Wharton Exam Question: How Can Having Your Credit Downgraded Lead to Greater Income?

2 Sep

September 2, 2012

Sometimes (some would argue many times) accounting rules lead to strange results.

To wit, take a look at the brief exam question below which appeared in the Summer 2012 issue of the Wharton Magazine.  It asks the question of how a company’s worsening credit risk can cause its accounting net income to go up.

Though this is not a situation that we at YPTC have encountered with any of our nonprofit clients, it speaks to the challenges that we often face in which accounting rules can lead to unintuitive outcomes.  Anyone who has ever tried to explain to a nonprofit board why all the revenue on an unconditional multi-year grant gets recognized all in the first year while expenses continue to be incurred in subsequent years knows what I mean.

Here is, reprinted verbatim from the Wharton Magazine, the exam question.

The Basics:

Assume a company has fixed-rate debt that matures in 10 years. During the year, general interest rates in the economy remain unchanged, but Standard & Poor’s and Moody’s decide the company’s future prospects look worse and both downgrade the company’s debt. The company does not repurchase, refinance or otherwise hedge this debt during the year.

The Question:

Explain how it can be the case that having the company’s credit risk get worse causes its accounting net income to go up. That is, what (legal) method of accounting would it have to be using and how would this work?

The Answer:

To find the answer, click on the link below which will take you to the Wharton Magazine’s website.  Enjoy.

http://whartonmagazine.com/issues/summer-2012/final-exam/

Comments welcome.

Eric Fraint, President and Founder
Your Part-Time Controller, LLC

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