Accounting for Assets, Liabilities, and Capital: One Measure or Fraud

Book: Financial Stability: Fraud, Confidence and the Wealth of Nations by Frederick L. Feldkamp and R. Christopher Whalen
ISBN: 978-1-118-93579-8

Chapter 17 completes the proof trilogy of law, economics, and accounting. Feldkamp and Whalen are clear that accounting is not a standalone science. It reflects conclusions from law, mathematics, and economics. When accounting practice diverges from those fields, practice must change.

Accountants exist to apply one measure consistently. That is their anti-fraud function.

Double Entry as the Guardrail

The double-entry system enforces two balances: assets equal liabilities plus capital, and revenues equal expenses plus earnings. Cash flows and inventories must carry positions accurately from one period to the next.

When transactions are reported in a way that reflects accounting convention but fails to reflect law, math, and economics, the convention loses. Since 1997, accounting standards have required that financial asset transfers be recorded as sales only when assets are presumptively beyond the reach of the transferor and its creditors, even in bankruptcy.

If universally applied, that standard aligns accounting with Supreme Court decisions on true sales and with the theory of financial stability.

The 1983 Mistake

From 1983 to 1997, the rules were different and worse. Accounting depended on the form of the transaction. Transfers that purported to be sales were recorded as sales. Transfers that purported to be secured borrowings were recorded as debt.

The Uniform Commercial Code made transfers effective regardless of label. Entities could choose pledge form to avoid reporting a loss or sale form to report a gain. Two measures. Bill Seidman called the S&L crisis the biggest mistake in government history. The 2007 crisis beat it by two orders of magnitude.

The 1983 standard was a big mistake because it was based on legal form, not legal result.

The FDIC Safe Harbor

The 1997 standard fixed the logic. Then the FDIC adopted it for banks and discovered a problem: applied literally, it made it nearly impossible for banks to sell financial assets. As receiver, the FDIC can unwind transactions. Banks needed liquidity.

Between 1997 and 2001, the FDIC created a safe harbor allowing bank transfers to be reflected as sales even when the bank retained continuing involvement inconsistent with the Supreme Court’s true sale standard.

That safe harbor is where U.S. banks hid much of the off-balance sheet shadow banking that fueled the 2007 crisis. In 2010 the FDIC ended the rule. Transfers after November 2010 must meet the high legal isolation standards applied to other entities.

What Proper Accounting Looks Like

Feldkamp and Whalen lay out the implications plainly:

• Repurchase agreements should be grossed up on balance sheets
• Participations without complete asset transfers should be secured loans or subordinate borrowings
• Derivative obligations that require payment regardless of asset collection should be grossed up, not netted
• Any transaction using two measures imputes fraud conclusively

Capital standards would need adjustment to avoid double counting, but regulators already handle similar issues with interbank deposits reported gross for financial reporting and netted for reserve requirements.

The 2007 Accounting Hole

In 2007, $30 trillion of U.S. shadow banking generated an equivalent hole in accounting. Investors had no idea which entities held how much unreported debt. The only safe response was to sell every potentially affected investment.

The resulting crash confirmed the theory. To create stability, all netting and off-balance sheet liability reporting must end. Accept that “off-balance sheet” implies fraud and the rest becomes straightforward.

My Take

This chapter made me rethink who the villains were in 2008. Yes, bankers packaged bad mortgages. Yes, ratings agencies slept. But accountants and auditors had a specific job: one measure, fairly stated.

The form-over-substance era from 1983 to 1997, combined with the FDIC safe harbor, gave banks permission to treat secured borrowings as sales. That was not a loophole. Under Brandeis, it was fraud by another name.

The 1997 and 2010 corrections were right in principle. The damage was already baked in. Trillions of securities had been issued under the old rules.

Accounting confirmed the theory of financial stability the hard way. When the books lie, investors eventually repricing everything is not an overreaction. It is the accounting identity catching up.

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