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Goldman Sachs Foretold Record Fines in Disclosures to Investors

Nov. 2, 2020, 9:46 AM

Long before it agreed to pay a record-breaking fine for charges that it bribed foreign officials to secure business, Goldman Sachs Group Inc. appears to have precisely followed the rules on how to account for the damage.

It warned investors over several years that steep fines were looming and built up billions in reserves to cover the penalties. The result: those paying attention to the bank’s financial statements weren’t caught off guard by the Department of Justice’s and Securities and Exchange Commission’s largest ever fine for a violation of the Foreign Corrupt Practices Act.

“Goldman did a good job of explaining this. That will make the SEC happy,” said Mike Walworth, CEO of GAAP Dynamics, an accounting training firm.

Goldman Sachs and its Malaysian affiliate agreed to settle authorities’ findings that it paid more than $1.6 billion in bribes to Malaysian and Abhu Dhabi officials to secure lucrative business for the bank starting in 2012, including underwriting billions of dollars in bond deals for a Malaysian government investment fund, the DOJ said on Oct. 22.

Much of the money raised by the scandal-plagued government investment fund, 1MDB, formerly known as 1Malaysia Development Bhd., was embezzled or stolen, authorities said.

For its role in the scheme, U.S. authorities levied $2.9 billion in penalties against the bank. After crediting for other fines, the bank expects to pay $2.6 billion to the U.S. It also will have to pay fines to regulators in the U.K., Hong Kong and Singapore. The bank’s overall tab comes to $5.1 billion, the bank said. The bank did not respond to requests for comment.

Adding to Reserves

That’s an eye-popping sum, but the bank has been bracing for it, its securities filings show. Goldman has built up reserves to cover the fines for at least a year.

That included a provision of almost $3 billion in the second quarter this year for litigation and regulatory proceedings, Fitch Ratings said in a note issued the day after the Department of Justice announced the fines.

“The settlement is in line with Fitch Ratings’ prior expectations and has no immediate impact on Goldman’s ratings,” Fitch wrote.

To cover what’s left, the bank will have to record an additional $250 million provision, an expense that hits earnings, in its upcoming third-quarter filing, the bank said on Oct. 22.

That’s “modest” given that the company reported $3.6 billion in net income for the third quarter, ratings agency DBRS Morningstar said.

Four Years of Disclosures

U.S. generally accepted accounting rules (GAAP) require companies to report fines and penalties that aren’t related to income taxes as contingencies, as prescribed by ASC 450. Fines are accounted for when reasonably possible, said Walworth.

Most public companies know when they’re under investigation. As soon as they know, the SEC requires that they reveal what they know about an investigation and any potential penalties.

Goldman first disclosed in June 2016 that it was under investigation for “transactions involving government-related financings and other matters,” including those related to the Malaysian sovereign wealth fund. By the third quarter of 2017, the bank said it had received subpoenas from governments and regulatory bodies. In its third-quarter 2018 filing, it said the firm couldn’t predict the outcome of the investigations but it could result in “significant fines, penalties, and other sanctions against the firm.”

“As it gets more and more probable, you have to have better and better disclosures,” Walworth said. “The SEC says your disclosure should evolve so it’s not, ‘It’s all good; it’s all good — whammy.’”

Once a company has an estimate of the fines or penalties it faces — and believes it’s more likely than not they’ll have to pay — it has to put some numbers on paper. The company must accrue to the most reasonable outcome.

In many cases, this is a range. Under current accounting standards, the company can pick the lowest number in the range to book. So if a company believes it faces a fine that could be anywhere from $1 billion to $2 billion, it would book $1 billion.

Tricky Calculations

Sometimes the range is too large and the numbers are too uncertain. If a company believes it could stave off a lawsuit or avoid a penalty altogether, the accounting rules allow it to book zero, said Heidi Bartholomew, a professor at the Katz Graduate School of Business at the University of Pittsburgh

Booking that number sets up a liability in the balance sheet for the eventual amount the company expects to pay. The corresponding liability is listed on the income statement as an expense, which can be continually adjusted.

This number is a sensitive calculation. It’s so full of judgment that Goldman’s auditor, PricewaterhouseCoopers LLP, highlighted it as one of the the trickiest figures for the auditors to verify in its 2019 annual financial statement.

This year, Goldman has updated the number as the investigation proceeded. In the first quarter, the firm said its estimate of “reasonably possible” losses for legal proceedings was $3.2 billion more than it had already stashed away, or reserved. In the second quarter of 2020, the firm said it agreed to pay the government of Malaysia $2.5 billion. It recorded an additional provision for litigation and regulatory proceedings of $2.01 billion.

To Break Out, Or Not

Once the reserves are set, it’s time to book a number .

Some companies pull out expenses related to penalties and settlements as separate line items in their income statements or balance sheets. BP plc did this following the 2010 Deepwater Horizon disaster, which resulted in the company paying $20 billion in penalties and fines to governments and individuals.

Other companies will lump fines in with “other liabilities” or another expense item. The difference depends on the company’s judgment call about the materiality of the fine.

“They want analysts to forgive them for it,” said Bartholomew, the professor. “Otherwise, if it’s just a regular old legal kind of quote unquote stuff, it’s in ‘other operating expense’ somewhere.”

Although the assessment varies for every company, generally any individual item greater than 5% of total assets should be presented separately, Walworth said.

Goldman’s numbers didn’t make analysts eyes pop, but that doesn’t mean they and ratings agencies are letting them off the hook. Both Fitch and DBRS Morningstar said the firm’s lapses in risk management from the scandal could have negative effects on the company’s reputation.

Significant governance deficiencies have prompted negative rating actions at financial institutions in the past, Fitch said.

“Further evidence of elevated conduct risk, governance weaknesses or risk management deficiencies could therefore increase incremental pressure on Goldman’s ratings,” Fitch warned

To contact the reporter on this story: Nicola M. White in Washington at nwhite@bloombergtax.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergtax.com; Bernie Kohn at bkohn@bloomberglaw.com

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