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.