Do Not Buy... into New Accounting Rules

Because of relevance to my probable future career and potential to impact the stock markets, I am directing attention to Mark Sunshine's article "M2M Accounting Still out of Control" at Seeking Alpha.

The author describes how new accounting rules skew results for financial companies in unrealistic ways. He writes:

As an example, if a fictitious company called “Sunshine Inc.” were to borrow $100 in the public debt markets and the trading price of this debt were to decline to $80 then Sunshine Inc. would recognize a $20 gain on its liabilities as if it had repurchased them in the market. It doesn’t make a difference if Sunshine Inc. actually has the cash or intent to retire its liabilities, merely its debt trading at $80 is enough to trigger a gain.

That is what Citigroup did in the first quarter. Its liabilities traded at a discount and it recognized a gain of about $2.5 billion in a quarter when, on a consolidated basis, the whole company earned about $1.5 billion. That means, without the make believe of fair value accounting, Citigroup lost a lot of money in the first quarter.

On the other hand, if the debts of Sunshine Inc. were to magically trade up in the market then Sunshine Inc. would record a hit to earnings. And, that is what happened to Morgan Stanley; they previous recognized valuation allowances on its liabilities and, much to its surprise, the trading price of its debt went up. As a result, Morgan Stanley’s first quarter earnings were trashed when it recognized a $1.5 billion hit to revenue. Because of fair value accounting Morgan Stanley reported a loss of $177 million for the first quarter.

He then cites another rule (which despite his degree, professional and academic experience in accounting, cannot understand) which would extend similar valuation methods to traditional industries.

There is no clear "Do Not Buy Security ___" in this article, rather, it is a look into the growing complexity of corporate earnings because of changing rules and regulations. The Citi and Morgan Stanley example is a perfect one - it shows how these new rules affect results in illogical ways. (Yes, some companies may buy back some debt when the price is attractive, but marking that value to market each quarter for companies like C and MS is unrealistic.) The charges or gains from this accounting may only end up as a footnote on some companies' financial statements, but it may add to uncertainty and volitility as companies report earnings. Analysts and investors will have to start looking at the changes in debt valuations over the previous quarter to figure out whether companies will book a gain or take a hit.

There is one plus to the growing complexity of corporate accounting - it should mean more jobs for freshly-minted accountants (like me, in 2011), which is something that I cannot complain about.