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THINKING ALOUD (Business&Law) Financial Statements: Auditor's or Director's Duties?
“An auditor is not bound to be a detective…he is a watchdog, not a bloodhound.”— A British judge 1896
Chén Róng’s Little English-Chinese Dictionary
amortization = tān xiāo ( wú xíng zī chǎn)
depreciation = zhé jiù( yǒu xíng zī chǎn)
Big ticket item =áng guì huò wù
Whistle blower =xiàn rén
smug talk =dé yì ér wàng yán
want to have the cake and eat it too = liǎng quán qí měi
Statement of Cash-flow
This is the company's report card and it shows the financial position of the business at a certain date. The itemized statement summarizes the assets and liabilities of the business at a certain date at the end of a financial year.
Readers of financial statements should note that a contingent liability has no impact on cash flow. They should also note that certain transactions are recorded here such as loans taken out as a standby need. And effect of exchange rate fluctuation has on cash and cash equivalent held should be included.
This statement shows a company's total operating costs. It provides gross sales and costs of sales. It shows whether the business makes a profit.
Readers should note off-balance sheet items e.g. to keep the company asset light, firms keep tangible assets off balance sheets. These assets may be sold to a separate legal entity; or probably listed as a real estate investment trust or REIT; or a listed Business Trust e.g. marine crafts, infrastructure assets, etc.
Is cash-flow systematically itemized? Example: (1) Investment activities (2) Finance activities (3) Operating activities
Without a single model for revenue recognition, generally, a wide range of methods and approaches to revenue recognition would apply to sales of goods, services and other contracts such as construction. Readers cannot assume that the company concerned has adopted the most appropriate revenue recognition policy, given the specific nature of its operation; unless specific details highlight significance of estimates and judgments made.
What happens if assets sold are leased back? These operating leases are executory contracts (off-balance sheet). Some may be financing in character, and they are subject to debt covenants.
Cash flow from investment activities -- cash and/or shares as payment for subsidiaries; sale of plant; or equipment & property.
A contingent liability is an off-balance sheet item. The accounting rules for the treatment of a contingent liability are liberal. Readers should review the disclosures accompanying a company's financial statements to see if there are additional risks that have not yet been recognized
Cash flow from finance activities -- this may review finance lease liabilities and probably also certain operating leases.
Real Estate Investment Trusts (REITs)
Writer: Chén Róng
The 102-storey Empire State Building (ESB) was completed in 1931 and last sold in 1961, when shares were offered to working-class New Yorkers at US$10,000 each in a partnership. Late last year, The Malkins family, as its manager, spearheaded a sales process and rolled up the building with twenty of its other properties into a new real estate investment trust (REIT) known as Empire State Realty Trust.
Some partners were against the consolidation process because they were convinced that their shares are worth more through a building sale than selling their shares to a REIT. So, were the shareholders in the ESB short-changed? We will come to that a little while later.
Is REIT a traditional trust? No, it is not a trust you would normally understand it to be – trust that is gratuitous or not involving a return benefit like leaving assets to children and next of kin. But a REIT structure is in the form of a commercial trust (a special purpose entity or vehicle) with an independent trustee (trust entity) holding assets on behalf of shareholders as beneficiaries. The trustee's duties can be found in a Trust Deed for protection of certain rights of its shareholders. Commercial Trusts use the trust form to diversify lending risks. The subtle similarities end there between a trust for gratuitous transfers and one for non-gratuitous commercial purpose.
As said in the above paragraph, REITs are special purpose vehicles (both public-listed and privately owned entities) structured for commercial transactions by owners of real estate assets. These owners or sponsors (as generally called under REIT structures) will set up REITs to hold assets they are selling. REITs will generally finance the purchase of these assets either privately or publicly through initial public offerings (IPOs), that is, listing of entity on a stock exchange. The REIT-sponsors, like all other investors, are shareholders. One catch for investors is: Their sponsors generally get a higher purchase price for their assets than if these properties were sold through a more cumbersome process in the open market. Some market observers have actually accused greedy property owners of selling second-rate assets in expensive IPOs.
