Category: Accounting


As If Accounting

Do reasonable Americans today regard housing markets, credit markets, stock markets or collectibles markets to reflect accurately the fair value of their homes, corporate bonds/equity and collectibles? My guess is that a large number could honestly and in good faith say “no, that they do not,” whether correctly or incorrectly. Many might say instead that at least some of these markets are at least periodically distressed (or even inactive in the case of collectibles and some housing markets) and that related prices, if any, “really represent distressed sales.”

If so, according to the logic of new accounting rules the country’s independent accounting standard setter adopted last week, valuation of these items may not accurately be ascertained by using recent comparable home sales or trading prices for corporate debt and common stock or auction sales of collectibles. Instead, they could be ascertained by reference to the owner’s own judgments about what those assets would sell for in an “orderly transaction” and “active market.”

The accounting body (the Financial Accounting Standards Board) last week gave analogous authorization to corporate America (and FASB’s London-based counterpart is being pressured to follow suit). In its plain English version of these new rules, FASB says they are designed “to figure out fair values when there is no active market or where the price inputs being used really represent distressed sales.” FASB continues: “The objective is to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced transaction) .”

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The Great Repression

Great Repression Human Brain in Cage.jpgAmid contending descriptions of the prevailing economic crisis, and candidates for causes and responses, I nominate The Great Repression and, in doing so, point out how unconscious exclusion of painful realities from the conscious mind caused the crisis and continues to infect policy responses to it.

No consensus appears on what to call the prevailing economic crisis, let alone diagnostics of its causes or prescriptions for cure. It’s not yet so severe to warrant Great Depression II or so mild to be called a mere recession. As something in between, some are tempted to call it a Great Recession.

People seem agreed that an asset price bubble, especially in housing, manifested crisis, but disagree on exact culprits. Consumers and businesses respond by curtailing borrowing and spending, but government’s responses are exactly the opposite.

All candidates for culprits ultimately involve false stories that people—citizens, business people, regulators and politicians alike—told themselves. Exemplars: the American dream of home ownership can be made available to all; housing prices tend inexorably upward; massive current borrowing can be repaid from future assumed prosperity; financial risk can be diversified, hedged, securitized away by carving up underlying financial instruments; regulators can let market participants self-monitor and self-correct; and politicians can safely respond to citizen appetites by sustaining all these false beliefs.

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Silver Lining and Lesson Department

silver lining in a cloud.jpgA compressed portrayal of US failures evident in the current crisis may arise from the following list of representations:

(A) firms: Countrywide, Fannie Mae, AIG, Citigroup, Moody’s, Lehman Brothers, General Motors;

(B) industries: mortgage origination, mortgage finance, insurance, commercial banking, rating agencies, investment banking, automobile manufacturing and finance;

(C) regulators: state mortgage, insurance and banking overseers; Federal Housing Finance Agency; Securities and Exchange Commission and Commodity Futures Trading Commission; Federal Reserve, Treasury, Office of Comptroller of the Currency; Federal Deposit Insurance Commission;

(D) lawmakers: Congress, Congress, Congress, Congress, Congress.

What representations do not appear on this list? Deloitte Touche et al, the auditing industry, and the Public Company Accounting Oversight Board. Three cheers.

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Forms May Fail Big Four Auditing Firms

org chart.jpgA common form of business organization designed to limit liability of participants may have failed the four largest auditing firms, according to a judicial opinion last week refusing a motion for summary judgment based on the design. The case, involving claims by defrauded investors in the Italian company, Parmalat, seeks to hold liable affiliates of the Italian accounting firm found culpable in the fraud, Deloitte S.p.A. The court refused to dismiss the latter’s US affiliate, Deloitte Touche LLP, and the Swiss entity that unites them, Deloitte Touche Tohmatsu.

If sustained after further fact resolution, the result would expose Deloitte US to crushing legal liability—and likewise expand the liability exposure of the other three large auditing firms that use similar structures (Ernst & Young; KPMG; and PriceWaterhouseCoopers). That, in turn, could increase the risks that one of those four firms may soon fail, which would make it difficult or impossible for many large publicly-listed companies to find outside auditors as required by federal securities laws. Ultimately, this could mean US federal governmental takeover of the traditional process of private audits of listed companies.

