U.S. accounting regulations often fail to adequately account for the assets and liabilities of corporates due to their failure to differentiate between actual and contingent assets and liabilities. David Shimko, president of Risk Capital Management Partners and senior lecturer at Harvard Business School, said that accounting requirements for corporates to mark assets and liabilities to market have often failed to demonstrate real corporate risks by failing to incorporate their contingent liabilities.
Contingent liabilities are potential future liabilities, some examples being a letter of credit, which would only be used in the case of a cash shortfall, or a loss on a future trade, Shimko explained. Where this becomes particulalry risky is when corporates adopt strategies of risk leverage, where they effectively increase their risk but not their capital base. This can be made, for example, by entering into a swap with a counterparty, which operates as a credit line to the corporate, he said.
While banks are required to report credit lines such as hedges granted to corporates, albeit in an aggregate form that does not name the client, no such demand is made on the corporate, Shimko explained. While a bank may grant a credit line that on the surface seems of limited risk in consideration of the corporate's cash assets what the bank may not see, for example, is that the corporate has executed similar strategies with several other firms, thus substanitally raising its leverage, he said. In this way the accounting rules do not give an accurate measure of the corporate's liabilities, he concluded.
