Dennis the Peasant

Timmy Teaches The Lefties

The ever-admirable Tim Worstall articulates a basic economic truth that has escaped the Whole Foods Market crowd until just last week: 

...[T]he founder and CEO of Whole Foods, that store which supplies exactly what you want, can have very different political and economic views from you. As he is pursuing profit, it doesn’t matter what he thinks, only whether he is offering you what you want at a price you’re willing to pay.

As I said last week, had any of the Prius driving lawyers and junior execs who shop at Whole Foods Market been paying attention, they would have known John Mackey was one of the "bad guys". Two weeks ago what John Mackey thought made no difference to that crowd. Now that reality has intruded they decide it's all Mackey's fault.

Morons.

Note: It's worth mentioning that there is absolutely nothing "egalitarian" about the kind of asshole who shops at Whole Foods. They're the sort that will loudly bitch out an attendant at Starbucks for screwing up their latte less than two minutes after they finish telling you why health care reform is a "moral and ethical" obligation.

Remember 'Mark-to-Market'?

Anybody notice, as I have, that the big controversy over the use of mark-to-market accounting (FASB 157) has gone away? Given that it was supposed to be a major impediment to "honest" accounting, correct bank profits, financial sector liquidity and truth, justice and the American Way, you'd think it would still be around.

But it isn't.

There's a reason for nobody's talking about mark-to-market accounting these days: There never was a real controversy over mark-to-market accounting in the first place. At least there wasn't amongst those that (a) understood accounting and (b) understood bank regulation. It's worth noting that most of the noise regarding mark-to-market came from (a) politicians, (b) bureaucrats, (c) political partisans and (d) journalists. And given that, it isn't particularly surprising that no one from columns (a), (b), (c) or (d) really knew what they were talking about.

The issue - the real issue, that is - was one of risk. That the use of the provisions of mark-to-market accounting as required by FASB 157 caused banks to book large losses on securitized mortgage-backed securities was a matter of concern; clearly these securities had some sort of worth, and just as clearly the losses booked under FASB 157 was overstated. That issue, however, would have remained a matter of concern for bank managements and shareholders only had it not been for the fact that bank regulators were using GAAP-based financial data to calculate required loan loss reserves.

The use of GAAP-based financial data by bank regulators - which was a matter of choice on their part - lead to banks' loan loss reserves being calculated using the losses booked under FASB 157. These losses were large enough to push many banks into a state of illiquidity: They were required to reserve so much of their available capital for the losses booked that there was little or no capital available to lend to businesses and individuals. Ergo, suddenly the U.S. economy in general, and the financial services sector in particular, is facing a massive liquidity problem.

Now, from my vantage point, the simplest and easiest way for bank regulators to mitigate the effects of FASB 157 would have been to either (a) revise their loan loss reserve requirements, or (b) have the banks use non-GAAP (or more accurately, modified GAAP) financial data in the calculation of loan loss reserves. Sure, revision or abandonment of FASB 157 and mark-to-market accounting could solve the problem as well, but it's important to remember why both were instituted in the first place: To end fradulent valuations of financial instruments that were either thinly traded or had no market.

What just about everyone connected with the fuss over mark-to-market accounting seems to have conveniently forgotten is that it was instituted by the Financial Accounting Standard Board in response to abuses under the old method of accounting. The old method was, in essence, this: If there was no market valuation available to value the financial instrument in question, an alternative method could be use if it was "reasonable". As you can imagine, it took the sharpies in the financial services sector about 15 minutes to come up with their own valuation models that were (a) "reasonable" in appearance, and (b) generated big, fat profits. Understand? New standards from FASB don't just drop out of the sky. They're instituted for very specific reasons.

It's worth noting that FASB 157 was instituted without objection by either Treasury, the FDIC, Congress or the White House. The reason there were no objections was simple: FASB 157 was the solution to a specific problem that had been identified by bank regulators.

So why didn't Treasury or the FDIC modify their regulations to get around the problems associated with  FASB 157 and mark-to-market accounting? The answer to that is simple: They were unwilling to shoulder the risk associated with making the necessary changes to their regulations. Lower loan loss reserve requirements and/or modified loan loss calcluations would then be their responsibility, and if there were future bank failures, they would then have to bear the burden of responsibility for their actions before their political masters (whose primary goal at that point would be deflecting responsibility from themselves) and to the political partisans and journalists who neither understand the issues nor care much for a sober analysis of the facts.

And that, my friends, is why you ended up with the pseudo-controversy over mark-to-market accounting. Somebody had to accept the risk of lowering loan loss reserves and freeing up bank capital, and the government was unwilling to do so itself. It much preferred the idea that the bankers and their auditors take on the risk by forcing them to value securities that cannot be valued by an objective criteria. To get from Point A to Point B meant putting pressure on both the banks and the accounting profession via FASB 157 and mark-to-market.

