Paradox of Writing Clear Rules: Interplay of Financial ReportingStandards and Engineering *S S†School of Management
YALE UNIVERSITY

ABSTRACT
Attempts to improve fi nancial reporting by adding clarity to its rules and standards
through issuance of interpretations and guidance also serve to furnish a better roadmap forevasion through financial engineering. us, paradoxically, regulation of financial reporting
becomes a victim of its own pursuit of clarity. e interplay between rules written to govern
preparation and auditing of financial reports on one hand, and financial engineering of
securities to manage the appearance of financial reports on the other, played a significant
role in the financial crisis of the recent years. Fundamental rethinking about excessive
dependence of financial reporting on written rules (to the exclusion of general acceptanceand social norms) may be necessary to preserve the integrity of financial reporting in its
losing struggle with financial engineering.
JEL Codes: G24; M41
Key words: Financial Reporting; Financial Engineering; Written Standards; Social Norms;
Regulatory Equilibrium

Since its introduction in the 1930s, federal regulation has sought to promote orderly, uniform,and comparable corporate financial reporting through pursuit of clear written rules with progressively
greater assertiveness and power of enforcement. Committee on Accounting Procedure’s Research
Bulletins, Accounting Principles Board’s Opinions, Financial Accounting Standards Board’s Standards,
and most recently, International Accounting Standards Board’s IFRS, have been steps in thisdirection.
is well-intentioned attempt to write clear rules has pushed U.S. financial reporting further* An earlier version of this paper was presented at the conference on Rethinking Capitalism, Bruce Initiative of the University ofCalifornia at Santa Cruz in April 2010.
† Corresponding Author. Address Yale School of Management, 135 Prospect Street, New Haven, CT 06511, USA.
Telephone +1 203-432-6160 E-mail shyam.sunder@yale.edu.

Copyright©2011 Research Institute for Economics & Business Administration - Kobe University.

120

e Japanese Accounting Review, 1 (2011), 119-130

away from tried-and-tested practices that constituted more ambiguously defined social norms ofbusiness and accounting community. Importance of, and reliance on those norms was reflected in
the original meaning of the phrase “generally accepted accounting principles” or GAAP. Over these
decades, this term which used to describe a bottom-up evolutionary process has been appropriatedfor top-down prescriptive written standards ordered by government or private sector regulators.
An unintended consequence of writing clear rules to replace the more ambiguous social norms
has been an imbalance of power between financial reporting and financial engineering. While theaccounting regulators seek and write down clear rules in their attempt to create order in the domain
of financial reporting, financial engineers use the written rules to redesign transactions, instruments,and even organizations, to defeat the regulatory intent. Financial engineers are well compensatedfor their endeavors to ensure that the appearance of the financial reports serve the interests of theircorporate paymasters. Most attempts to clarify the rules and standards serve as a better roadmap forevasion for the engineers, and thus, financial reporting regulation becomes a victim of its own actions.
is interplay between written accounting rules and financial engineering of derivative securities tomanage the appearance of financial reports had a significant role in the financial crisis of the recent
years. Protecting the integrity of financial reporting in this losing battle with financial engineering
calls for fundamental rethinking about the premises of regulation of financial reporting.
Financial crisis that started in 2007 had many elements, including (1) volatile stock markets;(2) run up and sharp decline of real estate prices; (3) massive expansion and shrinkage of derivativetransactions; (4) freezing of credit markets; (5) enlargement, failures, and further enlargement ofmajor financial service firms; (6) unprecedented transfer of funds to financial service employees; and(7) large government bailouts of banks and economic stimulus. ese events continue to reverberate
and amplify in difficulties of U.S. and several European governments with their banking, budgets
and borrowing. Yet little effective reform has occurred till late-2011. Some important aspects of thesecrises are rooted in the interplay between financial reporting and engineering which needs close
attention and serious rethinking to remedy its consequences.

