What is Driving Your Decision Process?

June 2021
By Kevin Chiappetta, CFA, President, QuantyPhi

Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics. Therefore, risk management strategies are directed at accounting, rather than economic, performance.

—Enron in-house risk-management manual

When we developed QuantyPhi, we started with a purpose – to help credit unions make better decisions for their balance sheets. This is no small feat, as credit unions have different purposes and distinct goals. However, there are some basic processes that apply regardless of purpose. We have shared insights into the decision-making process, especially in relation to the complexity of decisions we face, and our human limitations to incorporate all these complexities when making decisions. This is discussed at length in various books on our suggested reading list.

Many of our discussions with credit unions involve comparing two different types of investments. We help determine which is the better choice when it comes to purchasing, selling, swapping, or something else. Our benchmarking process helps make that comparison. However, we often find ourselves discussing the impact of these decisions on the financial statements, rather than the relative value of the investment. Questions about the holding period gain or loss, the book yield, or stated earnings impact often outweigh valuation discussion. While the accounting treatment of each decision is a part of the discussion, it should not be the primary measurement for the decision.

Now let us be clear. The opening paragraph, excerpted from the Enron in-house manual, is in no way trying to equate the use of accounting driven measurements to the fraud of Enron. Rather, the statement that management will use the accounting impact rather than review the economics of each decision did lead to some economically questionable decisions. Management at Enron started with bad decisions and amplified that to an order of magnitude with deceit and intentional fraud. (If you want a full examination of that story, we suggest you read further here).

To further amplify this point, let’s review an example we have used in past programs. We will focus on a decision presented to an investment manager by their trusted investment broker.

The investment portfolio has $10 million of a security with six years remaining until the final maturity. The book value of this security is recorded at $115.95, and the broker offers to purchase the holding at $114.52. This sale will produce a loss to the investment portfolio of $143,000 which is calculated as $10 million *(1.1595-1.1452), the difference between the book value and market price quoted.

The broker then informs the investment manager that the real value on this trade proposition is that they will offer the manager a security with six years to maturity, with the same coupon at a market yield of 1.796. since the yield on the bond recently sold was on the books below the new yield, the manager will see an increase in the book yield. The extra yield for a $10 million holding will increase the accounting income over the remaining six years to maturity beyond the loss taken on the sale of the original security, making a hero out of the investment manager.

The detail missing in the narrative is an important one. The security sold and the security purchased to produce this income gain are the same security. This is not a typo. Using only accounting principles to make economic decisions, the manager is encouraged to sell something they already own at a loss, purchase it back for more money, and somehow, make money. This yield pick-up trade was in fashion when market yields were rising and may come back again. Allowing someone to earn the difference in the purchase and sale price while the portfolio ends the day with the same security with which it began is the definition of a poor economic decision. Allowing accounting principles to cloud your economic good judgement can be harmful to the value of the portfolio.