At issue in the Parmalat securities case against Deloitte is the standard structure that the four large auditing firms use. They operate as networks of scores of member firms organized as separate legal entities in jurisdictions where they practice. They enter into agreements that enable identifying members with the global brand name and practice of a global firm. These structures are designed to promote a recognizable professional identity while insulating each member from the others’ liabilities. The delicacy of the balance appears in how the court last week questioned its liability limiting efficacy.

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Hello Ms. Schapiro

SEC Seal.gifThe Senate on Thursday confirmed President Barack Obama’s nomination of Mary Schapiro as Chair of the Securities and Exchange Commission. In Ms. Schapiro’s written answers to questions posed by Senator Carl Levin, she indicates a refreshingly sharp break with many policies of her predecessor, Chris Cox.

Differences appear on numerous particular subjects. These reflect a general orientation to re-dedicate the agency to its primary mission of investor protection. Examples from Ms. Schapiro’s letter follow (with full text available here from Investment News):

1. Corporate Governance. Ms. Schapiro favors (a) rules letting shareholders (at least significant, long-time holders) nominate candidates for corporate boards of directors; and (b) rules allowing shareholders to express advisory opinions and votes on executive compensation .

2. International Accounting. Ms. Schapiro, unlike Mr. Cox: (a) does not believe that the International Accounting Standards Board meets US legal criteria and is not prepared to delegate authority to it; and (b) believes that US authorities must oversee foreign auditing firms auditing financial statements of companies with securities listed in the US.

3. Internal Controls. Ms. Schapiro, unlike Mr. Cox, would enforce laws requiring internal controls as to small and large public companies alike.

4. Accounting. Ms. Schapiro also believes in: (a) maintaining the independence of the US accounting standard setter, the Financial Accounting Standards Board; (b) cracking down against abuses of off-balance sheet accounting; and (c) continuing the requirement that stock options be accounted for as compensation expense.

5. Regulatory Scope. Ms. Schapiro favors: (a) regulating hedge funds; (b) strengthening capital requirements for securities brokers; and (c) strengthening regulation of rating agencies.

So far so great.


Satyam Fraud’s Systemic Regulatory Implications

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From a systemic regulatory standpoint, the Madoff Ponzi scheme remains of limited significance, especially compared to the latest exposed fraud case, at the large Indian software company, Satyam Computers Services Ltd., whose shares trade on the New York Stock Exchange (in the form of American Depository Receipts, or ADRs). Its CEO released a letter yesterday disclosing an elaborate, and apparently simple, billion-dollar fraud that went undetected by the firm’s outside auditors, an India affiliate of PriceWaterhouseCoopers (PWC).

The Satyam fraud presents serious questions about systemic regulatory efficacy, particularly concerning auditing and audit firm oversight. True, it may seem outlandish that Madoff was able to use a rinky-dink auditing firm to review the books of a fund commanding billions of dollars in assets and it may be that even such small auditing firms of even private funds require as much regulatory supervision as larger auditing firms auditing public enterprises.

But the Satyam scandal presents a far more serious problem. Unlike Madoff, the company has shares listed in the United States. Also unlike Madoff, it was audited by a foreign affiliate of a large US auditing firm, PWC, whose operations apparently were outside the scope of review undertaken by the US auditing profession’s regulatory overseer, the Public Company Accounting Oversight Board (PCAOB).

Pending additional information from the newly-revealed fraud, of course, a couple of preliminary issues may prove to be lessons of the Satyam fraud. First, if foreign companies list securities in the United States, their financial statements need to be audited by a firm whose activities are subject to regulatory oversight in the United States.

Second, the fraud implicates the Securities and Exchange Commission’s recent enthusiasm for the concept of mutual recognition. This refers to a policy allowing foreign firms, especially brokers but potentially also companies and auditors, to access US securities markets without regulatory oversight here, so long as they are subject to comparable regulatory oversight at home. (I have questioned this policy before.)

Third, there is some possibility that audit failures by foreign affiliates of US auditing firms could expose the US firm to crushing legal liability. This could lead to the dissolution of one of the four remaining large US auditing firms (see my post here). Should that occur, with only three such firms standing, the country would face an additional blow to its system of corporate finance, with attendant adversity for the real economy and citizens.

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Spreading Blame in Ponzi Scheme

When word of Bernard Madoff’s alleged $50 billion Ponzi scheme broke last Friday, my systemic worry was whether the fund was audited by a prominent auditing firm. Public revelation of an auditor’s involvement in such a fraud would almost certainly destroy it. Cf. Arthur Andersen amid Enron (2002).

