Profiting from the dismal fortunes of your own credit has hit headlines in recent months, with Citi booking a $30m gain from the accounting rule in its otherwise lacklustre first-quarter results.
Put simply, current international IFRS and US GAAP accounting rules allow companies to account for financial liabilities at fair value — the estimated current market price — and to recognise the difference between that value and the carrying value of the liabilities as either gains or losses in their accounts. When it comes to the company’s own debt, when its credit profile deteriorates for whatever reason, the company can book a profit. If it improves, they can book a loss.
It’s the ‘own credit catch-22′, so to speak.
This has provoked something of an outcry from certain investors, primarily because the associated accounting gains/losses seem rather counter-intuitive when compared with what’s happening to the company’s own credit. Some investors argue that gains should come about from improvements in a company’s financial position — not deterioration. Posting gains from a bad situation is not only counter-intuitive then, but potentially misleading. The reverse is also true. When a company’s credit profile improves, they can book an own credit loss. That’s not exactly likely to be a fair development in the eyes of some investors.
The whole accounting kerfuffle is now getting some attention from the International Accounting Standards Board — with interesting potential read-throughs for the Board’s current consultation on fair value accounting in general.
From an IASB press release issued last week.
The International Accounting Standards Board (IASB) today published for public comment a discussion paper on the role of credit risk in liability measurement. The paper is accompanied by a staff paper that describes the most common arguments for and against including credit risk in measuring liabilities. . . .
The discussion paper responds to this concern. The issue of ‘own credit risk’ has relevance to other IASB projects, in particular in the accounting for financial instruments, insurance, fair value measurement and provisions, contingent liabilities and contingent assets.
The staff paper is open for comment until 1 September 2009 and can be accessed free of charge on eIFRS or on the ‘Open for comment’ section on the IASB’s website www.iasb.org.
Commenting on the publication Sir David Tweedie, Chairman of the IASB, said:
“We are aware that the practice of booking profits or losses resulting from changes in the fair value of ‘own credit risk’ has been identified as one of the major issues in fair value accounting. Responses to this consultation will assist the Board in further developing its comprehensive response to the financial crisis.”
The paper itself is a great round-up of the arguments for and against fair value accounting on own credit, with good hypothetical examples of each. They range from the counter-intuitive angle mentioned above, to more salient accounting issues such as the rule’s potential to increase the mismatch between assets and liabilities. On the for side, there’s the not-insignificant issue of consistency, amongst other things.
We would add one more thing to the ‘for’ side. Unlike regulatory capital requirements and mark-to-market accounting on other financial instruments, the own credit fair value rule is impressively counter-cyclical. When banks tend to be doing badly they book gains that can provide significant boosts to shareholder equity — à la Citi‘s Q1. When they’re doing relatively well, they take a hit, like Morgan Stanley in the same period. The downside of course, is that this is all basically an accounting gimmick – the own credit gains are something the companies will probably never actually realise.*
In any case, this is definitely one to watch in relation to banking earnings, but also in relation to the IASB’s general stance on mark-to-market accounting issues, as it sets forth on its overhaul of fair value rules.
* Assuming of course, they don’t rush in when their own credit is crummy and buy back all their debt. That’s a neat trick if you can pull it off, but one that assumes that the companies have bundles of cash to spare precisely when the market is worrying about their ability to repay their own debt.
Related links:
Banks face threat to debt valuations – FT
Profiting from your own crummy creditworthiness, redux – FT Alphaville
Banking credit catch-22 in action? – FT Alphaville
CVAs or ‘the magic of your own credit profits’ – Holding to account