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Beyond Binary Thinking

Excellent article in the FT of Oct. 30,  2015 by Conrad Wolfram RE: Binary thinking. Scholarly pursuits in the meta study of the investigation of potentially fraudulent financial statements or financial statements indicating under-appreciated financial distress may rely on models positing a relationship of comparative normalcy within the peer group. By analogy (the possibilities in development of a scale are numerous), a zero score may indicate a 0% chance of materially bad stuff (given the financial statements of the reporting entity and its peers) and a score of one may indicate a 100% chance of materially bad stuff, with many ambiguous possibilities for intervening scores. Bad stuff basically means the reporting entity’s financial statements indicate insolvency (or worse) in the short- to near-term. This type of meta study may be more helpful for gatekeepers such as credit rating agencies than fraud examiners such as FBI special agents. After all, we don’t dress for a walk today in NYC Central Park based on average historical temperature for Oct. 30 in the NYC metropolitan area.

The guidance I provide to my students includes the following questions to be asked in the development of professional divergent and critical thinking (in addition to the presumed awareness of convergent thinking – that is, what the commonly accepted ‘wisdom’ is):

  • The question is not whether fraud existed / exists in the given reporting entity – the question is whether it was / is material. We cannot avoid fraud in this high stakes, excessively competitive, winner-take-all, coopting of independence in law gatekeepers by their clients, puffery-dependent marketing and promotion schemes, etc. (examine your own experience for other attributes that tend toward depictions of something other than the truth, the whole truth, and nothing but the truth) socioeconomic and political environment.
  • Practice, at a minimum, tertiary thinking. For example, the question is often not either / or – it is either / or / neither / or something of a hybrid, and it may be something altogether different now!

Materiality and Multidisciplinary Collaboration

FASB is seeking comments on its proposed amendments to the meaning of materiality: See the Conceptual Framework proposal and the Accounting Standards Update, with the former applicable to nongovernmental entities (GASB has its own framework) and the latter applicable to all entities. Also, see Journal of Accountancy editorial comments. Compare IAS 1 and IAS 8 (International Accounting Standards), which have divergent interpretations of materiality.

FASB refers to materiality as a legal concept as part of an overall strategy to reduce the disclosure of irrelevant and immaterial information, the disclosure of which functions to add to the cost of reporting entities and obfuscate genuine material issues and explanatory data without providing meaningful benefit to users of financial statements. In practice, materiality would be defined by the entity’s governance persons (e.g., audit committee), senior management (e.g., CFO, in-house counsel), and outside experts (e.g., disclosure counsel). These are the same groups presently overseeing the preparation and publication of financial reports to the SEC.

Generally, I find it difficult to argue against the position taken by the FASB. Specifically, I am waiting for FASB to pronounce also that fraud is a legal concept, referring the opining on this concept to legal practitioners. Also, so many decisions relevant to the interpretation and application of generally accepted accounting principles (GAAP) depend on understanding commitments and contingencies and rights and obligations – a skill set more properly within the domain of legal practitioners and not accountants. For example, how are accountants educated and trained in contract interpretation? How are accountants educated and trained in risk management; should this practice be referred to actuaries and insurance professionals (I formerly practiced as a risk manager and insurance professional)?

The intent of this post is not to downplay the usefulness of accountants (I formerly practiced as a CPA) and to promote the usefulness of attorneys (I formerly practiced as an attorney) but to note that these practices overlap significantly. I fear that Humpty Dumpty may experience a renaissance.

Thinking Generally

This NYT article by Gretchen Morgenson on Oct. 17, 2015 suggests that presentation is as important as disclosure in communicating (or not) financial information (see also Enron for contrasts between presentation of a related party transaction in notes to the financial statements and disclosure of financing cash flows as operating cash flows in its financial statements, among other data materially misleadingly disseminated to the public). That is, where and how the data are published affects predominantly their interpretation by readers, especially those without sufficient experience in financial shenanigans, data aggregation risk, and commonly accepted methods of preparation of the data. Unsurprisingly, publishers and authors, even those hiding behind the corporate form and other legal fictions, have personal agendas, and the risk accompanying this hazardous condition is amplified where publisher and author are not independent in fact.

Part of the success of those dumping large amounts of data characterized by both presenting detail in too summary a format (see tables such as income statements) and disclosing detail in obfuscating layers of language (compare, plain English requirements and what passes as such in filings with the SEC) is due to deficiencies in training and education of the reader. While this may appear as blaming the victim, a shared condition of the event popularly known as fraud is that both the perpetrator and the victim often want (more or less) something for nothing. This is fertile ground for wrongful belief accepted as conventional wisdom.

