Re:Balance -- Jim Peterson

Once and Future Accounting Schemes -- What Will They Think Up Next?

       

"Everything old is new again ...."
                -- Peter Allen

To pull off the next large accounting scam – or, more virtuously, to try to prevent it – where would we look?

This always-pertinent question has global dimensions, with criminal charges now lodged against two Price Waterhouse partners in India – see here – for their alleged complicity in the fraud perpetrated at Satyam Computer Services Ltd. under the leadership of CEO Ramalinga Raju.

Those inclined to heed memory and history as guides for the future will find familiar the recited bad deeds by which the Satyam accused are now answerable to the Indian courts:

• Bogus invoices for customer work never performed lay at the heart of the mid-‘80’s house of cards known as ZZZZ Best.
• Inflated rolls of non-existent employees echo the ledgers of fictitious insureds a decade earlier at Los Angeles-based Equity Funding.
• Shadow businesses and opaque investments recall the undrillable pools of petroleum, said to lie deep under the Canadian Arctic, sold as snake oil in the 1960’s by Bernie Cornfeld in the original version of Fund of Funds.

In a world of borderless impacts, and with the certainty that details of the Satyam criminal file will now implicate the defensibility of the investor lawsuits lodged in the United States as well as in India, it’s well to ask what new risks lie over the next hill.

Especially since, as similarly structured schemes have kept recurring with dreary regularity, decade after decade, the learning capacity of the financial gate-keepers is slight enough in fighting the last war, let alone to anticipate or prevent the next.

A starting point will be the predictable re-emergence of another rogue trader – almost routinely expected if still highly impactful – the next generation’s reincarnation of Nick Leeson at Barings or Yasuo Hamanaka at Sumitomo or Jerôme Kerviel at Société Générale.

But it’s also back to basics, in a world said to be reverting to older styles of banking and finance. In the recent era of exotic financial derivatives and black-box valuation models, the pervasive separation of deal-doing incentives from underlying transaction risks provide illusory and ultimately disastrous. Looking ahead, it can be anticipated that the next generation of white-collar schemers will unsheathe the simpler tools that have served so effectively throughout the past to entice the investors and evade the auditors.

Old memories may still spark, for example, to recall the 1960’s tanks full of “vegetable oil” in the meadows of New Jersey: collateral for the negotiable warehouse receipts issued by American Express, but actually nothing but water – a scheme that succeeded because the auditors looked from the top of the tanks at the thin layer of oil on the surface, rather than taking taps from the bottom.

Or the herds of ghost cattle, sold in fractional interests to urban investors: the livestock numbers were inflated by repeatedly cycling the same calves through the counting chutes – under the noses of the city-based audit staff who failed to prevent double-counting by the simple control of a chalk-stick mark on the forehead of each animal as it passed by.

Or the heavy-duty oil-field trucks comprising salable equipment portfolios: sensibly counted as they were scheduled through their repair and maintenance depots -- except that each one slipped past the auditors multiple times by the simple expedient of driving behind the repair shed to swap the identifying bar code on its engine block.

Or – to tie off a list that could otherwise go on a while – the allocation to investors of interests in a giant hill of Latin American coffee beans: except that under a thin layer of the real thing, the mound consisted of sand and bales of hay – undetected by the auditors too fastidious or pressed for time to drill or dig deeply enough to the core to get a legitimate sample.

All real stories – none of them all that original. But any of them will likely show up again soon, as timeless devices used to inflate the performance of money-gathering institutions basing their business on asset-based transactions.

Let the gate-keepers be warned – and the future perpetrators too. But only if the lessons of the past are learnable.     

Drop me a note if you have a candidate for an industry or a practice having special exposure. As a teaser -- I will soon take a specific look at a particular sector where I would see this aspect of risk to be both newly emergent and especially acute.

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Bankers Under Stress -- A Colloquium Questing for Relief

A graduate student in anthropology, able to have joined my field trip of last week, would have been handed an honors dissertation topic on a platter.

For two days I was with an exotic tribe – about a hundred senior-level bankers and their governmental regulators, assembled together to perform rituals and incantations in search of illumination and enlightenment about their system’s risky and uncertain future.

The proceedings were as defined as a liturgy, in obeisance to the god of regulated capitalism. Deep within the imposing temple of our region’s Federal Reserve Bank, the devout convened in an amphitheater, all arrayed in careful and attentive rows. Dressed in the prescribed vestments – uniform grey suits and sober neckties – we gathered to receive the wisdom of the high priests and seers, as they posed at the central lectern and delivered their Gospels according to PowerPoint.

Margaret Mead among the Samoans would have felt no less an outside observer. I have not been around that much cult-like behavior or arcane and exotic jargon since my last trip to South Bend, Indiana for a Notre Dame football game.

There on autumn Saturdays, they assemble reverentially in the sacred oval arena, face the Golden Dome, ingest the ritual brew, and raise their voices to shake down the thunder from the skies.

No less, the congregation of bankers were invoking Saint Ben and Saint Tim, seeking deliverance from the last two years of darkness and agony, through the magical efficacy of TARP and TARF, successful entrail-reading of the “stress tests,” and exorcism of the bedevilings known as Basel II and Mark-to-Market.

On full display were the same tensions and stress that have beleaguered minor sects throughout history, from the Huguenots and the Pilgrims to the Mormons and the Moonies. A highly-placed risk officer at one of the truly solid institutions, spotlessly innocent herself of any role in the global carnage, bemoaned her baseless demonization by friends and neighbors as a “greedy banker.”

