Posted by: David Henry on May 19
Aside from however much the government’s stress tests say about individual banks, they point to failures in the accounting rules that investors and the financial system rely on. The flaws become obvious once you start asking what is in so-called “Tier 1” capital, the notion of net worth that was the starting point for the tests. The Tier 1 numbers are figured under bank regulatory accounting rules and are different from the net worth numbers produced according to generally accepted accounting principles (GAAP), the rule system used in earnings and balance sheet statements for investors.
Both systems are sanctioned by law. The disagreements between them are a reminder that accounting truth is an ideal, not reality. The reality is that there’s enough room for argument about how accounting is done for people, and political institutions, to spin numbers to toward their liking much the way they spin words. Numbers, of course, have an advantage over words in that they look precise, deceptively so. And, there’s a more specific lesson from the two accounting systems: When you see a headline about a new hit, or a new boost, to bank capital, you’ll know the newsworthiness of the article depends on whether it matters to regulatory accounting or GAAP, or both. (Hopefully, the significance will be spelled out in the story under the headline, but that’s frequently not the case.)
What flaws are in the two systems? We’ll answer with an example, Citigroup, whose 10-K is here. At the Dec. 31 starting point for its stress test, regulatory accounting said Citi’s net worth was $118.8 billion vs. GAAP’s tally of $141.6 billion (Tier 1 on page 95 vs. total equity on page 117). That’s a $23 billion of difference in value to Citi’s stockholders, and a huge difference in lending power to the economy—something upwards of $180 billion, assuming eight-to-one leverage.
Neither net worth number is right. Both tallies include steps that defy common sense. The stock market said both counts were wrong by at least $25 billion when Citi announced its year-end results on Jan. 16. But the stock market didn’t seem trustworthy either. It had cut Citi’s share price in half the two prior weeks. The only clear bottom line is this: You can’t trust GAAP, you can’t trust the regulatory accounting, and you can’t be sure of what the fickle market is telling you.
To see how the truth can be so elusive, look first at what goes into the GAAP numbers for Citi’s net worth. That $141 billion number counts $38 billion of intangible asset, including $27.1 billion of so-called “goodwill,” which is more-or-less the extra amount Citi paid for acquisitions over the estimate real value of what it bought. Also in the count is an estimated $23.5 billion worth of unused offsets to taxes. The bank regulators know better than to allows these to count as real capital.
But the regulators’ count of $118 billion of Tier 1 capital has its own flaws. It excuses $9.6 billion of losses on securities available for sale, plus $5.2 billion in losses on certain hedges and another $2.6 billion in pension liabilities. GAAP, logically, counts nearly all of these against net worth. Of course, the inadequacy of regulators’ rules were proven by the fact that the financial crisis happened before they put the banks through the stress tests.
The reason for these flaws is that both accounting systems have been undermined by politics and industry lobbying. In essence, their genetic codes have been corrupted by pressure for leeway to spin the numbers and make the banks look better. For a flavor of the kind of compromises that take place, look at how the Financial Accounting Standards Board, the keepers of GAAP, went down on one knee in its stand on counting declines in value against net worth. While FASB had GAAP subtract many of those declines from net worth, it did not require that the losses reduce earnings per share. Instead, GAAP sends the losses to a kind of purgatory called “other comprehensive income,” which appears as a note embedded in the balance sheet. There the losses factor into net worth but not into earnings. It is hard to believe it until you’ve seen it, but it is true: GAAP has an income statement that’s not in the income statement.
“FASB invented the comprehensive income statement in a political move to get business enterprises to do some accounting for items they didn’t want to disclose,” writes J. Edward Ketz, associate professor of accounting at Penn State’s Smeal College of Business. “Comprehensive income includes relevant items that have had a real impact on the business,” Ketz points out. He has made a specialty of finding relevant numbers GAAP obscures.
A few years ago Ketz wrote a textbook called “Hidden Financial Risk: Understanding Off-balance Sheet Accounting.” There’s something similar to his title going on here. “Other comprehensive income” is essentially an off-income-statement place for losses. You can remember it as an offspring of the same kind of liaisons that gave birth to off-balance sheet accounting. No wonder regulators struggle for respect.
BusinessWeek's Adrienne Carter, Jessica Silver-Greenberg, and David Henry deconstruct the mysteries of high finance, Wall Street, and hedge funds for pros and ordinary investors. E-mail them directly if you've got tips about big deals, a hedge fund, or even securities industry gossip.