Accounting uses the laws of mathematics to express economics in a manner consistent with the legal obligation of firms and individuals to fairly report their financial condition when they provide financial statements.

Accountants are supposed to safeguard against fraud by making firms apply one measure consistently. While it follows general principles to achieve consistent reporting, accountancy’s only goal is to responsibly reflect conclusions from other sciences and fields. Failure to recognize this ancillary (though vitally important) function of accounting has contributed to abuses that create instability in finance.

The vitality of accounting lies in the power of the double-entry system that is the heart of this analytic tool. Every credit or debit must generate a corresponding entry in order to maintain the two essential balances expressed in financial statements: (1) assets must always equal the sum of liabilities and capital, and (2) revenues must always equal the sum of expenses and earnings. Finally, cash flows and inventories must accurately carry balance positions from one financial statement period to the next.

When transactions are reported in a manner that reflects accounting practice but fails to reflect the law, mathematics, and economics, then accounting practice must change to assure compliance. Since 1997, accounting standards have conformed transactions involving financial asset transfers to the law, mathematics, and economics by recording financial asset transfers as sales only when the transaction puts assets presumptively beyond the reach of the transferor and its creditors, even in the case of bankruptcy or other receivership. The tests that address that standard are set forth in the appendix of this book.

This standard, if universally and uniformly applied, conforms accounting to the legal standards found in U.S. Supreme Court decisions on complete (or true) sales and statutes. That aligns accounting with the theory of financial stability.

From 1983 (when doubt remained as to the legal impact of an incomplete sale, because the UFTA had not been written) until 1997, accounting rules depended on the form of the asset transfer transaction. Transfers in a form that purported to be a sale were recorded as sales, while those that purported to be secured borrowings were reported as debt. Under the UCC a transfer is effective, whether it purports to be a sale or a pledge. The UCC was written to address only the Supreme Court’s 1925 concerns relating to pledges.

Whether a sale is complete matters in accountancy, because that is where one must distinguish sales from transactions that grant security interests (debt). To reopen markets for secured lending, the UCC gave pledgees and transferees that buy accounts identical rights: those of a secured creditor. In 1983 it was necessary to create a new accounting standard because stand-alone CMOs invalidated the assumption that one cannot add value merely by changing the form of a financial instrument. The 1983 standard was a big mistake.

Combined with economic circumstances of the 1980s and laws that allowed speculation by previously regulated thrifts, the 1983 standard led to duplicity. It was based on legal form, not legal result. Therefore, entities could choose a pledge form to avoid reporting a loss on a transfer and a sale form to report a gain.

This was a contributing factor to losses the federal government sustained in the S&L crisis (that, as we’ve noted, Bill Seidman labeled the biggest mistake in the history of government—a record that endured until the 2007–2009 crisis beat it by two orders of magnitude).

By requiring that only complete (or true) sales of financial assets be accounted for as sales, the accounting profession became aligned with the law in 1997. Had the new standard been applied uniformly, financial accounting would have had no role in the deceptions created by shadow banking and off-balance sheet liabilities. All such liabilities would have been reported on-balance sheet.

Before the 1997 standard became effective, the FDIC adopted it for banks, only to discover that the standard, applied literally, made it impossible for banks to sell financial assets. That’s because the FDIC, as a bank’s receiver, succeeds to the rights of innocent insured depositors and has power, by statute, to unwind any transaction.

This was pointed out to the FDIC soon after the 1997 effective date of the new accounting standard. Between then and the April 1, 2001, effective date of a revision to the 1997 standard, the FDIC was invited to reconsider its authority to unwind transactions. To preserve liquidity for solvent banks, in 2000 the FDIC adopted a safe harbor that, it later noted, gave banks a bye on legal compliance in allowing their transfers to be reflected as sales even in cases in which there was continuing involvement on the part of the bank that was inconsistent with the Supreme Court’s true sale standard.

It is within that safe harbor that U.S. banks hid a great deal of the off-balance sheet shadow banking liabilities that fueled the 2007–2009 financial crisis. In 2010 the FDIC reconsidered and ended the safe-harbor rule, meaning that bank transfers after November 2010 must meet the high legal isolation standards applied to sales by other entities. That finally gave the United States a single measure for a sale. Any transfer of a financial asset that is not a true sale must be reflected as a borrowing. The appendix provides the standard and the opinions needed for compliance.

Accountants are liable (along with other parties affiliated with an institution) for frauds committed by financial institutions. To avoid this hazard, accountants must obtain legal opinions that support reporting a transfer as a sale. If any part of the standard is not met, the transfer is a secured borrowing. Anything less “imputes fraud conclusively.”

Transfer terms must meet standards that preclude avoidance under requirements of the UFTA, the USBC, and various cases, which reject transfers that (1) violate the absolute priority of creditors over owners, (2) abuse corporate law to unfairly confer common shareholders priority over preferred security holders, or (3) give the compensation of owner-managers an unfair priority over creditors.

Properly applied, this accounting standard would eliminate shadow banking and all other off-balance sheet liabilities. All repurchase agreements should be reflected as grossed up on balance sheets and participations that do not involve complete transfers of underlying financial assets would be reported as secured loans (assuming the requirements for a valid pledge are met) and otherwise as subordinate borrowings by the lead bank from the participant. In cases in which derivative contracts obligate payment without regard to actual collection of related assets, the obligations and assets would be grossed up and not reported on a net basis.

In short, any transaction in which two measures are used “imputes fraud conclusively.”

The resulting changes in reporting will, of course, require adjustment to various capital standards so that assets and liabilities are not double counted. This, however, is something with which regulators are familiar. For decades, interbank deposits have been reported on a gross basis for financial reporting purposes and netted when calculating reserve requirements, to avoid multicounting.

Applied correctly, accounting for assets and liabilities avoids the problem, discussed above, that unreported debt creates for the economic axiom that savings must equal investment. In 2007, $30 trillion of U.S. shadow banking (off-balance sheet liabilities) generated an equivalent hole in accounting. Since investors had no real idea as to which financial entities had what amount of unreported debts, the only safe thing to do was to sell every investment that was potentially affected.

By virtue of the resulting crash, accounting confirmed the theory of financial stability. To create stability, all netting and off-balance sheet reporting of liabilities must end. Once we accept that the term “off-balance sheet” implies fraud, the rest becomes easy.