Accounting for Financial Services Industry
Accounting plays a role in success and failure of all organizations. But it has a special role infinancial services. e key resources of organizations in most industries—whether airplanes, clothing,computers, buildings, or food—have a physical existence independent of how they are accountedfor. e nature and the existence of these objects do not depend on how they are accounted for.
Whether an airplane appears as an asset on the balance sheet of an airline (from an outright purchaseor a capitalized lease) or does not appear on its balance sheet (from an operating lease), makes nodifference to the existence of the airplane; it still sits on the tarmac of some airport. e same is trueof an office building or a car.
In contrast, the key objects of finance, such as stocks, bonds, deposits, and derivatives, aredefined by how they are accounted for, and few of them can exist independent of their accounting. A
share of stock of a company, for example, is a bundle of rights that include residual interest and somegovernance. e flow (periodic income) or stock (owners’ equity) of residual interest of shareholders
in a corporation is determined by applying the chosen methods of accounting to relevant transactions
and events. Even within the range of accounting methods permissible in most regulatory jurisdictions,the choice of accounting can significantly alter the measured residual interest.

Sunder: Paradox of Writing Clear Rules: Interplay of Financial Reporting Standards and Engineering

121

Similarly, important rights of a bondholder, e.g., recall generated by covenants, depend on themethods of accounting employed. It is not possible to define the substance of a share of stock ora bond independent of the accounting system of the firm. is is also true of the more complex
securities such as convertibles and derivatives. e rights and obligations associated with thesecurities have little existence independent of the books of accounts. It would be difficult to conducttransactions in securities without some agreed upon and acceptable books of account to back themup. No accounting means no finance.
Financial crises had multiple causes including poor risk management, ignoring systemic riskof the financial system, proprietary trading by the banks, large cash rewards for positive outcomesof taking risk, insufficient bank capital, and lax oversight by the Federal Reserve Board and otherregulatory agencies. I do not delve into these factors. Although accounting is rarely mentioned
in lists of root causes of the crisis, I argue that it is one of them, and develop analysis of this link.
Examination of that link starts with financial engineering.

Financial Engineering
Although not recognized as an engineering discipline, term financial engineering has come toencompass a broad range of quantitative techniques used for designing and valuing securities (e.g.,mortgage-backed securities or MBS), transactions (e.g., sale-leaseback), and organizational forms(e.g., special purpose vehicles) beyond conventional stocks and bonds to serve specified purposes ofinvestment and commercial banks as well as their investor and borrower clients in all sectors of theeconomy. Structured finance is a subset of financial engineering, described as follows by Jobst ofInternational Monetary Fund:“Structured finance encompasses all advanced private and public financial arrangements that serve
to efficiently refinance and hedge any profitable economic activity beyond the scope of conventional
forms of on-balance sheet securities (debt, bonds and equity) in the effort to lower cost of capital andto mitigate agency costs of market impediments on liquidity.” ( Jobst 2007, p. 17).

It is worth parsing this carefully-chosen language into common parlance: complex (i.e., difficult tounderstand) financial deals specifically designed so one can borrow at a lower rate while concealing
the debt from view of the readers of financial reports. In absence of such expert help, lenders may
not be unwilling to lend, or may demand a higher rate of interest. When one cannot borrow becauseof questionable creditworthiness, financial engineers can “structure” the deals so they improve theapparent creditworthiness, hide the indebtedness from the view, and lower the interest rate one may
have to pay. In other words, structured finance is financial make-up. For a proper fee, structured
finance experts can make an ugly duckling of a corporation look like a princess in the lenders’ eyes.
“Structured finance is a broad term used to describe a sector of finance that was created to helptransfer risk and avoid laws using complex legal and corporate entities” (Tavakoli 2008).
is risk transfer as applied to securitization of various financial assets (e.g., mortgages, credit card
receivables, auto loans, etc.) has helped to open up new sources of financing to consumers. However,it arguably contributed to the degradation in underwriting standards for these financial assets, which

122

e Japanese Accounting Review, 1 (2011), 119-130

helped give rise to both the inflationary credit bubble of the mid-2000s and the credit crash andfinancial crisis of 2007-2009” (Lowenstein 2008).

