Where were the auditors

1
Where were the auditors?

• Bob Walker

2
Has that question been asked?

• Current attention is on the GFC / GEC and on
  prudential regulation of the banking system
• Yet origins of the GFC arise from trust in the
  financial position of major investment banks and
  other financial institutions
• Auditors had given clean reports on their
  financial statements

3
The question will be asked

• As more corporations fail, leading to more
  unemployment and financial dislocation
• As class actions are mounted on behalf of
  shareholders and other stakeholders (e.g. when
  pension plans fail)
• As debate on governmental response turns towards
  reform of regulatory arrangements

4
What went wrong?

• Distinguish
• financial management and
• financial reporting

5
Financial management

• US banks have less of a deposit base than
  Australian banks reliant on inter-bank lending
  which dried up
• Highly geared companies were stranded
• BUT some corporations were already in a parlous
  state (e.g. in the motor vehicle industry) so an
  economic downturn will lead to financial distress
  

6
Financial management (cont.)

• But why did bank lending between countries dry
  up? Apparently from the realisation that banks
  held toxic debt (mainly securitised receivables
  in the USA market but other more complex
  instruments)
• Australia likely to see similar problems (among
  banks, financial institutions)
• ( no deposit, nothing to pay for two years)
• banks are already strengthening their balance
  sheets with new issues

7
Financial reporting

• Valuation of receivables and financial
  instruments?
• If a retailer has a major investment in
  receivables, the auditor can examine payment
  records and debtors histories directly
• More difficult if the retailer engages in
  factoring and there are residual guarantees
• If an investment bank acquires a package of
  receivables the auditor is more remote from the
  action
• If securitised receivables are split into
  principal and interest packages and are linked to
  credit default swaps the auditor is even further
  from the action

8
Reliance on credit rating agencies?

• An auditor seeks to provide reasonable assurance
  that financial reports are not materially
  misstated
• the history of auditing shows that some auditors
  have failed to seek to directly assess asset
  valuations via physical inspection or other means
• In recent times, it appears that they relied on
  credit rating agencies (e.g. if debt was rated AA
  it was viewed as low risk)

9
How good are credit rating agencies?

• Incentives agencies paid to rate securities
• Some observations about Australian credit rating
  agencies
• NSW placed on credit watch in 1991 after article
  re the states hidden deficit
• SP and threats of downgrades in 2008 if
  electricity assets were not sold

10
Two questions that were put to SP

• Would you agree that investment risk is
  associated with volatility of cash flows?
• If the answer to 1 is Yes would you agree that
  the privatisation of NSW electricity assets (that
  generate stable cash flows and a rate of return
  of around 24) would actually increase the risk
  associated with NSW borrowings?
• No reply but a media release a two days later
  referring to possibility of higher borrowings

11
Financial reporting

• Valuation of properties
• focus likely to turn to property valuations
• HG Palmers experience in the 1960s
• Lehman Bros suggested that properties
  overvalued by 34
• accounting standards have required down
  revaluations to recoverable amount of impaired
  value

12
Financial reporting

• When is the value of assets impaired?
• (per AASB 136)
• when the book value is greater than (a) net
  resale value, or (b) PV of future cash flows
• prior interpretations of RAT test
• property may be in the books at twice its
  current resale value but not written down PV
  calculated as value of cash flows derived from
  renting a property and then subsequent resale
  when the property market picks up in 4 or 5
  years

13
Financial reporting

• Valuation of assets capitalised expenses and
  intangibles
• Still possible for balance sheets to record
  capitalised expenses as assets even though they
  may not be saleable or have no market value
• Again to be considered in terms of the
  ambiguously worded impairment test

14
Some regulatory responses?

• Need for a fundamental review and tightening of
  regulatory arrangements
• Minimal (light touch) regulation of securities
  markets in USA (and Australia) has arguably
  contributed to the bull market
• The venture of developing international
  standards for financial reporting tending
  towards lowest common denominator approach
• Anecdotal evidence of regulatory capture

15
The role of government

• Politicians have failed to outline a vision about
  the role of government
• Suggest one key role is to ensure that markets
  are adequately informed
• Contrary argument that has dominated debate
  markets (should) be encouraged to operate
  efficiently
• Regulatory arrangements may contribute to
  efficiency but should also ensure equitable
  treatment of market participants