Mafia Buzz Issue 3

Techtalk

The objective of ED167 is to convert the following AC statements to IAS standards (I suggested this seven years ago!): AC 000, 100, 102, 109, 111, 114, 115, 116, 118, 119, 120, 121, 124, 127, 130, 134, 136 and 137. (Note that there is no IAS equivalent to AC121 at present. They are busy working on insurance contracts.)

AC138/IFRS1, first time adoption of IFRSs, has been published.

ED166, which dealt with hedge accounting for a portfolio hedge of interest rate risk, was published. It is now part of IAS39.

ED168, which dealt with the transitional provisions for impairment of loans and receivables on the initial adoption of AC133 was published. (They got it wrong!)

ED169, dealing with changes in decommissioning, restoration and similar liabilities was published for comment.

On the auditing side the following have been published:

SAAPS1014: Reporting by auditors on compliance with international financial reporting standards.

A new preface to international standards on quality control, auditing, assurance and related services by the IAASB.

An ED on ISA300 – planning the audit

Other matters covered are developments in the public sector, tax, exchange control amnesty and the reporting by CAs in terms of the Immigration Act. (How in heaven’s name does a small practitioner keep up with all this every month and still try to give clients a service? In the last month, two of my friends in public practice have sold up because they can’t keep up!)

Tax

Taxgram

The Supreme Court of Appeal in the Warner Lambert case held that the Sullivan Code expenses are incurred in the performance of the taxpayer’s income producing operation and are, therefore, deductible expenses. (September 2003, issue 8)

If an amount owing to creditors is not claimed and transferred to profits, this amount will be included in taxable income. If the creditor makes a successful claim at a later date, then the amount will be allowed as a deduction. (September 2003, issue 8)

SA Tax Cases Reports

Two brothers sold their shareholding in a trading company to a trust for R380 000, as valued by the auditors. SARS placed a valuation of R3,3 million on these shares and hit the brothers for donations tax on the difference. The judge’s comments on the valuation were: “The auditor’s valuation was patently not reflective of the fair market value, of which fact he could not but have been aware. His claim that he was instructed to determine the fair market value and in fact did so, simply did not wash and he resorted, for obvious reasons, to the lowest possible valuation that he thought would pass muster.” (Two questions: Does this not amount to bringing the profession into disrepute? Is this what we can expect when CGT becomes payable? The answer to both questions is clearly “yes”.) (Volume 65, part 4, 2003)

Noseweek

In the past I have been terrified of being sued if I quoted from this source but there is an important lesson to learn in the article on page 28 of the November issue. A company received a large payment in error. The owner claims to have asked his lawyer what to do and was told to place it on call. He was told that any interest earned would be his to keep until the money was claimed back. The money never ended up in a call account but was used to pay the company’s creditors. The company has now been placed in liquidation. Question: “Why did the owner have to ask his lawyer what to do?” Clearly if you receive something that does not belong to you, you go out of your way to give it back. If you don’t, you are a thief.

CFA Magazine

The AIMR has commenced the publication of a bi-monthly magazine from which I will be quoting in future.

May/June 2003

Tom Bowman, AIMR President and CEO (they know nothing about the King Report!) says that the standard setters are now (after the Enron and WorldCom affairs) keen to entertain the perspectives of the users of financial statements. (With respect, my friend, the users have never been interested in standard setting in the past – they have been too busy making money!) He is encouraging users to get involved. (Page 3)

The following criticisms have been raised against expensing options:

1. 
   The cost that never was gets cancelled out by crediting equity.
   
2. 
   Options affect the number of shares and not the economic income of the entity.
   
3. 
   Diluted EPS accounts for options already – no need to duplicate.
   
4. 
   Analysts’ models already account for options in the valuations. (Page 4)
   

The original concept of a hedge fund was to go long on under-valued securities and to go short on over-valued securities. They funded their long positions by borrowing, hence the name. 14% of hedge funds in the US closed down last year compared to 4% of mutual funds. When investing in a hedge fund, one is really investing in the management of the fund. (They should differentiate between “investing” and “speculating”. Note: “long” means “hold” and “short” means sell something you don’t own.)

