In the sub-prime crisis and its ruinous aftermath, accountants fell short as gatekeepers
By HO YEW KEE 9 October 2008
The Enron debacle gave rise to the significant debate concerning the role of accountants. The end result is the passing of the Sarbanes-Oxley Act which redefines the role of accountants and strengthens their independence and professionalism.
The main lesson from Enron is the failure of accountants as gatekeepers in ensuring that the financial assertions of firms are reliable and truthful. This naturally assumes that accountants play an important role in the provision of financial information to the capital markets for the purpose of the pricing of securities.
In the massive failures of financial institutions arising from the sub-prime crisis, again it is not unreasonable to question the role of accountants as gatekeepers.
In the valuation of financial assets and liabilities, accountants have been blamed for the use of the three m-to-m: mark-to-model, mark-to-market and mark-to-myth, as the share prices of financial institutions collapsed overnight.
The first m-to-m (mark-to-model) raises the question as to whether accountants have diligently discharged their responsibilities in understanding, parameterising and applying the models correctly. In addition, one can even question whether accountants are adequately trained to understand the sophisticated valuation models used by financial institutions.
There are at least three major failures in the context of the role of accountants. Firstly, the internal risk management function of financial institutions had failed in correctly identifying the risk of these sub-prime assets.
Secondly, accountants have failed to correctly value these assets and reporting them in their financial statements. Alternatively, they have failed to provide sufficient timely impairment losses.
Finally, independent auditors had failed to provide an independent assessment of the true values of these sub-prime assets.
The first mark-to-model raises significant concerns about the competency of accountants and their roles as quality financial information providers.
The second m-to-m (mark-to-market) raises the question as to whether accountants should blindly follow the mark-to-market rule in valuing their assets. This is especially critical when the market is experiencing a free fall because of a crisis of confidence and a concern for liquidity.
In this instance, accountants - instead of providing reliable and relevant information to the market concerning the value of their assets - are literally following the market and reacting to whatever the fair value of their assets are, as determined by the market. In so following the market, they exaggerate the crisis of confidence in the market.
The second m-to-m makes the accountant a bystander in the provision of financial information. Surely, accountants must have a positive role in a period of financial crisis.
Finally, the third m-to-m (mark-to-myth) calls to attention the ultimate role of the accountants. If the first two m-to-m are not applicable in a state of crisis, what then is the role of the accountants as supplier of financial information to the market? Can the accountants play a role in shoring up the confidence in the market?
In fact, the third m-to-m suggests that accountants may not be as influential as they think; in a state of crisis, they are literally powerless to influence the market. Worse, accountants are viewed as magicians who can pull any numbers out of the hat.
Three major lessons
It may be still premature to ask what we can learn from the crisis concerning the role of accountants. I can suggest three major lessons for the accountants in this crisis.
Firstly, it is necessary for accountants to understand and question their valuation models. Of course, it is true that accountants are gatekeepers rather than path breakers and thus their valuation skills may lag the financial innovations existing in the market. Nonetheless, in discharging their responsibilities as gatekeepers, they need to critically assess the valuation models and the parameters used. Accountants must understand the valuation models they are using.
Secondly, accountants may need to reconsider the mark-to-market rules as the rules do not merely affect the valuation of an asset but the confidence of investors during a crisis. Much like the circuit breaker that was proposed after the 1987 financial crisis, accountants may need to seriously consider the equivalent of a circuit breaker in suspending the use of the mark-to-market rule when the market is no longer reliable or rational.
Finally, accountants need to seriously consider what their roles are in a state of crisis and how they can provide meaningful information to the market or to signal credibly to the market the true value of their assets and liabilities. This may require accountants to review their reporting responsibilities in the light of adverse financial information much like a specific accounting standard dealing with a hyper-inflation economy which is outside the norm of ordinary financial reporting.
In summary, when this financial tsunami subsides, there will be much discussion on the lessons to be learnt for the accountants and how accountants can play a larger role to prevent any future tsunami. The question is whether accountants will actually learn from this episode and what the lessons will be.
The author is vice-dean and associate professor of accounting at the NUS Business School. The views expressed here are personal
1 comment:
How Much are the Accountants to Blame?
