Thanks to a relatively new accounting rule, firms like Morgan Stanley, Lehman Brothers and Goldman Sachs last quarter booked hundreds of millions of dollars in gains based on worsening perceptions of their own creditworthiness.
How does that work? If the market decides a company is a bigger credit risk and starts demanding fatter risk premiums to buy its debt, the value of its existing debt falls. Under a rule being phased in throughout corporate America known as Financial Accounting Statement No. 159, that same logic applies to a company’s own debt. Companies that mark their liabilities to a market price, as Wall Street usually does, thus record as revenue a drop in the value of their own debt obligations.
In essence, they make money because they owe less.
Accounting experts said the exercise is perfectly legitimate, particularly if firms that mark liabilities to market do the same with their assets. At the same time, it highlights one of the ironies of so-called fair value accounting. “If you have a liability that declines in value because your credit worsens, you have a gain,” said Stephen Ryan, associate professor of accounting at New York University’s Stern School of Business.
But Moody’s Investors Service said buyers should beware of gains booked when brokers mark down their own debt liabilities. “Moody’s does not consider such gains to be high-quality, core earnings,” it said in a report issued Friday.
A misleading obsession with share prices
Ignore the wisdom of accounting at your own risk;
It was - rather surprisingly - Goethe who declared that double entry bookkeeping was the loveliest invention of the human mind. I doubt if the great German intellectual was thinking of his country's trading relationships with the US or the fiscal policy of the newly founded American republic. But double-entry bookkeeping is the key to understanding when deficits matter and when they do not.
The double-entry principle is that whenever there is a debt there is a credit. If there is a deficit, there is a corresponding surplus in the same column of someone else's books, and a corresponding surplus in a different column of your own books. America's trade deficit is, necessarily, a trade surplus for the rest of the world. The deficit that attracts attention is a deficit on current account: Americans buying more goods than they sell. There is therefore a matching surplus on capital account: the corollary of the current account deficit is that the rest of the world buys more dollar assets than it sells. These principles are as relevant to the public sector as to the books of private companies.
A good system of management accounts defines its categories so that deficits signal when management action is required. If a shop makes a profit on men's clothing and a loss on women's clothing, it needs to do something about the women's clothing division. But accounting expertise requires business judgment. An airline may lose money on its short-haul routes and make profits on long-haul operations, but only by understanding the business will you learn whether this is bad management or good strategy. Whether deficits matter depends on the context.
Three distinctions are particularly important to national accounts - those between capital and income items, those between public and private activities and those between domestic and foreign transactions. The capital-income balance indicates whether you are building for the future, the private-public balance spells out the implications for future levels of taxation and the domestic-foreign balance is a guide to the future course of your currency.
Auditors need to escape the Prisoner's Dilemma
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