Friday, March 26

Creative accounting

It need not come as a surprise the recent revelations in creative accounting emanating from the US Bankruptcy Court about the non-disclosure in Lehman Brothers accounts of about $50 billion in obligations to repurchase securities sold in exchange for temporary funding lasting only a few days. The only real surprise was the amount of money involved and the blatant nature of the omissions.

The non-disclosure of these arrangements was made easier because of the development of creative accounting practices within the financial services industry where sales of securities to counterparties were no more than the equivalent of a short-term funding arrangement using the security sold as collateral. Simple in execution, a sale of securities (collateralized debt securities) was in consideration for cash paid by a counterparty after deducting interest, but only on the proviso of a future obligation to buy back those same securities in a few days time. In effect all you are gaining is a temporary funding and paying a high interest cost deducted from the sales proceeds. However in reality each time the repurchase agreement became due inevitably another would be executed so that the cash flow acquisition of long term dated securities was subject to inappropriate short term funding covering just a few days. The purchaser could opt to make a margin call (ask for more money) should the underlying securities fall in value or simply decide not to allow any future funding. In the case of Lehman Bros repurchase obligations amounting to $50 billion were not revealed in the accounts nor was that omission uncovered by the auditors.

Although one looks aghast at the size and extent of such practices one need not be surprised since creative accounting pressures have infiltrated other industries throughout the globe driven by the rewards available in circumventing the law or spirit of the law. When I was working as a Financial Controller, I was often in the invidious position of having to defend vigorously one’s integrity in resisting overtures to adopt creative accounting which contravened regulatory provisions or the spirit of such provisions. Simply put you have a choice as to whether or not you opt to maintain good governance and utmost integrity to be applied in a principled manner and to be reflective always in the accounts of the company to provide a true and fair view.

However for the minority who succumb or are complicit in creative accounting the catalyst is oft carefully crafted legal input designed to exploit regulatory loopholes or the spirit of the law to render advantage to the few at the expense of the majority. At the other end of the scale we are all familiar with the less sophisticated more blatant forms of corruption involving secret commissions and bribes to drive inefficiency and misallocation of resources and create the conditions for impoverished economic outcomes.

But at the heart of these issues of varying degrees of sophistication is the ripple down effects of corruption of government officialdom whose use of creative accounting and non disclosures would easily have been stopped in its track’s given the application of half decent internal controls. Invariably all of the exposed failures we read about are from within organizations where internal audit and/or control scarcely existed or was woefully lacking. Creative Instruments developed by many leading US banks allowed politicians to mask additional borrowing in Greece, Italy and most likely in many other countries by receiving an upfront payment in return for forgoing future revenue streams which were then swapped for debt liabilities. The accounting entries involved are not complicated and by all accounts elected officials were lining up eagerly to postpone the reality of the financial mess their country was in. The creative accounting employed made the position look as if they were reducing public debt when in effect they were assigning away future revenue streams in exchange for a fee which was then offset against those public debts.

Creative accounting has always been a temptation in the world but has taken on larger proportions since the real power today resides much more with the large corporations and their CEO’s who play a key pivotal role in exercising that influence.

The modern day corporation hopefully will aspire to not only build sustainable shareholder wealth but to also ensure they exercise good governance. We are fortunate in Australia to have so far largely avoided much of the excesses that applied overseas but have inevitably experienced the flow-on effects since we are an integral part of the global economy.

We have witnessed the failures of the dot-com bubble and the Enron scandal that preceded the GFC – the latter becoming perilously close to a great depression to prompt a clarion call for improved governance. But that clarion call would not have been necessary had the CEOs of those failed companies acted with integrity and ensured adequate internal controls operated across their organizations.

Our evolution has always been more dependent upon survival through co-operation – not on survival of the fittest as evolution’s most misquoted quote suggests – since the way forward so far as our evolution is concerned has always depended upon co-operative efforts, so that CEO’s are coaches and are not solely responsible for the success or otherwise of the corporation. Occasionally you will have psychotic or narcissistic leaders who temporarily prosper but inevitably others will need to step up to the plate and make a stand for integrity which is not always easy. But in the end for inequities to flourish the legal profession has to engage its resources in continually finding loopholes outside the spirit of the law just as there needs to be those who support the presentation of misleading accounts, to be prepared to compromise integrity and to avoid taking a stand against unprincipled practices for a lack of integrity to continue. We all have the power to ensure we act with integrity and for shareholders to demand it at meetings and to ensure that safeguards are apparent within organizational structures.

Governance systems need to ensure responsibility and power is more evenly spread across organizations to place more reliance on leaders as coaches and not in the foolish culture as if they are the equivalent of individual rock stars and or superstars.


Mercutio said...
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Mercutio said...

I read through this and I think that we lost a good man on the day you entered retirement. I would hope that other up-and-comers would mark your words well that this same insistence on integrity should prevail in future generations.

Now, I've been going through my monthly statements for tax purposes, and frankly there are things I see in there that I don't care for so much. I can see that a trade that didn't work out so well netted a 14% gain, and others that did, as much as a 70% gain. Not bad. But I've been doing this long enough to know that the key to profitability lies in reducing losses on a bad deal to a manageable amount.
And so, I have to wonder why the inattentiveness. Surely others, those who would make such a thing their sole profession, have come to the same conclusion. Why weren't the monthly statements dealt with in a timely fashion?