Remember this: Regulators are bureaucrats. Bureaucrats are risk-adverse in the extreme. They are risk-adverse in the extreme because, in a bureaucracy, the only way a bureaucrat can get himself in trouble is by DOING SOMETHING.

If you don't believe me, go and look at the behavior of the regulators directly involved in dealing with Bernie Madoff's fraud.

Simple Graphs For Simple People...

Demonstrating the sort of subtle intellect he's become renowned for, Richard Murphy appropriates an embarrassingly simplistic graph from Huffington Post and uses it as "proof" that massive government spending is THE ANSWER. He thinks it is the sort of thing that will move adults to back the New Economic Institute's embarrassingly simplistic Green New Deal, which Dickie helped write.

Here's the graph:

 

It's worth noting that the author (one Paul Abrams) of the Huffington Post article uses the above graph to defiantly hurl the following dare at the non-Hopey/Changey:

Winning The Economic Argument: Show Opponents This Graph, Then Ask Them To Explain

It's also worth noting that were Mr. Abrams a college sophomore his graph and argument might, on a good day, rate him a B-/C+ in a typical Introduction to Macroeconomicscourse taught at a typical midwest land grant institution of higher learning. That Richard Murphy would slap this up on his web site and declare victory tells you all you need to know about his grasp of the dismal science.

Anyway, in answer to Mr. Abrams' challenge:

When I see Gross Domestic Product moving in lockstep with governmental (federal) spending over a substantial period of time, the conclusion I DO NOT REACH is that the New Deal ended the Great Depression. What the above graph suggests to me is that the federal government's spending has appropriated enough of the available credit to significantly depress private investment... thus prolonging, rather than shortening, the Great Depression. Private investment is, first and always, the only path to economic recovery and new growth.

Anyone interested in the finding the basis for my conclusion would be advised to read the following two books:

The Great Contraction: 1929-1933 by Milton Friedman and Anna J. Schwartz

Depression, War, and the Cold War by Robert Higgs

There are others, of course, but these two will give you what you need the fastest.

That someone with Murphy's educational and professional background would appropriate the sort of dreck Abrams is peddling is as disappointing as it is predictable.

It is worth noting that unfettered capitalism was not the root cause of the Great Depression... That honor must be shared by the Federal Reserve Board, Congress, and the Hoover and Roosevelt Administrations. I think there is an excellent chance that should this recession (largely caused by the Federal Reserve Board, Congress and the Bush Administration) deepen, it will largely be because of the Federal Reserve Board, Congress and the Obama Administration.

And for you Republicans out there, please understand that your "plan" is simply a different path to the same error being committed by the Democrats.

OK, OK, I Get It: You Don't Care That I Made Raj's Book...

Well, instead of Ragging on Raj, which is what I wanted to do, it seems most of my readers want to talk about this. Evidently, they have minds of their own, those readers of mine.

The bastards.

Well, as much as I'd love to jump right in there and regale you all with accounting theory, governmental GAAP and overall we're-on-the-fast-track-to-Hell-now-that-Obama's-in-charge fearmongering, I just can't do it. Neither the energy nor the enthusiasm is there.

Corsi's article is the financial equivalent of one of those global warming scare articles... You know, the sort that proclaims if we don't all go vegetarian, install pee-recycling toilets, forego having rug rats and stop the cows from farting methane, Gaia will be a 1,000 degrees in the shade wasteland by next Wednesday.

In both cases my response an appropriately apathetic Yeah, whatever...

If you're the sort that enjoy wringing your hands over the state of the national debt, by all means indulge. Who am I to deny you the pleasure of being neurotic? In the meantime, I'll concentrate on that which I find to be meaningful...

Disreputable Me...

Sorry for the unannounced disappearance, but a week ago Monday I contracted the mother of all flu bugs, which morphed into the mother of all head colds, which morphed into the mother of all killer sinus infections. I haven't had anything remotely like this since I quit smoking back in 1998.

Anyway...

In my absence Richard "Our Dickie" Murphy was alerted by one of his dim-bulb readers that I, Kenton E. Kelly, CPA, was a complete fraud, and that my sophisticated yet soothingly syncopated moniker was not my real name but yet another devious nom de guerre utilized by the anonymous yet offensive fellow blogging as Dennis the Peasant. As usual, neither Dickie nor his readers can handle a fact without mangling it. As you can imagine, Our Dickie was not amused in the least by my commenting under my real name... It seems that in his world, I'm bringing my profession into disrepute by leaving straightforward, nonabusive questions and comments under my own Christian name at other people's (i.e., his) web sites.

The man is dumber than a box of dead crabs.

In any event, Murphy never did get around to actually providing documentation supporting his contention the entirety of 4 years worth of profits earned by the S&P 500 "weren't real", although he did address a meandering and for the most part off-topic post to yours truly entitled "What is profit?". Evidently that was supposed to tide me over. It didn't.

