Off-balance sheet and off track
Tougher action against off-balance sheet accounting practices, global regulation of financial markets and permanent restrictions on short selling may all be long-term outcomes of the global financial meltdown.
Leaders of the leading industrial countries appear to have reached a consensus that light touch regulation of the financial sector is unsustainable. Governments in the US, UK and European Union all made statements supporting stronger regulation – although European countries are reluctant to copy US proposals to bail-out their banks by buying ‘toxic assets’.
Regulators in the US and UK blamed short-selling for much of the market turmoil and have instituted temporary bans on the short-selling of financial stocks. The US Securities and Exchange Commission said that it was calling “time-out” on the practice, but SEC chairman Christopher Cox added that it “would not be necessary in a well-functioning market”. But he also indicated the Commission was prepared to back this up with other tough measures. “The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets,” Cox said.
UK prime minister Gordon Brown directed some of his fire against off-balance sheet accounting practices. In a television interview, Brown said: “What we are discovering is that there were large off-balance sheet activities that were being run by some of the major companies in the world…. They were not fully disclosed, therefore the problem that had to be dealt with when the markets started to fall, and so you have had some of the biggest companies in the world having to bring back onto balance sheet and declare huge losses from off-balance sheet activities that people were not fully aware of.”
Brown added that he was “pressing” for “global supervision” of the financial markets. A similar emphasis was made in a joint statement by the leaders of the G7 major industrial nations and their central bankers. They spoke of the “importance of making regulation more effective” and the need to make the global financial system more resilient, improving “firms’ risk management practices, enhancing disclosure and transparency, and strengthening accounting frameworks”.
Toxins hit America
A ‘toxic soup’ of asbestos, lead and gasoline sludge was left behind by the Texan hurricane that hit the shores of the United States. Further north, meanwhile, ‘toxic assets’ destroyed the heart of Wall Street. Lehman Brothers collapsed; AIG, Freddie Mac and Fannie Mae were taken over by the Federal Government; and Merrill Lynch was saved by a Bank of America takeover.
In the wake of the financial hurricane, an era of tough regulation seems inevitable. Democratic presidential candidate Barack Obama had made proposals for increased regulation central to his campaign, having pledged back in March that he would introduce tighter regulation of investment banks, mortgage brokers and hedge funds and bring investment bank oversight into line with that imposed on commercial banks. Obama also proposed merging regulatory agencies and creating a commission to monitor threats to the functioning of the financial system, which would report directly to the White House and Congress.
A senior aide to Obama, Professor Austan Goolsbee, suggested that regulatory action would also be taken against market manipulation, including the talking down of stock prices by short sellers. Goolsbee pointed out that Bear Stearns had claimed that false rumours had brought it down. Obama’s campaign is proposing an increase in increased capital adequacy measures for the banks: a move also favoured by Hank Paulson, the US Treasury Secretary.
John McCain is perceived as a proponent of deregulation, but he went on the offensive against the Wall Street institutions. He said that despite the crisis, the “fundamentals” of the American economy remained strong. “Those fundamentals are threatened, they are threatened and at risk because some on Wall Street have treated Wall Street like a casino,” said McCain. “We’re going to reform the way that Wall Street does business and put an end to the greed that has driven our markets into chaos. We’ll stop multimillion-dollar payouts to CEOs that have broken the public trust.”
Short-term pressures on the federal government could see further market intervention – including by setting up a government-backed agency to buy billions of dollars of ‘junk’ securities.
PwC administers Lehman Europe
The collapse of the United States’ fourth biggest investment bank into the largest ever bankruptcy has led to PricewaterhouseCoopers’ appointment as administrators of Lehman Brother’s European operations. PwC will seek to sell the businesses and assets of Lehman Brothers Ltd, LB Holdings PLC and LB UK RE Holdings Ltd, all incorporated in the UK.
Tony Lomas, joint administrator and partner of PwC said: “Our priority now is to work with management and trading counterparties to agree the manner in which the assets and liabilities will be handled.” He said that some group companies remained solvent, including LBAM (Europe) and special purpose vehicles managing property assets. But other Lehman operations, it seems, cannot pay due salaries, nor meet pensions liabilities.
