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?