Equilibrating Corporate

Financial Engineering and

Reporting
Shyam Sunder
Yale University
20th Anniversary Conference on Financial
Economics and Accounting, Rutgers
University
November 14, 2009

An Overview
Let us look at accounting and finance from a social
science perspective
Objective in corporate financial engineering: to design
transactions to optimize from the point of view of the
organization, e.g., increase assessed creditworthiness
and lower risk based on facts and appearances of its
financial reports
Objective of financial reporting: to provide information
useful for investment and other decisions by various
agents in the economy
Does the interplay of these two objectives lead to a
stable equilibrium?
If yes, what is the equilibrium?
If not, what are the consequences and what, if
anything should be done about it?
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Accounting and Finance as

Aspect of Social Sciences

These disciplines have been seen from several points of view

One of them is to think of their topics of substantive interest
(e.g., corporate finance and reporting, investments, and
auditing) as social phenomena
Social phenomena are characterized by multiple levels of
analysis, e.g., macroeconomic, organizational, and individual
At each level, and across the levels, social phenomena
exhibit interaction among agents (individuals, organizations,
and government), learning by them, feedback effects, and
consequently, pervasive endogeneity
These features of a social science make it more difficult to
identify laws or relationships which are stable relative to their
discovery and characterization (e.g., small firm effect)
In these few minutes, I would like to discuss one aspect of
such interactions between financial reporting and
engineering, and share some preliminary thoughts about
their consequences
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Objectives in Financial
Engineering
The Financial Engineering Concentration
encompasses the design, analysis, and
construction of financial contracts to
meet the needs of enterprises. (Cornells
ORIE M.S. concentration in financial
engineering)
What are these needs? In at least some cases,
these needs consist of finding ways of
Reducing indebtedness on the balance sheet, or
Reducing expense on income statement, or
Increasing revenue on income statement, or
Increasing deductions on tax returns
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Securitization according to
International Finance
Corporation

A form of off-balance sheet financing which

involves the pooling of financial assets
Risk transfer mechanism that allows loan
originators to optimize balance sheet
management
Allows highly rated securities to be created from
less credit worthy assets
Can be in local or foreign currency, depending
on client needs
A rapidly growing asset class with proven
benefit for emerging market borrowers
For summaries of prior deals, please visit
www.ifc.org/structuredfinance
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Financial Reporting Standards

as Constraints on Financial
Optimization

In such optimization, standards of financial reporting

are treated as constraints
Most optimization problems have hard constraints
their violation brings well-specified penalties (dual
prices)
With optimization confined by the production
possibilities set and other such physical limitations,
external constraints make a real difference to the final
actions
What kind of constraints do accounting standards offer?
I am going to argue that these standards offer softer
constraints because the forms of contracts,
transactions, as well as organizational forms that
businessmen can devise and use are beyond the scope
of accounting standards
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Redesigning Contracts
A manufacturer needs to buy a machine for the factory
Borrowing is an option, but the manufacturer does not
want more debt on its balance sheet
The leasing subsidiary of a bank buys the machine and
gives it to the manufacturer on a long term lease
machine is in the factory but no debt on balance
sheet!
FASB writes Standard 13: leases >90%V and >75%T
must be treated as capital leases (debt is back on BS)
The bank revises the lease to levels below the
thresholds specified in the standard (debt is off the BS)
FASB goes back to work, and so on until the
rulebook grows to over a 1,000 pages

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Redesigning Transactions
Depending on the current standards
of financial reporting, transactions
can be redesigned to achieve the
desired consequences for revenues,
expenses and taxes

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Redesigning the
Organization
When design of contracts and transactions is
not sufficient, organizations themselves can
be redesigned, or new ones created in order
to have the desired consequences for balance
sheets, income statements and tax returns
Special purpose entities (SPEs and SPVs) are
examples of organizations created for this
purpose (see Klee and Butler 2002 and
Gorton and Souleles 2005)
Hundreds of respected U.S. companies are
ferreting away trillions of dollars in debt in offbalance sheet subsidiaries, partnerships, and
assorted obligations (Henry et al. 2002)
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Asymmetric Game
Note that financial reporting standards neither
have, nor can have, any say in any of these
business decisions of the management
The role of the accountant and auditor is limited
to preparing financial reports given all these
decisions
While these decisions clearly consider what the
accounting standards are, accountants have little
freedom to take into account how and why these
decisions were taken in the first place
There is great asymmetry between the freedom
available to the business decision makers and
constraints on the accountant who must abide by
relatively rigid written standards
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The Net Effect

