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.

Friday, August 15, 2003

Towards Greater Efficiency

I have heard on occasions persons in the private sector refer, both publicly and privately, to the inefficiency of the various government processes. The word inefficiency seems to have become somewhat of a cliché for some people and is used freely to explain every situation. A recent experience I have had with two government ministries has led me to question the source of inefficiency.

Over the past few weeks, the Managing Director of my organization and I have had reasons to interact with the Ministries of Agriculture and Finance. On one of those occasions, he intimated that the reason for the seemingly inefficient operations in Government is, in many instances, a result of the behaviour of the private sector. This led me to reflect on what we had experienced over the preceding days in dealing with these ministries, which, for the most part, was pleasant and fulfilling. In fact, our particular problem emanated from inadequacies in the communication between the private companies involved, thus, causing us to call upon the Government for a speedy resolution at short notice.

Despite this short notice, the Government personnel were able to deal with our problem expeditiously without any complaints. I found that their willingness to meet our needs was driven by their desire to satisfy the market.

I thought about Government personnel with whom I have been in contact over the past two years and the professional and courteous manner in which they have dealt with various issues. I am in no way saying that the service level is where it should be but, in my opinion, that has more to do, today with the archaic systems than the personnel. The truth is that the Government bodies have been gaining in efficiency.

There is no doubt that the business processes in Jamaica require far too much interaction with Government bodies which, in many instances, have arduous rules to follow, but beneath all of that is a reason for the procedures. Much of the seemingly difficult rules put in place by the Government have resulted from the private sector’s own actions. In many cases, we try too much to “beat the system”, and many times boast about the successes in doing so.

Many will, no doubt, have heard references to persons who will try to “beat the gate”, even though the function being attended is free. This type of behaviour is not restricted only to the man on the street, as many businessmen will try to buy favours, even when it costs more, in the long run, to beat the system than to do the right thing first time around. They are always trying to get ahead by bending the rules in their favour but, if someone else tries to do the same thing, they themselves will publicly call for that person’s head. This is not the only source of inefficiencies in the systems, resulting from the “red tapes” put in place by Government, but also our lack of international competitiveness, as we do not seem to have what it takes to compete fairly.

My own experience with Government has also made me aware that the reason Government bodies put legislation and rules in place is to ensure that the private entities (companies and individuals) do not take unfair advantage of a situation. The problem with our society is that the “beat the system” mentality seems to be so (pervasive?) that it has become a way of life for many. To counter this type of behaviour, therefore, the Government, in many instances, has had to put procedures and rules in place to prevent the abuse of the system by some to the disadvantage of others. This has resulted in having processes, which are both time-consuming and inefficient. Hence, the build up of a slow-moving and unfriendly investment environment, which hinders serious investors.

Our private sector has called, time and time again, for protectionist policies and has only taken advantage of those policies without adding any real value to the economy, thus, questioning our inability to survive globally, when this protection is lifted. This is, however, not the case in all situations, as some industries do need protection but, in some cases, the intention is not about national development but rather self-interest. This type of behaviour develops from the individual level where, for example, we will go into a bank and head to the front of the line and ask our friend for a favour, or we speak highly against indiscipline but refuse to pay our monthly housing maintenance fees or rent.

One of the problems that have contributed to the proliferation of this type of behaviour is our outdated laws, which are unfriendly towards investment capital and, ultimately, development. Over the years, Governments have placed band-aid solutions on this by offering incentives to certain investments, but this will not work, if we are serious about development, as we need to apply fundamental changes to our underlying structures, if we are to effectively deal with the problems.

We have seen the benefits that can accrue to us from a competitive and well-regulated market from the examples of the telecommunications and media industries. The introduction of multiple players has resulted in increased economic activity and greater benefits for all. This would not have been possible, however, without the efforts of the Broadcasting and the Fair Trading Commissions to ensure that there is a level playing field for all players. These are the models that we need to emulate in the development of other sectors.

The Government must continue to lead the change process, as they have been doing, as the private sector may not be capable of doing this effectively, due to self-interest. The Government has begun the process of change and this is evident by the type of persons they employ and the increasingly efficient ways in which issues are addressed. There is still a need for improvement in many areas but, over the past few years, the wheels have been turning in the right direction.
The private sector needs to be cognisant of the role they must play in the country’s development and, in this process, towards greater efficiency.

