Accounting For (Or By?) Idiots

Once in a while you just have to love those accountants. Their image of sober, almost stodgy, propriety and fiscal conservatism belies a wild and radical side most of us simply don’t appreciate.

When I was a student at undergraduate school those of us who were not on the mainstream track towards post-graduate economics all took the more simple course offerings in the subject. The simplest being dubbed by the hard core economists amongst us as ‘Economics for Idiots’. As a proud ‘idiot’ – my major was political theory, philosophy, and diplomatic history – I realized I had no hope in the business world unless I was qualified in something sensible, so I became an accountant.

So this out burst of affection for the accounting profession is heartfelt.

Well sort of.

I owe Paul Krugman and the Financial Times for pointing out the following story:

Those first quarter profits that our banks seem to be wallowing in reveal more about the tenacity and imagination of their accountants than they do about banking conditions. I have already decried the trickery embedded in Wells Fargo’s minimal loan loss provisions and Goldman Sach’s astonishing sleight of hand were it simply missed a month in its press release – a month of massive loss I might add. Those are simple tricks that anyone can play.

The real wild side of our accounting buddies only comes into focus when we compare the reports of Citicorp and Morgan Stanley.

Sit tight this gets weird.

An odd side effect of an obscure accounting rule for banks is that a drop in the market price of a bank’s debt can be viewed as a source of profit to be booked in an earnings statement. If the decline in market value is connected with an increase in the bank’s credit default swaps spread that is.

At least that’s how I understand it.

I have an image of someone being sent to the far reaches of a dusty book stack to gather the ruling for this one.

Think about that for a moment.

Credit default swap spreads increase because the market thinks you are getting weaker. People don’t want to hold your debt, it is getting riskier, so the price of that debt drops. And … you earn a profit on the difference in that debt one quarter to the next!

So as you sink into insolvency you appear more profitable. Conversely as you fight your way heroically away from near death, you appear to lose more money.

I hope that’s clear.

The worse you are, the more profitable you get. The healthier you get, the less money you make.

Only an accountant could defend that one.

I realize that in accounting speak it all makes perfect sense. But really … did they seriously intend this to be the result of whatever ruling the banks are using?

So back to the, kind of, real world: of Citibank’s first quarter ‘earnings’, $2.5 was due to the widening of its credit default swap spreads. Conversely, poor old Morgan Stanley, who reported a loss in the first quarter, would have reported a profit had it not been for a dramatic narrowing of its … you guessed it … credit default swaps spreads.

Did I say ‘back to the real world’?

Gotta love those accountants. They can make a bad bank look good and a good bank look bad. What magicians!

So the best thing we can say about all these first quarter earnings reports is that they provide great entertainment value. They certainly don’t reveal much about the solvency, or the sustainability of the earnings, of our big banks.

There’s only one hard conclusion we can draw: somewhere in the bowels of the accounting rules-setting bunker Lewis Carroll is having fun.