What’s an army major doing in a roomful of accountants?

Accountancy experts try to better qualify risk and uncertainty by seeking input from unexpected sources

U.S. Army Major Hugh Jones was telling an audience of accountancy professors and professionals at a conference on risk and uncertainty how the Army was using biometric information systems in Iraq and Afghanistan to tell people apart.

Many of the locals in that part of the world have never held formal IDs, not even birth certificates. Even if IDs existed, there’s a chance they could be stolen or forged. So soldiers were carrying camera-like devices that could capture detailed images of people’s faces, irises and fingerprints, and match them against a database. That way, troops knew if they were dealing with someone who had been detained before.

Jones spoke as part of an April 2011 conference, “Accounting for Uncertainty and Risk: Investor, Management and Policy Implications,” co-sponsored by the Notre Dame’s Center for Accounting Research and Education (CARE) and Columbia University’s Center for Excellence in Accounting and Security Analysis (CEASA). As the accountants listened to Jones describe the Army’s biometric detection system, some may have wished that they’d had a device capable of precisely identifying teetering financial institutions in the months leading up to the financial crisis. That’s because critics soon began to question why accountants hadn’t raised a public warning of the impending banking sector collapse.

The short answer is, they weren’t privy to critical information. For instance, to sidestep reserve requirements, many lenders created separate legal entities to bundle mortgages and market them to investors in the form of securities. By doing that, the banks were able keep the loans—which often included shaky mortgages—off their balance sheets and out of the sight of accountants. If accountants never saw the assets, they couldn’t very well calculate their value and report it to the investing public.

“If there had been more transparency in bank accounting, we may have all known what was going on in the financial sector a long way ahead of the collapse,” says Peter Easton, Notre Dame Alumni Professor of Accountancy, CARE director and a principal in the consulting group Navigant Economics.

But that’s only part of what should concern the profession, Easton says. Accounting is supposed to help managers and investors understand what the future may hold for an organization, he says. That requires reporting not only present conditions, but explaining—and, ideally, quantifying—“risks” (known potential variations around valuations and potential outcomes) as well as “uncertainties” (never-before-considered unknowns). Easton thinks accounting is doing a poor job with both. And he’s not alone.

Trevor Harris, co-director of the Columbia University accounting center and former head of Morgan Stanley’s Global Valuation and Accounting team in Equity Research, told the accounting scholars and professionals at the April conference, “l feel that we are totally lost when we talk about these particular issues.”

The financial crisis created multiple headaches for accountants, and not just because of the off-balance-sheet maneuvering by banks with their mortgage-backed securities. As Easton explains, non-financial companies, pension funds and even foreign governments invested heavily in the complex financial instruments. Unlike the banks, they had to report the mortgage-backed securities as assets on their balance sheets and estimate their value.

The most common way of doing that—both pre- and post-crisis—says Easton, was to treat them like bonds. There was a certain amount of principal invested and a forecast of cash flow from it, reduced by the likelihood of default at any particular point in the life of the security.

One of the problems with that approach was it assumed the change in value of one mortgage-backed security had nothing to do with any other. The thinking was that mortgages might be shaky in Florida, but that had no bearing on bundles from California or anywhere else, Easton says. 

“But they’re not independent. Nor is credit-card debt, nor are student loans. They’re all correlated at some level. So these complex debt securities had a lot of interdependences within them that was not correctly modeled, if it was modeled at all,” he says.

That bigger-picture view of the financial world and its risks is missing from conventional approaches to accounting, say Easton and others.

George Sugihara, a theoretician at the Scripps Institution of Oceanography at the University of California San Diego, has studied systems ranging from fish populations to financial markets with an eye toward predicting their future states. In a paper published in the journal Nature, he and two co-authors argued that companies pay too much attention to understanding and managing their own risk, and not enough to the risk of systemic collapse, which will inevitably have more serious consequences. Their paper was published in February 2008.

Seven months later, the financial crisis hit.

Speaking at the 2010 CARE conference, Sugihara said that, ironically, the financial crisis grew out of financial institutions trying to diversify through securitization. Diversification is a good strategy for individuals or companies to reduce risk, he said. But when everyone is diversifying, the result is homogenization. That leads to more interconnections among parties, which increases the risk of an extreme event, he said.

“What apparently was reducing individual risk created huge systemic risk because it created maximal connectivity,” he told accountancy professionals at the conference, which was co-hosted by the University of Miami School of Business Administration.

Besides failing to sound the alarm about such big-picture risks, accounting also has projected a false sense of certainty, according to some experts in the field. In valuing assets or liabilities, the profession has traditionally relied on point estimates of projections into the future. That yields a precise-looking number on a balance sheet, but rarely is it made clear that the number is just an estimate based on assumptions, says Mike Morris, accountancy professor and director of Mendoza’s Master of Science in Accountancy (MSA) program.

In the undergraduate course Decision Processes in Accounting, which Morris teaches, students learn to question such assumptions. Mendoza is unusual among accountancy programs in that the course is required of all undergraduate accounting majors. Most institutions offer it only as an elective at the graduate level, he says.

In one exercise, Morris has students read a 2010 Wall Street Journal op-ed by Andrew G. Biggs, a resident scholar at the American Enterprise Institute. Biggs warns that taxpayers may be on the hook for trillions of dollars in state pension-fund obligations in the future because of unrealistic assumptions about investment returns over time.

The typical pension fund assumes a risk-free 8 percent rate of return over time. No such investment exists today, when 20-year Treasury bills, considered extremely safe, are yielding less than 3 percent. In their models, Morris says, students discover that when risk is introduced into the equation by the fund having to put money into stocks and other investments, a 50-60 percent probability emerges that current contributions to the pension fund will not be enough to meet promised future payouts.

He says he then asks students if those odds of running out of money would be acceptable.

“They typically say that’s too high, it should be around 10 percent. But when they run the numbers, they discover that to lower the risk by that much, you’d have to double current contributions,” he says.

That may be hard news to deliver, but it’s the kind of unvarnished view of reality that people have come to rely on from accountants.

If the profession wants to provide a more complete picture of risk and uncertainty, it will probably need to take a broader view of reality than ever before.