Category: Accounting

Outsourcing Safety. . . to the Marshall Islands

Just when you thought the BP mess could not get more surreal, this comes up:

The Deepwater Horizon oil rig that exploded in the Gulf of Mexico was built in South Korea. It was operated by a Swiss company under contract to a British oil firm. Primary responsibility for safety and other inspections rested not with the U.S. government but with the Republic of the Marshall Islands — a tiny, impoverished nation in the Pacific Ocean. And the Marshall Islands, a maze of tiny atolls, many smaller than the ill-fated oil rig, outsourced many of its responsibilities to private companies.

Now, as the government tries to figure out what went wrong in the worst environmental catastrophe in U.S. history, this international patchwork of divided authority and sometimes conflicting priorities is emerging as a crucial underlying factor in the explosion of the rig.

Sounds a bit like asking a government to certify the safety of investments—and having it effectively delegate the job to Nationally Recognized Statistical Rating Organizations. Keeping authority in the US may have just made matters worse:

MMS depends largely on the self-reporting of oil and gas companies to determine how much they owe in royalties — a system the Interior Department’s former inspector general, Earl Devaney, described as “basically an honor system” in congressional testimony in 2007. . . . The MMS commonly negotiates settlements with petroleum companies over disputed royalties — but the process is often shrouded in secrecy. A 1996 inspector general report found that MMS officials kept no documents on nine out of 10 royalty settlements, to prevent disclosure under the Freedom of Information Act. In one case, the MMS could provide no records to explain why the agency reduced its estimate of a company’s royalty debt by $360 million. . . . [More errors] sparked outrage in Congress and yet another probe by Devaney, the inspector general. He later called the oversight a “jaw-dropping example of bureaucratic bungling” and said it could cost the government as much as $10 billion.

It has become fashionable of late to contrast enlightened, US-style “free market capitalism” with the “state capitalism” of petro-states like Russia. Anyone familiar with the work of David Cay Johnston or James K. Galbraith would suspect that analysis. Recent oil debacles complicate the distinction even further.

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Danger: Banks Politicize Accounting

Anyone who cares about the reliability of corporate financial information in the US—and everyone should—ought to oppose threatend Congressional action that would expressly politicize accounting standard setting.   Since the 1930s, accounting standards in the US have been set by a private, independent, non-political body called, since the mid-1970s, the Financial Accounting Standards Board (pronounced faz-bee).

Corporate America often hates what FASB requires—on subjects ranging, over the years, from accounting for pensions, mergers, stock options, and, today, financial instruments. It plies friends in Congress to push back against FASB when stakes are high enough. Sometimes that means FASB fights for its life.  (For a scholarly take on this, see Bill Bratton’s insightful BC Law Review piece here.)

An example: in the late 1990s, corporate America got Senator Joe Lieberman to threaten to preempt FASB if it required corporate America to account for stock options—a threat FASB heeded until after that period’s financial frauds restored its insulation from political pressure. (Since, FASB has required corporate America to account for stock options as an expense.  Then-SEC Chair Arthur Levitt recounts the story in his memoir Take on the Street.)

Banks are today’s most vehement proponents of turning accounting standards into political products—detesting FASB’s accounting standards concerning off-balance sheet financing, securitizations, and, especially, measuring financial instruments at fair value.  Banks want to politicize accounting standards because they are extremely good at influencing politicians, but have essentially no power to manipulate FASB directly.  One reason is Washington’s revolving door—banks have teams of lobbyists who formerly worked there, on the Hill or in agencies. Read More

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You, Lehman’s Re-Po Magic, and Ernst & Young

Ernst & Young, one of four remaining large auditing firms, allegedly botched its financial audits of Lehman Brothers, the bankrupt investment banking firm. E&Y responds that its audits met legal and professional requirements.

My view, reported in today’s New York Times, wonders, suggesting E&Y offers a “technical compliance defense,” when what’s needed is an objective judgment, based on professional skepticism, of whether financials provide a fair presentation.

