I have been meaning to write a long essay about Judge Engoron’s decision last week in New York v. Trump, the civil fraud trial regarding the interconnected series of Trump-owned enterprises that is commonly known as the Trump Organization. However this is a very busy time of year for me, which has delayed my ability to do that. As such I am now going to break the essay into two pieces: one that talks about background relevant to the case, and then a later one that delves more into the decision itself.

Many of the things I will write about in this essay start to get close to my professional interests. For that reason, I want to clarify that everything I write here are my personal opinions and should not be construed as the views of my employer.

The heart of the prosecution’s case in New York v. Trump is that, over an extended period of time, Donald J. Trump repeatedly disseminated to lenders and insurers Statements of Financial Condition that were fraudulent, in that they purported to comply with U.S. GAAP (Generally Accepted Accounting Principles) but did not in fact do so.

This is a strange case in many ways. To understand why, we need to step back and talk about how businesses generally prepare financial statements.

Many, if not most, of the businesses that we encounter in modern American life are public corporations — entities whose stock can be bought and sold on stock exchanges. These companies are required, by the Securities & Exchange Commission (SEC), to publicly file financial statements on an annual basis that comply with U.S. GAAP. Moreover, these companies are required to hire an independent public accounting firm to audit those financial statements and express an opinion that the statements are fairly stated.

An under-appreciated point is that the financial statements are the responsibility of company management, not the audit firm. The audit firm does not tell management what to record. However, the audit firm does play a societally important role in verifying the material accuracy of the financial statements, by performing various types of audit procedures. One example of this would include validating that management has appropriately followed/interpreted the applicable accounting literature in preparing its financial statements.

As another example that hits particularly close to home for me: If the company’s financial statement involves liability or asset balances that are uncertain and that require specialized expertise to estimate, the audit firm may employ their own specialists to assess the reasonableness of management’s estimates. That assessment includes looking at the data, assumptions, and methodology underlying management’s estimate, and may involve constructing an independent range of reasonable estimates. (This is, in fact, what I do for a living, with respect to a particular class of estimates relating to health insurance risk.) To the extent company management is unable to convince the audit firm and its specialists that management’s estimate is reasonable, and the difference is considered by the audit firm to be material to a reader of the financial statements, the audit firm could be unwilling to issue an unqualified audit opinion unless management agrees to change its estimate.

That is the audit firm’s ultimate “stick” in the audit process — the threat to withhold the “carrot” associated with the firm opining that the financial statements fairly present the company’s financial position. For this reason, it has become relatively rare for public companies to have significant material errors in their GAAP financial statements coming from either the misapplication of accounting principles or use of inaccurate data as inputs: An audit firm would likely detect, and require their client to correct, such an error before it appears in published financials. There are occasionally frauds perpetrated by companies that their auditors fail to detect, to be true, as well as misapplications of the accounting literature that initially went undetected before later being found and corrected. But for the most part, the audit process significantly enhances the reliability of a public company’s financial statement.

In light of this, it has become very common for privately held companies to also prepare GAAP financial statements, and get those financials independently audited, even in the absence of an SEC-imposed requirement to do so. These private company GAAP statements are often not released to the public. However, the providers of equity and debt capital to a private company may require that audited GAAP financial statements be prepared annually, so that they can monitor their investment. Also, if the company has ambitions of going public someday, they will need audited GAAP financials as part of their initial public offering registration statement. As such, even for many private companies whose financial statements aren’t publicly disclosed, an audit firm is in the background, playing a role to provide assurance that management’s financial statements comply with GAAP.

Which brings us to the Trump Organization. Not only is it not a public company, it is not even a traditional private company: There is no corporate entity called “Trump Inc.” whose stock is owned by Donald J. Trump and other family members, and that in turn operates various business ventures. Instead, the “Trump Organization” is an interweaving and opaque collective of various assets, most of which are organized into separate limited liability companies (LLCs), and all of which ultimately come under the common control of Donald J. Trump.

As such, when we’re talking about Statements of Financial Condition issued by the Trump Organization, we’re actually talking about a GAAP concept known as a “Personal Financial Statement,” covered by a piece of accounting literature called ASC 274. These statements, generally prepared by high-net-worth individuals who need to provide financial statements to lenders, focus on the balance sheet — that is, assets and liabilities — and the measurement attribute for those balances is called “estimated current value,” which is defined as “the amount at which this item could be exchanged between a buyer and seller, each of whom is well informed and willing, and neither of whom is compelled to buy or sell.”

Obviously there is considerable judgment involved in arriving at the estimated current value of the types of assets that Trump owns, such as office buildings and golf courses. Nevertheless, that doesn’t mean one has unfettered ability to invent the values reported on the financial statement; those values need to be supportable, by relevant data and methods and assumptions, as an estimate of current value consistent with the objective articulated in the language I quoted above.

Additionally, there are other more general aspects of GAAP that need to be adhered to in an ASC 274 financial statement, such as (to pick an example that will become relevant) what does or does not quality as “cash”. There are also disclosure requirements, many of which relate to things like the methodologies in use and the year-over-year consistency of the balances reported.

At the end of the day, a personal financial statement is the responsibility of the person involved, just as a corporate financial statement is the responsibility of the management of the corporation. In principle, an independent accounting firm could be involved in auditing a personal financial statement, just as they are involved in auditing a corporate financial statement. And if so, that audit would involve the accounting firm expressing an opinion that the financial statements are fairly stated in accordance with GAAP, which would mean the firm had reviewed the various estimates made and the application of accounting principles.

But more commonly, accounting firms perform what are called compilation engagements, rather than assurance engagements, with respect to personal financial statements. That is, an accounting firm is involved in helping the individual prepare and issue the statements, but does not actually audit the financials.

That’s what we’re talking about, when we’re talking about these Statements of Financial Condition that the Trump Org prepared on an annual basis and sent to its lenders and insurers. They are GAAP statements showing estimated assets and liabilities; they are the responsibility of, ultimately, Donald J. Trump; they were compiled by an external accounting firm, generally Mazars; but, importantly, they were not audited by Mazars.

And as such, there was no external gatekeeper making sure that the estimated values reported for various assets by Trump Org were reasonable, or that the overall financial statements and associated disclosures were compliant with the applicable accounting literature. However, Trump himself certified that the statements were compliant with GAAP, as part of the process for Mazars to release the compiled statements.

A question one might be asking at this point is: Why did Donald J. Trump organize his business affairs in this fashion? Why is there no umbrella holding company called “Trump Inc.” that would prepare normal corporate financial statements and have them audited by an independent accounting firm? Why instead does Trump have ownership of an opaque web of LLCs and then prepare personal financial statements that are not audited but compiled?

I’m sure the answer to those questions is multi-faceted. However I will observe the following: If one wanted to be able to play fast and loose with the accounting rules — to be able to inflate the values of one’s assets and hence one’s net worth without external oversight from accountants and their specialists — then issuing compiled personal financial statements, rather than audited corporate financial statements, would be the way to go.

I’ll pick up on that theme in part two, at a later date.