Failure to Demine the Accounting Minefields

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I borrowed the following two paragraphs to point out that the financial reporting world has not become better in two decades, despite many new  accounting standards and rules. The relevant article was titled  “Tread Lightly Through These Accounting Minefields” (H David Sherman and S David Young from the July–Aug 2001 HBR Issue), and I quote;

“The nightmare of risky accounting is on the increase. In the current economic climate, there is tremendous pressure—and personal financial incentive for managers—to report sales growth and meet investors’ revenue expectations. According to the SEC, misleading financial reports, especially involving game playing around earnings, are being issued at an alarming rate. …

To avoid such a calamity, shareholders and their representatives on corporate boards should keep their eyes peeled for common abuses in six areas: revenue measurement and recognition, provisions for uncertain future costs, asset valuation, derivatives, related-party transactions, and information used for benchmarking performance. If disaster strikes, it will most likely occur in one of these accounting minefields.”

The above situation has not changed for the better. The release of more complex accounting standards in the last few years has only aggravated the preparation of misleading financial reports. The latest standard to impact asset valuation is IFRS 9. The hope was that a realistic assessment of financial instruments would reflect a true picture of current economic reality. However, the estimates and judgments involved in the measurement of instruments has injected enormous subjectivity into the financial reporting process creating new avenues to manipulate financial statements and mislead users.  

Consider the accounting treatment of Greek bonds by European banks in 2011, involving government debt in Greece. Write-downs of the bonds varied from 21% to 51% despite all large European financial institutions having access to the same market data. The Royal Bank of Scotland, for instance, recognized a charge to earnings in the second quarter of 2011 of £733 million, after a 51% write-down from the balance sheet value of £1.45 billion for its Greek government bond portfolio. In doing this, RBS followed the IFRS fair value hierarchy, which states that if observable market prices are available, they must be used. On that basis, RBS noted that market prices had dipped by just over half the price paid for those bonds when they were issued. Meanwhile, two French financial institutions, BNP Paribas and CNP Assurances, looked at the very same data and chose to write the bonds down by only 21%. They rejected the market prices on the questionable grounds that the market was too illiquid to provide a “fair” valuation. Instead, they resorted to so-called “level 3” fair value estimates in a process known as mark-to-model (in contrast to the mark-to-market valuations used by RBS). Source: HBR/internet

If such difficulties arise with tradable securities, imagine how difficult it is to apply fair value principles and quantify expected credit losses in a loan portfolio, changing from the incurred loss model used previously. By selecting inappropriate methods banks can inflate the opening balance impact and show increased profits in the current period with inflated earnings per share being used to hype the market price of shares. An opportune time to ‘pump and dump’ bank shares and buy back when the market collapses further? It’s only my theory. You know what they say, “the proof of the pudding is in the eating”. The problem is one has to wait till the disaster occurs to prove the theory!

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About surenraj

“Views expressed are my own”
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