Friday, August 29, 2003

Accounting Rules and the 1990s Financial Crisis

Subsequent to Enron, questions were raised as to the possibility of a similar occurrence in Jamaica. The failures at the time were widely attributed to the American accounting rules (GAAP) leading to much debate about their adequacy.

Proper accounting by itself would not have prevented the crisis, as inappropriate management has more to do with integrity and competence than rules. It would, however, have highlighted the problems early thereby ensuring that proactive solutions are implemented. In Jamaica, some believe that this could not have occurred because our accounting standards provided a greater measure of protection than American GAAP.

While it could be argued that our accounting rules are stronger, I am not convinced that it could not have happened here. As a matter of fact, it is my opinion that we have already seen the likes of Enron in our financial meltdown of the 1990s, especially in light of the irregular practices that existed. During this time, many financial institutions collapsed because of existing reporting methods as well as weak regulatory execution by the authorities. This in no way excuses the failure of management, but the question to be answered is why did it take so long to uncover the problems? No amount of rules will prevent failure but proper regulations will ensure that it is detected much earlier.

The Financial Gleaner of August 15, 2003, carried the first in a five-part series on the 1990s meltdown and lists in chronological order the reasons for the failure of the various financial institutions. The list included almost 20 financial institutions that were affected and included names such as National Commercial Bank, Mutual Life, Century National Bank, Life of Jamaica and Eagle Commercial Bank.

International Accounting Standards
The same article referred to the deficiency in the process of dealing with loans past due, and also significant deteriorations in the asset base of the institutions. There is no question that reporting was taking place, which no doubt came to the attention of the authorities. However, as the situation worsened the banks were still reporting profits and carrying assets at their original values, giving a false impression of what the real worth of the companies were. It is apparent that there was a loophole with our accounting standards as we were reporting on historical trends rather than providing the public with information about the future.

This led me to wonder if we would have experienced the crisis in the same proportion had we introduced International Accounting Standards ten years earlier. I focus on the extent of the crisis, as I believe that the practices contributing to it would still have resulted, as the regulatory arm seemed to have been slow in recognizing and addressing the problem.

I believe that the public might have been better warned if International Accounting Standards were being used as it is a value based accounting approach rather than the historical cost accounting that was in place at the time. This would have forced companies to reflect the true values of their assets and would show up in reducing profitability and equity base. The focus of International Accounting Standards is on Future Cash Flows and, therefore, addresses the future viability of the company in a more significant way than the Jamaican accounting standards.

IAS 36 and 39
The two standards of most relevance to this issue are IAS 36 (Impairment of Assets) and IAS 39 (Financial Instruments). These standards seek to apply fair value measurements to the assets of organizations and require that any losses or impairment of assets are written off either against the profit or directly to equity. Both standards require that if the fair value measurement of the asset is materially lower than the carrying value in the accounts then the difference should be written off against profit or equity in the year of the impairment/reduction of the asset’s value.

This application would have provided more accurate information to the investing public and the authorities and could have significantly increased the chances of curtailing a sizeable amount of the public debt that is now wreaking havoc on our economy. The amount of debt we carry today resulted primarily from the 1990s financial crisis as well as FINSAC. The effect of creating FINSAC was to transfer the losses (asset reduction) that would be recorded under fair value accounting from the balance sheets of these institutions to FINSAC and ultimately the public. If we were using International Accounting Standards then a significant amount of those losses would already have been shown on the company accounts and we would have been better prepared for the problem that ensued. This is a major reason why the projected debt problem was significantly understated.

Indications of Impairment
Both standards refer to indications that an asset has lost its value and these include the following, which were clear indicators during the 1990s:

“Significant financial difficulty of the issuer” of the instrument and “…high probability of bankruptcy or other financial reorganization…”(initial failure of some institutions should have led the others to look at the value of what they were holding);
“…default or delinquency in interest or principal payments”;
“a historical pattern of collections of accounts receivable that indicates that the entire face amount of a portfolio of accounts receivable will not be collected”; and
Significant changes in technology, market or legal environment. For example, the liberalization of the telecom industry would no doubt have led to a reduction in the estimated future cash flows of the Cable and Wireless infrastructure subsequent to other players being introduced.

These are just a few telltale signs that should have been obvious to us in the 1990s pointing to the fact that disclosed asset values would not have been realized. If these principles were applied at that time then we may have caught the problem $100 Billion before it imploded.

Lessons to be learned
What lessons can we take away from the 1990s? Certainly, the need for proper accounting rules and application are critical, as well as a strong regulatory environment, which has since been significantly improved. This means not only applying the rules but also paying some attention to the accountant. Some persons look to their accountants as they do religion. In other words, just as they find religion when their backs are against the wall, they find their accountants in similar situations.

The newly introduced accounting standards do go a far way in addressing some of the issues that resulted in our high debt costs and needs to be understood and practiced by all. Some may say that accounting matters are to be left to accountants, but accounting is merely a way of objectively measuring performance and projections. It must, therefore, be treated with the importance that it deserves.

Let us remember that it was a general weakness in our reporting and regulations that led to the extent of the debt crisis that we face today and will continue to affect our children.

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