REITs operate much like companies as they use the same valuation and accounting rules as commercial enterprises, except that instead of passing through profits, REITs pass cash flow directly to shareholders which invariably increases dividend pay-outs. REITs are more akin to funds that operate like Unit Trusts. While Unit Trusts raise funds to invest in stocks and shares, REITs specialise in income-generating real estate assets, such as shopping malls, offices, industrial buildings and warehouses.
REITs are regulated by different laws from those on traditional trustee companies or private trusts. A number of Asian countries, including Hong Kong, Singapore, India, Japan, Malaysia, the Philippines, Pakistan and India have REIT-type legislation, taking cue from similar laws in more developed countries in Europe and USA. Rules regulating trusts do differ from country to country.
Putting our focus back on the Empire State Realty Trust, were shareholders of the original partnership being short-changed by The Malkin family as the manager turned REIT sponsor. It did have the support of at least 80 per cent of the shareholders before spearheading the sale process with an independent valuation on the Manhattan building and rolling it up with other twenty properties in New York.
It may be true that the Malkins refused to meet with any of the bidders and, never had one substantive dialogue with any one of them to ascertain whether they might be willing to offer an even higher price. They may have breached their fiduciary duties but such acts may be actionable. Nevertheless, it does not defeat the mandate they have from other shareholders to get the proposed REIT off the ground which they eventually succeeded with an IPO. Empirical evidence has it that assets generally get higher prices than private sales, although in this case, owners of inferior assets may get a free ride on a premium asset like the Empire State Building. According to CNN Money, ESB raked in US$92 million in sales from its observation decks in 2013, and this amount was for over 40 per cent of total revenue. As pastry lovers know, they cannot have the cake and eat it too. Shareholders do enjoy deferred taxation on shares which they find ready buyers and liquidate in tranches at favourable market prices over time. In other words, REIT shares provide liquidity and probable capital gains in the long term.
One big selling point of a big public-listed REIT emphasized by the Malkins is that obtaining ready financing is made much easier. REITS are becoming less reliant on traditional bank loans secured against specific assets. Instead these REITS are taking to using Medium Term Note (MTN) as an alternative source for financing their real estate portfolio. MTNs issued bonds guaranteed by the REITS Trustee. They are unsecured against specific assets. This provides an alternative source of debt which enables the manager to grow the REITS asset base and keeping a relatively stable gearing at the same time. Even closely held real estate companies which generally have to depend on property-specific mortgages for deals, still find a REIT structure more in tune with today's business environment than partnership structures, which are kind of anachronistic.
A REIT’s other major advantage is its tax exempt status at the trust level as long they distribute at least 90% of their income to their unit holders. In other words, the current income distributed to shareholders is not taxable to the REIT but tax exempt in the hands of resident shareholders in some countries.
There are gains and pains in investments. In many cases, REITS are run by an external manager -- a company fully owned by the sponsor. There may be questions over fees paid out and the quality and price of assets acquired, especially on properties owned by the sponsor. This is a potential conflict of interest between the manager and shareholders of the REIT. In other cases, if the manager is a direct employee of the REIT, he has a greater alignment of interest with shareholders. But the REIT may lack a pipe-line of assets for acquisition without an established sponsor.
There is no one-size-fit-all solution. Investors have to decide which model is suitable for their own requirements. They probably need a mensch manager.
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- A Director's Duties of Care, Diligence and Skill -
Writer: Chén Róng
In the 1970s, walking along Singapore’s business district, if you chance bumping into a company director and asked him as to whom prepared his Financial Statements; you would invariably get the answer: “my auditors did”. Surprisingly, some forty years later, entrepreneurs of small and medium-sized companies can still be heard saying the same one-liner without knowing that responsibility for preparing the financial statements resides with the management of the business. In short, the laid-back attitude and ignorance of company directors are putting the all-important auditor’s independence at risk of failing. Instead, they should look upon the auditors as partners for producing high quality financial statements.
