Mintzberg on Bonuses

In an article in the Wall Street Journal (click on title link), management guru, Henry Mintzberg, questions whether directors' bonuses are necessary at all. A very timely question, in my opinion. There is little evidence that bonuses create long term value or that managerial talent is in very scarce supply. My personal preference would be to pay CEOs a fixed multiple of the average salary in the organisation. At least it would stop directors pay increasing faster than the average and it would be an incentive for companies to give a better deal to their low paid workers.

Politicisation of Accounting Standards

The article in the title reports the Association of British Insurers bemoaning the EU's refusal to endorse IFRS 9 'Financial Instruments'. ABI spokesperson, Paul Vipond, regrets the 'politicisation' of accounting standards.

Is politicisation such a bad thing? Standard setters are in business making rules about how companies keep score. These rules can have real economic effects that make some people better off and some people worse off. For example, many people hold the pensions standards partly to blame for the demise of final salary pension schemes. Now, this kind of decision about wealth transfers is quite rightly in the political domain - our elected representatives should be the people making these decisions, not a private and largely self perpetuating organisation, such as the IASB.

The IASB likes to pretend that its work is purely technical and that it is devoted to improving the way that financial statements 'tell things as they are' so that decision makers are more fully informed. By denying that accounting standards involve choices that affect individuals and companies, the IASB attempts to avert criticism about its legitimacy.

If IASB were doing its job properly it would be looking at the likely economic and social impact of its standards.

Bob Monks lecture

My thanks to the corporate governance blog for drawing my attention to this lecture by Governance Guru Bob Monks on the past, present and future of governance. There is an accompanying paper at:

http://www.ragm.com/BlogPosts/HLSClass111009.pdf

A clash of philosophies?

The EU has deferred accepting the IASB's new standard on financial instruments (IFRS 9). According an article in the FT (see title link) this is because some EU countries (principally Germany, France and Italy) see a role for financial reporting in maintaining stability of financial systems, whereas the IASB doesn't.

This seems to be a case of the IASB being misled by its own propaganda. Although the constitution of the IASB gives it a role in wider economic matters, it steadfastly refuses to admit that its narrow focus on the presumed interests of capital providers may not provide those benefits.

In a recent lecture at the Institute of Chartered Accountants, Professor Mike Power suggested that, in relation to 'fair value', people could divided into fundamentalists and pragmatists. The fundamentalists couldn't see any alternative to fair value whereas the pragmatists' main interest was in whether accounting standards worked or not. His main point was that because of different philosophical standpoints the two groups of people couldn't understand each other's views.

In particular the 'fundamentalists' (I think he may have included the IASB staffers in this category) can't understand the objections other people have to their standards.

A useful website

The title link is to the World Gap Info website that provides access to news, commentary and the full text of International Standards without the need to register and login at www.iasb.org.uk.

New financial instruments standard

The IASB has just published a new standard as part of its project to update IAS 39 on the measurement of financial instruments. Accountancy Age (see title link) refers to this as a 'fair value' standard which is confusing as there is another ongoing project to redefine what is meant by 'fair value'. The IASB's press release about the new financial instrument standard is here. At first sight this looks like a considerable reversal of the trend towards fair value for everything but the Europeans are still suspicious that it might lead to an increase in use of fair value rather than the reverse.

Fair Value and Accounting Politics

The title link is to an article in the FT about the European reaction to the IASB's proposals on fair value accounting. The IASB proposes to reform the unsatisfactory IAS39, which classifies financial instruments into somewhat arbitrary categories. There will be the option to value items with predictable cash flows on an amortised cost basis (like a tangible fixed asset) rather than marking to market (fair value). However the EU is worried this will disadvantage European banks in comparison with US ones that account under different rules.

The moral of this situation: financial reporting is strongly influenced by politics and competition whatever the theoretical arguments may be.

Monitoring Board

In January 2009, the IASB formed a 'monitoring board' composed of representatives of international regulators. Said board has been fairly quiet but has just said that standards should be 'reliable, relevant, understandable and comparable'. This is an interesting straw in the wind because it reflects the old wording of the IASB conceptual framework, not the proposed new wording, which replaced 'reliable' with 'faithful representation'. Words matter and this was not just a cosmetic change. 'Faithful representation' was seen by some commentators as part of an ongoing trend to move towards fair values.

Another term, another financial crisis

The world seems to be a more stable place than it was a few months ago. The stock market has had a record run in the last quarter, house prices are stabilising, even the pound has stopped falling against the Euro.

