When Friedman, Billings, Ramsey Group Inc. announced its third-quarter earnings not long ago, the Arlington investment firm proclaimed it to be the "fourth consecutive quarter of positive results."

That it was.

It was also the third consecutive quarter in which Friedman, Billings, Ramsey changed the way it calculates the value of its venture capital funds, which have become the main source of FBR's profits.

Those accounting changes have produced a peculiar pattern in FBR's financial reports. The market prices of the stocks in its venture capital fund have dropped sharply, but FBR has reported that, by its accounting, the value of its investments has gone up.

FBR owns only a small piece of its venture capital fund, but its share and the management fees and incentives associated with the business have had a huge impact on the company's profits. According to a report issued a few days ago by Amy S. Butte of Bear, Stearns & Co., more than 70 percent of its bottom line in the first nine months of this year is attributable to the venture capital business.

While a decline in stock prices has forced the value of FBR's venture funds down, bookkeeping adjustments have offset the decline, allowing FBR to report profits on its venture capital business.

The Bear Stearns report gives FBR stock an unusual rating of "neutral." That term is anything but neutral in Wall Street parlance. Many investors consider it the equivalent of a "sell" rating, which is almost never used anymore. At best, it translates into "we're not telling you to buy this stock."

Butte's report points out how FBR has changed the way it calculates the value of its venture capital portfolio. She warned the practice is risky because "there is less room to offset the impact of declining public portfolio valuations."

In other words, if stock prices fall too much, FBR runs the risk of being required to wipe out some of the profits it has posted this year, the analyst said in an interview. Butte declined further comment, though, on the company's accounting practices.

FBR's chief financial officer, Bob Smith, said the accounting used by FBR is not unusual and does not increase the firm's exposure to falling stock prices.

"The risk to the company is the same market risk that any holder of securities faces," he said in a telephone interview Friday.

The adjustments FBR has made in the way it values the stocks in its venture capital portfolio are demanded by accounting rules, he said: "We are required to determine what is the fair value of those securities."

The valuations were not changed to offset the drop in stock prices from quarter to quarter, Smith said. Rather, they are based "on applying objective factors consistently from period to period."

One way to understand FBR's accounting is to think of your own house.

Pretend you paid $200,000 for it a few years ago, and now, with the inflation in home prices, you figure you could probably sell it for $300,000.

Accountants call that $100,000 increase in market value an "unrealized gain." Most people would be cautious about counting on that $100,000 "profit" until they sold the house. In common-sense accounting, they would consider the appreciation in the value of the house to be an asset, but they would not count that $100,000 as part of their income.

That is not the way FBR or other companies with major securities portfolios keep their books.

The usual practice for such companies is to evaluate their investments every quarter. If the price of a stock goes down, that's a loss. If it goes up, FBR counts that increase as profit. It's only a "paper" profit until the company sells the stock, however, and changes in value can affect the bottom line until the investment is sold. In many cases, FBR is prohibited from selling the shares because they are still under "lockup" and other restrictions placed on owners of shares in recently public companies. If the price of the shares drops before they are sold, the paper profit could be wiped out later.

On paper, these profits have been huge for FBR. One of FBR's venture funds provided financing to InforMax Inc., a Rockville genetic engineering software company. The fund paid about $1 a share for its stock, which was worth $16 a share after InforMax went public Oct. 3.

The InforMax shares are still in their lockup period, which prevents FBR from selling until 180 days after the initial public offering. For now, the firm must report a big paper profit on InforMax, but if the stock tanks before the shares are sold, that profit will evaporate.

To account for the fact that the shares cannot be sold, FBR uses an accounting technique known as a "liquidity discount," or, in the jargon of Wall Street, "taking a haircut."

Back to your house, the one with the value that increased to $300,000 from $200,000. If you decide to take out a home equity loan to pay your child's college tuition, most lenders won't let you borrow the full $100,000 increase in value.

