Auditors face challenges as they check the books
Auditing work for last year's earnings has begun and it is going to be a hair-pulling exercise for most corporate bean counters.
The challenge is in quantifying the 'unquantifiable', with subprime-related losses being top of the list in Hong Kong followed by the recent penchant for companies to cash in on the resources boom by acquiring remote mining assets.
The subprime crisis has wiped out enormous amounts of wealth. But for auditors, the question is how much of their client's wealth has disappeared and would disappear in the future.
To answer that, they have to determine the 'fair value' of the subprime-related products. This is no easy job.
Imagine you are holding a piece of financial paper which is so complicatedly structured that you can't even tell what is the underlying asset and value. As an alternative, you will suggest looking at the market price of the paper. Yet you find no trading of the paper at all.
That's what's happening with subprime-related products. The auditing issues have been so challenging that the Public Company Accounting Oversight Board, which regulates auditors in the United States, issued a guideline before last Christmas.
While their international peers are struggling with how to avoid under-provision of their losses, local auditors are at the other extreme.
Both the Hong Kong Monetary Authority and bank managements want more aggressive provisioning but the auditing profession is hesitant. While the regulator's prudence is understandable, the industry's position needs some explanation.
Imagine yourself as a chief executive. The operating business is sparkling but you have a lousy financial investment on hand. Would you go for a big or small write-off?
Big and for three reasons: the beaten but still acceptable bottom line can be more easily swallowed by shareholders; the subprime loss is expected; and there lies a chance of writing back in the future.
That's exactly the case for Hong Kong banks. Business was exceptionally good last year, in particular towards the end when the interbank rate was pushed to the bottom by the dollar injection of the HKMA to defend the peg. Interest margin has been handsome.
Yet it is an auditor's job to ensure the financial statement fairly reflects the business. The profession's debate with the regulator and bank managements is understood to be on-going.
No less controversial is the accounting treatment of mining resources and businesses that dozens of listed companies ventured into last year amid rising raw material prices.
Suddenly, auditors find their fashion or herbal drink-making clients owning a coal or iron mine somewhere in a remote part of the mainland, Outer Mongolia or Madagascar.
The question is how to value these assets. Those who've read the unaudited interim report of Sino Union Petroleum and Chemical International will know what I mean.
This inconspicuous company boasted a profit of HK$4.44 billion, largely from the HK$5.1 billion valuation the management put on the newly acquired oil that still lies thousands of metres underground in Madagascar. 'For sure management will get us technical reports proving there are good things down there,' said a partner with an international auditing firm. 'But that's only the beginning.'
Can the auditor trust the report done by some little-known geology team from the mainland? Can he or she trust the so-called official sitting somewhere in the mountains and confirming that the company does have the right to mine?
Even if the answers were yes, can he or she accept that the client has the technical and financial ability to get the mineral out of the ground and build the promised thousands of kilometres of railway or deepwater port to deliver the mineral to the market?
And when one is talking about countries where law and order is a problem, the challenges can only multiply.
(How difficult? Consider the conversation I had with an official of a major valuation appraisal firm.
'So, how can responsible appraisal be done with the mines that the companies are acquiring?'
'All I can say is that we are not involved in any of the deals that have been announced so far.')
Yet without a definitive answer to any of the above questions, no prudent auditor can comfortably accept a market value of any mining asset.
I've mentioned two mind-boggling issues that auditors can be confronted with. But the list goes on, for example, the accounting treatment of convertible bonds that many companies issued last year and the stake in mainland-listed firms that rejected external auditing.
So do not be surprised if you hear more resignations of auditors or last-minute changes in accounting policies. Just look at the audited numbers with your eyes wide open and trust your common sense.