In each issue of Wharton Magazine, we’ll test your knowledge with a question often straight from an actual Wharton exam or course, crafted by one of the School’s esteemed faculty members. Submit the correct answer and you’ll be entered into our drawing for a fabulous prize—tuition-free attendance at a Wharton Executive Education program. This Final Exam challenge comes from Richard A. Lambert, the Miller-Sherrerd Professor in Wharton’s Accounting Department, based on a question he asked in his Accounting 742 course this spring.

Please note: This issue’s contest is now closed. The answer is posted below.

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 Winner:

Winner of the summer issue Final Exam challenge: Rob Averick, WG’93

The Answer:

Accounting rules in the U.S. (and also internationally) now allow firms the option to account for their debt (as well as certain other financial assets and liabilities) on a “fair value”  basis or through the traditional “historical cost” method. If a firm’s credit risk worsens, the fair value of its debt goes down. That is, the debt is worth less out in the marketplace because investors feel there is a lower chance the firm will be able to make good on its payments. Under fair value accounting, a decrease in a liability is a gain for the firm (just like an increase in an asset’s value would be a gain). Therefore, the worse the firm’s financial status becomes, the lower the fair value of the debt and the higher its reported accounting income (all other things equal).  This has been done by numerous firms over the past several years.  Needless to say, not everyone believes this is good accounting.

(Out of all correct submissions, one winner will be randomly selected to attend, tuition-free, one Executive Education, 3- to 5-day open enrollment program. Does not include travel, expenses or personal costs incurred; subject to availability and admissions criteria; prize may be subject to taxation; excludes the Advanced Management Program, Executive Development Program, Essentials of Management, Health Care, Industry-Specific and Global Programs. Must be 18 years or older to win.)