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Enron's demise gives rise to issues over Telecom accounts

By Alan J Robb and Sue M Newberry

Friday 15th March 2002

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Theresa Gattung
The Securities Commission recently ruled Telecom's interim results were accounted for in accordance with New Zealand financial reporting standards. Subsequently, chief executive Theresa Gattung was reported as saying the Enron collapse could not happen in New Zealand "because our accounting standards make sense - they reflect the economic substance of the transaction."

Reporting economic substance, however, is only a general principle that seems often ignored; financial reporting standards cover only some of the many transactions and arrangements businesses engage in and may be silent on some matters.

Financial reporting standards-setters cannot be expected to anticipate every innovative transaction likely to be devised, and there exists an advisory industry in creative ways to avoid or subvert both the spirit of accounting standards and the objectives of financial reporting.

The reporting company is responsible for ensuring its financial reports give a fair presentation of its affairs, and its auditors are responsible for commenting in the absence of such a fair presentation.

In 1994, the commission's report on Applefields argued that strict compliance with accounting standards, even if combined with disclosure in the notes, is not good enough if what is reported in the body of the financial statements is likely to mislead the report's users.

The commission noted the existence of a UK standard on reporting the substance of transactions and invited the accounting profession to develop a local standard based on it. No such standard has appeared. Maybe it is time one did if, as Ms Gattung argues, reporting economic substance will help to prevent companies here from misleading investors.

Among the many concerns about Enron's activities were the way it used off balance sheet entities to conceal debt and inflate profits. The issues that gave rise to the recent inquiry were Telecom's treatment of the purchase and sale of cable capacity, which contributed $28 million to Telecom's reported result, and the pre-payment of cross border finance leases, which contributed a further $34 million. In total, these added 20% to the reported financial result and affected Telecom's reported gearing.

In light of Enron, however, another of Telecom's accounting treatments also requires thought. This is the treatment of dividends received from loss-making associate companies. This occurred in the year ended June 30, 2001 and so was not included in the commission's review.

Telecom reports three associate companies: Pacific Carriage Holdings, Southern Cross Cables Holdings and AOL Australia Online Services. The last-named is incorporated in Australia, the others in Bermuda.

New Zealand's FRS38 Accounting for Investments in Associates requires the use of equity accounting for reporting such investments. The investing company reports its equity investment in the associate and subsequently adjusts that amount for its proportionate share of the profits or losses of the associate.

However, when the losses exceed the amount of the equity investment, the investment is eliminated and FRS38 requires that equity accounting be suspended and remain suspended until the equity investment returns to a positive figure. During the suspension period time an associate might be viewed as an off balance sheet entity. In the year ended June 30, 2001, Telecom reduced its investment in its associates, which had cost $45 million, to zero, thus suspending equity accounting for all of them.

In the same period, one of the Bermudan loss-making associates, Southern Cross, paid $263 million in dividends, of which Telecom reported $245 million as operating revenue. According to the chairman's report, the dividend received from this "splendid investment" increased Telecom's reported after tax earnings by $221 million, or 52%.

Telecom chief financial officer Marko Bogoievski advised that, before writing off the investment in Southern Cross in March, 2001, the group had total assets of $US1.01 billion and total liabilities of $US1.04 billion (of which $500 million represented unrecognised revenue).

Where did this loss-making associate get the money to pay Telecom such a large dividend? It appears it came from Telecom, either from shareholders' advances and reported as an asset in Telecom's financial report ($280 million at June 30), or from money Telecom had paid Southern Cross for the purchase of cable capacity.

FRS38 is silent on the treatment of dividends received from an associate for which equity accounting has been suspended. There is no New Zealand requirement that says Telecom should have reported the $245 million as income, with its resulting effect on equity and reported gearing.

That decision was Telecom's choice based on its assessment of generally accepted accounting practice and what is appropriate for the circumstances, and its decision about what constitutes a fair presentation of its financial activities and results. Obviously Telecom's auditor agreed with that judgment.

Does Telecom's accounting treatment of these transactions reflect their economic substance? How is it that an equity investment of $45 million can be been written down to zero because of losses and yet be described as "a splendid investment?" How is it that a dividend of $263 million could be generated from this zero-value investment?

Given the inaccessibility of information about the associate companies and the nature of arrangements with the other shareholder in those companies, users of Telecom's financial reports must trust Telecom and its auditors on the accounting treatment.

All we can do is point out the existence of Telecom's off balance sheet associates, the effect the transactions with Southern Cross have had on Telecom's financial report, and remind readers Enron used transactions within complex corporate structures to conceal debt and inflate profits.

Alan Robb is a senior lecturer and Sue Newberry is a lecturer in accountancy at the University of Canterbury. Neither holds shares in Telecom

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