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Accounting, Governance and the

Crisis: Is Risk the Missing Link?
a b
Michel Magnan & Garen Markarian
a
John Molson School of Business , Concordia
University , Montreal, Canada
b
IE Business School , Madrid, Spain
Published online: 13 Jun 2011.

To cite this article: Michel Magnan & Garen Markarian (2011) Accounting, Governance
and the Crisis: Is Risk the Missing Link?, European Accounting Review, 20:2, 215-231,
DOI: 10.1080/09638180.2011.580943

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 European Accounting Review
Vol. 20, No. 2, 215– 231, 2011

Accounting, Governance and the

Crisis: Is Risk the Missing Link?

MICHEL MAGNAN∗ and GAREN MARKARIAN∗∗

∗ ∗∗
John Molson School of Business, Concordia University, Montreal, Canada, IE Business
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School, Madrid, Spain

(Received: August 2010; accepted April 2011)

ABSTRACT The period 2007–2010 marked one of the most severe economic and
financial crises in living memory. In this paper, we focus on two of accounting’s key
functions within organisations and markets, financial reporting and governance. In this
respect, we find that accounting exhibited shortcomings in its structural foundation and
in its application. Salient is its failure to account for uncertainty and to adequately
capture, measure and disclose the impact of risk-taking on the financial statements, thus
undermining their reliability and, potentially, their relevance as indicators of economic
performance. Consequently, boards were provided with misleading numbers, and
compensation was based on paper profits that did not materialise. As such, accounting
carried undesirable elements that interacted with other malicious market characteristics
such as excessive risk-taking by bankers, and failure in regulatory and market oversight,
thus potentially contributing to deteriorating economic conditions. The paper concludes
with suggestions for further research in this area.

Guns don’t kill people, but they sure help. (Exchange between Clive Owen
and Paul Giamatti, Shoot ’Em Up, 2007)

1 Introduction
We are in the midst of a severe financial and economic crisis which started from
the collapse of the housing market in the USA, and which ultimately affected
major economies worldwide. This paper analyses the role of accounting (and

Correspondence Address: Garen Markarian, IE Business School, Pinar 15, 1B, Madrid 28006, Spain.
E-mail: Garen.markarian@ie.edu

0963-8180 Print/1468-4497 Online/11/020215–17 # 2011 European Accounting Association

DOI: 10.1080/09638180.2011.580943
Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA.
 216 M. Magnan and G. Markarian

accountants) in the crisis. However, while we recognise that accounting’s societal

role encompasses various functions and that the crisis involved many potential
culprits, we focus our analysis on financial reporting and corporate governance.
Within organisations, governance mechanisms and management control struc-
tures rest on accounting information to monitor transactions, manage risks and
reward performance. Within capital markets, accounting-based information ulti-
mately determines the viability of a local bank, the risk assessments issued by
rating agencies, analysts’ forecasts and investors’ valuations of corporations,
with auditors being involved in the process throughout. However, despite its
apparent precision and its widespread use as an objective representation of a
firm’s economic activities and performance, accounting is a social construction
(Chua, 2011).
Given that accounting is critical for well-functioning capital markets, there has
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been an extensive debate regarding its role in the crisis among investors,1
bankers,2 politicians,3 regulators4 and academics.5 On the one hand, accounting
has been blamed for being one of the crisis’ major causal factors (e.g. Whalen,
2008; Forbes, 2009; Katz, 2008). From a financial reporting perspective, criticism
was aimed at its role in inducing market volatility and instability, the complexity
of disclosures and lack of decision usefulness, proneness to manipulation and
irrelevance in assessing risks. Failures in governance encompass boards that
were ineffective in their use of accounting information to fulfil their monitoring
role, as well as accounting information systems and controls that were not
designed to properly capture and reflect underlying risks and operating weak-
nesses. On the other hand, there have been continuous assertions that accounting
is merely an uninvolved messenger (e.g. Badertscher et al., 2010; Turner, 2008;
Veron, 2008; SEC, 2008). According to this position, accounting would be an
innocent bystander, a mere recorder of events, and the stability of financial
markets rests on bankers and regulators, not accountants.
Within the context of the crisis, our paper adds to prior research on fair values
and securitisations (Laux and Leuz, 2010; Sapra, 2010; Barth and Landsman,
2010; Badertscher et al., 2010), auditing (Sikka, 2009), accounting research
(Arnold, 2009) and regulations (Humphrey et al., 2009). First, most prior
papers published on the crisis were written as it was still unfolding and, therefore,
often relied on ex ante arguments. In contrast, our analysis benefits from the
insights provided by early empirical work which is now appearing in both
accounting and finance. Second, most accounting-based work on the financial
crisis has focused on the potential role played by fair value accounting, especially
its pro-cyclicality potential. Our paper does allude to the debate surrounding fair
value accounting but broadens the analysis of the crisis to issues such as disclos-
ure and transparency, and encompasses various governance mechanisms (e.g.
boards of directors, executive compensation, auditing) that rely on financial
reporting. Third, we put forward the view that the measurement, recognition
and disclosure of risks underlying financial performance are within the realm
of accounting. As such, we argue that accounting may have failed in adequately
 Accounting, Governance and the Crisis: Is Risk the Missing Link? 217