What is of interest to me in this whole episode - beyond confirming that in any battle of wits Richard Murphy will enter the fray virtually unarmed - is just how bad the journalism was in the original New York Times article that Our Dickie quoted. Here's the link to said article.

The first thing I would ask you to note would be the title of the article:

Easy Loans Financed Dividends

That's a pretty straightforward, declarative statement, right? You'd assume - or at least I'd assume - that if some reporter from the New York Times was writing an article with such a title, there would be some evidence of businesses actually borrowing money to pay dividends, right?

Wrong.

Look at this statement from the article:

From the fourth quarter of 2004 through the third quarter of 2008, the companies in the S.&P. 500 - generally the largest companies in the country - reported net earnings of $2.4 trillion. They paid $900 billion in dividends, but they also repurchased $1.7 trillion in shares.

Notice anything? Like the rather minor fact that if you subtract $900 billion in dividends from $2.4 trillion in net profits you end up with a residual net profit of $1.5 trillion? Based on the numbers supplied, it would seem there would be no need to borrow money to pay dividends, right?

Wrong again.

It least you're wrong if you buy into the argument of New York Times journalist Floyd Norris. According to Mr. Norris (and absolutely nobody else), open market share repurchases by companies are a form of shareholder dividend. Why?

Who knows.

When one gets over the hurdle of accepting Norris' rather novel construct, one can then subtract the $1.7 trillion in share repurchases from the residual $1.5 in net profits and voila! - Wall Street has financed dividend payments to customers by borrowing cheap money printed by The Bush Administration. (The bastards.) However, it should be noted that there's a tiny problem with Mr. Norris' analysis, such that it is.

It's wrong.

And meaningless. Other than that, though, it seems to reach the level of journalistic competence one associates with the New York Times. The first problem I noticed is obvious: Mr. Norris has assumed that the S&P 500 companies repurchasing shares did so with borrowed money. Why?

Who knows.

Norris provides no statistics regarding cash positions or debt levels from either the fourth quarter of 2004 or the third quarter of 2008 to support his contention. Evidently it never occurred to Norris that companies could have had on hand (or generated) the $200 billion in cash that was in excess of anticipated needs. In his primitive world, net profits and cash flow move in lockstep (which they most certainly don't in the real world).

Had Mr. Norris a bit of learning, he'd know that when a company finds itself with a pile of cash on hand that exceeds the company's operational needs, the company has a number of perfectly valid options for using that excess cash. Several of those options are as follows:

• investment in new business lines
• a one-time dividend to existing shareholders
• repurchase of shares on the open market
• debt reduction
• investment in existing business lines

Obviously, the decision amongst options is dictated by the individual company's circumstance. And once again, had Mr. Norris a bit of learning, he'd know that when a company repurchases shares on the open market, it can have several reasons for doing so. First, and most obvious, is to attempt to boost share price by reducing the number of shares available. However, there is a second, and we'll mention it here because it demonstrates just how far off base Mr. Norris could be...

Let's say Peasant Enterprises is an S&P 500 company selling chrome balls and plastic pink flamingos in the lawn ornament industry. Peasant Enterprises has 100,000 shares of common outstanding, which is presently selling for $50/share. The common has a yearly dividend of $5/share, and therefore yields 10%. This means Peasant Enterprises pays out $500,000/year in cash as dividends.

Now let's assume that the President of Peasant Enterprises, Mr. Dennis T. Peasant, is a greedy capitalist bastard who votes Republican and drives an SUV. He'd rather pay himself a larger salary for his hard work in looting and pillaging than pay shareholders $500,000 per year so they can retire in poverty at age 65. So what does Mr. Peasant do? If he lowers the dividend, chances are the stock price takes a dive, which will in all probability will get shareholders and analysts all cranky. No, that won't do at all...

Well, how about this: Mr. Peasant goes to the bank and borrows $200,000 @ 6.5%. He has just incurred an annual interest expense of $13,000. However, if he repurchases $200,000 of Peasant Enterprises common stock, he will save himself $20,000 in dividend payments (4,000 shares x $5/share) per year. And if Peasant Enterprises' marginal tax rate is 30%, the company will save itself $3,900 in taxes. All told, borrowing the $200,000 could increase Peasant Enterprises' cash flow to the tune of $10,900 per year ($20,000 - ($13,0000-($13,000 x .3))).

So you see, you could actually increase your company's cash flow while at the same time lowering net profit and increasing debt. Is it the wrong or right thing to do? That's entirely dependent on the facts and circumstances surrounding that particular company. Which is why Mr. Floyd Norris of the New York Times is so completely off base in his assertion. Then again, it seems clear from the tone of his article that he isn't so much interested in providing fact-based analysis as he is providing his readers a quick and easy villain to a economic situation that is well beyond their (and his) comprehension. For Norris, it's less taxing and more rewarding to nudge his readers and remind them that it's all about Greedy Capitalists. That, of course, is what attracted Richard Murphy's attention in the first place.

Fools And Cranks...