Off-Balance-Sheet Financing
If the balance sheet of a company is supposed list its assets (resources with measurable future
benefits) and liabilities (obligations to pay in exchange for benefits already received), the term offbalance sheet financing would appear to be an oxymoron.
“Off–balance-sheet transactions and entities are often used to artificially inflate profits and makefirms look more financially secure than they actually are. A complex and confusing array ofinvestment vehicles, including but not limited to collateralized debt obligations, subprime-mortgage
securities and credit default swaps are used to remove debts from corporate balance sheets. eparent company lists proceeds from the sale of these items as assets but does not list the financial
obligations that come with them as liabilities. For example, consider loans made by a bank. Whenissued, the loans are typically kept on the bank’s books as an asset. If those loans are securitized andsold off as investments, however, the securitized debt (for which the bank is liable) is not kept on the
bank’s books. is accounting maneuver helps the issuing firm’s stock price and artificially inflates
profits, enabling CEOs to claim credit for a solid balance sheet and reap huge bonuses as a result.
(Sneaky Subsidiary Tricks Can Cloud Financials provides insight into how the process works withsubsidiaries, and it’s not the only trick companies use.)” Downloaded on July 17, 2011 from (http://
www.investopedia.com/articles/analyst/022002.asp#ixzz1SMq5C8Op).

Operating lease is a common form of off-balance-sheet financing based on the distinction
between renting and buying a building or a piece of equipment. Even companies that needequipment (e.g., an airline in need of an aircraft) for long term, would prefer to pretend that they
have merely rented the equipment from its manufacturer or the bank so they do not have to show
the equipment as their asset, and the obligation to pay the lease rentals as a liability, on their balance
sheets. Such arrangements are called operating leases.
If the duration of the rental contract is a few days or months, treating it as an operating lease
does not seem to be unreasonable provided that the economic life of the rental equipment extends
well beyond the contract, when it may be rented out to other customers. However, when the rental
contract covers most or all of the economic life of the equipment, a non-cancellable lease contract is
economically indistinguishable from a purchase of the equipment with borrowed money to be paidback with interest in the form of periodic lease payments. Normally, if a company borrows money tobuy a property, its balancesheet must show its amortized cost as an asset, and the present value of theobligation to pay back the loan with interest as a liability. Borrowers with debt-laden balance sheets
would rather not do so, and hire financial engineers to devise a way of borrowing so the debt does notshow up on their balance sheets.
e financial engineer proposes that purchase be treated as if it were a rental transaction. Overthe past half-a-century, accounting rule makers have known this, and have tried to write rules todraw the line between leases that they would permit to be treated as short term rentals (operatingleases) and recorded as assets and liabilities on the lessor’s balance sheet (capital leases). Note that
accountants classify leases into two discrete categories on the basis of terms written in the lease
documents presented to them, and accounting rule makers try to identify an effective set of criteria
and thresholds in their attempt to separate routine short-term leases from long term ones which areSunder: Paradox of Writing Clear Rules: Interplay of Financial Reporting Standards and Engineering

123

to be treated as purchases.
In 1976, the Financial Accounting Standards Board, after years of careful deliberation, chose
two primary criteria to make the distinction: if either the present value of (non-cancellable) leaserentals exceeded 90 percent of the market value of the leased property, or if the term of the lease
exceeded 75 percent of estimated economic life of the asset, the lease had to be treated as a capitallease, and had to appear on the lessor’s balance sheet. is accounting standard (FAS 13) replaced
the judgment-based treatment of leases in the older APB Opinions 7 and 27 by a clear thresholdwith the expectation that the treatment of lease accounting in financial reports would improve. eidea behind the rule is not that 90 or 75 percent is the right boundary because it would be difficult to
defend them against, say, 91 and 74 percent respectively. Instead, accounting rule makers try to set a
reasonable but specific boundary in the hope of inducing uniformity and comparability in financial
reports.
is is where the financial engineer walks in and dashes the accountants’ hopes. He sees themultidimensional space of lease contracts to be essentially continuous. Some of its dimensions may
not have been considered by the accounting rule makers, giving him countless options to work with.
e two or three class discrete space created by the accounting rule is hardly a challenge for him,
because he can tweak any of the numerous lease terms, or introduce new ones, so the proposed leasewould fall on the operating side of thresholds specified by a given set of rules. He could, for example,
miss the 90% and 75% thresholds by, say, 1 percent and radically change the classification of the lease
without making much difference to its substance in the continuous space he operates in. e lease,which the accounting rule makers spent years to put on the balance sheet, goes off the balance sheet
after being reengineered. Since accountants have a say only on how to account for a lease, and no sayon the terms of the lease itself, it is always possible for the financial engineer to skirt the intent of theaccounting rules through redesign of transactions, instruments, and even the organizations. What isremarkable about this process is that it has continued for half-a-century and not much has changed
except accumulation of a very thick rulebook on lease accounting.
Look at what Enron did:e sudden collapse of energy-trading giant Enron Corporation caught regulators, politicians,
lenders, analysts, and the public by surprise. In large part the surprise resulted from the billions ofdollars of debt the company had been able to hide by using off-balance-sheet financing throughhundreds of partnerships. e hidden liabilities allowed Enron to maintain the appearance ofa rapidly growing but financially stable company until near the very end, when bankruptcy was
imminent. Enron’s financial arrangements were complicated and sometimes entailed transferring
overvalued assets to partnerships which it had a controlling interest in but was not required to include
on its own balance sheet. e partnerships, with minimal equity capital from outside investors, raised
most of their capital from loans using Enron stock, transferred assets, or pledges from Enron as
collateral. Although Enron used aggressive accounting methods, many of the accounting techniques
it employed were not illegal. For this the accounting profession was called to task. (http://financialdictionary.thefreedictionary.com/Off-Balance-Sheet+Financing downloaded on July 17, 2011).

Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment
grade is worth a lot more than one that just barely fails to make the grade. As with a would-be
immigrant sneaking across the border, so with financial reporting, there is a huge incentive to getover the line.

124

e Japanese Accounting Review, 1 (2011), 119-130

e challenge to investment banks is to design securities that just meet the rating agencies’
tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money
comes into the pool and is available for paying bond interest. But if the mortgages are too risky,
rating agencies such as Moody’s will object. Banks are adroit at working the system, and pools like
Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over theborder. “Every agency has a model available to bankers that allows them to run the numbers until
they get something they like and send it in for a rating,” a former Moody’s expert in securitization
says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime
analyst at JPMorgan, “Gaming is the whole thing” Lowenstein (2008).

Financial Reporting Environment
Interplay of financial reporting and financial engineering takes place in an environment
populated by individuals with varied interests, organizations and markets. A brief review of somefeatures of this environment may help us appreciate the consequences of clarifying the written rulesof accounting.
1. What is Risk?
Of the many definitions of risk in economics and other social sciences, we focus on two betterknown approaches. e first concerns objective or subjective uncertainty, often measured as dispersionof the possible outcomes of a process. e return on a share of stock over a given month may have a
90 percent chance of being in range from +20 to -20 percent. Dispersion of outcomes, measured byvariance, range or other such statistics, captures this concept of risk. e second, and more common,
concept of risk concerns the possibility of harm or undesirable outcomes. ese two are, obviously,
quite different.
e first is symmetric in losses and gains, and emphasizes uncertainty of outcomes. It is usedin portfolio theory, and can be reduced through diversification. e second is concerned with themagnitude and the chance of losses only, and is used in insurance, credit, medicine, engineering, etc.
It can be reduced by screening but not much by diversification. It is not meaningful to prefer thiskind of risk, because if you do, it cannot be harmful which is an essential part of this meaning of risk.
In many contexts, specification of the intended meaning is left out, leading to avoidable confusion in
specification of rules of financial reporting.
2. Motivating Managers with Compensation beyond Salary and Benefits
What is the theory of white collar compensation and the rationale for the current practices? We
assume that people are motivated to work by promise of pecuniary and non pecuniary compensation.
Higher and certain compensation is more desirable than lower and uncertain amounts. To inducethem to work more and better, we should promise additional compensation linked to their measured
performance, in the form of bonuses, stock options, etc.
Compensation of bricklayers and carpenters is often based on their measured performance. Can
this piece wage approach serve well for managerial work? Perhaps not; even cashiers and clerks who
may have no managerial functions are salaried. What happens to quality of work when a significant
part of the compensation is based on measured performance? When the quantity and quality ofoutput are measurable, and the measurements are not subject to significant control of the employee,

Sunder: Paradox of Writing Clear Rules: Interplay of Financial Reporting Standards and Engineering