Also, I see a legitimate use for such short-term instruments, though any accumulation of debt at high interest could hardly be seen as preferable. Say, were an equipment lease due and liquid funds lacking, then a short-term high interest debt instrument could satisfy the immediate need. But just as paying the monthly minimum on a credit card with another credit card is not such a wise move, using a high interest debt instrument to satisfy a call isn't quite the most exemplary of maneuvers.
And so, I'm wondering if it's really the disclosure aspect of this which is at issue.
Of course, now that the matter has been made public, sentiment toward these instruments will sour somewhat; but the time-span involved remains to be seen. Just a few days ago, rumors before a Fed meeting sent the market in some very unexpected directions about an hour or so before the meeting. So much for a rational market. The reality is that expectations account for more than facts.
Still, were disclosure the issue, then there would have to be a balance between how much is offered and how much is demanded. It's still the buyer's choice.
I have no idea why someone would fail to disclose claims on future revenues, and frankly the practice appears to me to be criminal. It negates the possibility of a fair trade.

I saw on the wire a few days ago where the Aussie unemp numbers came in at 5.3, and this at a time when the the pundits are contemplating how long unemployment in the States will remain above 10%. And frankly, you and I both know that this wasn't so much a matter of being fortunate as it was of foreseeing the worst of the crisis and negotiating policies accordingly.
Although I am well aware from speaking with relatives from NSW that the Australian system isn't quite the perfect method, the manner in which the losses were minimized in this instance is quite commendable.

(ps: I just hit the preview button and realized how incredibly long-winded I am.)

Seraphine said...

an unfortunate truth with big american companies: one is required to "get on beard" and "toe the line" with whatever the ceo says.
if one question an executive decision, one is branded a troublemaker and risks being unemployed.
the free exchange of ideas is discouraged. and so it goes.
this "old boy" system is inherently dangerous, because successful governance relies on checks and balances.
in theory, good governance should provide a level playing field and a voice of conscience which allows the business, employees, shareholders and customers to prosper.
in practice, many companies lose their vision in the pursuit of short term policies and profits. it's entirely the fault of executive management and the board of directors of those companies.
government has not always served a proper role in regulating the activities of these institutions, especially when public well being is threatened. government has to be the conscience of last resort.

susan said...

I've been reading a bit about futurism recently and one fascinating topic that's been pointed out is that the world may be coming to the end of relying on monetary systems altogether. It's interesting when we understand that in a culture based on profit we don't produce goods based on human need, nor do we build houses based on population requirements. Just today I read about hundreds of acres of strawberries being destroyed in Florida because there were so many and the price per bushels had drooped too far to make them worth picking. That's crazy. Obviously, this wasn't about growing food for people but instead manipulating a commodity. Everything is based on economic disparity.

Do you think we'll ever see responsible corporations or the demise of narcissistic CEO's? At the moment (from the perspective of living in the US) that seems as much of a dream as having a truly cooperative society. I'd love to think it could happen though.

lindsaylobe said...

Hi Mecutio, Sera and Susan
Thankyou for your insightful comments.
Mercutio - The difference this time round in the Australian economy is the way employers retained their workers by ensuring additional leave was taken, less hours were worked or they negotiated lower temporary wages to retain their employees and ensure there were no wholesale retrenchments. These moves, along with targeted stimulus measures impacted favorably on the general level of employment.
Looking ahead huge capital expenditure is now planned for Australia's resources projects with about $250 billion in spending projects subject to feasibility analysis on top of $100 billion already recently invested. Last year the comparative figure was only $80 billion, which gives some idea of the future likely effect. Most of the money is earmarked for liquefied natural gas (LNG) projects.
It is indeed an unfortunate truth about big American companies - particularly in the circumstances of relatively high unemployment where many are fearful for their position and don’t want to rock the boat for fear of the consequences. However, amongst financial executives, one still has the option and responsibility to make a stand, and many do to their short term detriment. You only hear about the failures and not about those who continue to act with integrity. The US whistle blowing provisions are better than what we have here.
Susan & Sera
The whole nation of calculating profit is flawed. We eat cheaply produced fast food which might cost a consumer only a few dollars or even in the cents yet in reality costs an additional $50 per item in environmental damage. The accounting profession is endeavoring to come to grips with this reality by introducing sustainable accounting standards but it will take a long time to infiltrate in the mainstay in our thinking and recording.
I have come across narcissist leaders who were given various names such as chainsaw ……. They can temporarily be even foolishly admired as the tough men willing to take those tough decisions and retrench massive numbers of people at the drop of hat. But over the long term they are ultimately seen as both irresponsible and very poor leaders who undermine the culture and long term success of a corporation.
Most large companies here engage independent consultants to interview anonymously all staff segments so that the CEO is then faced with the results about how people feel about the company. If the level of staff satisfaction sinks or stays low than the CEO and other executives are in danger of losing their position to make way for others who are more likely to achieve those expected results. It is not perfect but a big improvement on what happened previously. A narcissist, given such a system, won’t survive for long.
Best wishes

susan said...

If the free enterprise system could be said to create incentive it's also understood that it creates greed, corruption, and economic hardship among other things. It's also not always true since most major developments have been the result of the efforts of people working on things that interested them. Galileo, Eddison, Watt, Curie and so many more weren't looking for economic compensation but wanted to improve processes even when they were opposed.

I sincerely hope you're right that there are new and sustainable accounting practices under development because there are too many who are entirely motivated by the false doctrine of money as it's practiced in our society.

Thanks for your cool and rational response as always :-)

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gfid said...

i've always been good at creative accounting.... though not by design. in truth, creativity comes more easily to me than accounting, so it's just logical that there'd be some spill over.