Does this mean the financial crisis is over? I doubt it. The public finances are a mess and we can't see any fundamental change to them until after the election. What then? My guess is that whoever wins is going to squeeze public expenditure hard. Universities, inter alia, will be in for a thin time of it. However the size of the cuts needed to reduce borrowing to manageable levels is enormous. The alternative course of action - a rousing bout of inflation - is going to look awfully tempting to whoever wins the election. Index-linked bonds anyone?

The trouble with markets

Roger Martin argues (see title link) that linking managers rewards to share prices (eg with options) gives them an incentive to manage the 'expectations' market rather than the real market for production of goods and services. He fingers efficient markets theory, shareholder value and agency theory as the intellectual culprits and advocates reward based on 'real' performance.

He has a convincing case and a corollary of his argument would be a return to historical cost accounting rather than the use of fair values, which are based on the expectations market.

The unacceptable face of capitalism reborn?

The title link is to a report that hedge funds are buying poor quality corporate debt in order to take over ("loan to own") or liquidate ("loan to bust") the issuing companies. Edward Heath dubbed some of the activites of Tiny Rowland's Lonrho as "the unacceptable face of capitalism". We seem to be seeing that face in a new guise.

Accountants plead for protection

In possibly the least unexpected news item of the year, Accountancy Age reports that the Big 4 are seeking immunity from law suits arising from the credit crunch. Perhaps they should have thought a bit more about the risks their financial clients were running.

Financial Oligarchs

Writing in the FT, Martin Woolf asks whether 'America is the new Russia'. The power of the financial sector to influence government and attract subsidies from the public purse is corrosive. Graphs of relative wages and financial sector profits show how much hold the financial sector had generated over the economy as regulation was reduced.

Will increased regulation, which everyone now expects, reverse this? The volume of noise generated by interested parties seeking to reduce the impact of regulation makes one wonder whether new regulation will be toothless.

Credit crunch humour

Here is a piece of internet humour about the credit crunch, I'd attribute it if I knew the author. For the moment credit it to 'anon'.



The Credit Crunch Explained

At last! An explanation I understand...

Heidi is the proprietor of a bar in Berlin. In order to increase sales, she
decides to allow her loyal customers, most of whom are unemployed
alcoholics, to drink now but pay later. She keeps track of the drinks
consumed on a ledger (thereby granting the customers loans).

Word gets around and as a result increasing numbers of unemployed alcoholics
flood into Heidi's bar.

Taking advantage of her customers' freedom from immediate payment
constraints, Heidi increases her prices for wine and beer, the most popular
drinks. Her sales volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes
these customer debts as valuable future assets and increases Heidi's
borrowing limit. He sees no reason for undue concern since he has the debts
of the alcoholics as collateral.

At the bank's corporate headquarters, expert bankers transform these
customer assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities
are then traded on markets worldwide. No one really understands what these
abbreviations mean and how the securities are guaranteed. Nevertheless, as
their prices continuously climb, the securities become top-selling items
because (insert here the name of your financial advisor) recommended them as
a good investment.

One day, although the prices are still climbing, a risk manager of the bank,
(subsequently of course fired due to his negativity), decides that the time
has come to demand payment of the debts incurred by the drinkers at Heidi's
bar. But of course they cannot pay back the debts.

Heidi cannot fulfill her loan obligations and claims bankruptcy.

DRINKBOND and ALKBOND drop in price by 95%. PUKEBOND performs better,
stabilizing in price after dropping by 80%.

The suppliers of Heidi's bar, having granted her generous payment-due dates,
and having invested in the securities, are faced with a new situation. Her
wine supplier claims bankruptcy, her beer supplier is taken over by a
competitor.

The bank is saved by the Government following dramatic round-the-clock
consultations by leaders from the governing political parties.

The funds required for this purpose are obtained by a tax levied on the
non-drinkers.

Some serious arguments against fair value accounting

The title link is to a very thoughtful and authoritative set of arguments against fair value accounting by a previous chair of the Federal Deposit Insurance Corporation. William Isaac argues, cogently, that the current recession is largely caused by mark-to-market, aka 'fair value', accounting and that the previous, historical cost system served us well for decades. He argues the Savings and Loan crisis of the 1980s had the potential to be much worse than the current crisis but serious harm was averted because banks were permitted to carry items at the lower of cost or economic value rather than being required to mark them to temporary unrealistic values.

My thanks to Stella Fearnley for pointing this piece out to me.

Sue the auditors

Former Chancellor Nigel Lawson and 'semi-house trained polecat' Lord Tebbit have both suggested that the auditors of failed banks might be sued by the government. If they did so the auditors would doubtless rely on the defence that they reported the fair values of the assets held by the banks. It would be an interesting case and well worth arguing in court in order to clarify the role of the auditors.

The FSA report on the current crisis is likely to make some interesting observation of the pro-cyclical nature of banks' accounting.

