One favorite phrase of those who work with accounting fraud issues is that of the “cookie jar.” The usual accounting fraud is done in order to boost revenue and possibly overstate assets. But there’s a flip-side to this: reporting higher losses and maybe bigger liabilities. This idea of making the financial statements look even worse than they are, is known as filling the cookie jar.
The concept is simple. The company can “afford” to book greater losses or liabilities now, due to market expectations or other business issues. Take a larger than appropriate loss now, and the company can reverse that loss later, turning the old losses into current profits. Voila! That future period has increased its profits by playing this accounting game.
The Wall Street Journal reports that investors are suspicious about the possibility of global banks playing this cookie jar game now. The volatility of the stock market and the wide-reaching effects of the subprime mortgage debacle are making this a real possibility for banks. Wall Street is already expecting poor financial results from banks, and the stock of the banks is beginning to rebound because of the belief that the worst is over.
As the banks prepare to report quarterly numbers, the possibility arises that banks will book large losses (even larger than warranted) to establish their cookie jars. These losses are related to the market value of investments held by the banks.
If the market value of the investments increases in the future, the banks will then reverse those losses and will report gains. If the banks have already weathered the worst of the storm, the temptation may arise to book even more aggressive loss estimates in order to make a future recovery look even better.
One example: This week, Deutsche Bank AG reported that it would take about a $3 billion charge in the third quarter for write-downs on loans, loan commitments, complex securities backed by mortgage loans, and losses on stock and bond trades. In spite of these write-downs, the bank’s stock rose 2.1% in European trading.
Other banks taking significant write-downs on mortgage-related assets and other investments include Bear Stearns, Citigroup, Morgan Stanley, and UBS. Following the announcement of their write-downs, some of these banks also saw increases in their share prices.
But users of the financial statements are left to wonder about the details of those write-downs. Were they aggressive or conservative? Will more write-downs come in the future, or have the securities been written down as far as they are expected to fall in value? Industry experts suggest that the securities holders should write them down as far as possible, and recognize profits later if the securities become worth more.
The bottom line is that these write-offs are essentially based upon estimates of value, and involve a great deal of judgment on the part of executives. This leaves the numbers open to manipulation and the fraud often called “earnings management.” The banks say that they are using consisten methodology when valuing investmetns from year-to-year, but who can really be sure?