[DEBATE] : FT - Mind the GAAP - and find out about your risks (accounting)

[Riaz K Tayob]

Mind the GAAP - and find out about your risks

By Andrew W Lo

Published: April 2 2009 03:00 | Last updated: April 2 2009 03:00

One of the most important causes of the financial crisis is the fact 
that accounting - the language in which banks and other corporations 
communicate, strategise, and plan - is inherently backward-looking. This 
is no fault of accountants but is instead a hardwired aspect of their 
stock-in-trade: generally accepted accounting principles. GAAP is 
intended to capture past performance, allowing managers to see how their 
businesses have fared and which components have added or subtracted 
value. Only with the benefit of hindsight can we tease apart the 
intricacies of corporate cash flows and how they have affected assets 
and liabilities.

But the past may not be indicative of the future, to parrot a common 
disclaimer. Balance sheets and income statements are not designed to 
capture risk, a forward-looking concept. The past has no risk! To 
illustrate this gap in GAAP, suppose a company enters into a credit 
default swap contract for a notional amount equal to the company's total 
assets - would this contract appear on the company's balance sheet as an 
asset or a liability? The surprising answer is neither, on the day the 
contract is struck. Because the contract has zero net present value at 
initiation, it cannot be considered an asset or a liability, and can 
only be included in the balance sheet as a footnote! However, such a 
contract surely contributes to the company's risk profile. As credit 
conditions change, the swap's present value will become positive or 
negative, in which case it would be categorised as an asset or 
liability, respectively, but the swap's impact on corporate risk remains 
invisible through the lens of standard accounting measures.

An even more striking example of the challenges that financial 
innovation poses to GAAP is how its "Fair Value Measurements" framework 
or "FAS 157" is applied to the valuation of a collection of mortgages 
owned by a bank. If the bank makes the loans and holds them to maturity, 
the pool of loans is not covered by FAS 157; it is valued at its 
amortized cost, with no risk analysis required. If the loans are 
purchased as a liquid pass-through security, according to FAS 157, the 
security is valued at its observed market price (a "Level 1 asset"), 
also with no risk analysis required. However, if the loans are purchased 
as a collateralised debt obligation (CDO), FAS 157 considers the 
security illiquid (a "Level 3 asset"), and must be valued by the bank's 
internal model rather than market price, and risk analysis is required. 
In each of these three cases, the risk exposures to the bank's investors 
are identical, so shouldn't the same risk information be reflected in 
the corresponding accounting data?

In 1995, Robert Merton and Zvi Bodie pointed out the need for a new 
branch of accounting which they called "risk accounting" to deal 
explicitly with the unknown future. The current crisis should be 
sufficient motivation to follow through on their advice. The basic 
structure of risk accounting is simple. It takes the GAAP accounting 
framework as the starting point, but uses the language of probability 
and statistics to describe the future realisations of any accounting 
variable. For example, while a company's short-term tangible assets last 
quarter are known with certainty, its short-term tangible assets next 
quarter are unknown as of today.

Therefore, the value of the assets can be treated as a "random 
variable", a well-known concept in probability theory, which yields a 
multitude of tools for capturing the variable's statistical properties. 
For example, standard deviation and value-at-risk are two familiar 
measures of investment risk that can also be used to measure the risk of 
future short-term tangible assets. If, for example, the standard 
deviation of future short-term tangible assets is much greater than the 
expected value of future short-term liabilities, this suggests the risk 
of a potential mismatch in assets and liabilities that could cause 
financial distress if credit markets are not functioning smoothly. 
Because a corporation's assets must add up to its liabilities plus 
equity, the assets' standard deviation must also equal the standard 
deviation of liabilities plus equity. This identity gives rise to the 
concept of a "risk balance sheet," which would also include zero 
net-present value contracts such as credit default swaps if they 
contribute to the riskiness of the company's assets or liabilities.

By viewing future values of accounting concepts as random variables, the 
well-developed framework of probability and statistics can be used to 
quantify the impact of events such as credit crunches, 
flight-to-quality, and volatility spikes on corporate balance sheets and 
income statements. Without filling this gap in GAAP, the relationship 
between financial crisis and a company's prospects cannot even be 
articulated in an operationally meaningful way.

Andrew W. Lo is the Harris & Harris Group Professor at the MIT Sloan 
School of Management and chief scientific officer of AlphaSimplex Group, 
LLC. This article was co-authored by David E. Runkle, Director of 
Quantitative Research at Trilogy Global Advisors, LLC.

Copyright The Financial Times Limited 2009