“That it might please you to give quiet pass
Through your dominions for this enterprise,
On such regards of safety and allowance
As therein are set down.”

Hamlet, Act II, Scene II



Every investment begins with a company analysis. Men worn black politely request BS, CF of the scrutinized company and then start calculating ratios. What are these capitalistic Puares searching for?  The answers might differ, but essence remains – one must be sure that investment is secure enough and there is no bubble which might burst, thus burdening the liquidity of the portfolio and reporting negative returns.

The fabulous Big Four

KPMG, Deloitte, EY and PWC are the world leaders in accounting. However, their profits does not emerge from low-margin and non-liquid audit; they extended their services to consulting as well. Consequently, companies grow exponentially: Prem Sikka, professor of accounting at the University of Sheffield points out that the UK has about 34,435 general practitioners to take care of family health but has more than 360,000 professionally qualified accountants out of an estimated global total of almost 3m. The UK, he says, has the highest number of accountants per capita in the world and more accountants than all the other countries in the EU combined.

Therefore, why the accounting scandals (Kinross Gold 2010, Lehman Brothers 2010, Amir-Mansour Aria 2011, Bank Saderat Iran 2011) do arise, given the large employee numbers, world- wide network of offices and continuously improving standards?

There is a problem in the system

Neither MBA nor BSc students are taught how to detect accounting frauds. The reason for that is simple: accounting examinations both in EU and US and do not cover these topics, so given the dense schedule, no one really bothers whether sophomores and future CEOs will able to identify accounting data falsifications. Moreover, acquainted knowledge would be inapplicable unless one is employed in accounting dept. However, opinions differ. As noted by B. Fox in “Accounting for fraud” for some CEOs it is important “To better align accountants’ skills with their responsibilities” and “exams should include more questions on fraud”, while some “CPAs believe that detecting fraud is still not one of their core responsibilities.”

Check the checkbox

We, authors, first met the term “checking the checkbox” as referred to audit in the book “Fundamentals of Corporate Finance” (Brealey &Co). Alongside with the outlined accounting principles, the editor argues that modern auditors just check the boxes, denoting what they have done. So that later in the court, they could protect themselves if the company goes bankrupt, thus contradicting the smooth numbers.

Modern accounting is about paperwork. Not the prudence, not clarity, not the fair check – auditors just see whether “every debit has a credit”, as Luca Paccioli, the founder of double entry once proposed. And stop there.

Lehman Brothers and audit

One of the main reason, why 2008 crisis happened, was a greed. Firms  wrote their collateralized debt obligation exposure to be more than 50% when the underlying mortages wrapped  inside the C.D.O.’s may have fallen only 15%. It means firms showed that they are much more resistant to the downturns of the market than they actaully were. Best example for this is Lehman Brothers, who went into bankruptcy September 15, 2008. (Dealbook, 01.07.2008)

They were first of the Wall street firms to move into the business of mortage origination. Lehman had morphed into a real estate hedge fund disguised as an investment bank. By 2008, Lehman had assets of  $680 billion supported by only  $22,5 billion of firm capital. From an equity position, it was very risky, because when the structure is strongly leveraged, a three- to five- percent drop in real estate values would lose all of the firm’s capital.

Compared with three- to five percent drop, 2008 was a year, where real estate values declined over 30%. It was too much for the company, who has borrowed significant amounts of money to invest into housing-related assets. Being highly vulnerable to the downturn of the market a big company collapsed staying the largest bankruptcy filing in the U.S. history.

How it bubbled? Hiding loans was not a good idea. Which came to light in 2006 when housing prices started to fall, first it was thought as a good thing – the market is overheated and soon will likely return to sustainable level. It was not realized that there were too many people, whose credit was non-existent and banks loan money too easily. (Kimberly Amadeo, 05.10.2018).

Same goes with Lehman brothers, if banks would had closely look into company’s balance sheet and cashflow statement, and seen how the money circulation goes in the firm, they had seen that firm do not have funds to cover market downturns.

 

Authors:   Nikita Stepanovs, Martin Hõbemägi

 

 

References:

Bookdeal (2008, July 1) Did an Accounting Rule Fuel a Financial Crisis? Retrieved from https://dealbook.nytimes.com/2008/07/01/blaming-the-bean-counters/

 

Kimberly Amadeo (2018, October 10) 2008 Financial Crisis. Retrieved from https://www.thebalance.com/2008-financial-crisis-3305679

 

Brian Fox DECEMBER 5, 2013 Accounting for fraud

https://www.ft.com/content/8586985a-157a-11e3-b519-00144feabdc0

 

Dr Edward Vickers JULY 1, 2014 Bully tactics by accounting firms

https://www.ft.com/content/2ba4b8fc-fe32-11e3-acf8-00144feab7de