C&B Notes

Accounting Obfuscation: Clouding the Real Economics

We are constantly reminded how critical it is to understand the limitations inherent in financial accounting and the risks that lurk behind the ways individual companies are applying the rules.  It is imperative to look through reported numbers to see what is really going on with the underlying business (important note: conservative accounting policies are a key indicator of good managers).

The Financial Times reports on a particularly opaque outcome of the application of a currently in place (but not well thought out) accounting rule:

“Try this on your credit card company: your creditworthiness has weakened, so you write down the value of what you owe them to reflect the greater risk that you will not pay it all back and credit the difference to your personal income. That is exactly what accounting allows; the five big US banks — Citigroup, Bank of America, JPMorgan, Morgan Stanley and Goldman Sachs — have just reported gains equivalent to more than four-fifths of their quarterly $16bn net profit as a result of falls in the value of their own debt and credit standing.  Now European banks are set to report with the same system.

This is wrong. “Fair valuing” of their own debt and other credit instruments produces fantasy profits that will not be realized.  Why?  Because, in theory at least, banks can buy back that debt for less — regardless of the fact that their weaker position makes it far less likely that they would.”

>> Click here for the full story on Financial Times