Though the allegations sound esoteric, it is easy to translate them into simple terms.  When considering the following analogue between Lehman’s deals and your personal finance, think about how an independent accountant would assess what I suppose you are doing.

Read More

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SEC Should Calm Markets, Ahead of Possible Audit Crisis

If you thought the 2008 credit crisis that temporarily froze global debt markets wrought havoc, watch out for the next shoe to drop.  At stake is the viability of global equity and other financial markets that could freeze if one of the four large auditing firms goes extinct.

And the existence of one of them, Ernst & Young, is threatened, as it faces the prospect of billion dollar liability for botched audits of Lehman Brothers, the defunct investment bank struggling in bankruptcy. It is an eerie echo of the fate of erstwhile big auditing firm Arthur Andersen, which dissolved after its culpability in 2001’s Enron fraud emerged.

Today, only four auditing firms have the resources and expertise to audit the vast majority of thousands of large public corporations. If one of those dissolved, its clients would have to scramble to find a replacement. Some of the remaining three lack requisite expertise for some of those corporations and others would be disqualified from auditing due to consulting work they do for them.

The result would be hundreds, possibly thousands, of large corporations who could not get their financial statements audited as required by US federal securities law. Stock markets could go berserk, along with other financial markets. The costs now, of moving from four firms to three, would dwarf those incurred when Andersen’s dissolution moved the total from five to four.

It does not appear that the US government, specifically its Securities and Exchange Commission, has any plans to deal with this prospect. It should. And it should announce them promptly to get ahead of any market crisis the failure of E&Y, or of the other three, would wreak. 

If not, the credit crisis of 2008 will look mild in comparison. After all, the credit crisis was readily addressed by government pumping enormous amounts of capital to rejuvenate liquidity; an auditing crisis cannot by solved by throwing money at it. Read More

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A Whopper of an Assumption in Free Enterprise Fund v. PCAOB

In his dissent in Free Enterprise Fund v. PCAOB, D.C. Circuit Judge Brett Kavanaugh characterized the SEC – Public Company Accounting Oversight Board (PCAOB) relationship as “Humphrey’s Executor squared.” His analysis assumes that two firewalls shield the PCAOB’s exercise of executive power from presidential control. First, PCAOB members can be removed only for cause by SEC commissioners. That’s clear enough. Second, SEC commissioners can be removed only for cause by the President.

The strange thing is that no statute says that the President may remove SEC commissioners only for cause. The idea that the President may not remove SEC commissioners except for cause turns out to be only a whopper of an assumption. Removing that erroneous assumption, there is only the PCAOB-SEC firewall to presidential control of the PCAOB and so understood that arrangement looks no worse than Humphrey’s Executor to the first power. Unless the Court is prepared to abandon Humphrey’s Executor altogether, this part of the challenge looks like a loser at this point in time.

The significance of the assumption was not lost on the Court during oral argument.

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The Globalization of Securities Regulation: Competition or Coordination?

Thanks to Danielle, Dan, and entire Concurring Opinions team, for having me back for a return stint.

I write from the University of Cincinnati Corporate Law Center’s 23rd Annual Symposium, on the subject of The Globalization of Securities Regulation: Competition or Coordination?

Our host is Professor Barbara Black, and other panelists include Bill Bratton, Chris Brummer, Hannah Buxbaum, Eric Chaffee, Andrea Corcoran, Steve Davidoff, Jim Fanto, Robert Patterson, and my colleague, Fred Tung.

I mention all this because, for those who may be interested, the symposium is being webcast as I type (and listen to Hannah’s presentation, on The ‘Global Enterprise’ in Cross-Border Securities Litigation).  You can find it here:

https://www.uc.edu/ucvision/event.aspx?eventid=245

And if you have questions you’d like raised, you can e-mail them to Barbara here: corporatelawsymposium@law.uc.edu.

Hope you can join the discussion!

