A plea for simplification
Business Finance (thereafter referred to as finance) has
grown in complexity over the years.  There are many activities
within finance which can be simplified or even eliminated
altogether.  There is a need to undertake a total review of this
complex universe with a view to simplify it and make it more
accessible and less (financially) risky to the public at large.
To clarify what I just said, I will discuss some (finance is a
vast topic, what follows is a small sample) problem areas of
finance.  I will also revisit the financial earthquake that shook
the world in 2008.

Who should carry out the review?  I propose a group made up
of experts (examples:  economists, accountants, financial
analysts, bankers, actuaries, former corporate executives, and
lawyers) and non-experts (examples:  teachers, doctors,
administrators, journalists, and small business owners).

Where should it take place?  Since the U.S. is the financial
heart of the world, it should be centered there, but it should
include as many countries as possible.

What will the end result of this review be?  Recommendations
will be made and as much as possible should be translated into
regulations.  In turn these regulations will vary from country to
country.  Ultimately, variations between states should take into
account the need to maintain a certain degree of global
uniformity, and should respect the ultimate objectives:  simplify
the system, and put an end to our yo-yo economies (recessions,
followed by financial prosperity, with the cycle repeating itself
ad infinitum).

Who will bear the cost?  The U.S. and developed countries.
There will be a need for a complete administrative structure with
researchers, analysts, and various other bureaucrats.  While the
cost will be substantial in absolute terms, it will be small
change for countries such as France, Italy, Canada, Japan, and
the U.S.  The return on their investment will hopefully be the
end of the present financial madness prevailing on this planet.

One last point before I move on.  If implemented, the review
should be revisited and updated (taking into account prevailing
economic conditions) every X number of years.  In effect the
first review will be our model T.  We will go on to improve this
first draft until we have a stable economy across the world.  You
and I will no longer be around when this dream will be realized.
But we will have the pride of knowing that it all started during
our lifetimes, and in a small or large measure have contributed
to it.

Trading shares on the stock market is a “two way auction.”
In an auction, two or more buyers bid against each other to
purchase the object auctioned; the eventual sale price is driven
in one direction – higher.  In a bidding for a block of shares
the stock price is pulled in two directions, the seller wants the
highest price possible, the buyer the lowest price possible.  In
other words, the price of the shares of a given corporation is
“floating,” it can differ from day to day or even from hour to
hour.  This is problematic and a better way (in keeping with the
spirit of the free market) should be devised.  Why is it
problematic?  Let us look at three examples.

Options

An option is the legal right to engage in a specific
purchase or sale at a stated price within a given time frame.
Let us look, and contrast, two situations, one in stocks and the
other in real estate.

Let us assume that the stock of ABC corporation is presently
$50 a share.  Let us further assume that you pay someone $500 for
the right to purchase 100 shares of that stock from him at that
price ($50) anytime within the next three months.  If, at a point
in time, within the next three months the price of the stock goes
up to $70, you can decide to exercise your option, giving the
other investor $5,000 (100 shares x original price of $50 a
share).  You can then sell them on the open market for $7,000
(100 x $70).  Your profit on this transaction will be:  $7,000
less the original purchase price of $5,000 less the $500 you paid
for the option = $1,500.  (Commissions and interest, if you
borrowed the money, were ignored in this example).  If we now
assume that the price has stayed at $50 or gone down during the
three months, your option would be worthless, and your loss would
be $500 or 100% of your investment.  (Options are securities in
their own right, they are commonly traded by themselves).

Let us assume that a tract of land is up for sale for
$50,000.  Let us further assume that you’re interested in buying
it, but haven’t made up your mind.  You offer the seller an
option to buy the land at the present price ($50,000) anytime
during the next three months, for that privilege you pay him
$2,000.  He agrees, and that means that for the next three
months, he cannot accept offers from other potential buyers.  At
the end of three months you decide not to buy the land and lose
the $2,000 you paid the seller.

