Soapbox

June 6, 2011 12:07 am

Academics need to get ‘down and dirty’

Accounting scholars must acknowledge their failure to keep abreast of changes in financial innovation and practice over the past 50 years

The financial crisis that shook the world three years ago had multiple causes, including perverse incentives, inattentive corporate governance and weak regulation. But shortcomings in academic accounting research over the past 40 years also contributed, if only by errors of omission.

As I documented in a recent essay in The Accounting Review, a journal of the American Accounting Association, academics must painfully acknowledge that we failed to keep up with big changes in financial innovation and practice over the past 50 years. While we did extensive and successful studies about external uses of accounting information, we did little to improve accounting within companies. To cite one important example, we failed to develop relevant approaches for the reporting, valuation and disclosure of innovative financial instruments, such as those that enabled collateralised mortgage lending and securitisation.

 
Beale cartoon

Politicians attempt to prevent future crises by promulgating new regulations designed to mitigate the crisis that just occurred. But such retrospective regulation will always lag behind innovation and regulators cannot regulate what they do not understand. Avoiding another economic collapse without stifling financial creativity will depend on better understanding innovation in real time rather than regulating it out of existence.

When it comes to assessing the default risk of a financial institution, a government regulator is no match for the aggregated beliefs of sophisticated professionals betting hundreds of millions of dollars on understanding and pricing that risk via credit default swaps.

How can accounting scholars stay abreast of practice innovations and help to forestall future financial crises? I have identified three avenues for scholarship: 1) measuring the risks of private and public pension plans; 2) assessing the pricing of credit default swaps; and 3) improving fair value measurements of complex financial securities.

In all three, progress requires systematic observation, description and classification, activities generally out of favour today in academe, where clever mathematical modelling and statistical analysis earn the greatest scholarly rewards. More academic scholars need to get down and dirty to learn about leading contemporary practice.

Take pension plan risk. To date, the focus of the few accounting academics who study this issue, as well as the principal standard-setting bodies, has been on how to value pension plan assets and liabilities. While accurate valuation is necessary, it is not sufficient to understand the different risks of the assets and liabilities within plans. We will not remedy this by analysing data produced by others. Instead, we should learn from skilled practitioners, for example in investment banks, whose financial officers must manage risk exposure from mismatched asset and liability positions daily.

As for fair value accounting, academic scholars have outsourced this critical function to finance specialists and use these third-party estimates with virtually no understanding of how they are calculated. We teach accounting and business students how to enter the debits and credits when an asset is marked to its fair value but not how to do this estimate themselves or to verify it independently.

How serious is this educational deficit? The chief accounting officer of a leading bank told me the bank cannot hire graduates from US accounting departments for fair value accounting. This sad state of affairs is a direct result of accounting scholars not doing research on fair value measurement and therefore being unable to teach our students how to perform such calculations.

Business school scholars should test their research ideas by teaching them to experienced professionals on executive programmes. If the expertise we develop is irrelevant to their practice, we will quickly be told of our shortfalls. But if we can offer innovative approaches to problems faced in practice, we will contribute to society by making such enterprises more successful and less likely to cause a future crisis.

Robert Kaplan is the Baker Foundation professor at Harvard Business School

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