‘ACCOUNTANCY’ – JUNE 2016

The term “creative accounting” always carries the pejorative implication that accepted accounting rules are being manipulated to make trading results over a defined period appear to be better (never worse!) than warranted by facts.

Perennial rule-tightening is like painting the Forth Bridge – the job is never done. Standards, the building blocks of true and fair reporting, remain susceptible to “creativity” – a term that, in any other field of human activity, would be counted as virtue rather than vice.

What if the rules themselves are defective?

Will compliance of itself always give a true and fair view? What if the rules themselves are defective, or supposed compliance masks a distortion? In such cases, a good auditor must be prepared to incur management’s displeasure by putting a spotlight on the fakery. A clean opinion would merely dissemble truth.

The EPS buybacks trick

Earnings per share has been a standard performance measure for decades. If management’s policy of share buybacks makes earnings look better on a per-share basis, is the enhancement a real plus for remaining shareholders? Since real profit growth is unaffected by share buybacks, the EPS enhancement is a mirage. Yet if not highlighted, you would have to do the sums yourself.

Low interest rates should encourage directors to invest in operational enhancements that generate gains over years to come, whereas buybacks provide a one-time benefit that rewards sellers of shares more than long-term holders.

My view? I believe in putting a mandatory spotlight – if necessary by auditors – on any performance improvements achieved by accounting conjuring. This would facilitate more realistic assessments of board quality. If shareholders don’t like the board’s strategy of returning a chunk of their capital they would have the choice of installing a different management, with skills to develop operations instead. This is particularly relevant in the context of governance when executive pay has gone into orbit.

Excluding buybacks from performance

Performance metrics enhanced by buybacks or similar devices should never play a part in determining executive rewards. No one, not even the chief of BP, should be paid a salary of £14 million, and no opaque assemblage of facts and figures thrust before a remuneration committee can justify the obscenity of paying a man more in one month than many will earn in a lifetime of work.

Even the Institute of Directors is sounding a recall to sanity, stressing that pay should reflect company performance; be clear and simple; and aligned with shareholder interests. When the FTSE 100 Index stands at the same level as 18 years ago and 10% below its peak, why has executive pay over the same period more than trebled, with a rising disparity between average and top pay?

The economic explanation

Is there an economic explanation for all this folly? You bet there is. All the fiat money conjured up by successive waves of ”stimulus”, courtesy of the central bank’s magic printing press, must go somewhere.

The artificial suppression of interest rates has destroyed consumer time preference as a natural investment guide, causing the first receivers of all that credit to invest in capital projects whose outcome cannot be known by the banks on whose lending it depends. Which projects will be completed before the business or bank runs out of money? What will the supposed collateral realise in a distressed market?

In this totally unmeasured world an obscene level of executive pay creates asset price bubbles in luxury goods and property, while banks contemplate their books of non-performing loans.

Fudging bad debt recognition

Since the rules allow lenders to fudge recognition of toxicity in their loan books, the pretence applies equally to counterpart liabilities in the borrowers’ books. Banking regulators have no workable metrics either, so another Basel hike will require banks to carry yet another layer of capital. When the blind lead the blind it is all guesswork anyway.

The 2008 sub-prime collapse lives vividly in auditors’ memories. It demonstrated the extent of financial devastation that follows unrestrained monetisation of bonds conjured out of thin air. The truth of “once bitten, twice shy” depends on lessons being learnt – by sovereign states, central banks, commercial banks, regulators, politicians – and auditors.

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