Peeling away financial reporting issues one layer at a time

“Big Bath” Accounting at Merrill Lynch: Give Me that Old Time Conservatism

In a story whose main subject was increasing auditor vigilance, the Associated Press wrote as follows on November 2, 2007:

"Merrill Lynch last week reported a bigger-than-expected $8.4 billion in writedowns…. On Oct. 5, the investment bank had initially said it would take $4.5 billion in writedowns when it announced earnings later in the month.

Merrill executives said they got that much bigger number by deciding to go with a valuation at the more "conservative" end of the range they had established weeks before. Company officials cited their more "conservative" approach 12 times during a conference call with analysts, according to a transcript provided by Thomson Financial StreetEvents.

That sounds like the company’s managers found some religion when it came time to account for such losses, surely preached to them by their auditors." [emphasis supplied]

Sorry, but it looks more like a big bath to me, and the auditors are falling down on the job to let them get away with it.  The nefarious thinking behind big-bath writedowns is that if you have to take a loss, and analysts know its coming, then by all means make it a big one. If analysts perceive the whole tubful to be non-recurring, score chutzpah points for you.  And, award yourself more points if the inevitable writebacks can be recycled to earnings under the radar — thereby lumped together with other ‘permanent earnings’ in valuation rubrics.

"Conservative," My Tuchas

What really irks me is the way Merrill apparently believes they have legitimized their big bath by a virtuous appeal to the conservative approach taken in measuring their losses.  In fact, conservatism was officially repudiated by the FASB 27 years ago: 

"Conservatism in financial reporting should no longer connote deliberate, consistent understatement of net assets and profits.  The Board emphasizes that point because conservatism has long been identified with the idea that deliberate understatement is a virtue.  That notion became deeply ingrained and is still in evidence despite efforts over the past 40 years to change it." [Statement of Financial Accounting Concepts No. 2, para. 93, emphasis supplied]

I think that Isaac Hunt, when he was an SEC Commissioner, stated the obvious as well as it could be stated in a 1999 speech when commenting on Staff Accounting Bulletin 100, which was issued with the objective of curbing big bath accounting shenanigans:

"…balance sheet amounts must reflect management’s best [i.e., not conservative] judgement — i.e., be reliably and appropriately based." [pp. 3-4; emphasis supplied]

For the auditors’ sake, I’m hoping that the "conservative" spin was conjured up solely for the entertainment of the conference call audience, and not also for the purpose of persuading the auditors.  Not to beat a dead horse, but according to the FASB, conservatism died sometime during the Truman administration.  If the auditors actually bought into the conservative hokum, the AP’s story is more about auditor capitulation, or incompetence, than about their newfound vigilance. 

Here’s hoping and expecting that the SEC staff will review Merrill Lynch’s 10-Q, and give a close look at their mark-to-model calculations leading to the big bath.  Based on the AP’s reporting, it may well be that Merrill has unwittingly already made a strong case for draining some of the suds from the tub. 

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