Re:Balance -- Jim Peterson

Accounting Standards Convergence -- Sometimes the Bear Eats You

For months now the trans-Atlantic regulators have kept up a complex choreography, hoping to converge the global standards for accounting, reporting and auditing corporate financial information.

It’s like watching a carnival performance of dancing bears – notable not that they’re so slow and clumsy, but that they dance at all.

The publicity machinery has been cranking:

First was the US Securities and Exchange Commission, announcing in November – here -- that it would start to accept the financial statements of non-US companies, as prepared in accordance with International Financial Reporting Standards – widely used around the world except in the US – only now without the reconciliation to US standards that has been so costly, disruptive and questionably useful.

Next followed EU internal markets commissioner Charlie McGreevy – here -- with a symmetrical plan for American companies to list in Europe using accounting principles generally acceptable in their home country – good old familiar US GAAP.

Third was the December 5 announcement by the US Public Company Accounting Oversight Board – here -- that starting in 2009, its inspections of non-US audit firms would move toward fuller reliance on the inspection and enforcement regimes of that agency’s counterparts in other countries.

And lately, inputs from the US Chamber of Commerce – here – to the SEC’s Advisory Committee – here -- have been extolling the necessity of integrated global standards and principles.   

A theme played for years, the case for convergence has stayed consistent -- that the use of common standards promotes strong globalized capital markets, supports investor comprehension and confidence, and fuels economic growth.

But the background has changed since the time the Americans were calling the tune: When convergence was first seriously sounded, corporate listings were migrating to the New York Stock Exchange, the Euro-to-be was predicted to be a regional form of play money, and the extensible hegemony of accounting principles as issued in the US was taken for granted. Little wonder the Europeans were mostly unenthusiastic wallflowers at the party.

And then? Still shadowed by the darkening gloom of the Enron era, the American-led scandals around executive options and subprime mortgages have showed the limits on its capacity for regulatory detection and deterrence. London became the center of the IPO market, and the Euro is hovering around $1.55.

Europe ascendant has had its mis-steps, of course. The French-led opposition to unqualified EU endorsement of the standards for derivatives accounting showed the survival of its parochial difficulties.

And although the subprime contagion started in and primarily affects American markets and institutions, it extends from the regional German banks to the funding of villages in northern Norway, while the Bank of England stubbed a toe against the collapsed mortgage lender Northern Rock and UBS showed the storied competence of Swiss bankers to be as holed as its cheese.

Back in the USA, while the London bankers merrily stole the lunch of their New York counterparts, the SEC’s readiness to accept IFRS-based financial statements – half a decade after Sarbanes-Oxley -- now rings as an effort to protect against market-share erosion. And fair-value accounting has become the target of choice for blame-shifting to evade the dysfunctions of the bankers’ black-box valuation models.   

At the same time, the PCAOB’s readiness to “increase its level of reliance on non-US oversight systems” needs to be translated out of agency obfuscation into real English. If so, a candid statement from Chairman Mark Olson would read like this:

    "Since 2002 we haven’t made a dent in achieving the legislatively-imposed mandate to inspect and oversee the 800 non-US audit firms forced by the law to register with us. We will never solve the foreign law prohibitions or find the competent resources to do this ourselves. We have no realistic choice but to devolve our responsibility over to the authorities of 86 other countries, although they mostly have neither real track records of success nor the resources to get there. Whether any progress is actually made or even measurable will not be known for many more years to come."         

Meanwhile, taking a look at the PCAOB’s record at home, Sarbanes-Oxley has neither restored virtue to financial reporting nor unsprung the auditors from the limits on their performance:

•    The subprime-triggered chaos across the capital markets originated with and is traceable to the confessed failure of the players to understand, value, control, account for or report on entire balance sheets full of complex financial instruments. What leadership role does an audit regulator deserve, having sat that one out?

