Category Archive

A question for the auditors amongst us with some direct recent relevance. A friend asked me to get some comments on it. Corrections to the “facts” below are welcome as it may not be correct in all particulars.

Facts

Basis Capital

Basis Capital’s (”Basis”) Basis Yield Alpha Fund (”Basis fund”) has substantial holdings of Collaterised Debt Obligations and other instruments that are the subject of considerable uncertainty as to value.

Basis fund is a “hedge fund” which took highly leveraged, and risky, positions in these and other instruments. Investors were allowed buy out of the fund with a month’s notice - giving notice at the end of a month resulted in the refunding of the investment plus profits (or minus losses) at the end of the next month. There was no active secondary market for investments.

On 17 July 2007, but backdated to take effect as at 30 June 2007, Basis suspended redemption from the Basis fund, citing that the fund was not “…currently able to repatriate funds required for the purpose of making payments“. This means that the last possible date for redemptions was 31 May 3007, due to the operation of the one month call discussed above.

The next day (18 July) Basis announced that Grant Thornton had been retained to assist in an orderly realisation process, and said that “that the enforcement action by the financiers of the Master Fund at distressed sale prices would result in a reduction in the net asset value of the shares in the Basis Yield Alpha Fund to below one-half of the level as at 31 May 2007“.

In a letter sent to investors on 15 August 2007, Basis announced that it was unable to “accurately estimate” the net asset value of units in the Basis fund because of “further deterioration of market conditions” and put the estimated losses at “in excess of 80%“.

On 30 August Basis announced that Grant Thornton has been retained to act as provisional liquidators of the Basis fund. Press speculation is that losses in the fund have increased further and that a total loss of investor funds can be expected. Read the rest of this entry »

I just finished an update on IFRS 7 and was reminded about how much of a load this standard is going to put on most firms - and how little value this will add to published accounts.

In Australia, all firms, big and small, need to use full IFRS if they are reporting entities (this is most firms), which means that full compliance with all standards is mandatory.

For corporates IFRS 7 is of dubious value at best. As an investor, unless the firm I am investing in is taking large, naked speculative positions in foreign currency, am I really interested in their forex sensitivity or perhaps the holdings of HTM, AFS assets and loans and receivables?

Even for banks I doubt this will be useful - but it will require the disclosure of much information that is market sensitive, meaning that those reporting early in the first year of implementation will have their holdings a bit more exposed than those reporting later.

In summary - you have to do it, you have no choice; so learn to live with it. Engage with your auditor early, but get independent advice on what does, and does not, have to be disclosed. Make sure the person you are getting the advice from knows what they are talking about (there are not many who do) and even your normal audit partner / manager may not know. Check they have at least some experience.

If they do not, and for those of you reporting early, read widely. This is an example of disclosure for the sake of it.

One for the real pedants amongst us - but one that is important for hedge accounting with options under IAS 39 (AASB 139). FAS 133 has answered this one through DIG E19, but IAS 39 has an important difference.

Theory 

How is the value of an option correctly split between the time component and the intrinsic component? Essentially, from my point of view there are actually three components of the value of an option:

1. What I will call the current intrinsic value - i.e. the difference between the current spot price of the underlying and the strike price of the option;
2. The value that stems from the volatility over time of the underlying; and
3. The difference between the value in (1) and the forward value of the underlying.

In the context of IAS 39 para 74, the question of whether element (3) is considered to be intrinsic or time value may become important - the precise reason is not important, but, if you really want to know it, feel free to ask in comments.

Question 

I am aware of at least three definitions of intrinsic value sometimes used in the market - they are:

1. The difference between the current spot price of the underlying and the strike price of the option;
2. The present value of the difference between the strike price and the forward price of the underlying;
3. The difference between the strike price and the undiscounted forward price of the underlying.

Which of these do you consider the most common and / or correct and why?

You can almost feel the sense of … I don’t know - maybe triumphalism? satisfaction? feeling of a job well done? in the IASB (International Accounting Standards Board) these days. With over 100 countries now either requiring or allowing the use of the IFRS (International Financial Reporting Standards) that feeling is probably justified. The IFRSs are now the global de facto reporting standards.

That is not to say they are faultless - there are plenty of areas where they could be improved. In my specialist area of IAS 39 (Financial Instruments: Recognition and Measurement) I can think of a few - hedge accounting is a good example. IAS 17 (Leasing) is another area with some real absurdities. (Further examples may be added in comments if you want to let off a little steam).

To be honest, I think one of the reasons they have achieved the position they are in now is the Sarbanes-Oxley legislation in the US. Read the rest of this entry »

Just a quick update to let you know I am still around. The last week has been very busy, with a quick trip to Melbourne for an update on AASB 139 (on which more in a subsequent post), an article in production for Business Islamica magazine and the close of one (Advanced) Basel II project and the proper start of an other (Standardised) one.

I have also decided to (temporarily) discontinue the series on the Basel II projects in the Australian banks. With APRA currently going through the approval processes for most of these projects it was just getting too sensitive. Some of the pronouncements from APRA on these projects have been questionable at best, so I think it best to discontinue these for the moment.