In the US, Lehman Brothers entered Chapter 11 insolvency protection. Chapter 11 protection is designed to enable a gradual and structured reorganisation or disposal of a business. Britain’s Conservative Party intends to introduce a similar system in the UK, if it wins the next general election.
According to an affadavit lodged in the US by Lehman’s chief financial officer Ian Lowitt, the bank will now seek to “restructure operations, reduce overall cost structure, and improve performance” in order to continue. It quickly sold core assets to Barclays and is seeking to sell more of the remaining business. In a statement, the US Securities and Exchange Commission said that its staff would be on site in future weeks to oversee the transfer of clients’ businesses to other brokers.
Lehman Brothers was one of the oldest investment banks in the world, established in 1850. The bank was valued at $60 billion before the sub-prime crisis hit, but it has bond and counter-party exposure of several times that value.
SEC publishes IFRS ‘roadmap’
The US Securities and Exchange Commission has agreed a ‘roadmap’ to extend the use of International Financial Reporting Standards to US listed companies from 2014. A final decision on whether to move to IFRS would be made in 2011 – but a series of milestones need to be reached for approval to go ahead.
Despite the global financial crisis, the SEC remains upbeat about the importance of moves towards a worldwide single accounting framework. “An international language of disclosure and transparency is a goal worth pursuing on behalf of investors who seek comparable financial information to make well-informed investment decisions,” said SEC Chairman Christopher Cox.
“The increasing worldwide acceptance of financial reporting using IFRS, and US investors’ increasing ownership of securities issued by foreign companies that report financial information using IFRS, have led the Commission to propose this cautious and careful plan. Clearly setting out the SEC’s direction well in advance, as well as the conditions that must be met, will help fulfill our mission of protecting investors and facilitating capital formation.”
Progress towards IFRS was underlined by the publication of an updated memorandum of understanding between the International Accounting Standards Board and the US’s Federal Accounting Standards Board, which reaffirmed the commitment of the two bodies to the global use of IFRS. Separately, the IASB and the Accounting Standards Board of Japan confirmed they were making progress on eliminating by the end of this year outstanding major differences between Japan’s accounting standards and those of IFRS.
More than 100 countries now use IFRS, of which 85 require IFRS reporting for all domestic, listed companies. Japan, India, Canada and Korea intend to adopt or converge with IFRS from 2011.
Robert Herz, Chairman of the FASB, said that there were now a number of major projects that need to be completed in the coming years to achieve convergence between international and US standards. He said that the two boards will decide before the end of the year whether to modify short-term convergence programmes to help them focus on priorities.
Dr Steve Priddy, ACCA’s Director of Technical Policy and Research ACCA , said: “ACCA strongly supports global standards and we think the US is doing the right thing in moving to IFRS.” Soon-to-be-published ACCA research found that US finance executives regard US reporting standards as out of step with the rest of the world.
Mortgage lenders ‘used questionable accounting practices’
A senior US senator has accused the collapsed mortgage lending giants Fannie Mae and Freddie Mac of using ‘questionable accounting practices’, suggesting that this had been common knowledge for many years.
Fannie Mae and Freddie Mac are lenders and guarantors in the US mortgage market, which lost billions of dollars in the sub-prime meltdown. They were eventually rescued by the US Government, through a $200 billion bail-out. With the two institutions holding liabilities of $5,400 billion, there is a serious prospect of eventual financial support growing even larger.
Senator Richard Shelby, a Republican on the Senate Banking Committee, said in the television interview that he supported the Government’s move, but suggested that action should have been taken earlier. “The Fannie Mae and Freddie Mac situation was a debacle just waiting to happen,” he said. “We knew for a number, four or five years, that they were thinly capitalized, questionable accounting practices, and, in a lot of instances, poorly run, although they did do some good things, as far as buying mortgages, securitizing mortgages from the housing industry. But they’re a hybrid…. They’re a privately owned company with the implicit guarantee of the taxpayers. And that brought about a lot of risk with it.
“So, I tried and a lot of us tried, starting four or five years ago, tried to strengthen the regulator and bring up capital standards to where they would not go the way they have. But we were unsuccessful to do that politically, and we’re where we are today.”
