Do not change the fundamental purpose of accounting

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17 Jul 2009

Paul Boyle, Chief Executive of the UK Financial Reporting Council (FRC), argued in a speech to the FRC Annual Open Meeting against proposals to use accounting as a public policy tool to reduce pro-cyclicality and challenged the proposition that accounting measures that show volatility should be adjusted to create an impression of stability.

Mr Boyle also warned that the risks to confidence in corporate reporting and governance remained higher than normal and that there was no room for complacency. Click to Download Mr Boyle's Remarks (PDF 98k). Here is an excerpt:

It is not clear that accounting has the potential to be a public policy tool to reduce pro-cyclicality, or 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.

It is worth considering the dangers of altering measurement systems to make them less pro-cyclical. It could be argued, for example, that unemployment statistics and house prices have damaging pro-cyclical effects. Yet no-one seriously argues that it would be in the public interest for these statistics to be adjusted because the public cannot be trusted to react in a way consistent with financial stability.

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.


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