As many of my regular readers have noticed, in the past several weeks I've picked up a new dimwit to pick on: Richard "Our Dickie" Murphy. Murphy is a Chartered Accountant out of the United Kingdom, and quite alarmingly, he seems to have a certain cachet amongst Lefty/Progressive Euroweenies in matters having to do with accounting, finance and economics.

The reason I find his status alarming is simple: He's a fool and a crank.

The reason I say this is equally simple: Facts never trouble a fool or a crank. And the bottom line is Richard Murphy does not care a whit about facts. He has a dauntingly simplistic worldview that is based on a couple of pet notions, and his interest lies in nothing more than snatching whatever factoids he might come across that seem (and I emphasize the word seem here) to confirm those pet notions.

The fact that he's your basic garden variety anti-capitalist, anti-free market statist doesn't offend me. What offends about Richard Murphy is (a) his ignorance about a remarkable number of different aspects his profession, and (b) his hypocritical indifference to fact.

It further offends me that he is the British equivalent of a Certified Public Accountant, which means there are folks out there who could end up making the assumption that all Chartered Accountants and C.P.A.s are as sloppy and stupid as Richard is.

The first thing to remember here is that Richard Murphy spends a great deal of time claiming that the real problem with audits and auditors is that they don't "look behind"(i.e., audit beyond what is required by Generally  Accepted Auditing Standards) the valuations required by Generally Accepted Accounting Standards and establish a "true and fair" valuation based upon some sort of cosmic measure of worth.

It a standard he holds everyone but himself to. 

Here's Murphy's post:

Modern finance: making dividends out of loans

The N[ew] Y[ork] T[imes] reports:

From the fourth quarter of 2004 through the third quarter of 2008, the companies in the S.& P. 500 - generally the largest companies in the country - reported net earnings of $2.4 trillion. They paid $900 billion in dividends, but they also repurchased $1.7 trillion in shares.

We know the profits weren’t real. [My emphasis - DtP] Much of it was simple mark to market revaluation. [My emphasis - DtP] In which the dividends and share repurchases were paid for out of borrowing. [My emphasis - DtP]

No wonder leverage has shot through the roof. And now companies will fail as a result.

I know this is the US and they use different rules, but the IASB has a lot to answer for in releasing this madness on the rest of the world.

Those are three genuinely amazing generalizations. Here's the question I posted at his site:

Richard-

You say we know these $2.4 in earnings “weren’t real”.

Really?

Would you have anything in the way of documentation to support your assertion? Like, perhaps, a detailed analysis of that $2.4 trillion in earnings?

Just leave a link, if you please.

Thanks

Here's his response:

Kenton

Try this:

“A big part of the problem is that accounting rules have allowed banks to inflate the value of their assets, he said.

“Accounting has become a new exercise in creative fiction,” with the result that banks are carrying a lot of “sludge” assets clogging up the balance sheet, hindering their ability to fuel economic growth, he said.”

That’s Lazard Ltd (LAZ.N) Chief Executive Bruce Wasserstein

http://www.reuters.com/article/GCA-CreditCrisis/idUSTRE49T77O20081030

Why are you in denial when the rest of us aren’t?

Is it all hunky dory in your world?

Richard

And my reply was:

Dennis-

Why, in this context, would you ask me if all is hunky dory in my world? What a strange response to a straightforward question.

What I am trying to do is verify that your claim has is based in fact. That’s all.

Given that the financial sector represents 20% of the S&P 500, what you are claiming is the following:

1) All $2.4 trillion in profits are directly attributable to the financial sector of the S&P 500.
2) The remaining 80% of the S&P 500 had profits and losses netting to $0.
3) All of the $2.4 trillion in profits were a result of market-to-market gains.
4) The financial sector had, on a net basis, $0 in operating profit.

In other words, you’re claiming that 100% of the S&P 500’s profits for October 1, 2004 through September 30, 2008 were the result of mark-to-market accounting for marketable securities.

Those are extraordinary claims, which is exactly why I asked you to provide meaningful substantiation. I find it interesting that what you provide is:

1) An opinion expressed by a Wall Street executive, and
2) An accusation that I am “in denial”.

You know, you often go on at great length about the duty of an auditor being an obligation to “look behind” the numbers to get to the “true and fair” value of an asset.

What I am doing is much the same. I am attempting to look behind your claim (to the actual numbers - not Wall Street opinions) to get the true and fair value of its merit.

That has nothing to do with denial. Or the level of hunky dory in my world. What is has everything to do is with having a appropriate level of professional scepticism for sweeping generalizations and extraordinary claims.

Again, I request that you provide appropriate substantiation.

This is where we stand at the moment. Once again I have not linked to Murphy's post because he seems to still be unaware that Kenton E. Kelly, CPA and Dennis The Peasant are one in the same. For my purposes I would prefer to keep it that way for the time being.

