A dangerous road to be on?

A recent article penned by fellow Celt Brian Gaynor in last Saturday’s Herald -  Good and bad news in reporting season - got me thinking about Enron and similar corporate shenanigans. Poster for the Broadway production

It’s an interesting piece as it highlights the practice of a significant amount of notable NZ organisations declaring a profit figure which differs from that produced by the audit.

Now, even among accountants, the application of International Financial Reporting Standards (IFRS) is considered problematic, to say the least.

Brian is a somewhat more forthright and calls IFRS a shambles.

Unfortunately, he’s right – and not for the first time has a differing interpretation of value confused and distorted the position of corporate entities in our free market system.

It’s a dangerous road to be travelling as astute analysts and perceptive commentators like Brian Gaynor pick up on the trend, investors lose confidence in the veracity of ‘audited’ financial statements, investment flows into the share-market diminish, companies re-interpret their results to recover investor confidence, analysts query the validity of the re-interpretation, investors retreat further - and so it goes on.

But if the corporate world and IFRS are not entirely aligned, what does this auger for the highly specialised and even more complex world of life insurance accounting?

In Australia, there was one year when our accountants had to deal with Margin-On-Services reporting (a peculiarly Australian invention), IFRS, Sarbanes-Oxley, and US GAAP reporting. Don’t ask me for the technical aspects – I only remember my poor CFO having considerably less hair at the end of the reporting period than at the beginning.

But back to the local scene – a recent report stated one life company’s after tax losses were reducing year-on-year.

I have two issues with this;

  1. Who ever reported ‘after tax losses’ as a true indicator of financial position?
  2. Why would you choose to take this approach in the first place?

I can’t recall any life company declaring ‘after tax’ losses, and I can only imagine the figures were quoted to make the financial position look positive?

But it gives rise to questions on life insurance accounting which IFRS seems to be incapable or unwilling to address.

Commentary is frequently made, both here and abroad of the high levels of initial commission payable on new life insurance business. This is NOT a piece about whether this is good, bad, or neutral.  However, as an aside, from recent discussions, I can state categorically that they are a deterrent to new entrants to the market – whither the stimulus of open competition and the free market now, I ask?

Sustainability of the highest commissions in the OECD is provided by the Deferred Acquisition Cost  (DAC) policy adopted by the life office. Put simply, if you pay 200% initial commission, and DAC the item over 10 years, you need only recognise 20% expense in year one. This does wonders for your financial statements, and, with a willing reinsurer, your cash flow can be easily managed. And the longer you DAC your up-front commission, the more you can pay to attract new business, the more investors like the cut of your jib, and with more capital invested, you can attract more new business by paying higher commission, and the longer you can DAC the commission expense, and....see a pattern emerging yet?

Sounds a lot like the dangerous road described above from Brian Gaynor’s analysis of companies re-stating their profit figures.

Of course, you will rightly point out that the DAC is only applied to year 1 commission and that eventually any lapses which fail to produce a commission recovery will hit the company’s financial statements in that year.

In most instances, CEO’s, Executive Management, Staff, and Distributors are measured by, and rewarded for, new business sales. New business to me might mean a lapse to you, but what do I care? My bonus is on my new business – your lapse is your tough bananas, pal.

And how does the client fare in this transaction? Well, who cares?

Re-interpreting audited figures, spinning a positive media release on a negative position, and using smart techniques to manipulate financial statements – all characteristics present in the Enron scam in the 1990’s.

Incidentally, Enron were given a blessing by the regulator in the USA to record their pricing on a mark-to market basis, reflecting the market value of their commodity (energy) rather than the true value which they were able to sustain – or not as it turned out. To be totally accurate, Enron actually employed a ‘mark-to-model’ technique – the model being shaped to produce pricing which created artificially inflated profits - and off we go again in the same blind-man’s-buff described earlier.

So are we on the same terminal path in the life industry as Enron was in the 1990’s?

Well, we’ve already seen the demise of AXA and Tower recently - and the rationalisation battles earlier which saw NZI Life, Prudential, and Colonial Mutual etc. disappear from the local industry

So who’s next?


The Laird of Albany