Sants and sinners

All right the title is a bit forced, but the link is to one of Peston's Picks on the BBC website. Peston examines a speech by Hector Sants of the Financial Services Authority where Sants says

"Markets have shown not to be rational; excesses have not been corrected by market discipline".

Peston draws the lesson that markets won't stop management making stupid decisions. He doubts that the FSA would be able to stem the tide of irrational exuberance on its own and concludes that only expert non-executive directors would be up to the job.

Jack Welch says shareholder value a 'dumb idea'. Last 28 years a mistake.

In an article in its 'Future of Capitalism' series the FT has interviewed Jack Welch the legendary ex-CEO of General Electric and the man widely regarded as the father of 'shareholder value'. He now rejects shareholder value as a strategy, calling it 'insane', but suggests shareholder value is an outcome of good strategy based on employees, customers and products.

This is yet another straw in the wind indicating the end of Anglo-Saxon capitalism as we know it, and it is to be hoped, the equating of 'liberal democracy' with the freedom to make as much money as possible.

Along with squadrons of flying pigs, look out for Francis Fukuyama explaining that history wasn't dead, merely tired and shagged out after a long squawk.

Costing: a warning for the unwary

A widely used text book, Jones's 'Accounting' says

... costing concerns (1) setting a price for a product or service so that a profit is made and (2) arriving at a correct valuation for stock. (p379)

This is seriously in error and we shouldn't be teaching it to vulnerable young minds. Using costs to set prices is a way of going bankrupt quickly. Prices need to be set at the price that will optimise profits, which is largely determined by the market. Using costs to set prices is likely either to set prices too cheap, in which case profit opportunities are lost, or too expensive, in which case volumes will be too low earn the best profit.

Valuation of stock is a relatively minor function of costing, since it is only about finding a number to attach to stock in the financial statements and should have no substantial economic consequences. The notion that there is a 'correct' value is something beginners in management accounting should be warned about. All management accounting valuations are essentially arbitrary to some degree. What is important is to know how the application of the arbitrary rules is likely to affect decision taking and distribution of wealth.

In my view, management accounting is firstly about maintenance of control within organisations. Costing is a process of accumulating costs so that someone is made responsible for keeping them under control.

The second purpose of management accounting is to provide information for taking decisions - but the people taking the decisions really ought to understand where the numbers come from so they can work out what is going on. Sadly, that is often not the case.

The third thing that management accounting does is to consolidate the position of those in power in the organisation, for good or ill. Not only are they provided with information that others don't have, but they also get to decide on resource allocation through the budgeting system. By labelling your group or department as being in deficit (for example by allocation of central overheads) the people in power get the chance to intervene, demand cuts, veto appointments and do all sorts of other damage. Again, sadly, people often believe deficits have more substance than they do. Management accountants like deficits. Deficits give them power. They get asked to write reports and join task forces looking for cost savings and all kinds of other exciting stuff. People defer to them and ask their opinion. When everyone is making a profit, accountants don't have much to contribute. Their role is not to comment on strategy and they don't know about marketing or product development issues so they tend to be ignored or reduced to number-crunchers.

Odd man out

Who is the odd one out?

Lord Stevenson, former chairman, HBOS
Andy Hornby, former chief executive, HBOS
Sir Fred Goodwin, former chief executive, RBS
Sir Tom McKillop, former chairman, RBS
John McFall MP, chairman of Treasury select committee
Alistair Darling, Chancellor of the Exchequer
Sir Terry Wogan, presenter of Radio 2 breakfast show.

Answer: Sir Terry Wogan. He is the only one with a banking qualification.

(Courtesy of Private Eye)

Those in power determine what counts as knowledge

The title is a summary of one of the ideas of Michel Foucault and has particular application to accounting. No better illustration of this is to be found than in the pensions debate and the current hoo-ha over the Post Office Pension Fund. We are told that the fund is in deficit, that this is a bad thing, the pensions of current pensioners and employees are at risk and urgent action must be taken. The solution is to sell off the Post Office to provide private capital, (at the same time as banks are being nationalised because of the failure of private capital).

My point, however, is that the idea of a 'deficit' is highly contestable. The deficit is the difference between the market value of the fund's assets compared with a discounted cash flow value of the fund's liabilities. Matching these two quantities is not what matters. The important thing is that the future cash flows of the fund are adequate to support the future cash outflows into the far distant future. Getting the funding of the pensions right is a serious matter, but it is not urgent.

We all know stock markets are down at present but we also know that dividend streams are far less volatile than stock prices. Pension funds used to be valued on the basis of projected future dividends interest flows and that is far more relevant to the long term solvency of the fund than temporary stock market fluctuations. We can only know the extent to which the Post Office pension fund needs long term support when someone gives us some sensible projections about future cash flows.

