Financial Reporting Highlights

Imagine if you went to a vendor to purchase something you wanted and needed.  The vendor happily sold you what you were looking for but as a condition of that sale, you were also required to buy something you had no interest in whatsoever.  To make matters worse, imagine that you had no idea what that extra something should cost or what you would be charged if you purchased it elsewhere because all of the transactions are conducted in private and the prices are never disclosed.  Finally, imagine that the extra something was terribly complex and something understood by a tiny fraction of 1% of sophisticated business people.  

The vendor on the other hand is well versed in that thing you are being required to buy.  In fact, the vendor buys and sells that particular product thousands of times every year and has deep knowledge of the pricing of that product.

Do you think you would be charged a fair price for that extra something?  Fat chance.

That something extra is an interest rate swap.  If a business borrows a few million or more from a bank today, the bank will require that the loan be a variable rate loan.  The bank will also require the borrower to buy something extra; an interest rate swap to convert that variable rate loan into a fixed rate loan.  (Yes it would be easier to simply structure the loan as a fixed rate loan but there’s little profit in that for the bank.)  There is no up-front charge for the interest rate swap but the bank charges a swap rate that is very favorable to the bank.  Once the loan and the swap are finalized, the bank can then resell the swap at a profit.  If swaps were publicly traded like stocks the banks wouldn’t be able to get away with this.  However, the swaps are not publicly traded but are instead traded in private.  As a result, borrowers have no way of knowing if they are getting a good deal or not.  Rest assured they are not.

A new rule required by the Dodd-Frank financial reform law is being considered by regulators that would require the vast majority of derivatives trades to be conducted on an open electronic platform.  Banks are resisting the change.

It’s important that the new rule be adopted.  Financial institutions are a critical and valuable sector of any developed economy and they deserve a profit on their activities like anyone else.  However, they don’t deserve to generate a profit by requiring their customers to purchase products they don’t want and which they have no idea how to determine a fair price for.  By requiring derivatives trades to be conducted in a transparent market, customers will be able to determine a fair price for the derivatives they are required to purchase.

Contact Sander Abernathy at sander@sanderabernathy.com or 404 229 4045

There was an article I found interesting in the WSJ yesterday.  It details a study by Stanford law professor Joseph Grundfest, who was previously a board member of the SEC, and Nadya Malenko, a doctoral candidate at the Stanford Graduate School of Business.  The study looked at reported EPS in nearly a half-million earnings reports over a 27 year period and specifically the first digit of EPS not reported; a tenth of a cent.  Though companies don’t report EPS to the tenth of a cent, the number is easily calculated and Ms. Malenko obvously developed a software application to do just that for hundreds of thousands of earnings reports.  

If earnings are not managed, earnings reports at the one-tenth of a cent level should be evenly distributed among ten possible reported amounts:  zero to nine-tenths of a cent.  They aren’t though.  4/10ths, 3/10ths and 2/10ths are all underrepresented in the survey while 5/10ths and amounts greater than 5/10ths are overrepresented.      

The authors coined the term “quadrophobia” to desribe companies that have an aversion to reporting EPS amounts ending in .4, .3 and .2 cents per share.  What causes this ailment?  The authors believe it is earnings management and note that 1/10th of a cent is, on average, only $31,000 in additional quarterly after-tax income among the survey companies.  When the opportunity to round EPS up to the next penny presents itself, managers find the $31,000, $62,000 or $93,000 necessary to do so a statistically significant portion of the time.

The more interesting part of the study is that quadrophobia is a leading indicator of later earnings restatements and charges of accounting violations.  The WSJ article cites Dell,  which never reported earnings at 4/10ths of a cent from its 1988 IPO until its restatement of earnings in 2007.  The WSJ pegs the probability of 76 straight earnings reports with not a single one ending in 4/10ths of a cent occurring randomly at 1 in 2,500.  

Obviously, the study is based on the idea behind the earlier studies that revealed backdating of stock option grants.  Certain variables should be random unless the outcome is intentionally altered.  Where outcomes that should be random are not, they are probably influenced by an outside agent that interferred with the data.  In the case of stock option grants, those issuing stock options to themselves and their colleagues did so disproportionately on dates when the stock was at the bottom of a trough.  In the case of EPS, companies round the number up more frequently than they round it down. 

What does this study teach us?  The people who calculate and audit EPS don’t believe it is accurate to the penny or 1/10th of a cent.  Investors probably shouldn’t either.

The linked article by Barrons and Propublica.org details the allegations facing two of the largest second tier firms, McGladrey & Pullen (No. 5) and BDO Seidman (No. 7).  BDO Seidman already had a $522 million judgment levied against it for its audit of ES Bankest LLC; a Florida factoring firm that was looted by management.  Now the firm is facing litigation arising from its audit of funds managed by J. Ezra Merkin who invested at least $3 billion of client money with Bernie Madoff.  McGladrey audited another Ponzi scheme managed by Thomas Petters and faces further litigation arising from its audit of the failed Sentinal Fund.

Here’s an interesting NY Times article about accounting fraud at Archway which was owned by a private equity firm. It just goes to show that public companies aren’t the only ones that run into accounting problems.