November 2016 “Accountancy”
The central bankers’ obsession with interest rate cuts as a means of stimulating economic recovery reminds me of the “dare” games we played as children, such as “how long can you keep your finger in the candle flame?” Or, in banking terms, “how close to zero can you fix interest rates before unleashing a retributive counter-force, the impact of which is unknowable because it has never been experienced?”
Or, discovering the law of diminishing returns in action: “identifying the point at which the level of benefit or profit gained is exceeded by the amount of money invested.”
If I were the auditor of a “defined-benefit” pension scheme I would be seriously concerned right now: my job is to ensure that the scheme’s trustees, apart from complying with its investment rules, are acting responsibly in interpreting what is in the scheme members’ “best interests” – which implies finding a sensible balance between risk and prudence within the limits of the sponsoring company’s covenant.
Bond yields are the wrong measure
Traditionally this has involved reference to government bonds as a proxy for “risk-free” future yields when calculating the present value of cash that will have to be paid to pensioners over decades ahead. But in today’s eccentric climate of relentless interest-rate cutting, the unsurprising outcome is that reference to bond yields will simply (but falsely) dictate that the fund needs more money.
I would sympathise with the trustees’ frustration in being caught between directors having to withstand relentless incursions into corporate profits and cash; and employees approaching pensionable age facing the prospect of pensions so paltry that retirement aspirations have to be severely trimmed.
I could, of course, avoid any charge of overstepping my brief by simply standing back from this moral dilemma and ticking all the boxes in my audit programme. But I would prefer the role of devil’s advocate and turn protocol on its head, recommending that trustees re-examine the scheme’s constitution, bearing in mind the law of diminishing returns as cited above.
Since notional gilt yields bear little relationship to the returns which the fund’s assets are capable of achieving, trustees should seek a legitimate way of breaking out of this self-defeating cycle, in which the snake feeds on its own tail – incidentally causing the sponsoring company to cut other, much needed, investments.
Shadow of 2008 still looms
When the sub-prime debt crisis struck in 2008 I quizzed colleagues in the top audit firms about their apparent failure to check the quality of the paper debts with which their clients were stuffing their balance sheets. The defensive retort was always the same: “If a client buys a parcel of ‘triple-A’ debt we (i) authenticate its purchase by reference to transactional evidence;(ii) check correctness of classification; and (iii), if required, approve its disclosure”.
“But don’t you take a peep at what’s actually inside the parcel?” I would ask incredulously. The condescending response was invariably a variant on the same theme: if the basic transaction is consistent with normal business patterns; the parties have proved reliable in the past; and the supporting documentation gives rise to no significant query, “auditing standards do not require us to second guess management’s own decision-making processes by delving into the content of each purchase”.
That smug certainty has given way to harsh reality: the 2008/2009 mortgage crisis has left a devastating residue of contagious audit litigation in its wake, the scale of which is without precedent. PwC, which currently leads the field, is contending with a record claim of $5.5 billion following the collapse of mortgage lender Taylor, Bean & Whitaker (TBW), whose key executives have now been jailed.
As PwC’s lawyers have pointed out, they were never auditors of TBW. They were, however, the auditors of Colonial Bank, whose largest client was TBW, and to which a package of $3 billion in fake mortgage assets had been transferred.
This is the point I was making eight years ago, and it is the very point at issue in this trial: is it enough to verify the purchase of the proverbial can of worms without at least sniffing the contents?
What goes around, as they say, ………
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November 2016 “Accountancy”