Former hedge fund manager Shah Gilani says corporate assets can be accounted for in multiple ways, at the discretion of management. And this makes comparative analysis nearly impossible. Shah says understanding these tricks is crucial to finding out the true state of any bank’s finances.

More from Shah in Money Morning:

Who says accounting can’t be fun? When it comes to determining capital adequacy and the solvency of banks and investment banks gutted by this historic capital markets credit crisis, accounting cards are magically being shuffled to manifest the illusion of repaired balance sheets – and sometimes even profits.

On the dark side, these few seemingly simple tricks are actually masking the thick red ink of buried losses.

The props in this “hocus-pocus accounting show” determine how assets are accounted for. In fact, there are three “accounting boxes” into which assets are placed. Let’s take a close look at each of the three:

• The first accounting box is labeled Held-to-Maturity: Assets that are held-to-maturity are accounted for on the balance sheet at cost. That’s good and bad, but at least it’s transparent. If an asset has appreciated, it doesn’t show, nor does its depreciation change the balance sheet or hit the profit-and-loss (P&L) statement. The generally good news is that longer-term, fixed-type assets appreciate over time. The caveat to continuing to hold an asset at cost is that it should be accounted for differently if changes in value are considered either “more permanent” or “other than temporary.” Hocus-pocus accounting is possible here simply by virtue of manipulation of the definition of the terms more permanent and other than temporary.

•  The second accounting box is labeled Held-for-Trading: In this box, assets are marked-to-market on a quarterly basis (quarterly for reporting purposes, however, they are usually marked internally on a daily, if not hourly, basis). And their fair value – relative to the last time they were marked-to-market – reflects a profit or loss that is accounted for on the institution’s balance sheet and in its quarterly earnings. Marked-to-market means that the asset is priced based on the last sale price on the day it is being accounted for. For example, if you wanted to mark-to-market the shares of International Business Machines Corp. (IBM), you would use the closing price for the stock on the day you want to value it. The difficulty, which includes transparency issues and the potential for manipulation, is valuing assets that do not trade frequently, or may be priced based on internal mathematical models. These hard-to-value assets are classified as Level 3 assets. There’s plenty of room here for hocus-pocus accounting. Valuing Level 3 assets is a magic act all by itself.

• The third accounting box is labeled Available-for-Sale: This box is the magician’s version of a “black hole.” In here assets could be sold, but are likely to be held. Gains and losses on assets in this box are not accounted for on the balance sheet in terms of profit or loss, and instead are accounted for under equity. And they don’t show up on the P&L (corporate income statement) – unless, of course, any change in value is determined to be not temporary. I’ll come back to “not temporary” value changes shortly, but please realize it’s important to know where these gains and losses are floating, and to understand the circumstances under which they’ll affect earnings.

Instead of hitting earnings when changes occur in the value of assets in the available-for-sale box, the changes are parked on the balance sheet under shareholders’ equity, and from there, under accumulated other comprehensive income (AOCI). It is in this floating netherworld that gains or losses are neatly stashed, potentially for years, until they are released into net income when desirable. Another term for active use of this trick is “managed earnings.”

The hocus-pocus accounting is in the determination of temporary, or when these losses should be extracted from the darkness of the netherworld and accounted for in the light of day. Generally, they should be accounted for in earnings when they are impaired, as defined under International Accounting Standard (IAS) 39, paragraph 58.

The important exposure of this trick is in understanding that losses held under AOCI do not count in calculating either Tier1 capital or capital ratios. If these rules were to be changed, only God could help the banks meet capital adequacy and solvency tests.

All this prestidigitation, or sleight-of-hand, is revealed by understanding what you can’t see. The problem is “intent-based” accounting. If assets can be accounted for in multiple ways – and the determining factor is the intent of management – there isn’t much room for transparency, and there’s even less for the comparative analysis of balance sheets, earnings, capital and capital ratios.

Source: Inside Wall Street: The Hocus-Pocus Accounting Tricks That Will Perpetuate the Capital Markets Credit Crisis