Also increasing worrying is the situation in the US. The Fed is now saying the 30 June target date for the release of the rules is looking aggressive - meaning they may either be rushed or incomplete and therefore subject to later alteration. Madness.

As always, we remain open to suggestions for future posts, so please suggest away.

One of the things I am commonly called on to do it to look at option valuations to see whether they are appropriate and likely to be correct. These are often prepared by an accounting firm or a consultancy. This is normally for a fee of around $1,500 to $2,000 - or even more in some cases.

These are often done for audit purposes, to ensure that the options are (materially) correctly valued for presentation in the financial accounts. Some good news here if you are looking at doing this - you can do it yourself and save (almost) all of the money. Read the rest of this entry »

I seem to be getting a few friends sending things through to me over the last few weeks - this one, though, raised a good few laughs. I guess I have been through the audit process a few times, so this all makes some sense.

the auditor’s bedtime story.pdf

Warning - if you have never been audited, this will just make you worried, so do not open it.

Mark will probably like this the most.

AIFRS (IFRS outside Australia) requires collective provisions to be determined based on the observation of objective evidence of impairment. Roll rates are calculated using historical data relating to account arrears, losses and run off rates. The roll rates percentages are applied to the existing portfolio which is broken down into arrears categories. In order for the roll rate to be applied to the current portfolio, AIFRS requires either objective evidence (an impairment trigger) to be identified or an Incurred But Not Reported (IBNR) concept to be applied. Read the rest of this entry »

Over the period since the introduction of AASB 139 in Australia (and FAS 133 in the US and IAS 39 everywhere else) one of the more profitable areas of business for the accounting profession has been helping clients achieve hedge accounting. This, for anything other than plain vanilla forwards or other such hedges is a difficult process, typically involving extensive modelling by high priced resources. Big tip - in most cases you should not do it. Read the rest of this entry »

It may seem prosaic, but one of the problems that “Western” banks have with Islamic financial structures is the question of how to account for them. Under interest-based banking it is an easy call. In most of the world, you apply IAS 39 (AASB 139 as it is called in Australia) and in the US you apply FAS 133. The problem with Islamic finance is that it does not operate in the same way and a good, hard, detailed look at the way the arrangements will actually work is called for if you are using these standards, as most of the world’s banks do. Read the rest of this entry »

This is the last in this series. I hope you have found it useful and informative. 

Since the late 1990s the Islamic banking world has stepped up efforts to standardize regulation and supervision. The Islamic Development Bank is playing a role in developing internationally acceptable standards and procedures and strengthening the sector’s architecture in different countries. Several other international institutions are working to set Shari’a-compliant standards and harmonize them across countries. These include the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Islamic Finance Service Board (IFSB), the International Islamic Financial Market, the Liquidity Management Center and the International Islamic Rating Agency. Read the rest of this entry »

Having completed the discussion below on the implications for banks, perhaps a quick discussion on the implications for the non-financial services companies is in order. In Australia, as with the rest of the (IAS 39 - FAS 133 is quite similar) world, the main impacts for the resources and industrial companies were quite different for those of the banks, largely due to the differing structures of the businesses and what had gone before.
The important thing to note is that, unlike the banks, each and every company here was different, so the below are fairly gross generalisations which may be true overall, but are unlikely to be correct in any specific instance. Read the rest of this entry »

Now that most (or hopefully all) the banks in Australia have now completed their AASB139 implementation projects, perhaps it is time for a look back to see where the major challenges were. Considering that many of our neighbours to the near north are about to go through the same process, some guidance and assistance would be in order. Those needing to look at FAS 133 can also read on - the effects are very much the same. Read the rest of this entry »

The last of the papers from the workshop on ‘Accounting, risk management and prudential regulation’ held by the BIS in Basel on the 11th and 12th of November have been released. These may appear a bit dry, but they give some important pointers to where the regulators will be heading over the next few years in relation to both IFRS and improved risk management. Those implementing IAS 39 and FAS 133 should pay particular note.

These have already influenced the Australian regulators, as evidenced by APRA’s recent(ish) Regulation Impact Statement.

I just want to get one thing off my chest. The day you let accounting standards dictate to you what you should or should not do in business is the day you should be retiring. Sure, have a look at the standards and see if you can do the right thing a different way to get better treatment under the standards, but, no matter what the accountants say the cashflows are unaffected by the accounting treatment.

It is the cashflows that really matter.

[UPDATE]

OK - there are areas to be careful of. Ones that are going to hammer your P&L without any future or current P&L benefit. An easy example is a no-interest loan from a parent company, with the initial plus being to equity and the unwind going through your P&L. Evil stuff. If you want details, ask a question.

Two important papers on the BIS website today. The paper on sound credit risk assessment and valuation for loans should be an interesting one for those managing the credit risk areas and the one on the use of the fair value option for financial instruments also promises to be interesting for treasury and finance staff.

Give them a read and pass comments.

APRA have released their update to the prudential standards in response to AIFRS. Have a look here. I have not gone through them myself yet, but lets hope they are better that the transitional provisions which essentially required ADIs to account under the old standards.

The main changes are (apparently) to APS 111 on the measurement of capital and APS 220 on credit quality. Both of these would have had their major changes emanating from AASB 139 (Financial Instruments, Reconition and Measurement).