Homer & Friends on Lehman Brothers and Accounting Rules v Principles – Part 2

Our panel – Homer Simpson, Henry David Thoreau and Gordon Gekko – continues its discussion of Lehman Brothers and Accounting Rules vs Principles:

Thoreau – If the only purpose was to hide the extent of Lehman's debt, it's still a gimmick,, in fact it's worse because it makes no sense to sell a $105 security for $100 – even if Lehman did get it back at the same discount less interest.

Gekko – Your a born regulator Henry.  The SEC just sent a letter to the CFO's of twenty-four large financial firms asking for details on repos accounted for as sales, and one of the first questions in the letter is “what is the business purpose”.  A good answer might be, “overcollateralizing lowered my cost of funds and I just followed GAAP on the accounting.”  One not so good answer might be, “we needed to reduce debt to avoid triggering expensive  defaults under covenants in our loan agreements”.  Another not so good answer might be, “we knew the analysts wanted to see less debt, and we followed the rules on the accounting.”  Note that even the not so good answers are, from a narrow perspective, preserving value for the existing shareholders, but doing so at the expense of the creditors and the securities markets.

Homer – How come you know so much about this, suit?

Gekko – In the good old days, before Sarbanes Oxley, before the SEC got a bee in its bonnet about earnings management, before my unfortunate incarceration, I majored in balance sheet manipulation.  As long as you don't go broke, everybody wins – your stock price stays up and your borrowing costs stay down.  Lehman's repos bother me, but not because the “business purpose” was shaky.  Regulators and CPAs have no business second-guessing management on the purpose of a legal transaction.  What bothers me is Lehman did so much of this repo stuff it materially changed the balance sheet, and they kept doing more as they knew they were in a liquidity crisis that would lead to insolvency if they could not find a buyer for the company.

Thoreau -  If the SEC or the auditor wants to address the proper accounting for a transaction, like a repo, is that really none of their business, regardless of how large or small the transaction? 

Gekko – Point taken, but I'm thinking about transactions that meet technical accounting rules, and don't cause any real world problems until the scope gets out of hand.

Thoreau – Forget the technical accounting rules,  Isn't this a matter of principle?  Even the smallest repo should be treated as a loan if the business purpose is to borrow money, especially if the borrower is accepting oddly less favorable terms just to qualify for accounting treatment as a sale.

Gekko – I'm still in the no harm, no foul camp for accounting that follows the rules – but you  have a point- a time honored one.  Tomes have been written on the fundamental accounting issue of rules vs principles.  If you want to see the fullest expression of rules based accounting – look at tax accounting.  Uncles Sam knows the taxpayers will take advantage of broad principles, so he makes a rule for everything then makes another rule every time someone finds a loophole in the first rule.  The tax laws and regulations fill a room.  In a sense, principles have no loopholes, but they rely on the judgement and ethics of the person doing the accounting.  Apparently Uncle Sam has little confidence in taxpayer ethics.  Even if you could count on ethics, a pure “principles” approach might lead to an awful lot of different accounting treatments for the same types of transactions in financial reporting-  no treat for the investor who wants to understand the financials without reading an encyclopedia of footnotes with each report.

Homer – Doh, guys, I'm not getting this whole ethics thing.

Third and Final Part tomorrow.

Photo credit: jm3