What Is Accounting For?

Q: How did you decide to go into accounting?

I thought that I wanted to be a lawyer. I grew up in Mannford, Oklahoma, a small town about 20 miles west of Tulsa. My father was an iron worker. My older sister and brother were the first people in our family to go to college. They went to Oklahoma State, so that’s what I did.

The head of the accounting department at OSU, Wilton Anderson, was one of the most energetic, thoughtful, passionate and dogged people I’ve ever met. He believed that accounting was a great profession, especially for somebody like me who didn’t have a family background in some other profession.

Dr. Anderson built up the accounting department at OSU almost entirely through his own efforts. He focused on the students, and he approached it like a football recruiter. He had students tell him their favorite high school teacher; he invited those teachers to dinner on a Friday night in their own town, if they would bring their best uncommitted student. He drove all over the state recruiting students, and Oklahoma is a big state. From Stillwater to Guymon, for example, is over 250 miles. He made his pitch that the student should consider coming to OSU and studying accounting, which he thought was a great career.

He also recruited students from other majors. He got me that way. I’d been given a small scholarship my freshman year. It was a few hundred dollars, but that was enough to cover tuition. I made all As, but the scholarship was only for one year. When I told Dr. Anderson, first he said, “There’s no better training for a lawyer than accounting. A CPA-attorney will never have trouble finding work.” Then, he offered me a scholarship from funds he had raised from the accounting firms. So, basically, the answer to your question of “Why accounting?” is, I was bought for $400.

Now, what I found when I got into accounting was that it was challenging, rigorous, and interesting, partly because OSU had great accounting professors. Again, this was due to Dr. Anderson, who worked long and hard to improve the faculty. He did it the same way he improved the student body: by recruiting talented people. Several of my professors had been identified by Dr. Anderson when they were in OSU’s undergraduate program and then encouraged to get Ph.D.’s from other institutions. Then he recruited them to come back to OSU.

Q: Why did you choose academics over being a practitioner?

I was very receptive when Dr. Anderson approached me about getting a PhD. I have a very intellectual view of things. I’m interested in high-level abstract structures. That said, I’m not one of those people that get wrapped up in an area for its own intellectual beauty. I like to learn things that can used to solve problems in the world. The intellectual and the practical come together in accounting, and in business generally, where you repeatedly discover that nothing is more useful than an idea.

For me, this discovery started early. With my background in the nitty-gritty of accounting, I worked for Arthur Anderson for a couple of summers while I was in school. I’ve started several businesses. I’ve served as an expert in legal proceedings for a very long time. And I’ve been the trustee of a couple of liquidating trusts of Madoff feeder funds.

These experiences have all informed and re-enforced my belief in the practicality of ideas. They help you decide what’s important and what’s not important.

Yale SOM when I came in 1985 was perfect for me: a small, very intellectual place with the goal of being the Yale Law School of management schools. From the faculty side, the school was off to a great start: four of my SOM colleagues from that time, Oliver Williamson, Bengt Holmstrom, Paul Milgrom and Bob Shiller, went on to win Nobel Prizes in economics. Unfortunately, only Bob Shiller stayed at Yale.

Q: What is accounting? What is its function?

When you look deeply enough, accounting is a set of agreed-upon rules to produce the evolving financial story of an organization. Notice I didn’t say a history. The history is part of the story, but not all of it.

Sometimes people think that accounting is all backward looking, but that’s a misconception. One of the core ideas accounting uses in its story is that of an asset. What is an asset? It’s a future benefit. Saying an expenditure generated an asset inherently involves prediction. As time goes on, and the future becomes the past, we also have to deal with, “What did we predict? What actually happened?” The story accounting tells is a complex mixture of predictions and a historical record.

Another misconception is that accounting measures value. There is a lot of very deep academic work on what can be measured and what it takes to measure something, and the real world of accounting doesn’t come close to satisfying the conditions. The best analogy I can give you is IQ assessment. If you walked over to the psychology department and said, “Do you measure intelligence?,” I hope the answer would be no. Intelligence is a pretty vague idea that, at its best is multi-dimensional, and culturally based. IQ stands for Intelligence Quotient. The “quotient” part implies it is some number that’s related to something that we think is intelligence. It’s not a direct measure like height or weight. And I won’t even get into the problems with the interpretations of IQs and the ways they have sometimes been used.

But it’s comparable to what accountants do with value: we’re producing numbers that are somewhat associated with value and value creation, even though we can’t exactly define what that is, and we know our efforts are imperfect. It’s a triangulation, getting you in the right vicinity.

Q: It’s hard to think of accounting as not measuring value.

In a strict sense, value can’t be defined or measured except when markets are complete and perfect. If markets were complete, everything anyone might produce or consume would be available in a market. If they were perfect, there would be no transaction costs of accessing the markets. In that case, there’d be no reason for accounting because the only information anyone would want would be the prices in those markets. But markets aren’t complete and perfect, and the incompleteness and imperfections open the possibility of a role for accounting.

When you think of things this way, you don’t think of accounting as a measurement discipline, you think of it as a social process. Here’s another analogy. In American football, we define what it means for a pass to be caught, and then we apply that definition to plays in the game. But there are situations where, however many camera angles you look at, it’s impossible to tell whether the pass was caught or not.

Teams might be willing to contest calls indefinitely, but the game would become unwatchable. The delay would keep adding to the transaction costs of actually playing football. Similarly, accounting provides the rules that keeps things moving—the call on the field stands unless a review finds convincing evidence in a reasonable time. If it takes 20 minutes to review the play, that’s not a convincing case.

That’s a practical part of accounting that I also like a lot. It’s aimed at reducing the transaction costs.

Q: Explain that intersection of practical and theoretical with respect to measurement and value.