•    The academics’ confident proclamations of a year ago, that the level of US securities class action litigation was enjoying a structural reduction, now yields to the reality: case filings are back up to Enron-era levels, with the very large and rapidly-expanding group of subprime-based cases still comprising only a fraction.

So let’s wait a bit to evaluate the extent and effect of whatever convergence may actually be achieved within our lifetime.

Or, to invoke the ursine advice of the 17th century French fabulist La Fontaine, “don’t sell the bearskin until you’ve killed the bear.”

What the Wine Sellers Buy -- A Metaphor for Understanding Subprime

The credit crunch spreads – from tapped-out holders of adjustable-rate mortgages, to specialty insurers desperate to preserve their ratings, to the leaders of Citigroup and Merrill Lynch on begging-bowl fundraisers in Asia and the Middle East, to a swell of big-number litigation enough to enrich the lawyers world-wide.

And as spring foretells the release of the finest French wines, my wine-collecting friend in Paris confronts a crunch of his own. 

He prefers his tangible cellar of fine vintages over a portfolio of financial derivatives. But he has learned that – as with countless investors ranging from holders of the Bear Stearns subprime funds to pension funds and village treasurers and any number of other yield-chasing funds and institutions -- he has an uncomprehended and volatile commodities market exposure.

Like the small investors who clamored to share the sexy returns of the hedge funds, my friend ventured beyond his retail wine shop. Going to an internet wine vendor in 2006, he bought a quantity of a fine Bordeaux 2005, then being offered en primeur – that is, an advance sale just after the harvest but two years before the wine would be ready for retail sale.

In simpler times, the wine makers would sell perhaps half of their production en primeur – only to sophisticated professionals – in a direct form of forward contracting that both financed inventory and mitigated price volatility.

But the en primeur market then became open to individual players. Buyers of the 2005 vintage made the leap of faith that as this wine is even now being released for delivery, they will actually receive the specific wine contracted for, rather than some poorly made or inferior substitute.

Additionally, though, my friend faces a huge market exposure.

Namely, the vendor – who is said to have made some € 10 million of advance sales – is now exposed as were Bear Stearns or Merrill or Citi, who had sold highly-leveraged investments in hard-to-price slices of the subprime mortgage sector. Instead of locking in a contract with the vineyard for the necessary physical supply, at the time it took its customers’ deposits, the vendor reportedly chose to wait and play the fluctuating secondary market.

That is, like the bankers who sold the mortgage-based derivatives on the assumption that ever-rising housing prices would bail out all the dodgy mortgages, the wine-seller assumed an ability to cover its needs at delivery time, perhaps even hoping that a soft market might give it a windfall.

Here arises the problem of unexpected risk and uncontrollable price volatility in an underlying commodity. Holders of subprime paper were whacked by collapsing real estate values, unpredicted under their black-box pricing models. Just as with killing frost in the orange groves or warfare in the oil fields – serious re-pricing has hit the wines of 2005. With the publicists touting 2005 as a vintage for the century, the entire Bordeaux market took a major upward spike. Prices for my friend’s particular wine are up over 60%, and the very top wines have shot up 300% in less than a year.

Again as with the subprime sector, my friend has learned to his bewilderment that he is in an unraveling commodity hedging operation -- the vendor’s naked delivery problem being piled onto a whole structure of risks.

At a simple level, the vendor generated two years of float for itself, by immediately cashing its customers’ checks. And although dealing frequently with Anglo customers investing dollars and pounds, the vendor could easily hedge any currency fluctuation exposure.

But like Bear Stearns or New Century Financial or Northern Rock or UBS today – or others in recent memory such as Long Term Capital Management or Amaranth – the wine vendor is hostage to externally-delivered pricing shocks.

With the vendor facing a massive and expanding loss, my friend has the entirely legitimate anxiety that when the time comes, it may be unwilling or unable to deliver.

While he waits, it has been brought home – for both the bankers’ one-time valuation geniuses and their management who blithely assured that their controls were all in good Sarbanes/Oxley order -- that market reality has a stubborn unwillingness to behave according to unprovable mathematical models. And there is a lesson for central bankers: one-time bailouts have a terrible tendency to be under-calculated, insufficient, and fraught with unintended consequences.