Real estate options are bought to keep someone else from
getting a given property, therefore they play a useful role, even
if the option is not exercised and the potential buyer loses his
investment.  The usual reason for buying or selling stock options
is to make money.  There is, of course, nothing wrong in making
money; we invest money, and accept the risks, to make money;
however, in this case, we make money as in gambling.  Investors
bet on the outcome of a future event (the future price of a given
stock) and can get hurt.  In fact, it’s been estimated that 80% -
90% of nonprofessional futures and options traders lose money.
(Futures are not discussed here).

The existence of a floating price for shares is what permits
stock options to exist.  I realize that the replacement of
floating prices is a new idea; it is open for debate, but before
we start the debate, let us look at two more examples.

An investor can make money through short selling if he
determines that the price of a stock is likely to decrease in the
future.  The following example illustrates how it works.

Let us assume that the shares of XYZ corporation are
presently $80 a share.  If you expect the price per share to
decrease, you borrow from your broker 100 shares, sell them in
the open market and receive $8,000 (100 x $80).  A week later,
the price goes down to $70, you then buy 100 shares on the open
market and return the loaned shares to your broker.  Your cost
will be $7,000 (100 x $70).  Your profit will be $1,000 (8,000 -
$7,000).  (Commissions and interest charged by your broker for
the loan of the stock were ignored in this example).

However, the above example is not typical, not all investors
who engage in short selling fare as well.  There is an
interesting psychology here, short selling of a particular stock
tends to increase as the price of that stock decreases, thus most
short selling is usually at the bottom of the stock’s price.  For
this reason, many investors who engage in this practice can be
hurt.

Say that you borrow from your broker 10 shares of a stock;
presently, the price per share is $10.  You sell them in the open
market and receive $100.  A week later, the price is $12; you
decide that it is risky to wait, you buy 10 shares on the open
market for $120 and return the loaned shares to your broker.
Your loss will be $20 plus commissions and interest.  Of course
you could have waited, but it is a risky strategy, the price can
go even higher and you risk increasing your loss.

Again we can see that the existence of a floating price
brings an element of gambling (by buying the stock when the price
is low, investors are too close to the edge and are more likely
to get hurt).

Hedge funds

There is no strict definition of hedge funds.  They might be
thought of as high-end mutual funds.  A hedge fund is, generally
speaking, the pooled capital of usually 100 or fewer partners
(rich individuals or institutions), led by a single manager or a
small team.  They are subject to few regulations, if at all; many
are registered in offshore havens, even though they are managed
from places like New York and London.  They can invest their
capital any way they like, from government bonds to highly
speculative stocks.  Since they don’t need to file any reports,
we can only guess at their numbers.  As of 1994 (this is the only
information I could find, even though dated, it will still give
you a good idea of the magnitude of the problem), it was
estimated that there were between 800 and 900 hedge funds with
total capital of $75 – 100 billion.  Since hedge funds borrow
aggressively, they can take positions from 5 to 20 times their
paid up capital, meaning that in total they can control anywhere
from $375 billion to $2 trillion in securities.  Compounding the
problem is the fact that they move very quickly in and out of
investments.  As we shall see, hedge funds has had a substantial
impact on the markets.

They were responsible for much of the turbulence in the
European Monetary System in 1992 and for the U.S. bond market
debacle of 1994.  Since they borrow so heavily from banks, a
really disastrous year for the speculators could do serious
damage to the broad financial system; central bankers and
regulators may face the choice of a bailout or systemic collapse.
Finally, with the vast sums of money at their disposal, there is
the concern that hedge funds operators could manipulate the
markets.

Hedge funds are a case in point, they clearly show the
potential for damage if we do not find a substitute to the
floating price of shares.

Sources

1) How to Read and Understand the Financial News
Gerald Warfield
Harper & Row, Publishers, Inc.
New York
1986

2) Wall Street, How It Works and for Whom
Doug Henwood
Verso
New York
1997

The name is somewhat misleading since stocks are not the
only instruments traded on the stock market; bonds, warrants, and
even financial futures are routinely traded.  However, stocks
have the lion’s share in term of trade volume.

