Give or Take $600MM

I spent most of last week in audit training classes.  It’s no secret that the nuts and bolts of audit work are not exciting.  Unfortunately, the relevance of the task at hand was in the news.  I agree with  Lynne Turner, former head accountant at the SEC, on the missing money at MF Global.

 "It's like it just vanished into thin air and the fact that people today can't tell us where the $600 million went is not a good sign. The fact that they were held in custodial accounts that someone should have been on top of only further complicates the issue and makes it even more concerning."

Whether it was for meeting margin calls or going to a personal account in the Cayman Islands is still TBD, but that’s where the boring work that I was studying  is really important.  It may not be material for a new TV series, (CPA: Miami ??) but trained forensic accountants are the best chance for finding the needle in the haystack.

It’s important to note here that in a forensic engagement, where the task is finding the missing $600 million, the work is structured to find the needle.  However, in an audit, that level of detail work would cost too much money.  So the guys at PwC were just looking for potential misstatements that are material.  In accounting, something is material if it would cause a user of the financial statements to make a different decision about the company. 

In this case, MF Global had structured the sovereign debt deal so they could, in compliance with accounting rules, move the debt off their balance sheet.  Would investors have made a different decision if the debt were sitting in the liabilities section of the financial statements?  We’ll never know that, but FINRA regulators did find the accompanying disclosure of “off balance sheet arrangements and risk” inadequate. (My word, not theirs – I didn’t read the FINRA notice.) So with full disclosure it could have been just “caveat emptor” to investors.  You have to wonder about the judgment call to do a deal of that size and expect no one would care about the detail of a massive increase in leverage. 

Of course, the guiding light of that judgment was Jon Corzine.  One thing that’s always discussed in audit classes is how the person who is least likely to commit fraud is the one the auditors should be most worried about.   While Corzine doesn’t have the kind of financial motivation that say a bookkeeper has, clearly he sanctioned decisions that can only be described as rationalizing illegal behavior.  The fraud triangle is motivation, rationalization and opportunity.  Corzine had all three.  Who knows, this could be material for the first episode of CPA & Order….    

Structural Damage Control

Financing and market opportunity get all the attention in a business start up.  However, an equally important question that needs to be addressed early on is the legal structure of the business.  As early stage companies make life and death decisions pretty regularly, legal structure feels like one of those things to think about “when you have time”. This leads to the “common wisdom” of  trying to start with the simplest structure possible, and then let it evolve with the company’s needs. A new study by the SBA indicates this evolutionary approach to business structure is a myth.  Over the first four years of a business’ life less than 10% of companies make a change in their legal structure.  By that time, many issues that should have been addressed earlier have turned from minor problems to major issues.

The reasons business structure is so important fall into two buckets – legal liability and taxes.  I know very little about the legal liability bucket – it was too gross when I looked inside.  My summary from the quick, unpleasant glance is that you get more protection from either a tightly crafted partnership agreement or a corporation, but you trade some flexibility for the protection.  Think of it like wearing a bullet proof vest.  If you need it, it’s worth the trouble, but it’s no fun to wear while you’re running a race. (This is another way of saying make sure to ask someone knowledgeable or you’ll really be in trouble.)

In terms of taxes, it’s essentially the opposite.  A more complex company structure typically provides more tax flexibility.  One unusual consideration related to tax payments and business structures is there’s a choice to be made about whether the business entity or the business owners pay the income taxes.  The Cliffs Notes version of this very high level view is that typically capital intensive businesses are better off paying taxes.  Generally, all others should let the participants pay the taxes, albeit ensuring these tax payers have taken steps to minimize those payments.

Notice how even at the most basic level this is already dense, headache inducing material.  Unfortunately it really is worth taking some aspirin and getting clarity about areas of risk for your particular business that can be offset through structural decisions.   Think of it as making sure the foundation on your house is done correctly.  You wouldn’t wait until after it’s built to check…