That’s it, public company accounting is broken

One of the dirty little secrets — or rather, dirty huge non-secrets — of Wall Street is that public company accounting has been diverging further and further from cash accounting — which is to say, reality — over time.

Over the last several years, a whole series of new laws and rules have larded up income statements and balance sheets with all kinds of fictional, non-cash components to the point that you basically can’t conclude much about any public company financial statement you see, except that you really better read all the fine print.

Our new poster child:

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. [Well, not really. They still have to pay off the debt according to its original terms. Unless they actually buy it back — which they apparently are not required to do, according to this accounting rule — and which, if they actually did buy it back, could move its price right back up to fair value. This situation is thoroughly screwy.]

Accounting experts [here it comes] 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. [Cough.]

FAS 159, which brokers are adopting earlier than most companies, couldn’t have come at a better time for Wall Street. The firms are taking writedowns of billions of dollars to reflect the lower value of leveraged buyout loans and securities backed by mortgages and other assets that are stuck on their books. Concerns about those exposures weighed on perceptions of the big investment banks’ creditworthiness all quarter. The cost of protecting their bonds against default shot up, and the risk premiums on their debt widened as well.

Morgan Stanley said it booked about $390 million, or about 26% of its third-quarter profit, “from the widening of credit spreads on certain long-term debt” that it has issued. It isn’t alone. Goldman Sachs said Thursday it booked a gain of “a little bit under $300 million” because of adjustments in accounting for its structured notes. That’s a sliver of the $2.9 billion of net income it reported in the third quarter, but still helped offset some of its fixed-income and equities losses.

Bear Stearns Cos. added $225 million of equity revenue, “principally reflecting gains in our structured notes portfolio.” Without it, the 83-year-old firm – which boasts on its website that it has never had an unprofitable year — would have registered a third-quarter loss…

I’d just like everyone to whom I owe money to know that you’re never going to get it back. And I plan on booking the dollar value of your outrage as revenue in my current quarter.

From the Wall Street Journal.