February 11 2008: 2:16 PM EST
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AIG's bad accounting day

The insurer says that derivatives in one of its units are a bigger headache than previously thought - and that its accountants raised the red flag.

By Roddy Boyd, writer

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NEW YORK (Fortune) -- AIG's unexpected announcement today about "material accounting weakness" in part of its portfolio has sent its stock careening down 11 percent in mid-day trading.

In a Securities and Exchange Commission 8-K filing this morning, AIG said that based on new data inputs, the company has said it has revised sharply higher its pending charge related to one of its key unit's derivatives holdings. The unit, AIG Financial Products and its super senior credit default swap portfolio, is being forced to take a massively higher charge than it had previously anticipated.

The unrealized, pre-tax charge will be $4.88 billion, in addition to whatever the swap portfolio's decline in valuation for December amounted to. Assuming a 35% tax rate, this amounts to at least $3.17 billion after taxes. Under previous valuation methods, according to the 8-K, AIG would have taken a charge of about $1.25 billion. And the portfolio could have been damaged more, since December saw the sharpest deterioration yet in that segment of the market, according to hedge fund traders. An AIG spokesman confirmed the amounts to Fortune. According to AIG's filings, its AIG Financial Products unit had $505 billion in notional exposure to credit derivatives as of September 30.

Fitch Ratings said that it is placing AIG on "Ratings Watch Negative." The company's senior debt is currently rated AA.

Intriguingly, PricewaterhouseCoopers, AIG's auditor, appears to have prompted the filing. Following an AIG investor presentation on December 5, PWC apparently argued that the methodology it was using to value credit default swaps could not support the claims that AIG was making for the financial products unit. Put briefly, PWC did not think the giant insurer should be allowed to book credit for the spread differential between credit default swaps and the underlying tranches of collateralized debt obligations that the derivatives sought to protect.

Such disputes are rare; indeed, AIG's earnings charge appears to be the first incident in the current credit crisis that alludes to an internal difference of views between its financial reporting unit and its outside auditor. It is, of coruse, PWC's job to insist on objectively verifiable pricing evidence to support management claims. But in challenging AIG - one of the most-prized clients in accounting - PWC was taking a risk. It seems likely that the massive financial settlements paid out by auditors accused of negligence - notably in the Enron and Worldcom incidents - had at least some bearing on their decision.

While AIG may have helped its long-term standing by accepting PWC's views, the short term will be tough. The stock dropped to $44.82, a drop of $5.86. Bloomberg reported it was AIG's biggest one-day decline in 20 years.  To top of page