Finance Theory and Accounting Fraud: Fantastic Futures versus Conservative Histories

Intellectual tension between the fields of finance and accounting may help to explain explosion of public company frauds. Finance theory diminishes the relevance of accounting information. Enron exploited this consequence while the SEC bought into it. After widespread frauds were exposed, Congress passed laws that address symptoms of finance’s futurism, not disease. Laws essentially prohibit pro forma financial reporting and regulate the selective flow of futuristic information to financial analysts. Untouched is the underlying disease of regulatory mandates requiring extensive disclosure of forward-looking information. Until the 1970s, the SEC prudently prohibited such futuristic disclosure as inherently unreliable; assisted by finance theory, the SEC’s stance steadily eroded to require such disclosure. The SEC likely had it right the first time. It is too late to reverse the mandatory futuristic disclosure regime. So reform policies must work within it. After elaborating the foregoing critique, this Essay mentions two: (1) future oriented disclosure should focus on material risks of future adversity and (2) accounting figures should be reported in ranges, not single amounts. Cunningham, Finance Theory and Accounting Fraud, Buffalo Law Review (2005) FINANCE THEORY AND ACCOUNTING FRAUD: FANTASTIC FUTURES VERUS CONSERVATIVE HISTORIES Lawrence A. Cunningham A secret at many leading business schools in the United States is a certain intellectual tension between the academic accounting and finance departments. The secret should be shared, however, because the underlying reasons for this tension may help to explain the explosion of public company frauds in the late 1990s and early 2000s. This possibility is important because policymakers responded to those frauds without awareness of the tensions. But the value of their reforms is diminished by ignoring how tools developed in the finance department retard those developed in the accounting department. Finance theory’s rise to intellectual and policy influence began in the 1970s. It threatened accounting’s relevance. In essence, it denied that accounting forms matter, holding that markets pierce those forms to determine value independent of accounting presentation. Numerous side effects manifest this theory’s dominance. Prominent among these are two practical accounting developments—a movement toward fair-value measures and discounted cash flow analysis—and two widespread market practices—pro forma financial reporting and analyst earnings forecasts. These and other side effects reside under the broad chapeau of the forward-looking disclosure regime inaugurated in the 1970s and expanded ever since. Reforms responding to financial fraud addressed the two pervasive market practices—targeting symptoms of pro forma reporting and analyst forecasting—but failed to address the disease. Reforms quite possibly made financial reporting worse. To correct this oversight, this essay recommends two steps: the forward-looking disclosure regime should include delineation of probable variability in financial data and financial data should be presented in ranges rather than discrete numerals.