Monday, July 14, 2008

The Great Disappearing Liability : the mother of all off-balance sheet transactions

Fair value accounting is taking over the entire balance sheet.

First, there was mark-to-market of assets. Its implication is that an adverse movement (decline) in asset prices results in lower income for an operating company, as value written off eats into the current year’s profit.

From CFOs complain that fair value accounting already affects dozens of accounting areas, and the folks who write accounting standards are adding new ones all the time. Major areas affected already include accounting for: pensions, mergers, stock options, environmental liabilities, hedging and derivatives, and uncollected debts. Some of these — for example, the value of the stock in a company's pension portfolio — can have a huge impact on a company's financial results.

Then, if you were a bank, investor, or fund, a decline in asset prices also resulted in lower equity. Hence, the equity side of the balance sheet is also subject to mark-to-market accounting.
Now - liabilities are also being targeted by the FASB, the accounting standards regulating body, as the next item up for mark-to-market treatment. News of the latest controversial discussion is reported in a recent article in titled “How Fair Value Rewards Deadbeats”. You have to read it to believe it.

In the provision, paragraph 15 of standard number 157, the Financial Accounting Standards Board’s controversial new stricture on fair-value accounting, FASB states that the fair value of a company’s liability must reflect the risk that the company won’t pay it back. Thus, as the risk that companies won’t pay back their debts rises, their reported liabilities actually decrease--and may even provide an earnings boost.


This is just the kind of news that would save the asses of the most highly leveraged firms in today’s credit crunch environment. The more debt these firms have, and the less likely they are able to pay these back, the more they can mark down their liability. And the more they are able to mark down, the greater the boost in income, as this means less implied debt servicing costs for the company.

I have to highlight “implied” though, since for sure, most prudent lenders will have ironclad agreements that make sure a borrower will actually pay back its debt. Thus, many opponents of the proposal say this will not necessarily mean companies who decide to mark down their liability can actually monetize the gain.

Nonetheless, the ability to mark down liability in itself potentially is a huge relief for a company that can foresee itself becoming illiquid, or worse, insolvent, in the future.

The proponents of the idea in the FASB say that any gain the liability side will be offset by the loss on the asset side.

To be sure… when a company’s credit risk rises, its share price is likely to fall accordingly. That suggests why the earnings boost created for some companies by the inclusion of nonperformance risk in fair-valuing liability seems so counterintuitive. But a fuller use of fair value would show that “the loss on assets would certainly outweigh the gain on the liabilities,” Petroni says.


But let me say it again. The ability to mark down liability in itself potentially is a huge relief for a company that can foresee itself becoming illiquid, or worse, insolvent, in the future.

This will be another useful tool in a corporate fraudster’s bag of tricks to lull investors into a false sense of security. I’m pretty sure that there will be many cases when a company will find that reporting a liability write-down or write-off in its notes to financial statements unnecessary as this had already been coupled with a corresponding writedown/write-off on the asset side. In a slightly exaggerated example, if a company decided to write off the billion dollar debt it incurred to fund an acquisition gone wrong, simply writing off the acquisition on the asset side automatically cleanses the balance sheet altogether. It would be as if the disastrous acquisition never took place. But guess what happens when the debt reaches maturity. The company still needs to pay back its debt.

Taking advantage of this liability writedown provision may mean a smaller balance sheet for a company. But it also means a healthier debt-equity ratio, and cleaner balance sheet with a “stronger” debt coverage ratio.

This will be the mother of all off-balance sheet transactions! And companies who effect this, ironically, will do so in compliance of best accounting practices.

If this FASB provision ever sees the light of day, we might as well forget about credit risk management techniques as we know them.

Update: Similar-themed posts here and here.

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