Lords blame Auditors for Banking Crisis

This is in response to the report in Accountancy Age titled:Lords Enquiry: accounting fuelled banking crisis: http://www.accountancyage.com/accountancyage/news/2272237/audit-enquiry-accounting written by Mario Christodoulou dated 26 Oct. 2010:

The Quote/Unquote below is an extract from the book I have authored Inactivity Based Cost Management: Measurement of Intangible: Governance, Ethical & Fiscal Responsibility and Accountability, that answers Lord Lawson’s accusation and at the same time the reasons for banking collapse. It offers the next logical step to follow. It takes into the historical perspective of the collapse and the specific reasons for the same as well the role of IASB.

Trend of 1977 and the Role of IASB

1. It was a commendable role IASB had played over the years that one instrument – Balance Sheet had come to be relied upon as the most reliable record of activities transacted by companies globally.

2. Industry was made aware that they had no other recourse than to get the approval from the professional accounting bodies through published accounting standards for any inclusion on change of Balance Sheet items. Meaning a journal entry at corporate level needed a prior approval from the accounting governing body. Governance was at its best.

3. The industries looking for approval for capitalization of R&D costs, be it aerospace, pharmaceuticals, automobile, hardware, were all for an end product that was a tangible item. Accounting firms armed with IAS 9 would have no difficulty to verify the product as well the costs related to the R&D capitalization. IAS 9 emerged after due diligence.

1995: Exposure Draft E50 Intangible Assets is introduced

However year 1995 could be termed as the year of Windows 95 and Nick Leesons. The tussle between technology and technology had begun, for good or bad. During the year there were disturbing reports on brand related IPOs with several warnings filed with SEC but hidden from private placement memorandum. Offshore tax havens were used liberally to establish companies without disclosing the ownership information while filing the court papers.

Chilling statement from World economy and Social Survey 1995: “Traditionally, the major financial intermediaries have been fractional – reserve banks and thrifts, whose assets and liabilities are, except in bankruptcy, redeemable at par. The assets and liabilities are not directly traded on secondary markets and hence are not ‘marked to market’. In other words, the ‘prices’ of loans and deposits on the banks’ books are always at par, notwithstanding interest rate changes. When the financial markets are important sources of funds, however, the story can be different. If the market interprets the monetary easing as inflationary, the prices of bonds and notes fall and the yield on credit from the market does not, or not as much as the cost of bank credit. If the market’s share of total finance were small, this would not matter: but traditional par-value banking is gradually being eclipsed by the so-called share of ‘mutual fund’ banking which deals only in securitized assets. Such market intermediation has grown especially rapidly in the United States. The erosion of Balance Sheet assets had already begun in 1995.

During the discussion stage of E50 [Intangible Assets], brand value being used as a tangible asset was quite apparent. Because of this importance of brands for the economic development of certain businesses, the accounting treatment of brands has been a matter of debate and controversy in many countries, such as Australia and the United Kingdom for instance, where companies, such as Grand Metropolitan and Rank Hovis McDougall, decided in 1988 to include the value of brand names, either purchased or internally developed, in their consolidated Balance Sheets. It shall be noted that it was seven years before the use of intangible asset in a Balance Sheet that the exposure draft E50 was released for inclusion in the IAS standards!

The purpose of international accounting standards is: “Our mission is to develop, in the public interest, a single set of high quality, understandable and international financial reporting standards (IFRSs) for general purpose financial statements.” What really emerges out of the standards is: a. Auditors’ responsibility and b. public perception or confidence in the Balance Sheet.

As a going concern auditors’ are fairly protected which is not the case when a major scandal breaks out. The tendency among the public naturally is to question how the auditors’ did not ferret it out. Intellectual Property for example could be a matter of dispute if the individual who created it, challenges ownership. The valuation of an intangible asset could be one figure for the Balance Sheet purposes but could be a highly padded up figure for a Private Equity Investor. In such cases risks associated with internally generated Intangible Asset could be high. Purchased intangible asset is an asset generated out of a transaction when the market would decide the price taking into consideration the risk factors and future economic benefits.

It is not the case with an internally generated Intangible Asset. It has a sting in the tail that was not deliberated threadbare during the exposure drafts discussions or at the review stage of IAS 38. The conditions are entirely different on capitalization between 1977 and 1995. There was no need to displace IAS 9 and substitute with IAS 38 enlarging the scope of assets covered. Such Intangible Assets could have remained or made use of, as off-Balance Sheet assets, without bringing into the books of accounts. Balance Sheet must be fortified to exclude non-transactional entries.

It is not the responsibility of an accounting governing body to accommodate any industry, which is a state subject who could offer incentives and concessions to promote a favored industry time to time. This is despite some favorable comments from professors earlier: “Knowledge-based assets make up a growing proportion of economic valuation, but “people believe that current accounting models really don’t capture their worth,” says Wharton accounting professor David F. Larcker. “For example, despite the fact that [a company] may have intellectual property (IP) that holds significant value, the IP may not in fact have ever been catalogued or identified.” Maybe, but it is not the accounting profession that could accommodate such assets that are misused by the unscrupulous few.

