Acc 541 - Accounting Role in the Financial Crisis

Wei Wang

Instructor: Bill Vadbunker

Accounting 541

2 November 2010

Accounting's Role in the Financial Crisis

Before analyzing the off-balance sheet transaction, let's talk about the on-balance sheet. As we all know, the purpose of a balance sheet is to provide a full disclosure of a company's assets, liabilities and equity. A balance sheet is a paramount financial statement if it accurately reveals how much leverage a business has. A leverage ratio communicates the potential for the return on equity and the level of risk a company would assume. Imaging the company record a newly purchased million dollar house at fair value which presumed to be the only asset the company owned, the balance sheet would like this: on the left side, a $1 million asset, and on the right side, liabilities of $900,000 and below that, equity of $100,000. This would show up a leverage ratio of 10:1 assets-to-equity. If the housing price immediately rise by 10 percent, the company would have a house worth $1.1 million and have doubled the equity to 200,000. However, if that million dollar house promptly declines in value by 10 percent, meaning that the house depreciates to $900,000 and the company would have wiped out the equity. So this simplified example illustrates the magnifying effect of leverage ratio and what a balance sheet meant to portray. So it is really important for every company in one industry and across all issuers to play the same rules in terms of being honest about the debt they are taking on and the quality and value of their assets. If the balance sheet is falsely misrepresented as a more positive and camouflaged portrayal of the company's health than it really should, an investor might make a purchase decision and pay more than he or she should for that stock. Also the investor who loaned the money to the business would likely to accept a lower interest rate or less collateral if the company is made to look less debt-hidden.

Traditionally, investors in the stock and bond markets operate in their own separate worlds. Nevertheless, in recent volatile markets, even quiet murmurs in the bond market have been amplified into movements in stock prices. Sales of receivables have increased substantially in recent years and a typical phenomenon in the transfer of the long-term receivables such as loan is securitization. Securitization takes a pool of assets such as credit card receivables, mortgage receivables or car loan receivables, and sells shares in these pools of interest and principal payments. This in effect creates securities backed by these pools of assets. Virtually every asset with a payment stream and a long-term payment history is a candidate for securitization. It used to be that lenders such as the banks or mortgage companies carried the