Reference no: EM131341218

Badly in need of repair
Read this extract from ‘Badly in need of repair' (The Economist, 2 May 2002). Which accounting conventions/concepts does it refer to? Think of examples of these conventions which are bypassed thanks to some legal loopholes. Base your discussion on examples from your own country.

Off-balance-sheet holes
Accounts certainly rely too heavily on historic costs. But what concerns investors far more is the stuff that lurks beyond the balance sheet. Although numbers recorded on the balance sheet are often misleading, investors can adjust them by using information that companies are obliged to disclose elsewhere. The worrying thing about so-called ‘off-balance-sheet items is that they can appear suddenly out of nowhere, without warning. There may be clues in the footnotes, but few people pay close attention to these impenetrable bits of legalese.
Special-purpose entities (SPEs) are a sort of non-consolidated, off-balance-sheet vehicle that have some legitimate uses, such as, for example, the financing of a research and development partnership with another company. They can, however, also be used to shove nasty liabilities and risks into corners where, with luck, nobody will see them. At the moment, investors are assuming that they are being used mostly for the latter purpose.

In November 2000, Enron restated its financial statements, reducing its profits by $591m over four years and increasing its debts by $628m. Most of the restatement came from the consolidation of two SPEs. America's standard-setter, the Financial Accounting Standards Board (FASB), points to Enron's restatement as evidence that it was the energy trader's disobedience that was the problem, not the rules on special-purpose entities.

Another of Enron's special-purpose vehicles, however, called LJM2, stayed off its balance sheet in accordance with FASB standards. And there are many more SPEs out there, notably off the balance sheets of companies which securitise (ie, repackage and sell on to investors) large chunks of their assets.

Another example of off-balance-sheet deceit is the dry-sounding yet potentially dangerous phenomenon of commitments, a variety of contingent liability. A company commits itself to a future contingent payment but does not account for the liability. Telecoms-hardware manufacturers, for example, often guarantee bank loans to important customers in return for buying their products. That is fine so long as the business is healthy, but if a company enters into such a transaction purely to lubricate its own cashflow, the commitment can become a risk. At the moment, according to American, British and international accounting rules, many varieties of commitments are mentioned only in footnotes since there is, in theory, only a low probability that they will crystallise.

Operating leases, through which a company agrees to rent an asset over a substantial period of time, make up most off-balance-sheet financing. Airlines use them to clear their accounts of large numbers of aircraft. The practice helps to avoid tax, but it also results in a drastic understatement of the airlines' debt, according to Trevor Harris, an accounting analyst at Morgan Stanley Dean Witter. In 1997, one-third of the aircraft of the five biggest American airlines were treated as operating leases rather than as assets.

Needless to say, this is all done in accordance with accounting rules. Standard-setters have come up with hundreds of pages of rules on operating leases, but they have failed to get companies to admit what any analyst knows: that airlines reap the economic risks and rewards of their aeroplanes and ought to treat them as assets.

Unlike off-balance-sheet financing methods, most of which date from the last 15 years or so, the trick of recognising revenue too early (or booking sales that never materialise) is an old one. Global Crossing, a bankrupt telecoms-equipment company now under investigation by the Federal Bureau of Investigation and the Securities and Exchange Commission (SEC), is accused of swapping fibre-optic capacity with a competitor as a way to manufacture revenue. And according to the SEC, Xerox, a photocopier company, wrongly accelerated the recognition of equipment revenue by over $3 billion. Standard-setters admit that no country has adequate rules on the recognition of revenues. A solution in the meantime may be to look at cash, which is far harder to disguise or invent. Comroad duped its auditor about its revenues, but it could not conceal the fact that its cashflow was negative.