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A profit without honour

By Shoeshine

Friday 29th November 2002

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Shoeshine's been hearing a lot lately about how New Zealand accounting standards are so much better than US standards at preventing companies from using accounting tricks that might be used to make things look rosy.

Shoeshine's mate Roger the Dodger is known in the trade as a highly principled accountant. That means he knows just which of the many generally accepted accounting practices (GAAPs) to follow to present things in the best possible way. Shoeshine and Roger have been discussing, hypothetically of course, how a local company might improve things by creating a friendly off-balance-sheet entity or two. The conversation went something like this:

Shoeshine: I hear New Zealand accounting standards are principles-driven and that it would be impossible to create off-balance-sheet entities like Enron did. Is that so?

Roger the Dodger: Yes and no. Our standards are principles-driven but it's very easy to create off-balance-sheet entities. We don't call them Special Purpose Entities as the Americans do but they produce similar results.

Shoeshine: I know accounting standards require subsidiaries to be consolidated and associates to be equity accounted. How would you get around those standards?

Roger: Easily. The first step is to create an associate, Invisible Ltd, and take up between 20% and 49% of the shares.

Shoeshine: Who would hold the other shares?

Roger: Two of the staff of Shoeshine Ltd. But they must not be directors or in key management positions. They would also be appointed as directors of Invisible Ltd.

Shoeshine: Why use such low level staff?

Roger: You don't want "related parties" involved or you will have to disclose quite a lot of information. Related parties are defined as directors and those in "key management positions". So the principle is to comply strictly with the rules to ensure that Invisible's directors and its other shareholders fall outside the category of related party.

Shoeshine: But an associate company isn't off balance sheet.

Roger: Not when it's formed but it will be when Shoeshine Ltd writes off its investment in Invisible. And you must write it off when it makes a loss equal to the capital invested. What's more FRS38 bars you from resuming equity accounting until all the losses have been reversed. Provided the losses are not reversed, Invisible stays off Shoeshine Ltd's balance sheet. Hey presto! You have your off-balance-sheet entity, and then you can use it to make things look much better for Shoeshine Ltd.

Shoeshine: How?

Roger: You said you wanted to improve Shoeshine Ltd's profits and reduce its debt. So Shoeshine Ltd sells goods and services to Invisible, at an "arms-length price" of course. Shoeshine's profits improve and Invisible makes a loss. This way you can write off your investment and none of Invisible's other transactions need be known to Shoeshine Ltd's shareholders.

Shoeshine: But where will Invisible get the money to pay Shoeshine Ltd for its purchases? It can't trade while it's insolvent. I know that much!

Roger: No problem. Invisible can borrow the money which is guaranteed indirectly by Shoeshine Ltd.

Shoeshine: But won't that have to be disclosed in Shoeshine Ltd's annual reports?

Roger: There's a GAAP that lets us get around that. If Shoeshine Ltd guaranteed the loan directly you would have to disclose that and, if Invisible were unlikely to be able to repay its debts, you might have to provide for repayment in Shoeshine Ltd's financial reports. But if the other shareholders ­ who are merely Shoeshine's low level executives ­ provide the guarantees you don't have to disclose that.

Shoeshine: But would they provide guarantees?

Roger: Of course they would ­ Shoeshine Ltd will indemnify them. Then they can happily provide guarantees to the bank knowing it won't cost them anything personally. It's quite common for a company to indemnify any of its staff holding shares, directorships or key management positions in companies in which it has an equity interest. Disclosing the fact that such an indemnity has been given won't cause anyone to suspect you've created an off-balance-sheet entity.

The possibilities are endless for off-balance-sheet arrangements in any of Shoeshine Ltd's investee companies, even those that are not associates.

Shoeshine: And this is all in accordance with New Zealand's principles-based standards?

Roger: Yes, and it's all in accordance with GAAP but it's very important to be transparent about the things the standards cover. You should disclose that you have indemnified your staff and you must disclose material transactions and investments in related parties. So of course you make sure the transactions are not material in the context of the Shoeshine group's total transactions.

Shoeshine: But what about auditors? Won't they have to audit the associate companies?

Roger: No. You simply engage them to audit only the parent and group figures. That way the auditor never produces an audit report on each subsidiary or associate company.

Shoeshine: But don't you have to follow "substance over form" to comply with GAAP?

Roger: No. There's no principle of "substance over form" mentioned in New Zealand's accounting standards. You simply have to follow the legal form where a standard exists. I'm sure Shoeshine Ltd would have very tight audit schedules and that it would be trying to keep down audit costs. You would want the auditors to limit their audit to material associates and subsidiaries. If your investment in Invisible is small, then it will be immaterial.

Shoeshine: Will this sort of thing still be possible when New Zealand adopts international accounting standards?

Roger: Oh, indeed it will. International accounting standards are no tougher or more logical. If anything they have more defects and ambiguities and loopholes.

Shoeshine is now taking a closer look at the balance sheets of listed companies.

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