Sometimes a company's accounting problems speak more to the arbitrariness of the rules than to the credibility and soundness of its financial reports. A recent exchange of letters between Morgan Stanley and the Securities and Exchange Commission's staff, released today, is a classic example.
Although this didn't get much attention at the time, Morgan Stanley last year corrected a classification error that had a large effect on the numbers it showed on its cash-flow statement. Cash flows from operating activities for 2011 were revised to $15.9 billion from $6.7 billion. Meanwhile, cash flows from investing activities for 2011 were changed to negative $11.2 billion from negative $2 billion.
A $9.2 billion error on a company's cash-flow statement might seem like a big deal, if only for its sheer size. Morgan Stanley, however, deemed the correction to be immaterial for accounting purposes. Based on that determination, the company didn’t formally restate its financial reports. The company cited a bunch of justifications after the SEC challenged its conclusion. Namely, the correction had no effect on earnings or the company's balance sheet. The SEC seems to have given Morgan Stanley a pass and let the matter drop, at least for now.
Here's another argument for why the error wasn't material that Morgan Stanley probably wasn't in a position to make: When it comes to financial-services companies, cash-flow statements are pretty much worthless. Investors generally don't pay attention to them because the numbers in them aren't useful.
"Operating cash flow for a financial institution is a meaningless figure," says Charles Mulford, an accounting professor at Georgia Institute of Technology in Atlanta and co-author of the 2005 book "Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance."
Under U.S. accounting standards, all items on the cash-flow statement are classified as operating, financing or investing activities. This system may work fine for a shoe manufacturer. It doesn't hold up so well for large banks. Their assets and liabilities consist mostly of financial instruments, much of which they have broad discretion to shift from one category to another, rendering the classifications pointless.
Morgan Stanley said its error had to do with how it classified certain loans. Under the accounting rules, cash flows associated with loans that the company intends to sell are supposed to be classified as part of operating activities. Loans that a company plans to hold must be shown under investing activities. Morgan Stanley said it misclassified some loans as operating activities that it should have presented as part of investing, because it intended to hold the loans. The company said the error was discovered as the result of an inquiry by its auditor, Deloitte & Touche LLP.
In other words, the classifications hinged entirely on what was in the heads of Morgan Stanley's executives. That had nothing to do with the company's overall cash flows, which didn't change. The same problem arises with other types of financial instruments, such as securities. Anybody looking to a bank's cash-flow statement for answers about its operations, investments or financing activities during a given period winds up looking at a bunch of confusing slop.
Another area the SEC scrutinized was Morgan Stanley's decision not to disclose problems with its internal controls. In an Aug. 2 letter, the SEC's staff noted "multiple significant deficiencies involving multiple accounts and processes" that the company identified in its response letters.
Once again, a big part of the problem comes back to the rules. As the SEC's division of corporation finance wrote in a 2004 question-and-answer memo, "material weaknesses" in internal controls always must be disclosed. However, "significant deficiencies" don't necessarily have to be. What's the difference? The plain-English meanings of those terms are the same. The difference between the terms' technical definitions is fairly squishy, too. The end result is that companies get lots of wiggle room to avoid disclosing problems with their controls.
Morgan Stanley's accounting might not be pristine. In this instance, however, the rules are even worse.
(Jonathan Weil is a Bloomberg View columnist. Follow him on Twitter.)