Crisis Calculations

Better accounting and auditing standards may not restore faith in the world’s financial markets. But it’s a start. By Rita Florez

Thus far, say officials from the International Monetary Fund, the global financial crisis has erased some $3.4 trillion from the balance sheets of the world’s banks and financial institutions. This year alone, according to the Federal Deposit Insurance Corporation, more than 120 banks in the United States have failed. Bank losses and the accompanying credit crunch have, in turn, hammered the wider economy. The Federal Reserve calculates that, in 2008, household worth in the United States—a measure of families’ total assets— fell by close to $11 trillion.

For the vast majority of investors and householders, the financial shocks that heralded the Great Recession came as a bolt out of the blue. But for a handful of accounting experts, including MU’s Jere Francis, the unraveling was no surprise. All of the signs were there.

Francis is an internationally renowned auditing expert who is Curators’ Professor and Trulaske Chair of Accountancy in MU’s Robert J. Trulaske, Sr. College of Business.

For the better part of the past two and a half years, he says, corporate accountants had been making huge write-downs, reducing the book value of assets.

“Accounting was actually a bellwether in the sense that it drew attention to the securities that were held by financial institutions. It was recording write-downs of these assets that really started to draw attention to the fact that a lot of these financial institutions had [themselves] become ‘toxic’ assets.”

Because they had to record those holdings at “fair market value,” Francis adds, auditors were forced to figure out and report the current worth of those securities. Of course the amount of that estimation turned out to be, in many cases, “close to zero.”

Bad news for assets was, however, good news for accountants. Unlike the infamous Enron and WorldCom collapses, the financial crisis cannot be pinned on poor accounting. In fact, Francis says, his research shows accountants and auditors are crucial to providing the sort of credible information markets need to prevent financial meltdowns.

“The penalty for not performing correctly, misreporting or being dishonest is more severe in a [well-regulated] country. So the question that researchers are trying to disentangle is, ‘What’s the cause of high-quality accounting in a country? Is it really the accounting and the auditing, or is it these fundamental institutions that create incentives for people to not misbehave?’”

In a pre-crisis study involving data from 42 nations, Francis and Dechun Wang, now a faculty member at Texas A&M University, found that stricter investor protection in a country, when coupled with rigorous enforcement and auditing, correlate positively to more accurate accounting and leads to more vigorous economic growth. Their paper, The Joint Effect of Investor Protection and Big 4 Audits on Earnings Quality Around the World, was published in the journal Contemporary Accounting Research last year.

“Accounting did a pretty good job of doing what it’s supposed to be doing, which is serving as a warning indicator of a problem. In this case, it was the financial sector,” he says. “I actually think, while the economy is in a very rough patch right now, accounting has come through this pretty well. It’s not seen to be a bad guy at all.”

Francis’ upbeat view echoes the findings of his investor protection research, investigations that examine the quality of a country’s “information environment” and the effectiveness of national institutions that enforce compliance with auditing standards.

Loosely defined, an information environment describes the milieu of accessible knowledge surrounding a particular enterprise. Accounting reports and audits, news published in various media, and reports prepared by regulatory bodies: all contribute to this world of data. Investors, for their part, depend on the reliability of this information when making decisions about where to put their money.

“In countries that have better information environments,” Francis says, “companies out-perform companies in countries with a weaker information environment.”

Reliable accounting and auditing, he adds, are key. In another recent study, this one published in the Journal of Accounting Research with his MU colleagues, Profs. Inder Khurana and Raynolde Pereira, Francis found that accounting contributes to helping money get to the places where it can earn the highest return. “That, of course, then translates to higher economic growth rates,” he says. “This is some pretty compelling evidence that accounting has what we like to call a ‘first-order effect,’ meaning that the actual quality of accounting itself can play a major role in directing where money goes in an economy to get it to the best sources in terms of economic growth.” ' Mark DeFond, the Joseph A. DeBell Professor of Business Administration at the University of Southern California, says Francis’ work provides a unique insight into how capital markets develop.

“It’s sort of like looking up and saying, ‘We’re in the most dynamic capital market in the world,’” DeFond says. “But in the last decade, the world has started to catch up. Jere looks at what is driving and causing this. What does it take to build vibrant capital markets? And that’s where auditing comes in.”

DeFond first met Francis in the mid-1980s, when DeFond was a doctoral candidate at the University of Washington. He says that since then Francis’ contributions to the field of accounting have been considerable.