In a buddy-system culture where directors are roped in for their business and political connections, it is hard to tell just how many of them fully understand the financial statements of the companies where they have their board seats. Do not get me wrong: business and political connections are personal assets and they are valuable to every business; attributes that professional qualifications are important for those at the top echelon of multi-national companies. But today’s business world is complex and challenging, and it is difficult to have the grasp of things; responsibility and liabilities of directors are getting more challenging with each passing day. For instance, it is difficult to grasp the full implication to a business of a syndicated multi-option bank facility. It is supposedly a short term arrangement aimed perhaps at replacing existing trade bill facilities – a temporary flexible measure in hope of a more stable business environment. But what events would cause a breach of such a banking agreement? Does a sudden fall in seasonal sales trigger a breach? Similarly, I will need a securitization expert to explain the workings of a REIT BDO loan. Is there a risk of an adverse tax consequence? There are other derivative financial assets and financial liabilities on financial statements that are equally mind boggling. Besides, under wrongful trading legislation in certain jurisdictions, if a company continues trading while insolvent, directors may be held personally accountable; they may be asked to contribute to replacing company’s assets and pay unsecured creditors for any shortfall.
It is amazing how some directors could hold a dozen or more board seats of companies in diverse business operations, and stay employed on a full-time high profile management position simultaneously.
What do you think will be the result if we were to put directors to a financial knowledge test? Just ask if they know the difference between amortization and depreciation, and you may not get a perfect score from a boardroom of ten members. Similarly, you may not get unanimous votes for Statement of Cash Flows as the most important of Financial Statements of a company. The year 2012 was tough for businesses. Smart business people who survived were the ones who have been making sure that their cash flow is not further hamstrung by delinquent debtors. In all the financially distressed business which we have seen last year, every one of them could have alleviated some of the distress by paying closer attention to the collection of debts. Companies may find it easier to collect a week-old debt than one which is overdue for a month. Slow repayment of the company’s aging trade receivables can deplete cash balances rapidly, especially for cash-only trades in countries like Myanmar, Cambodia and Vietnam. We should be looking at free cash flow when looking at a company’s financial health, that is, cash after laying out money required to maintain or expand its asset base. It is the cash left after deducting capital expenditure from operating cash flow. If free cash flow is in the negative territory, directors authorising a fund transfer to an affiliate may breach fiduciary duties for failing to consider the company’s on-going cash flow requirements and/or the consolidated cash balance of the group. Under such circumstances, directors may have to examine closely at how the business spends on its big ticket items; and those huge investments, or that its customers are grossly behind schedule in payment. Are directors using fine-tooth combs for their analysis? Or are they equipped for such work?
It is not uncommon for companies to issue bonds when investors are receptive of such debt instruments. If negative cash flow requires that a scheduled redemption of corporate bonds be postponed, are directors able to unequivocally declare the firm is ‘of going-concern’ even if bond-holders have yet to demand for an immediate payment? What is the company’s debt-to-equity ratio as compared to that of its peers? A company with high debt gearing and a disproportionate level of short-term loans may face problems financing its debt in particularly tight situations if banks do not agree to a request for loan roll-overs. Are directors detail-oriented enough to mull over every single doubt and innuendo before reaching a consensus? Responsible directors do.
