Management malpractice has several origins, and comes in many forms, but the market, and prosecutors, are no more lenient with old and new creative account- ing gimmicks than in the past (see Chapter 11 on creative accounting). Moreover, the company’s senior management is not the only stakeholder characterized by unfair practices. Other parties are:
● Labour unions asking for more and more benefits, when they should know the company cannot afford them.
● Shareholders pressing for increasingly profitable figures, faster capital appreciation, and fatter dividends.
● The government itself, whose craven failure to prosecute wrong-doers has been at the origin of a boom in scams.
While the wave of scandals led to more business failures, bankruptcies and near- bankruptcies are nothing new. Over the years they have been the way to prune from the market system its weakest nodes and links. What is relatively new is the mas- sive number of scams which hit the industry and the economy as a whole when:
● Business ethics are set aside
● The rules of competition are purposely violated
● Accounting standards are manipulated, lack focus, reflect only past reali- ties, are uneven, or are altogether unreliable.
Beyond regulatory compliance, financial institutions and all other entities must be on the alert to avoid involvement in different scandals. Misdeeds are being revealed with increasing frequency.8 Major corporate scandals which happened or came to light in the early years of the 21st century have also cost the banks plenty of money because they involved legal risk.
Enron, the seventh largest American company at its time, theoretically focusing on energy trading but practically it was a hedge fund, went bust in December 2001. Two months earlier, in October 2001, Enron had declared a $1 billion write- off on bad investments and a $1.2 billion reduction in equity capital. In the after- math, US authorities launched an inquiry into Enron. In November 2001 Enron restated its financial statements for the period 1997–2001 to account for nearly
$600 million in losses which had been concealed in complex financial transac- tions – and Standard & Poor’s downgraded Enron’s debt to junk bond status.
The year 2002 had plenty of bankruptcies, many of them involving scandals:
Adelphia Communications, Global Crossing and WorldCom, to name a few.
WorldCom was the world’s largest provider of internet and e-commerce services.
In June 2002, the company admitted to having significantly manipulated its accounts, especially by wrongly declaring costs as capital expenses. In the period from 2001 alone, $3.8 billion of alleged profits should have been stated as losses instead. In July 2002, WorldCom filed for the largest bankruptcy in US history.
In 2003 came the Parmalat scam. This was theoretically a multinational food and dairy company based in Italy. Practically, it has been a hedge fund with a dairy line on the side.9The public downfall came in November 2003, when Parmalat failed to repay a 150 million euro ($187.5 million) bond despite apparently large amounts of cash and liquid assets on its balance sheet. A month later, Bank of America stated that a document purporting to show a large account of a Parmalat subsidiary at Bank of America had been forged. As a result, a 3.95 billion euro ($4.94 billion) black hole emerged in Parmalat’s accounts.
On 27 December 2003 Parmalat was declared insolvent. A month thereafter, in January 2004, Parmalat’s new administration admitted that the company’s level of debt was over 14 billion euro ($17.5 billion), almost eight times more than previ- ously stated. This has been the largest bankruptcy ever. Prosecutors are still work- ing on the Parmalat case. Both international and Italian banks which financed the dairy firm have already been tangled in legal fights. Also, the court rejected the request of Calisto Tanzi, Parmalat’s ex-CEO, to be spared legal proceedings. Tanzi joined the line of other chief executives on their way to trial for malfeasance.
Mid-January 2005, Bernie Ebbers, the former WorldCom chief executive officer, went on trial on fraud charges. The trial of Ken Lay and Jeff Skilling, Enron’s for- mer chairman and former chief executive, also came up in 2005. Neither are these the only ex-CEO legal travails. Richard Scrushy, former chief executive of HealthSouth, is also in court for alleged accounting fraud.
Quite interesting is the case of Dennis Kozlowski, former Tyco CEO, as well as Marc Swartz, his former CFO. Their first trial ended without conviction, but the second trial began in January 2005 in New York State Supreme Court. That first trial, which lasted more than six months, was terminated in controversy centring on one elderly woman juror who received a threatening call and letter. Originally indicted in 2002, Kozlowski and Swartz faced charges of:
● Allegedly stealing about $170 million in unauthorized bonuses, and
● Allegedly gaining $430 million on share deals benefiting from an inflated stock price after lying to investors.
