What's the Difference Between Accounting and Fantasy? Not Much

Imagine a world in which the worse a company's credit rating was, the better things looked on the earnings statement. Sound crazy?

Well it may be crazy, but it's also the law.

A controversial clause in Financial Accounting Standards Board regulations is being used by troubled companies to boost earnings. Through a preposterous, but legal, accounting technique, companies are recording a surge in paper profits whenever Wall Street's credit-rating agencies decide things look bleak.

The latest troubled firm to employ this accounting sleight-of-hand maneuver is, remarkably, one of the key players in the entire bond and credit-rating industry! Ambac, the bond insurance company that had its own credit rating lowered earlier this year, saw its profit surge in the most recent quarter because the SEC allows them to report bad news as good news.

It's a complicated and bizarre story. And it would help to have an accounting degree or a well-developed sense of cynicism to understand it. But as CFO magazine reports, Ambac's declining credit rating led to a widening of its credit spreads. That's exactly what you would expect to happen. But under FASB rules, Ambac was able to convert those widening speads into soaring profits -- at least on paper.

So what's the lesson for bond investors? Certainly, this is yet another reason to exercise caution before buying any investment. But there may also be a deeper lesson here. As much of the regulatory world blames the credit-ratings agencies for the credit crisis, it's worth noting that in the often irrational world of finance, the credit-rating agencies are often the only rational players. So if S&P, Moody's and the rest say Ambac is a mess, I'm going to assume Ambac is a mess -- no matter what the earnings statement says.

Want to know more about Ambac and the rest of the bond-insurance market? Here's an explanation of the role the so-called monoline insurers play in the bond industry.