Time will tell. Come this summer, while the Bordelaise prepare to press the grapes of 2008, my friend may be preparing to press his legal rights.   

Meanwhile, shareholders and investors in subprime funds have enlisted their lawyers to assess whether their glasses are half-full, half-empty or only holding the bitter dregs.

Société Générale’s 2007 Annual Report – Jérôme Kerviel Is So Last Year

The recurring claim of French exceptionalism got a big boost early this month – at a price. Société Générale asserted that the only fair way to report its loss of € 4.9 billion, inflicted in January by junior trader Jérôme Kerviel, was as an event occurring in 2007.

Deep down in footnote 40 of SocGen’s massive annual report – to get the English version -- here – ou bien la VO Française ici – the bank discloses that Kerviel was in a net positive position of € 1.471 billion as of the end of 2007. His blow-up came on January 18, and the unwinding losses in the following days came to an eventual € 6.382 billion.

Over-riding the compelling guidance of the International Accounting Standards Board, that would book the effects of Kerviel’s mischief as they fell, would be rare enough under the UK’s high-level “true and fair view” rubric, much less under the American guidance of “present fairly in accordance with generally accepted accounting principles.”

But that didn’t stop the French bank – supported by its national banking and securities market supervisors, as well as the two Big Four accounting firms -- Ernst & Young and Deloitte & Touche -- who share responsibility for its audit.

There is at least behavioral history on the French side: for years the European practice of booking the effect of deliberate errors in the year of discovery rather than in the year of perpetration has avoided the litigation hazard of the American requirement to re-state erroneous financial statements for prior years.

And on the recent and highly political side, the French have been vocal and steadfast in resisting the international standard for marking financial derivatives to market – the infamous IAS 39 – arguing the difficulty of valuation models other than historical cost but also conveniently retaining the flexibility of corporate management to time their recording of results to suit their discretion.

SocGen’s tone-deaf approach starts with its footnote description of Kerviel’s trading “plain vanilla” financial instruments – a colloquialism lacking both a usable French translation and a common understanding in the industry. Nor is there any positive spin to the term, since the more ordinary Kerviel’s scope and job description, presumably the more effective SocGen’s oversight and control of his desk should have been.

As I am told by the technical accountancy wonks, SocGen may – just barely – have a straight-faced justification, that its year-end balance sheet should reflect the € 4.9 billion body blow that struck only three weeks later.

Fair enough, on a casual first glance. But the argument for evading a well-known body of international standards, under an exception so obscure and elastic that prior examples are virtually unknown, fails on three grounds – technical, strategic and political.

First, on the technical side. Moving around Kerviel’s impact cannot lessen its prominence or significance. As a post-closing event it is comprehensively discussed for three pages in the SocGen report. A pro forma balance sheet presentation right there would do as much for disclosure as the roll-back could.   

Even if it can be done, in other words, doesn’t mean that it should be.

Strategically, then, what’s the point? The known facts are so notorious that no one will be diverted or misled. Whether CEO Daniel Bouton survives – whether the bank itself survives – or how much the bank will ultimately pay out to the shareholders who are now at the courthouses with claims that the bank was running a “culture of risk” – none of these will be affected by the choice of years. So if SocGen can achieve no good for itself, what constructive purpose could there be in adopting a lightning-rod position?

And politically, the bank has succeeded only in setting back the global arguments for international accounting convergence, harmonization and improvement. If a “fair reporting” excuse can be made for Kerviel, there is no intellectually defensible line-drawing guidance by which investors can anticipate where the next similar exception will be invoked.

The size of the event can’t be a factor. A knock of € 4.9 billion is big, to be sure, but consistency in the reporting of small things is of little use if it’s the really worrisome big problems that qualify for revision and exception.