125

performance-contingent compensation may induce them to work harder. But what are a senior
executives supposed to do in exchange for salary and benefits? Are they expected to hold back someof their effort, imagination, and creativity until they are promised additional performance-contingent
bonus? Senior managers exercise a significant degree of control over how their own performanceis measured. Transferring large amounts of money to them by encouraging them to take risky bets
at the taxpayer or stockholder’s expense is a key part of the current compensation theory. ere islittle evidence that such compensation induces them to operate organizations efficiently to generate
more wealth for any stakeholders others than themselves. Use of financial reports generated
under accounting rules to promise large contingent rewards to senior executives offers them strong
incentives to hire financial engineers to serve their personal interests.
3. Limits to Organizational Transparency?
What is the meaning of transparency and how far can it be fruitfully pursued in financial
reporting to serve the interests of organization’s participants. ere are good reasons to choose thefinancial reporting system of a corporation so it would better inform the investment decisions of
the investors. But that is only one of many objectives sought through financial reporting. Certainly,
financial reporting should serve the shareholders as a legitimate class of users. But even for this classof users, we must ask how transparency serves their interests.
Although it is often argued that greater transparency is necessarily better, total transparency isneither feasible nor desirable after considering the reactions of the people whose actions are sought
to be made more transparent to others. ere are good reasons why few people wish to live or workin a fish bowl.
e problem is that in social contexts transparency is not a free good. If a 10-minute nap in
mid-afternoon refreshes you for another few hours of productive work, it may be a good thing for theindividual as well as the employing organization, as long as it is done privately behind closed doors.
ere will be no nap in a glass-walled office, no matter what its individual and organizational benefits
may be. Beyond certain limits, greater transparency simply diverts more resources into posturing andmanipulating appearances (see Arya et al. 1998, 2003).
Also, one must not confine analysis to the interests of shareholders. e life and work ofmanagers is defined by their accounting and control environment, to which they are highly sensitive.
Encouraging them to do what is right after considering the interests of all the stakeholders (i.e., tofulfill the respective expectations of all, not just of the shareholders), is a useful way of looking atfunctions of accounting. Is that possible by pursuing transparency as the goal, or as an instrumentof achieving better financial reporting? A great many accounting rules, that make financial reporting
more susceptible to financial engineering, are justified by little more than the pursuit of the presumed
benefits of greater transparency.
4. Discipline
Accounting and control need to be able to enforce discipline through effective constraints onorganizations. Disciplining managers is a difficult challenge in any organization because, being at
the procedural hub of organizations with preferential access to information, they exercise significant
control over accounting, the boards of directors, governance, and the auditors. Instruments ofaccounting control are written standards consisting of words of a given language. Liability, forexample, is defined in so many words. Any definition of a word must be precise enough to exclude
from its scope elements which we would prefer to keep out and yet broad enough to include most126

e Japanese Accounting Review, 1 (2011), 119-130

if not all elements we would like to keep in. e more precise a definition is, fewer of the unwanted
elements would qualify but more of the wanted elements would be left out. e reverse is true of
expansive definitions. is inclusion-exclusion or precision-breadth dilemma applies to definition ofcars, shirts, assets, and revenues. ere is a limit to the precision of meaning of words. Eliminate all
ambiguity of meaning and words cease to be useful as a means of communication.
is general characteristic of meaning of words in natural languages is especially problematicwhen we try to write rules to impose constraints and discipline on managers of organizations,especially in the financial services industry. Instruments, transactions, and organizations can be andare redesigned by engineers to ensure that the application of the existing accounting rules yields
financial reports with the desired features. ey may raise or drop income, and get the debt off thebalance sheet so they do not show up as a liability. It is always possible to get around any set of
written accounting standards because the rules cannot be made perfectly precise in the presence oftransactions designed to evade them. If nothing else works, bankers pressure the standard setters,
and the politicians to achieve their ends. Even a fraction of the compensation of the CEO of a large
company can buy considerable political influence by legally financing elections.
We can examine the history of banks’ positions on asset valuation. In 1938 the banking industry
pressured the Federal Reserve chair Eccles, and the Treasury secretary Morganthau for the infamous
Uniform Agreement to force the Federal Deposit Insurance Corporation, Office of Controller ofCurrency, and the Federal Reserve Board to substitute “intrinsic” in place of market values. In thelate 1930s towards the later part of the Depression, they went from market value to fundamental
values. In the mid 70’s, the bankers forced the SEC to back down on the market based valuationof distressed real estate investment trusts. In the late 70’s, they forced the Financial AccountingStandards Board to back down on the restructuring of troubled bank loans. In 1991, they forced
President George Bush and Treasury secretary Nicholas Brady to ease up on valuation of troubledloans to give the “benefit of doubt” to bankers. In the 1990s, they kept zombie savings and loan
associations open, increasing the cost of bailouts and, more recently, after 2000, financial accounting
standard FAS157 and International Financial Accounting Standard 39 switched to mark-to-market
accounting under the label of fair values.
“Fair values” is a comforting, phrase, but has little to do with fairness. When prices were goingup, bankers wanted their assets to be written up to market values, so their bonuses and compensation
too would increase, and they will be able to loan out more money. is created a positive feedback
loop and accountants, through Statement 157 in the United States and IFRS39 in Europe undermark-to-market accounting, complied. Bankers have always been able to get the accounting rules
they want over the past 70 years. ey demand and get accounting rules that serve their interestsof the moment. In 2009, after pushing for mark-to-market accounting from the mid-90s to about
2007, they forced the accounting standards boards to back down from mark-to-market accounting
when the prices had gone down. is does not inspire confidence in the ability of government or
accounting standard setters to regulate banks in the future.
5. Information for Markets or from Markets?
Fifth, the accounting system of the corporations is supposed to provide information for themarket participants, to assist them in making informed decisions, so markets can set prices based onwhat participants learn from accountants and other sources. An alternative is for the accountants
to learn what they should report depending on where the stock market is. Is accounting going to bea source of information for the markets, or should it be a carrier of information from the markets

