The news today that KPMG is being sued over its audit of New Century Financial, the collapsed mortgage lender, especially grabbed my attention. Not that it was surprising. Auditors have not caught a break all millennium, being first blamed for Enron and then having to completely re-organize the industry in the wake of Sarbanes-Oxley. If the allegations of the plaintiff, the liquidating trust of New Century, are even somewhat true, it represents the further inability of auditors to remain independent from its clients.
The plaintiffs make some bold claims. They blame KPMG for neglecting their role as a watchdog. In their view, if KPMG had correctly audited New Century’s loan reserves then New Century would not have disseminated subprime loans like rabbits in Australia.
This claim makes little sense to me if one considers the operations of New Century, but it brings up an interesting comparison. Regulators and auditors perform a similar role in the economy. Both operate in the public trust and provide functions crucial for a healthy economy. Both must avoid falling under the sway of industry and both have a long list of failures under their belt. Regulators are as liable for New Century’s failure as its auditors. As Sec. Geithner said before the Financial Services Committee the other day, “Lax regulation also left too many households exposed to deception and abuse when taking out home mortgage loans.” From Chain of Blame, a recent book about the origins of Subprime, “New Century largely depended on owners treating their homes like ATMs, withdrawing cash as…their equity expanded.”
With re-regulation one of the G20’s biggest goals and Geithner calling for “new rules of the road,” why doesn’t accounting change as well? Just like the US regulatory system, the current US accounting system is malfunctioning. We can do bettah!
My accounting professor described financial statements as a “portrait of an entity’s resources, claims against those resources, and changes in those resources over time.” But that’s easier said than done. Financial innovation and securitization have greatly increased the difficulty of assessing a firm’s economic performance. Not only have the individual assets and liabilities become more complex, their interactions have become increasingly important and unpredictable. Consider a credit default swap. By itself it has an NPV of 0. Whether the CDS turns into an asset or liability depends on the credit markets. We’ve already seen how hard some of these assets are to value. Consider how far our valuations must be removed from their intrinsic value when a loosening of mark-to-market is expected to increase earnings by 20%.
One of the key attributes, perhaps the overarching principle in the FASB conceptual framework, is the idea that financial statements must be useful to its users. How can financial statements be useful when they provide little indication of a Banks’ true value. Financial statements are not globalized yet in the sense that they do not assess systematic and counter-party risk.
Goldman Sachs CEO Lloyd Blankfein wrote in the Financial Times a couple weeks about the need for this forward looking risk management.
“Given the size and interconnected nature of markets, the growth in volumes, the global nature of trades and their cross-asset characteristics, managing operational risk will only become more important.”
One interesting suggestion he has is for “dynamic regulation” where regulators adjust their regulatory involvement according to market moves, much like the Fed increases interest expenses during times of excess. Another interesting suggestion is his support for completely independent risk managers at financial institutions. This idea reminds me a lot of the emphasis on internal controls after Enron and WorldCom. As systemic risk increases, so does the importance of corporate governance.
Blankfein thinks regulators and internal risk managers should have more information on systemic risk. Why stop there? Accountants could be the public’s window into the risks of these institutions.
In today’s FT there is a great article by Andrew Lo of MIT called “Mind the GAAP” where he advocates such an approach. He argues accounting is inherently backward-looking when it should be forward-looking, assessing risk.
In his article, Lo mentions that in 1995 Robert Merton and Zvi Bodie pointed out the need for a new branch of accounting called “risk accounting.” When trying to find more information on this subject I stumbled across a more recent paper of theirs from 2006 called, “A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy.” Here is a short excerpt from the abstract:
“The high cost of international economic and financial crises highlights the need for a comprehensive framework to assess the robustness of national economic and financial systems. This paper proposes a new comprehensive approach to measure, analyze, and manage macroeconomic risk based on the theory and practice of modern contingent claims analysis (CCA). We illustrate how to use the CCA approach to model and measure sectoral and national risk exposures, and analyze policies to offset their potentially harmful effects. This new framework provides economic balance sheets for inter-linked sectors and a risk accounting framework for an economy.”
http://www.hbs.edu/research/pdf/07-026.pdf
Back to Andrew Lo’s article:
“By viewing future values of accounting concepts as random variables, the well-developed framework of probability and statistics can be used to quantify the impact of events such as credit crunches, flight-to-quality, and volatility spikes on corporate balance sheets and income statements.”
I hope this is the direction accounting is headed. As globalization and financial innovation continues, systemic risk will become an even more important variable for the global economy. Plus it would make the industry a heck of a lot more interesting, and I think we can all agree accountants deserve a break.