I find it interesting to see the sort of replies I am getting as a named member of his profession... You'd think (or at least I'd think) he would understand that as a C.P.A. I'd be harder to bluff than the average bear, but evidently that is not the case.

To the extent that Murphy continues to oblige, I'll continue to report here.

Update: Well, it's been roughly 24 hours and Our Dickie still hasn't found the time to provide us the information we requested. He has, however, found the time to put up a few new posts. Guess he was talking out his ass. Imagine that.

Let's Talk Stimulation...

Well, we're starting to get some of the specifics of President-elect Obama's plan for stimulating us back into the '90s, and given that it has already upset Paul Krugman, I suspect parts of it actually make some sense. What I'm interested in is the two initiatives making up the bulk of Obama's proposed tax cuts. The first is the $3,000 tax credit to companies for every job created. The second is the liberalization of tax-loss carrybacks.

The $3,000 Tax Credit For Jobs Created

Critics are already pointing out that this sort of scheme will be difficult and expensive to administer as well as vulnerable to fraud and abuse. It is difficult to argue with that. What I haven't seen anyone mention that a $3,000 tax credit simply isn't enough of a credit to provide a real incentive for companies to seriously consider hiring new employees. Think of it this way:

The Peasant Accounting Corporation, a C corporation based in Ohio, is considering whether to create a new position for a CPA. Here are the fixed costs associated with the potential hire:

Salary:  $50,000

Employer portion of the Social Security payroll tax (FICA):  $3,100  ($50,000 x 6.2% of first $90,000 of wages)

Employer portion of the Medicare payroll tax (FICA):  $725  ($50,000 x 1.45% of all wages)

Federal Unemployment Tax (FUTA):  $56  ($7,000 x 0.8% if covered by state unemployment, applies to first $7,000 of wages)

State Unemployment Tax:  $180  ($9,000 x 2% of first $9,000 of wages... Note the rate starts at 5.8% and lowers on a yearly basis based on company experience. I used 2% largely because I'm drinking a glass of 2% milk at the moment.)

State Disability Insurance (Worker's Compensation): $1,250  ($50,000 x 2.5%... For an accountant working both in-office and outside at clients. If your running construction company in Ohio, your bill is 25% of wages, if you do landscaping, you pay 22%, roofing is 36% and if you trim trees using a bucket truck, you pay 60%. As you can see, SDI is a huge variable, and tends to be high for many blue-collar jobs.)

Basic Health Insurance: Say my candidates are all married with a wife and two kids and no pre-existing medical conditions. I've seen rates run from $200 to $600 per month. Add a pre-existing condition and I've seen it as high as $950 per month. For the sake of argument, we'll go low end:

$3,600  ($300 x 12 months, employer pays 100%)

Total cost of adding a new employee (ignoring office space, telephone, travel, supplies, etc.) works out to be...

$58,911

Update... Oops! Sharp-as-a-tack reader Jeffrey W. pointed out that I had the whole break-even thingy completely wrong. The tax credit actually doesn't change the break-even point for PAC. It remains $58,911. What the tax credit does is shield income over and above the break-even point. For example:

PAC's marginal tax rate is, say 25%. The amount of income shielded by the credit is $12,000. The tax savings are $3,000 if PAC's new accountant can generate $70,911 in revenue. The primary problem is this; the tax credit won't motivate an employer who doesn't think a new employee will generate at least $58,911.

(Sorry about that. It's what happens when I try to write posts about taxes after spending 10 hours working on corporate income tax estimates and payroll tax returns.)

In any event, I still am not a fan of this particular tax credit scheme. It would be very difficult and expensive to administer properly, to put it mildly. If you're intent on blowing money to stimulate, in this case just forget this tax credit and let Dick Durbin build that $18 billion "green" coal plant in Illinois he's all warmed up about (so to speak).

The Liberalization of Tax-Loss Carrybacks

Professional journalism being what it is today, I have yet to see a discussion in the mainstream media about this issue where the journalist(s) in question actually understood what they were talking about.

Yeah, I'm shocked too.

Anyway, here's the deal. Under tax law, the Peasant Accounting Corporation can, when appropriate, utilize tax-loss carrybacks and carryforwards to minimize their taxes over a period of years. Presently companies are allowed to carry back losses two years and carry them forward 20 years. The Obama plan would increase the carryback period from two to five years.

Here's how tax-loss carrybacks and carryforwards work:

In the years 2003 through 2007 the Peasant Accounting Corporation had taxable income of $100,00 per year. In 2008, due to the economy and whatnot, PAC managed to lose $325,000. Under present tax law, PAC would then file amended returns (Form 1120X, or in certain cases, a Form 1139) for 2006 and 2007. The amended returns for each year would use $100,000 of 2008's loss (for a total of $200,000). Then the IRS would send PAC checks for 2006 and 2007 refunding all federal income taxes paid. The remaining $125,000 of 2008's loss are then set aside for use against future profits (hence the term carryforward).

