Go Figure

The fine art of spotting creative accounting

Listener: 3 November, 2007.

Keywords: Business & Finance;
Ian Cross, a former editor of the Listener, says I was one of only two commentators who warned in early 1987 that shares were overpriced. But even if I predicted the 1987 sharemarket crash – albeit not its timing – I didn’t get it quite right, though more so than those commentators who said the economy was sound. (The other exception was Rob Muldoon: sometimes one has very strange bedfellows.)

I looked at the share-price-to-earnings ratios of reported companies, which were then wildly out of line with past levels. Moreover, they were unsustainable unless investors were willing to accept very low rates of return on their investments, well below the then current interest rates.

I learnt from my mistake. Share prices reflect the actual prices trading in the sharemarket, and I assumed that reported earnings of the businesses had the same integrity. With hindsight, they had not. Creative accounting was a reality in 1987, to be exceeded only by the whizkids in Enron, the giant US energy company that went bankrupt in early 2005.

So in 1987 true earnings were often much smaller than was reported, the price-to-earnings ratios were even more out of line than I assumed, and the crash was more imminent than I expected.

I made my mistake because I was used to the economists who prepare the National Accounts for Statistics New Zealand. They produce estimates of GDP with integrity. Inevitably there are errors and revisions, but I have never found them fiddling the data to make the economy’s performance accord with their prejudices. Sadly, that is not the record of all business accountants nor even, as in the case of Enron, of auditors.

A (now-retired) Canterbury University accountant, Alan Robb, has proposed rigorously monitoring business cashflow. Robb has shown that companies that crash normally have a clearly deteriorating net cash position. As far as I know, no sharemarket analyst regularly monitors financial performance in Robb’s way.

Are we suffering from shonky accounting this time, too? Perhaps the answer is “always”. Despite the profession’s dour reputation, some accountants seem to be very innovative. But do their inventions undermine the interpretation of the accounts? Let’s hope there is only the odd reprobate and that you are not investing with them. But I was wrong in 1987.

It’s true that even reputable financial institutions can face major difficulties in valuing their assets. The giant Swiss bank UBS recently announced a $US3.4 billion (say $NZ5b) write-down on its fixed-income assets. Many were securities backed by American subprime mortgages, for which markets have dried up, and so there are no market prices. UBS is also laying off 1500 workers.

Other giant banks are making parallel write-downs, although, as huge as their losses are, they will usually be covered by reducing shareholders’ equity. That is what capitalism is about. Businesses make judgments: their shareholders take the risk of a good or bad return.

But there are limits to shareholder exposure. If the mistakes cost more than their equity, others have to take the pummelling. Which is what is happening in our finance sector as debenture holders and depositors lose all or part of their investment in some – but not all – finance companies.

It may be that some finance companies have been over-optimistic about valuing their bad debts, thereby including in their balance sheets assets that will not give any return. At least one seems to have done so. But they are on the fringes of our financial system. The problem we face will be a macroeconomic one, when sectors that have depended on easy credit adjust to the new stringencies.

Things are more unsettled offshore. We cannot write off the possibility of an international financial sector implosion large enough to disrupt their economies. If that happens, our economy will also be affected for the worse.