To the layperson the stock market exists to raise capital;
the truth is that it does so only to a very limited extent.
Between 1982 and early 1996, U.S. nonfinancial corporations
retired over $700 billion more in stock than they issued, thanks
to takeovers and buybacks.  Most of the daily trading is of
existing shares.  Nevertheless, the trading of existing shares
represents an important activity; for instance, chronically low
stock price for a corporation can be an invitation to a takeover.

Even after a total review of our financial system, and a
replacement of the floating price of shares, I believe that the
stock market will still have an important role to play.  We will
still need the stock market to trade bonds, other instruments,
and existing stocks.  But the stock market of the future may be
quite different from the present one.

Sources

1) How to Read and Understand the Financial News
Gerald Warfield
Harper and Row, Publishers, Inc.
New York
1986

2) Wall Street, How It Works and for Whom
Doug Henwood
Verso
New York
1997

I do have to ask at this point the following question:  Of
what use is history to us?  We never seem to learn.  Past history
has provided us with many lessons of the problems that can affect
the banking system.  And yet, what did we do?  We have given
the banks, in the ’90s and the first part of the 21st century,
unfettered freedom.

The Savings and Loans (S&L) saga

As an example of a more or less recent financial meltdown,
and the impact bank problems can have on the financial system,
let me recount the sad tale of the Savings and Loans (S&L).
(S&Ls are also known as thrifts).
The S&L debacle of the 1980s is one of the greatest monetary
disasters of all times.  When they collapsed, the cost to the
U.S. government was estimated at $200 billion.

S&Ls were born in the 19th century, they were mutual savings
banks that pooled the savings of workers to finance home mortgage
loans.  In the 1960s, S&Ls faced competition from banks both for
deposits and mortgages.  In the 1970s, money market funds were
competing with S&Ls for deposits.  However, it was the inflation
and the high interest rate of the late 1970s that exposed the
S&Ls flaw:  depositors tempted by higher rates in the unregulated
markets withdrew their funds, but these funds have been committed
by thrift managers to long term mortgages.  As rates rose, the
value of outstanding mortgages sank (loans such as bonds and
mortgages move in the opposite direction of interest rates).
S&Ls find themselves mired in the red.  The solution was to
deregulate them.

Once free of strictures, thrifts engaged in doubtful
financial ventures, examples:  superfluous shopping centers in
the middle of nowhere, speculative office buildings, and junk
bonds.  To engage in these pursuits, and later on to cover
losses, thrifts pushed up interest rates to attract deposits from
Wall Street.  Predictably, many thrifts went bust.

The financial disaster that ensued was blamed (depending
upon who you listened to) on greed, incompetence, fraud,
inflation, interest rate volatility, real estate slump, deposit
insurance, auditors, the media, regulators (federal and state),
and Congress.  However, this blaming game offered no solace to
the government when it had to come to the rescue; Washington had
no choice in the matter, no modern government can afford to let a
financial crisis turn into a general collapse.

In any financial review we undertake, we will need to take a
close look at the banking system.  There is a lot at stake here.
Mistakes, as we have found out as recently as 2008, can spell
disaster.

Source

Wall Street, How It Works and for Whom
Doug Henwood
Verso
New York
1997

                                               *  *  *

There are two more topics to be addressed:  The need for
regulations and auditing.  Before doing so, I will take a bird’s
eye view of the financial crisis of 2008.  It will provide a
context for what I have said before, and what I will discuss
after.

The subprime mortgage meltdown

The subprime mortgage crisis was due to the fact that one of
the cardinal rules of extending credit was broken.  Subprime
borrowers were given a loan, even though their ability to repay
was questionable   The result was a dramatic rise in mortgage
delinquencies and foreclosures in the U.S.  A chain reaction
followed that affected first the homeowners, then the banks, then
the numerous investors who got caught in that scheme, and finally
the financial markets around the world.

It all started towards the end of the ’90s, and became
apparent in 2007. The problem is still very much with us, many
accounts are still delinquent, and many more houses will be
repossessed.

Who is a subprime borrower, and how could a family be
tempted to overextend itself?

Some red flags which indicate that a family will not be a
prime borrower are:

*  Low family income.
*  The absence of any assets (car, securities, etc.);
*  Overdue loan repayments to previous loan(s);
*  Repossession (example a car), or non-payment of a loan in the past;
*  Bankruptcy in the last 5 years;
*  Relatively high default probability as indicated by the credit score;
*  Accuracy of the credit data as reported by the underwriter.

