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 state’s ‘hidden deficit’ • S&P and threats of downgrades in 2008 if electricity assets were not sold

10. Two questions that were put to S&P: • 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