This is the third occasion in the course of this book when I have mentioned the famous dictum by Dr Louis Brandeis, the US Supreme Court Justice, that
‘Sunshine is the best disinfectant’. Paraphrasing Brandeis’ dictum, when it comes to financial reporting by business entities, and all other organizations, sunshine is not just the best disinfectant, it is the only one that makes sense.
Sunshine, and therefore, transparency, should be a basic characteristic of every accounting standard and financial reporting regulation. Indeed, not only IFRS and US GAAP but nearly all standards of accounting have been established to promote disclosure. The aftermath of steady innovation is difficult enough to appreciate, without the true risks being obscured or hidden. In Enron’s case, and many others, shareholders were cheated because they:
● Received misinformation about the true debt, profits, and losses of the company, and
● They were misled by a corporate policy of always disguising its financial data.
A similar story has happened with WorldCom. During 2001 and the first quarter of 2002, just prior to crashing, the company counted as capital investments (Capex) some $3.8 billion that it had spent on ordinary everyday expenses. This makes a big difference because, for accounting purposes, capital investments are treated differently from other expenses.
● Capital spending is money used to buy long-lasting assets, such as fibre- optic cables or switches that direct telephone calls.
The cost of capital investments is spread out over several years. For instance, if WorldCom spent $35 million on switches it expected to last 7 years, this money
would be booked as $5 million expense for 7 years. In contrast, if it spent $35 million on office space, it had to count all of that expense in the period in which it occurred. Switching everyday expenses into the capital budget is one of the perverse ways of creative accounting.
The company said, to its justification, that the expenses that were counted as capital expenditures involved line costs, which are fees WorldCom paid to other telecom players for the right to access their networks. But line costs are ordinary expenses. Creative accounting comes in because counting such expenses as cap- ital investments boosts net income:
● Eventually expenses are counted in one quarter
● But capital expenditures are spread out over years, sugar-coating the P&L.
The regulators, investors, and the general public have been misled and cheated by this sort of false accounting. WorldCom originally reported net income of $1.4 billion in 2001 and $172 million in the first quarter of 2002. After bankruptcy, it was found that it had lost money on both occasions.
Another creative accounting practice in which WorldCom specialized has been the massaging of its cash flow. What it did affected cash generated from operations – a closely watched line in financial statements. The company originally reported that its operating activities in 2001 produced $7.7 billion in cash. After bankruptcy, it was revealed that its cash flow really was $4.6 billion.
Where WorldCom, and so many other companies, have been masters in manag- ing accounting data is with earning before interest, taxes, depreciation, and amortization (EBITDA). This is one of the areas where creative accounting has a big impact. WorldCom originally reported that its EBITDA for 2001 was $10.5 billion. After bankruptcy it was found this figure really was $6.3 billion.
Moreover, in the first quarter of 2002 it reported EBITDA of $2.1 billion but in reality the figure was $1.4 billion; the company was in much worse shape than investors thought.
This sort of swindle in financial reporting was not the sort of thing that hap- pened only once. Rather, it was a steady business practice. Yet, over long stretches of time creative accounting cannot be done without the external and internal auditors’ complicity.
WorldCom’s external auditor was Arthur Andersen. Immediately after the event the now-defunct auditor said its work for the company complied with all account- ing standards (!). The fake numbers came to light through a probe conducted by
WorldCom’s new auditor KPMG, as well as by WorldCom employees who had had enough with the prevailing culture of duplicity in financial accounts.
As this example, and so many others, document, transparencyin financial report- ing means not only releasing accurate and timely information, but also structur- ing this information in a way that it tells nothing but the truth. This ‘truth’ about the financials of a company must be presented in a way that board members, risk controllers, regulators, investors, and the public can understand and act upon it.
This is the role of rigorous accounting standards like IFRS and US GAAP.
Notice that sometimes variations between different accounting standards may be exploited to conceal the true financial figures. In early 2000, Nomura Securities published a comparison of American and Japanese financial reporting in the 1980s and 1990s. This pointed out that Japanese banks, and other companies, tried to conceal their financial problems:
● Through shady accounting practices, and
● By capitalizing on loopholes in financial reporting standards.
For instance, during the bubble of 1980s in the Japanese stock market, firms depended for their financing almost entirely on banks which, in turn, relied on shares and property as collateral for lending. That left banks completely exposed to falling asset prices. The thunderbolt which hit the Nikkei 225 after the burst- ing of the bubble left the whole Japanese banking industry comatose – in which state is has practically remained until today, 15 years down the line.4
Contrary to the Japanese, the better known US companies depend for financing on capital markets. Capital markets, however, will not be cheated for long, though this happens from time to time as the Enron and WorldCom examples suggest. In the years to come, borrowing in the capital markets must be charac- terized by increasing transparency, as major investors are now carrying out more analytical accounting investigations than ever before. This means that compa- nies must not only adopt reliable reporting practices, but also show greater dis- cipline with capital investment decisions in the economic environment(s) in which they operate. At the same time, new global capital adequacy guidelines must be matched by careful domestic reform. This is written in full understand- ing that globalization and technology have:
● Changed the credit dimension
● Made markets more dynamic, and
● Forced companies to take more risk which should be fully reflected in their income statement and balance sheet.
Central bankers and regulators also depend a great deal on reliable financial reporting. The European Central Bank (ECB) regards transparency as a crucial component of its monetary policy framework. ECB says that transparency requires central banks to clearly explain how they interpret and implement their mandates. This helps the public to monitor and evaluate a central bank’s per- formance. But it also requires an understanding of the analytical framework used for its internal decision-making on monetary policy and assessment of:
● The state of the economy, and
● The economic rationale underlying monetary policy decisions.
In the case of a central bank, for example, transparency is strongly enhanced by means of a publicly announced monetary policy strategy. A comparable criterion of transparency for a commercial bank would be a public announcement to all stakeholders of the level of risk the institution is willing to assume, including:
● Leveraging
● Loans
● Investments
● Trades other than derivatives, and
● Derivatives trades.
Not only companies but also nations should observe the transparency principle, which they often don’t. South Korea, Indonesia, Thailand, Brazil, Mexico, Argentina, and other countries might have avoided sudden exchange-rate crises and panics ifinvestors had a more accurate idea of the country’s foreign reserve levels. Also, investors might have steered clear of the abyss if firms in these countries had been forced, by their regulators, to disclose:
● The size of their foreign liabilities, and
● Their financial staying power when confronted with huge debts.
Lack of transparency encourages governments, companies, and people to indulge in reckless behaviour or use second rate criteria which minimize outstanding risk. An example from the 1990s has been lending short-term to Asian borrow- ers because such loans carried a lower risk-weighting in the scales established by Western regulators, which proved to be a big mistake.