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  • Negotiating a Volatile Economy


    11/27/2007

    Anyone caught up in the housing meltdown or the gyrating stock market might want to know why corporate financial statements didn’t give fair warning of what was to come.

    One way to understand how this economic tsunami struck without more warning is to look at the financial system through the eyes of accounting and finance specialists. Perspectives asked three accounting experts at the College of Business—Professors Ira Solomon, A. Rashad Abdel-khalik, and Mark Peecher—to explain what financial data can tell investors, and what it can’t.

    Ira Solomon: Working With A System Designed For An Earlier Age



    “What we really have here is another facet of a pervasive problem in our financial reporting system,” says Ira Solomon, professor of accountancy, and head of the department. “It’s a system devised for an earlier era. Trying to fit this system into our current world leaves certain gaps. The system is really designed for an industrial era where companies created value by using physical assets — like property, plants, and equipment — to create products like cars.

    “Now we’ve got companies increasingly creating value by methods other than harnessing tangible assets. Some companies today are creating value via knowledge-based services and products. And we even have companies that make money by creating exotic financial instruments.”

    Those instruments include things like mortgage-backed securities, collateralized debt obligations, hedge funds, and derivatives—things that didn’t exist in an earlier era. And some of these financial instruments have gone sour seemingly overnight. For instance, two major hedge funds that were exposed heavily to the imploding sub-prime mortgage markets were recently declared essentially worthless.

    One factor is that the way home loans are made today is radically different from the conservative system that once ruled the mortgage industry. In the old days, the financial institution that made the home loan retained the mortgage. “These institutions would do a very thorough credit check because they would be stuck with the consequences if the borrower defaulted,” says Solomon.

    Things are very different these days. Mortgage companies don’t use their own funds to make housing loans—they use investors’ money. In the current system, once the loan is made, it often is bundled with other loans into mortgage-backed securities. Some of these securities are made up of sub-prime loans—loans to borrowers who have credit problems and are more likely to default.

    Wall Street packages these mortgage-backed securities and sells them to a variety of buyers. Some go to individual investors, some go to pension funds, some wind up in hedge funds, for example. But the bottom line is this: the local savings bank no longer holds the debt. The people who hold the debt, both individuals and institutions, are far removed from the homeowners that borrowed the money. And some of these individuals and institutions have been badly burned. “It turns out,” says Solomon, “that there is not enough transparency in the system for the people who wind up owning the debt to understand what they’ve acquired.”

    So the system needs to be changed to make sure the new risks are more apparent to investors. “I think greater transparency is always better,” says Solomon. “If people understood the risk, people might not invest in exotic financial instruments, or these instruments might be priced to offer a high return (in return for the risk).”

    Changing the system is difficult, however, so the changes tend to be made after things go awry. “That’s usually what happens,” says Solomon. “We operate in catch up. By that time, some catastrophe has occurred. Then there is a backwards inspection of the system to try to determine what went wrong and why. This has been the case for, say, 75 years.

    “We go through economic cycles of one form or another and these financial problems occur. Then people try to fix them. The Sarbanes-Oxley Act of 2002 is a recent example. Of course, by then, there’s another problem. Most of the time, the money is gone.”

    A. Rashad Abdel-khalik: What Financial Reports Show, What They Don’t



    When ordinary investors read audited financial statements, they may assume that they are looking at numbers that represent cut-and-dried “observable truth.” That’s not the case, says A. Rashad Abdel-khalik, professor of accountancy. Furthermore, they rarely recognize that the financial statements are prepared by the management and are, in fact, management representation.

    Most of the numbers reported on the balance sheet and income statement involve making numerous assumptions and estimations. Take pension costs, for example. To estimate the cost of a defined benefit pension plan for the year requires making many assumptions that may not pan out.

    “You have to make actuarial assumptions,” says Abdel-khalik. “You make assumptions about expected future raises in compensation of the employees. You estimate projected investment income from the pension fund. And, using an estimate of cost of capital, you estimate the future obligations in terms of current dollars. When you report the numbers, people think it’s the truth. But the truth is contingent on the realization of the related assumptions. If, for example, pension fund investments fail to perform at the assumed level, then the cost being charged would be understated.”