Many analysts and others are educated and trained in statistics and related social science methods and techniques that overvalue the ability to generalize. That is, problems are identified and solved according to the strategy of thinking that takes what can be measured in one context and rigorously applies it to another context. For example, consider the reasoning underlying analysis based on benchmarks, industry norms, etc. that leaves those not conforming to the overarching influence of exaggeration, puffery, excessive optimism / pessimism, and other BS in its wake. Reasoning by analogy and the transfer of understanding and skill developed in one context and qualitatively applying it to a different context is normally given short shrift as something too soft and unscientific. In brief, the poets and novelists’ voices are muted under the virtually suffocating cover of spreadsheets and other predefined database outputs.

There are few, if any, tools better at generalization than the computer. Preparation and presentation of tables, figures, and other exhibits may wow the reader that glimpses the bar charts, graphs, and other outputs allegedly demonstrating the point of the presenter in a summary and conclusive matter, but the essential question – are we looking at the right data for the decision at hand – is often taken for granted. After all, past performance is not invariably a reliable indicator of future performance, and this is due both to changes in external conditions (for example, an earthquake off the coast of Japan) and/or changes in internal conditions (for example, a decision to discontinue a line of business). Additionally, no one has ever read a financial statement filed with the SEC containing the line item “fraud expense.” At best, one may observe a note about inventory shrinkage. Does this suggest that fraud generally is an immaterial part of entities’ financial reporting? In practice, fraud is neither routinely estimated nor assumed as an element of spreadsheet calculations – it is some other dude’s problem.

In brief, the issue may not be whether enterprise A reports a superior performance based on metric M than enterprise B, but what metric is really key for this decision? What data are excluded? How did the norm in fact become the norm; whose influence swayed? Management bias is realized in practice through related party and self-dealing transactions – some fair exchanges of value, some not. The legal opacity of many entities’ beneficial ownership (see straw man) makes the gatekeepers’ job, including independent registered public accountants, error-prone. Publisher, author, and inadequately undisclosed related parties may be closer than they appear.

Aggregation of Data Risk

From the NYT Oct. 12, 2015 by Patricia Cohen on gaming by for-profit colleges to protect their indirect financing via student loans through the U.S. Dept. of Education (and the U.S. taxpayers):

  • “…even schools with egregious violations have become adept at exploiting loopholes, sidestepping rules or taking advantage of yearslong (sic) appeals processes. Companies with several campuses can pool graduation, financial, enrollment, staffing and other statistics to mask weak performers…”

This may be seen in other contexts too as even fraudulent enterprises such as Enron reported many transactions accurately and completely. Aggregation of data is a wonderful way to bury things, creating composite averages and account balances that tend to demonstrate normalcy in reporting (or close enough to it). The cliche of ‘pigs getting fed and hogs getting slaughtered’ as a strategy to evade fraud detection by the usual suspects (e.g., auditors, regulators) is common and effective. Even when it fails it may add years to the lifecycle of a fraudulent scheme, providing fraudsters an opportunity to escape with riches and reputation while the music still plays.

Attorneys, accountants, and other service providers (cf. facilitators) with an excess in creativity and client advocacy skills and deficiency in ethics and reality-tolerance capacities too often get exorbitantly rewarded for behavior that tends toward the shadowy side where integrity is measured by how much one can get away with.

Who Benefits, again?

An interesting article in the NYT of Oct. 10, 2015 by David Segal illustrated the utility of technology to evade identity and accountability under (variable) corporate forms across the U.S. A remedy is posited: Detection of real identity and initiation of attachment of real accountability for the decision-making individuals operating and benefiting from wrongful schemes would be enhanced by resort to the data of the institution receiving the financial resources of the victim (e.g., records of electronic transfers of cash) for conversion by the corporate form and its breathing persons to their own secreted (and remote from legal process such as bankruptcy) private property. The electronic trail of the financial flows provides inculpatory (and exculpatory) documentary evidence.

Confidentiality as policy embedded in law and regulation is a public good where it promotes responsible stewardship of resources protected under federal or state laws (e.g., private property rights, broadcast rights). Where it allows the exercise of undisclosed (breathing) principals to exploit confidentiality and create a pool of fools in the dark, responsible stewardship is practicably in the eyes of the beholders – including undisclosed principals – a privately defined and maintained concept.

Sources and uses of financial resources, especially privately created money under the protection and support of the Federal Reserve System – an institution partially accountable to the public under its Board of Governors specifically and federal laws generally, lead to the issue of whose money is it? The account holder? The institutions backstopping it? The public whose tax payments support the state and its infrastructure (e.g., roads) and capacity (e.g., public safety)? The state whose public interests trump private interests?

Ironically, deficient and short-sighted reasoning similar to that used by individuals who do not care about their privacy rights as ‘if you are not doing anything wrong, who cares if the government and its private contractors are eavesdropping?’ may be applied to confidentiality that allows financial flows to remain hidden to all but a few – why not disclose the identities of the principals if they are not doing anything wrong? Is protection of private sector profitability a means to lead to the highest and best use of resources? In all cases? Fraud risk management and due diligence, including financial forensics and analysis, are not easy where the public domain is not the default repository of data.

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