Balance Sheet is one instrument that should be kept sacrosanct and not to be tampered with non-monetary assets.

Financial Crisis 2009

International Accounting Standards Board [IASB] has constituted Financial Crisis Advisory Group [FCAG]. Commenting on the IASB’s decisions, Sir David Tweedie, IASB Chairman, said: “We have heard a clear and consistent message on financial instruments accounting — fix this once, fix it comprehensively, and fix it in an urgent and responsible manner. The IASB is committed to do just that by developing proposals within six months for public comment.”

The Implication

1. Governance is a combination of Responsibility and Accountability. When responsibility is shouldered accountability follows. Governance ensures that.

2. In a historical perspective, the year 1977 saw the initiative for IAS 9 capitalization of Development Costs. Lockheed scandal was already a story, Yom Kippur war resulted in increased cost of development for re-engineering and IASB’s issuance for IAS 9 Research and Development Activities in 1978 was understandable in order give relief to the manufacturing industry.

3. The increased cost of raw materials on account of oil prices, shot up cost of development. At the same time unproductive goods were manufactured and sold at an increased cost of marketing that included bribing the customer appointed agents. Corruption has been added to the brand value.

4. IAS 38 Intangible Assets was released in 1998 and on the same day IAS 36 Impairment of Assets was also released. An asset is considered as an asset because it has future economic benefits. Impairment of Assets happens when its carrying amount exceeds its recoverable amount. Meaning there is no future economic benefits for this asset category but a future economic loss. This is acceptable as for as IAS 36 is concerned as the future economic loss is considered after the impairment takes place.

5. Intangible Assets – Oxymoron

When IAS 38 Intangible Assets emerged it was released after the pressure from the industry, but the industry scenario has changed completely in 1998. The pressure was only for the brand value to be included as Intangible Asset. IASB gave in. What’s wrong in that, one may ask? Matter is the one that takes up space and has mass. Meaning it has two sides. In case of a brand value of Rolls Royce or Cadillac one could see both sides whereas in the freshly brewed intangible assets one could see only one side with a question mark as to what would be the future economic benefits. It is ironical as well strange that the question of future economic loss of intangible assets was not considered during discussion stage of IAS 38. Perhaps it was a premonition to release the IAS36 Impairment of assets at the same date that these intangible assets would bite the dust ere long. An asset is bound to impair and disappear, whereas Intangible is everlasting!

6. Impairment of assets is a cost incidence written off in the Profit and Loss Account, whereas future economic loss is a cost consequence which is never considered for a Balance Sheet. Financial Crisis 2009 can be summed up by one sentence, as mentioned by Timothy Geithner the then President and CEO of Fed. Reserve Bank of New York: “The scale of long-term risky and relatively illiquid assets financed by very short-term liabilities made many of the vehicles and institutions in this parallel financial system vulnerable to a classic type of run, but without the protections such as deposit insurance that the banking system has in place to reduce such risks.” Intangible assets had played a major role based on which the parallel financial system made itself vulnerable and collapsed taking with it the banking system as a whole.

7. It is the natural instinct of an animal to resist being caged. Balance Sheet is a regulatory framework and it is natural for the management to resist being confined to a set of rules. For the Donigers the present caves in.

8. A regulatory framework will however have to be necessarily established. Why IASB during the deliberation between 1995 and 1998, when IAS 38 was released, did not discuss and ultimately left the term ‘intangible’ undefined? When International Standards are issued every word, particularly the title, needs to be defined to the utmost care and diligence. By not defining the term ‘intangible’ IASB has also failed to discuss the cost consequence of ignoring a term of reference. Would brand value of Cadillac have helped GM the needed finance from the bankers or investors instead of taking the amount from the government? Timothy Geithner again: “This crisis exposed very significant problems in the financial systems of the United States and some other major economies. Innovation got too far out in front of the knowledge of risk.”

9. If Sir David Tweedie, IASB Chairman, wants to ‘fix this once, fix it comprehensively, and fix it in an urgent and responsible manner’, then IFRS should deliberate on cost consequence, during the Exposure Draft stage itself, so that fixing mechanism and troubleshooting clauses are sent with the manual under the heading ‘Governance’. Cost consequence analysis opens up the risk factors on account of misuse of the term propounded by the accounting standards at the time of deliberations rather afterwards. Mechanism for management of cost consequence is Governance. Intangible Asset is a nightmare for Governance.

10.When a fiasco takes place, the first question raised is – who is responsible for it? When “I am not” follows the “I am not”, the next question raised is – is there not any accountability for such a disaster? The auditing methods adopted by the external auditors are investigated by another equally reputed audit firm – meaning they could take their turn for a similar peer review later – with a clean chit finding the external auditors cannot be made accountable as it is the responsibility of the management to institute proper preventive measures to avoid such a fiasco. Then it is back to square one, responsibility. The third question is then raised – how do we come out of this fiasco? Governance, governance is the best answer to all these ills? Excellent, some important personalities within the organization shall be charged with governing the Governance. The Accountability factors are settled and matter closed, until reopened for another fiasco or scandal.