They'll lend you only 80 percent of the value, which means taking a haircut of 20 percent.

FBR also takes a haircut when it evaluates its venture capital investments. What's striking is that it has been cutting the hair closer and closer every quarter.

In the first quarter of this year, FBR reported to stockholders that it was taking a 60 percent haircut on the value of its venture capital investments. Based on the prices the stocks were selling for on March 31, those investments were worth more than $1 billion before the haircut. But FBR said it applied "discounts averaging 60 percent to reflect restrictions on liquidity including the size of the fund's holdings relative to the public market float and marketability."

In other words, some of its stocks could not be sold--and if they were sold they might drive down the price, so the $1 billion worth of stocks went on FBR's books at a value of about $600 million.

Those stocks actually belong to a special investment fund called FBR Technology Venture Partners, one of Washington's most successful venture capital investment funds ever. Two of the companies TVP backed were grand slams: Aether Systems Inc., an Owings Mills wireless Internet company, and WebMethods Inc., a Fairfax e-commerce software maker, each has a market value of more than $4 billion.

TVP is owned primarily by outside investors. As the general partner and manager, FBR gets 20 percent of the fund's gains, which is reported on the company's financial statements as revenue. Most of that money goes directly to the employees who manage the fund. After expenses and taxes, the rest trickles down to FBR's bottom line.

The key factor in the company's profits, then, is the value of the venture capital portfolio at the end of each quarter. The 60 percent haircut that FBR took from the market value of the TVP stocks in the first quarter is considered very conservative, accountants say.

Since last spring, however, FBR has decided such a conservative haircut is no longer needed. In its second-quarter financial report, the firm discounted the value of the stocks only 43 percent. And in the third quarter it trimmed the haircut even further, to just 15 percent.

Smith said that, based on the standards FBR uses to evaluate stocks, smaller discounts were all that were needed. Time limits on when some of the stocks could be sold had expired, he said, and the firm calculated that its holdings in the stocks were small enough that they could be sold without depressing the price.

The valuations were based on "objective criteria," Smith repeated, and were approved by FBR's outside auditors, Arthur Anderson & Co.

Nonetheless, the smaller haircuts had big advantages for FBR.

They not only allowed the firm to dodge a bullet on a big paper loss from plunging tech stock prices, but also to produce new profits.

During the second quarter of this year, the value of the stocks in FBR's venture capital portfolio dropped from a little more than $1 billion to less than $700 million. And remember, using accepted accounting rules for investment portfolios, any reduction in the value of these investments usually would come straight off the bottom line.

But shaving its haircut to 43 percent from 60 percent had the effect of reducing the big drop in the value of the investments carried on FBR's books.

The same thing happened in the third quarter. From June 30 and Sept. 30, the market value of the portfolio dropped to about $440 million from nearly $700 million.

In its third-quarter financial report, however, FBR trimmed its haircut back to 15 percent. That and other factors enabled the company to report that even though the value of its investments had plunged, it gained revenue.

FBR disclosed what it was doing. "This revenue increase was the result of several valuation factors that offset the decline in the market value of certain of the underlying securities in our venture capital fund," FBR partner Eric Billings said in a conference call with investors Oct. 26.

Since the first quarter, the value of FBR's venture capital investments has dropped by roughly half a billion dollars.

Yet so far this year, FBR has reported roughly $52 million in venture capital incentive fees and about $12.5 million in venture capital net income, Bear Stearns analyst Butte calculates.

That amounts to about three-quarters of the company's total earnings of $16.5 million in the first nine months of the year. Even the Bear Stearns analyst could not determine how much of that was actual cash and how much was paper gains. "We believe a majority . . . has not yet been received in cash/securities," she told clients.

That, she warns, is "a non-diversified earnings stream" that leaves FBR highly vulnerable to a decline in the stock market.

Jerry Knight's e-mail address is knightj@washpost.com