Regulatory requirements do not allow companies to pay dividends directly out of business cash flow. It can only distribute dividends out of accounting profits (or retained earnings) it gets from the business after deducting non-cash items such as depreciation for machinery and buildings. It is hoped that board members appreciate the existence of such accounting rules. But what happens if the financial statements of subsidiaries with business structures such as Business Trusts and REITS (real estate investment trusts); or a REIT hybrid (incorporating a business trust) with stapled securities? From a financial standpoint, these subsidiaries are off-balance sheet financing for holding companies which restructured themselves based on an asset-light business model. That these securitized entities (usually listed on major stock exchanges), which run like companies, actually pay dividends out of cash flow; paying as much as 100% of funds from operation! Are these REITS able to find funds to cover the costs of building renovations and other expenses? Some REITS structures compute their earnings and dividend pay-outs without due consideration for depreciation of their tangible assets! Others divert some of the depreciation to their dividend pay-outs. When REITs distribute almost all its income to investors, transparency of information on the properties and normally confidential cash flow items becomes vital. Board directors must ensure sufficient transparency exists in its business’s fair-value financial reports, particularly if a company is highly leveraged. The use of fair value information required by accounting standards to be included in financial statements of businesses is beyond many directors with the exception of those with specialist accounting background. There is need for extra care by directors if financial statements are relied upon for investment and other decision making by a Board. Frankly, I am on a long learning curve myself. Those directors who are wearing many hats, they should beware and be warned!
Still on the subject of cash flow – unlike property holding entities, REITS pay little attention at capital values when appraising their properties. REITS use a discounted cash flow-based valuation; using a method with which the appraiser looks to the expected cash flow generation from a particular asset, and use that to determine the value of the building. The onus is on the REIT manager to secure properties that can command good leases and good cash flows to keep valuation at high levels. Are directors expected to fully rely on REIT manager’s professional judgment and knowledge; done in manner complacent old guards fully entrusted their auditors with financial reporting responsibility? In discharging their fiduciary duties, board directors are to exercise due diligence beyond professional advice they receive from industry experts.
Aggressive acquisitions by REIT manager or, for that matter, any company on heavy capital expenditure will have negative cash flow that may lead to the collapse of the company. Heavy buying activity need not be tangibles like real properties; acquisitions can be in the form of intangibles such as goodwill and operating licences that a company may place unrealistic valuations in its financial. One such case was listed ABC Learning (Australia) which went into administrative receivership a few years ago. It was the world's largest provider of early childhood education services. Imponderables indeed for a person acting in the capacity of director; the nuances of the industry that mixes both politics and culture and woven into its business fabric, it is a hard bed for directors to lie! An independent director needs specific industry knowledge in today’s complex world of business. He should never accept a board seat irresponsibly - accepting a position as independent director just because his long time buddy-CEO finds him agreeable almost on every issue he may want to table at directors meetings. It amounts to back scratching!
Late last year, a research firm (a whistle-blower) took to task commodity-firm Olam on account of opaque accounting practices. It was such a hullabaloo. We will not discuss the rights and wrongs of the allegations but stick to the main issues at hand. Commodities-related companies have complex business models that can be hard to understand - practices difficult to grasp and seemingly risky to investors in general - particularly so if the company also engages in trading activities which potentially carry more risks. Trades can go both ways. I do not buy shares in Olam, Noble or Wilmar, but it does not mean these companies are poor investment candidates. They work within accepted accounting guidelines of their host countries. The onus is on investors (mainly institutions) and their proxies (directors) and board members themselves to fully grasp the many technicalities and subtleties of the business. The question is: do they take time to fully appreciate the nuances of the adopted business models; commercial methods that are key to the company’s risk management. An investor is privy to specifics of trade deals with suppliers and buyers of commodities, but board members do have every inside opportunity to learn of the challenges faced that may lead to systematic defaults and re-negotiations. It may include arbitration proceedings commonly experienced by commodity firms in settling disputes. There is also the question of fair value accounting which requires considerable analytical judgment and assumptions on values of assets and liabilities. Fair value application dependents include biological assets (e.g. crops and plantations); derivative instruments (based on assumptions where market quotes are unavailable) and intangibles such as goodwill, which may sometimes be in negative instead of positive territory. Nevertheless, accounting practices purportedly done in accordance with accounting and reporting standards of a country concerned; practices both executive and independent directors must ensure comply with acceptable accounting standards and stock exchange listing rules. To sum up: it does take considerable skills and time for someone acting in the position of a full-time director to fully appreciate the complexities of his job. Independent directors with little time on hand and not necessarily having all the information readily at hand, can they juggle between various responsibilities of everyday life and other business ventures and claim having fully discharged their fiduciary duties?