At last investment performance in the US is now being measured on an after tax basis. (We just need to get the standard setters to understand that tax is an expense in their standards.) This becomes complicated in the US as different states have different tax rates, e.g. tax in California is 9% compared to 3% in Illinois. (Page 13)

The AIMR supports fair valuing of financial instruments in the financial statements of companies as this makes the financial statements more transparent and relevant. (But does it make them more reliable? I have seen many cases in RSA where management have a field day attaching values to financial instruments to meet their own agendas. Note that the concept of value is “exit value”, i.e. what the company could get for the asset if it sold it at the balance sheet date. (Why then ignore selling costs?) (Page 17)

A fund manager questions whether the threat of being audited by SEC will stop fraud in the hedge fund industry. “I haven’t seen how the threat of audit by the IRS has stopped tax cheating!” (Page 25)

Fair value accounting becomes a joke when you have to place a value on an OTC (over the counter) path determinant binary option! (Page 43)

When one evaluates returns it is instructive to measure the Risk Adjusted Return of Capital (RAROC) of that investment. A corporate bond may, for example, give a return of 4% p.a. whereas an investment in a hedge fund may give a return of 20%. However, if the value-at-risk (VAR) at a confidence level of 95% for the bond is 10% and that of the hedge fund is 80%, the RAROC of the bond would be 40% (4%/10%) and that of the hedge fund only 25% (20%/80%). This might make one think twice about going for the hedge fund “investment”. (Page 43)

July/August

There is a massive investigation going on at present in the UK on soft commissions. The way it works is: The broker gets orders from the fund manager, executes the orders, charges brokerage for the service and then passes as much as 40% of the brokerage over to the fund manager in a disguised form, e.g. buying computer or computer supplies for the fund manager. The fee charged to the client is therefore not a true reflection of what the fund manager earns. This has real potential for fund managers to churn portfolios to generate soft fee income. The practice is, at last, under attack by the authorities. (Pages 3 and 19)

Should one invest in under-performing markets purely to reduce portfolio risk? I have always believed that the focus should be on maximising returns. Agreed, you must look at the risk but it seems crazy to invest in a falling investment merely to reduce portfolio risk. (Page 5)

The debate is heating up on quarterly reporting at the EC. The main argument for quarterly reporting is to align with US reporting. The main argument against is that it will encourage short-term thinking and actions by management. No one seems to have looked at the disruption in the companies themselves. No sooner have you got the last quarterly financials out, you will be working on getting the next lot out. What compensation will there be for the company for the additional costs incurred? (Page 18)

Three aspects of SOX are discussed:

1. 
   The Act calls for full details of all off-balance sheet transactions, arrangements, obligations and other relationships of the issuer that could have a material impact on the company.
   
2. 
   Non-GAAP disclosures, such as EBITDA, must be tied back to a GAAP measure and a statement by management explaining why such disclosures are beneficial to investors. Companies will not be able to label obvious recurring write-offs as “non-recurring”.
   
3. 
   Directors with a 10% or higher holding in the company must disclose within 2 business days of the transaction, details of any purchases or sales in the shares of the company.
   
4. 
   Companies and their subsidiaries may no longer make loans to directors or top managers. (Page 20)
   

The problem with the US approach to standard setting is that they write as many rules as they can and demand that accountants don’t break them. The glaring deficiency is that if it’s not prohibited, it’s okay. What sets the US apart is their strict enforcement. (I wonder if this is not why we get more scandals in the US? They find them. Other countries allow them to go on undetected.) (Page 23)

September/October

Malaysia supports little gaap for little companies. The AIMR is against having a two-tiered approach. They want big GAAP to apply to all companies. (Why would they want a butcher to pass eight journal entries when she imports meat from the US when two would do? Let’s keep big GAAP for general-purpose financial statements and let’s leave small companies to get on with the task of creating jobs, making profits and paying taxes.) (Page 19)

The rest of this bi-monthly journal is devoted to the behavioural aspects of investing. Here are some ideas I captured:

1. 
   Keynes said that picking stocks is like a beauty contest – the judges must decide on not only who is the most beautiful but whom everyone else will think is most beautiful.
   
