, alternative suggestions or criticisms of this initial compilation. 

The following is a top ten list of subjects in Law and Accounting that Modern Finance Theory has influenced. In each case, it is difficult to deny the role MFT had in augmenting legal or policy change. In some cases, there is little doubt this has been an improvement but in others the resulting law or policy backfired or is of contested appeal. On balance, the influence of MFT on L&A warrants an uncertain appraisal, with many positive effects along with some offsets.

An interesting issue in each case is how, if at all, changing confidence levels in the validity of MFT would warrant changing the related policy. Notably, at least some of the policies could remain justifiable even were MFT deemed invalid. The appeal of others depends quite heavily on its validity.

1. Establishment of the Forward Looking Disclosure System in Federal Securities Law

2. Rise of Fair Value Accounting in lieu of Historical Cost Accounting

3. Creation and Rise of the Cash Flow Statement and Analysis

4. Proliferation of Pro Forma Reporting and Analyst Earning Estimates

5. Rise of Discounted Cash Flow Analysis in State Appraisal Proceedings

6. Expansion of the Stock Market Exception to the Appraisal Remedy

7. Rise of the Reputation Model of Auditing and Curtailed Ambit of Auditor Liability

8-9. Protraction and Politicization of the Accounting Standard Setting Process with illustrations from accounting for:

(a) Business Combinations and

(b) Stock Option Compensation.

10. The Appeal and Potential of International Financial Reporting Standards.

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3 Responses

  1. A.J. Sutter says:

    Perhaps one could argue that this is subsumed in some other categories, such as ##2 or 8, but how about the reification of goodwill and other IP assets, which has played a role in M&A accounting (see, e.g., the narrative in Chapter 1 of L. Moore & L. Craig, Intellectual Capital in Enterprise Success (Wiley 2008)). At a more fundamental level is Delaware’s enshrinement of the notion that “shareholder value” means the value one gets paid to cease being a shareholder (or ‘stockholder,’ to be more punctilious about it), though maybe that doesn’t fall so cleanly into the field of accounting.

  2. At a more fundamental level is Delaware’s enshrinement of the notion that “shareholder value” means the value one gets paid to cease being a shareholder