Friday, August 01, 2003

Problems with inner cities

Recently during a workday, I was driving along Spanish Town Road, from Three Miles to Downtown. As I was traveling, I noticed several empty buildings that once boasted some of Jamaica’s most successful/productive entertainment centres and businesses. In addition to the wasted real estate, I noticed many young men and women loitering on street corners, evidently searching for something to occupy their time. A conversation I had with one person revealed that most, if not all, would love to have the opportunity of employment.

It suddenly hit me that this is one of the reasons for our current economic condition. The real problem of the inner city emanates from the extensive idle resources they contain. These resources are potential business establishments and productive labour that are going to waste. What’s more, the situation worsens with each passing day. How can any nation or company survive in a competitive environment, if it does not fully utilise all of its available assets? Yet, we have been trying to compete with other countries that fully utilise their productive resources.

The problems facing us as a nation are primarily:

1. Idle real estate that lies in many inner city areas because of crime, as well as neglect by the relevant authorities over the decades. These properties, potentially, are thriving businesses that could be employing thousands of persons; and
2. Increasing idleness of our human resources, particularly, in the inner city.

Both these factors are wasted resources, which, as long as they are idle place a greater requirement on the productive sector, as the wants and needs to be satisfied remain relatively inelastic.

In my opinion, the productive employment of these resources is certainly one way of more evenly distributing the tax burden. For example, take two companies with assets valued at $100. If company A invests the whole $100 at 20% per annum it will earn $20 over a year. If company B invests only $70 and leaves $30 unused, it will have to realise a return of approximately 28.5% to earn that $20. Similarly, in our situation, we are competing against countries using a higher percentage of their productive base, both in terms of real assets and labour. In order for us to compete effectively, we, therefore, must realise a higher rate of return on our assets.

A review of statistics on the population and the economy reveals some interesting points. Our total population has increased while our labour force in absolute numbers and as a percent of total population has decreased, moving from 44.52% in 1997 to 42.86% in 2002.

The implication of this is that we have less persons working to support an increasing population. Over this same period, there has been an increase in the average US$ weekly earnings from US$145.50 to US$173.08 - a 19% increase. Similarly, the total earnings over the total population has increased from US$64.78 to US$74.18, a 14.5% increase, over the same period. The implication is that the work force was, on average, earning more in real terms in 2002 than in 1997. Other implications include a growing young population, increased dependence on the breadwinner and, more importantly, a greater concentration of wealth in the hands of the working class. Whatever the fundamentals are, it translates to a decrease in the productive population.

I deliberately neglected to imply an increase in productivity, as while earnings per capita has been increasing, there has been a decrease in real GDP growth. How is this possible since greater earnings should imply more productivity? I would propose that the increased earnings have more to do with increased debt levels rather than productivity. Over the same period of declining GDP, we have seen significant increases in the debt, moving from J$196 Billion in 1997 to J$497 Billion in 2002.

The implication is that increased earnings are stimulated through the injection of borrowed money. It is only recently that we have seen any growth in GDP and, even so, it has been marginal and equivalent to earlier declines. This means that debt is being used to create earnings without any productive assets to support it. Thus, the debt is being channeled significantly towards consumption, rather than capital investments. On the other hand, it could be argued that the debt was necessary to spurn consumption and positively affect growth, which will inevitably feed on itself.

This situation again follows the argument above regarding the underutilisation of property and human resources. Here, we are again underutilising financial assets. In all areas, we seem not to be using our resources in the most productive manner. This problem may be as prevalent in the private as in the public sector and it may do well to do some research in this regard. The Government seems to have recognised this, and is attempting to address it through its public sector modernisation programme, but is already at a disadvantage as decades of cultural and infrastructural acceptance of waste is difficult to overcome.

Apart from the non-use of assets, we also have been placing emphasis on industries that have long become unproductive and uncompetitive, thereby not using our assets in the most effective and productive way.

Whatever the approach, we must put to productive use the many idle and unproductive resources existing in the inner city. This necessitates a shift in the social and economic paradigm of the country. If we are not able to fully leverage our assets and make them productive, then we are already at a disadvantage in a global environment.
It is within this context that the work of the Kingston Restoration Company is critical to the future of our country and the Government and private sector must be applauded for the effort being placed on this venture. The Government has also shown its intention to focus on the renewal of the inner cities, which can only be beneficial for the country and should be supported by all. If we can address this, focus effectively, then many of our economic and social problems will be resolved.