Can the present disclosure practices take credit for bringing to surface runaway credit crisis we currently witness? Or, were there gaps in reporting that allowed the problems to fester far too long? Would we therefore need better reporting practices, going forward? Pose these questions to Mr Shankar Jaganathan, and he comes up with an interesting analogy, by comparing the current financial crisis to a heart-attack, and the adequacy of disclosures to the effectiveness of health check-ups.

"Did the heart-attack occur after the patient was admitted during the quarterly health check-up or did it occur when the patient was going about his routine life?" asks Mr Jaganathan, the author of the recently-published book Corporate Disclosures 1553-2007: The Origin of Financial and Business Reporting (Routledge).

A chartered accountant and a law graduate, with two decades of experience in corporate, academic and social sectors, he was the Corporate Treasurer of Wipro from 1995 to 2003, and from 2003 he is a guest faculty in the Indian Institute of Science, Bangalore.

The fact that bankruptcies brought this financial crisis to the attention of regulators for action does indicate that adequacy of disclosures cannot be taken as given, Mr Jaganathan observes. With the benefit of hindsight we can see two distinct areas where adequacy of information could have alerted the regulators to the risks, he feels.

"The first, disclosures on off-balance-sheet positions on OTC (over-the-counter) instruments held. And, the second, details of counterparty credit risks of insures for credit risk - that is, hedge funds that received premium for undertaking risks."

The fact that a $62 trillion CDS (credit default swap) market functioned without regulatory control is definitely a critical factor in this crisis, avers Mr Jaganathan, during the course of a recent email interaction with Business Line. Looking ahead there is definitely a need to regulate the derivatives market, or for that matter any market once its size reaches a level where it can hurt parties not part of the contract, he adds.

Mr Jaganathan, who divides his time between teaching, research and consulting assignments, is currently studying sustainable development with a historical lens. He also consults for select companies and is an independent director on the boards of companies and NGOs (non-government organisations).

Excerpts from the interview, in which Mr Jaganathan looks at similarities between accounting and beauty contests, apart from drawing inspiration from rain-interrupted cricket matches and picking up disclosure lessons from movie certification.

What according to you are the major turning points in the history of corporate accounting?

In bull markets, valuation models are innovated; and bear markets promote accounting developments. Evolution of corporate accounting is a tale of scandals, crashes and panics. The root causes for most of the scandals and crashes are traced back to accounting lacunae.

In the aftermath of scandals, regulators pick up the practices of a few longsighted businesses and mandate them for the rest, thereby progressing accountancy a step ahead.

If I had to pick the top three turning points in the evolution of corporate accounting, it would be the mandate for profit and loss accounts in the 1870s, the policy to use disclosures to protect investors in 1933, and the advent of accounting standards in 1970.

The valuation bubble in the UK railway companies burst in the 1840s. Subsequent inquiries revealed payment of dividend out of capital. Two decades later a leading insurance conglomerate, the Albert Group, failed. Its cause was traced to excessive commission payments made for obtaining insurance policies. This brought the inadequacies of the balance sheet, where profits were inferred from increase in net worth.

When specific statutes were enacted for the monopoly utilities - railway companies, insurance companies and gas companies - profit and loss account was prescribed as a mandatory financial statement to be reported, giving the stakeholders information on revenue, costs and the profits. This was the precursor to mandating profit and loss accounts for companies in the 1928 Companies Act amendment in the UK.

Likewise the 1929 stock market crash in the US resulted in the enactment of the Securities Act, 1933. This Act sought to protect investors by making companies disclose information.

The birth of accounting standards first in England and Wales was also the result of a hat-trick of accounting scandals in 1967, 1968 and 1969. The scandals involved inconsistent measures used to compute profits that came to light post acquisitions.

Do you see any problems that a global set of accounting standards we are now headed to can pose?

The podium position occupied by the US GAAP (generally accepted accounting principles) is now taken by the IFRS (International Financial Reporting Standards). While the move from rule-based accounting to principle-based accounting is welcome, the question of increasing complexity in business transactions remains unaddressed. Higher the complexity in business transactions, the greater will be the role for detailed rules. This is an area of concern that is not addressed by the IFRS.

Just as we have the `Universal' and `Adults Only' classifications for movies, I think there is a need for classifying businesses into `Simple Business Models' and `Complex Business Models.' Businesses that use complex structures and complicated instruments should be classified as Complex Business Models. This will highlight to the stakeholders the profits from a Complex Business Model are products of higher discretion and uncertainty.

If accounting is all about measurement and reporting, in a manner that is comprehensible to all stakeholders, won't an exercise of judgment (especially by those within the enterprise) come in the way of such a goal?

There are two types of measurements: quantitative and qualitative. Quantitative measurements such as height and weight are impersonal, whereas qualitative measurements of goodness and beauty are person-specific. Accounting is like gymnastics or beauty contests. In these, a qualitative measurement is expressed in quantitative terms. The judges score on a ten-point scale in beauty contests and gymnastics while accountants report profits in monetary terms.

This often gives a misleading sense of objectivity to a subjective judgment. While in a beauty contest or gymnastics the judges are the same for all the participants, in accounting the judges are firm-specific, increasing the degree of subjectivity.

The need for judgment in accounting cannot be eliminated in all but very small businesses or very simple business models. The need for judgment comes from two critical aspects - credit transactions and accrual accounting. Credit transactions require judgment on whether an amount due will be recovered and accrual transactions require judgment on value consumed or value delivered even before the entire transaction is completed.

Just as in beauty contests and gymnastics, in accounting too, the quality of results dependent on the quality of judges; impartial judges equals fair results.

Is there any rationale in the separate profit computation for the taxman? Also is there a case for corporates to be transparent about their tax returns?

The objectives of accounting and taxation are different; hence different rationales for computing profits. For the businessman or the investor a rupee spent is a rupee spent and a rupee earned is a rupee earned. But for the Government imposing taxation, a rupee spent or earned often can be more or less than a rupee spent. Governments have social objectives. A rupee earned/spent by business in backward areas, earning foreign exchange, research and development, employment creation, ecological conservation are valued more than a rupee as they supplement or substitute Government expenditure. For instance, to promote computerisation in India, investment in computers is given accelerated depreciation at 60 per cent, while the life of a computer is longer.

Transparency helps in building long-term relationships and reduces transaction cost. As the popular saying goes, human beings cannot escape the two events - death and taxes - and for the corporate there is one inescapable event - taxes. Corporates have to face the taxman year after year. Hence it pays to invest in a transparent relationship with the taxman.

Does the accountant have any strategic role to plan in organisations?

The role of a good accountant is like a scorer in a one-day international or 20-20 cricket game. The insights provided by the scorer can significantly influence the decisions of the team. But it is only in a rain-interrupted match the scorer moves to the centrestage. The current business environment is more like a rain-interrupted match. Both the scorer and the scoring system are in focus today. The Duckworth Lewis system in question here is the mark-to-market method for valuing financial instruments.

On a more generic note, the importance of the accountants' role comes up in situations like equity infusion in business, mergers and acquisitions, divestures, accepting financial covenants while raising debt. In all these situations, the role is to calibrate the external measures with the internal yardsticks for the benefit of the management team.

As specialists in external measures of business performance, increasingly accountants are called upon to structure business transactions. While conservative approaches are dull and unappetising, daring approaches endear them to the business leadership. It is in these situations they play a make or break role. While the life of a corporate entity is in the hands of its business leadership, its death is more often than not in the hands of its accountants.

Interview by D. MURALI, Editor - The hindu business line.