Sunder: Paradox of Writing Clear Rules: Interplay of Financial Reporting Standards and Engineering127

to the investors? Accounting and accountants cannot be an efficient means of conveying market
information to investors and others. Since accountants prepare their reports once in a quarter orso, while markets move by the second, investors have far more efficient ways of accessing market
information than financial reports prepared by periodically by corporations and their auditors. Is
financial reporting an input to the markets or is financial reporting a reflection of events in themarket? In the former case, markets cannot possibly be efficient because they would depend, at leastin part, on what the accounting system tells the market, and the efficient market theory cannot holdin its extreme form.
If we take the latter position, (accounting from the markets because they are efficient, or at least
have more information than historical costs have) then what is the point of financial reporting or
accountants? We can get rid of accounting and save billions of dollars. If the market capitalizationof a corporation changes by $2 billion from January 1 to December 31, it can report that change
in market value as its income for the period. What could this market value be based on? What
information will the market have to set the stock prices if we create financial reports to be a reflectionof market events, not as an input to markets?
6. Neutrality and Reflexivity
Neutrality or reflexivity concerns the relationship of financial reporting to the world it reports
on. We can see and try to shape financial reporting as a neutral unobtrusive observer of the world
and its events on which it has little discernible influence. A satellite camera, for example, orbits
hundreds of miles above the earth, and candidly records and reports images without influencing themin a significant way. is neutrality perspective on financial reporting often appears in the conceptual
frameworks published by organizations entrusted with the task of writing rules of financial reporting.
Reflexivity, on the other hand, emphasizes an active engagement between accounting, accountant
and the agents whose activities it records and reports on. e relationship between a model and thephotographer, for example, could be described as a reflexive one. Unlike the satellite camera scanning
the terrain, there is active interaction between human beings on either side of the lens in the second
example. e photographer records not simply the appearance of the model as it is in fact, but actively
engages with the model to produce images that serve the purposes of both. When the camera points
to the model, the model smiles; as the camera is put down, the model relaxes.
Should we think of financial reporting as if it is a neutral eye in the sky, or as if it engenders
a reflexive interaction exemplified by a model and the photographer? If we choose the former
perspective, can we get the accounting system to record and report the way things really are when,
in fact, there is active interaction—reflexivity—between managers and accountants not only in
preparing the accounts, but also in the actions and events being accounted for. In the presence ofactive financial engineers, financial reporting risks its own irrelevance by ignoring the reflexivity in its
environment.