And there was no little sense of persecution and paranoia in the manifest wish for relief from the daily howling of the uninformed critics at CNBC and the other media, whose intrusive drum-beating may well be serving only to distract and inflame an uneasy populace.

The concern is likely justified. The taxi driver who had delivered me to the meeting recognized the address. “Since you’re not a banker,” he said, “tell them that the businesses in my neighborhood are dying. They’ve got to start lending again.”

The legendary J.P. Morgan is cited for the story that it was time to become seriously worried about the markets when he was offered stock tips by his shoeshine boy. A cabbie is likewise an unlikely strategist on financial rescue plans. So the likelihood of populist street sentiment contributing to success in the current environment must be slight indeed.

Still – dim in the memory of an undergraduate lecture hall, I recall learning of the “cargo cults.” Isolated Micronesian peoples responded to the god-like appearance of airplanes dropping blessings from the skies, by re-creating avatars out of bamboo and thatch, donning head-sets carved from coconuts, and lighting bonfires to guide the expected parachutes. With these rituals they would pray for the continued benevolent intercession of the gleaming new deities -- with, it must be conceded, a conspicuous lack of results.

In today’s troubled context, the degree of resemblance is ominous. We who are non-initiate observers can do little but hope for the best. 

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Antagonisms Among the Audit Regulators -- A Warning Bell, or a Final Toll for the Profession?

There’s a gaping disconnect between the pieties on coordinated regulation of the global financial markets, espoused at last week’s G20 conference in London, and the contrary behavior of the national-level minions on the ground.

Recall Aesop’s simple little tales, where the Greek storyteller often leaves a hanging question. For today, it’s the conundrum that ends the debate among the mice -- just who is to bell the cat?

It is unremarked in fabulist scholarship that from the perspective of the large and dangerous cat, the rodents’ vacillations are inconsequential. Whereas, a seriously threatened interest goes unrecognized – namely, who is looking out for the cheese?

The same dissonance continues in the trans-Atlantic mouse-tussling among the various national agencies that claim to oversee the global accounting firms.

I wrote recently about the Securities and Exchange Commission as international spoilsport, for its hostile declaration that financial statements of a United Kingdom company would be unacceptable for American compliance, if using the legitimate UK rules permitting negotiated limits of auditor liability (here).

In so doing, I had missed an earlier shot aimed the other way. On February 19, EC Internal Markets and Services Commissioner Charlie McCreevy shut down further discussion about mutual recognition and reliance by the various national accountancy oversight bodies – here -- until the Commission receives the Obama administration’s views as to the attitude of the US regulators.

McCreevy may have a long wait.

Back in 2002 when the unfortunate coupling of Senator Paul Sarbanes and Representative Mike Oxley begat the Public Company Accounting Oversight Board, the world of regulatory oversight was not really crying out for the birth of a hegemonic American agency. But it got one anyway, under the “go it alone” attitude of the Bush era.

The resistance made it unsurprising that long-outstanding proposals on cross-border relations – here – have languished unapproved by the Americans:

•    From the passage of Sarbox down to date, as recently as PCAOB Chairman Mark Olson’s platitudinous speech to the Fédération des Experts Comptables Européens in December 2008 – here -- there has been no more than cosmetic attention to the unresolved issues of competing legal systems in such compelling areas as client confidentiality and personal data privacy.

•    Meanwhile the PCAOB has been obliged, faute de mieux, to adopt rules deferring its inspections of a roster of non-US audit firms, in the face of unfinished dialog to resolve the very outstanding issues that have been pending since 2002 -- here.

To an observer interested in the nourishment of international comity, the compound adjective “mickey mouse” is appropriate to characterize nearly seven years of murine antagonism.

While the regulatory mice play cross-border tit-for-tat, unfortunately, the world is not sitting still:

•    Last week’s billion-dollar lawsuit against KPMG by the liquidating trustee of New Century Financial (here) is not the first of the new wave of auditor mega-claims, but it does show that the predatory plaintiffs’ bar continues its aggressive prowling for appetizing targets.

•    And although troubling questions about the role of the accounting profession in the tumult of the global credit and financial markets have largely gone unasked, the question “where were the auditors?” is increasingly heard. There’s the business press – here. The always-trenchant Tom Selling (The Accounting Onion) is as skeptical on the dysfunctionality of accounting standards as I am about assurance. The idea of some form of nationalization is even floated, by both bloggers and academics -- here and here.

The American regulators cannot progress global auditor oversight on their own, beyond and despite all the threat and saber-rattling -- among other places, the PCAOB faces unsolved inspection impasses in China and Hong Kong. For his part, Commissioner McCreevy has put down the marker that continued American bluster means nothing more than further stalemate. But whether Mary Schapiro as President Obama’s new SEC head can cut a path out of the diplomatic swamp – or even wants to – remains to be shown.

This period of uneasy quiet is not a sign of stability – quite the opposite. Nothing has happened since the collapse of Arthur Andersen in 2002 to address, much less to reduce, the potential for a systemic shock to the franchise of privately-provided large company assurance. Yet the continued squabbling among the regulators makes plain their lack of vision or authority by which to collar the many challenges to auditor survivability.

All the while the deliverability of ostensibly valuable audit services to global-scale companies – the block of cheese in this little folktale – sits unprotected and exposed – nibbled away by hostile forces and showing signs of the furry mold of neglect.

Parenthetically, I plead no contest to the several weeks passed in sniffing out McCreevy’s statement, among the emanations from the bilge-pump of the European Commission’s publicity machinery. Oscar Wilde observed that when good American die, they go to Paris – while the city of Brussels, modest as its other virtues may be, must surely be the graveyard of effective regulators’ press.  

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