“His early work is in the area of auditing quality, and he did some path-breaking work,” DeFond says. “Then he moved into more philosophical work that analyzed the research. After that, he started doing an office-by-office analysis.”

The office-by-office work involved delving into the quality differences within the large auditing firms. “Before Jere came along, everyone looked at big firms versus little firms. It was a very crude dichotomy,” says DeFond.

For his part, Francis says it all boils down to what is going on at the company level. In the United States, for example, the Securities and Exchange Commission acts as a mechanism to spur the flow of information, and there are real consequences for companies and auditors that seek to mislead the commission. These can include fines, trading restrictions, criminal prosecutions and, perhaps more to the point, ammunition for disgruntled investors seeking to sue. “You have to think about how these regulatory agencies create incentives,” Francis says. “In many countries around the world, if auditors misreport or are slack and don’t do their jobs well, they will get little more than a slap on the wrist with little impact on their practices.”

The upshot is that auditing firms, particularly the so-called Big Four of PricewaterhouseCoopers, Ernst & Young, Deloitte Touche Tohmatsu, and KPMG, when working in countries with vigorous reporting requirements, produce higher-quality audits. But in weaker countries, the audits by these accounting firms are of lower quality. Institutions do matter.

“The penalty for not performing correctly, misreporting or being dishonest is more severe in a [well-regulated] country. So the question that researchers are trying to disentangle is, ‘What’s the cause of high-quality accounting in a country? Is it really the accounting and the auditing, or is it these fundamental institutions that create incentives for people to not misbehave?’”

Francis’ work suggests that robust regulatory institutions and information environments are, in fact, the keys to keeping businesses and their auditors in line. Here in the United States, there are times when the SEC might discover suspect behavior simply from reading articles in the business section of leading newspapers such as the New York Times or Wall Street Journal. “Sometimes it’s outright fraud,” he says. “Other times, it’s being exceptionally optimistic compared to what is actually happening.”

Whatever the cause, he says, the company suffers, auditors are punished, and both suffer a costly loss of reputation. Thanks to the wide dissemination of news of their transgressions, other businesses and auditing firms learn from their pain and are less inclined to sin in the future.

One interesting result of this information effect, Francis adds, is that even countries with less-than-perfect regulatory frameworks can still thrive: “I find that those countries with higher quality accounting practices experience greater economic growth rates, even in those countries that have weaker legal and regulatory regimes.”

Today, the big policy debate is about whether the United States should abandon its own accounting standards in favor of the International Financial Reporting Standards, a set of guidelines meant to impose global uniformity on the world’s financial reporting. The IFRS was drafted by the 15-member, London-based International Accounting Standards Board in 2001. It is now used in over 100 countries, including all the nations of the European Union.

Francis says big companies and audit firms are in support of the initiative because it would simplify their practices by giving them one set of global standards. But he is concerned that such a move will lead to less rigorous accounting enforcement here in the United States. “My own research suggests the real driver of accounting quality is not the standards per se, but the rigor of enforcement through high-quality audits,” he says.

U.S. accounting standards have evolved over the past 100 years to provide a complex set of rules and guidelines to calculate the numbers and related disclosures, Francis says.

“The standards are quite complex, and the quality of their implementation is affected by the institutions that oversee corporations, like the Securities and Exchange Commission, and the enforcement of these standards by high-quality, independent auditors,” he says. “The incentives of companies and their auditors are critical, and this is the role played by regulatory agencies, as well as having a strong legal system in which investors can sue companies and their auditors when corporate accounting reports are misleading and the enforcement by auditors has been negligent.”

One of the main differences between the IFRS and American standards is the way in which the IFRS uses fair market values in balance sheets. Although the idea of market values sounds good in principle, Francis is not as optimistic about how things would shape up in practice.

For most non-financial assets, market values must be estimated, and thus are highly subjective. Subjective values, in turn, give companies enormous room to fudge numbers. What’s more, Francis says, the information is virtually impossible to audit. In fact this was a leading problem with Enron’s financial statements.

This could spell real trouble, especially in a world economy still struggling to emerge from perhaps the worst fiscal crisis since the Great Depression. “Any time there are corporate failures, people are going to ask the question, ‘Was it an accounting failure?’” Francis says. “It often comes as a surprise when a company fails, and people wonder, ‘Why didn’t we know about this? Was this because management was reporting too optimistically the results in the past and the auditors were letting them get away with it?’ Those issues always arise because accounting is not an exact science; it relies on subjective estimations that cannot be verified with certainty. For this reason auditing is crucial in giving credibility to the numbers that companies report.”

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University of Missouri

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