Final answer:
Book value accounting includes expected loan defaults in annual expenses to account for credit risk, factoring in the potential decrease in loan portfolio value which affects a bank's net worth.
Step-by-step explanation:
Book value accounting recognizes the adverse effects of credit risk by factoring in the possibility that some borrowers may default on their loans. This is calculated into the bank's annual expenses as a provision for loan losses, showing that the value of the bank's loan portfolio on its balance sheet includes assumed risk. If the actual defaults exceed the expected amount, this can lead to a decline in the value of the bank's assets, as seen when unexpected defaults caused the Safe and Secure Bank's loan values to drop from $5 million to $3 million, resulting in the bank having a negative net worth. Such a scenario would impact the bank unfavorably, especially in adverse economic conditions like a recession.