And with a French tradition to favor management’s opportunity to manage the timing of bad news, agreed by the supporting players, predictability of reporting at the global level is out the window.

So vive la difference – but let it be kept to matters of local impact only. 

Accounting and Audit Judgments -- Please, No More Standards!

A new one-liner in the cultural vocabulary was introduced when the hit comedy, “No Sex Please, We’re British,” opened in London in 1971.

Today’s plea – with the Securities and Exchange Commission’s proposal to inflict an analytic structure upon the making of accounting and audit judgments – would be “No Standards Please, We’re American.”

On February 14 the SEC presented for public comments the interim progress report of its Advisory Committee on Improvements to Financial Reporting – here – which among its suggestions was that the Commission should adopt a “judgment framework” in the accounting area, and that the country’s audit regulator, the Public Company Accounting Oversight Board, should do the same for audit judgments.

Responses to the SEC are due the end of this month. Meanwhile, the PCAOB sponsored a panel discussion on February 27 by its Standing Advisory Group – summarized here by Edith Orenstein of Financial Executives International.

The signal achievement of this day-long effort was that the competing interests in the debate managed at the same time to expose both the hazards and the vacuity of the whole idea.

As co-presented to the PCAOB group by a managing director of Moody’s – yes, the credit rating agency – the notion is this:

•    Preparers of financial statements would be assisted by yet more pages of codified bullet points, in choosing and applying among the myriad of alternatives for selecting and implementing accounting standards, quantifying estimates, evaluating evidence and all the rest.

•    Auditors, likewise, would be similarly enlightened across the spectrum of judgments required to choose audit procedures, to evaluate the likelihood and impact of fraud and other risks, to conduct audit sampling, to evaluate controls and – layering the irony – to assess management’s own judgments.

Wait.

In the century and a half since the emergence of independent accounting early in the Victorian era, preparers of financial statements and their auditors have been striving get their judgment processes right. So who are these bureaucrats, with their presumption of assistance?

This is, after all, the same SEC that was caught flat-footed over the pervasive extent of executive options back-dating. The same PCAOB that in its sixth year has no more than a pilot program for constructive engagement with non-US regulators and inspection beyond the samples taken within its own borders. And the same Moody’s whose involvement in the subprime mortgage fiasco, along with the other major credit ratings agencies, finds them to be central in the still-spreading credit markets turmoil.

Put another way, taking advice on the process for judgment-making from this crowd could be viewed like hiring Noah to give flood-control advice to the city of New Orleans.

As for the parody that passes for debate, the self-interested and antagonistic participants are circling the topic and each other like stray and wary dogs around a hydrant.

The accounting firms at the PCAOB’s table gave cautious endorsement to the framework idea, despite the obvious hazard: By getting it right they would obtain no more credit, safeguard or protection than is available today under existing guidance. Instead, they would only have one more procedure to get wrong, and therefore increase their already debilitating litigation exposure.

The large accounting firms remain muzzled on their fragile and threatened state, unwilling out of either fear or denial to acknowledge the shockingly low litigation impact that would cause their disintegration (which I've calculated and discussed here).

As a result, they are inhibited from insisting that the only realistic usefulness of yet more regulation on the exercise of their judgments would be under a “safe harbor” within which they could explore and apply new modes of working.

But on the other hand, investor advocates among the profession’s critics make plain the political reality that no adjustments in the American legal liability framework that entraps the auditors today are about to be forthcoming.

Exposing the sterility of the discussion, even the regulators themselves are in full self-protection mode, making clear that nothing in the application of the suggested framework process would inhibit the SEC or the PCAOB from examining and criticizing the judgments made by issuers or auditors.

For British theatre-goers the farce of “No Sex Please” ended when the nightly curtain came down. Because a new "judgment framework" would offer benefits that range from elusive to non-existent, would impose costs of extra work and documentation that are extensive, and would inflict potential litigation hazards that are considerable, the farce now playing out in Washington deserves a closing notice.   

