Accounting Issues: Part V

To our earlier discussions in this blog of the various items on a balance sheet we must add this: many important liabilities and assets – important, that is, for the future of the company – never get on the balance sheet at all. The rules governing what may be kept “off book” generated a good deal of controversy associated with the demise of Enron at the turn of the millennium.

Enron, you may remember, created special purpose entities (SPEs) and supplied these off-book entities with Enron stock. Then it dealt with those entities in ways that spruced up its own books. 

The SPEs could be kept off book, under then extant rules, so long as 3 percent of their equity belonged to someone who was neither Enron nor an Enron “related entity.” The 3 percent figure may seem modest under the circumstances. But the point of it was that someone else had to be willing to put their own investment at risk. Indeed, as a matter of corporate law throughout the English speaking world, a defining feature of an owner of corporate equity is its role as the bearer of “residual risk.”

The ways in which Enron satisfied that 3 percent requirement to establish the reality of its corporate puppets were sometimes risible. The well-suited executives reasoned for example that since Texas laws don’t recognize homosexual relationships, the gay life partner of an Enron executive isn’t an Enron “related party,” and can contribute the 3 percent.

Less amusing but more important: Enron sometimes entered into explicit side agreements with the parties who contributed that 3 percent in which it assured them that it would make good on any losses. So – recalling that the bearing of residual risk is a defining feature of equity – this required 3 percent of non-related-party equity wasn’t really equity at all.

In early November 2001, Thomas Bauer, a partner with Arthur Andersen, confronted Richard Causey, Enron’s chief accounting officer, about certain of the related-party transactions, especially one involving an SPE called Chewco.  “How were you able to conclude that Chewco is valid, given the impact of the side letter?” Bauer asked.

Causey answered, “What side letter?”

There was, indeed, a side letter to the Chewco deal. Bauer showed it to Ben Glisan, Enron’s treasurer. Glisan put the document down on the surface of a conference-room table, closed his eyes, and said, “We’re toast.”

And with that bit of drama we might fittingly end our discussion of balance sheets and move on to income statements. We might, but we won’t. There’s one more bit of business. We have to relate that the balance sheets of financial institutions (especially banks) have a peculiar mirror-image quality to them, when compared to the balance sheets of the sort of companies we’ve discussed so far, (“operational companies” if you will), the sort of companies that make widgets, or conveyor belts, or own pipelines and power plants.

It is still the case, for banks as for operational companies, that A = L + Eq. And it is still the case that the balance sheet is designed accordingly, with assets on the left and liabilities on the right. BUT the A and the L have counter-intuitive significance.

For banks, the chief asset consists of loans to customers; the chief liability consists of deposits from customers. Intuitively, you might expect that to work the other way around. Having assets is a good thing, right? And for a bank to attract depositors’ money into its vaults is a good thing, right? So … why should that money not count as an asset?

The answer is that the customers’ money is due to that same customer on demand. Having an account for John Jones in the amount of $100 is indistinguishable in point of legal obligation from having borrowed $100 from John Jones for 30 days … 30 days ago. In either case, you can hold on to the money so long as he doesn’t ask for it back, and you must pay Jones as soon as he does.

Another crucial point: banks and other financial companies are much more likely than are operating companies such as widget retailers to hold assets that may have to be assigned a negative value, so-called toxic assets.  You might think that once an asset (say, a trading position) becomes of negative value it becomes by definition a liability and goes to the right side of the balance sheet. Logical as that is, convention and convenience keep some assets on their left with, but give them a minus sign there.

Interest-rate swaps are an example. These are contracts that entitle one party to a fixed stream of cash payments and the other party to a variable stream (in practice, of course, they net out payments as they come due.) The size of the variable steam will depend upon some reference rate, such as the London Interbank Offered Rate. So one party is betting that LIBOR will be, at least most of the time, higher than the agreed upon fixed rate, the other party is betting the other way.  

Suppose a bank in Cyprus holds one side of an interest rate swap, while a bank in London holds the other. Logic tells us that the value of the two positions together must net out to zero. Since the significance of the positions consists entirely of payments they do or will owe each other, any gain for one is a loss for the other.

But of course they’ll both hold their position on their balance sheet, as an asset. Further, it seems likely that when the deal is made both regard their position as an asset of positive value, although in time one or the other may have to mark their side of it down into the negatives.

In the context of the Cyprus banking crisis of early 2013, a witticism made its way around the econoblogosphere that purported to explain the problem. “On the right, nothing left. On the left, nothing’s right.”

[I agree, that sounds a bit nerdy as witticisms go, but you’ve been reading several consecutive pages about accounting already so you’re hardly in a position to throw the first stone.] 

You’re now in a position to understand the joke, if not necessarily to guffaw. On the right, on the liabilities section of their balance sheet, the Cypriot banks didn’t have anything left, their depositors were fleeing. On the left, their assets, the holdings they had made by investing when they had had depositors, nothing was right: those positions had become significantly eroded because of the troubles in the other nations of the Eurozone.