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Publicly-traded companies have obligations as regards accurate accounting of their balance sheets, so how do they determine the value of novel types of securities which are often too complex to analyze accurately?

For example, say it's the '80s and someone wants to structure a CDO for the first time. We all know from the financial crisis that nobody really understood how much these things were actually worth. So what legal basis under corporate accounting rules do these companies have to put such a thing on their balance sheets? Are you just allowed to put anything liquid on your balance sheet, with the current market value? If so, what happens with initial offerings of securities when there's no indication yet whether they'll be liquid?

Basically, I'm looking at some of these really complex structured products and wondering what's actually preventing someone from crafting the ultimate impossible-to-analyze twenty-thousand-page instrument and using it to hide their toxic assets.

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Intentional concealments or misstatements of assets and liabilities are punishable under criminal law (e.g., Sarbanes-Oxley), as well as by numerous regulators (e.g., SEC) and professional organizations (e.g., those that credential auditors, accountants, and lawyers).

There's no way around the fact that some assets and liabilities are complex and/or illiquid. For this purpose, in 2006 FASB issued "FAS 157" which has been adopted for U.S. GAAP and which explicitly classifies assets and liabilities using three levels:

  • Level 1 assets can be evaluated based on public and liquid markets.
  • Level 2 assets, though lacking a liquid comparable market, can be priced with reasonable accuracy using commonly-accepted models that reference independent data.
  • Level 3 assets are the really tricky things that can only be priced using "assumptions about assumptions."

GAAP means what it says: Generally Accepted Accounting Principles. Accountants that monkey around and don't follow GAAP are putting their professional credentials in significant peril.

Furthermore, anyone who has lived through the last decade is likely to be very wary of Level 3 assets and liabilities. Since audited financials are used not only by investors but also by lenders and regulators there is usually a real incentive for management and auditors to use Level 1 or Level 2 pricing methodologies whenever possible.

No company enjoys the questions, audits, and general scrutiny that comes with putting anything substantial or unusual in Level 3.

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