Perverse profits from smug accounting

The American financial whiz kids invented Credit Default Swap (CDS), a perverse and deadly default protection insurance policy whose bottom line was picturesquely brought out by an American commentator as practically amounting to one insuring his neighbour's house, and hoping or contriving for it to go up in flames.

Setting flame to one's own house by policyholders so as to make a fast buck is an insurer's nightmare. Small wonder, CDS brought AIG, the American insurance behemoth, on its knees, calling for State bailout at the height of the US financial crisis in 2008, when it blithely sold CDS on bonds emanating out of mortgage loans and the speculators in the derivatives market relentless drove down the bonds in an act of self-fulfilling prophecy.

UNDERVALUING DEBT

The incorrigible US banking and financial community refuses to be tamed. This time round, the five ivy-league banks, Citibank, Morgan Stanley, J.P. Morgan, Goldman Sachs and Bank of America, have hit upon the novel idea of undervaluing their debts on the basis of lower market quotations vis-à-vis the offer price and showing the resultant savings as profits.

To be sure, they would glibly quote the IFRS (International Financial Reporting Standards) when called upon to explain their facile act reminiscent of pulling a rabbit out of hat. The IFRS swears by fair value accounting, which in simple terms means assets and liabilities should not be shown at their transaction value but at current value in what many cognoscenti aver as the end of ‘going concern' concept and institutionalisation of liquidation accounting as the norm in its stead even when liquidation of an enterprise is simply not on cards now or in the foreseeable future.

The erstwhile department of company affairs of India now elevated to Ministry of Company Affairs had rightly opined that there was nothing wrong in revaluing assets as long as they were not treated as being available for distribution as dividend to shareholders till the notional gains were actually realised.

Indian companies, especially those with hoary antiquity often suffered from the revaluation itch so as to command more respect from investors and banks and financial institutions especially when it came to seeking loans. Restating the value of land acquired at Rs 10 lakh whose market value had risen to say Rs 100 crore made perfect sense. But what the department said also made perfect sense, you can't distribute the unrealised profits as dividend, period.

To be sure, a bond is not as dynamic a financial instrument as an equity share given the fact that it begets but a fixed rate of return for its investors, whereas for equity shares sky is the limit for rewards, and therefore its value is not as volatile as share's.

In the bourses, in the event, a bond's value is predominately a function of the interest rate, if the promised rate is more than the prevailing rate on freshly minted bonds with similar maturities, its value appreciates and vice-versa testifying to the inverse relationship between bond prices and the prevailing interest rates.

This happens in normal times. But when a company is rattled by a scam or is otherwise perceived to be financial shaky, the bond prices can register a steep fall as a consequence which is what is happening to the bonds of the beleaguered banks. It is patently unethical for a company to take credit for profits accruing out of its own ineptitude.

PROFIT OR NOT?

What the department of company affairs said with regard to Indian companies holds a larger implicit and unstated lesson to the world, notional gains from devaluation of liabilities to outsiders cannot be perversely booked as profits. Indeed they can be booked as profits if the company buys its own debts from the market at a discount to the issue price.

This they dare not do for the fear of ending up bolstering the sagging quotations thanks to the demand push factor.

There are reports that the beleaguered European banks are all set to emulate their American cousins. One hopes authorities everywhere wake up to this potentially devastating accounting jugglery that would further erode people's faith in accounts. Fair value accounting cannot be an alibi to overstate profits.

A unilateral, premature act of toning down the liabilities to the outside world with glee can never make a conservative accountant proud.

Indeed the International Accounting Standards Board seems to have gone overboard in dumping the time-honoured concept of going concern accounting and with it the dyed-in-the-wool accountant's calling card, prudence and conservatism, when it showed excessive zeal for fair value accounting.

They demand that while all anticipated losses are scrupulously provided for, no anticipated profit is taken credit for unless it has actually been realised either in cash or in the form of a firm commitment as a receivable.

(The author is a Delhi-based chartered accountant.)

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