Under the Obama plan, because the carryback period has increased from two to five years, PAC can then amend tax returns for 2005 (applying $100,000 of the 2008 loss) and 2004 (applying the last $25,000 of 2008's loss). PAC receives a couple more checks from Uncle, and doesn't have to wait for profits in future years to qualify for an additional tax refund.

The bottom line is this: Increasing the tax carryback period from two to five years generates a timing difference... Companies don't get more taxes refunded per se, what they get is more of the tax refund now, as opposed to in a year (or more) from now.

Personally, I like this proposal. It will be easy and cheap to administer, will be difficult to defraud or abuse, and could provide meaningful and immediate help in the area of cash flow.

So in my book, Obama's batting about .500 right now. Of course, whether either provision makes into law is anyone's guess.

Why I'm Betting Madoff's Auditors Were In On The Scam...

Here are a few reasons I'm betting Jerome Horowitz and David Friehling, the partners of Bernard L Madoff Investment Securities' audit firm Friehling & Horowitz, will be found to have actively participated in Bernie Madoff's Ponzi scheme.

Reason One: The firm of Friehling & Horowitz was never independent of Bernard L Madoff Investment Securities.

The AICPA Code of Conduct, Section 100 - Independence, Integrity and Objectivity, Rule 101 - Independence:

A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by Council.

From Interpretation 101-1 (of Rule 101):

Application of the Independence Rules to Close Relatives

Independence would be considered to be impaired if—

1.    An individual participating on the attest engagement team has a close relative who had

a.    A key position with the client, or

b.    A financial interest in the client that

(i)    Was material to the close relative and of which the individual has knowledge; or

(ii)    Enabled the close relative to exercise significant influence over the client.

2.    An individual in a position to influence the attest engagement or any partner in the office in which the lead attest engagement partner primarily practices in connection with the attest engagement has a close relative who had

a.    A key position with the client; or

b.    A financial interest in the client that

(i)    Was material to the close relative and of which the individual or partner has knowledge; and

(ii)    Enabled the close relative to exercise significant influence over the client.

The cardinal rule of professional ethics for auditors is simple: You, your firm and your personnel must be completely independent - both in substance and in appearance - from the companies you audit. That means no family ties, no financial ties, no nothing... Period. End of story.

While I haven't been able to verify this as fact, Harry Markopolos' November, 2005 presentation to the Securities and Exchange Commission mentions several times that a partner at Friehling and Madoff was the brother-in-law of Bernie Madoff. As David Friehling is married to Jerome Horowitz' daughter, it would seem that the Markopolos presentation is suggesting that Bernie Madoff is married to Jerome Horowitz' sister.

If it is true that Madoff and Horowitz are related by marriage, there is no way Jerome Horowitz or his firm could audit Madoff's firm without knowingly violating the profession's ethics rules regarding independence. And this one isn't even a close call either, kids; we're talking a two CPA firm auditing a family owned business here. There is absolutely nothing in the way of mitigating circumstances that Jerome Horowitz or Friehling & Horowitz could present to the AICPA to back the claim that they were able to maintain their independence from Bernard L Madoff Investment Securities.

At least nothing that would pass the Laugh Test, that is...

Reason Two: Friehling & Horowitz deliberately lied to the AICPA about providing audits to clients.

News reports have stated that over the course of 15 years, Friehling & Horowitz avoided professionally mandated peer review by falsely stating to the AICPA that the firm did not provide attest services (i.e., perform reviews and/or audits). If true, this in and of itself is as close to an outright confession of active participation in Madoff's fraud by Jerome Horowitz and David Friehling that we are likely to have until things land in court. 

All public accounting firms are required to submit to a peer review every three years. It is the profession's internal quality control and the AICPA and the state boards that administer it take it very seriously. That means that Jerome Horowitz and/or David Friehling lied at least five times to the AICPA about the nature of their professional business. In addition to avoiding peer review, these lies allowed them to avoid registering Friehling & Horowitz as an attest firm with the AICPA and the State of New York.

Outside of murder, rape, kidnapping, tax fraud or theft, I can't think of a quicker way to get your CPA certificate revoked than lying to the AICPA or a state accountancy board about your professional conduct. That means loss of livelihood. That means going from saying "I'll have the porterhouse, rare." at Morton's to saying "Would you like fries with that?" at McDonald's. It goes without saying it's also a very quick way of getting your firm's registration revoked and permit to practice pulled, too.

Peer reviews are a pain in the ass (I have one coming up this year myself), but lying to the authorities is not the sort of thing you do just to get out of one. The only reason for this deception I can come up with that makes sense (to me, at least) is that Jerome Horowitz and David Friehling didn't want anyone reviewing their audit workpapers. If they were signing off on Bernard L Madoff Investments Securities financial statements without actually doing the required audit, there would be no way to disguise it during the peer review process.