Accounting and FinanceWe can now return to interaction between accounting and finance. Corporate financial
engineering designs transactions to optimize some specified objectives. Since organizations arecontracts among a large number of agents with divergent interests (Sunder 1997), it is not always
obvious that these objectives necessarily serve the organization as a whole. For example, if some128

e Japanese Accounting Review, 1 (2011), 119-130

obligations of the corporations are engineered to be kept off the balance sheet to make it appear
more credit worthy than it is, the creditors who may be misled into making loans to the corporation,or charging a lower interest rate, are not served well. Even the current shareholders who may benefit
from massaging the appearance of the balance sheet may benefit in some circumstances but get hurt
in others. Since the decisions to engage in such engineering are taken by corporate executives, it isperhaps reasonable to think that such engineering is designed primarily to serve their own interests.
e objective of financial reporting, presumably, is to provide information useful for investment
and other decisions by various agents in the economy. Does the interplay between accounting andfinance and between the conflicting objectives of financial engineering and reporting yield a stableequilibrium? If yes, what is that equilibrium? If no, what are the consequences of this interaction?
Most social phenomena can be analyzed at multiple levels, and at each level and across theselevels, social phenomena exhibit interaction among agents. is multiplicity of social science makes
it difficult to identify laws and relationships which are stable relative to their discovery. We can lookat the interaction between financial reporting and financial engineering from this point of view. efollowing quote is a typical description of financial engineering programs in universities: “Financial
engineering concentration encompasses the design, analysis and construction of financial contracts
to meet the needs of the enterprises.” ese needs include, for example, restructuring so it doesn’t show up on the balance sheet-not reduce the debt obligation itself, but to deploy methods so the
obligation doesn’t show up on the balance sheet as a liability. Or, show an increased income by either
reducing expenses or increasing revenues that are shown on the income statement. is is achieved,
not by changing the substance but the form of transactions so the financial reports look the way
management wants them to appear.
According to the International Finance Corporation (a private sector arm of the World Bank),
securitization is2:
• A form of off-balance sheet financing which involves the pooling of financial assets.
• Risk transfer mechanism that allows loan originators to optimize balance sheet
management.
• Allows highly rated securities to be created from less credit worthy assets.
Recall that off-balance sheet financing is financing whose obligation to pay to others does
not appear on the balance sheet of the debtor. A large part of financial engineer’s work consists ofplaying this game with accountants. Because they can redesign transactions and instruments as wellas organizations, accounts are guaranteed losers in this game. e special purpose entities (SPEs)of Enron fame were about this game of financial engineering in frustrating the intent of written
accounting standards.
It is an asymmetric game which the accountants cannot win. Accountants take years to write
new rules and financial engineers take minutes or hours to find a way around them. e net effectis that financial reporting standards serve as relatively weak or nonexistent constraints on whatbusinesses can do. Even after some 700 pages of rules, it has not been possible to close the door
because newer derivatives can always be designed to get around any new accounting rules. is noncooperative game between financial engineers and accountants has not led us to a socially efficient
outcome.
2

http://www.ifc.org/ifcext/treasury.nsf/AttachmentsByTitle/SF_Securitization_PD/$FILE/Securitization2.pdf (downloaded on
April 28, 2011).

Sunder: Paradox of Writing Clear Rules: Interplay of Financial Reporting Standards and Engineering

129

Over the past eight decades accountants have increasingly come to rely on “clear” written rules
as opposed to their judgment and social norms of their profession. ese clarifications appear invarious forms under labels such as staff bulletins, interpretations, and guidance. Financial engineers
on the other hand consider it their own professional duty to design whatever instruments will best
serve the interests of their clients so the social norms play a diminishing, if any, role on either side. Is
it possible that some part of the blame for systemic failures of the recent years can be linked to thisdiminishing role of judgment? A large part of securitization had to do with getting debt obligations
off the banks’ balance sheets.
e same U.S. Securities and Exchange Commission that has the wisdom to refuse to clarify themeaning of non-public information for the purpose of enforcing insider trading laws has failed to see
the wisdom of ambiguity in accounting rules. Lang and Wambach (2010) analyze the advantages ofambiguity in the context of preventing fraud to force people to use their judgment.
Shiller (2005) writes: “Many schools now offer a course in business ethics, and some even
try to integrate business ethics into their other courses. But nowhere is ethics seen as the center
piece or even integral part of the curriculum. And even when business students do take an ethics
course, the theoretical framework of the core courses tends to be so devoid of any moral content
that the discussion of ethics must seem like some side order of overcooked vegetable”.
 erole of ethics and moral code has been discussed often but never really integrated into our businessprograms. Having taught accounting for many years, I don’t see a way of accountants being able toget around this problem of financial engineering by writing and trying to follow increasingly “clear”
written rules. As Catanach and Ketz (2011) point out:
“It is not enough for principles to be better than rules. Principles-based accounting produces value
only when managers and their advisers are principled men and women. Unfortunately, the past
decade contradicts such a presumption. Yes, there are some honest business people, so we do notwish to indict everybody, but there are far too many dishonest CEOs and dishonest CFOs anddishonest advisers to dismiss this point. IFRS that are supposedly principles-based will not solve thefundamental accounting problems of society until and unless the vast number of managers become
principled individuals. Sadly, hundreds and hundreds of restatements and many SEC litigation
releases and scores of lawsuits and plenty of criminal cases prove that society does not have enoughprincipled managers to make it work.”