When I said earlier that accounting doesn’t measure value, I did not mean to imply that accounting’s stories don’t contain any measures at all. We count how many widgets are in inventory and how many shares of common stock are issued. Accounting involves counting, but it is not just counting.

Accounting produces a lot of numbers that put a financial value on something. If steel is an input for your product, we track what you buy and how much it cost. It gets more interesting when the steel starts to be used to make a product. Say it’s going into a Tesla. If accounting is telling the evolving story of Tesla’s financial situation, there are markets for the steel and all the other inputs. There are markets for finished Teslas. Those allow us to tell a clear story for those items. But what about all the half-built Teslas? There’s no market for them. At any given moment, how much stuff do they have sitting there half-done? In some cases, it’s a very important component of the story. How do you tell it in a way that’s convincing and not too costly to generate and understand?

The fact is that when you explore the intellectual foundations of accounting, you will be led to think about all these different pieces and how they fit together.

But we should keep in mind why we are doing accounting in the first place. Anytime someone wants to be informed about something that involves quantitative or monetary things, they’re probably going to look at some type of an accounting report. Shareholders use them, executive compensation decisions are based on them, internal resources allocation use them. Inevitably, accountants confront things that have good markets outside an organization and things that don’t, but the ultimate test is whether outcomes are improved.

Q: You’ve helped with unwinding some of the damage from the Bernie Madoff Ponzi scheme. Could you explain the work?

For the last eight years, I’ve been the trustee of two liquidating trusts of Madoff feeder funds. The investors in the funds either had their money stolen or were unwittingly recipients of money stolen from someone else. The scandal was discovered in 2008; the main trustee for the recovery of funds, Irving Picard, still has more to do, but my small role is wrapping up.

The way you clean up such a mess is you go to the “net winners”—people that took out more than they put in. If someone put in $5,000 and took out $15,000, you try to recover the $10,000 they took out, over and above their contribution, to be redistributed among those who lost money. Of course, many of the net winners are deceased, have spent the money, etc., etc. But you try to recover what you can.

I start a lot of my classes with a discussion of Bernie Madoff and other Ponzi schemes, because they take advantage of people making a key accounting mistake. Think about what Madoff did. He raised money from a bunch of people, he paid some of that money to other people, and raised more money from yet other people. He redistributed value; he did not create any value.

This is a fundamental accounting problem that every society has at a very deep level. Who is producing value? What kinds of activities produce value? How do you distinguish things that produce value from things that are consuming more than they’re producing? If we could measure value, we could answer these questions exactly—that is why the measurement perspective on accounting has such an attraction. But in the real world, we just have to do the best we can, sometimes with only vague notions of what we mean.

To see how completely bad this can go, I often think about the former Soviet republics. When they opened up their economies, one of the first things that happened was people started Ponzi schemes.

Quite a few of the countries sought advice from academics on how to start up a market economy from nothing. Bengt Holstrom, my colleague at the time, who is Finnish, had gone to Poland for such a consultation. When he returned, he told us free market-loving colleagues, “Americans are so funny. You think freedom is unequivocally a good thing, but let me tell you, the first thing you give people, when you give them freedom, is freedom to commit crimes.”

This took me aback a little bit, but I came to realize what he meant. As time went by, I saw that in Albania, the Ponzi schemes were particularly bad. The public had no experience with investing. More than half of the country put money in. The schemes held the equivalent of half the country’s GDP before the collapse began. About 2,000 people died in the unrest that followed.

After I talked about it once on the first day of class, a student informed me, “That’s how I came to America.” His father didn’t invest because it seemed too good to be true. But in the aftermath, his family fled. It made an abstract example personal to know someone whose life had been turned upside down by it.

Q: Where does accounting fit in an MBA program?

Every MBA student needs to understand what I call the plumbing of accounting: concepts including assets, liabilities, equities, revenues, expenses, gains, losses, and how those concepts go into producing financial statements and bottom-line statistics.

The what and how of accounting, those are important skills that, frankly, I got a pretty good dose of as an undergraduate. How’s SOM supposed to do better? What we can do is talk about why. We’re willing to view that as integral to a management education. Why is accounting important? Why do we account for things the way we do?

You can’t start talking about why unless people know what and how. So first you have to understand what accounting does and how it does it. This is not easy. But I hope we can go further. If you want to fundamentally change your organization’s way of doing things, you need to understand why things are the way they are. Or if there’s a crisis. It’s like any infrastructure: when things are going well, people don’t necessarily have to appreciate or understand all the foundations of it, but when you need to adapt to a big shock, it behooves you to understand how things work at a pretty fundamental level. That is the level of understanding I aspire to for Yale SOM students.

But beyond just understanding, I also hope our students appreciate the ethical dimensions of accounting. Writing the accounting story involves “judgment calls” that can be made fairly and ethically, or unfairly and unethically.

There are famous examples of organizations that have just blown up because their accounting processes lost integrity. Jeff Skilling joked about “hypothetical future value” accounting, where basically you just make up whatever numbers you want and put them in. And it was too close to what Enron actually did.

Auditors call this the tone at the top, and the smart ones have a big ear out for it. Is the tone at the top, “We’re straight players, we don’t monkey with the numbers. If they’re bad they’re bad, we’re going to tell you”? Or is it playing games with the numbers to hit growth targets?

To take an analogy from this moment, we have a process by which we test vaccines and decide whether they are safe or not. If you undermine the integrity of that process, I don’t want to even talk about it. It’s just insanity to create noise that damages the perceived integrity of the process.

The rich story that accounting tells has a quantitative core. Balance sheets, income statements, cash flow statements—all the parts of the story have to fit together to be believed and need to be carefully overseen and protected so they have the social integrity that lets accounting serve its purpose.