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New Journal: Accounting, Economics, and Law

Scholars like me interested in law as it interacts with accounting and economics will be excited to learn of a new joural offering to link these three fields and many others. Called the Journal of Accounting, Economics and Law, this is a welcome new forum to celebrate study of the relation, too often under-appreciated, among these subjects. The journal’s founding editors are three scholars I’ve come to know and admire, Michigan law prof Reuven Avi-Yonah, Yale accounting prof Shyam Sunder and University of Paris business economics prof Yuri Biondi.  

I’m flattered to have  been asked to serve on the Advisory Board, which boasts many luminous scholars from around the world, including, from the US, Sudipta Basu (Temple, accounting); Jonathan Glover (Carnegie Mellon, accounting); David Kennedy (Harvard, law); my colleague Larry Mitchell (GW, law); Roberta Romano (Yale, law); Martin Shubik (Yale, economics); and Lynn Stout (UCLA, law).

Following is a description of the journal.   Manuscript submissions are encouraged!

“The Journal of Accounting, Economics, and Law aims to encourage a comprehensive understanding of the relationship between individuals, organizations, and institutions in economy and society.

Financial, economic and legal techniques and languages play an influential and neglected role in this relationship. Concerns of finance, control, accountability, responsibility, valuation, regulation, and governance will be raised in their connection with accounting, economics, law, sociology, anthropology, history, finance, political science, and the management and policy sciences.

The journal encourages works that seek to recombine disciplinary domains in response to practically relevant issues, while encouraging theoretical advances and insights, and comparative historical perspectives.”

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Finance Theory and Accounting Policy

Amid the financial crisis, considerable debate attends the enduring validity of Modern Finance Theory, including assumptions of capital market efficiency, reliability of recognized risk measurement tools and models of risk reduction through diversification.  There’s little doubt that MFT has had considerable effects on positive law and legal scholarship in the past three generations.  Looming are questions about whether those policies warrant reconsideration given ongoing discoveries of potential deficiencies in those models.

Some of these implications appear in contexts covered by the broad subject called Law and Accounting, topics within securities regulation, corporation law and financial reporting policy. In writing a paper addressing the influence of MFT on L&A, I’m trying to identify the most significant subjects. In outlining a draft, I’ve identified the following as the most consequential, and would be delighted to hear, through comment or email, alternative suggestions or criticisms of this initial compilation.  Read More

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Accounting 101 and the New Bank Tax

Christine Hurt and Erik Gerding have several good posts at Conglomerate on how the White House tomorrow will formally propose a tax on banks to recover losses government incurred providing capital infusions under the so-called Troubled Asset Relief Program (TARP).

It appears the tax would be computed based on a bank’s total liabilities other than its insured deposits, although some reports say the tax could be based on profits. Aside from recouping costs, the liability approach suggests creating an incentive for banks to avoid incurring liabilities deemed riskier than insured deposits, though without appearing to distinguish among risk types.

Aside from the inevitably contentious debate about the merits, fairness or efficiency of such a proposal, a particularly strange feature is how, according to a Wall Street Journal report, liabilities other than insured deposits would be calculated. The report says that liabilities would be calculated as “the difference between a firm’s assets and its combined equity and insured deposits.” Isn’t this a convoluted way of speaking?

Anyone vaguely familiar with business or accounting knows that owners’ equity equals total assets minus total liabilities. For five hundred years, bookkeepers have used this relationship to define the fundamental equation of accounting. Contemporary corporate law students describe equity as the residual claim on firm assets, reflecting that same subtraction of liabilities from assets.

Isn’t it confusing and backwards then to propose to measure liabilities as the difference between assets and equity (setting aside insured deposits)? Assets and liabilities are the normative categories forming the substantive content of accounting’s fundamental equation. Equity is only the difference between them.

So if you want to impose a tax on liabilities, there is no need to think of them as the difference between assets and equity. Apart from looking forward to hearing the President tomorrow defend the proposal’s merits and spell out its details, I’d like to know whether this reported feature appears and, if so, why it makes any sense.