Consulting Corner

Bad Accounting: Don’t just get mad, get even
by Andrew Davidson

The current accounting paradigm has given importance to certain measures of economic value such as Fair Value, retained earnings and comprehensive income. As a consequence, companies are incented to generate good results measured in these accounting terms. This issue of Pipeline presents a hedging technique that financial institutions can use to help manage their key reporting results.

The primary accounting measure of value is the economic Fair Value of the firm. In general, firms seek to stabilize and increase the Fair Value of the firm in order to maximize the value of the company and to ensure that the company is fit to survive various economic shocks. Firms also seek to maintain the stability of retained earnings and accumulated other comprehensive income (AOCI). Good management of these metrics indicates that the company can control its risks, and limits the potential that the market will interpret adverse accounting results as real economic instability.

For a firm that applies cost based accounting and holds par priced loans that are match funded with its own debt, changes in the economic value of assets and liabilities will not have any impact on Retained Earnings or AOCI. Retained Earnings will change by the amount of net interest income, less expenses. Consequently, companies using cost based accounting for par loans should be concerned primarily with stabilizing their economic value and maintaining stable net interest income. The chart that follows summarizes the reported risk exposure under cost based accounting for a hypothetical firm having $100mm of par loans with a duration of 3 years, that are match funded with debt. The results assume an instantaneous change in rates.

Rates fall 100bp:
($millions)

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