The Role of Accounting in Serving Public Interest Versus Self-interest - Coursework Example

7BSP0380 - Contemporary Issues In Accounting And Finance (Semester B 2010/11) This paper will answer the question whether academic research has no real life relevance and makes no contribution to the development of accounting or finance regulations. Academic research is research done for a scholarly purpose only and it is not client-oriented; it is intended for theoretical or speculative purposes and does not have a practical intent or benefit. Accounting is imbued with a public interest and must serve the public interest first because it is put in a position of trust. Public interest is the collective well-being of people and the institutions they serve. Failure to fulfil this mandate can have very serious adverse consequences such as what happened to the Arthur Andersen auditing firm for being complicit in the Enron scandal. This paper examines the role of accounting in serving public interest versus self-interest when accountants and auditors are engaged for their services. I will state the answer to the above question is in the negative in relation to the financial crisis brought about by the bursting of the real estate asset price bubble and the issue of stock buybacks within the context of academic research. Real life as used in this paper refers to actual business and economic conditions; regulations pertain to all the government orders issued to control conduct of business to protect public interest. The accounting profession adopted a code of ethics and professional conduct for its members to guide them in serving public interest. The foundation principle of public interest is contained in this code of ethics and yet only 62% of accountants in a survey were able to identify correctly that a formal definition of public interest can be found in their code of ethics. The accountants cannot be faulted because accounting services are contracted in private during service engagements (Thomadakis, 2009:3). Contracts are usually done in private and it is easy to forget public interest during the discussions and focus on self-interest only (Cohen and Eimicke, 2008:160). The dilemma that most accountants face often is conflict of interest between public interest and their self-interest. In conflict-of-interest situations, the tendency is to side with private firms that had engaged their services. The International Federation of Accountants (IFAC) was formed to guide members in 164 countries how to conduct themselves to resolve issues involving professional ethics in diverse areas like public accounting and auditing. The chief ethical dilemma of most accountants is what constitutes timely and full disclosure (Duska and Duska, 2003:7). Another example would be the issue of what is appropriate to use: historical cost accounting or fair value accounting. There are plenty of materials that discuss the advantages and the disadvantages of either of these approaches (Penman, 2007:33). Accounting reports prepared for financial users such as investors and shareholders do have important bearing on investment decisions because people rely on them. Accounting is used to improve risk disclosure among publicly-listed companies in terms of adequate internal controls so investors feel assured (Solomon, Solomon, Norton and Joseph, 2000:447). Financial statements have a public interest when investors use them in evaluating the alternatives in several companies. Professional bodies emphasize to all members to put public interest over and above self-interest and accept full responsibility for all their work (APESB, 2006:3). The International Accounting Standards Board (IASB) has guidelines to integrate global capital markets through common language for financial reporting through the International Financial Reporting Standards (IFRS). It is now used in a hundred nations (McPhail and Walters, 2009:161). A recurring question is whether academic research in the field of accounting has any influence or beneficial contribution to financial regulation. Example is the use of fair-value accounting (FVA) but using FVA can introduce unintentionally “excess volatility” in earnings. This happened in the recent financial crisis (housing mortgage meltdown) as prices separated from intrinsic values (Laux and Leuz, 2009:826) that resulted in price “bubbles” in markets and in lowered living standards afterwards (Anderton, 2006:192). The accounting profession failed to protect public interest when it did not warn about inflated house values which could have prevented the crisis; it was a failure of institutional self-interest too (Roberts and Jones, 2009:856). The collapse of the housing market through bursting of the bubble is example of how accounting research failed to translate its knowledge into regulation. There is a degree of ambiguity in the accounting profession when it comes to using the ideology of public interest in regulatory matters because of a neo-liberal stance (Baker, 2005:691). What this means is the profession would prefer self-regulation by its use of financial accounting