capturing and reflecting uncertainty, thus potentially contributing to misguided

decisions by investors, boards and executives. Finally, we argue that evidence
emerging from the crisis should lead investors, auditors, directors and regulators
to revisit or, at least, reassess, many of their a priori beliefs about what constitutes
effective governance or financial reporting: the crisis exposed many cracks in the
logic underlying investor-focused governance, performance-based executive
compensation or fair-value-driven accounting which were not readily apparent
under normal economic times.
Although there are many inter-linkages among the topics discussed, we try to
delineate them as much as possible, thus our paper is organised into the following
sections: Section 2 discusses financial reporting, Section 3 discusses accounting
and corporate governance, and Section 4 has our concluding remarks and direc-
tions for future research.
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2 The Crisis and Financial Reporting

Complexity and lack of transparency have been a problem for certain inno-
vative products aimed at investors. (Bernanke, 2009)

The bulk of the criticism directed toward accounting during the crisis relates to
the usage of fair value accounting for investment securities, most notably its
potential pro-cyclicality. In turn, this results in over-leveraging when fair
values are increasing or into a ‘death spiral’ when they are declining (Sapra,
2010). Furthermore, this raises concerns over disclosures (Barth and Landsman,
2010), as well as about reliability and verification issues (Magnan, 2009). In this
respect, Mingzhe (2010) argue that a defect of fair value accounting is its non-
completeness, especially in illiquid markets. Consequently, a huge fair value
trap may be created by fair value accounting, where risks are not properly dis-
closed and understood. On slightly different premises, an unfavourable view
toward fair value accounting is also voiced by Allen and Carletti (2008) and
Plantin et al. (2008), who argue that under conditions of market illiquidity and
complementarities in trading behaviour, the use of fair value accounting may
translate into fire sales, artificial volatility and contagion among financial
sectors (see also Melumad et al., 1999). Bleck and Gao (2010) contend that rela-
tive to historical costs, fair values lead to excessive exposure to risks and to lower
quality loan origination.
Given the theory-based arguments above, a number of studies have empirically
undertaken these issues. Khan (2010) finds that the extent of fair value usage is
associated with an increase in the risk of failure of the entire banking system,
while Bowen et al. (2010) provide further evidence that fair value accounting
may undermine the solvency and solidity of the financial system. However, the
findings presented above are not unanimous. For instance, Badertscher et al.
(2010) find no empirical evidence that regulatory capital was affected by fair
value losses, and find no evidence of fire selling.
 218 M. Magnan and G. Markarian

In addition to debates regarding fair values, off-balance sheet transactions

received a media comeback after the demise of Arthur Andersen, generating sub-
stantial controversy. The practice still lingers in full bloom and as of 2008 out-
standing securitisations amount to about $10 trillion in the USA and $2 trillion
in Europe (SIFMA, 2008). A number of works cite the benefits of securitisations
when it comes to reducing risk and obtaining favourable financing terms (Barth
and Taylor, 2010; Barth and Landsman, 2010). In contrast, benefits in terms of
value creation for banks have been less than clear. From a risk perspective,
Acharya et al. (2010) argue that eventual losses from conduits remained with
banks rather than with outside investors, with financial risks being concentrated
in the banking sector. In fact, from a performance perspective, Sarkisyan et al.
(2009) do not find supporting evidence about the beneficial impact of securitisa-
tion upon banks.
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When it comes to disclosure-related issues, it is yet unclear whether disclosures

