I published Hidden Financial Risk: Understanding Off-Balance Sheet Accounting in 2003.  The book was written in response to the collapse of Enron and dozens of other corporations and over 1,000 restatements of financial reports.  I discussed the accounting shenanigans of our day and I dissected the causes behind these scandals and put forward a number of ideas on how to correct the system.  As policy makers ignored my ideas, I was sure that such financial catastrophes would repeat.

Four chapters, in particular, dealt with the problem of off-balance sheet accounting.  Firms have become less transparent in recent days, despite public rhetoric to the contrary.  I investigated how business enterprises hide their debt with the equity method, with lease accounting, with pension accounting, and with special purpose entities.  Make no mistake about it—corporate managers collectively have been concealing hundreds of billions if not trillions of dollars.

Debt matters.  Managers can magnify returns to shareholders as they add debt to the financial structure and obtain good returns on corporate assets, but managers also can magnify losses when returns on assets become less than the cost of debt.  Because of this double-edged sword, investors and creditors scrutinize the financial leverage of any institution.  When the debt-to-equity gets too high, investors increase the cost of capital to protect themselves.  Managers frequently counter that move by not reporting the liabilities of the business enterprise.  Investors must understand these tricks if they don’t want to lose half their wealth in a matter of a couple of weeks.

Chapter six of my book explains “How to Hide Debt with Special Purpose Entities.”  Structured finance, securitizations, and derivatives strike at the heart of financial accounting inasmuch as bookkeeping methods are not designed to capture their effects in a timely and informative manner.  Fair value accounting for the assets and liabilities helps, despite the protests of bank executives, along with full and complete consolidation.  However, even these treatments prove ineffective when a contingent risk deemed of very small probability explodes on the scene one day.  That is why disclosure plays a critical role with respect to these activities.  Too bad corporate executives don’t provide much meaningful disclosure these days, especially with respect to securitizations and derivatives.

Yes, the collapse of the real estate market and the massive defaults in the system are behind the current economic fiasco.  But, the obscurity of financial reports of banks is also to blame.  If they had revealed the riskiness of their securitizations and their financial derivatives, maybe investors would have been more wary.  But Congress and banking regulators have a vested interest in your not knowing the truth, and so they assist corporations in hiding the toxic nature of the banks themselves.  Investors must protect themselves from these accounting games that hide hundreds and hundreds of billions of dollars in debts.

So far in 2008, my portfolio is in the plus column, just as it was in 2001 when I dumped equities about six months before Enron’s stock headed south.  I was well aware of the hidden financial risks on Wall Street then.  And I am well aware of those risks today.

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.