Orwellian accounting cannot damp economic cycles

Financial Times
By Paul Boyle
Published: July 15 2009 19:36 Last updated: July 15 2009 19:36
The financial crisis has generated a philosophical debate about the role of accounting, notably the extent to which it is pro-cyclical, exacerbating booms and busts.
It is clear that the financial sector has been badly damaged by the crisis and the risks of similar costs to the public purse occurring again should be minimised. However, it is not clear that accounting has the potential to be a public policy tool to reduce pro-cyclicality, nor that it would be appropriate to use it in this way.
An equally, or perhaps even more, dangerous argument now gaining currency is that accounting should be given an explicit role in promoting financial stability, rather than its traditional role of providing information useful to investors in their decision-making. The implication of this view is that accounting measures that show volatility should be adjusted to create an impression of stability.
Accounting is a measurement system that presents the financial performance and position of a company in as neutral a way as possible. It is not surprising that banks report substantial profits when the economy is doing well and reduced profits, or even losses, when the economy is doing badly. This is accounting reflecting the economic cycle, which is a good characteristic of a financial measurement system.
Can this reflection of the economic cycle become too much of a good thing, and pro-cyclical?
To answer this, it is worth considering the dangers of altering other measurement systems to make them less pro-cyclical. It could be argued, for example, that unemployment statistics have damaging pro-cyclical effects. Low unemployment numbers make consumers feel confident, thus encouraging them to borrow and spend at levels which might prove unsustainable. High unemployment numbers make consumers worried, causing them to reduce their spending and pay off debts, with the undesirable consequence of even greater unemployment.
Yet no-one seriously argues that it would be in the public interest for the unemployment statistics to be adjusted in the interests of financial stability.
One could also argue that house price statistics are pro-cyclical; reports of rising prices encourage consumers to make more purchases at higher values, thereby driving up prices further. Reports of falling prices have the opposite effect. I have not heard pleas that the national statistics agencies should intervene to prevent these seditious numbers being disclosed to a public who cannot be trusted to react in a way consistent with financial stability.
If there were to be an intervention to adjust the reported economic numbers then the monetary authorities, and perhaps a small number of other people in influential positions who could be trusted to respond appropriately, would have to be permitted to see the true figures.
Most people would regard this as a deeply unattractive prospect with Orwellian implications. It is for this reason that calls to adjust accounting measures to make them less pro-cyclical should be treated with suspicion.
The way in which consumers or investors will react to statistical or accounting information is not easy to determine in advance, as it will be influenced by a large number of variables. It is, therefore, not reasonable to expect that national statistics agencies or accounting standard-setters should be asked to predict those reactions, far less take a view as to whether those reactions are “good”, in making their measurement choices.
Those who argue that accounting should be amended to make it less pro-cyclical must believe investors are not to be trusted to react appropriately to unadjusted numbers. Once again, however, there would be certain people, including prudential regulators, who would have to be trusted to see the raw figures.
It would, though, be hard, perhaps impossible, to persuade investors to fund financial institutions without showing them the true, unadjusted numbers.
This is not to say that current accounting standards need no improvement. But the merits of proposed “improvements” need to be assessed against a clear understanding of the purposes of accounting.
It may well be appropriate to attempt to reduce the volatility of economic cycles, but there are more appropriate tools than accounting to achieve this.
The writer is chief executive of the UK’s Financial Reporting Council