made by financial institutions during the crisis were deceiving or just incom-
plete.6 With perfect hindsight, we know that financial statements did not ade-
quately reveal the extent of risk-taking by banks, and did not warn of
impending meltdowns.
The standard response to complexity in efficient markets is to enhance disclos-
ure, thus reducing frictions and allowing for the identification of on- and off-
balance sheet positions, risk concentrations and related hedging (Ryan, 2008).
But not all types of information have the same value relevance and processing
costs (Merton, 1986), and complex financial products can undermine such infor-
mational efficiency. Thus, Schwarcz (2008) argues that a structured financial
product would take more time for a market to understand, as compared to a
change in interest rates by the Federal Reserve (see also Gilson and Kraakman,
1984).
Ryan (2008) contends that part of the opacity in structured securities is due to
the partitioning of instruments into complex financial products. Although theory
suggests that fair value accounting provides for more timely disclosures than his-
torical costs (Bleck and Liu, 2007), empirical verification has not been forthcom-
ing. Liao et al. (2010), for example, find that fair values are opaque and subject to
information risk, throwing doubt on recent efforts to improve disclosures and
transparency (e.g. SFAS 157). Similarly, Song et al. (2010) find that investors
discount level 3 values,7 with governance problems within a firm leading inves-
tors to even greater discounting.
Given shortcomings in financial statement ability in revealing firm riskiness,
such as discussed above, some have suggested integrating risk-reporting into
financial statements.8 Conversely, Pozen (2009) advocates creating a separate
statement for fair value re-measurements in order to increase transparency by
quantifying and highlighting key risk measures. Regarding the latter issue,
empirical evidence suggests that fair values have been manipulated, given that
structured products have long been a ‘powerful tool for inflating company
profits by hiding losses and hence the risks of company operations’ (Hildyard,
 Accounting, Governance and the Crisis: Is Risk the Missing Link? 219

2008, p. 30). From a macro perspective, the indirect evidence on manipulations is

pervasive: in 2008, more than 60% of US banks had equity market values that
were less than their book values (while this figure was only 8% in 2001). Mean-
while for these same banks, Tier 1 capital stayed constant at 11% throughout that
period (Huizinga and Laeven, 2009).9 Hence, indirect evidence on the manipu-
lation of real-estate assets accounted for by fair values. In addition to the
macro-level evidence above, studies at the firm level also suggest that fair
values are prone to manipulation. For example, Dechow et al. (2010) argue
that flexibilities inherent in securitisations make them a candidate for discretion-
ary managerial reporting decisions.10 In a similar vein, Dong et al. (2009) find
that firms reclassify more gains than losses into the income statement. Moreover,
Fiechter and Meyer (2010) provide evidence that banks exhibiting poor pre-
managed performance levels report ‘big bath’ type discretionary level 3 losses,
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leading to subsequent positive earnings.

Discussion Regarding the Role of Financial Reporting in the Crisis

On various fronts, financial reporting experienced a number of shortcomings
during the crisis, it did not properly account for uncertainty, and did not ade-
quately monitor, measure and disclose the impact of risk-taking on financial
statements. In this manner, this hampered the reliability of financial statements
and relevance. Overall, there is evidence that during the crisis, preparers and sub-
sequently auditors, did not exhibit the necessary judgment when reporting
accounting numbers, applying accounting practices and interpreting Basel Com-
mittee recommendations (FSA, 2010; Rona-Tas and Hiss, 2010). Hence, often-
times, publicly available market-wide risk/valuation indices were more
indicative of firm risk positions than firm disclosures themselves (Vyas, 2009).
While corporate disclosures have been extensive,11 large segments of them are
of the boilerplate type, and hence inadequate in informing investment decisions.
An important implication regarding the usage of fair values is that reported
numbers affect social welfare. If the aim is to promote growth, then fair values
promote efficient investment.12 However, if the desired outcome is to evade
steep economic declines such as the ‘death spiral’, then historical cost accounting
is preferred. Given that the current societal and regulatory outlook is one prefer-
ring the avoidance of steep declines at the expense of speedy growth,13 historical
costs point the way forward, especially since accounting systems cannot change
as a consequence of shifting macroeconomic conditions. As fair values are for the
contracting/investing environment of firms, then such values can be disclosed in
the footnotes, and in supplemental voluntary disclosures. In this manner, the
market may value the efficacy and decision usefulness of such numbers.
However, other intermediary solutions are also possible. For example, for level
1 assets, there are fewer reliability concerns.14 But for level 2 and level 3 assets,
given a reliability argument, only historical costs may be desirable.15 The usage
of historical costs is not per se detrimental in measuring and assessing firm
 220 M. Magnan and G. Markarian

