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Legal Accounting in US

1.Mage the Horse

The Kentucky Derby is a 1-1/4 mile horse race held annually on the first Saturday of May at Churchill Downs in Louisville, Kentucky. The winner in 2023 was a horse named Mage, which overcame 15-1 odds to win. A $2 bet on him paid out $32.42.

The owners of Mage made available, via a "fractional investment" app called Commonwealth, a 25% stake in Mage; and according to the New York Times, 382 people purchased one or more units of ownership for as little as $50 per unit. Without getting bogged down in math, from the $3 million prize, each ownership unit earned $95 after taxes.

Further according to the Times,"Investors have been earning on every race [Mage] has run and will receive a percentage of what is likely to be a multimillion-dollar breeding deal. They also have behind-the-scenes access to the horse and his training regimen and the opportunity to attend workouts and races."

Suppose the owners (including "fractional investors") of Mage want to see a balance sheet and income statement for Mage as a business "entity." Please comment on what these might look like. Along with a description, feel free to provide "assumed" numbers for illustration.

2."Juicing"Profits

On June 1, 2023, the Wall Street Journal ran an article by Ben Foldy titled "Business Is Slowing. So Companies Are Juicing Profits." It carried the subheading "Reallocate costs. Unwind charges. Delay depreciation. Companies are using nontraditional ways to boost the bottom-line." The article is at https://www.wsj.com/articles/profit-numbers-get-spruced-up-as-business-slows-8eec5017

Suppose you are Vice President and General Counsel of a publicly-traded company. A member of your company's board of directors read the article and noticed it said:

One way companies are trying to make their results look better is to provide numbers that don't adhere to accounting standards-what are often referred to as pro forma measures-alongside the official data....

[Google's parent company's] filings noted two material changes in its accounting that helped boost the bottom line. First, the company revised its estimates on the useful life of its server infrastructure, saying it would last up to six years instead of four. The change, the second such extension in two years, added 6 cents a share of earnings, according to the company. The change mirrored similar moves by competitors.

Separately, the company said it was shifting its stock-compensation awards for employees from January to March, resulting in the company recognizing less expense in the first quarter relative to the rest of the year....

Ten days before the quarter ended, [online used-car seller] Carvana executives said they expected adjusted gross profit per car sold to come in between $4,100 and $4,400 for the quarter. Carvana surprised Wall Street by losing only $1.51 [not $2.03] a share, which sent the company's shares soaring. Driving the beat was a better-than-forecast adjusted gross profit per car sold of nearly $4,800.

One reason Carvana's earnings jumped was because it unwound $51 million in charges it made in the previous quarter. The company took the charges because it had expected to sell cars in its inventory for less than it had once expected but was then able to sell them for more as used car prices appreciated.

Suppose that board member knows little or nothing about accounting; but, seeing other companies are doing such things (providing non-GAAP pro forma numbers, extending useful lives, giving [stock] bonuses in a later quarter, "unwinding" "charges" to "inventory "from previous quarters,) wonders and asks you if your company can or should do similar things. Please explain how you would respond. Include what difference these accounting steps might they make to the reported financial results. And, do you think stock market investors and analysts will be impressed or fooled? Why?

3.Berkshire and Pilot

Berkshire Hathaway Inc. (Berkshire") is a holding company or conglomerate that invests in other companies, for partial or complete ownership. It owns insurance company GEICO, which among other holdings provides cash flow helpful for more acquisitions. Berkshire also owns roughly 19% of American Express, 27% of Kraft Heinz, 12% of Bank of America, 9% of Coca Cola and 6% of Apple.

The long-time CEO of Berkshire is Warren Buffett, age 93, who pens folksy shareholder letters every year. (Check them out sometime, not for this assignment.)

The company has loyal shareholders, some of whom "sold" Berkshire their family businesses for Berkshire stock, with the result they diversified their investments without recognizing taxable gain because they did not "sell" for tax purposes but received stock for stock. The value of Berkshire and the price of its stock has increased phenomenally over the long term; perhaps this inclines owners to sell their companies to Berkshire at prices attractive to Berkshire. In addition, Berkshire tends to retain in-place managers at acquired companies, at least for a time, which may lead them to think a sale to Berkshire is a good idea.

