Is Bigger Really Better? Not When It Comes To Financial Reporting Transparency

Includes: GS, MS
by: Anthony Catanach

For those of you that may have thought that my grumpiness may have been tempered a bit by the advent of the holiday season…Bah Humbug! There is just so much accounting and financial reporting nonsense out there this quarter, that I have been simply overwhelmed by stuffing stockings with lumps of coal for my favorite global accounting firm (GAF) partners, and the humbug large bank clients they serve.

Let's begin with Jonathan Weil's recent discussion of Morgan Stanley's "immaterial" $9.2 billion correction of an operating cash flow (OCF) classification error. The problem? Morgan Stanley (NYSE:MS) accountants didn't formally restate the Company's financial reports for the error as required, instead opting for the sleazier "stealth restatement" route on the basis of immateriality. Where were the auditors? Well, the auditors actually appear to have discovered this error…my heart be still. But MS has been "audited" by Deloitte (of recent PCAOB fame) since 1997 according to Audit Analytics. Why should I be surprised that a GAF auditor actually found something, then looked the other way?

The U.S. Security and Exchange Commission (SEC) specifically requires that a restating company file a Form 8-K to disclose a restatement. Also, the SEC's Staff Accounting Bulletin No. 108 (SAB 108) provides guidance on how the effects of a prior year misstatements (i.e., accounting errors) should be considered in quantifying a current year misstatement. Finally, the Public Company Accounting Oversight Board (PCAOB) in Auditing Standard No. 6 (paragraph 9) requires that a material restatement be highlighted in the auditor's report via the addition of an explanatory paragraph. Well, I guess we now have a better appreciation for why MS opted for the "stealth restatement"…they chose lack of disclosure over transparency.

Before leaving SAB 108, I just had to point out another nugget that may provide some insight into the weak financial reporting practices of MS and other large banks. Below is an extract from SAB 108's introductory summary. Note the highlighted text.

This is absolutely unbelievable! What is even more incredible is that large companies would actually share such thoughts with their securities regulator. If allowing financial statement errors to go uncorrected is acceptable, can outright financial statement fabrication be far behind? Or are we already there and simply don't know it? And if we call out big bank managers and their auditors on such behavior, how long will it be before they assert the Affluenza defense?

But back to cash flows…I was a bit disappointed that Mr. Weil's article seemed to downplay the significance of OCF in financial institutions, largely on the assertions of the cash flow king, and my idol Charles Mulford. I beg to differ. My decades of analyzing distressed financial institutions of all sizes and shapes (as an auditor, acquirer, and researcher) has led me to conclude that OCF can be quite informative in financial institutions, and sometimes even useful in predicting financial distress. OCF capture the realized credit and interest rate risks common to financial firms. In fact, my PhD dissertation was devoted to this very topic in the thrift industry…I am shocked that Professor Mulford missed this stimulating piece of research…NOT! So, OCF do matter in banks, and MS's failure to restate properly is a BIG DEAL.

And shouldn't the public hold financial institutions to a higher standard when it comes to cash flow reporting? After all, they are the custodians of our hard earned monies, and if big banks can't accurately report their own cash transactions, why should we believe that they can manage and / or safeguard the funds we entrust to them? And if you're thinking that I am overreacting to MS's isolated "error," then consider the 2008 restatement by PNC Financial Services which reduced OCF by almost half a billion dollars for cash inflows related to the issuance of perpetual trust securities (clearly a financing activity) in 2006. The sad truth is that cash flow statement classification errors have reached an all time high according to Audit Analytics (13.3 percent of all restatements in 2012).

One of Mr. Weil's conclusions on MS's OCF error could not have been more appropriate, that "the classifications hinged entirely on what was in the heads of Morgan Stanley's executives." That's exactly why we need more transparency in financial reporting! So management can explain to us what motivated their business decision-making. And yes, while disclosure rules aren't perfect, isn't the "real" problem management's propensity to engage in deceptive reporting practices that purposefully ignore the intent of accounting rules?

While I'm on the subject of bank manager intent, I would be remiss in not mentioning the Volker Rule, another well-intentioned attempt to curb bank greed. Unfortunately, this regulatory intervention also will likely fail given all the wiggle room it potentially provides. How so? Do you really think regulators will be able to verify management intent when it comes to enforcing proposed proprietary trading restrictions? No way, management will contend that speculative financial instrument transactions are all hedges related to bank positions. Intent will raise its ugly head again…

Let's look at a current example of just how difficult it likely will be for us (and regulators) to discern proprietary trading using the GAAP-compliant, and auditor reviewed disclosures related to Goldman Sachs' recent $1 billion loss on currency trades. Let's say we want to find out what really happened here…read the financial statements, right? WRONG! Let me show you what I mean…

Goldman Sachs (NYSE:GS) reported revenues from market making activities of $1.364 billion for the quarter ended September 2013, a decline of almost 50 percent from the previous year's quarter (10-Q, page 2). And one major reason highlighted below was a $1.3 billion loss from currencies (10-Q, Note 4).