performance. For example, holding short-term assets at historical costs would be

desirable, as the quick trading horizons of these assets would continuously show
up on the income statement. For intermediate to long horizon assets, historical
cost could also be desirable: fair value fluctuations do not matter since such
assets are held for the long term.
Regarding securitisation, the evidence clearly points out that they were used
to hide underlying firm riskiness. Citibank lost $14 billion when it guaranteed
off-balance sheet assets during the crisis. At the time, it was unknown that Citi-
bank had potential exposure to more than a trillion of off-balance sheet secu-
rities held through special purpose entities (Sikka, 2009). The demise of
Lehman Brothers sheds light on the appropriateness of accounting for off-
balance sheet financing. For example, a report commissioned by the court hand-
ling Lehman’s bankruptcy concludes that the firm did not properly account for
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some sale and repurchase agreements worth $50 billion (otherwise labelled
Repos 105), shifting them off-balance sheet just before the release of financial
statements in 2008 (Valukas, 2010). Such outcomes raise questions on the
reliability and representativeness of financial statements in reflecting such trans-
actions, and suggest that revenue recognition and measurement criteria may
have been too aggressive. In our view, in securitisations where the issuer
retains an exposure to transferred assets/liabilities (control, influence, guaran-
tees) should be accounted for ‘on-balance sheet’. This approach would be con-
sistent with the recent IASB/FASB proposal regarding lease contracts (IASB/
FASB, 2010).
The failure to account for risk also extended to auditors and put them under
the spotlight on two dimensions. First, similar to credit rating agencies, audi-
tors are being blamed for giving a seal of approval on too many securitisa-
tions and off-balance sheet deals. Such transactions hid a firm’s riskiness,
and ended up bankrupting involved firms. Second, as argued by Magnan
and Thornton (2010), the crisis showed that the audit function must comprise
more extensive risk assessment, especially regarding the uncertainty of under-
lying cash flows.
Prior research has consistently shown that accounting has both constitutive
and reflective powers – that it creates a reality as well as merely reflecting
it (see Hopwood, 1987; Macintosh, 2009). In instances where assets are
being marked to model, fair value accounting is very much creating a reality
that approximates market values at best or provides fully irrelevant numbers
at worst. Such numbers did not exist until accounting regulations allowed/
required it (Woods et al., 2009). In our view, accounting needs to move
beyond its traditional role of recording economic events and transactions and
must eventually encompass and reflect underlying risks. Such an expanded
role entails not just reporting traditional point estimates, but also estimates of
risk profiles, and measures of the uncertainty surrounding transactions (see
Borio and Tsatsaronis, 2006).
 Accounting, Governance and the Crisis: Is Risk the Missing Link? 221

3 Accounting and Corporate Governance during the Crisis

The root cause of the crisis lies in the breakdown of shareholder monitoring
and ill conceived managerial incentives. (Kashyap et al., 2008)

Accounting is central to governance processes, from boards’ reliance on account-

ing numbers to make oversight-related decisions, to the audit committee’s inter-
action with auditors, to compensation committees’ usage of accounting numbers
in setting remuneration. In this section, we present the arguments that we deem
pertinent in this debate. So far, sparse but growing evidence from politicians,16
regulators17 and governance experts18 suggests that lax governance structures
have led to the crisis. We attempt to focus on the relationship of accounting
vis-à-vis the role of the board, incentives/compensation and external monitoring.
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From the perspective of regulatory oversight, macro-structural imbalances