Another CEO who failed to appreciate one of the basic rules of business in the 21st century – that directors, auditors, and lawyers are more powerful than ever – is Maurice R. ‘Hank’ Greenberg, former chief executive of America International Group (AIG). Yet, this is a shift in corporate life which has funda- mentally altered relations between CEOs and the professionals they depend on.
Some of these professionals, who in the years following World War II largely worked as advisors, have been assuming new power. Directors, for instance, were always supposed to work for shareholders, not for the CEO, though many were members of rubber stamp boards and only a few exercised their power as watchdogs in moments of genuine crisis.
This started changing in the early 1990s with the revolt of IBM’s board against its CEO. A dozen years later the boards toppled Fannie Mae CEO Franklin D.
Raines, Boeing CEO Harry C. Stonecipher, New York Stock Exchange CEO Richard A. Grasso, Walt Disney CEO Michael D. Eisner, and Hewlett-Packard CEO Carleton S. Fiorina, among several others. Similarly, in March 2005, accounting problems led independent directors at Delphi Corp, to force out the chief financial officer.
Dozens of similar cases are playing out in office towers across the United States.
The reason for defiance among directors is that watchdogs are finally facing gen- uine liability for their failure to act. For instance, board members at Enron and WorldCom are paying off fraud claims from their own pockets.
Whole companies may disappear in a scandal, as the case of Arthur Andersen documents. This led to an earthquake among certified public accountants (CPAs).
The US Big Five in the accounting world became the Big Four after prosecutors effectively put Arthur Andersen out of business for its role in the Enron scandal.
Suddenly, board members became much more prudent and proactive. At Delphi, tipped off by an SEC inquiry, the audit committee hired investigators to probe accounting problems. The CFO had to quit after the board lost confidence in him.
Thereafter the company had been restating its financial accounts.
At Electronic Data Systems (EDS), KPMG, the CPA, demanded more documents to determine how big a write-down to take on troubled assets, delaying quarterly earnings release. KPMG got its way. In the aftermath, EDS took a $375 million charge. At Countrywide, the new auditor declared some loan sales improperly booked over a technical issue. Despite the CEO’s objections, the company:
● Had to restate results, and
● It also pledged to tighten internal controls.
Acting on a tip, Echostar directors ordered an investigation of company financial controls, discovered problems, and obliged the CEO to discipline an executive and clean-up the accounting.10What practically all of these cases have in common is that fiddling around with accounting is no longer as acceptable as it used to be.
Beyond the opportunity for fraud of Enron, WorldCom, and Parmalat dimen- sions, weak accounting standards and unreliable financial reporting help in cre- ating major and sustained asset price bubbles. Historical evidence suggests that high stock returns and inordinate capital gains on residential property trading induce an increasing number of investors to enter the market in the belief that the price of these assets will continue to rise.
● Traders bid up prices for a while, and
● The visible capital gains this generates initially confirms expectations that huge profits are within every investor’s reach.
In the aftermath, asset prices become fragile, sensitive to news, and subject to bubbles. As the stock market hecatomb of 2000 documents, bubbles blur the information content of asset prices, making accounting evidence and the content of financial reports irrelevant. By so doing, they destroy investors’ ability to act on a factual and documented basis – and thus kill the goose which might lay the golden egg.
Notes
1 D.N. Chorafas, Economic Capital Allocation with Basel II. Cost and Benefit Analysis, Butterworth-Heinemann, Oxford and Boston, 2004.
2 D.N. Chorafas, Wealth Management: Private Banking, Investment Decisions and Structured Financial Products, Butterworth-Heinemann, Oxford and Boston, 2006.
3 D.N. Chorafas Integrated Risk Management, Lafferty/VRL Publishing, London, 2005.
4 Business Week, 28 March 2005.
5 D.N. Chorafas, Financial Models and Simulation, Macmillan, London, 1995.
6 D.N. Chorafas, Transaction Management, Macmillan, London, 1998.
7 D.N. Chorafas, After Basel II. Assuring Compliance and Smoothing the Rough Edges, Lafferty/VRL Publishing, London, 2005.
