Countering Opportunism in Structuring and Valuing Transactions: The Case of Securitizations

Abstract

During the financial crisis of 2008, the debate on the accounting profession's role has focused mostly on mark-to-market accounting rules. We argue that other weaknesses in the accounting rules as applied to securitizations predate the current crisis. The accrual system that underlies all accounting allows revenues to be recognized in advance of cash flows but requires reserves on receivables. Similarly, the fair value system books unrealized gains, but fails to recognize reserves explicitly. In illiquid markets, fair value estimates have to be based on internal models. Compensation arrangements that are closely tied to these estimates create a perfect setting for managers to increase their compensation by inflating asset values. We propose a method of recognizing fair value reserves that builds on existing practice. Such reserve accounting, an application of conservatism, will mitigate procyclical swings in fair value estimates and reduce incentives for overly optimistic asset valuations. Our analysis is conceptual in that we describe issues and their potential causes, and we propose a solution. We neither build a formal model nor perform empirical tests. Our article is exploratory and is intended to generate debate that could lead to significant improvements in accounting standards and provide a basis for rigorous empirical tests.