To the extent that there is a pensions crisis at all (I'm not convinced there is one) it has largely been caused by two things: firms taking contribution holidays when stock markets were high, because funds seemed overvalued; and, the effective removal of tax relief on dividends received by pension funds. Now, let me see, who was responsible for that? Ah yes, Gordon Brown.

For the time being, it is politically expedient to talk up pension deficits, so don't expect any sense on the matter any time soon.

How long can you wait?

Writing in the FT Managed Funds Section, John Authers reviews Elroy Dimson, Paul Marsh and Mike Staunton's 2009 edition of the Global Investment Returns Yearbook. He comments:

The FTSE-100 is still languishing far below its all-time high, set at the end of 1999. According to the yearbook, using the historical risk premium, the odds are only 50/50 that it will get back to that peak by 2018, on a capital appreciation basis.

Indeed there is a 25 per cent chance the FTSE will not even have regained its peak by 2033 (on a total return basis, with dividends reinvested, it should get there much quicker).

Numbers like this suggest anyone aged about 50 in 1999, who invested in the FTSE safe in the knowledge that stocks are best in the long term, would have reason to feel angered.

With the FTSE just over 4000 and with a P/E of about 9 stocks are selling just below intrinsic value on the basis of past history. Have we moved into a new world or will previous patterns reassert themselves? My guess is we haven't moved into a new world - new dawns are often hailed but seldom arise.

An amazing revelation?

Writing in the Financial Times, Matthew Engel reports noticing an astonishing gaffe by one of the bankers being interviewed by MPs about the Credit Crunch.

Two revelations stood out. One was a phrase that came out in mid-waffle from Lord Stevenson, who startlingly referred to “the balance between the sales culture on the one hand, and caution and integrity on the other”, thus suggesting an organisation so dysfunctional that these were incompatible.

Just how much integrity was the bank willing to sell for each pound of Sales?

What shall it profit a company if it loses its reputation?

Barclays Bank published its final results for 2008 and reported what a appears to be a healthy profit of £5.2bn after tax. However two items are worth a second look. Included in the profit is £2.4bn of gains on assets acquired from Lehman Brothers after the collapse. Marking to market can have odd effects where so-called 'bargain purchases' are made.

The second item is even more remarkable. The company recorded a £1.6bn gain on its loan notes. The reason for the gain is that Barclays credit worthiness has deteriorated since they were issued and the company is recording a profit because of it. When the EU adopted IFRS standards it originally forbade companies to treat their own financial instruments at 'fair value through the income statement'. However in 2005 the 'carve out' was removed and companies were allowed to designate some instruments as being treated at fair value.

What shall it profit a company if it loses its reputation? In Barclays' case it seems to be £1.6bn.

RIP EMH?

The title link is to a Times article that almost makes a good point. The Efficient Markets Hypothesis (EMH) says that securities are priced taking into account all publicly available information. It doesn't say the price of a security is an objective assessment of value. A consequence is that one shouldn't be able to beat the market by using public information.

However it seems to me that the EMH has been asked to bear too much weight for regulatory purposes. In particular EMH seems to justify using current market prices in mark to market accounting, but prices are not values and reporting prices only reflects back at the market what it already knows.

Economist admits error shock horror

In an unusually frank article (see title link) Anatole Kaletsky reviews his predictions for last year and why he got them so wrong. He gives three reasons for the September 2008 meltdown in markets:

1) The surge in oil and commodity prices driven by speculation
2) Regulatory blunders culminating in the decision to let Lehman fail but sparked by 'mark to market accounting'
3) Ideological adherence to a belief that the 'markets are always right'.

Predictably, Ian Powell, chair of PWC the largest UK accounting firm, jumped into the debate to defend fair value, using the hackneyed mantra that fair value reflects 'reality'. Accountants in official positions spout this cliche over and over again. There are two things wrong with the view:

1) No one is arguing that fair values should not be reported as footnotes, only that they should not be used for measuring profit, hence there would be no loss of transparency if the role of fair values was reduced in profit-measurement.

2) Fair value is not 'telling it like it is', it is reflecting an error prone market value back at the market. As defined by SFAS 157, fair value is effectively an estimate of the price of an asset that isn't going sold, as agreed between two hypothetical participants in a market that doesn't exist. This is certainly not 'reality'.

To his immense credit Powell says quite explicitly:

However, fair value accounting is pro-cyclical and on its own this does carry risks for the banking sector.

If everyone could be persuaded to agree to that proposition and that financial reporting has a role in maintaining market stability, then it is possible some progress could be made in improving financial reporting.