Published on the Malta Independant, issue Wednesday, 10 October 2010
In the last decade, public confidence in the auditing profession was dented by corporate scandals such as Enron in the US, Dutch retailer Ahold, Parmalat in Italy and Societe Generale in France (to name a few), and lately the Madoff scandal. In response to these scandals and as part of the preparations for a broader action plan on corporate governance the EU Commission has conducted a number of studies. One such study has concluded four key areas.
These covered the international market for statutory audits of listed and very large companies as this is highly concentrated and dominated by the Big-4 networks. Locally, we have been seeing a pattern of regular assignments issued by the Ministry of Finance, which uses the services of the Big-4 audit firms in areas of tax reforms, investigations of fuel / electricity tariffs by Enemalta, studies of performance on specific loss making jobs at the now-closed shipyards and sundry transport studies. This has placed the services of the dominant Big-4 firms under the spotlight as consultants to the state.
Back to the international scene. As a result of pressures due to accounting and corporate governance scandals, the EU Commission implemented a new audit rule called the Eight Directive. This includes, inter alia, mandatory audit committees at listed companies and the need for compulsory rotation of audit firms on a seven-year term. This is a heavy piece of legislation concerning the regulation of auditors. As members of the EU, once this directive is implemented then rotation of auditors of quoted companies will take place. In serving the public interest, the International Auditing and Assurance Standards Board (IAASB) went into overdrive to set high-quality international auditing and assurance standards.
The IAASB recognises that standards need to be understandable, clear, and capable of consistent application. These aspects of clarity serve to enhance the quality and uniformity of practice worldwide. In 2004, the IAASB began a comprehensive programme to enhance the clarity of its International Standards on Auditing (ISAs). This programme involved the application of new drafting conventions to all ISAs, either as part of a substantive revision or through a limited redrafting, to reflect the new conventions and matters of clarity generally.
Recently, the Clarity Project reached completion when the Public Interest Oversight Board approved the due process for the last several clarified ISAs. Auditors worldwide will now have to reform their approach based on 36 newly updated and clarified ISAs and a clarified International Standard on Quality Control (ISQ). This of course was exacerbated by the onslaught of the credit crunch, which saw solid triple “AAA” banks such as Lehman Brothers face the wall. The financial crisis has exposed numerous flaws in the financial markets – as well as some shortcomings of fair value accounting for debt securities. Fair value accounting has led to banks publishing some very dispiriting financial results, but this is because the news itself has been bad, not the way in which it has been presented. With hindsight one can admit that fair value accounting was found to be a suitable scapegoat for the hubris, poor risk controls and some excessively greedy decisions of the banking sector.
During the recession, most financial instruments held by banks for trading were expected to be measured using fair value accounting. Under normal circumstances, where there is an active market for the instrument, this method follows naturally for it to be assessed at its current market value. Trouble ensues when a market value is unavailable or unreliable, since by definition fair value “is an estimate of what the market value would be if there were a market”. For this reason, fair value is also defined in the regulations as mark-to-market. Some commentators have strongly argued that fair value accounting contributed to the financial crisis by exaggerating the severity of problems in banks’ portfolios.
They reason, rightfully, that if you have a trading activity, then the use of a market value approach is appropriate, but, where you have a distressed market or assets and liabilities held for the long term, then it is not actually appropriate to force short-term fluctuations in values through the balance sheets and profit and loss accounts of companies. The uncomfortable truth for some banks is that market participants had over-inflated asset prices, which subsequently had to be dramatically scaled down.
To be truthful, one can credit the existing regulation of fair value accounting as the agent responsible that has actually exposed this correction, and done so more quickly than any alternative method would have done.
Naturally, when things go wrong and in times of unprecedented recession and markets are deeply depressed, the fair value concept produced a somewhat distorted view of the future potential of a bank’s assets. Many have lamented that there is no perfect system, yet when things turn sour everyone expects that accounting frameworks encourage transparency and consistency across firms and asset classes. Again, accountants are being heavily blamed for the dismal results reported last year by financial institutions that partially started the so-called credit crunch. Can a perfect solution be in sight such that one can build a bridge to span the great divide? Something must be done so that the financial markets can rapidly return to normality. Optimists hope that investors receive financial statements that lead them to take intelligent decisions.
Regulators are left with egg on their face when politicians blame them that the safety net did not work. One need only mention the loose regulation in America that led to the proliferation of easy banking credit leading to the now infamous sub-prime crisis. All this has culminated in severe political pressure being exerted on accountancy regulatory bodies like the IASB and IFAC to respond with adequate and more watertight regulation.
Realistically, the revised Eight Audit Directive is not seeking to alter the fundamental mechanics of the relationship between auditors and the market – but merely to ensure that these mechanics are based on high international standards. They are perceived to be more transparent and are subject to greater external oversight. A more important paradigm shift is the reprieve from using fair values or marked to market for banks.
This pressure on International Accounting Standards Board by the European Commission resulted in a carve-out clause. This alleged pressure effectively presented the IASB with an invidious choice between either losing the IASB’s coverage of the European Union on the one hand or acceding to the Commission’s demands at the expense of a loss of credibility in other nations. Certainly a dilemma.
Commentators argue that the arm-twisting tactics used by the EC on the IASB was badly timed. But change had to happen. Thus we witnessed sudden amendments to IAS 39, (recently updated by IFRS 9) announced by the IASB, which led to insert enhanced disclosure requirements. Thus, an alternative to using mark-to-market during distressed markets scenarios is the mark-to-model. The latter refers to the practice of pricing a position or portfolio at prices determined by financial models in contrast to allowing the market to determine the price. This has permitted banks in Malta to value their portfolios in a better light and we have already seen unpredicted improvement in earnings by local banks for last year. Beleaguered shareholders heaved a sigh of relief after seeing the bank’s results suddenly blossoming in 2009 even though the local economy had shrunk by two per cent.
They all agree that mark-to-model is perfectly sound once the bank has no immediate reason for selling them. This compromised solution at a time of recession and high unemployment may appear to be a temporary respite for banks and other institutions, although the sad news is that the EU Commission has now approved a new transactions tax on banks. Naturally regulators have been under extreme pressure particularly in America not to unduly downgrade values of securities in distressed market conditions. However, auditors have to be assured that the use of models do reflect current positions while trying to make the best use of market data in the public domain (which in most instances is not readily available).
To conclude, accountants nowadays are under extreme pressure to enhance quality. They need to spend more time simply to catch up with complex audit regulations that are being issued by the hour at neck-breaking speed. The time one needs to invest just to keep abreast is getting horrendous. It is typical for accountants to lock horns with regulators, complaining of the added stress arising from over-regulation. Locally, as most audits by mid-tier audit firms are for private family owned entities such costs are not easily recovered. Yet one cannot but agree that the scandals that rocked the markets during this unprecedented recession are showing positive signs of fading away and stability is returning, albeit slowly. One hopes that the reforms instigated by IFAC and IASB will lead to a normalisation effect on the accountancy profession in time for the recession to ebb away.
by George M. Mangion
The writer is a partner in PKF Malta, an audit and business advisory firm.
View article online : http://www.independent.com.mt/news.asp?newsitemid=113473