General Motors (GM) will have negative shareholders equity as of 12/31/06 thanks to FAS 158.

In the Q3 2006 Earnings Call on October 25, 2006 (9:30 am ET) General Motors CFO Fritz Henderson stated that due to a change in accounting rules for pensions, they "expect that reduction in shareholders' equity to be between $18 billion and $25 billion, and that is on a tax affected or after-tax basis" on the 12/31/06 balance sheet.

This change in accounting rules, FAS 158 (pdf), requires that underfunded pension plans to be posted to the balance sheet - a big change from only having to record it in the comment section. For a more in depth explanation, read this article from the New York State Society of CPAs titled "New Pension Accounting Rules: Defusing The Retirement Time Bomb". Basically, it boils down to the fact that both GM and Ford have made some BIG promises to employees, and have failed to sock away enough money to cover those obligations. In the past, this was ok because it wasn't directly on the financial statements and didn't impact all sorts of ratios. Starting at the end of the year, it will appear as a liability on the balance sheet.

What this really means:

If you're not an accountant, this all might be mumbo-jumbo to you. Let's break it down with a simple example.

Assets = Liabilities + Owners Equity

Say you have a house that's worth $400,000 with a mortgage of $150,000. What portion of that house is owned by you? $250,000 right? Plug that into the accounting equation:

$400,000 (Asset) = $250,000 (Liability) + $150,000 (Owner's Equity)

As you make money from your job, you plan to slowly pay down that liability until (hopefully) one day you won the entire house outright with no mortgage. Unfortunately, instead you have a medical problem and can't work for a few years. Instead of having to sell your house and move out, you refinance and pull out $100,000 of that "owner's equity" to pay the bills.

$400,000 (Asset) = $350,000 (Liability) + $50,000 (Owner's Equity)

What if instead of $100,000, you wanted to pull out $300,000? Would the bank loan you the money? Probably not, right? In fact, they'd probably tell you to go fly a kite since your house would only secure 72% of the debt.

$400,000 (Asset) = $550,000 (Liability) + ($150,000) (Owner's Equity)

The case of General Motors:

Now, say you are General Motors, and you have $470.5B of plants, inventory, equipment, etc (assets). You also currently have a LOT of loans - $458.9B.

Assets = Liabilities + Owners Equity
$470.5B = $458.9B + Owners Equity
Owners Equity = $11.6B

It turns out that they promised a lot more to employees than they actually saved up, to the tune of $18B-$25B. In the previous years, their balance sheet looked like this:

$470.5B (Assets) = $458.9B* (Liability) + $11.6 (Owner's Equity)

*Unreadable note that effectively says "we owe an awful lot more than that but fortunately we don't have to include all of our debt in this statement!"

FAS 158 rolls along and says "Woah there. This isn't the way to do it. How will the shareholders know that you owe all that money?" So now, it will instead look like this:

$470.5B (Assets) = $476.9B (Liability) + ($6.1B) (Owner's Equity)

Why does this matter?

So now you're thinking "This is just an equation, not real life. It doesn't really matter. Even good ol' Fritz said so during the earnings call." The CFO's words exactly:

"The practical impact of adopting FAS 158 are, to some degree, limited. No impact on pension expense. The statement didn't change how you determine pension expense. No impact on cash flow, no impact on benefit plans. Doesn't result in event of default under any debt covenant that GM has and doesn't have any direct impact on our ability to pay dividends under Delaware law. Under Delaware law, dividends must be paid out of surplus, which is defined as fair market value of the Company's assets, reduced by the fair market value of the liabilities and capital measured by the par value of outstanding stock. The accounting change will impact our book value under U.S. GAAP, but not necessarily the fair market value of GM's assets and liabilities"

The reality here is that GM has effectively "borrowed" more than it has assets to pay. Liabilities exceed assets, technically the company is insolvent. However, because of the length of the time to repayment on the debts and the amount of cash GM can generate through operations, it doesn't mean that the company will be suddenly declare bankruptcy.

What it DOES mean is that GM will have a hell of a time borrowing more money. Even if it is able to get loans, they are going to be at one heck of a premium to cover the risk of loaning money to company that may possibly be unable to pay them back. So both GM and Ford have moved to borrow what they can now:

DETROIT -(Dow Jones)- General Motors Corp. (GM) on Monday said it plans to execute a $1.5 billion senior secured loan with a seven-year term by the end of the year, an effort to take advantage of asset-backed fund-raising opportunities that may not be available to the company in 2007.

They want to max out the amount of cash they have now, because they are about to go through a period where they won't be able to easily get more until they dig themselves out of the negative shareholder's equity hole. In addition to the loans, they are also selling off assets to generate cash - the GMAC sale should result in $10B in cash for them.

But here's the catch: Restructuring is EXPENSIVE. And there are new debts on the horizon (Delphi Bankruptcy). If the market slows down further and GM can't sell as many cars or makes less profit on each one, they could be in for a sudden and deadly cash crunch. Between 2003 and 2005, GM burned through $10 billion in cash. In Q3 06, "the company showed negative cash flow of $5.1 billion, double the amount from a year ago, as it poured cash into restructuring initiatives and paid for a large U.S. sales incentive campaign, among other items."


Although the company is clearly more secure than it was a year ago, the risk of default is still hanging like a noose around the neck of the company. A further slow down in the economy could result in even stronger competition in auto sales, whittling away further from already razor thin margins. GM will be more vunerable than ever before by it's inability to easily borrow more money to cover short term liquidity issues.