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Thursday, April 17. 2008
It all started with Enron. The company was just too clever and set aside moral scruples in a feverish drive to maximize reported (as opposed to real economic) earnings.
The next step was auditors, who traditionally were employed by companies’ boards to check the math in the financial statements and ensure that balance sheets balanced.
Occasionally, under suspicious circumstances, they were instructed to conduct what were termed “fraud audits”, where they really took a close look at things like cash, receipts and bank accounts to see if someone was cheating or embezzling.
When Enron’s frauds came out, there was a frantic drive to find someone with significant economic resources - other than Enron’s crooked officers - who could be blamed. Enron’s auditors, Arthur Anderson, long reputed to be the toughest firm in the country, took the hit for not identifying the frauds they were not paid to investigate. Lawyers and frantically grandstanding officials declared Anderson to be guilty, and applied a pre-trial death penalty for the entire firm for the conduct of the partner on the Enron account. Not only was this in gross violation of the U.S. Constitutional requirement of a fair trial, it was enforcement of a notion of collective guilt previously unseen in Western democracies, and it put thousands of Anderson’s innocent employees out of work. As the gentle reader might recall, Anderson received a post-mortem judgment of “not guilty”.
Well, the accounting profession was not pleased, and began to look for a way to strike back.Next, the Securities and Exchange Commission got involved. The SEC had been established to ensure that securities offering documents and corporate reports to shareholders contained full disclosure. Accused by the press and Congress of lax enforcement, the SEC sought to find a way to co-opt the private sector as enforcers of Federal securities laws, and found lawyers and accountants an easy choice, declaring them responsible for finding and reporting any corporate hanky-panky that might be occurring, making corporate advisors into government snitches, and vastly increasing their risk of doing business.
Again, the accounting profession was not pleased, and its counter-attack came when accounting standards boards around the world invented (over corporate objections) a new system they thought was more theoretically pure, called “fair value accounting” with particular aim taken at the recent innovations in financial derivatives. These rules require assets to be valued at whatever someone will pay for them at any given moment.
As an example of the impact of Fair Value rules, if the Kondratiev family were a public company and - like a lot of people - not able to sell our house right now, we would have to write its value way down and take an “accounting loss” for that entire amount, making us technically bankrupt even though we know the house will indeed sell this year or next. Fortunately as a family, we don’t have to follow those moronic rules, and can wait and live in our home until the housing market recovers.
What’s worse, if a public company owns some sophisticated assets like esoteric options that don’t trade often, the rules require that they value them in accordance with a black-box mathematical model – and isn’t that the greatest opportunity for fraud yet invented? Then, if it later happens that there are few buyers of those options, accountants will require around 55% write-off in their value, even if the underlying assets have not diminished in value. Remember when some banks were required to write down assets fully secured by US Treasuries?
Nevertheless, our ivory-tower CPAs hold that regardless of a notion of long-term real value, if you cannot sell something today it has little – or no – value. Just look at the ultimate market proof that that notion is intrinsically false – private equity funds are snapping up these securities by the armload as soon as the banks write them down, and Kondratiev confidently predicts that some Great Fortunes will be made by those funds over the next three years. Business Week will predictably have a cover feature on the brilliant investors who gambled on purchasing deeply-discounted, scorned securities and against all odds won big. Ja. Remember where you read it.
To make a long story short, between SEC rules and new accounting standards, company financial statements are now unreadable by almost everybody except a tiny group of trained professionals, and companies are now having to add annexes to their financial statements that say things like "our audited statements are presented in accordance with Generally Accepted Accounting Principles, but as such they are not useful in managing our business, so the following figures are the (unaudited) numbers we actually use to manage our business.”
Furthermore, and more importantly, the accounting deck has now been so stacked that every possible financial negative is emphasized and every possible financial positive is deferred. The result for us analysts and investors is that current financial statements are for most part presented in a way that grossly understate the real worth of companies.
“But,” you may well ask, “how did Bear Stearns so overvalue its assets?” Answer: it didn’t. Bear Stearns owned pools of residential mortgages, yours and mine, that might have a default rate of 5% in hard times, 15% in a depression, and was forced to write them down to nothing simply because, like our house, nobody was buying that day. As we wrote earlier this week, Bloomberg and everybody else (except the accounting rulers) knows that the foreclosure rate is expected to be 1.99%, which means that JPMorgan as purchaser of Bear will probably collect over 99% of the face amount of these mortgages, even if the foreclosed properties sell for half the loan balance. Only an accountant could insist that those mortgage pools had an accounting value of 40-45%.
Thousands of innocent people will be thrown out of work due to an intellectual ivory-tower artificiality perpetrated by the Financial Accounting Standards Board and the SEC.
The accountants’ revenge is complete.
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I'm a poor artist and I am stunned at the damage I see coming. There are literally going to be two sets of books: the unofficial business books and the accountants'. The first, as the article says will be un-audited; and the second, with the legal imprimatur, will be the accountants'. Will any in-house accountant work on the first or be bound by law to do only the second: the answer is obvious, this means non-accountants will be doing the business books.
This also means that the management cannot trust either set of books. But it must operate by one set or the other: the non-audited will be the closest to reality -- but murky. This also means difficult, if not broken,communication between investors and management.
As the presence of two sets of books becomes public knowledge, government will start criminalizing the un-audited managers' set. Then mangers attempting to do their job will be considered "white collar" criminals: we will see many "perp walks". The public, not knowing the reason or truth, will think there is business wide corruption. the socialist activists will call for increased business regulation; and most politicians will respond.
I do not think we will recognize the business landscape in ten to fifteen years. Let me rephrase that: the business landscape will be socialist.
To be sure, there will be great transfers of wealth as the credit crisis works out.
Mark to market accounting rules, including mark to model methods, have significant problems such as those cited.
Today's market price for a security does not always reflect the intrinsic value of future cash flows. That simple fact is why you buy equities or bonds and why an investor such as Warren Buffet and long-term investors in Berkshire Hathaway have become so wealthy.
In fact, accounting rules require assets to be reported at the lower of cost or market. BRK's balance sheet does not reflect the unrealized gains of it's securities portfolio and Sun Trust held Coca Cola stock at almost no cost.
The application of accounting rules today is just that - an application of rules. There is no judgment - just compliance.
Mark to market rules will always overstate the downside because securities historically become undervalued during periods of economic weakness or contraction. However, mark to market rules eliminate the ability of management to overstate the value of assets when the known long-term value of those assets is lower than book. That was essentially what the Japanese banks did during the 1990s when the value of real estate collapsed in Japan or the banks would have truly been insolvent.
I see little hope of returning to accounting rules that are balanced, allowing management and independent auditors to agree on the longer term value of assets. The reason is lawyers. If you make a judgment call that turns out to wrong even with the best of disciplines and intentions, you (i.e. accountants, companies, management and directors) will be sued.
Seems big government can't lose. Given the public trust of voters, they make the laws and then they remake the laws and then a few years later they investigate why those laws had such bad unintended consequences.
Also, seems almost easy to predict with cap and trade influence on commoditys, government will make the rules and then 5-10 years down the road they will also set up the large committees that will hold extensive hearings to determine where all that money went. Then a few years later those committees will submit complicated papers and reports that will attempt to explain how "the people" were misled. Then the legislatures will pass a whole pile of new laws and rules to prevent it happening again. Again. Cannot help but be a bit of a cynic. Guess maybe it comes with the years.
What's the point of an audit? I thought it was to provide an accurate picture of the finances of the audited company. How could Arthur Anderson not have some culpability for the fraud that was Enron. Enron was a financial sham. Why didn't its accountants speak up.