standards setting than government regulation. There is a risk of conflation when public interest is thwarted by economic interests of pro-corporate lawmakers and regulators (Conrad, 2004:313). Housing prices doubled in a very short period (Malkiel, 2010:1) but the accounting profession had stayed silent (Sikka, 2009:868) although auditors had some information about the bubble. Firms which sought bailouts had unqualified audit opinions before their collapse. Bank of England under Governor Mervyn King was forced to infuse billions in guarantees to depositors of the collapsed mortgage lender Northern Rock. The accounting profession failed in its public duty of citing moral hazards of too much liquidity and excess credit growth (Baum, 2008:2) by not using historical-cost accounting (HCA) and issue warnings. The shift to FVA methods contributed to the housing bubble because the latest in market prices was used to determine the next sale instead of the more conservative original cost. Auditors of financial intermediaries like banks did not warn the dangers of derivative instruments like collateralised debt obligations (CDO) and credit default swaps (CDS). The housing market is a significant asset class and accountants cannot miss the big rise in house prices in a short time period. FVA created herd mentality that was self-fulfilling because of the greater fool theory on dubious house values (Litan, Pomerleano and Sundararajan, 2003:508). Use of HCA can help prevent asset price bubbles because it uses replacement cost which is more appropriate. Historical-cost accounting (HCA) can prick incipient bubbles if information it gathers about asset prices in balance sheets is used as policy inputs for regulators. It is because HCA will highlight original acquisition costs and hence fundamental value of a house; FVA uses the latest market price which is now inflated. There is a need to augment accounting research to detect unwarranted price increases but this vital information should be made known to monetary authorities. Auditors and accountants have a lot of inside information but they have to distinguish and choose between public interest (full disclosure) and their self-interest (employed for professional services) for the greater public good based on the firm’s information environment (Hopwood, 2009:798) but still maintain confidentiality. There was a lot of useful accounting information on the housing bubble. Admittedly, accountants are under no obligation to warn authorities but they have a responsibility to prevent crises because they have needed information. Academic research must be put into practical uses for society to benefit from all the research findings on how accounting theory affects finance (Humphrey & Lee, 2004:67). The IASB should take the lead in this undertaking by acting as resource speakers during legislative deliberations and provide inputs. Moral hazards can be avoided if accounting profession will raise the issue of banks taking on too much debt and extending credit based on doubtful practices. Another accounting issue that impacts on finance is the stock buyback program. Justification of a share buyback program is supposedly to increase the value of a company’s stock price. Accounting and finance experts opine buying its own shares does not create value (Pettit, 2001:1). It is of public interest because of possible harm to investors; accountants can give policy inputs against this practice to prevent manipulation. In conclusion, accounting research showed stock buybacks can be disastrous to a firm. This was the case of computer giant Hewlett-Packard which spent $8.2 billion buying shares between November 1998 until October 2000; by January 2001, the share price was only half of the $64 average price it paid in the buyback program (Pettit, op cit). American regulators relaxed their rules on buybacks but the United Kingdom has strict rules by not allowing it for chronic accounting tinkering and manipulation (BusinessLine, 2006:1). Research has shown buybacks are not good but accountants have not lobbied for regulations on this. Enron president Jeffrey Skilling convinced Ken Lay, top Enron management, the SEC and Arthur Andersen to shift to mark-to-market accounting with disastrous results as the change allowed it to recognize unrealized gains (Bierman, 2008:156) from the rising energy prices. Using HCA could have prevented it. The accounting profession did not prevent an Enron from happening; it was not able to prevent the housing bubble or stock buybacks too. Academic research did not contribute to formulation of the right finance regulations. References Anderton, A (2006) Economics. London, UK: Pearson Education Limited. APESB (2006) - APES 110: Code of Ethics for Professional Accountants, Accounting Professional and Ethical Standards Board. Available at: [accessed 11 May 2011]. Baker, C. R. (2005) “What is the Meaning of ‘the public interest’?: Examining the Ideology of the American Public Accounting Profession.” Accounting, Auditing and Accountability, 18 (5), pp. 690-703. Baum, C. 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