Friday, February 1, 2019

The slippery slope with accounting standards dilution

It is a feature of historical evolution that what was abnormal and abhorrent some time back becomes normal and desirable today. There is perhaps no more striking example about this than how people view the idea of taking another person's life (murder or killing). It is most likely that Donald Trump's actions have irreversibly changed and normalised several hitherto abhorrent behaviours and practices in US politics and global diplomacy.  

Gaming rules is par for the course in the corporate world. Even more pernicious is how gamed rules gradually become the norm. 

An examination of how "tax evasion" has come to become dignified and legalised as "tax avoidance" would be interesting. One could imagine a series of creative interpretations of tax regulations, either by stretching the boundaries of legality or being plain illegal, to favourably manipulate what constitutes profits. They have over time become the normal practice and legalised.

The latest example of "creative interpretation" of rules comes in the context of the recent European rules that mandate companies change their auditors every twenty years. The FT reports that Goldman Sachs intends to embrace "rotation in form but not in substance" by "top-slicing" their audit  - hire a small accountancy firm for a small part of its European audit while continuing to rely on PwC, its auditor since 1922 (yes!), for the bulk of the work.

The world of auditing and advisory/accounting is a cosy club. Most major firms (97% of UK's largest firms, for example) are audited by one of the Big Four (EY, PwC, KPMG, and Deloitte), and also buy consulting services from the other three. The Big Four have been at the vanguard of helping businesses achieve a new normal with corporate accounting. Transparency and safeguards for protection of shareholder capital are no longer the guiding principles. Instead obfuscation and creative interpretation to minimise tax outgo are both the guiding principle in corporate accounting as well as the value proposition of the Big Four accounting firms. One could easily add manipulation and fraud to the list of their service offerings. 

Sample this on the progressive dilution of accounting standards,
In the UK in the past three decades, standards setters have progressively dismantled the system of historical cost accounting, replacing it with one based on the idea that the primary purpose of accounts is to present information that is “useful to users”. The process allows managers to pull forward anticipated profits and unrealised gains, and write them up as today’s surpluses. More recently, it is behind a string of accounting scandals involving overstatements of profit, including at the UK supermarket chain Tesco and the software company Quindell. It hangs over the insolvency of the UK outsourcing group Carillion, where sudden contract restatements in 2017 erased the previous six years of dividend-bearing profits. In the US, the conglomerate GE is under investigation over the way it accounts for its contracts...
The principle that assets were valued at the lower of cost or net realisable value (or the price at which it was thought they could be sold) did not rule out estimates. But they only came into play when values had fallen. It was not possible for managers to conjure up unrealised gains and profits and present these as fact... From the 1960s, academics such as William Beaver at Stanford University advanced the notion that for markets to channel capital efficiently to the most productive outlet, accounts needed to give traders of securities a clearer understanding of the current valuation of a company. That meant abandoning inconvenient notions such as prudence and conservatism; instead, accounts had to be “neutral” and use more up-to-date values for balance sheet items... From the 1990s, fair values started to supplant historical cost numbers in the balance sheet, first in the US and then, with the advent of IFRS accounting standards in 2005, across the EU. Banking assets held for trading started to be reassessed regularly at market valuations. Contracts were increasingly valued as discounted streams of income, stretching seamlessly into the future... auditing firms have used their lobbying power to erase ever more of the discretion and judgment involved in what they do. Hence the explosion of “tick box” rules designed to achieve mechanistic “neutral” outcomes. It is a process, says Prof Karthik Ramanna, that is tantamount to a stealthy “socialisation or collectivisation of the risks of audit”.
Pretty much every major corporate scandal in recent years, and there have been too many of them, has failures of auditors and accountants as an important contributor. Several reforms have been suggested - break-up the Big Four, separate their auditing and advisory services, have two auditor with one from outside the Big Four, rotation of auditors, independent appointment of auditors, cap on market shares of the Big Four, stronger regulatory oversight etc.

The recent controversy over e-commerce regulations in India is a rare example of failure of corporate gaming of rules. Extant regulations explicitly mandate e-commerce firms to be marketplaces and prohibit them from holding inventory or having equity stakes in on-sellers. But even major firms like Amazon have sought to game the existing rules, only to have been caught out. Unlike in most cases of gaming, here they got caught out partly because of the power of local interest groups in a large economy like India as well as perhaps the tacit backing of a corporate behemoth like Reliance

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