In the sub-prime crisis and its ruinous aftermath, accountants fell short as gatekeepers
By HO YEW KEE
9 October 2008
The Enron debacle gave rise to the significant debate concerning the role of accountants. The end result is the passing of the Sarbanes-Oxley Act which redefines the role of accountants and strengthens their independence and professionalism.
The main lesson from Enron is the failure of accountants as gatekeepers in ensuring that the financial assertions of firms are reliable and truthful. This naturally assumes that accountants play an important role in the provision of financial information to the capital markets for the purpose of the pricing of securities.
In the massive failures of financial institutions arising from the sub-prime crisis, again it is not unreasonable to question the role of accountants as gatekeepers.
In the valuation of financial assets and liabilities, accountants have been blamed for the use of the three m-to-m: mark-to-model, mark-to-market and mark-to-myth, as the share prices of financial institutions collapsed overnight.
The first m-to-m (mark-to-model) raises the question as to whether accountants have diligently discharged their responsibilities in understanding, parameterising and applying the models correctly. In addition, one can even question whether accountants are adequately trained to understand the sophisticated valuation models used by financial institutions.
There are at least three major failures in the context of the role of accountants. Firstly, the internal risk management function of financial institutions had failed in correctly identifying the risk of these sub-prime assets.
Secondly, accountants have failed to correctly value these assets and reporting them in their financial statements. Alternatively, they have failed to provide sufficient timely impairment losses.
Finally, independent auditors had failed to provide an independent assessment of the true values of these sub-prime assets.
The first mark-to-model raises significant concerns about the competency of accountants and their roles as quality financial information providers.
The second m-to-m (mark-to-market) raises the question as to whether accountants should blindly follow the mark-to-market rule in valuing their assets. This is especially critical when the market is experiencing a free fall because of a crisis of confidence and a concern for liquidity.
In this instance, accountants - instead of providing reliable and relevant information to the market concerning the value of their assets - are literally following the market and reacting to whatever the fair value of their assets are, as determined by the market. In so following the market, they exaggerate the crisis of confidence in the market.
The second m-to-m makes the accountant a bystander in the provision of financial information. Surely, accountants must have a positive role in a period of financial crisis.
Finally, the third m-to-m (mark-to-myth) calls to attention the ultimate role of the accountants. If the first two m-to-m are not applicable in a state of crisis, what then is the role of the accountants as supplier of financial information to the market? Can the accountants play a role in shoring up the confidence in the market?
In fact, the third m-to-m suggests that accountants may not be as influential as they think; in a state of crisis, they are literally powerless to influence the market. Worse, accountants are viewed as magicians who can pull any numbers out of the hat.
Three major lessons
It may be still premature to ask what we can learn from the crisis concerning the role of accountants. I can suggest three major lessons for the accountants in this crisis.
Firstly, it is necessary for accountants to understand and question their valuation models. Of course, it is true that accountants are gatekeepers rather than path breakers and thus their valuation skills may lag the financial innovations existing in the market. Nonetheless, in discharging their responsibilities as gatekeepers, they need to critically assess the valuation models and the parameters used. Accountants must understand the valuation models they are using.
Secondly, accountants may need to reconsider the mark-to-market rules as the rules do not merely affect the valuation of an asset but the confidence of investors during a crisis. Much like the circuit breaker that was proposed after the 1987 financial crisis, accountants may need to seriously consider the equivalent of a circuit breaker in suspending the use of the mark-to-market rule when the market is no longer reliable or rational.
Finally, accountants need to seriously consider what their roles are in a state of crisis and how they can provide meaningful information to the market or to signal credibly to the market the true value of their assets and liabilities. This may require accountants to review their reporting responsibilities in the light of adverse financial information much like a specific accounting standard dealing with a hyper-inflation economy which is outside the norm of ordinary financial reporting.
In summary, when this financial tsunami subsides, there will be much discussion on the lessons to be learnt for the accountants and how accountants can play a larger role to prevent any future tsunami. The question is whether accountants will actually learn from this episode and what the lessons will be.
The author is vice-dean and associate professor of accounting at the NUS Business School. The views expressed here are personal
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