AFTER THE FIRE SALE: VALUATION OF BAD PAPER, THE KNOWLEDGE PROBLEM, AND RECURRENCE OF FINANCIAL CRISIS

Abstract

Financial crises often result in government intervention to reallocate “bad paper” to new owners (purchasers), introducing valuation challenges for accountants, auditors, and those relying on their judgments. This paper argues that financial reporting of this reallocation and its subsequent collections is an example of the knowledge problem since the accounting mechanism may distort the purchaser’s relative profitability due to a mismatch of accounting for this “bad paper” for the whole society versus the purchaser. Consequently, market participants who focus on the reported returns of the purchaser will shift their investments into the seemingly (but not actually) more profitable area. The central implication is that limitations in financial accounting foster conditions that are likely to yield a succeeding financial crisis.