American Capital Avoids Loss With Fishy Math

Last month, the Center for Audit Quality issued a white paper on FAS 157. The report states: "If the market is considered active, even if transaction volumes are lower than in the past, FAS 157 states that the quoted price (a "Level I input") provides the most reliable evidence of fair value and shall be used to measure fair value whenever available. The use of Level II or Level III inputs is generally not permitted when Level I inputs are available."

European Capital, which went public on the London Stock Exchange earlier this year, trades under the symbol ECAS. It was a spinoff from American Capital.

American Capital owns 70.8 million shares of ECAS, or a 65% stake. For American Capital's third quarter, ECAS shares fell 18% from about EUR10.58 to EUR8.66. During this same period, the euro rose 5.4% vs. the U.S. dollar.

Thus, using the prices of the shares and currencies under a Level I valuation, American Capital should have booked some sort of loss on the ECAS investment -- and analysts calculate it should be at least $140 million.

Instead, voila! American Capital said its investment in ECAS appreciated $2 million because it added a "control premium" to the valuation of the investment.

In essence, the company is arguing that its ECAS investment is worth more than the stock market says it is simply because American Capital owns a lot of the stock and could liquidate ECAS if it wanted in order to achieve some higher net asset value.