If one of the four very largest auditing firms (Deloitte, Ernst, KPMG or PWC) were involved, the world would face an additional crisis by reducing from 4 to 3 the number of auditing firms capable of auditing most global companies. Indeed, such added crisis could occur if one of the next three largest firms (BDO Seidman, Grant Thornton or McGladrey Pullen) were implicated in such a fraud.

Fortunately, Madoff’s vehicle was not audited by one of those 7 firms (it was apparently audited by a storefront neighborhood accountant). Yet there is continuing fallout from this fraud that, some assert, does implicate one of the large 7 firms. In a putative class action lawsuit filed yesterday, New York Law School is suing investment advisor, Ezra Merkin, and his outside auditor, BDO Seidman.

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KPMG-BCE: Auditor Conflict in Huge LBO Deal?

Green Eyeshade.jpg As one of the largest leveraged-buy out deals in history verges on collapse, much attention is being paid to a central condition in the agreement, the target’s solvency; little attention has been given to conflicts of interest facing the firm, KPMG, deciding whether the condition is met.

The deal is a $28 billion LBO for BCE, Canada’s largest telecom firm. A principal lender in the proposed deal is Citigroup, the struggling commercial bank. BCE has made clear it wants the deal to close as scheduled on December 11; Citigroup, like other lenders amid the current financial crisis, may prefer that it does not.

The agreement contains a condition to the lenders’ obligation to close that BCE shall have obtained an opinion from KPMG, or another public accounting firm, attesting to the solvency of the post-LBO company. This may be difficult to deliver, given the considerable debt being used in the LBO and terrible market and economic conditions.

Trouble is, KPMG is the outside auditor for both BCE and Citigroup, presenting it with a potential conflict of interest. One arm of KPMG may wish to bless the deal, to promote favorable relations with BCE, while another may wish to scotch it, to promote favorable relations with Citigroup.

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SEC Schizophrenic on Global Accounting

SEC Seal.gifWith surprising absence of fanfare, the Securities and Exchange Commission released over the weekend a 165-page document outlining its delayed and long-awaited proposals for how the US might switch from using its own generally accepted accounting principles to new international financial reporting standards. The release bears a schizophrenic quality. It offers one unsurprising and one surprising proposal.

The unsurprising portion reflects what the Commission reluctantly came to accept last summer: the US is not ready for such a switch and is not likely to be until 2014 at the earliest. Accordingly, the release principally outlines the many obstacles to such a switch and lays out milestones that would have to be met before considering such a radical move.

The surprising portion contemplates allowing selected US issuers voluntarily to make the switch as early as the year after next—2010. This radical proposal would be limited to US issuers whose industry uses IFRS as the basis of financial reporting more than any other set of standards. The release struggles to explain why this special approach for such issuers overcomes the many obstacles facing other US issuers.

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Rescue Plan Relies on Accounting Finesse

Green Eyeshade.jpg Treasury’s latest plan to address the credit crisis by direct investment of $250 billion in US banks has politicians telling Americans one thing and firms telling investors another. Politicians tell Americans the investments are temporary, no threat to private market capitalism in a democracy; thanks to deals brokered by Treasury and the Securities and Exchange Commission this weekend, firms will tell investors the investments are permanent, necessary to account for them as increasing firms’ permanent capital and minimizing dilution of common stockholders.

The tension is finessed by imaginative design and classification of the two components of the government’s investment: preferred stock and warrants to buy common stock. As to the preferred stock, the solution is designing terms to exploit a gray area in accounting dividing debt from equity. Borrowed funds a firm must repay are debt (liability); permanent funds a firm need not repay are equity (capital). Preferred stock is a liability if the firm must repay it and equity otherwise.

Critical to the Treasury’s plan is boosting firms’ equity capital, which means making the securities look as permanent as possible. But if they look too permanent, that would impeach the political story. The result is a term sheet negotiated this weekend calling the preferred perpetual while incentivizing firms to repay it within five years, without an explicit obligation to do so. Examples include a spike in the dividend rate at year five from 5% to 9%, forbidding firms to pay dividends on common stock unless dividends are first paid on preferred and limiting firms’ right to repurchase common stock while the preferred is outstanding.

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