Lending agreements-increasing trend of outsourcing monitoring to professionals

Conventional financial theory holds that financial intermediaries(like banks) add value('spread'/NIM) by aggregating deposits and lending them to qualified borrowers. For these loans to be profitable, banks should have the expertise in credit risk assessment and monitoring. But the past few years(decades?) trend seems to be negating this theory. While banks are focusing their energies on gathering deposits(more channels, multiple access mechanisms, marketing) and processing loan applications faster('retail loan factories'), their response to scams seems to outsource that monitoring function to a professional. For example

1. Some banks give 0.25%-0.5% interest rate discount to their SME borrowers with credit ratings. 
2. Stock audits/financial audits(where not otherwise done) are made mandatory for those with working capital/other operating facilities.Incidentally, this is the mainstay of many a SME practice.
3. For borrowers with multiple bank relationships('consortium lending etc), RBI has mandated a compliance certificate to be issued certifying governance issues, no fund diversion etc. Interestingly, this circular also contains a best practice of different statutory/internal auditors for group companies, where facilities cross Rs 50crores.
4. Often, the audit clause contains a 'Big 4' auditor appointment insistence-this is true of the Indian private sector banks, but this trend seems going down though. 
5. In additional to the general purpose financial statements, auditors are often asked to sign a compliance certificate(under the lending agreement) which contains proforma ratio calculations, covenant compliance affirmation etc. When the auditor is tasked to do this(albeit for extra fees), he is in reality doing the monitoring function of the bank.
6. Auditor/CAs are often asked to certify the utilization of the earlier sanctioned funds, before the next disbursal is approved. 

 Conceptually, there is little quarrel with the proposition of 'bundling of services' or delegating to experts. When the auditors/credit rating agency are expected to know the client well and perform their tasks with due diligence, then the bank is entitled to rely on them. The only possible issues with this, is that the processing fee/interest rates should reflect this reduced risk, as well as reduced costs for bank. Otherwise, the benefit from these activities directly flow to the bank's bottomline. Btw, the professional referred to in this are practising CAs/CSs/CWAs-most of whom can do the above work. Still, the statutory auditor is preferred for most of this.

Will IFRS kill pre-IPO convertible bond financing in India?

If there was ever the case of the 'tail wagging the dog', this is it. Take the example of pre IPO financing by a strategic investor. Typical covenants include:-

1. Debt security with nominal interest(or even zero interest)
2. Call option-to convert the debt to equity at the IPO price/other reference price. This may even be adjusted with the performance of the company.
3. Put option-promoters/company to buyback the debt at a fixed IRR

Earlier, Indian companies were permitted to account for these securities as debt. But now IAS-39 mandates that the embedded derivatives(call option/put option)should be separately valued-even if not accounted for separately on balance sheet. And given the typical deal sweeteners, the option value by any model is likely to be high. And as the IPO approaches, the increase in option value will need to be expensed out by the company('issuer'). This may render it ineligible for listing/fetch low price on listing, due to the MTM losses on the derivatives issued by it.

Of course, the company could argue that investors should consider a proforma picture ignoring this adjustment, analogous to ignoring 'credit value adjustments' on own debt. But if this loss leads to an enhanced call option for investors/exercise of put option due to triggering earnings based covenants, then the company has a problem. This calls for top notch investor relations and legal experts to help cover all such bases during financing. But despite that, such transactions would need to be structured much more carefully because more the protective covenants, likelier is it that more embedded options exist.

Why banks & their clients deserve the poor accounting standards they have

By now, post the infamous Lehmann 105 repo/Bear Sterns portfolio valuation etc, many laymen(and a not insignificant number of industry veterans) blame accounting for the subprime crisis. They argue that if financial instruments were required to be valued consistently at MTM(mark to market), the sudden earnings shock would not have happened.

This argument is flawed given that  the widening CDS spreads(insurance premium for insuring the bonds against default) were widening for the overall market quite early on-so there was enough of early warning. That said, the standards ARE a hogmash of inconsistent principles and valuation basis. But for that, the banks/their clients have themselves to blame.

1. Many of the cumbersome provisions in these standards(like hedge documentation, anti tainting provisions) were inserted to prevent financial engineering led abuse by structuring transactions to achive unintended results. 
2. And the standards are quite vague because when you give 'bright line' guidance, the effort goes to achieve the bare minimum effort necessary to do so. 
3. Also, when the standard setters wanted to apply a consistent fair value framework, doing so for financial assets was easier because of the excellent markets there. But banks lobbied the EU to prevent macro hedging and other rules from coming into place. And when politics enters the equation, good practice does tend to go out
4. Also, response to the discussion papers tends to be skewed and repetitive. As any reader of the various response letters would attest to, each take their own parochial limited views and argue for a rule benefiting them, instead of a rule which is fair, transparent and workable. In that context, even the standard setter has limited options to work with.