According to Matt Levine, Bloomberg journalist (and former Goldman Sachs investment banker and M&A lawyer at Wachtell Lipton,) in 2017, Berkshire agreed to buy a truck-stop chain called Pilot Travel Centers (or "Pilot" or "PTC") in several tranches for 10 times its earnings. Levine explains:

Berkshire bought 38.6% of Pilot Travel Centers in 2017 for 10 times its EBIT (earnings before interest and taxes)[$2.8 billion]that year, but also agreed, at the same time, to buy another 41.4% in January 2023 [for what ended up being $8.2 billion], and to buy the remaining 20% in January 2024, each time using the same formula, that is, 10 times the previous year's EBIT. The first two purchases have closed, so Berkshire now owns 80%of Pilot Travel Centers; the other 20% is owned by "truck-stop mogul Jimmy Haslam," the son of Pilot's founder. And soon Berkshire will have to buy the other 20% of Pilot Travel Centers from Haslam for 10 times its 2023 earnings. Whatever they are.

Indeed.

Very recently-settled litigation involved the following claims. The Haslam's sued Berkshire in October 2023 for changing Pilot's accounting methods to reduce its net income and, therefore, the price Berkshire must pay to acquire the final 20%of Pilot. Analysts calculate the net income difference at $120 million, leading to a (10X earnings) price difference of $1.2 billion.

Berkshire countersued, claiming Haslam caused Pilot to offer its executives "Special Distribution Award" payments (bonuses? bribes?) outside normal compensation structure and practice based on the price Berkshire paid for the remaining 20% of Pilot. In other words, if executives could boost Pilot's net income in 2023, Berkshire would need to pay a higher price for the final 20% of Pilot; and those executives would reap huge special bonuses. Berkshire alleged that there was "an unwarranted urgency among certain employees to close deals in 2023."

The specific accounting issue is technical and beyond the scope of our course, "pushdown accounting," where the costs incurred to acquire a company appear on the separate financial statements of the target, rather than the acquirer. Pushdown accounting used to be mandatory when a company acquired 95% or more of another target company; but in 2014 the percentage rules were eliminated, and the acquiror has a choice whether or not to choose pushdown treatment. In normal course, the financial accounting would apparently lead to $120 million less income for 2023 at Pilot itself.

On January 7,2024, Berkshire and Pilot announced they had settled the dispute. Terms were not disclosed. A two-day non-jury trial in Delaware Chancery Court had been scheduled for January 8  (coincidentally, the first day of our class.)

Without getting too deep into details of pushdown accounting (which, again, is beyond the scope of our course,) what could Berkshire's and Pilot's lawyers have suggested and/or implemented to keep their clients out of disputes and avoided the lawsuit? What do you think are the reasons these things were not done or implemented?

4. VC Legal Fees

It is a common feature of venture financing deals that a venture capital fund ("VC") purchases preferred stock in a (venture) company ("Company") for cash. Another common term is that the Company agrees to pay the VC's legal fees in connection with the transaction (perhaps up to a certain limit.)

In other words, instead of the VC writing a check to the Company for stock and a check to the VC's own law firm for legal services, the VC writes a check to the Company, and the Company writes a check to the VC's law firm. Of course, the Company also must write a check to its own law firm, which in some sense was negotiating against the VC's law firm(!)

Please comment on why, from an accounting perspective, this arrangement may have evolved.  Does anyone avoid or defer recognizing expense? How and why? Won't the Company's net income be less, so it will appear less "successful" trying to raise more money or to offer shares to the public in an IPO? Might expense be deferred, and how and why? Is our goal to "present fairly" the financial positions of the parties supported or challenged by the arrangement? Does it matter?

5. Silicon Valley Bank

Due to the COVID-19 pandemic, the US Federal Reserve Board ("Fed") slashed interest rates to near zero to stimulate the economy and help avoid economic collapse. (The government also enacted spending measures to protect jobs, avoid airline bankruptcies, defer debt payments and tax collection, and dole out spending money.)

By 2022-23, the economy had rebounded, and ready "cheap" money that could be borrowed at low interest rates stoked fears of excess inflation, of which there were growing signs. The Fed began to raise interest rates.