For other aspects of the PCAOB’s meeting last week, see my friend Francine McKenna at Re:The Auditors -- here.

Accounting for Subprime -- Scoring the Scorekeepers

This audit season the skeletons just refuse to stay in the closets. Latest this month, but far from last, are AIG’s $4 billion loss estimate increase and Credit Suisse’s $2.85 billion write-down in its asset-backed securities.

Both examples read directly on a question put by a friend and regular reader -- a business school professor in Paris: “How much of the subprime thing is related to the accounting?”

Not that she needs my help with a lesson outline for her MBA students. But having been a guest in her classroom, I’m happy to offer. If I were teaching her class, I’d get there in three steps:

At the level of human behavior, subprime in its origins was first about the disconnect between incentives and risks: the mortgage originators took their fees immediately, but repackaged and laid off the future stream of payment obligations. Then the bankers, abetted by the ratings agencies, gamed the credit rating system by pushing untestable valuation models onto their credulous customers.

Second, as after-effect, subprime is now about legal responsibility. With the filing of new investor lawsuits back to Enron-era levels (for which, see the helpful running count being kept by the D&O Diary,here ),  the roster of defendants includes not only the banks and mortgage companies, but also the three dominant credit rating agencies and, at last count, three of the Big Four accounting firms.

But third, with the global harm extending from villages in the Norwegian Arctic to counties in rural Florida to bush hamlets in Australia, we should go back to basics: accounting principles and methods for the recording and reporting of transactions are as old and pervasive as trade itself.

As soon as commerce moved beyond one-to-one barter, conventions were required to quantify such inherently judgmental issues as the hazard of re-payment in future periods, the time value of money to change hands at a later time, or the transfer of performance to a third-party.

So viewed, subprime and the credit market turmoil are all about the accounting, and nothing else. Fundamentally flawed assessments were made – whether out of venality or ignorance – about the quantification, timing and transferability of the risks associated with uniquely complex financial derivatives, and the collapse in their values as knowledge and experience eventually caught up.

So the accounting for mortgage-based assets and their off-spring should be seen as a proxy for the reckoning of financial reality in all aspects:

For a family buying its first home with an adjustable-rate mortgage, the expense entry for housing cost changes from rent to mortgage payment. Its balance sheet now has an asset, the house, with the associated mortgage debt as a liability. When a depressed housing market erodes any equity, and the payment escalates beyond the family’s means, the accounting confirms the reality – red ink and foreclosure.

An investment bank that sponsored and sold exotic tranches of financial products now has the task of re-assuming them back onto its balance sheet and marking their value to a collapsing market rather than a discredited black-box model, which means filling the accounting holes. Costly new rescue capital, opportunistically supplied to the likes of Citi and Merrill, Northern Rock and the monoline insurers, may provide a lifeline but dilutes or even destroys the prior shareholders.

As for investors – whether an individual shareholder of the banks or a pension or retirement fund that bought the exotic products – their losses may not yet be realized for accounting purposes, unless they have sold out the positions, but they can plainly feel the real-world loss of wealth, and unsurprisingly are taking advice from the plaintiffs’ lawyers.

As shown already by AIG and Credit Suisse, the accounting challenges pinpointed by the professor are fraught both for the financial institutions and also for any investor who heard the siren song of higher rates and traded off for unknown future risks.

That’s because the more candor and rigor are brought to this year’s audit process, the more stark will be the ultimate concession that the valuation models on which subprime was built were creatures of myth and unreality. And therein lies a ghastly liability implication -- that the well-controlled and smoothly operating systems required under Section 404 of the looming Sarbanes-Oxley law simply weren’t there.

In the end, to wrap up for the good professor’s class, the quality of accounting is an effect, not a cause – the level of its virtue and integrity is observable in a mirror held up to commercial society.

Or as first put in the early 1970’s by cartoonist Walt Kelly’s swamp philosopher, Pogo the possum, “We have met the enemy, and he is us.”   

