Own Credit Risk Accounting, Modigliani-Miller Theorem, and the Fallacy of Counter-Intuitive Results

  •  Francesco Bellandi    


Purpose: This article tests own credit risk accounting under Modigliani-Miller theory to determine whether there is a fundamental fallacy in the unsolved issue of counter-intuitive results.

Design/methodology/approach: A system of equations derived from the MM theorem to own risk.

Findings: Solutions to the wealth transfer hypothesis. Parameters of issuer and holder that nullify own credit risk gain/loss and impairment loss/gain. A theoretical framework is developed to reconcile accounting to Modigliani-Miller theory. If the MM theory is true, as generally it is held to be, the system of equations shows that the recognition of own credit gain or loss would arise from different accounting measurement bases of liability own risk versus assets impairment, and by not reflecting the rebound effect in liability fair value measurement, in both cases not a faithfully representation of the substance of the facts and circumstances. The former would require a re-alignment between impairment and financial liability measurement rules. The latter would require a rethinking of fulfillment vs. fair value measurement to these liabilities. In addition, given the tenet that the accounting does not recognize shareholder wealth transfer, the current financial performance dilemma can be solved by recognizing in equity the concept of capital maintenance adjustment.

Originality: Rare, if not unique, innovative direct application of MM paradigm to own risk.

Implications: Significant contribution to the debate on performance and OCI, counter-intuitive results and accounting mismatch, fulfilment value versus fair value, incomplete recognition of contemporaneous asset value, and the definition of income in the Conceptual Framework.

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