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Abstract: This paper shows that banks use accounting discretion to overstate the value of distressed assets. Banks ’ balance sheets overvalue real estate-related assets compared to the market value of these assets, especially during the US mortgage crisis. Share prices of banks with large exposure to mortgage-backed securities also react favorably to recent changes in accounting rules that relax fair-value accounting, and these banks provision less for bad loans. Furthermore, distressed banks use discretion in the classification of mortgage-backed securities to inflate their books. Our results indicate that banks ’ balance sheets offer a distorted view of the financial health of the banks. Key words: bank regulation, accounting standards, fair value accounting, real estat