International accounting firms try to be accurate. But investors must be acutely aware of who produced them, where they are from, and who they work for. Blind faith in numbers insures only loss
One of the wonders of globalisation is the free movement of capital. One basic assumption of this movement is that the numbers are the same everywhere. This uniformity is supposed to come from accountants, the bean counters, who serve up financial information with the same uniformity that McDonalds produces Big Mac or Coke produces soft drinks. A balance sheet produced in Argentina should have the same quality as one produced in Thailand. The reality is that although distinctions in national cuisine are on the decline, the plates of beans served up by the accountants vary enormously, some certainly spicier than others.
In the United States, the strength of the regulators and the self-regulation are supposed to be strong enough to allow an accurate picture of the financial health of a firm. The system is backstopped by investigative journalists, multi-levels of watchdogs at different levels of government, and the possibility of a protected whistle blower exposing the whole game. None of this was sufficient to protect investors, or the entire financial system from the profligate ways of Lehman Brothers.
Lehman used 'reality cloaking' off-balance sheet transactions whose only purpose was to obscure the level of Lehman's leverage during reporting season. As soon as the time for reporting was over, Lehman's finances moved from solid ground to the edge of the cliff. Its auditors, Ernst & Young, were well aware of the issues, but since it did not believe that disclosure was required by any accounting rules, they remained silent and engendered a catastrophe.
Laws in different countries vary quite a bit, but accounting rules on the other hand are supposed to be uniform so we can compare the quality of investments in different markets. Of course, they are anything but. The International Financial Reporting Standards (IFRS) have been required of the listed companies in the European Union since 2005. The whole idea behind the IFRS was that they would be truly international and their use would be uniform among all countries. Certainly some countries use them, but like St Augustine, they want to have accounting uniformity, but not yet.
The countries that are supposed to use them include Australia, Canada, Hong Kong, India, Taiwan, Japan, Pakistan, Russia, Singapore, South Africa and Turkey. India was supposed to adopt IFRS in 2011, but they changed their minds. India is now set to transition to the new rules by April 2012. Japan is supposed to resolve all inconsistencies between IFRS and its system this year. Russia has been trying to adopt the IFRS since 1998. Of course the big holdout is the US which still clings to Generally Accepted Accounting Principles (GAAP). There has been a process of merger, convergence and now endorsement going on for years, but no agreement as of yet.
But the standards used are no indication of quality. According to Ambit, a research firm, the quality of accounting in India has been deteriorating for the past four years. Size apparently is no guarantee of quality. The top 50 companies by market capitalisation on the Bombay Stock Exchange 500 had the highest average decline. The best firms were transport equipment and telecoms. The worst were in tourism, textiles and media.
The recent scandals in China have brought its accounting foibles to international attention. China, for a number of years, has felt that international standards impinge on its national sovereignty. It has tried with limited success, to develop its own. The Chinese accounting standards are known as Accounting Standards for Business Enterprises (ASBE 2006), but their use is not a sign of quality. According to Fitch, the rating agency, use of Chinese accounting standards was a 'key weakness indicator'. "Companies which adhere to international financial reporting standards (IFRS)-and the audit trail that lies behind such scrutiny-would have more difficulty in perpetuating fraudulent statements compared with domestic standards."
Since 2005, Hong Kong has used Hong Kong Financial Reporting Standards (HKFRS) which are identical to International Financial Reporting Standards. This is changing. Despite questions, the operator of the Hong Kong Stock exchange allows Chinese companies listed on the exchange to prepare their financial statements using Chinese accounting standards and permits mainland firms as auditors. The stock exchange claims that there have been dramatic improvements.
This may be contrary to experience. According to Deloitte, the financial information supplied my mainland Chinese companies had become a "high-risk area". One of their employees was carrying a confirmation document about a company from a mainland bank and then "out of nowhere, people from the company suddenly appeared, grabbed the confirmation document and ran off."
The numbers produced by international accounting firms try to be accurate. But investors must be acutely aware of who produced them, where they are from, and who they work for. Blind faith in numbers insures only loss.
(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected].)