Mind the GAAP

Tim Annett has a post on MarketBeat, the WSJ's blog, on a practice that gives new meaning to the term 'creative accounting':

Jed Horowitz explains how an accounting rule helped Wall Steet earnings reports shine a little brighter this week:

Wall Street firms are teaching investors another lesson in alchemy by turning distrust of their creditworthiness into a little gold.

Thanks to a relatively new accounting rule, firms like Morgan Stanley, Lehman Brothers and Goldman Sachs last quarter booked hundreds of millions of dollars in gains based on worsening perceptions of their own creditworthiness.

How does that work? If the market decides a company is a bigger credit risk and starts demanding fatter risk premiums to buy its debt, the value of its existing debt falls. Under a rule being phased in throughout corporate America known as Financial Accounting Statement No. 159, that same logic applies to a company’s own debt. Companies that mark their liabilities to a market price, as Wall Street usually does, thus record as revenue a drop in the value of their own debt obligations.

In essence, they make money because they owe less.