    Accounts receivable and loans are another case in point. “Accounts receivable come from selling on credit to other people. The number on the balance sheet for accounts receivable is what’s owed, minus bad debts and estimates of debts that the company thinks might go bad. So the reported number is not a hard number. It’s an estimate or a forecast of what you will collect. There is no such thing as 100 percent certainty in the numbers. The numbers are all estimates involving judgment.”

    Financial statements also may not be a good barometer of trouble to come. For example, companies must report or write off an impairment when they expect the value of an asset to be impaired. This would serve as advanced warning to investors of future difficulties. But the warning may not come as soon as investors might like. “Five years ago, there was no expectation of trouble from sub-prime loans,” says Abdel-khalik. “So there was no reason to expect these assets to be impaired. And so there was no reason, given the available information at that time, to ask for writeoffs or give investors a warning.”

    Still, there are things investors need to do to protect themselves from the myriad risks of the market. “As an investor, you must practice due diligence,” he says. “Due diligence demands, for example, a very careful reading of a section of the annual report called ‘Management Discussion and Analysis.’ A good investor should not skip over this section. It tells you about the investments that a company has made or plans to make. It tells you about the company’s business. It gives information about a company’s product lines. And it includes information that you may not see in the numbers. For example, a company may say that it is going to invest in ethanol plants. The company can’t put that on the balance sheet because it hasn’t happened.”

    Investors must combine the bits of information from financial statements with information they may glean elsewhere, he says. In other words, they shouldn’t depend solely on information from accountants. “Accountants are not prophets,” says Abdel-khalik. “They can’t look into a crystal ball and tell you what’s going to happen. So it’s up to the investor to get more information on the management, the nature of the company’s business, the company’s business strategy, and its position in the marketplace, for example. Financial statements give you only a piece of what you need in order to answer these questions. So you need to do a lot of work.”

    Mark Peecher: Taking A Very Big View Of The Financial World



    Over the years, a new way of thinking about the world has evolved. It’s called systems thinking. As the name suggests, systems thinking takes the bigpicture view of things. The business and financial system is particularly complex because it is global. Far-flung events can send shock waves around the world. So systems thinkers try to head off trouble by thinking big.

    Systems thinking is not a crystal ball, but it increases your ability to deal with dynamic risks. “Financial markets are hard to predict because many geo-political, technological, and social events impact them,” says Mark Peecher, professor of accountancy. “These events can have global ripple effects because organizations’ operational and financial risks are interwoven.” Thus, a recent headline in the New York Times read: “Why A U.S. Subprime Mortgage Crisis Is Felt Around the World.”

    Standard operating procedure for systems thinkers is to keep an eye open for potential trouble, while recognizing that it’s not always possible to see it coming.

    “The systems thinker tries to anticipate unintended consequences,” says Peecher. An example would be a new drug that treats some malady but also produces unexpected side effects that subject the pharmaceutical company to liability lawsuits.

    Those who practice systems thinking ask many questions: Is this industry going to be impacted by global warming? Is a trade war likely? What happens if there is a revolution in a country where a critical parts supplier is located? And at the same time, systems thinkers have to understand fundamental pieces of the puzzle. “You still need domain expertise to fruitfully apply systems thinking,” says Peecher.

    Even then, there is no silver bullet. “The bad news is that people who think in terms of systems realize that there is a lot more unpredictability than most of us would like,” he says. “Sometimes, you get hit anyway. But the idea is that you take actions to get hit significantly less than others. For example, a systems thinker might limit or entirely avoid investments that others pursue,” Peecher says.

    Systems thinkers also gain an edge when disaster strikes. Because they are vigilant about what can go wrong, they often have given thought to what could be done should the worst case scenario occur.

    While this may sound pessimistic, Peecher observes that: “Systems thinkers aren’t negative. But they do acknowledge weak links. They recognize that actions can have multiple side effects and some can be very damaging.”

    Related Information:

    Perspectives Magazine - Fall 2007 Issue (PDF file)

    Professor Ira Solomon - Faculty Profile

    Professor A. Rashad Abdel-khalik - Faculty Profile

    Professor Mark Peecher - Faculty Profile

    UIUC College of Business Department of Accountancy