This article originally appeared in incompliance magazine
A growing number of cases involving undisclosed losses has highlighted the need for greater disclosure and transparency if trust is to be restored in the global financial markets. Peter Wright, James Carlton and Sona Ganatra explain.
The UK regulator recently fined Lamprell Plc for failing to disclose its deteriorating financial performance in a timely manner. This case, together with the ever-increasing catalogue of cases involving undisclosed losses and oversights both in the UK and abroad, has highlighted once again the need for greater disclosure and transparency if trust is to be restored in the global financial markets.
Lamprell, a UK-listed company based in the United Arab Emirates, was earlier this year penalised by the Financial Services Authority (FSA, the now defunct UK financial regulator), for breaching the Listing Rules, the Disclosure and Transparency Rules, and the Model Code on directors’ dealings in securities after it failed to update the market on the true state of its financial performance.
Lamprell was found not to have reacted quickly enough when it recognised the deterioration in its financial performance and was slow to prevent its employees from dealing in its shares once its poor financial position became clear internally. Once Lamprell finally admitted its true position in May 2012 its share price dropped by a staggering 57%.
Cost to complete
Of interest in the Lamprell decision was the fact that its failure to recognise its true position was in part due to its use of an accounting method known as “cost-to-complete” accounting, an accounting methodology used predominantly in the oil, gas and renewable energy industries. In broad terms, using this methodology, Lamprell produced project-estimated documents (or PEDs) setting out the projected revenue and profit of given projects. Those PEDs were used as budgets for each project. Whilst revenues were recognised throughout the life of the projects, profits were only recorded on long-term projects when costs reached 20% of the total budgeted costs. At this point, Lamprell recognised the profit in proportion to the percentage of costs incurred.
As a result of recording revenue and profit on a percentage of completion of a project, financial statements produced can be, in the regulator’s words, “lumpy”, in that large shifts in revenue and profit can occur between one month to the next. If not analysed and understood correctly, the consequential risk is that the true financial position of the corporate is disguised, as was the case with Lamprell.
The distorting impact of accounting methods has also been a hot topic of debate in the financial services sector. The Financial Policy Committee of the Bank of England recently announced that UK banks could be overstating their capital position by more than £25bn once impending regulatory fines and the risk of asset write-downs is taken into account. The shareholders group, PIRC, has also added further fuel to the fire by announcing that UK banks were in effect hiding losses when reporting on their financial position using the, often criticised, International Financial Reporting Standards. Applying the historic UK GAAP rules to the 2012 financial statements of UK banks, and therefore taking into account bad debts that may have to be written off in coming years together with other items such as deferred bonuses, PIRC said that UK banks in fact have undeclared losses totalling some £30bn. In particular, HSBC is said to have £10.4bn of hidden losses and the Royal Bank of Scotland losses of £9.4bn. Whilst the true scale of the financial “black hole” in the UK banks is still unclear, there is increasing pressure on banks to review and restructure their capital positions as we move closer to the implementation of the Basel III regulations.
Far from being a matter of domestic concern, the issue of financial black holes is also high on the international regulatory agenda. The multi-million dollar trading scandal surrounding JPMorgan Chase is a stark example of how adopting certain methods of valuation can impact an institution’s true financial position. A JP Morgan London-based trader, dubbed the “London Whale”, was said to have incurred over $6bn in trading losses in the credit derivatives market which were then alleged to have been mismarked in order to cover up their magnitude. The US Senate issued a report in March condemning the bank for failing to make the full extent of the problem known to regulators and the public.
In a similar vein, the German regulator, Ba-Fin, together with Bundesbank is currently reported to be investigating whistle blowing allegations made by former Deutsche Bank AG employees that it deployed various tactics and accounting practices in order to hide significant losses during the financial crisis.
Given these recent developments, it is unsurprising that there have been calls for increased levels transparency and disclosure in order to improve the market’s ability to assess a corporate’s true value. Whilst the move towards implementing the Basel III regulations will go some way to alleviating some of the concerns, the potential risk to investors remains a matter of concern. If market confidence is to return, corporates must face up to their disclosure and compliance responsibilities and be conscious that every disclosure made externally to the regulators and the wider market must be an accurate and true reflection of their financial position. Financial regulators across the globe also have an important part to play and must ensure that they vigorously investigate allegations of financial misstatements and punish those that are responsible.