The first part of this article explains what financial institutions have been doing in accounting for their supposed gains in various derivatives. We will be discussing derivatives in Intermed II, start reading.
Essentially the companies are booking profits today, and borrowing to pay bonuses and dividends even though they have not received any cash. This is the same stunt Enron pulled and of course violates the revenue recognition principle. This is so important I am copying the article and pasting it here.
More on CDS and Kabuki on the Potomac
By Bruce Krasting
Very interesting piece on the Kabuki. I think there is another angle to the banks trying to hold their control over CDS. It is accounting.
Simplistic example. You are a bank. You have two customers. Southwest Airlines (NYSE:LUV) and Chevron (NYSE:CVX). SW calls and says, "Lets do a deal. Every 6 months for five years we will swap money based on 1 mm barrels of oil at $60. If the then cash price is less than $60 I pay you. If it is more than $60 you pay me."
You say "fine" and then call Chevron. You enter into the exact opposite of the first swap trade. You make money doing this. You have a matched book. As a result of your purchases and sales you will have $50,000 in profit every six months for the next five years or a total locked in gain of $500,000.
At the end of the day your boss asks, "How did you do today?" You answer, "we made $500,000". He says, "Great. Here is your bonus". If you went to three market makers who did exactly the same as you did on that day the profit and loss results might be significantly different. For example:
– One could report a gain of $500,000. That would be justified. But would overstate the economic results
– Another might just record a gain of $100K (the current year portion that is "locked in"). The balance of the income is realized annually for five years. This would understate income. No one like that.
– Yet another might book just $400K of gains currently. This would represent the NPV of the $500k over the five-year period based on an internal capital rate set by the banks management. This is close to economic reality and is the form that most banks use to value this type of business. While it is the most appropriate and reasonable approach, it too is badly flawed.
The next day your bank announces quarterly earnings and says, "We made $400K. We are paying a dividend based on that and we are paying bonuses based on that. Net-net, retained earnings will go up by $250,000. It was a good quarter"
In this very simple example there is no cash from this profit. The cash will come to you over five years. So you have to borrow to pay the dividend and the bonus and all the other current expenses relating to this profit.
What you have done is 'borrow' retained earnings from future cash flow. You look like you have retained earnings to support your tier one capital ratios. But when there is a real 'cash call' on your equity (2008) you do not have the cash equity to survive. So you have a TARP party.
The OTC reform proposal plan does not give the banks the ability to do this. And that is why they do not like it. This same income recognition issue exists in the OTC swap market for currencies with maturities greater than one year.
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Professor Elam 
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