2. 
   Cognitive bias is the tendency of intelligent, well-informed people to do the wrong thing.
   
3. 
   Attention grabbing stocks do not outperform the market.
   
4. 
   Know the intrinsic value of a share. This way one can determine to what extent behavioural factors are built into its price.
   
5. 
   There is no evidence that behavioural finance techniques can enable an investor to make money on stocks. (But I believe that a knowledge of this technique can reduce the risks of losses.)
   
6. 
   A stock is not necessarily a good buy just because the company is sound. The price of the stock may be inflated.
   
7. 
   Just because you know that the market is undervalued you can’t make money on it right away – you can’t trade against sentiment. (Ever tried waiting?)
   
8. 
   Familiarity bias is where we believe that things that are familiar to us are better and less risky – this is why so many people put so much of their money into the stock of the company they work for, e.g. the poor staff of Enron.
   
9. 
   The brain uses shortcut methods to make financial decisions without having to do the full analysis.
   
10. 
    We tend to hold onto loss making shares as we do not want to admit that we made a mistake.
    
11. 
    We tend not to like boring companies when they can make sound investments.
    
12. 
    We tend to be overconfident in our decisions (overconfident bias).
    
13. 
    We focus on information that confirms our beliefs and ignore inconsistent information (confirmation bias).
    
14. 
    We tend to place too much emphasis on similarities (representative bias).
    
15. 
    We tend to anchor estimates to salient numbers even if the figures have little or no relevance to the estimates (anchoring bias).
    

According to Kenneth Fisher, category picking is far more important than stock picking. (Page 43)

To expect people to make wise decisions in their defined contribution plans is asking too much. Participants usually lack investment education, display all the wrong behaviour patterns, do not have enough time (or incentive) to allocate to the problem and are too busy in their jobs to think about it anyway. They do not save enough to cater for their retirement. An interesting idea is the Save More Tomorrow Plan (SMTP) where participants commit in advance to allocate a portion of their future salary increases toward retirement savings. Inertia takes over and participants tend to stick to the plan. (Page 45)

One of the most effective means for dealing with poor behaviour patterns is to write out a thorough investment policy statement and stick to it. The statement should be specific, i.e.: Why are you saving this money? What do you want to buy? When do you want to acquire it? (Page 51)

November/December

The total sum of all the advisory fees, marketing expenditures, sales commissions, brokerage commissions, transaction costs, custody and legal fees and securities processing expenses (and audit fees?) come to $300 billion a year in the US. This is nearly 3% of the total capitalised market value of $12 trillion. So the mutual fund industry confiscates nearly 50% of the historical real rate of return earned on the market. (It would be interesting to compare this in RSA were we do not have the same economy of scale as in the US.)

75% of analysts worldwide say that financial information provided by companies is extremely or very important to their investment decisions. Those who use this information are disappointed by the quality of it. Companies should distinguish themselves by improving the disclosures they provide. (Page 10)

Every company wants to establish a strong track record earnings-wise. However, it becomes messy when companies start over-managing expectations. (Page 11)

Burton Malkiel of A Random Walk Down Wall Street fame says that 66% of professionally managed portfolios are beaten by low-cost index funds. The third that beat the index in some particular period are not the same as those that beat the index the next period. (Page 29)

Professionals act not to make the most efficient risk-adjusted return but to protect their careers. (Page 31)

The equity risk-premium is not a fixed number but varies through time with market conditions, with demographics and with all sorts of phenomena that are determined by evolutionary forces. (Rhys, you will like this!) (Page 38)

The valuation evolution started at earnings, marched up the income statement to EBITDA (which ignores some expenses) and finally ended at revenue, thereby ignoring all expenses! EBITDA, pro forma earnings, eyeballs and hits have largely been discredited. The raw materials of valuation models still depend on the quality of the financial statements. The problem is that creative accounting makes it difficult to value companies. There are, however, methods to catch this sort of thing, (Page 40)

Standard and Poor have found that over one and three year periods ending 312 March 2003 18 out of 26 active managers did not beat the corresponding indexes. (69%, which correlates to the other survey above.) Some active managers beat the market because they take outlandish risks. (Page 44)

Mellon Capital Management uses enhanced indexing to manage its portfolios. It is well diversified across various economic sectors and over weights stocks that it believes will do well, based on fundamental analysis. (A sound approach.) (Page 45)

