Financial accounting amid the virus, a brief thread. 1/n

As the economy plunges into recession, an open question is how many businesses will run out of cash and be forced into bankruptcy. 2/n

For many businesses, bankruptcy is not as bad is may sound, because they may be able to "reorganize," a polite way of saying "force creditors to take equity for debt while remaining open for business." 3/n

However, that only works if the business is going to be viable over some reasonable time frame. So despite the possibility of reorganization, bankruptcy threats are serious, and can have knock-on effects on others. 4/n

Add to the risk of full liquidation (and the costs of re-starting later), the costs of the bankruptcy process itself are material, dead-weight losses (payments to lawyers, accountants, and others needed to conduct the reorganization). 5/n

Finally, in the current moment, courts are functioning even less well than usual, so bankruptcy will take longer than usual to process, augmenting costs. 6/n

So that brings us back to financial accounting. The question is how many businesses have so much debt they won't be able to survive without bankruptcy? 7/n

Basic financial ratios can help answer that question: debt/equity, cash flow / interest obligations, cash-on-hand / near-term liabilities. 8/n

But those ratios are built on financial statements, under generally accepted accounting principles. 9/n

And companies and auditing firms have incentives to try to game those principles. 10/n

The latest in a long line of efforts to game GAAP is to engage in "reverse factoring," which is a fancy way of saying "a particular type of borrowing in a way that doesn't count as debt under GAAP". 11/n

"Reverse factoring" involves a big company -- say big UK-based global construction company Carillion -- arranging to pay its suppliers early by agreeing to pay its own banks back for "buying" the invoices from the suppliers to the big company. 12/n

If that sounds like debt, it is, in economic terms, but accounting principles sometimes permit the big company to not treat it as such. As a result, the financial ratios that might indicate bankruptcy risk look better than they really are. 13/n

A report from UBS found less than 3% of surveyed companies disclosed reverse factoring “despite evidence indicating that a much greater percentage – perhaps as much as 40%” were using the technique. 14/n

Given that global firms are being hit particularly hard by the current crisis, with rolling lockdowns and travel bans interrupting supply chains, reverse factoring may mean that the number of bankruptcies is going to be larger than expected. 15/n

This is, of course, down the list of problems we're having now, but writing this thread let me distract myself from the worse problems, and it is a real problem that will add to the medium-term costs of the crisis. /end