Mafia Buzz Issue 3

Mafia Buzz 2009

Introduction

Following on from 2008’s changes in policy, Mafia Buzz 2009 will deal with information of general interest to preparers, auditors and users of financial statements. Topics specific to IFRS will be covered in IFRS Buzzes, topics specific to valuations will be covered in Valuations Buzzes and topics specific to portfolio management and financial analysis will be covered in SowB Buzzes. The workshop material will contain back copies of the relevant Buzzes.

January 2009 (10 Minutes)

Accountancy

An ACCA student in Pakistan got a friend to write the examination for him. Each was fined £50 and both were removed from the register. [Good! We do not need people like this in our profession.] (Page 8)

The recession is starting to bite. This is how audit firms in the UK are dealing with the issue:

Grant Thornton: Shedding 250 jobs (5%)

BDO: Shedding 250 staff and partners (8%)

PKF: Shedding 5% of staff

PwC: Inviting a number of staff to “give up their jobs”

Deloitte: Offering a number of staff severance pay

KPMG: Making a small number of job cuts (about 90)

E&Y: Seems unfazed and continues to recruit (Page 12)

The Individual Audit Investigation Unit in the UK left some firms dissatisfied after the reviews. Of course the investigating team are claiming that everything is fine but some of the firms are saying “unfair”. The article in February on this issue (see below) gives a very different spin on the outcome of the investigations. We have the same problem in SA – the auditors complain bitterly about their treatment at the hands of the reviewers – note that I only hear one side of the story. (Page 14)

Prof Stekka Fearnley of the Bournemouth University says: “How can any sensible person believe it is right to treat unrealised gains on securities held for trading as distributed profits and pay dividends and bonuses out of them? The IASB needs competition to get rid of seriously flawed thinking in some of its standards which can produce counter-intuitive results and encourage the blowing of market bubbles.” [I am not too sure what she means by “needs competition”. Maybe they need a wake-up call, which hopefully the present crisis has given them.] (Page 16)

Chris Dickson says that E&Y is being sued by a Californian municipality over the Lehman Brothers collapse. He says that US litigators and prosecutors are targeting professionals as never before. (Page 23)

Half of the countries in the EU have adopted liability caps for auditors so there is an uneven playing field in Europe. (Page 27)

The SEC has said that fair value accounting is meaningful and transparent but that additional guidance would be useful in inactive or illiquid markets. [I would love to see how this will work!] (Page 63)

The Bank for International Settlements recently reported that there are over $683 trillion of outstanding over-the-counter derivative contracts around the globe. This is a lot of paper to value for IFRS purposes! In an illiquid market, it is very difficult to determine values that approximate market prices. Because of this uncertainty and the size of the problem, the financial strength of holders of these instruments becomes problematic. Suggestions given to mitigate the problem are:

1. Base valuations on quality data.

2. Collection, processing and cleansing the data requires adequate technology.

3. Analyse outliers, market depth and reliability of sources.

4. Select and calibrate the model used.

5. Get an independent third party to evaluate the values.

[Do they really think that making up rules like this will solve the fair value problem?]

Mark-to-holding (valuing the asset as if will keep it to maturity) has been suggested as an alternative to mark-to-market. Unfortunately, IFRS does not permit this if there is a “market” for the security. [Question: A company holds 1m shares in listed company X. Last year 100 000 shares traded hands and at present there are buyers for 100 shares at 10c per share and sellers for 1 000 shares at 50c per share. What is the fair value for this share?] (Page 67)

With the recession starting to bite, the going concern assertion underlying the presentation of financial statements is becoming a “challenge” for auditors. If they give an emphasis of matter on this issue in their report, lenders may get cold feet and call up their loans resulting in the demise of the entity. If they don’t and the company does go under, they will be in trouble. So what is the solution? Well the profession in the UK are trying to educate the users by telling them: “Don’t take a going concern emphasis of matter too seriously.” Cute. (Page 79 and page 85)

Amazing what a recession can do: Some auditors in the UK are sending their clients invoices for work they did for them ten years ago! (Page 84)

Chairmen of audit committees are going to find some serious challenges in the coming months, among them fair values, impairments, pension fund accounting and going concern issues. [I have heard of two companies in SA that are facing massive inventory impairments due to the market for their products falling through the floor.] (Page 92)

Accountancy SA

I do not summarise this journal as you should read it in full.

Business Day 26 January

Indian police in New Delhi have arrested two PwC employees over the fraud at Satyam Computer Services for failing to pick up a massive fraud. PwC says that the arrests are unfortunate as there is no evidence of any wrong-doing by the men – see the information in Time below.

FinWeek 22 January

Bruce Whitfield reports that there was some exposure to investors in SA to Bernie Madoff. Apparently a few wealthy clients of Investec and BOE were advised to invest in his scheme. “We knew it was at the riskier end of the investment spectrum and presented it to a small part of our overall client base for their consideration” said one asset manager. Clearly someone needs to tell investors that the higher the risk, the higher the losses! (Page 19)

Time 1 December 2008

Malcolm Gladwell’s book called Outliers is profiled. I bought the book and could not put it down – brilliant. The book looks at what makes people successful. He gives examples of geniuses who fail at life because they did not have the right ingredients. He maintains that if you have a reasonable amount of talent and come from the right family and culture and are in the right place at the right time you are on the way to success. However, there is one additional ingredient that is essential for success in any discipline. He calls it the 10 000 hours rule (20 hours a week for 10 years). If you are not prepared to do the time, you will not achieve perfection.

