Items filtered by date: August 2010

Earnings Management, Part II: Why Current Financial Reporting and Enforcement Efforts Fail

Tuesday, 31 August 2010 22:12

Current financial reporting practices often produce fictional and sometimes aberrant statements that are misleading if not outright fraudulent.  For example, consolidated financial statements are traps for the unwary, hiding and masking transactions through Byzantine group structures and idiosyncratic consolidating techniques.

Consolidation procedures require that inter-group transactions be eliminated when the financial statements of the group are consolidated, on the theory that this procedure eliminates transactions between the group that are not at arm’s length and which may in fact be shams. But consolidation accounting has another, less obvious yet insidious result – it purposely conceals and buries subsidiary information within the group's consolidation, hiding both the enlightening and damaging aspects of subsidiary performance within the whole.

Consolidation accounting purports to represent the economic activity of a group of legally separate and unique entities under the fictional mantra of the group, relying on economic form over legal form and financial substance. They conceal data that might normally be available to users of financial statements, and may serve to hide data from shareholders and creditors that is damaging or otherwise disparaging.

Data not found in unconsolidated financial reports mysteriously appear in consolidated statements under the guise of economic substance, yet bear little relation to real-world substance and the individual, disaggregated accounts of the subsidiary. This theory of aggregation is contrary to the norms found in GAAP – that of full disclosure and careful consideration of an entity’s viability as a going concern.

Prevailing consolidation techniques ignore the legal and financial implications that the aggregated assets and liabilities are neither owned nor made available to the group. This group mentality encourages users and readers of financial statements to view the entities of the consolidated group as virtual branches of the parent, again creating a dangerous fiction rendering the financial statements less meaningful. The grandest of these fictions, though, is the assumption engendered by consolidation accounting that profits and losses of the subsidiary entities will pass through to the parent entity through dividend payments.

Category: Financial Fraud

Earnings Management: An Academic Primer

Tuesday, 31 August 2010 22:08

Our financial reporting system is under siege as never before. Corporations are under intense pressure from shareholders to meet or exceed earnings targets. Globalization continues to relentlessly compress profit margins. The response from many companies has been dramatic: radically reduce expenses by slashing services, wages and benefits, raise prices whenever possible, and employ accounting gimmicks and sleight-of-hand to manipulate earnings whenever these measures fall short.

These gimmicks, some quite elaborate, have resulted in a string of accounting failures and corporate scandals. Accounting failures have become rampant and more pervasive, undermining the credibility of the accounting profession and the inherent reliability of the financial reporting model as an evaluative tool in shaping investor confidence and awareness.

The financial statements, which include both quantitative and qualitative information, purport to transmit the financial data of an entity or group of entities into a prescribed format that stakeholders of that entity can use as a means of evaluating the financial health and viability of that entity. Financial statements must be able to accurately and faithfully convey the economic substance of a transaction, over a period of time, and as of a given date.

Financial information presented in these statements must be capable of accurate comparison to financial statements of other entities. These other entities may or may not be within the same industry as the target company, and the financial statements must convey the economic substance of the transaction rather than merely the economic form of it.

Category: Financial Fraud

Those Pesky Pensions

Tuesday, 31 August 2010 21:40
In a sign that the looming pension battles continue unabated, the New York Times reported, here, that the Securities and Exchange Commission accused the State of New Jersey of securities fraud and claimed that it had not been properly funding public worker’s pensions, while claiming it had. The SEC settled its suit with New Jersey by issuing a cease-and-desist order, and no penalties were imposed.

The SEC claimed that from 2001 to 2007, New Jersey claimed to have set aside funds to pay for pension benefits, when no such funds had been made available or earmarked. According to the SEC, New Jersey engaged in an accounting fiction to make it appear that the funds existed. The SEC also claims that this accounting illusion allowed New Jersey to sell $26 billion worth of state bonds to unsuspecting investors, who were never made aware of the magnitude of the state’s pension troubles.

New Jersey’s public pension fund is one of the largest in the country, and its chronic underfunding can potentially undermine future budgets by requiring significant redistributions from the operating budget to service its pension obligations. According to the SEC, the state treasurer repeatedly certified that the pensions were being funded according to the plan, which was never true. Interestingly, though, the SEC chose not to pursue charges against the treasurers who certified the misstatements or other professionals and auditors who reviewed them.

Category: The Economy

Extend and Pretend: More Balance Sheet Fiction

Tuesday, 10 August 2010 19:46
Balance sheet fiction continues unabated, as evidence mounts that banks are creating bogus loan modifications to avoid having to write down loans and destroy capital.  

A recent article in the Wall Street Journal, here, highlights how accounting manipulation has increasingly become the tool of choice for dealing with a souring economy. Regulators, the Federal Reserve, the Treasury, and those with clearly vested interests have largely failed in their efforts to stimulate the broader economy. The one remaining tool in the toolbox, though, remains their most potent: create more fiction and re-write those facts which are inconvenient.

“Extend and pretend” has become de rigueur at banks and other financial institutions, financial sleight-of-hand which masks bad loans by purportedly modifying loan terms or providing repayment assistance. These modifications prevent the need to immediately write-down the loans or fully reserve for them. By forestalling these write-downs, banks avoid further destruction of their capital positions, which have been decimated by the economic firestorm.

Many of these loan modifications are shams, and are not designed to protect the commercial project’s viability. Instead, these bogus loan modifications ensure that banks maintain the loan as performing assets and prevent further weakening of their capital.

As the FDIC grapples with an uncertain economy, spurious loan modifications and the fictitious balance sheets they create may purposely delay efforts to close many of the 1000 or so troubled banks that are projected to be shuttered by the FDIC in the next few years. Efforts to delay these closings will, in turn, postpone the FDIC’s own financial Armageddon and taxpayer bailout. 

Category: The Economy