combined with risks generated by aggregate financial flows and global move-
ments in capital, posed particularly strong challenges for governance (Dymski,
2008). In essence, given inadequate regulatory oversight, extant policies imply-
ing ‘too big to fail’ gave an incentive to large financial firms for not worrying
about ‘tail risk’ (Lang and Jagtiani, 2010). Furthermore, politicians playing
second fiddle during the boom encouraged government-sponsored enterprises,
such as Fannie Mae and Freddie Mac, to buy risky subprime mortgages
(Taylor, 2009).
Accounting information, a key input for effective regulatory oversight, did not
seem to provide much warning of forthcoming problems. In this respect, recent
trends in standard-setting led financial statements to focus on value relevance
and to cater to the needs of investors, potentially to the detriment of other stake-
holders’ needs (Kothari et al., 2010). It may be that regulators were not up to the
task of interpreting these firms’ financial statements, which did contain some
warning signals. Alternatively, accounting may have been more explicit in cater-
ing to investors. It is our view that both factors were likely at play.
From the perspective of monitoring at the firm level, boards of directors have
attracted severe criticism from capital markets participants. For example, the
Institute of International Finance (2009) indicates that ‘events have raised ques-
tions about the ability of certain boards to properly oversee senior management
and to understand and monitor the business itself’ (p. 34). In many cases, risk
management systems failed not because of computer models per se but
because of a failure in governance, as information about exposures and strategies
did not reach senior management (Kirkpatrick, 2009). Moreover, a majority of
banks have indicated that their boards were not properly knowledgeable about
their risk management (Ladipo et al., 2008). In contrast to expectations and estab-
lished best practices, this suggests that risk management is not at the heart of
planning and governance, a blatant functional failure.
Overall, estimates are that two-thirds of bank directors have no banking experi-
ence (Guerrera and Thal-Larsen, 2008). Additionally, many directors without
 222 M. Magnan and G. Markarian

financial backgrounds sit on audit and risk committees, which are known to be
demanding in terms of technical proficiency: at Lehman, 7 out of 10 directors
were retired CEOs of non-financial firms, and a theatre producer sat on the
audit committee. Of particular interest in the governance function is the fact
that it complements the audit function within a firm. Hence, the power of an
audit is reduced in the absence of a complementary governance function that
responds to recommendations from the audit, follows up on material weaknesses
and understands sources of risk.
Evidence indicates that governance responses have been country specific. For
example, there have been numerous cases of CEO turnover in the USA but none
of the French banks dismissed their CEO, despite their losses (Erkens et al.,
2009). In general, research post-crisis provides mixed evidence regarding the
role of governance. For example, Beltratti and Stulz (2010) find no evidence sup-
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portive of a relation between governance and the crisis. Furthermore, they

suggest that banks with more shareholder-friendly boards performed worse
during the crisis, implying that bankers were pushed by independent directors
to maximise shareholder wealth through excessive risk-taking which was not ade-
quately measured, reported and monitored.
In contrast, other studies report a direct relationship between governance struc-
tures and the crisis. Francis et al. (2009) find that independence in terms of con-
nections to the CEO, in addition to financial expertise, predicts firm performance.
Chesney et al. (2010) suggest that banks with fewer independent boards experi-
enced higher write-downs, confirming the notion that fewer independent boards
are related to lower performance. Similarly, Vyas (2009) indicates that measures
indicative of agency and governance problems are related to the timeliness of
write-downs (see also Hau and Thum, 2009).
Governance need not be only internal. Erkens et al. (2009) provided evidence
consistent with institutional investors exerting pressures for short-term-oriented
performance and bonus plans. In a similar vein, Manconi et al. (2010) conclude
that short-horizon mutual funds, which were particularly exposed to securitised
bonds, transmitted the crisis.
Compensation often depends on accounting numbers and there is far-ranging
anecdotal evidence in this respect. At the business unit level, given that returns
on an AAA government bond were inferior to the returns to be obtained from
an AAA rated structured security, the latter was preferred to the former
(Bhagat, 2008). Consequently, investment managers were compensated on profit-
ability without recourse to corresponding riskiness. At the firm level, studies gen-
erally support the notion that compensation-related incentives played a part.
Erkens et al. (2009) argue that the structure of remuneration, especially
bonuses based on short-term performance, likely focus the CEO’s attention on
short-term results. In this vein, Livne and Markarian (2010) relate CEO
bonuses to short-horizon investments that increased a firm’s risk and might
have fed the crisis. Similarly, Dechow et al. (2010) find that securitisation
gains were as compensation relevant as other components of earnings, and
 Accounting, Governance and the Crisis: Is Risk the Missing Link? 223