The decision to write an accounting standard is a matter of
social policy that calls for a deliberative due process; it
typically takes years to determine which rules might best
serve investors and others. Inevitably, these standards are
written on the assumption that the current forms of
contracts, transactions, and organizations will continue to
be used in the future when these standards are applied
The decision to change contracts, transactions and
organization is an individual decision that may be taken
within days if not hours. Further, the scope of these
decisions is virtually unbounded (except by the imagination
of the businessmen). Soon after the standards are issued,
the environment to which they are applied changes relative
to the what the standards were written for
The net effect: Financial reporting standards serve as
relatively weak constraints (if at all) on what businesses can
do
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Three Major Classes of

Derivatives
Futures/Forwards are contracts to buy or sell an
asset on or before a future date at a price specified
today.
Options are contracts that give the owner the right,
but not the obligation, to buy (in the case of a call
option) or sell (in the case of a put option) an asset.
The price at which the sale takes place is known as
the strike price, and is specified at the time the
parties enter into the option ( European vs.
American options)
Swaps are contracts to exchange cash (flows) on or
before a specified future date based on the
underlying value of currencies/exchange rates,
bonds/interest rates, commodities, stocks or other
assets.
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Six Types of Underlying

Assets

Interest rate derivatives (the largest)

Foreign Exchange derivatives
Credit Derivatives
Equity derivatives
Commodity derivatives
Weather derivatives

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Over-the-Counter
Derivatives

Traded (and privately negotiated) directly between two parties,

without going through an exchange or other intermediary (e.g.,
swaps, forward rate agreements, and exotic options)
This largest of the derivatives market is largely unregulated with
respect to disclosure of information between the parties (banks
and hedge funds etc.)
Reporting of OTC amounts are difficult because trades can occur in
private, without activity being visible on any exchange.
According to the Bank for International Settlements:
The total outstanding notional amount is $684 trillion (as of June
2008)[4].
67% are interest rate contracts,
8% are credit default swaps (CDS),
9% are foreign exchange contracts,
2% are commodity contracts,
1% are equity contracts, and
12% are others
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Exchange-traded
derivatives
A derivatives exchange acts as an intermediary to all
related transactions, and takes Initial margin from both
sides of the trade to act as a guarantee.
The world's largest derivatives exchanges (by number of
transactions): Korea Exchange, Eurex, and CME Group
(made up of the Chicago Mercantile Exchange, the Chicago
Board of Trade and the New York Mercantile Exchange.
According to BIS, the combined turnover in the world's
derivatives exchanges totaled USD 344 trillion during Q4
2005.
Some types of derivative instruments also may trade on
traditional exchanges (convertible bonds and/or convertible
preferred, warrants, Performance Rights, Cash xPRTs and
various other instruments that essentially consist of a
complex set of options bundled into a simple package)

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Why Is It So Difficult to Write

Standards for Derivatives
Accounting?

Some derivatives are designed to get around the

intent (provision of information) of the extant financial
reporting standards
How does one write standards for these instruments?
Is it possible to have an equilibrium between design
of such instruments and standards for reporting
them?
The problem seems to have gone largely unnoticed in
the flurry of proposals on financial reforms now on the
table
The question is: Are the optimization in financial
engineering (relative to prevailing reporting
standards), and search for standards that provide
useful information to investors mutually consistent
goals?
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Social Norms of Accounting

and Finance
I personally doubt that a non-cooperative game between
financial engineers and accountants has led us to a
socially efficient outcome
Accountants have, over the past eight decades,
increasingly come to rely on written rules as opposed to
their judgment and social norms of their profession
Financial engineers, on the other hand consider it their
own professional duty to design whatever
instruments/transactions/organizations will best serve
the immediate interests of their clients under the
prevailing written standards of financial reporting
Social norms play a diminishing, if any, role on either
side
Is it possible that some part of the blame for the
systemic failures of the recent years may be linked to
this diminishing role?
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Ethics and Moral Code in

