The most sombre issue to emerge from the world’s current financial woes is that of trust. Putting it succinctly, who can you trust in markets where it pays to deceive?
it was all in conformity with existing EU accounting rules..
Take Greece’s desperation to sell its bonds to reduce the size of the European bailout. The sales followed a series of swap transactions, strategically orchestrated by the usual parade of investment banks, enabling the Greek treasury to hide the extent of its fiscal deficit – which was actually four times higher than the limit permitted to Eurozone states. Its finance minister justified the deception by explaining that it was all in conformity with existing EU accounting rules.
When Lehman Brothers was criticised in a court-ordered report for accounting practices that allowed $50 billion of debt to be temporarily removed from its balance sheet at every quarterly reporting date, the justification cited was compliance with a discredited Standard FSAS 140, as if this legitimised a deception labelled “inherently improper” by the court.
As explained by Ian Sanderson in “Accountancy” in April, Linklaters in the UK supplied an opinion on FSAS 140 that allowed Lehman, by reference to criteria coded Repo 105 and Repo 108, to treat short-term asset repurchase agreements as sales rather than financing transactions. Cash received from counter-parties was used to reduce liabilities and improve apparent gearing, thereby misleading investors.
Use and abuse of standards
The highlight of the court report on Lehman is its insistence that more is required than mere technical compliance if GAAP’s ultimate goals of fairness and accuracy are to be achieved. Yet this statement of the obvious continues to elude those whose job it is to enhance investor confidence in accounts.
We are back in the age-old debate on substance versus form. An accounting policy, devised unashamedly to deceive, attains legitimacy solely because it does not explicitly breach a standard. Thus are financial statements released into the public realm which, while containing no overt technical contraventions, dissemble rather than explain; obfuscate rather than clarify.
The Companies Act 1929 required company accounts to give a “true and correct” view, but in prescient recognition that technical accuracy provided no guarantee against misleading presentation, the phrase was amended to “true and fair” in the 1948 Act. And here we are, 62 years, five Companies Acts and a dead-weight of accounting rules later, facing the same problem.
Hiding behind the rules
What Lehman and 18 other banks were indulging in was plain old window-dressing – but on an unprecedented scale. Quoting Matt McCormick of Bahl & Gaynor, “the banks do it because there is no real penalty for these activities”.
There is nothing new in hiding debt. Enron did it 10 years ago using special-purpose partnerships, claiming that no standards were breached. Who were the so-called “partners” in those partnerships? The same banks now being investigated for deceptive accounting practices. And how better to hide toxic assets than to apply toxic accounting standards!
Goldman Sachs stands accused of fraud in having created collateralised debt derivatives comprising sub-prime mortgage assets which it sold to one group of investors while another investor, who helped to choose the mortgages, was betting that the derivatives would crash. Which they did. Can accounting practices employed by the entire investment banking community be categorised as fraudulent? Or just morally reprehensible, but legal?
The truth is that regulation will never keep pace with financial innovation
The truth is that regulation will never keep pace with financial innovation. Bankers will always devise techniques to circumvent the best-intentioned accounting rules. Worse, those very rules will finish up being re-interpreted as a shield against liability.
I may be old-fashioned, but a balance sheet that exploits a technical disparity between UK and US law to allow $50 billion of real, current liabilities to vanish into thin air may, semantically stretching the point, be “true” – but “fair”? Never.
Presumably that’s why I wasn’t invited to audit those accounts.