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.