Amongst other services, Turnkey Trading Partners provides bookkeeping support to Futures Commission Merchants (“FCM”), Introducing Brokers (“IB”), Guaranteed IBs (“GIB”), Commodity Pool Operators (“CPO”), and Commodity Trading Advisors (“CTA”). In our experience over the years, many small firms prefer cash-basis accounting for its simplicity. On the other hand, the Commodity Futures Trading Commission (“CFTC”) and National Futures Association (“NFA”) operate on a different set of expectations. The following article walks through the obligations for CFTC Registered, NFA member firms to maintain both accurate and timely, United States Generally Accepted Accounting Principles (“GAAP”) Accrual books and records.

The Regulatory Mandate for US GAAP

While GAAP accounting may seem like a suggestion or choice for accounting approach to some, for NFA members, it is a regulatory requirement and expectation. Under CFTC Regulations 1.18 (for FCMs and IBs), 4.23 (for CPOs), and 4.33 (for CTAs) the commission requires that financial records be prepared in accordance with US GAAP. While not explicitly spelled out for CTA and CPOs, the regulations state “accurate, current, and orderly” books and records must be maintained. Accurate, current, and orderly in the eyes of both the CFTC and NFA are books compiled on a GAAP accrual basis. Aside from the regulations, regulators expect that firms utilize a “standardized chart of accounts.” Such a chart of accounts would be required to include entries for receivables and payables. With respect to books being “current”, it has been Turnkey’s experience working with thousands of industry registrants, that regulators expect month end books to be closed by the subsequent 17^th business day of the following month. Here as well this standard is not strictly spelled out for CTA and CPO registrants. The standard is established primarily for firms with a net capital obligation. It has however been our experience that this standard, at least for basic books and records, is the baseline for current, accurate, and orderly accounting.

US GAAP is inherently an accrual-based system with subtle nuances for CFTC and NFA required obligations. This standard of accounting ensures that revenue is recognized when earned and expenses are recorded when incurred, providing regulators with a transparent view of a firm’s true financial health and “going concern” status. As a practical matter it also provides business operators with accurate financial data to make key corporate decisions. Apart from US GAAP being the CFTC and NFA standard, it is the best choice for operating a highly regulated, highly sophisticated derivatives brokerage or trading business with recurrent commission or fee receivables and corresponding accounts payables. In the following paragraphs let’s focus on some other specific obligations for each registration category.

FCMs and Independent IBs

For firms with formal net capital requirements, the stakes for using an appropriate accounting methodology, are perhaps highest. CFTC Rule 1.10 requires these firms to file periodic financial reports that must be GAAP-compliant. A failure to properly accrue a single large liability can result in an “under-capitalized” status, triggering immediate notification requirements and potential suspension of operations. There is no question or reasonable debate that for firms with a net capital obligation US GAAP Accrual accounting is mandated.

Guaranteed IBs

A common misconception among GIBs is that because they do not have a net capital requirement, their bookkeeping standards are lower. This is incorrect. Under NFA Compliance Rule 2-10, as well as CFTC Regulation 1.31, GIBs must still maintain “accurate, current, and orderly” books. Without accrual accounting, a GIB cannot demonstrate its ability to meet ongoing operational obligations. It can also not adequately demonstrate to NFA its brokerage commissions and related payouts to APs are being handled properly as just one example. In Turnkey’s experience the GIB community often uses cash-based books and records which are prepared only for tax purposes. Often, books maintained in this format comingle personal and business expenses inappropriately. Further, cash-based books prepared only for tax reasons are often not timely or “current” at the time they are compiled.

GIBs are notoriously bad at being able to produce professional general ledgers which properly identify transactions running into and out of a firms operating account. Poor quality books and records can lead to other regulatory problems. As another example, without a current general ledger it can be difficult to identify potential violations of NFA Bylaw 1101 which can lead to further regulatory headaches. Similarly, an outdated ledger may cause decision makers to miss key business trends or patterns and potential fraud or inaccurate financial transactions. FCMs expect GIBs to monitor their financial health and often include provisions about being a “going concern” within guarantee and brokerage agreements.

NFA will expect during GIB reviews accurate and current books and records. Turnkey has worked with many GIBs over the years to recompile company financials after NFA has cited deficiencies or control weaknesses. It is much easier to stay on top of accounting, than to recreate it. While it is true that GIBs do not have a net capital obligation, this is not the same standard as the best practice obligation (and practical regulator expectation) of using US GAAP based accounting methods.

CPOs and CTAs

Recently, the NFA removed the requirement for CTAs and CPOs to report specific financial ratios on quarterly filings submitted via Forms PR and PQR. Some registrants have incorrectly viewed this as a rollback of accounting standards. However, the requirement to file Form PR (and for CPOs, Form PQR) remains. Under NFA Rule 2-46, these filings must be “true and correct,” a standard that can only be met if the underlying data is maintained on a monthly, GAAP-accrual basis. As an example, CTAs and CPOs must prepare performance or fund accounting in accordance with CFTC Part 4 standards. These books and records are used to determine if appropriate advisory fees have been charged and subsequently collected. Both performance and fund accounting standards require the use of US GAAP and accrual principals. In order to properly reconcile CTA and CPO operating accounts, carried interest, or receivable and payable balances only US GAAP Accrual accounting will suffice. Cash accounting or books and records which are not accurately maintained, regardless of whether or not firms are required to submit financial ratios on the next PR, represent a potential nightmare waiting to happen during a firms next regulatory examination.

