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May 19, 2023

Beware of the Gray Areas in Accounting

Recent high-profile bank failures have raised concerns about the reliability of accounting auditing standards. U.S. government agencies are still investigating the reasons behind the collapses of Silicon Valley Bank and Signature Bank earlier this year. 

However, it’s likely that these banks exploited some gray areas in the accounting rules to make them appear more economically secure in their year-end financial statements than they actually were. 

Learning from Enron

Andrew Fastow often speaks publicly about issues concerning financial misstatement. A convicted felon, Fastow has a unique experience with fraud: He was the CFO of Enron in October 2001, when it the company became famous for the largest U.S. bankruptcy case of its time. 

Fasto recently addressed the Public Company Accounting Oversight Board (PCAOB), which was established by the Sarbanes-Oxley Act of 2002 to prevent future scandals like Enron. He recommended that the PCAOB consider revising the accounting and auditing rules to deter corporate fraud. 

Rather than solely focusing on detecting deliberate fraudulent activities, Fastow urged the PCAOB to pay attention to the “fraud that arises from exploiting loopholes resulting from the ambiguity and complexity of the rules.” According to Fastow, this scenario played out in the Enron case, where misleading information was often a consequence of exploiting the complexities of the rules rather than intentionally reporting false numbers.

Compliance vs. reality

To illustrate how companies can exploit the complexities of accounting rules, Fastow provided a good example of how financial statements that are fully compliant with regulations can deviate from economic reality. 

Here is that example: In 2014, the average price of oil was $95 per barrel, and although the price hovered around $110 for most of the year and dropped to $50 at the end of the year, companies were required under the accounting rules of that time to calculate an average based on the price on the first day of each of the preceding 12 months. This calculation resulted in an average of $95 per barrel despite the market price being $50 when oil and gas companies issued their financial statements.

All oil and gas companies followed this rule, reporting reserves based on $95 per barrel even though the market price had dropped precipitously to $50 by the end of the year. Consequently, they massively overstated their economically recoverable reserves, a critical metric used by Wall Street when evaluating independent oil and gas companies. 

Fastow concluded that the prevailing mindset was that as long as the rules were being followed, the misleading nature of certain financial statements was deemed inconsequential.

A complex problem

A founding member of the PCAOB, Charles Niemeier, has acknowledged that resolving the issue of financial reporting fraud extends far beyond simply revising auditing standards. The challenge becomes even more daunting when dealing with financial reporting matters that rely on subjective judgments.

For example, accounting estimates can be based on subjective or objective information involving varying degrees of measurement uncertainty. Some examples of accounting estimates include allowances for doubtful accounts, impairments of long-lived assets, and valuations of financial and nonfinancial assets. While certain estimates may be straightforward, many are inherently subjective or intricate.

Another area prone to manipulation is the going concern assessment, which forms the foundation of all financial reporting, according to the U.S. Generally Accepted Accounting Principles. 

The accounting rules grant company management the final responsibility for determining whether or not there is substantial doubt about the company’s ability to continue as a going concern and disclosing the related information in footnotes. The standard provides management with guidance that aims to reduce the inconsistencies in the timing and content of disclosure commonly found in footnotes.

Misrepresentation of finances can occur in a variety of ways when executives seek to exploit the ambiguous aspects of financial reporting for their own benefit, particularly as regulations have transitioned from historical cost in favor of fair value estimates.

Have questions? Smolin can help

When making subjective estimates and evaluating the going concern assumption, it’s important to step back and ask whether your institution’s financial statements, even while they are in compliance with regulations, could potentially mislead investors. 

If you have questions about these issues, contact our team of professionals at Smolin, and we’ll help you understand the rules and assess current market conditions.

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