Net Capital Computation
Common Errors Made in the Computation of Net Capital
By: Stephen J. Sussman
The net capital rule was designed to protect securities customers, conterparties, and creditors by requiring that broker-dealers have sufficient liquid resources on hand at all times to satisfy potential claims if a firm were to cease its operations.
The Net Capital computation begins with the broker-dealers GAAP equity and is then adjusted by both additions and deductions per the rule. Most of these adjustments are straight forward and few errors are made following the written rule.
The common errors are made by not knowing or understanding various interpretations of the adjustments. Some of these interpretations adjust net worth with additional items not covered by the net capital rule. These are the areas where we see the most errors.
The most recent adjustment that has been misunderstood by broker dealers relates to expense agreements with third parties. Prior to NtM 03-63 and subsequent interpretations, there was no guidance in this area except for the application of GAAP to the broker dealer’s financials. If the broker dealer does not follow the interpretation exactly as written, all the expenses assumed by the third party could become a liability of the broker dealer. This interpretation is difficult to understand and it has been noted that the regulators have changed their view of the interpretation making hard to be in compliance. This interpretation has been proposed to become part of the Net Capital Rule that should simplify complying with it. Any firms that have this type of arrangement should review their agreement and make sure it complies with the interpretation. Minimally, firms should review this agreement annually.
Other interpretations that adjust net worth where firms may make errors include the treatment of:
- Any capital contributions that are contributed but withdrawn in less than 12 months. If capital is withdrawn within 12 months of contribution, the contributions would actually be considered a loan and, therefore, must be recorded as liabilities and may not be considered for net capital.
- Any guarantees for liabilities to any other entities which must be deducted from net worth.
- Certain liabilities that are recorded/adjusted different then GAAP rules. For example, GAAP records long term liabilities at present value but interpretations override this and record it at the full value. Additionally, GAAP has certain rules on when a liability should be recorded but broker dealers have been required to record them in lieu of GAAP rules.