In any event, both Jerome Horowitz and David Friehling knew they had to register their firm appropriately and they knew they had to submit to peer review if they were going to go about the business of legitimately offering attestation services. They didn't do it, and they had to know what the consequences would be on a professional level if they were ever caught. I've seen reports that Jerome Horowitz is claiming he didn't know about Madoff's fraud. Bullshit. If that was true, then why all the shennanigans?

Other Miscellaneous Reasons...

1. Maintaining an audit practice is too expensive (in terms of compliance with professional standards) for a one or two CPA audit firm. Twenty years ago any CPA or CPA firm could jump in and do an audit or two when the mood struck them. Not anymore. Professional standards have tightened considerably, and if you're a CPA looking to do audits, be prepared to spend a minimum of $5,000 to $10,000 in adminstrative time per year to stay in compliance with those standards. According to news reports, Friehling & Horowitz never had more than 2 CPAs on staff. If that's true, there's no way the either Jerome Horowitz or David Friehling could make a decent living auditing.
2. Friehling & Horowitz didn't have the in-house expertise to audit Bernard L Madoff Investment Securities. Auditing in any industry requires specific skills and expertise, and there is nothing available suggesting that either Jerome Horowitz or David Friehling possessed that expertise in the securities industry. I can find no indication that either Jerome Horowitz or David Friehling trained with firms that specialized in the securities industry. Based on what little I know about them, auditing hedge funds correctly cannot be easy. This is not the sort of audit you can do using an industry standard audit program.
3. It doesn't appear that Friehling & Horowitz audited any other investment firms. I'd expect them to have a stable of such clients if they actually had the expertise to do so... Especially given the fact that Bernie Madoff was about as high-profile a client as one could hope to have. Real industry expertise is a major plus when marketing your firm's services. That Friehling & Horowitz wasn't leveraging Bernie Madoff to acquire new clients tells me something was rotten in Denmark.

Well, that's about all I can think of for now. If anything else occurs to me, I'll be sure to pass it along. 

Let's See If Our Dickie Can Get It Right (With Prompting, Of Course)...

It seems dim-bulb Euroweenie chartered accountant Richard ("Our Dickie") Murphy has finally got around to noticing that last week The Spectator picked up my evisceration of his analysis of the Madoff Scandal. He was not amused (and we'll discuss that later this week), so when I saw he was repeating his error regarding Goldman Sachs' tax expense (I gutted him on that one here), I decided to use my real name when leaving a correcting comment on his web site. 

This is his post (I'm not linking to it because I'm hoping he won't realize Dennis the Peasant and Kenton E. Kelly, CPA are one in the same):

Tax Freedom Day for Goldman Sachs has already happened

Goldman Sachs paid tax at an effective rate of 0.6% in the year to 30 November 2008. If that is replicated this year that means that their tax freedom day fell on 2 January, but since most people weren’t around then, I thought I’d mention it now.

And yet the Adam Smith Institute argue that Tax Freedom Day is on June 2nd.

Why do they spread such misinformation which so obviously ignores the fact that the tax burden is spread so unfairly in society?

Here's the comment I left on his site:

 

Richard-

I'm afraid you're wrong about the amount of tax GS is paying. The tax number you've picked up on the 8-K is neither the actual tax paid nor the actual amount of tax expense incurred.

What is shown on the 8-K is the tax expense as calculated using FASB 109 'Accounting for Income Taxes', which is required to be used for GAAP-basis financial statements.

Here is how tax expense is calculated under FASB 109:

 The objective of accounting for income taxes are to recognize (a) the amount of taxes payable or refundable for the current year and (b) deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an enterprise's financial statements or tax returns.

As you can see, taxes are recalculated to conform with income per GAAP, as opposed to income per tax code. Therefore, there is no direct correlation between actual tax paid (or incurred) and the tax expense computed per GAAP during any given fiscal period.

You should either (a) revise/correct your post(s) accordingly, or (b) use the amounts from the various GS tax returns from the countries where GS does business to compute tax expense.

(Using the GAAP-based number provides you no useful information with regards to the point you are attempting to make.)

As of this writing, my comment is awaiting "moderation".

Any bets on whether it will (a) actually be published, or (b) acknowledged as correct, or (c) shown to be incorrect?

Update: Richard hasn't figured out it is me. Here's his response:

Kenton

Thanks for commenting

But are you really arguing there is a complete disconnect between the accounts and tax owing?

I know, and you’ll see I know if you read The Missing Billions and Th[e] Tax Gap, about the problems of accounting for tax, but your claim seems to be there is no connection between the accounting data and tax paid.

I accept they’re not the same, but they’re not that far out. And it’s the best figure we’ve got right now so it will have to do.

Richard

To put it plainly, I lack the skill as a writer to be able to fully convey how bizarre this response actually is to a Certified Public Accountant. Here is my response:

Richard-

I'm not arguing there is a disconnect between the accounts and tax owing... Nor am I claiming there is no connection between accounting data and tax paid. There is nothing to either argue or claim. If you read FASB 109 closely you will see the purpose of accounting for income taxes in GAAP-basis financial statements has nothing to do presenting actual tax expense. In GAAP-basis financial statements, actual tax expense is not meaningful.

