Finance Theory and Accounting Fraud: Fantastic Futures versus Conservative Histories

Abstract:     
Intellectual tension between the fields of finance and accounting may help to explain explosion of public company frauds. Finance theory diminishes the relevance of accounting information. Enron exploited this consequence while the SEC bought into it. After widespread frauds were exposed, Congress passed laws that address symptoms of finance's futurism, not disease. Laws essentially prohibit pro forma financial reporting and regulate the selective flow of futuristic information to financial analysts. Untouched is the underlying disease of regulatory mandates requiring extensive disclosure of forward-looking information.

Until the 1970s, the SEC prudently prohibited such futuristic disclosure as inherently unreliable; assisted by finance theory, the SEC's stance steadily eroded to require such disclosure. The SEC likely had it right the first time. It is too late to reverse the mandatory futuristic disclosure regime. So reform policies must work within it. After elaborating the foregoing critique, this Essay mentions two: (1) future oriented disclosure should focus on material risks of future adversity and (2) accounting figures should be reported in ranges, not single amounts.

Keywords: pro form financial reporting, analyst earnings forecast, forward-looking disclosure, financial fraud, efficient market hypothesis, accrual system, reforms

JEL Classifications: M1, M43, M44, M45

Accepted Paper Series