The matter is clear:  you’re prime if you have a good income, some assets, and a good credit rating as evidenced by your past credit history.  You’re subprime if you have some of
the aforementioned issues, and under no circumstances should you
get a mortgage.  But how did you get one anyway?  How where you
tempted?  Let me answer the second question first.

The Jones are struggling financially.  Mr. Jones is a part-
time messenger by day, and a security guard in the evening.  Mrs.
Jones is a waitress.  Their only son study and works a few hours
a week.  Their only asset is a 10-year-old car.  They used to own
a better car, but it was repossessed when they couldn’t keep up
with the payments.  They are consistently late paying their rent.
They owe sizable amounts to their credit card companies.  Would
you loan a substantial amount of money to the Jones?  Of course
not.  And yet …

One day, the Jones get a flier in the mail.  They apparently
can own their own home.  Call this number and somebody will come
and explain to you how you can realize your dream.  The gentleman
who meets them is very reassuring.  Down-payment?  We don’t need
any.  Our income is low, we can hardly make the rent?  Don’t
worry about that, I’ll show you how it works.

So how does it works?  The interest rate at the beginning is
low, but then, after two years it increases substantially because
they are a high credit risk.  That, however, shouldn’t present a
problem; the price of homes is continually rising, they can
refinance (i.e. get another loan based on the increased value of
their house).  The amortization period is 35 years, instead of
the traditional 25 years.  (I read that amortization periods of
50 years were offered by some banks!)  It’s a bedtime story!  But
the Jones do not have the necessary education to properly
evaluate this foolish offer, and they accept it.

In time, interest rate, as promised, increases; the value of
their home, as promised, go up too; all is well so far.  However,
the day comes when the price of their home decreases and keeps on
going down.  It doesn’t take long before they find themselves
facing a painful financial situation.  By 2007, they can longer
make their mortgage payments and they lose their home.  The dream
has turned into grief.  The Jones are a fictional family,
countless other American families are real flesh and blood
people, and their pain is just as touching.  But what is the
interest of the lenders?

Put in a simple way, the loan given is rolled up and
amalgamated with all other subprime mortgages.  The whole thing
is in turn sold out to the big boys on Wall Street.  But that
requires phenomenal amounts of money; as well, why should Wall
Street institutions be willing to assume such an enormous risk?
The simple answer is that they are getting the funds from
numerous investors, both average Joes, and big institutions, and,
yes, they (the investors) are the ones who assume the risk.  But
how and why should people invest in such risky mortgages?

There is something called Assets-Backed Commercial Papers
(ABCP).  They were born in the ’90s, the return is somewhat
better than a bond, and they are backed by solid (or so we
thought at the time) assets.  Security and good income, who can
ask for more?  I never invested a penny in ABCP even though they
were touted as granny’s investments.  Why was I suspicious?  No
logical reasons, except that I detected a faint bad smell around
them, the smell of it’s too good to be true.

When in time many of the ABCP proved worthless (because they
were largely backed by subprime mortgages), many ordinary
investors and institutions lost substantial amounts of money.
For instance, many big banks had their capital and cash reserve
sharply reduced when their ABCP proved valueless.  Many
corporations had their near-cash (called this way because it’s
considered almost as good and as liquid as cash) reserve greatly
reduced when their ABCP lost their value.  This lack of
confidence, needless to say affected markets around the world.
But you might say that the so-called investor banks on Wall
Street fared well since the whole scheme was meant to benefit
them.  Well, not exactly.  When the house of cards came tumbling
down, they were gravely wounded.  Why?  For that we need to
understand the principle of leveraging, the weapon these storied
firms used to make enormous profits.

Big investment banks on Wall Street such as Lehman Brothers,
Merrill Lynch, and Morgan Stanley were until recently the most
prestigious financial corporations on Wall Street.  They made
huge investment bets with borrowed money, opened branches all
over the world, paid enormous salaries to their executives, and
in the process helped transform the financial landscape.