Interest rate changes affect the value of interest-paying loans and bonds(assets) previously issued at a different interest rate. For example, a long-term $100 bond issued last year that pays 2% ($2 per year) will be worth less today than a $100 bond issued today that pays 5% ($5 per year.) Put differently someone with $100 would lend it to last year at 2% interest plus eventual repayment of $100, but someone with $100 would demand 5% interest currently as well as the eventual repayment of $100. And the bond issued last year is now worth less than $100-because even though the face value of $100 will eventually be paid off years from now, the present value of future cash flows (interest and eventual principal repayment) are now discounted by a higher current interest rate, so the bond may trade for a market rate well under its $100 face value.

(Finance people have formulas to compute these value drops. Or increases, if interest rates go down lower than what a bond is obliged to pay.)

Silicon Valley Bank ("SVB") provided banking services to many technology start-up companies in the San Francisco Bay Area. It would take their deposits (typically money the companies raised from venture capital investors). SVB earned money on those deposits by investing them in US government securities that are considered risk free, as well as other loans. (The government borrows by selling bonds for cash and promising to re-pay with interest.) These securities include Treasury Bills maturing (paid back) in one year or so, Treasury Notes maturing in 2-5 years and Treasury Bonds maturing in 20 or 30 years. They are sometimes called T-Notes, T-Bills and T-Bonds.

Because SVB intended to "hold to maturity" the securities, GAAP allowed the bank to keep the assets on its balance sheet at cost, rather than adjusting them to current (lower) market value when interest rates rose. After all, there was no risk SVB would not get back the face value of government securities at the end of their term-even if their market value was temporarily depressed.

However, as journalist Matt Levine observed:

Lots of US regional banks were doing more or less the same thing in 2021: They were taking money from depositors, promising to give it back whenever the depositors wanted, paying 0% interest on those deposits, and investing the money in long-term bonds at like 2% interest. Then interest rates went up and those bonds were worth much less than they used to be. If the depositors all asked for their money back at the same time, as is their right, the banks would have to sell the bonds at a big loss, leaving them without enough money to pay depositors.

Another Bank, First Republic Bank, had on its balance sheet $173 billion of loans ("carried" at book value) but estimated the current value of its assets was about $27 billion less than "carrying [on its books] value," mostly because of decrease in the value of loans.

This situation might have been fine-if no depositor worried other depositors would worry and withdraw their deposits. But, if you think others might worry: you yourself worry, and try to withdraw your deposits before others might try to. A "bank run" thus becomes a self-fulfilling prophecy, recalling the metaphor of a stampede for the exits.

Which happened. SVB and First Republic failed in liquidity crises as depositors rushed to withdraw deposits. Other banks took over these banks and their liabilities to depositors, on potentially very attractive negotiated terms based on (overly?-) distressed price "fire sales" and government concessions and guarantees (and/or downside liability limits) to shore up the financial system.

At the beginning of 2023, SVB shares began trading at $232 per share, and First Republic shares at $123. With the banks' failures, SVB and First Republic shareholders were wiped out, with essentially no value left in equity.

(Side note, somebody at a hedge fund betting against the value of SVB or First Republic equity shares could have made a bundle on the demise of those banks. And probably did.)

(Also, as you can guess, these banks should have better managed their interest rate risk exposure. But maybe the bank executives thought not hedging [insuring against] interest rate risk would reduce expense, improve return, and increase bank profit and the value of their shares-now zero.)

Please comment, without needing to re-explain why the loan asset values went down, on how GAAP's "hold to maturity" accounting did or did not "present fairly" or "conservatively" and affected what happened. And why do you think "hold to maturity" accounting made any sense under GAAP in the first place? Please explain.

6. Theorem Fund Services

Theorem Fund Services, LLC, ("Theorem" or "TFS,") based in Boca Raton Florida, describes itself as "a multi-service fund administrator which offers a unique turn-key solution to investment managers that combines institutional-level technology with strong industry experience and a deep understanding of our clients [sic]needs and goals." A recent Theorem press release more succinctly says Theorem is "a leading third party fund administration firm."

Theorem lists its services thus: advisory services, fund accounting, investor relations, crypto fund services, management company accounting, banking services and offshore compliance services. Among the subheadings under fund accounting, the company lists “Calculate fund net asset value (NAV).”