In other comments, Senator Shelby said that the two lenders had used deferred tax credits to meet regulatory capital requirements. “That’s not even real money,” he said. “They [the regulators and government] found out they had a house of cards. Once they got someone looking closely at Fannie and Freddie’s books, they realized there just wasn’t adequate capital there.”
Class action law suits are now being taken against the executives of Fannie Mae by investors, alleging that the company’s accounts misrepresented its financial position.
MEPs call for single VAT rate
A single VAT rate of 15% should be instituted for all cross-border trade within the European Union, Members of the European Parliament have declared. This would eliminate opportunities for cross-border fraud, achieving savings to member states’ governments of €200 billion to €250 billion annually.
The proposal originated in a report from British Liberal Democrat MEP Sharon Bowles, with the strong backing of 391 votes, with just 93 MEPs voting against and 178 abstaining. The report criticised the failure of some member states to take cross-border VAT fraud sufficiently seriously, accusing them of a “blockading attitutude”.
Member states would not be required to standardise their VAT rates under the proposal. Instead, they would charge a ‘top-up rate’ where they charge more than 15%. In the case of the UK – which charges 17.5% VAT – a rate of 2.5% would be charged on goods and services imported from within the EU. The 15% would be transferred from the producing country to the recipient country through a reciprocal charging mechanism, operated by a central clearing house.
A clearing house system for rebalancing payments between Member Sates could be rapidly developed, concluded the report. At present, intra-community supplies are exempt, with tax charged only when goods or services are re-sold in the destination country – creating the opportunity for massive fraud. In the long run, VAT should be based on taxation in the country of origin, said the report. The report also calls for more cooperation between Member States’ tax authorities in tacking fraud and tougher action against tax avoidance by widening the scope of the Savings Tax Directive, backed by action against tax havens through the OECD.
Companies drift offshore
Investment giant the Henderson Group and engineering company Charter are the latest UK companies to move their headquarters to Ireland, to keep their foreign earnings out the UK corporation tax net. They follow Shire Pharmaceuticals, United Business Media and Experian to Dublin.
The trend looks set to continue, as companies express their dissatisfaction with both the UK’s foreign earnings taxation regime and its corporation tax rate. Despite the UK’s 2% cut in the base corporation tax rate – from 30% to 28% in April this year – it is becoming increasingly uncompetitive compared with many of its international competitors.
According to analysis by KPMG, average corporation tax rates globally have fallen to 25.9%, a cut of 0.9% against 2007. For the first since KPMG began surveying in 1994, not a single country raised its corporation tax rate. The UK’s rate cut marginally improved its position within the European Union, moving it to joint 19th place – with Sweden – out of the 27 member states. Both Germany and France lie below the UK. The average rate across the EU is 23.2% – making it the lowest tax rate region worldwide.
Ireland has gained particularly at the expense of the UK, benefiting from its basic corporation tax rate of 12.5%. Yet there is pressure on Ireland to cut its rate further. The managing director of Microsoft Ireland, Paul Rellis, suggested that Ireland was losing its competitive edge and itself needs to consider a rate cut. “There are countries that have much lower effective tax rates in Eastern Europe and I think it’s extremely important that we recognise that a more competitive tax rate brings a higher tax yield and generates a massive economic contribution,” he said. He added that Ireland “is no longer winning the race when it comes to corporation tax”.
Sue Bonney, head of tax at KPMG Europe, explained: “As corporate tax rates fall worldwide and corporations become more fleet of foot in relocating to favourable jurisdictions, national governments can no longer rely on corporate tax receipts. But they still need to collect revenues and they are looking towards indirect taxes to do this.”
A recent KPMG survey found that the UK was the most popular country internationally for its indirect tax regime. But another survey by the firm found that more multinational companies are considering relocating to lower tax jurisdictions.
KPMG warned XL Leisure
KPMG resigned as XL Leisure auditors in October 2006, citing “material errors” in the company’s accounts, it has emerged. XL Leisure went into administration in September, after the rising prices of fuel put the UK’s third largest package holiday operator into a trading loss. According to newspaper reports, KPMG had earlier complained that it had been prevented from carrying out a full investigation into possible accounting misrepresentations.
