Rescue Plan Relies on Accounting Finesse

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3 Responses

  1. A.J. Sutter says:

    Thanks for your post. I’m a little confused by something in the WSJ report; maybe you can set me straight. WSJ says, “However, the $700 billion rescue legislation passed by Congress requires that the warrants be treated as a liability on their balance sheets.” I did a word search on ‘warrant’ and ‘liability’ in the enrolled version of the Act, and couldn’t find any such express requirement. Is it buried away somewhere subtle?

    If so, then how could SEC unilaterally decide to ignore something that Congress has passed?

    As for finessing accounting rules, isn’t that generally what asset-backed securities, and derivatives generally, are all about? To do off the balance sheet what would look bad were it on?

  2. Lawrence Cunningham says:


    Thanks for the comments.

    Nor can I find where the statute requires government investee banks to treat warrants as liabilities on their balance sheet. In fact, Section 113 suggests the opposite: it uses the phrase “warrant or other equity security” and repeatedly juxtaposes warrants against debt instruments.

    But GAAP may require treating warrants as debt. Usually, GAAP treats freestanding warrants as equity. But when terms unconditionally require settling them by transferring assets, GAAP (in SFAS 150), and SEC interpretations, treat them as debt, at least in part.

    The SEC has plenary statutory authority to set accounting standards. Its letter to Treasury, in the style of a no action letter, probably is within its power.

    But suppose the statute really directs that warrants be treated as debt, or that the statute could plausibly be so read. An interesting question of agency interpretation of statutes appears. Expert colleagues tell me this subject has received surprisingly limited scholarly (or judicial) attention.

    One approach, courtesy of my colleague Jon Siegel, would give deference to agency interpretations consistent with the “field specific principles” the agency applies in its regulatory activities. Alternatively, given exigencies of this statute and Treasury’s policy switch after enactment (from buying assets to making investments), perhaps the SEC’s functional no action letter deserves no rebuke.

    I’m not sure that asset backed securities and derivatives are all about finessing accounting rules. For ABS, there are substantive economic reasons to transfer assets for immediate cash that costs less than other financing sources and for derivatives there are substantive economic gains from hedging. It is true that deal and instrument design must contend with accounting constraints (and other constraints) and the result can be accounting finesse.

    And, to be sure, accounting finesse rarely is good practice; it is hard to see how it could be good policy.

  3. A.J. Sutter says:

    Thanks for your reply. BTW, from a business perspective, the off-balance sheet nature of these instruments is a *big* part of their appeal, not just an incidental feature.