11. In the meantime a millennium merger takes place with AOL take-over of Time-Warner creating a $335 billion company, proving that in a world ruled by finance, intangible assets rather than real assets are the indicator of real wealth. What’s true in such a scenario is that the real finance is completely mopped up by speculative enterprise, a privileged area of the government, denying the much needed funds for priority spending, globally.

12.Intangible Asset is croupier’s delight.

A loophole provided however insignificant it could be, is enough to break the dam of confidence and deluge the entire system of Governance. That loophole when exploited by men of greed the one that is never get examined is the cost consequence. UNQUOTE

While discussing the auditors’ role on corruption: Quote: The accounting firms have taken the stance that it is the responsibility of the management to take the appropriate action. They have emphasized the materiality aspect: “Regarding any external reporting obligation, financial statement materiality is the only reasonable standard for an outside auditor since that is what governs the auditor’s undertaking of an audit and the form of the eventual audit report. The definition of materiality is: Information is material if its omission or misstatement could influence the economic decisions of users on the basis of the financial statements. Materiality depends on the size of the item or the error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point….” ISA 320.3. It is significant that the auditors work within their framework of scope of auditing that the public should realize the limitation set by the audit profession. Public building a confidence level based on Auditors’ capability to ferret out the corruption within, is unfounded. Unquote

On Responsibility: Quote: The OECD analysis by different interest groups clearly opines that Responsibility and Accountability are a matter of conjecture and each group wants to avoid shouldering them. It undermines the confidence level of the public that resources entrusted to the care of the managers are not governed. The lacunae apparent in Governance standards need to be plugged and a robust system brought to practice. Unquote

Finally for the way out: Quote: “In the line of International Accounting Standards Board [IASB], an International Ethical Standards Board [IESB} be formed.”

All Member States participating in the UNCAC initiatives would do well to consider a similar institute such as accounting firms to train, educate and establish professionals to prevent corruption in public life. Professionals awarded the certificates, affiliated to an international body say, IESB – International Ethical Standards Board, should form part of the body of Managerial Force to implement the Policy Statement of UNCAC. The central body of the institute shall be under the aegis of United Nations Office on Drugs and Crime that shall function similar to IASB issuing standards and professional conduct with complete independence. The syllabus for becoming a certified professional, besides other curriculum details appropriate for the course should include, as per UNCAC Article 60.

The UNCAC initiatives to be successful and effective International Ethical Standards Board with well qualified team of Fiscal Responsibility Group needs to be set up emergently. Proposed International Ethical Standards Board shall certify Corporate, senior executives and the Board of Directors. Proposed International Ethical Standards Board shall certify the entire gamut of industry and shall incorporate public reporting as the very essence of social responsibility. Unquote

My comment on “Lord Lawson accuses auditors of being “the dogs that didn’t bark” during the banking crisis.

Banking woes are not due to financial accounting but due to Governance. From 1995 it has become quite tricky when Nick Leeson could bring down the whole empire of Baring Brothers. The guys sitting in London didn’t know ABC of derivatives nor how the computer worked. It was said the auditors were also ignorant about the way such transactions taking place. This continues to happen, the tussle between technology and ignorance, as we have seen with Madoff and Kerviel of Societe Generale but yet no one could surely say they are the only two men behind the scam. Governance is beyond the auditing standards. Auditors will never get caught in that and should not. IASB has done a wonderful job over the years with bodies representing all over the world where it remains the only profession guided by integrity and accountability. No other profession has that reputation. Lord Lawson must make a note of it.

The purpose of my book as indicated above is to establish International Ethical Standards Board [IESB] because the terms of reference is more expansive would bring into scrutiny all managerial quality ethical as well fiscal. I have suggested this be formed in the same pattern as IASB. In fact IASB is the right body to initiate the process of establishing IESB and hand over to be run as a separate independent board. I have suggested in the book to train at least half-a-million professionals worldwide so that Governance standards are quickly established. Lord Lawson should initiate this process.

Most important of the above is that Auditors’ are concerned about the cost incidence and not about Cost Consequence because it is not their mandate, and that is their limitation.

In this context the report quotes, Tim Bush, a member of the Accounting Standards Board’s (ASB) Urgent Issues Task Force, that international accounting standards forced auditors to abandon the principle of prudence in their audits. “The biggest factor has been the loss of prudence in accounting standards,” said Bush. I would rather agree as Bush is not blaming the Auditors but the loss of prudence in Accounting Standards. From what I have analyzed since 1977 from IAS 9 to the emergence of IAS 38 is the functioning of IASB that did acquiesce to the demands of the industry. This is not called for.

Jayaraman Rajah Iyer

Kodaikanal, India

Twitter: @jayaribcm

Author of Inactivity Based Cost Management:

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Author - CorporateMOM - Sustainability of Corporate Stability

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