Business Programs
Shiller: Many schools now offer a course in business
ethics, and some even try to integrate business ethics into
their other courses. But nowhere is ethics seen as the
centerpiece or even integral part of the curriculum. And
even when business students do take an ethics course, the
theoretical framework of the core courses tends to be so
devoid of any moral content that the discussion of ethics
must seem like some side order of overcooked vegetable.
If the role of ethics in curriculum is minimal, what is the
role of ethics (i.e., social consequences of our work) in
choosing the substantive topics of our research
Identifying mispricing of securities, for example, may help
move prices to more efficient levels
What about identifying a way of redesigning a transaction
so a financial obligation will not show up on the balance
sheet under the prevailing reporting standards?
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Ethics and Moral Code in

Research Programs
In some recent theoretical and experimental work, we
find that the constraints imposed by financial and social
institutions (e.g., bankruptcy laws, commercial code,
accounting) can help resolve otherwise mathematically
intractable problem of multiplicity of equilibria in
economy. Could this also apply to interaction between
financial engineering and reporting?
Which one of us would refuse to work on either an
optimal transaction design or accounting standardization
problem on ethical (social consequences) grounds?
If I were a locksmith, and published the locking codes for
the university doors, I might bear some moral culpability
Is, or should, there be any moral culpability associated
with devising a way around a standard of financial
reporting intended to provide better information?
When, and where, should we raise such issues?
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Some Fundamental Issues

Role of social ethical norms in accounting and
financial institutions
Reflexivity of markets and of financial
reporting (Keynes, Sunder)
Rationality can serve as an anchor, not a
description; irrationality offers no explanation
Fractal structure of knowledge (try for
yourself, e.g.,
http://www.coolmath.com/fractals/fractalgene
rators/generator1/index.html)
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Roles of Accounting and

Finance Research
Progressive micronization of research
Progressive shift in research attention to
better explanatory power through additional
variables
This process is understandable, but does not
create a micro-macro issues balance
Discarding of details, standing back, to allow
a big picture to emerge is just as important
What is the big picture of corporate financial
reporting and engineering today?
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In Summary
Accounting and finance originated as a single
discipline have increasingly diverged in the recent
decades
Interaction of financial reporting standards on one
hand and financial engineering on the other has
created a newer kind of interaction between them
with its own special consequences
What, if any thing, should we, and can we do
about this?
Are there some alternatives to bringing in a sense
of social responsibility for the consequences of
our research agendas? If so, let us explore them.
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References

Hans J. Blommestein, The Financial Crisis as a symbol of failure of academic finance (a

methodological digression), The Journal of Financial Transformation, Fall 2009.
G. Gorton and N. Souleles, Special Purpose Vehicles and Securitization, FRB Philadelphia
Working Paper, 2005.
Henry, David, Heather Timmons, Steve Rosenbush, and Michael Arndt (2002), Who else is
hiding debt?, Business Week (January 28), 36-37.
J. Huber, M. Shubik, and S. Sunder, Default penalty as disciplinary and selection
mechanism in presence of multiple equilibria, Cowles Foundation Working Paper 1730,
October 2009.
K. Klee and B. Butler, Asset-Backed Securitization, Special Purpose Vehicles
and Other Securitization Issues, Uniform Commercial Code Law Journal 35 (2002), 23-67.
J. Mason, E. Higgins and A. Mordel, Asset Sales, Recourse, and Investor Reactions to Initial
Securitizations: Evidence Why Off-balance Sheet Accounting Treatment Does not Remove
On-balance Sheet Financial Risk LSU Working Paper, 2009.
Robert J. Shiller, How Wall Street learns to look the other way, The New York Times, Feb. 8,
2005.
Shyam Sunder. Theory of Accounting and Control. Southwestern Publishing, 1997.
Shyam Sunder, Determinants of Economic Interaction: Behavior or Structure. Journal of
Economic Interaction and Coordination 1, no. 1 (May 2006): 21-32.
Shyam Sunder, True and Fair as the Moral Compass of Financial Reporting, in Cynthia
Jeffrey, ed., Research in Professional Responsibility and Ethics in Accounting (Forthcoming
2009).
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Thank You.
Shyam.sunder@yale.edu
www.som.yale.edu/faculty/sun
der