FRC strengthens director rules
Directors of listed companies face tougher disclosure rules on whether their businesses are ‘going concerns’, under proposals from the UK’s Financial Reporting Council. Directors will be given a fourth option – declaring that they ‘have identified material uncertainties that may cast significant doubt about the ability of the company to continue as a going concern and so additional disclosures are required by IFRSs’ – as an alternative to the existing three, that they have ‘a reasonable expectation’ that the business will continue and is a going concern; that they have doubts, but consider it ‘appropriate’ to use a going concern basis; or that the business is ‘unlikely to continue’.
IASB ‘is not investor-friendly’
IFRS need to take more account of investors’ needs, says the Association of Investment Companies. The AIC is calling on the International Accounting Standards Committee Foundation to revise its governance framework for the IASB to require it to engage more closely with investors.
Charity Commission warns on accounting practices
Poor accounting and reporting practices lie at the heart of many of the problems at charities investigated by the Charity Commission, its first compliance report revealed. The report ‘Charities Back on Track’ provided other examples of poor governance, including giving previous offenders ‘another chance’. The sector regulator published 42 inquiry reports in 2007/8, closed 171 compliance cases that did not go to inquiry and claimed its work protected £16 million of charity income.
PAC reveals HMRC finance director is no accountant
The interim finance director at HM Revenue & Customs is not a qualified accountant, a report from the House of Commons Public Accounts Committee has revealed. A permanent finance director, who is a qualified accountant, has now been appointed. The Ministry of Defence permanent finance director is also not qualified, but will be replaced by an accountant when he retires. The Crown Prosecution Service’s finance director is training to become qualified. In 2004, 39% of finance directors had professional qualifications: now the figure is 93% and will be 100% when the MoD finance director – appointed in 2004 – retires.
UK Government takes emergency economic measures
The UK Government has temporarily lifted the stamp duty threshold on the purchase of homes from £125,000 to £175,000, in an attempt to boost the dormant housing market. It has also given the green light for local authorities to re-establish council housing schemes and will provide extra cash for housing authorities’ social housing programmes. Other measures include increasing the amount of support for shared equity home purchases and it will relax the income support rules to provide mortgage interest support.
Cable & Wireless sparks fresh interest in pensions disposals
Cable & Wireless’s disposal of its £1 billion pension scheme is expected to further stimulate the market in the transfer of pensions obligations by major PLCs. Under the transfer, Prudential will take on the defined pension liabilities of Cable & Wireless, including any underfunding risks. Cable & Wireless were advised by Lane, Clark and Peacock, which predicts that the total market value of pension scheme transfers will exceed £10 billion this year.
Most accountants ‘could become home workers’
Increasing numbers of small firms of accountants are abandoning their office accommodation and working from home, according to IT services company Ulysses IT. It says that its survey of small businesses revealed that two-thirds are actively considering closing commercial premises to run their business from home. The rising cost of operating offices, the impact of the credit crunch and the availability of on-the-move technologies are stimulating more home working. Ulysses predicts that this year, for the first time in the modern era, more than half of small firms will be run from people’s own homes.
‘Share buy-backs motivated by executive incentives’
Executives are pushing their companies into share buy-back schemes in order to inflate earnings per share (eps) and trigger their own pay increases, according to research from Lancaster University Management School. The study compares executive directors’ compensation arrangements for a sample of UK companies that bought back shares with a matched sample of non-buyback companies, which showed that companies that tie executive compensation to eps are almost twice as likely to buy back shares as are companies where pay is independent of eps.
Payment times ‘getting longer’
US businesses are taking longer to pay their bills, according to a survey conducted by the REL consultancy. Average payment times have risen from 39.7 days in 2006 to 41 days in 2007. This compares with less than 39 days when the US was last in recession in 2001.
PKF says M&A market remains active
Mergers and acquisition activity in the UK has slowed, but the market remains active, according to research from Mergermarket for PKF. Activity in the UK in the first quarter of 2008 continued to outperform that in the rest of the EU. More than a quarter of all M&A transactions involve private equity funds. Changes to the UK capital gains tax regime helped drive continued activity.