For so many years, it looked so rosy.  Nothing could go
wrong in this Shangri-La.  But these fortresses were built on
sand.  They were built on leveraging.  And, sooner or later, the
whole thing was destined to come tumbling down.

A $100 investment funded with you own money and earning $10
will provide you with a return of 10%.  But a U.S. investment
bank would typically borrow $95 and use just $5 of its own money;
by earning $10 they would double their original investment of $5.
This in a nutshell is what leveraging is all about.  You can make
enormous profits.  You can also take major risks since you’re
largely using somebody’s else money.  (The interest payable on
the money borrowed is ignored in this example).

But there are two sides to leveraging.  If the venture were
to lose $10, the investment bank would not only lose the $5 it
had invested, but also $5 of the borrowed money.  It wouldn’t
take too many such bad deals to exhaust its thin capital reserve.

Essentially, this is what happened to Bear Stearns and
Lehman Brothers.  They had bet heavily on risky securities tied
to the disastrous U.S. mortgage market.

By now you’ve figured that the above behavior is the reason
why these banks are called investment banks.  A regular bank will
mostly (but not exclusively) take deposits and provide loans to
prime borrowers.

In Canada (and most other industrialized nations) investment
banking (stock trading, packaging and selling securities, etc.)
is mostly done by the same commercial banks that provide you with
banking services through its numerous branches.

Commercial banks in Canada are regulated, and their leverage
(the amount of borrowed money they use to do business) is limited
to a fraction of that found in the lightly regulated U.S.
investment banks.

While Canadian banks can never earn the fabulous profits of
their counterpart in the U.S., they are exposed to much less risk
in bad years.

“Changes that usually take place over years are happening in
weeks and days,” said Craig Wright, chief economist at the Royal
Bank of Canada.

In the spring of 2008, the news of the near collapse and
forced takeover of Bear Stearns took me totally by surprise.  I
read the article relating to its demise twice; I wanted to
properly understand how such an institution could fail.  Little
did I know that this was the beginning of a serious crisis.  By
the time it was over (assuming it is), I was reminded of the
biblical expression:  “How have the mighty fallen!”

By September 2008, two financial giants found themselves on
their deathbeds.  Lehman Brothers, founded 158 years ago, filed
for Chapter 11 bankruptcy protection after failing to find a
buyer.  Merrill Lynch, a storied institution for the last 94
years, sold itself to Bank of America for $50 billion in a rush
deal hashed out on a Sunday.

A week before, the U.S. Treasury placed mortgage companies
Fannie May and Freddie Mac into conservatorship (they guaranteed
their liabilities while all but erasing their equity value).

American International Group (AIC), once the world’s largest
insurer, is struggling financially and is attempting to raise
cash.

The survivors:  Goldman Sachs and Morgan Stanley.  They are
now deposit-taking and lending institutions (i.e. they are no
longer investment banks).  With the extinction of the dealmaking
banks, an adventurous era has come to an end.

Those that are struggling

The largest and third-largest U.S. banks by assets,
Citigroup and Bank of America, have been badly affected by the
credit crisis.  They have now taken $45 billion from the
taxpayer-funded $700 billion Troubled Assets Relief Program.

British lender Barclays PLC has seen the value of its shares
sliding on concern it might not have enough capital to cover
writedowns.  There has been some recovery in the share price
after the bank announced that pretax profit would exceed
expectations.

Ireland nationalized Anglo Irish Bank.

Government intervention

After years of parenting, there comes a time when our
children are grown up.  Our responsibilities towards them,
however, never really ends.  If they are in trouble, we, out of
love, do our best to help out.

The government is sometimes forced to play the same role.
It is not for nothing that the expression “The Nanny State” has
been coined.  There are two differences between parents and
government:  First, the government doesn’t do it out of love!
They only intervene when it becomes absolutely necessary.
Second, unlike parents, they are sure to be called upon to clean
numerous messes, big and small.