Chesney et al. (2010) show that stronger risk-taking incentives (and weaker own-
ership incentives) are positively related to write-downs (see also Suntheim,
2010). Finally, Bebchuk et al. (2010) suggest that compensation plans may
have induced excessive risk-taking, where investors lost almost everything
while executives cashed out hundreds of millions of dollars (see also Bicksler,
2008).
However, the research evidence supporting the notion that compensation-
related incentives fuelled the crisis is not unanimous. Fahlenbrach and Stulz
(2010) show that banks in which CEO incentives and shareholder interests
were properly aligned, did not outperform their counterparts not doing so
during the crisis. They do not find either that CEOs reduced their equity holdings
before the crisis, which suggests that CEOs were unaware of deteriorating market
conditions.
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Shortcomings in internal control have also been highlighted during this period.
The enactment of Sarbanes –Oxley raised the attention devoted to internal con-
trols which maps directly into risk management. Evidence from the crisis indi-
cates that positions in complex derivatives were valued by those who created
and/or sold them, and hence accountants conceded measurement to traders
(Goldstein and Henry, 2007). At Northern Rock, performance-based targets led
to mortgage data being misreported, both internally (board) and externally
(markets). This was largely due to improper communication between those in
charge of internal controls and those in charge of governance (Fortado, 2010;
IAASB, 2009).
Within the control domain, the role of rating agencies cannot be neglected. As
rating structured securities was a very profitable business, credit rating agencies
were reluctant to alienate their big customers by providing less than stellar ratings
(Rona-Tas and Hiss, 2010, p. 145). These agencies also failed to insulate analysts
from fee negotiations with issuers, where some analysts simultaneously rated,
and traded, client securities (SEC, 2008, pp. 23– 32). Failures by rating agencies
were accompanied by a similar failure on the part of institutional investors, since
they are the main buyers of structured products that are rated by agencies (Kregel,
2008).
However, why did institutional investors fail to properly assess the value and
risks of many structured products? One key reason was the lack of adequate dis-
closures about these products. Thus ‘a lot of institutional investors bought struc-
tured securities substantially based on their ratings, in part because the market has
become so complex’ (Schwarcz, 2009).

Discussion Regarding Accounting and Corporate Governance during the

Crisis
The crisis revealed failures in governance. Banks gave out bad loans, and boards,
rating agencies, regulators and non-aligned compensation schemes, did not
provide the proper oversight. In this context, failures in accounting contributed
 224 M. Magnan and G. Markarian

to the ineffectiveness of the oversight process. Even if structures seemed good on

paper, proper functioning and empowerment are essential – a prime issue is that
form should never be confused with function. Lehman’s risk committee met
twice in the year preceding its liquidation and Bear Stearns established a risk
committee only during the last year prior to its takeover by J.P. Morgan (Kirkpa-
trick, 2009). Independent board members were not versed in bank operations, and
did not understand the scope of underlying exposures. Failures in governance
interacted with shortcomings in accounting which did not reveal underlying
riskiness.
Despite evidence about governance lapses and weaknesses at several financial
institutions, formal empirical evidence is still scant and relatively mixed. In terms
of the role of the board of directors, extant research is hindered by reliance on
observable, quantitative attributes which may or may not reflect actual actions
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and decisions at board or committee meetings. Regarding the role of controls,

we document failures within rating agencies and free-riding institutional inves-
tors, both of which relied on numbers and disclosures produced by the accounting
system. Correspondingly, we show the essential role accounting and control
played in the financial meltdown.
Regarding the role of incentive compensation, the evidence is still building up.
For instance, managerial incentives at the business unit level may have been mis-
aligned. Such managers’ incentives were to increase departmental profitability
(for example, through selling/trading, loans and securities), without a related cor-
respondence to overall firm riskiness. This traditional principal – agent problem is
expected, given the structure of pay-offs in relation to outcomes (Lang and Jag-
tiani, 2010). To some extent, it leads to a rethinking of prior research conducted
on compensation, and the notion that extant practices were a key driver under-
lying the strong performance of the US stock market, and the strong growth in
US productivity (see Holmstrom and Kaplan, 2003).