It is this simple: When computing tax expense using United States Generally Accepted Accounting Principles, the expense is computed using income per GAAP (not tax code) and an estimated tax rate.

The amount of tax expense presented on Goldman Sachs' financial statements is a theoretical number, and as such provides absolutely no taxes actually incurred or paid information. Unless you have compared the expense in the 8-K to the expense derived from the actual tax returns, you have absolutely no basis for claiming actual tax expense and GAAP tax expense are "not that far out" from each other.

My criticism of your original posts on the subject still stands. They are inaccurate and without merit, and will remain so until you find and present Goldman Sachs' actual tax expense figures. Claiming that you have to use the wrong number (the GAAP tax amount) to make your point about Goldman Sachs because it is the only number available is very strange indeed.

I really enjoyed the "Well, it may not be the right number, but it's the only one I have" argument, and find it somewhat amazing that I'd never thought to use it myself.

I can hardly wait to see what comes back.

Update the Second: Oh boy, the answer is here and it's a hummer...

Kenton

Since the original tax expense figures are not on public record what are you suggesting? That no one say anything?

Sorry - in the real world we use the data we’ve got - and this stuff, inadequate as it is - has to do

Richard

Got that? Murphy admits he doesn't have the correct data to back his claim, so he just uses whatever data he can find, irrespective of whether that data is appropriate.

Richard wants to know what I am suggesting. Fair enough. What I was suggesting is this: 

If you are going to accuse corporations of "avoiding their obligation to pay tax" - which is exactly what Murphy did in his original post - wouldn't it make sense to actually know what the fuck said corporations actually pay in tax?

A Few Notes On The Bernie Madoff Scandal...

Ol' Dennis has been doing some digging and has managed to find a copy of Harry Markopolos' November, 2005 presentation to the SEC regarding Bernard L Madoff Investment Securities. It's 19 pages long and filled with lots of mathematics related to arcane investment strategies (well, they're arcane to me, at least), so it won't qualify as light reading. There are, however, some points of interest...

Point the First:

This will come as a great disappointment to professional partisan/pseudo-journalist Josh Marshall, but on page 1 Markopolos states he had first alerted the SEC that Madoff was running a Ponzi scheme back in May of 1999. He goes on to state that his May, 1999 presentation was substantially the same as his November, 2005 presentation. The last time I checked, George W. Bush wasn't president in May, 1999. No doubt Marshall will be following up on why the Clinton SEC dropped the ball in 1999.

And if you believe that, I have a wonderful investment opportunity in a hedge fund you'll just love...

Point the Second:

On page 10 we get this:

Madoff doesn't allow outside performance audits. One London based hedge fund, fund of funds, representing Arab money, asked to send in a team of Big 4 accountants to conduct a performance audit during their planned due diligence. They were told "No, only Madoff's brother-in-law who owns his own accounting firm is allowed to audit performance for reasons of secrecy in order to keep Madoff's proprietary trading strategy so that nobody can copy it." Amazingly this fund of funds then agreed to invest $200 million of their clients' money anyway, because the low volatility of returns was so attractive!!

A couple of things to note here:

First, this demonstrates just how far Richard Murphy's head was buried in his ass when he accused the Big 4 firms of negligence in the Madoff Scandal.

Second it demonstrates that Richard Murphy doesn't understand how one performs due diligence and who is responsible for performing due diligence.

Third, it is apparent that many of Madoff's investors were either exceptionally greedy, exceptionally stupid, or both. If someone refuses to cooperate with the due diligence process, you run for the hills. Period. End of story. And, if someone's fucking brother-in-law is doing the company's audits, you run for the hills. Period. End of story.

Fourth, Madoff's accounting firm will be shown to be an integral and active part of the fraud. The sort of family connection between Madoff's company and Madoff's auditors normally renders the audit firm as unqualified because of a lack of independence. That Madoff's auditors would do the audits anyway (and then lie to the AICPA about it) means those boys were in for a dollar as well as a dime.

Point the Third:

As stated on page 12, evidently Bernard L Madoff Investment Securities liquidated all investments and went 100% cash as of the last day of each year:

BM (Bernard L Madoff Investment Securities) goes to 100% cash for every December 31st year-end according to one FOF invested with BM. This allows for "cleaner financial statements" according to this source.

If true, this is incredible. It means both the SEC and investors accepted the idea that an investor would completely liquidate his investment holdings (regardless of loss) at year-end to be able to present is assets (holdings) as 100% cash. That doesn't make for a "cleaner financial statement", folks. Once again, that's run-for-the-hills stuff: The only reason to liquidate and go to 100% cash is to hide something. Period. End of story.

Read the whole thing. It is amazing.

Note: Here's a WSJ article that provides a useful timeline for regulatory scrutiny of Madoff. It began in 1992.