If you create and manage an investment fund, Theorem can provide integrated reporting such as periodic statements to your investors on how your fund is performing. These services allow you to focus on investment work, rather than yourself building computer systems to handle accounting, reporting and compliance. The Theorem systems also assist with financial audits.

According to an SEC press release dated August 7,2023"

[Theorem]provided administration services to a fund managed by EIA All Weather Alpha   Fund Partners [(EIA")] and Andrew M. Middlebrooks....[D]uring TFS's engagement, the fund suffered significant losses as a result of trading by EIA and Middlebrooks; however, TFS, at the direction of EIA and Middlebrooks, calculated the Net Asset Value, which did not recognize the losses, and sent investors account statements that materially overstated the value of their

Investments https://www.sec.gov/news/press-release/2023-148 .

In the related Cease and Desist Order https://www.sec.gov/files/litigation/admin/2023/33-11218.pdf at 17, the SEC indicates that EIA was incurring trading losses on its investments but convinced Theorem to "change the accounting for the losses." In more detail:

During February and March 2018,[EIA]continued to lose money trading on the [brokerage] Platform, losing an additional $342,000. TFS received trading statements showing these losses and TFS accounted for these losses as losses of the [EIA] Fund. TFS then provided the NAV and Investor Statements to [EIA] for review. Upon reviewing the NAV and the Investor Statements that evidenced the losses, [EIA] instructed TFS to change the accounting for the losses. Specifically, [EIA] instructed TFS, and it agreed, to record an expense reimbursement for all losses from [EIA's]trading as an asset, specifically, a receivable "due from the Manager(EIA)," which offset the effect of the loss, resulting in no reduction to the Fund's NAV. [EIA] further instructed, and TFS agreed, that going forward, any losses from [EIA's]trading would be treated as an increase to the receivable due from the manager (EIA). At no point was EIA actually liable to the Fund for losses.

Please explain in clear and simple terms how this accounting worked, its effects on reported results, and why it did not  "present fairly"but instead was deceptive.

7. Two Banks' Income Statements

Exhibit 7A contains some historical income statement information for two financial services companies, Morgan Stanley ("MS") and Goldman Sachs (GS").

These data are also presented normalized two different ways: first, in Exhibit 7B, with all revenue normalized to 100 for all periods, and second, in Exhibit 7C with revenue normalized to 100 for the first chronological period for each company (so subsequent periods may be more easily compared to those first period results for each company.)

(Note, some very recent information for Goldman Sachs does not yet have a breakdown among four non-interest revenue categories for 2023, so those are condensed into "trust income, commissions and fees," marked with an asterisk. The $37.777 billion reported by that"*"for 2023 will, when more detail is available, be spread among the three accounts above that one, as they are in earlier years' reports.)

Please analyze and comment on these financial statements in the referenced Exhibits, including discussion of any trends or non-trends and what the statements indicate the companies' managements may or may not have done, what was or is happening in the companies' markets, how the companies have performed alike or differently, and how all this could be reflected in those financial statements.

8. A Collection of Companies' Income Statements

Exhibit 8A contains partial annual income statements of five(5) companies, along with certain other financial information. Exhibit 8B normalizes some of these data to a scale where Revenue 100 on the income statements and Total Assets 100 on the balance sheets.

Note, some secondary sources were used to compile this information. These sources at times cut corners and consolidate, for instance, items that may have been reported separately on the companies' SEC filings. For example, the sources report SG&A (Selling, General and Administrative) expenses as a single line item, although the original filings may have reported them separately. In addition, not all of the secondary sources report R&D (Research and Development) expense. So we might assume that some R&D was folded into SG&A for some companies. (And that given even more time, the constructor of this question could at the risk of diminishing returns provide even more information.)

Please discuss which of companies A,B,C,D,E may be the following: (1) Integrated Energy Company, (2) Grocery Store Company, (3) Luxury Goods Seller, (4) Discount Retail Company and (5) Technology Licensing Company.

For simplicity these may be referred to (here in alphabetical order) as Energy, Grocery, Luxury, Retail and Technology.

Your analysis is more important than simply getting the "right" answers; so even if you somehow find a shortcut, please comment on relevant supporting accounting information contained in the Exhibits. It may be helpful to compare ratios of one account to another (rather than absolute amounts,) and then discuss based on how you might expect those ratios to vary among the different industries or segments of industries.