This article is not smug talk. The opposite holds true - to point out why directors should not manage dozens or more board seats of companies with diverse business structures; companies with diverse business and debt obligations. A board member lacking banking expertise will not know the hidden risk buried in collateralised debt obligation thinking that a Grade A rating means the instrument carries little or no risk to investors. Companies of the past were different, both in structures and business models. Now companies operate globally across many regimes and jurisdictions, there is a need for better quality disclosures and consistency in understanding and interpreting of complex financial and risk matters. One such potential risk in a globalized economy is foreign exchange fluctuations, if directors are caught unawares; these can significantly impact a company’s financial performance and profitability. Yes, a director’s remuneration that goes with the position is great, but just as important is the need not to be seen as an opportunistic hunter. Judging by the high double-digit directorship numbers in public-listed companies, the reality is: despite the serious obligations that go with the job of an independent director, these business elites want to have the cake and eat it too! In a self- regulatory environment, mind-sets are unlikely to change when good times keep rolling in for an elite minority. Any intended legislation that aims at curbing multiple directorships will soon collapse when faced with a strong network of social business elites. As laws cannot be enacted to punish a critical core group, any proposed legislation is unthinkable. The only hope for a better governance environment lies in a change of personal philosophy; a change of heart of business elites that will help mount pressure on others to follow suit.
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Hubpages do not support words written in the Chinese Language. Readers can get a free online English-Chinese translation from GOOGLE TRANSLATE OR TRANSLATED.net
I have also included ChénRóng’s Little English-Chinese Dictionary for a more precise translation of select English phrases from the article.
The writer makes no warranty of any kind with respect to the subject matter included herein or the completeness or accuracy of this article which is merely an expression of his own opinion. The writer is not responsible for any actions (or lack thereof) taken as a result of relying on or in any way using information contained in this article and in no event shall be liable for any damages resulting from reliance on or use of this information. Without limiting the above the writer shall have no responsibility for any act or omission on his part. Readers should take specific advice from qualified professionals when dealing with specific situations.
AUDITORS ? Let's cut a long story short.
Why do we need auditors?
No, we do not need them if everyone is honest. Unfortunately, that is not the case. Hence, we need auditors to check on whether a company recorded transactioons according to the Rules.
Interestingly, auditors are paid by the firms which require the accounts auditing.
There is obviously a conflict of interest but the world has not found a better solution.
Who are these auditors?
Ernst & Young,
Cluster of local auditors
Everyone knows that local auditing firms are less strict about enforcing accounting rules. It is okay because family run business or smallish local firms use their services. The big four auditing firms prevail where multinational companies are concerned.
What are the Rules?
In Asia: The International Accounting Standards or IAS
In USA: The Generally Accepted Accounting Principles or GAAP
Does the auditor protect you - the directors and shareholders of a company?
The answer is - Not really !
Oftentimes, auditors go easy on clients, passing them even when there were problems. This is more prevalent with the family run and small capitalised firms and their local auditors. In this way, they protect their clients and continue as auditors of the firms year after year. Watch it though as it does not mean that your financing bank is going to like what they see. You might not get the loan you ask for. So, honesty is still the best policy when it comes down to bank loans.
We will not discuss the audited accounts of multinational companies where directors and shareholders are usually different people.
What happens if there have been fraud and there was a bad audit?
Sorry, auditors do not look for theft or wrong-doing in the companies they audit. It is not their job. The law is set up in a way that relieves auditors of this responsibility. It is the job of the audit committee on the board of directors to spot wrong-doing or theft. If no committee is formed, then it would be the board of directors who failed in their duty and the company can only blame itself if fraud occurs.
Auditors are very happy with the present arrangement.
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