In the years leading up to the 2008 financial collapse, banks gobbled up risk while turning out sunny financial reports. Accounting standards may be partly to blame.
On September 15, 2008, the financial world looked on in disbelief as Lehman Brothers collapsed and Merrill Lynch was forced to sell itself to Bank of America.
Lehman’s dissolution was just the most dramatic of Wall Street’s failures brought on by the now infamous subprime mortgage derivatives and credit default swaps. As the banks piled on risk in the years leading up to the crisis, however, few foresaw the looming disaster. According to Doron Nissim, financial reporting may be partly to blame.
At the time, Nissim says, “people assumed because so much of the balance sheet is fair valued that they had a good understanding of the risk the bank faced.” Over the last twenty years, accounting standards have increasingly required the use of fair value, or mark-to-market accounting, for financial instruments, requiring those items to be recorded on balance sheets at their market value at the time of reporting. The standards were meant to bring greater transparency to financial reporting, but, as Nissim points out, “fair value is a point estimate; it doesn’t necessarily give you information about volatility or the potential for losses.”
The problem, according to Nissim, is a failure to properly account for risk. The fair value model, he explains, “basically looks at one scenario: the expected scenario. But we know in life there are many different possible scenarios.” A single point estimate extended out to the future, in other words, not only fails to capture important information about the past by eliding changes in value over time, it projects certainty onto an inherently uncertain future.
The problems are further compounded by incomplete information in financial statements. “The reported financial statements are not complete, in the sense that there are important assets, liabilities, and exposures that are not reflected in the financial statements,” Nissim explains. Among the liabilities not reported on corporate balance sheets are those of unconsolidated variable interest entities — e.g., securitization vehicles like the collateralized mortgage obligations that underlay the 2008 crisis — and joint ventures, as well as obligations associated with executory contracts like operating leases, and contingent obligations related to litigation, regulatory actions and other exposures. Many investors don’t understand that balance sheets fail to fully capture these exposures and so misunderstand the true financial position of companies, particularly in the case of a sudden shock to the system.
Despite the existing difficulties in assessing the risk faced by corporations through their financial reporting, the regulatory environment, Nissim notes with concern, continues to shift towards offering companies greater discretion in their reporting. “Surely there are differences across companies, and you need flexibility to capture those differences,” he says. “But in the end, the way we look at companies is very much relative. And if we’re not comparing apples to apples, it’s a problem,” he explains.
“Even for savvy investors, if you don’t have the information the company used when they came up with their estimates, you won’t be able to assess the underlying risk,” Nissim says. “Even if everybody is honest and trying to do their best, you’re giving up quite a lot when you allow companies too much discretion. Comparability and consistency are very important.”
Doron Nissim is the Ernst & Young Professor of Accounting & Finance and chair of the Accounting Division. His research focuses on equity valuation, fundamental analysis, and earnings quality.
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