Missing the Point

Everyone\’s favourite accountant, Richard Murphy, is at it again. Not seeing the wood for the trees.

Now suppose you have debt of $2 billion on your balance sheet, but your rating goes down because it is perceived that you are a risker organisation. The price people will now pay for your debt (and remember, debt is traded) has fallen. Let’s suppose the fall is 5%. That reduces the value of your debt to $1.9 billion. In accounting terms under IFRS this has to be reflected in your balance sheet. The fair value of a liability (what you owe) has fallen. Liabilities are credits on your balance sheet. So you debit your liability account with $100 million. This cuts the value of the debt.

But now you have the job of ‘losing’ the credit in your accounts because in accountancy there is an immutable rule that for every debit there must be a credit. You can’t, of course, put it back on the balance sheet. You’ve just taken it off that. And it’s not cash so it can’t appear in the cash flow. And nor is it a reserves movement because it is a result of current activity. So there’s only one place left to put it, which is in the profit and loss account.

There’s one problem though. On the balance sheet this credit represented a sum owing to someone else. It was a debt. By and large debt is seen as a negative in accounting even though it is a credit because it owed. In the profit and loss account though credits are quite different. Credits are good things in the profit and loss account. They are sales or cost reductions. And that’s exactly how this credit of $100 million behaves when it hits the profit and loss account. It goes straight to the bottom line and increases the profit for the period.

Now, yes, it does indeed seem a little odd, that a deteriorating credit rating should lead to an increase in profits. But that is in fact what has actually happened, isn\’t it? You really have made a profit if you sell something for $1 and buy it back for 90 cents.

But even if that isn\’t enough, look at what\’s happening over on the other side, to those who have bought that debt. They are also marking it to market. And they really have made a loss: what they bought for $1 is now worth 90 cents. Now that number really does have to go into their P&L doesn\’t it? Most especially if they\’re, umm, a bank that trades debt instruments. Sauces for geese and ganders sort of thing.

So, if those who make a loss have to report it, how can those who profit not have to?





8 comments on “Missing the Point

  1. Richard Murphy is a prime purveyor of twaddle.

    The debtor company stills owes €2bn, and that is the end of that. It does not have to book the $100m as a profit, unless it is really cunning and buys back its own debt for less than face value.

    I am surprised that you fell for this.

  2. Under IAS39 debt, unless the fair value option has been taken, is not valued at fair value only amortised cost. Therefore, the fall in market/fair value is irrelevant to the balance sheet and income statement of the issuing company. The fall in fair value would be disclosed in the footnotes though but who looks at those?

    The company holding the paper may, depending upon the IAS39 classification status it ascribes to the asset, value the paper at fair value so booking the loss. The accounting falls directly from how the holding company views the asset, trading or non-trading.

    As Mark states the issuing company still has to stump the cash in any event.

  3. Mark Wadsworth is right. The change in the market value of the debt doesn’t affect the liabilities of the debtor. They still must make the same payments, on the same schedule.

  4. Matthew, if the WSJ says that there is a new rule in the US that you can do this, then I would take it at face value.

    But a) it is a new rule and b) it is in the US, not IAS or UK GAAP and c) even if these people book a profit now, they still have to pay back the same amount (unless they redeem their own debt, but I have covered that above) so in future years, that discount they book now as a profit will turn into losses in the period to redemption.

  5. It would help if you lot did your research.

    And looked at the accounts of Lehman and Goldman Sachs in the last quarter where this has happened.

    And realised this is exactly what is required by International Financial Reporting Standards in Europe as well

    Because this certainly is twaddle, but it’s also what’s happening

    So why shoot the messenger? Why not look at the message?

    Tim adds: Richard: my major point is that we want the buyers of bonds, if they’ve made a loss on said bonds, to refelct that fact in their P&L, don’t we? We want banks and others to mark their holdings to market, yes?

    If that’s so, then we want the issuers to do so too, don’t we?

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