Jay,
I too read the article this morning, and told myself, 'here they go again'. At this point, I would like to point out some fuzzy feelings I have on a closely related subject, and over which I wrote my concerns in general last week, but they're somewhat clearer now. If there are experts on this field on this thread, I would dearly like to receive their comments, concerns, assurances or clarifications.
The subject I wish to cover is hedge funds, but broadly speaking, derivatives, as is the case with this RD situation. I have the following concerns:
a) some years ago, when I was responsible for the accounting operations of DEC (Digital Equipment) at its European Headquarters, we always had trouble applying the relavant FASB pronouncements on forward foreign exchange contracts. The relevant GAAP standard, #52 was subject to a lot of interpretation, so much so that at the end of each quarter, we were required to post 'adjusting entries' to get the currency translation results 'right' for Wall Street.
The adjustments were never intended to meet WS expectations, rather the results were just too fluid to interpretation by the experts in Controllership, Treasury, and oh yes, the Auditors. At times the Tax Dept was involved too, as the forex contracts were typically taken by tax haven based entities.
A few years later, SFAS 52 was replaced by the infamous SFAS 80 which imho, only added even more confusion to the subject, esp with respect to companies which were engaged in consolidation of both operating as well as tax haven-based legal entities, each doing different things.
The net result has been that forex accounting continues to this day to be a 'black art', and understood by a precious few, highly specialised, nerdy type accountants and treasury folks.
No doubt everyone will recall how many companies have lots bundles on their foreign exchange accounting in previous years, with little explanation as to how these losses occured.
b) In recent years, the simple forward contract for forex trading has been augments by options, swaps, and all forms of derivative instruments, the accounting for which, I do not recall, has been properly clarified by the FASB.
c) The truly worrying aspect, which is the reason for this note, is that the underlying logic of the above 'hedging' instruments has now been extended to metals, energy and every other form of commodity trading, much like the exotic instruments RD appears to have entered into, and which were the cause of demise of Enron, and what would appear to be also contributory in the case of WCOM, Global Crossing and Enron.
In many of these contracts, the FASB has failed to understand the accounting concepts involved, and has, imho, over the years, failed to 'regulate' the proper, GAAP accounting treatment, that ANY Big 5 Accounting Firm could advise on, and thereafter, with a good Chinese Wall within the firm, audit the relevant company's accounts as well.
d) The other causal factor in Enron's demise, imho again, is the use of the SPE's (Special Purpose Entities). Since WS required ever increasing EBITDA, ROE and consistent meeting of WS analyst estimates, these SPE's were formed, which allowed for off-balance sheet accounting.
Again, the FASB has hitherto failed to understand the true financial implications of, let alone regulate on, the tremendous impact these activities had on the company's long and short term financial performance, ie the eventual goal of earning 'true cash' to justify the invesments shareholders made in these companies.
e) Another factor that contributed to this state of affairs is the increasing involvement of maths types in the conceptualisation, creation, entering into and ongoing management of these derivates in most companies. Having watched "A Beautiful Mind", one realises how complex some of these derivatives calculations have become, and how the line is oftentimes ever so casually, sometimes by 'black art' economic gobbledygook, and other times, these Nobel Economics Prize winning formulae, to justify the entering into of these derivatives and then going on to accounting for them, often to the benefit of the companies short term profit goals.
Anyone who has had a close enough experience with calculating the value of stock options, using the Black Scholes model, will attest to what I'm talking about, as the model starts out being simple enough, but in almost every instance, the valuation of the stock option never stands the test of 'does the actual ever actuallly equal the original valuation'.
f) I've been reading quite a lot on hedge funds, and I have to admit, that I am more than worried at the reported profits of these funds. A few tentative conclusions come to mind:
- I would dread being an auditor of any of these funds, as they are largely still, to this day, unregulated by appropriate SFAS by the FASB, to provide clear transparency to the investors in these funds.
- These funds, I suspect, can easily justify continuing profits on the basis that their derivative activities are 'continuing', and therefore, the 'negatives' are overwhlemed by the 'positives', something akin to the Nasdaq bubble of a few years ago.
- The people who run these funds are nerdy types, very brilliant, but their operations cannot be understood by the normal Big 5 auditors...Andersen types probably could make a start, but they too are history.
In conclusion, I feel, we are on the crest of something much worse than anyone imagined, in terms of corporate trust and reliance on financial results, which, in many ways, makes the allure of our golden metal all the more alluring....
Have a nice day,
Selva |
