Thinking about the AIG-Fed-Goldman Sachs (GSG) fiasco made me realize it and "le affair Jett" had a common accounting issue: improper revenue recognition. One would have hoped a Big 87654 firm like PriceWaterhouseCoopers (PWC) would have learned something from Big 87654 firm KPMG's failures at KP. One would have.
JJ recognized the difference between a T-bill's cost and maturity value at purchase instead of amortizing it over the T-bill's life, clearly improper. However, KP adopted this accounting method before JJ's employment. Neither KP's nor GE's internal auditors ever questioned this nor did KP's controller's office. KPMG never objected.
Let's look at AIG's credit default swap (CDS) business. How could it have made a profit? Suppose on day 1, 20-year Treasury paper yields 4% and 20-year Fortune 500 Inc. (F500) paper yields 6%. How much should AIG charge for a 20-year CDS on 20-year F500 paper? Assuming the market is smart, and Eugene Fama groupies always assume it is, the interest difference between Treasury and F500 paper is 2% (6% - 4%) a year for 20 years. Discounting 2% a year at 6%, the F500 interest rate, I get 23.26% of par as the fair value of such CDS. If AIG charged less than 23.26% of par, AIG must have thought F500 was a better credit than the market thought it was. Alternatively, AIG gave say GSG, the CDS purchaser, a gift, or AIG was too stupid to know what it was doing. Since PWC was on the AIG and GSG sides of this transaction I now ask: did PWC ever consider this? Or is this type of analysis beyond PWC's intellectual capabilities? Or did GSG tell PWC about this and to "shut up". Did the PCAOB note that PWC audited AIG and GSG and tell it to drop one client?
PWC should not have let AIG recognize any income from its CDS business. I commented on PWC's finding a "material weakness" at AIG with respect to CDS accounting on 20 February 2008, link: http://skepticaltexascpa.blogspot.com/2008/02/pwc-on-guard.html. The more I think about AIG's CDS business, the more I conclude PWC either: did not know what it was doing, bad; or knew exactly what it was doing, worse. PWC, fool or knave, you decide.