Accounting and finance originated as a single discipline but have diverged during the recent
decades. Separation of reporting standards from financial engineering has created a new kind ofinteraction between them with special consequences. Are there any remedies? How do we think
about financial reporting? Perhaps 360 degree accounting, which will take care not only of trying
to measure income from corporation to the shareholders but also to other stakeholders including
employees, suppliers, and customers, etc., as I have proposed in Sunder (2008).
To conclude, I don’t see a way of dealing with this confrontation between finance and accounting
by writing more “clear” accounting rules and standards. Ultimately, we shall have to go back to someethical and social norms of the business and accounting community. In the “roaring” 1920s days of
go-go accounting, business adopted mark-to-market valuation. at led to the great market crash of
1929. ey gave up mark-to-market accounting. Eighty years later, we did exactly the same thing,albeit under the “fair value” label, and we find ourselves in a similar situation. Of course, history neverrepeats itself exactly the same way. e next time you think about financial crisis, it may be worth

130

e Japanese Accounting Review, 1 (2011), 119-130

sparing a thought for its accounting roots.

REFERENCES

ARYA, A., J. GLOVER, AND S. SUNDER. 1998. Earnings management and the revelation principle. Review of Accounting Studies 3(March): 7-34.
ARYA, A., J. GLOVER, AND S. SUNDER. 2003. Are unmanaged earnings always better for shareholders? Accounting Horizons 17(Supplement): 111-116.
CATANACH, A. H., AND J. E. KETZ. 2001. IFRS is for criminals. Grumpy Old Accountants.
HELLWIG, M. 2008. e causes of the financial crisis. Max Planck Institute for Research on Collective Goods. Bonn, Germany.
JOBST, A. A. 2007. A primer on structured finance. Journal of Derivatives and Hedge Funds 13 (November) : 199-213, ICFAI Journalof Risk Management 13.
LANG, M., AND A. WAMBACH. 2010. e fog of fraud: Mitigating fraud by strategic ambiguity. Max Planck Institute for Research on
Collective Goods. Bonn, Germany.
LOWENSTEIN, R. 2008. Triple a failure. e New York Times, April 27.
SHILLER, R. 2005. How Wall Street earns to look the other way. e New York Times, February 8.
SUNDER, S. 1997. eory of Accounting and Control. Cincinnati, OH : Southwestern Publishing. Trans. by YAMAJI H., K. SUZUKI.,
Y. MATSUMOTO., AND A. KAJIWARA. 1998. Kaikei To Kontororu No Riron: Keiyaku Riron Ni Motozuku Kaikeigaku Nyumon.
Tokyo, JAPAN: Keiso Shobo.
SUNDER, S. 2002. Regulatory competition among accounting standards within and across international boundaries. Journal of
Accounting and Public Policy 21 (Autumn) : 219-234.
SUNDER, S. 2005a. Minding our manners: Accounting as social norms. e British Accounting Review 37 (December): 367-387.
SUNDER, S. 2005b. Social norms versus standards of accounting. In: DOBIJA M., AND S. MARTIN. General Accounting eory: Towards
Balanced Development. Cracow, POLAND : Cracow University of Economics.
SUNDER, S. 2007. Uniform financial reporting standards: Reconsidering the top-down push. e CPA Journal (April).
SUNDER, S. 2008. Extensire income and value of rhe firm: Who gets what ? Working Paper, Yale ICF.
SUNDER, S. 2009. IFRS and the accounting consensus. Accounting Horizons 23 (March): 101-111.
SUNDER, S. 2011. IFRS monopoly: e pied piper of financial reporting. Accounting and Business Research 41 (August) : 291-306.
TAVAKOLI, J. 2008. Structured Finance and Collateralized Debt Obligations. Second Edition. New York, NY: Wiley Finance.