Blackstone's Pre-IPO Accounting

Hindsight is so wonderful. A week after this column ran in the IHT, Blackstone pulled back from the proposed accounting treatment discussed here. In the circumstances it would be a shame to go back and re-edit the verb tenses.

It also brought its offering at $31, into the teeth of the subprime mortgage meltdown, and saw its price sag immediately below $22. For the company’s principals whose net worth expansion is measured in units with capital “B’”, little sympathy is indicated.

Private Equity Discovers the Value of Myth

Originally published in the International Herald Tribune on May 25, 2007

A timeless but troubling story lurks in the plans of Blackstone Group, the private equity giant, to raise $4 billion through an initial public offering.

Blackstone proposes, through the use of options accounting, to book as immediate profits the gains it estimates that will presumably be made once its transactions are ultimately wound up. In other words, as soon as it goes into a deal, Blackstone's 20 percent carried interest - that great profit engine of private equity - will be valued like a salable financial instrument, and recorded as an asset.

Noncash profits today, in eager anticipation of an undated and uncertain but rosy future, and investors - including the Chinese government - lining up to hurl their funds at the prospects. Sound familiar? Has everyone forgotten Enron, the creative energy trader that crashed, or the academics' darling among the trading models that flamed out, Long-Term Capital Management?

Generations ago, the investment maxim on Wall Street was "buy on the rumor, sell on the news." The lore in the bubble years of the 1990s then became, "Buy on the fantasy." All too often, the result was "hold till the debacle."

The lesson seems irresistible: The origins of the next wave of corporate misadventures will be a new set of compelling stories. After all, we have been eager to devour simplistic myths and fables ever since our ancestors gathered around the fires in front of their caves, to listen to tales spun by those hailed, rightly or wrongly, as the wisest men in the tribe.

Here's an example: Because I dislike shopping, I look increasingly to catalogs. One features clothing and accessories no different in quality or cost from a number of others, but its goods are promoted in seductive little vignettes that locate the wares in such modestly exotic locations as Mumbai, Portofino or West Egg. That's good enough for me.

Consumers willingly buy into a good story. Brands of premium ice creams are all as alike as Tolstoy's happy families, but think of the success of Häagen-Dazs - a word concocted from no known human language, but evocative of Danish quality. And think of two unknown guys from Vermont, Messrs Cohen and Greenfield - mythicized as Ben and Jerry.

We buy look-alike vehicles, by reference to wilderness spots those vehicles will never visit - Denali, Sierra, Tahoe, Kodiak. Again, why? Imagine a marketer trying to sell a 4x4 branded for its real venues - a Chevrolet Strip Mall, a Subaru Speed Bump, or that new luxury offering, the Cadillac Cul-de-Sac.

Financial products and services are subject to the same power of myth. The meltdown this year in the subprime mortgage-backed securities market destroyed a bubble built from two stories: first, that ever-increasing housing prices would forestall a reckoning for credulous but unqualified home buyers, and second, that the inverse relationship between bond coupon and default risk had somehow been suspended for equally credulous investors.

Neither proved true, but the crash in this industry segment has failed to dampen the appetite of a myth-driven market. No less a tale-spinner than Warren Buffett has warned of unsustainable returns for alternative investments. But, depressingly, it appears that the only information commanding attention is that conveyed in stories worthy of re-telling around the modern version of the prehistoric campfire.

So today, the story of Blackstone's IPO overrides two antagonistic realities: that the private equity funds are awash in the cash of ever-smaller investors, even while chasing deals that are bigger and richer but doomed to deterioration in quality and results.

Blackstone's circular approach to its profit picture - booking profits today based on a collective blind vote of confidence on a future bet, as a proxy for real results down the road - not only echoes the immediate past of Enron and LTCM. The same approach came to grief in the late 1960s for the investors in Bernie Cornfeld's Swiss-based Fund of Funds, which did the same in a wild bet on deep oil in the Canadian Arctic.

But memories are short, and if the stories are timeless, so are the failures to learn from the past.