And how did GS explain the loss? Not very clearly. The same note indicates that the loss is related to financial instruments reported at fair value. Additionally, the note seems to suggest that currency loss disclosure is misleading because it is "not representative of the manner in which the firm manages its business activities." GS would rather that we focus on the net "market making" total since "many of the firm's market-making and client facilitation strategies utilize financial instruments across various product types." Okay…I can buy that…so why did market making revenues decline almost 50 percent? Oh…it was the $1.3 billion currency loss! Duh, back to the original question!

Note 4 in the GS 10-Q suggests that foreign currency derivative contracts used for hedging were to blame. So how big is the GS potential exposure at quarter-end going forward? Of the $1.3 billion in losses, how much was realized (actual cash losses) and how much was unrealized (paper holding losses only)? All seem like reasonable questions to me…and apparently to other analysts as well.

So let's continue digging…GS reports a total of $61.5 billion of derivative assets and $48.5 billion in derivative liabilities (10-Q, page 13), over 90 percent of which are over the counter (OTC) traded instruments (10-Q, page 28). This is likely where the foreign currency derivatives in question reside. And sure enough, according to Note 7 (10-Q, page 29), GS reported a total gross fair value of currency related derivatives of $69.3 billion ($69,229 million not accounted for as hedges plus $44 million accounted for as hedges). Similarly, we find that GS had derivative liabilities of $63.1 billion ($62,972 million not accounted for as hedges plus $135 million accounted for as hedges). According to the below schedule from the GS filing (10-Q, page 35), the overwhelming majority of these financial instruments were considered Level 2 assets, whose reported values were based on complex valuation models whose inputs according to GS were "verified to market transactions, broker or dealer quotations or other alternative pricing sources with reasonable levels of price transparency."

However, we are not provided any detail on offset amounts related specifically to the currency asset or liability derivatives. Furthermore, we still have no answers to the currency trading loss issue. Like what you ask?

Well, first off, how much of the losses relate to financial instrument contracts that no longer appear on the balance sheet (i.e., realized losses)? And how much of the losses reflect management's downward adjustment of currency derivative asset and liability values (i.e., unrealized, holding losses) for financial instruments still carried in the balance sheet?

Also, exactly what was the portfolio or risk-based hedging strategy employed by GS that required currency derivative positions (10-Q, page 28)? GS tells us:

"The firm's holdings and exposures are hedged, in many cases, on either a portfolio or risk-specific basis, as opposed to an instrument-by-instrument basis. The offsetting impact of this economic hedging is reflected in the same business segment as the related revenues."

Why was the "hedge" used? How was it structured? Was the currency "hedge" considered a success or failure? When a regulated entity reports losses of this magnitude, such questions are not unreasonable.

And how are we to resolve the apparent discrepancy between the firm's use of derivatives for risk management (i.e., hedging) in managing its market-making and client facilitation strategies (10-Q, page 14), and its election to NOT use hedge accounting for currency derivatives, particularly those responsible for the huge quarterly loss? After all, GS did report:

"Substantially all gains and losses on derivatives not designated as hedges under ASC 815 are included in "Market making" and "Other principal transactions."

This suggests that GS use of currency derivatives was more speculative in nature, doesn't it?

Finally, exactly what market conditions or events prompted the large currency loss? We need a lot more detail than the generic commentary provided below (10-Q, page 126):

More transparency from GS sure would have been nice. And the Grumpies actually provided some recommendations over a year ago on how to improve financial statement transparency (see Improving Transparency in Note Disclosures: Can FASB Make the "Hard" Decisions?). Had GS followed our advice, a reader wouldn't have had to jump all over the place to find answers, they would have all been in one place.

So, what is one to conclude from all of this holiday season grumpiness? As management intent increasingly becomes a major driver in financial accounting and reporting, the transparency of business "intentions" is critical. After all, a lack of complete and transparent information can lead to inappropriate conclusions. For example, in the case of GS's recent currency losses, I am left to conclude that they resulted from speculative trading. And the unwillingness of CFO Harvey Schwartz to provide details on the GS currency positions only adds to my convictions. Now prove me wrong… give me more transparent information. Oh, and good luck with that Volker rule thing…

Disclosure: No positions

Disclaimer: This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.