Investors have more than one reason to celebrate two new accounting rules. Besides forcing banks to fess up to the risks they are carrying on their books, new standards for off-balance sheet assets will make it harder for companies to inflate earnings artificially.
The new rules - FAS 166 and 167 - are desperately needed to prevent banks from hiding assets to increase leverage. Lending that isn't supported by capital is a main ingredient behind unsustainable credit bubbles, and banks' off-balance sheet games played a big role in the most recent one.
But another reason banks like off-balance sheet structures is that it enables them to manufacture profits.
Coming up to the end of a quarter, if a company is a bit short of its earnings target, it can package some assets together into a security and "sell" them to an off-balance sheet entity.
The entity is conjured out of thin air with a small equity investment by the company itself. The entity "buys" the securitized assets at a nice markup, enabling the company to book a profit on the sale.