4 Discussion and Conclusion

The last decade witnessed financial scandals that raised concerns over firms’
aggressive accounting practices. In many respects legislative reforms were
aimed at restoring public trust and avoiding sudden corporate meltdowns,
mostly by enacting (alleged) improvements in the audit and disclosure processes
and in corporate internal controls. At that time, the culprits were clearly outlined:
managerial greed, sky-high expectations, funny accounting, lax auditing and
cheerleading capital markets.
Indications are that the bursting of the bubble could have been foreseen and
avoided (Demyanyk and Van Hemert, 2011). Accounting was not an innocent
bystander in the proceedings, as accounting interacted with extant processes
and contributed to the bubble and subsequent meltdown. Ultimately, if account-
ing had no causal role in the crisis, there would be no need for any changes,
 Accounting, Governance and the Crisis: Is Risk the Missing Link? 225

guidance, activity or lessons to be learned for the future, contrary to what we are
witnessing today.
The crisis opens up various avenues for research in accounting and financial
reporting. Many years and a large number of scientific investigations will be
needed before we fully understand the causes and consequences of the crisis as
it relates to accounting. For one, the controversy regarding fair values has gener-
ated a lot of heated debate. As discussed previously, it does not help that aca-
demic research, before and after the crisis, has not provided the necessary
guidance. Did the usage of fair values propagate the crisis? Would the crisis
had been avoided had banks’ investments been accounted at historical costs?
What is the way moving forward – from a standard-setting perspective and
from a policy perspective? Research in this domain not only has to evaluate
the role of the usage of fair values in accounting, especially for banks, but also
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needs to identify the potential role of the alternatives when it comes to future
social welfare. If fair values promote efficient resource allocation and historical
costs moderate steep declines – what are the welfare implications of accounting
choices?
Future research investigating fair values may focus on its costs vs. benefits
within the framework of relevance vs. reliability. Liao et al. (2010) contend
that related disclosures are opaque and subject to information risk while Vyas
(2009) argues that such disclosures are not timely. As such, are fair values
timely and informative? What is their relevance to decision making? These are
questions that need resolving. Research needs to also investigate the reliability
of fair values, given that there have been many allegations of manipulations. Is
managerial reporting of unobservable fair values, particularly of level 2 and 3
assets, consistent with managerial compensation related incentives to misreport?
Do governance structures constrain opportunistic reporting choices, if any? From
a disclosure perspective, research in financial reporting (a) needs to consider
reporting of risks, so that accounting numbers are more relevant in a complex
world, (b) research needs to come up with clear and concise disclosure
methods and standards across firms that quantify exposures to underlying vola-
tility and risk factors.
From a governance perspective, the crisis offers many opportunities for future
research. One shortcoming is that research so far has looked at governance
systems singly, ignoring the complex amalgam of forces that shapes a firm’s gov-
ernance environment. Board structures need to be examined jointly with CEO
and other executive compensation related incentives, along with anti-takeover
provisions, the presence of large blockholders, institutional investors, media cov-
erage and the litigation environment, all of which jointly shape a firm’s govern-
ance. Future research needs to look at the interaction of these forces to come up
with clear policy recommendations – as past studies have failed to document
even the most basic effects of governance, such as on firm performance (see
Hermalin and Weisbach, 1998). Future research needs to also define optimal
structures when it relates to preventing crises, which is necessarily different
 226 M. Magnan and G. Markarian

from one needed to promote growth. Research on the effectiveness of risk

management processes and oversight, beyond traditional internal controls, is also
sorely needed if boards and regulators are to play an effective role in this regard.
From the research conducted on board composition, many questions need
resolution. What are the costs vs. benefits of having non-bankers as external
directors on the board of banks? What are the benefits of having general business
expertise, providing a diverse viewpoint and a broad picture of affairs, vs. the
costs of a lack of financial monitoring and understanding banks’ inner workings?
What are the implications of such diverse expertise and experience mixes among
directors on their ability to monitor management through financial reporting and
disclosure? From a compensation perspective, some studies have linked compen-
sation structures to firm performance during the crisis. However, the necessary
link, often professed in the media, that bonuses caused the crisis is yet
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missing. Studies need to establish whether compensation structures led to risky

investment choices, which in turn led to contagion and systemic effects.
Generally, what are the compensation structures needed to prevent a future
crisis such as this one? However, addressing these governance and incentive
questions will require researchers to go beyond externally observable director
attributes and examine board processes and dynamics.