8 D.N. Chorafas, Management Risk. The Bottleneck Is at the Top of the Bottle, Macmillan/Palgrave, London, 2004.
9 D.N. Chorafas, The Management of Equity Investments, Butterworth-Heinemann, Oxford, 2005.
10 Business Week, 25 April 2005.
2
The International
Accounting Standards Board and Corporate Governance
1. Introduction
The history of the International Accounting Standards Board (IASB) goes back to 1973, when the International Accounting Standards Committee (IASC) was cre- ated. IASC has been a private-sector entity whose members included profes- sional accounting bodies and private firms from several countries. Its original objective was to provide technical support to developing countries in their efforts to establish appropriate accounting standards but, over the years, this aim was enlarged.
Featuring part-time board representatives from around the world, mainly indus- try specialists, accountants, and financial analysts, the way IASC worked was, up to a point, similar in terms of role and operations to the US Financial Accounting Standards Board (FASB). In 1999, the International Accounting Standards Committee issued an accounting standard that required the use of fair values for certain financial products, in particular:
● Derivative instruments, and
● Debt and equity securities held for trading or available for sale.
More precisely, International Accounting Standard 39 (IAS 39, see Chapter 4 and Chapter 5) distinguishes between four categories of financial assets: held for trading, held-to-maturity investments, loans and receivables originated by the firm, and available-for-sale assets, including issues that do not belong to any of the previous three classes.
As it will be recalled, that same year (1999) FASB published Statement of Financial Accounting Standards 133 (SFAS 133), which promoted a similar approach to fair value accounting, specifically in connection to derivatives held for trading. By contrast, those held to maturity continued to be reported through accruals, the difference being made by management intent(see Chapter 1).
In 2000, IASC underwent major restructuring, and the International Accounting Standards Board was created in 2001. IASB adopted the International Accounting Standards (IAS) prepared so far by IASC. The output of its work has been the new standard of accounting and financial reporting known as the International Financial Reporting Standards(IFRS, see Chapter 3).
IFRS as a whole, and most particularly IAS 39, were to have a particularly impor- tant impact on financial firms, including banks and other institutions. IAS 39 has been heavily criticized and considered prematurely finalized. Such criticism is
light-hearted. As General George Patton said: ‘One does not plan and then try to make the circumstances fit those plans. One tries to make plans fit the circum- stances. I think the difference between success and failure in high command depends on the ability, or lack of it, to do just that.’
This is precisely why IASB, IFRS, and AIS 39 are so closely connected to good cor- porate governance. It is also the reason why the present chapter addresses itself, at the same time, to issues regarding IASB standards and governance effectiveness.
Modern standards are not monolithic. They are adaptable to changing markets, conditions, and factors underpinning them. In December 2000, an integrated and harmonized standard to use fair value accounting(FVA) for all financial instru- ments, including loans and deposits – regardless of the intention with which they are held – was put forward by the Joint Working Group of Standards Setters (JWG), in which the IASB and national accounting standards setters are represented.
This proposal for full FVA, which could apply to trading book as well as bank- ing book instruments, was received with scepticism by the banking industry as well as parts of the supervisory community.1One of the criticisms has been that an across-the-board FVA implementation will, more or less, do away with the distinction between banking book and trading book, which was established in the late 1980s.
The main argument against the FVA proposal, however, is that there would be increased volatility in financial statements. Another issue of concern was based on the inadequate development of credit risk models and that valuation methods for non-marketable instruments would be used to derive fair values (see section 7 on the need for a model culture).
Ultimately, the move towards a more extensive use of fair value progressed even if this generalized FVA standard was not adopted. In August 2001, IASB announced that it would undertake a project to amend IAS 39. In 2002, an Exposure Draft, including a proposal to give firms the irrevocable option to apply FVA to any financial instrument if the firm chose to do so when entering the transaction, was published and comments were invited. A further exposure draft on macro-hedging was issued in August 2003 for public consultation.
In December 2003, IASB released the revised versions of its IAS 32 and IAS 39 standards (see Chapter 4), which came after extensive consultation. Further amendments to IAS 39 were issued early in 2004 and in July 2005 – though effec- tive implementation of IFRS started in January of that same year.