Can Public Companies' Financial Statements Be Trusted?

A New York Federal Reserve Bank study found that big banks understate their debt by an average of 42% four times a year -- at the end of each quarter when banks report to shareholders on their financial condition. The other 361 days of the year, big banks hold more debt than what they report to the public. This throws a wrench in the idea that U.S. financial markets are transparent -- and that murkiness should strike fear in investors' hearts.

Before getting into the reasons for the fear, let's look at the details of the big bank debt fake-out. The Federal Reserve Bank of New York analyzed 18 banks and concluded that they understated how much they borrowed to buy securities by 42% over each of the last five quarters.

Once that reporting date has passed, those banks go right ahead and resume their previous debt level until the end of the next quarter. Among the 18 banks analyzed are the biggest names in the business: Goldman Sachs (GS), Morgan Stanley (MS), JPMorgan Chase (JPM), Bank of America (BAC) and Citigroup (C).

Brings to Mind Repo 105

Temporarily manipulating financial statements has a long history. But we need only look back less than a month to a 2,200 page report on Lehman Brothers' collapse that fingered an accounting trick known as Repo 105. Without getting into too much detail, Repo 105 exploits the difference between British and U.S. legal systems to enable Lehman Brothers to hide $50 billion worth of debt.

The big-name banks that are still around think they have finessed any legal issues with their disclosure by claiming that their financial statements make it clear balance-sheet items can fluctuate during the quarter. It's a nice-sounding phrase that offers false assurances.

For example, according to a Wall Street insider, during the months prior to the financial crisis, banks would report debt-to-equity ratios of 30:1. But after the reporting period was over, they would raise them as high as 50:1. This means that an asset-value drop of as little as 3.3% could have wiped out the bank at the end of the quarter -- but only a 2% slip in asset value was needed during the in-between period. When banks are so highly leveraged, such minor fluctuations can mean the difference between solvency and bankruptcy.

One of Many Tactics

This is one reason why this New York Fed report should scare investors. But Repo 105 is likely just one of many accounting techniques that banks and other public companies may use to dress up their financial statements when the Securities and Exchange Commission comes calling at the end of each quarter.

I've said it before and I'll say it again: If we want to restore credibility to our capital markets, we need to stop letting CEOs of public companies write their own report cards. Producing financial statements should not be the core competency of any company.

Instead, it ought to be the job of a government agency that taxpayers fund to protect shareholders' interests. If we continue to let CEOs massage financial reports, they will push the envelope in accounting policies and use their company's huge auditing and consulting payments to bend their auditors to their selfish wills.