Acknowledgements
The authors would like to thank Santhosh Gowda, Rami El-Husseini and an
anonymous referee for many helpful discussions. Many thanks to Robert Watson
who debated various ideas put forward with the authors. The authors would
especially like to thank the editor, Salvador Carmona, for continuous encourage-
ment and numerous edits of this paper.

Notes
1
On 9 March 2009, the former CEO of Caisse de Depot et Placement du Quebec (Caisse), one of
the world’s largest institutional investors, declared that the Caisse’s abysmal financial perform-
ance in 2008 (a return of 226%), was caused by a perfect storm of three elements, one of which
was the application of fair value accounting in the valuation of its assets.
2
In an SEC panel, William Isaac, former Federal Deposit Insurance Corporation (FDIC) chair-
man, exclaimed: ‘I gotta tell you that I can’t come up with any other answer than that the
accounting system is destroying too much capital, and therefore diminishing bank lending
capacity by some $5 trillion, It’s due to the accounting system, and I can’t come up with
any other explanation.’
3
In a House Financial Services subcommittee hearing on 12 March 2009, Paul Kanjorski, a
Pennsylvania democrat, demanded an immediate reversal of fair value rules.
4
At a conference of the American Institute of Certified Public Accountants on 8 December 2008,
SEC chairman Robert Cox declared ‘accounting standards aren’t just another financial rudder to
be pulled when the economic ship drifts in the wrong direction, instead they are the rivets in the
hull, and you risk the integrity of the entire economy by removing them’.
5
See, for example, Barth and Landsman (2010), on the role of financial reporting in the crisis.
 Accounting, Governance and the Crisis: Is Risk the Missing Link? 227

6
Several lawsuits are currently pending on this issue. For example, a class action suit has been
initiated in the Ontario Superior Court of Justice against the Canadian Imperial Bank of Com-
merce (CIBC) alleging, among other things, that CIBC engaged in fraudulent, negligent and
statutory misrepresentation regarding the extent of its exposure to US subprime securities
(around $12 billion).
7
Level 1, 2 and 3 assets are classifications based on their reliability, where level 1 assets have
readily observed market values, while level 2 and 3 assets are valued according to prices of
comparables or financial models.
8
The notion that financial reporting does not integrate risks is not new. From a banking point of
view, the Bank of International Settlements issued a report, pre-crisis, arguing ‘financial report-
ing should provide a good sense of the impact of . . . risks and uncertainties on measures of
valuation, income and cash flows’. See Bank of International Settlements report on ‘Account-
ing, Risk Management and Prudential Regulation’ (Borio and Tsatsaronis, 2006).
9
According to Basel I, Tier 1 capital is the core measure of bank financial strength.
10
Barth and Taylor (2010) discuss possible research design issues with Dechow et al. (2010), and
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argue that it is not possible to identify the source of earnings manipulation (e.g. whether from
manipulating assumptions about fair value vs. discretion in business decisions).
11
For example, the HSBC 2010 annual report is 389 pages.
12
Fair values are useful for firm valuation, which is an objective of US GAAP (see Statement of
Financial Accounting Concepts No. 1, regarding the provision of information for rational
investment decisions), and IFRS (see the IFRS Framework, Chapter 1). Proper valuation, in
turn, enhances efficient investment allocation.
13
See, for example, the new Basel III regulatory standards for increased bank capital require-
ments, and ensuing estimates by the OECD regarding decreases in future GDP growth.
14
Kothari et al. (2010, p. 251), in their discussion regarding the efficiency/efficacy of using fair
values in financial reporting, observe ‘use of fair values in circumstances where these are based
on observable prices in liquid secondary markets is consistent with economic GAAP’.
15
On this point, Kothari et al. (2010, p. 251) observe ‘in the absence of verifiable market prices,
fair values depend on managerial judgments and are subject to opportunism. Accordingly, we
caution against expanding fair-value measurements to balance sheet items for which liquid sec-
ondary markets do not exist.’
16
In 2009, the OECD published a three-phase report that identified shortcomings and rec-
ommended changes to practices encompassing executive compensation, risk management,
board practices and the exercise of shareholder rights.
17
Jane Diplok, executive committee member of IOSCO, recently declared that the crisis ‘was a
result of poor governance in institutions which had a poor regulatory framework’.
18
Nell Minnow, co-founder of the Corporate Library, recently declared: ‘the recent volatility
proved that the need for better corporate governance has never been clearer or more pressing’.

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