Stephen Dillenburg of Summit Investment Partners says that it is not fraud that causes inefficient pricing but the market’s failure to detect it. He uses the cockroach theory that says: “If you find one cockroach in your home, you know there are more.” The signs at Enron were:

1. 
   Excessive CEO compensation.
   
2. 
   Excessive dilution of shareholder value through staff options.
   
3. 
   Dominant inside directors on the board.
   
4. 
   Pandering to the financial analysts.
   

Many knew that Enron had problems but chose to ignore them. Even though information is knowable and solid, it does not mean that people will take notice. Even insiders, who were party to the deceit, ignored the events and maintained their holdings in their pension fund portfolios! (Page 52)

What You Always Wanted to Know But …

The Shady Side of Fund Management

The following terms are used in describing the shenanigans that go on in fund management:

Market timing: Trading in and out of mutual funds to make a quick profit.

Late trading: Buying or selling shares of a fund at a given day’s price after the usual close to enable to allow investors to act on after hours developments that could move prices.

Front-running: Trading stocks or bonds ahead of a mutual fund when you have information that the fund is about to buy or sell a particular counter.

Scalping: When a portfolio manager uses mutual fund assets to buy a stock to jack up its price when he already owns it in his personal account.

Cloning: Setting up a special brokerage account to conceal an investor’s identity thus helping him avoid detection by mutual funds that are trying to prevent market timing activity. (Fortune, November 24, page 92)

Value at Risk

In Mafia Buzz 13 I commented on an article written by Graeme Tosen on VAR. I said: “I would have thought that one could halve these percentages as we are only dealing with one half of the population mean.” He replied the day MB was published – I now have evidence that at least one person reads this publication! Here is his reply: “The fact that you only deal with one half of the population has already been factored in. The standard deviations used in the example (1,28, 1,65 and 2,33) are for one-tailed tests. If you performed a two-tailed test you would use 1,53, 1,75 and 2,67.” Thanks Graeme, you are a star.

Gross Domestic Product

GDP is a measure of total economic activity. It measures total production of goods and services within an economy that are not then used in producing other goods and services. It can be expressed in three ways:

1. 
   The sum of value added for all those involved in productive activity.
   
2. 
   The sum of all expenditures on goods and services, less imports.
   
3. 
   The sum of incomes generated by domestic production.
   

(Accountancy, December, 2003, page 52)

Fun Corner

Donald Rumsfeld won the foot in mouth award for the following utterance: “Reports that say that something hasn’t happened are always interesting to me because, as we know, there are things we know we know. We also know there are known unknowns, that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.” (Now you know!) Second prize went to Arnold Schwarzenegger who said: “I think gay marriage is something that should be between a man and a woman.” (Citizen, 2 December 2003)

A young person asked Charlie Munger, vice-chairman of Berkshire Hathaway (of Warren Buffett fame), how he can become rich like him but faster. His reply was: “Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you will get ahead, but not necessarily in fast spurts. You build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day. At the end of the day, if you live long enough, most people get what they deserve.” (Charlie, the guy wanted to know “faster”!) Other advice given was: “You need to read, and read and read.” And: “The idea of caring that someone is making money faster than you are is one of the deadly sins. Envy is a stupid sin because it’s the only one you can’t have fun at.”

Suggested motto for SARS: We have what it takes to take what you have. (Finance Week, 10 December, page 62)

Honest criticism is hard to take, particularly from a relative, a friend, an acquaintance or a stranger. (Franklin P Jones)

How does one account for Mr. Claus’s fleet of nine reindeer? Well these are biological assets but Mr. Claus does not carry on an agricultural activity so they are dealt with under property, plant and equipment (cost or value and depreciate). (Accountancy, Dec. 2003, page 86)

Websites to Visit

Here are some websites you could visit:

www.iasknowledge.com for international accounting issues.

www.icaew.co.uk for news items in the UK.

www.ifac.org for auditing standards.

www.saica.co.za for all sorts of professional matters.

www.paab.co.za also for all sorts of professional matters.

www.aimr.org for information on CFA.

www.hotchicks.com for . . . sies!

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