 Hopefully, my own future interactions with the standard setters will not commit the above mistakes.

IFRS transition-more than just an accounting change

While the Big4(and others) have covered this in depth via white papers, this post just intends to bring up the major issues(with examples) for investors and non accountants  to be aware of. So next time your Finance Dept brings up the issue of IFRS adoption, you would hopefully be agog with questions about its impact on you and your Dept/profit centre. Following are the functions which would see major workload:-

• Corporate finance—If key numbers on which certain debt covenants are based change due to the transition to IFRS then early discussion and negotiation with the banks is critical. Though most agreements do have a clause covering accounting changes, it is still safer to run a test on that
• Tax—The tax team needs to be in the loop, so that they can properly account for the transition differences, and subsequent impact(s) in the tax returns.
• Human resources—Given the growing trend to use accounting based numbers for compensation plan(rather than shareholder return only), executives should be concerned about the impact of transition to IFRS on their key metrics and incentive plans.
• Technology—Changes are required in the consolidation systems and in the general ledger
accounting systems.Also, to present the required segment information, the systems would need to be built.
• Internal controls—IFRS requires a higher level of judgement and estimation than US
GAAP.  This means the controls and process surrounding accounting judgements and
estimate must be robust since it will be challenged by the internal controls testing process.Also, given the increased scope for fraud/mistake, the controls need to be fraud proof as far as possible.

• Investor relations—Investors need to be educated about the initial upfront changes(say in equity) and the subsequent income statement volatility when earnings smoothing is no longer allowed/much more difficult. This would impact companies with heavy pension liabilities, financial instruments etc.
• Operations—Given the asset component method for depreciation, impairment testing and other asset specific tagging requirements, Facilities/Operations would need much more information about their fixed assets than they have presently. This may lead to outsourcing of this labour intensive function

In passing, we will see much more activity on this in the coming year 2011-12 on the Indian front. Those of you interning in those companies may already get to see some of these changes

Will 'search engines' or 'situation economics driven judgement' dominate accounting?

In his speech to the US Chamber of Commerce on global convergence of accounting standards, the IFRS policy head Sir David Tweetie,(full text here http://tinyurl.com/5tj9twh)  explained the concept behind 'principles based accounting standards'. I have merely rearranged those points in a more user friendly format but urge that the original speech be read in full.

1. How are IFRS laid out? The core principles of any standard must be clearly worded. Other sub-principles are then articulated in a tree-like structure. Inconsistencies with other standards must be avoided, if possible, or fully explained. All application guidance and examples that are aimed at helping users to understand the principles have to justify their inclusion. Would anything be missed if they were deleted? If guidance is necessary, is the principle sufficiently clearly stated? Does the standard include bright lines and arbitrary limits? Why are these necessary? Does the transition follow the normal pattern? If not, why is a change proposed?
2. How does this help prevent 'window dressing'? The use of principles eliminates the need for anti-abuse provisions. It is harder to defeat a well-crafted principle than a specific rule that financial engineers can bypass. A principle followed by an example can defeat the ‘tell me where it says I can’t do this mentality’.
3. Impact on financial engineers:-  If the example is a rule, then the financial engineers can soon structure a way round it. For example, if the rule is ‘when A, B and C happen the answer is X’, the experts would restructure the transaction so that it involved events ‘B, C and D’ and would then claim that the transaction was not covered by the standard.  The abuse of unconsolidated special purpose entities, are an example of how well-intentioned rules present opportunities for financial engineering.
4. But how would the system then work? A principle-based standard relies on judgements. Disclosure of the choices made and the rationale for these choices will be essential. If in doubt about how to deal with a particular issue, preparers and auditors should refer back to the core principles. The basis for conclusions should also include, in particular, the question of whether there is only a single view on how to tackle the economics of the situation. Often there are competing views—is one deemed to be more relevant? If so, the reasons for choosing that particular view should be explained in the basis for conclusions and the reasons for rejecting the others should be clearly stated.
5. In litigation prone checklist driven regulations, can principles based IFRS work? Risk mitigation can be achieved via  careful generation, collection and retention of documentation and by seeking of expert advice and the views of professional colleagues throughout the life cycle of transactions. Above all, defend those who make such judgements, document them and make an honest and fair attempt to meet the principle. 

We humans are hardwired to defy authority. So if rules are proposed, 'search engine' type mentality looks for a loop hole to violate the spirit while obeying the letter. While a principles based approach, by its sheer ambiguity, would compel skilled professional judgement seeking to reflect the economics of a particular situation.Given that IFRS is an idea whose time has come, hopefully more rational(and well disclosed) choices will be made, equipping investors with tools/information to critique/appreciate that accounting.