Monday, December 20, 2010

Will IFRS reduce 'financial engineering' risk for investors?

Enron, WorldCom, Lehmann have been (in)famous scams covering a plethora of accounting, legal, business, financial and ethical issues. But a common thread has been structuring transactions to window dress a better profit as per financial accounts. 'Rule based' accounting standards such as US GAAP are so complex that invariably some loophole or the other is left. And it is such loopholes which enable companies to legally comply with(but violate the 'spirit'/'intention' of the law) GAAP while having poor operating results. Sample the following
  • Instead of creating a wholly owned subsidiary, Enron had its top management(the CFO) become a partner/director in a operating SPV which was wholly financed by Enron, which sometimes even guaranteed their external debt from banks . The economic substance remained the same-that Enron ran the risk of its capital being lost- but this was not reflected in books of accounts
  • WorldCom faced declining revenues due to sector problems. It entered into capacity swaps with AT&T and others. These swaps were just exchange of inventories but were recorded as sales to boost the topline(bottomline remaining unchanged)
  • Lehmann did not want to reveal its portfolio of illiquid securities. It therefore decided to 'sell at quarter end and  buyback later' its illiquid assets. The gimmick named 'Repo 105' overstated the liquidity while complying to the letter of GAAP
  The structuring of the above transactions had little economic rationale save window dressing. While analyzing the above scams, calls have been made to simplify GAAP and shift to a principles based accounting system like IFRS.This simplistic argument misses the point that due to the IFRS-US GAAP convergence, it is quite likely that the new IFRS will be interpreted similar to  the erstwhile US GAAP.

Investors therefore should not let their guard down even under IFRS. They now must contend with the chance of fair value fraud(to be explored in subsequent posts).

1 comment:

Sandip said...

nice one....though I have to say I did not understand the whole of it...