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You want me to do what?

Complex financial arrangements have to be brought into the books.

In their scramble to create value for shareholders, fund overpaid executives and take out competitors, companies can fall prey to the various dirty tricks that can be used to create revenue, obscure wealth, hide debt and conceal or recharacterise transactions.

However, even the most complex of financial arrangements have to be brought into the books, usually via the journal entry. And the person who dreams up the particular, sometimes convoluted, journal entries is our hapless accountant. Yes, that often over-qualified extremely bright gatekeeper of financial morality, the bean counter.

Those tasked with checking the entries and the transactions are the internal auditors, and finally, the external auditor. Don’t they stop to think?

Examples of complex arrangements

  • The holding company incurred a tax-deductible expense, but doesn’t have any taxable income? No problem – engage in a complex series of transactions to either pass the tax-deductible expense down to a company in the group that can utilise it, or obtain ‘taxable income’ that is passed on from another group company.

  • A company has received a massive amount of interest on an investment and needs to ‘shelter’ it from taxation? No problem. It can enter into a complex round of partnerships or joint ventures from which it can share expenses, or create expenses. The list of possibilities is endless.

  • A company requires funding for its business, but is already in a tax-loss position? No problem. It can enter into various partnership structures in which it can share (sell) its tax base to a company that has a tax base.

  • A company has valuable intellectual property but doesn’t want to incur any tax expense on licencing it out? Not a problem. Lend it to an offshore partnership/joint venture. It is not this simple, however, but further complex arrangements can be entered into to deal with the income generated by the partnership/joint venture.

  • An offshore investor ‘funds’ a management buyout. How? Form a new company that purchases the business operations of the existing company, but at inflated values – using debt. Often offshore debt. The interest is tax-deductible. Is the interest payable ever taxed anywhere? Most unlikely. On a more cynical note, South Africa will tick this off as a direct foreign investment.

Accounting ‘standards’

The objectives of accounting standards are to make companies more comparable, and let us not forget about the requirements of transparency, consistency, reliability … Unfortunately, accounting standards are not aligned. While we have International Financial Reporting Standards (IFRS) and the International Accounting Standards (IAS), many countries follow their own standards, such as the Generally Accepted Accounting Principles (Gaap) used in the US. Being 95% similar to IFRS doesn’t always cut it.

IFRS is extremely complex, and the statements are written in long-winded legalise. They are difficult to follow, and extensive – IFRS 9 is some 650 pages long. In addition, the standards are peppered with subjective judgements, leaving them open to abuse.

Is IFRS abused?

  • A company has an accumulated assessed tax loss, and is of the view that the assessed tax loss will be utilised in the future. Sure, look at all the companies that have tanked over the last few years. If the company genuinely believes it will claw back the assessed loss, it can create a deferred tax asset (assessed loss x tax rate) as provided for in IFRS 12. The journal entry is: debit deferred tax asset, and credit income. Yup, income. Is this open to abuse?

  • Mark-to-market accounting is used to value financial assets at the current market price. Adjustments are taken through the income statement. Financial assets include shares, bonds, options and swaps. Valuing an option or a swap is fraught with difficulties. Does the average auditor have the skills to value these? How long does it take the international accounting fraternity to react to a scandal like Enron? Enron is old hat. Let us start counting the days (years) it will take for IFRS to be tightened following the Steinhoff and countless other recent international accounting scandals.

  • Goodwill. Where the purchase consideration is greater than the assets and liabilities, goodwill must be recognised (IFRS 3 and IAS 36). Goodwill should be tested every year, and impaired if necessary. Huh? I can think of a few companies that overpaid for acquisitions and have goodwill on the group balance sheet. Where are the auditors? But what is goodwill? It isn’t visible, it cannot be separated from the business operations, and it cannot be sold. Some companies would be technically insolvent if the goodwill evaporated. But IFRS mandates that it must go onto the balance sheet, and impaired when necessary.

  • Intellectual property (IAS 38) – valuations range from discounted cash flows to pie-in-the-sky dreams. Intellectual property can include rights that are embodied in an issued patent or a registered trademark, or  information included in a company manual. Some intellectual property is easier to value than others. But who is verifying the valuations? The auditor? We have some recent examples on listing that could have included overvalued companies. What do the auditors say?

  • Cash and cash equivalents (IFRS 9). This includes short-term investments with a maturity of less than three months from the acquisition date. Available-for-sale financial assets are measured at fair value. Cash is cash – until it isn’t. We have some recent examples of cash that wasn’t fungible. It couldn’t be exchanged for anything. It was a ghost.

Professional scepticism …

Accountants are now supposed to apply professional scepticism, whether they are working as an accountant or an auditor.

Will a partner be comfortable if a young accountant disagrees with the manner in which a transaction has been treated by a company that happens to be a key client? Will that young accountant be seen as obnoxious and troublesome?

It may take some years for behaviour to change.

 

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Just my 2 cents:
Deferred tax assets – from my experience most companies running at a loss struggle to prove objectively that there will be future profits and don’t recognise deferred tax assets. But even if they do, the other side of the entry is a credit to tax (so you could end up with a negative tax figure) I wouldn’t go so far as to call this an income. Plus, this “income” would be sitting below the “profit before tax” figure so would be excluded from many of the performance indicators such as EBIT and EBITDA which are more commonly used to determine a company’s performance.

Mark-to-market accounting and intellectual property – You ask if the average auditor has the skill to value these and the answer is generally no. But any audit firm big enough to audit a listed entity would have a team of professionals specialising in these valuations as well as qualified actuaries to look at complex areas such as pension valuations. If the auditors don’t have access to these teams they would use a qualified third party to assist in the audit.

Goodwill – I see your point here but are you implying that if a company acquires another entity for an amount greater than the net assets of that entity, then the difference should be expensed immediately? How would that result in more accurate reporting? Although this may be appropriate where they have clearly overpaid but, in many cases, there is intangible value in the acquisition which can’t otherwise be recognised.

IFRS may not be perfect but its main aim is to present a true reflection of an entity’s performance and value provided it is not abused. If you remove all the areas of IFRS that allow for estimation it may make the auditors’ work easier but will make the job of the users of the financial statements much harder in determining whether to invest or not.

Good read Barbara. As an article clerk, I agree that there is shortcoming in IFRS is applied and how auditors apply professional skepticism.

“Is IFRS is abused?” typo

Yes, more skeptisim would be great but you also have to consider the realities of companies wanting the cheapest audit with shortest timeline which I suspect means clerks work mostly with long hours. Hence looking at complex structures (these don’t see that complex on first viewing) should be the value that the partner or experienced manager adds to the pot and perhaps that is a area that can improved on. You are also asking auditors to be specialists in IFRS, company structuring, tax and law which is unrealistic, they should be outsourcing where they don’t have the skills but it circles back to the fees for audits being quite low.

“In the annual financial statments, there are only 2 figures you can trust. Those are the page numbers, and the dividend payout, because you can verify the latter in your bank account.” – Warren Buffet

Thank you Barbara, for highlighting a number of complexities.

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