Time 19 January

Adolf Merckle, a 74 year-old billionaire threw himself in front of a train because he took a bad bet on Volkswagen shares thereby endangering the future of his companies. The global financial turmoil probably help pushed him over the edge.

An outsourcing company in India (Satyam) has admitted to hugely inflating the company’s profits for years and for fabricating $1bn of assets. The company employs 53 000 people – or is that figure also fabricated?

February 2009 (10 Minutes)

Accountancy

Fraud specialist, Andrew Ford, says that it is unlikely that an auditor of a fund that invested with Madoff would be liable for losses incurred by investors of the fund. [This really would be stretching an auditor’s liability!] (Page 8)

Try this for size: “Auditors must use IAS 19 to calculate deficits, which assumes pension funds are invested entirely in bonds.” What they are really trying to say is that actuaries (not auditors) should use bond rates when applying the projected unit credit method when determining the pension fund obligation. (Page 11)

Commenting on the Madoff affair, Emile Woolf says that one cannot rely on the trio of regulation, governance and audit to provide comfort regarding returns earned by an investment fund. He said that there were warnings on record ten years ago that threw doubt on the returns Madoff was claiming to earn. Madoff forbade anyone to look behind the protective curtain he set up. The auditors of the fund consisted of a secretary, a 78 year-old living in Florida and a character who wore tight pants and tie-died shirts. The firm only had one client – Madoff! (Page 16)

Questions are being asked whether auditors could have done anything to mitigate the current corporate collapses in the current financial crisis. People are questioning whether present audit practices are effective. It appears as if there will be fallout for the auditors. Talk is that better policing of auditing standards rather than changing the standards is the solution. [I believe that there should be a fundamental re-think of auditing standards and procedures.] (Page 25)

When asset prices fall, working capital available as collateral for debt financing falls forcing businesses to sell assets which sets off another round of asset price reductions. To reverse the spiral, government needs to print money to create inflation to stabilise/increase asset values. And what is the result? Zimbabwe! [My conclusion] (Page 26)

Governments around the world have ended up controlling banks, not by choice but by necessity. The question now is: “Do they consolidate the banks?” The governments are baulking at the thought that they are going to have to consolidate subsidiaries which they do not intend holding indefinitely. They are trying to use the fair presentation override. [When you have the power you can carve out sections of IFRS from your accounting policies.] (Page 62)

We have practice review and the UK has practice assurance. An excellent article describes the objectives, procedures and findings of the UK’s PA. The spin is positive, probably because it is presenting the PA side of the story. A good case is made for PA, e.g. they say that they are not trying to catch firms out but are trying to help them stay within the bounds of regulation and standards. Their goal is to protect the firm, the client and the reputation of the Institute. 94% of PA’s ended with a clean bill of health. This clearly shows that they have a practical and helpful approach to practice assurance. My guess is that in SA we do not come close to 94%. (65)

Business Day

Profit of Berkshire Hathaway fell by 96%, the fifth straight quarterly decline in Mr Warren Buffett’s company. The cause? Derivative losses tied to the market. Did Mr WB not warn us a few years ago of weapons of mass destruction? Seems like he did not heed his own advice!

Business Day 20 February

John Gapper makes some interesting comparisons between the Madoff and Stanford frauds:

1. In both situations the vehicles used for the fraud bore the names of their founders.

2. Despite the volatility in the markets, both companies reported almost identical returns two years in a row. [We used to call this “smoothing” in the old days.]

3. Both companies were audited by small auditing firms, Madoff by Friehling and Horowitz, a three person outfit, and Stanford by CAS Hewlett.

4. Management of both companies was dominated by their founders.

Moral of the story: DIY.

Business Day 26 February

J.S. Armstrong of The Wharton School University of Pennsylvania says that people are prepared to pay for expert advice on predicting economic trends, analysing stock trends, etc. but evidence shows that this money is poorly spent. So he has developed what he calls the “seersucker theory” being “No matter how much evidence exists that seers do not exist, suckers will pay for their existence.” [I think JSA is wrong in one respect: Investors do not willing pay for this because they do not know that they are paying for it. It is built into the fees, churn, etc. I have a simpler saying: “Nobody knows nutting!”] (StreetDogs)

FinWeek 19 February

Shaun Harris gives some background to the single stock futures fiasco that resulted in Absa taking over the shares on the default of the holders of the SFFs. What I can gather from the article is that the JSE started realising early on that single stock futures on small illiquid shares was not a good idea so upped the required margins. Of course that put stress on those who held the SFFs and when they could not meet the margin calls, Absa was forced to take over the underlying shares. Shaun says that one single financial advisor did most of the damage by aggressively pushing clients into SSFs (presumable Cortex Securities). (Page 71) (See next month for a discussion on SFFs and CFDs.)

March 2009 (10 Minutes)

Accountancy March 2009

The UK is looking into the ethics of auditors selling non-audit services to audit clients. The CEO of the Financial Reporting Council commented that if the auditing profession wants a principle based approach to standard setting but a rules based approach to enforcement, it will not lead to a good outcome. One needs detailed rules to guard against using the defence: “If it is not specifically prohibited by the rules, then it is ok.” [This reinforces my argument that one needs rules or checklists if you want to get the job done or if you want to regulate.] Pushing for principled based accounting standards without rules is asking for serious trouble. (Page 5)

Arthur Andersen was fined £75 000 and had to pay costs of £100 000 for failing to detect that a condom-maker was stuffing the channel (excuse the pun). Since when is this the job of the auditor? Apparently Coca Cola does this all the time. I did not hear of their auditors being nailed. (Page 9)

A former US accountant was jailed for 24 months for creating documents that showed that doctors had approved services provided by his company. (Page 9)