Financial sector lacks standards

Quarterly profits are quarterly profits, right? A company simply reports the revenues and costs associated with a three-month period and the difference must be the net gains or losses accrued by the firm. In theory this is how it works; reality often paints a different picture.

Let us take a look at Goldman Sachs, which just recently announced huge and unexpected profits for the first quarter of 2009. Goldman Sachs reported $1.8 billion in profits in the first quarter of 2009. This announcement was coupled with the decision to issue $5 billion in stock in order to raise the funds necessary to pay back the Troubled Assets Relief Program money borrowed from the Treasury. Closer inspection of the profit announcement shows that Goldman Sachs made some tactical financial maneuvers to craft these profits.

Goldman Sachs had originally been on an accounting year whose first month is December. This means that in 2008, the first accounting quarter — in the books of Goldman Sachs — was from December to February. There are reasons to make the accounting quarter different from the calendar quarter. For example, December is a month that features high levels of retail sales due to the holiday shopping season. By including December in first quarter projections, a firm can mitigate the low levels of sales in January, again associated with returns from the holiday shopping season, and project moderate levels of profits. High profits will make it easier for the company to raise capital through stock offerings and will also cause stock prices to rise, resulting in increased portfolio and stock option values for executives and investors.

This year, however, Goldman Sachs embraced a calendar year accounting schedule. This means that for 2009, the first accounting quarter consists of January, February and March. Good-bye December! Besides the obvious changes with respect to comparison — the first quarter of 2009 does not correspond to the same time period as the first quarter of 2008 — it also begs the question, what happened to December? Looking at the accounting books of Goldman Sachs, it seems that December was essentially ignored. This exclusion of December from the accounting books has led some economists and accountants to label December an "orphan month."

It should come as no surprise to anyone that December featured lots of losses and write-offs. Write-offs occur when an asset loses much of its market value, and its value to the firm, represented in the accounting books, must be adjusted downwards. According to Floyd Norris, who live-blogged the accounting issue at Goldman Sachs for the New York Times, December included $1.3 billion in pre-tax write-offs. This amounts to approximately $780 million in write-offs after taxes. If December were included in first quarter estimates for Goldman Sachs, it would make a large dent in the reported profits.

What this amounts to is a lack of integrity in accounting standards in the financial sector. There is absolutely no reason to believe that this behavior is unique to the quants, analysts and executives at Goldman Sachs. If you found a way to give your company the appearance of gold when the underlying metal was bronze, it would be irrational not to do so. What is irrational is that the Financial Accounting and Standards Board allows companies this much leeway in deciding how to best misrepresent themselves to potential investors.

Companies and their accountants already have many options when deciding how to represent their earnings and profits to investors. Firms that actually sell items can decide whether or not the first or last items in inventory are those that are considered sold. These systems are known as First In First Out and Last In First Out, respectively. Depending on the rates of inflation or deflation, either FIFO or LIFO can exaggerate profits during a given time period and make the company appear more attractive to potential investors than it actually is. A more sensible approach would be to simply find the average cost of a unit of a good in inventory and apply this price to all units of that good. In the end, the numbers all add up the same and do not exaggerate profits to the detriment of investors.

Another accounting concept is known as mark-to-market. Mark-to-market accounting refers to the practice of valuing assets at their current price as determined by the market. This is a good way of valuing assets whose prices can accurately be determined by the market. However, many over-the-counter derivatives, such as credit default swaps, are contractual agreements between buyer and seller and are thus not traded in regulated and organized exchanges. There are no true market forces determining the fair and appropriate price for these assets. The values are estimated using complex mathematical and financial models that sometimes appear to rely on unfounded assumptions. The mark-to-market prices, determined within the mathematical models, were used to assign inflated values to many assets in order to give the appearance of profits and capital gains by a firm. The Emergency Economic Stabilization Act of 2008 gave the Securities and Exchange Commission and the FASB the "authority to suspend mark-to-market accounting."

Some have argued that mark-to-market accounting does not work in a market gripped by fear and turmoil. Mark-to-market accounting must be done away with in order to give some semblance of fiscal stability to the balance sheets of major financial institutions. This is nothing more than a gimmick; when the prices of these assets increased during a speculative bubble, there were no qualms about using mark-to-market accounting practices. However, when the bubble bursts and asset prices are depressed, perhaps rightfully so, it is dishonest to value these assets at prices reached at the peak of the bubble. To do so would greatly exaggerate the net value of a firm that deals in these types of securities. When the price of a gallon of gasoline dropped to approximately $1.50, companies like ExxonMobil and British Petroleum were not allowed to value gasoline at the market-high price of more than $3 per gallon. To allow financial institutions to do so would be hypocritical, dishonest and detrimental to the individual investor.

These are just some of the recent accounting scandals that have come to light. It is very likely that there are many more that are still uncovered. When details about Enron first emerged, it was considered the black sheep and a rogue company. When details about WorldCom and other companies also emerged, it became clear that there were systemic problems not unique to a particular firm.

When times are good, nobody wants to question the party and speculate about tomorrow. But when times are bad and the waters recede, it becomes easy to spot, to paraphrase John Kenneth Galbraith, the garbage that lies under the water's surface. We must make sure that we are committed to cleaning up the garbage rather than being content to let the water cover it up again and hide it from our sight.

Alexander Draine is a Rutgers College senior majoring in economics. His column, "Draine on Society," runs on alternate Tuesdays. He is a contributing writer to the Johnsonville Press.

Alexander Draine

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