The Tax Conundrum

A key reason that some firms prepare books on a cash basis is that they work with book keepers and accountants that are not familiar with CFTC and NFA regulations. These book keepers, while well intentioned, strive to reduce tax liability. They also use tax book keeping conventions which may be appropriate but are not allowable for CFTC and NFA regulated business. When a prospective customer comes to Turnkey with accounting problems, often a tax-based accountant is involved. Many prospective customers are not aware that most accounting systems allow for both US GAAP accrual accounting and cash-based accounting. Many versions of popular small business accounting software include a “toggle” feature where US GAAP books can be converted instantaneously to cash-based books. There is a struggle between tax accounting and regulatory accounting. Turnkey’s view is that as a federal regulated entity under CFTC authority and NFA membership, regulatory accounting should come first, and tax accountants should make appropriate adjustments separately at tax time. Keeping GAAP books on a platform with a cash to accrual toggle eliminates this concern. Significant regulatory problems can, and do, often come from a tax-based accountants driving the book keeping discussion for regulated entities. Having a knowledgeable CFTC accountant and leveraging accounting software properly can help firms avoid this all together.

The Danger of “Inadequate Supervision”

Regulators frequently use NFA Compliance Rule 2-9, which covers all forms of supervision, as a “catch-all” for firms with poor bookkeeping. If a firm cannot produce a reconciled balance sheet or income statement during an exam, if they cannot tie out customer fees, if they have no ability to demonstrate ledger activity to meet compliance standards with NFA Bylaw 1101, its likely a citation for a failure to supervise its own financial operations may be coming.

In various NFA Business Conduct Committee (“BCC”) actions, firms have been penalized for “inadequate books and records” even where fraud was not present. For example, firms have been cited for:

• Failing to record accrued liabilities (unpaid bills) which artificially inflated their net capital position, assets, or generally made the company look better on paper than was the reality.
• Inability to reconcile management or incentive fees earned, or incentive allocations for carried interest, against the actual performance tables and fund administrative accounting provided to investors.
• Failing to close books within the expected 17th business day of the subsequent month. Mor generally not having timely records within the period of an examination.

Turnkey is a leader in CFTC and NFA related compliance and accounting matters. We are approaching our twentieth year in business and have assisted many industry registrants throughout our history. It is critical that holdout firms implement or remain on a US GAAP Accrual accounting standard. While GAAP standards may seem cumbersome, it is the expectation of regulators. It is also the best practice approach for bookkeeping when running a highly specialized and sophisticated business.

Below please find some real frequently asked questions that Turnkey has received over the years on this topic from prospective and current customers.

Frequently Asked Questions (“FAQ”)

I operate a GIB; do I have to maintain GAAP accrual books and records even if I do not have a net capital obligation? Yes. In Turnkey’s view you do. All NFA members, regardless of capital requirements, are bound by NFA Rule 2-10 and relevant CFTC recordkeeping regulations. Regulators expect every member to maintain a professional, GAAP-compliant set of books to ensure the firm is operating as a viable business entity.

NFA eliminated the financial ratios from the CTA PR filing; should I stop doing my accounting or switch to cash? No. The removal of ratios from Form PR was a change in reporting, not a change in accounting standards. CTAs must still maintain the records necessary to prove the “accuracy” of their filings. Switching to cash-basis would make your books non-compliant with the GAAP standards required by the CFTC. You also would not be able to properly reconcile advisory fees to your required accrual based managed account performance or fund accounting records.

Is cash accounting a sound methodology for a financial services firm? Cash accounting is insufficient for financial services businesses. It fails to account for earned-but-unpaid fees and incurred-but-unpaid liabilities. For a registrant, this “timing gap” can lead to a misleading picture of the firm’s financial condition, which is a significant red flag for regulatory and certified auditors.

What are the practical benefits of maintaining current (within 17 business day) US GAAP accrual vs. cash accounting? Beyond compliance, accrual accounting allows you to properly match revenue to expenses, providing a clear picture of profitability. It also ensures you are “audit-ready” at all times. Reconstructing a year’s worth of cash-basis entries into an accrual format during an active NFA exam is both stressful and incredibly expensive.

Under CFTC rules, can I do my accounting on an annual basis or must I close my books monthly? CFTC and NFA rules require books to be “current.” In the industry, “current” is defined as closing the previous month’s books by the 17th business day of the following month. Waiting until the end of the year for tax purposes is a direct violation of NFA member obligations and expectations.

If I compile my books on a US GAAP Basis but pay my taxes on a cash basis is this a problem? No. Most accounting software allows a user to toggle between properly presented US GAAP accounting and Cash Basis accounting. CFTC and NFA regulated firms should, from a compliance perspective, not allow tax accountants to drive the presentation of regulatory accounting. Tax based accounting certainly has its place but should not be the sole driver of accounting choices for heavily regulated firms.