Friday, July 20, 2007

Be Careful

Anyone picking up a newspaper recently has read about the quick turn of events unfolding in the sub-prime market. Two leveraged Bear Stern funds have wiped out all their investors capital, while the ABX index tracking sub-prime loans has fallen sharply and keeps hitting record lows. With every new low the market keeps trying to shrug it off as the new "bottom", yet I believe this is just the beginning of things to come. Here are two things that haven't been mentioned frequently that you should know about.

1. Accounting Tricks
There was a recent change in accounting rules that allows companies to mask investment losses and keep them out of their earnings statements, even though the balance sheet and equity will still be negatively impacted. Well, we are beginning to see the first signs of companies using this policy. In my opinion, investors should look unfavorably on any company that tries to hide their true results using an accounting rule which makes no sense. But this isn't the first accounting rule that has seemed illogical.. remember the time when options didn't need to be treated as an expense?

2. Inverted Yield Curves
We've all heard about the recent inverted yield curve in the United States and its usual indication of recession. Well, what you might not have known is that it is a common phenomenon worldwide. A look at the Economist's interest rate statistics shows that 13 other countries (of the ones listed) currently have inverted yield curves, also.

So, in short, be careful.


highlowbrow said...

I reached some different conculsions about Cadence and their earnings restatement. The issue is the company, not the accounting rules. The accounting rules are fine.

The crux of the issue is that firms hold securities for various purposes. A trading desk's p&l is a mark to market of it's securities. Should a life insurer that buys a bond ladder to offset an annuity record changes to the bond prices as a profit or loss?

I think that it is helpful to keep in mind that earnings are an opinion. In the case of Cadence, it seems helpful to ask whether the securities in question are "for sale" or "for trading", and then decide how to take their opinion of earnings.

Nnejad said...

SFAS 159 in principle, is not a bad idea. "FAS 159 allows entities to account for most financial instruments at fair value rather than under other applicable generally accepted accounting principles (GAAP), such as historical cost. The accounting results in the instrument being marked to fair value every reporting period with the gain/loss from a change in fair value recorded in the income statement. This accounting treatment is an election made by the entity, on an instrument-by-instrument basis, when the financial instrument first becomes eligible for the election."

So essentially, the new accounting rule gave the choice: a company could mark to fair value a security and then subsequently record fluctuations in fair value in the income statement, or it could keep the security at historical cost.

The problem is, some securities were taking advantage of the new rule to do something that was unintended. Basically, the companies could shift securities that were at a loss to trading, sell the securities, and avoid it showing up on the income statement Then, the proceeds could be reinvested and the realized loss would never be noticed unless someone paid close attention to the balance sheet. The link at the bottom is very good at explaining the entire problem. Anyways, because most people don't pay that close attention to the balance sheet or footnotes, it is unknown how many companies snuck this through their financials. The SEC and Accounting Board are starting to look into it, and so you are starting to see some companies such as Cadence come out and rescind their application of the rule. So in the end, yes the accounting rule is fine, but it had certain loopholes that led to abuse. We will see soon how many companies tried to pull this off.

Nnejad said...
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Nnejad said...