Accounting for subprime investments: Denial is not a river in Egypt

Implications: This article reveals the bizarre mindset of managers who (a) want to take huge risks for a shot at high returns, (b) don’t mind reporting results when they succeed, but (c) don’t want to report their losses. To put it another way, they want to invest in risky securities but report income from their ventures as if they put money into certificates of deposit. There is no legitimacy in twisting the accounting to cover up the results, and no reason to blame the chief accountant or FASB for the problem, or to expect the regulators to take them off the hook by allowing the losses to be hidden.

Analysis: When managers choose to engage in risky behavior, the only certainty they face is that the distribution of possible future income effects will be widely dispersed.  While it is possible to make a large profit, it is also possible to have a large loss, with a variety of outcomes in between.  

This situation is quite different from engaging in less risky behavior where the tails of the distribution are curtailed; they can’t make as much, but they also cannot lose as much.

The task for accounting policy makers is to devise principles that allow financial statement users to distinguish between these two behaviors.  The clear solution is to force the recognition of all changes in market value when they occur.  This practice puts useful information on the balance sheet by showing the economic value at risk; it also puts useful information on the income statement by showing the consequences of the risk.  Specifically, the more risky the investment behavior, the more volatile the income.

Consider this quote from the unnamed “senior Wall Street executive,” who says: “We can explain why we took the writedown, but the fact remains that we will still have to take it on our profit and loss account and that is a big burden.”  

He is in denial.  He put his shareholders’ capital at risk, a great deal of risk, in fact, and lost a large chunk of it.  What would he have the policy makers do?  Relieve him of the responsibility for reporting the outcome of his bet?  The burden that he refers to is being borne by the shareholders, and it is his fault.  He should not expect to escape accountability, and he certainly should not expect the SEC to give him a free pass.

The writers clearly do not understand the problem either.  There is no “crumb of relief” in a policy that would keep the truth out of financial statements.  Allowing management to hide its mistakes by making up numbers would not be relief.  It would be a public policy that organized deception is suitable for protecting managers against themselves and against full accountability for their actions.  Without doubt, this sort of policy would destroy confidence in the capital markets.

If managers want to report smooth and growing income, then they should invest in guaranteed securities, like certificates of deposit, and watch them grow little by little each year.  They cannot invest in subprime mortgage-backed bonds and expect to account for them as if they are CDs.

This time, they bet on the wrong thing, and they bet big.  It’s time to face the music.  And, to mix metaphors, it’s also time for some of them to walk the plank because of their poor judgment.  They’re only making it worse by asking accounting regulators to let them cover up their mistakes.  That would do no one any good, not even the managers.  Instead, it would merely allow them to continue in their state of denial that something really bad happened because of their decisions.