To say that Congress needed to have its arm twisted to
provide a bailout is to understate the case.  A bailout of $700
billion was requested; not surprisingly, Congress balked.  It was
first voted down.  However, when representatives and senators
were apprised of the consequences, they very reluctantly
relented.  There was a carrot for the American taxpayers who were
advancing huge amounts to an ailing banking system; they were
investing in these banks and could make money down the road.
People in the know have great doubts that this venture will one
day turn into a profitable deal.

When the executives of the three Detroit automakers came to
Washington for a bailout in their private jets, they were turned
down by Congress.  The Bush administration advanced them funds
(to avoid another catastrophe) out of the original $700 billion.

President Obama is talking of a deficit exceeding $1
trillion.  An amount ordinary mortals cannot grasp.  How much is
the National Debt of the U.S.?  How much will it be after this
deficit?  I could find out if I wanted, but I prefer to remain
ignorant!

Canada has not been as badly affected since its banks are
well-regulated.  Nevertheless, the credit crunch has not passed
them by.  The banks are reluctant to lend money.  The government
has advanced them money to allow them to loosen their purse
strings.  The final amount to address this crisis is difficult to pin down; it’s continually shifting.

Sources

Ottawa Citizen, Business & Technology section:

1) September 16, 2008
Storied firms victims of “tectonic shift”
By Christine Harper

2) September 16, 2008
Wall’s Street’s turning point
By Jacqueline Thorpe

3) September 23, 2008
The gilded age of Wall Street comes to a dead end
by Jay Bryan

4) September 23, 2008
Concerns mount over U.S. bailout plan
By Mark Egan

5) January 17, 2009
Bank of America, Citigroup post losses in billions
by Jonathan Stempel and Dan Wilchins

Laissez faire

Laissez faire is a French expression which means let them do
it.  Put another way, it means give them the freedom to do as
they wish without interfering.

Laissez faire is both a political and economic doctrine
which advocates a minimum of government meddling in industry and
trade.  It was born in the 18th century in France, and its
principles were enunciated by the French physiocrats (pioneer
economists).  Britain adopted these rules, and further expanded
them.

Adam Smith, father of classical economics, believed that
individual welfare was more important than national power.  When
individuals were free to pursue self-interest, competition among
them would become more effective than the British state imposing
its own regulations.  Smith did not believe in laissez faire in
an absolute sense; the state still had many important roles to
play.  Jeremy Bentham made it into a philosophy of individualism
and utilitarian ethics; and John Stuart Mill brought it to what
was probably its highest point.

By the 19th century, more and more businesses find it in
their interest to join forces in order to control prices and
production.  Thus monopolies were born, and the underpinning of
laissez faire, competition, was being thwarted.  As well, there
were abuses such as long hours and woman and child labor in the
factories.  The British government (as well as other governments)
found itself forced to put water in the (free enterprise) wine.
The original ethical principles were trampled underfoot.  And the
need to regulate this new capitalistic society was born.

The need for regulations

Imagine watching a tag of war.  Both sides are neither
winning nor losing; there is a movement in one direction, a
movement in the other direction, and on it goes with no end in
sight.  This is what takes place between the business world and
modern governments.  States are caught in an endless dilemma:
Regulate too much and you risk killing the goose that’s laying
the golden eggs.  Avoid overregulating, and greed followed by
grief will result.

I said at the beginning that nobody is winning the tug of
war.  That’s not quite true; our governments in North America
and Europe have in the last few decades given the free
enterprise world far too much freedom; regulations has become a
dirty world not to be mentioned in polite company!  This despite
bitter past lessons.  We never seem to learn.

Enter 2008.  The naked face of greed has turned our
unregulated world into a living nightmare.  The naive assumption
of “letting the managers manage” has exploded in our face.  The
sharp executives have proved to be very human; human in their
inability to properly manage their businesses; human in being
greedy and paying themselves obscene salaries and bonuses; human
in protecting their interest first and foremost.

Will our governments get wiser in 2009?  Will they realize
that the corporate leaders are not choirboys, but rather
individuals with only their own welfare in mind?  Will they
finally understand the need for regulations?

Regulating by itself isn’t enough.  Monitoring what goes on
in the business world is just as important.  And this is the role
of the auditors.  A different breed of auditors.

Source

The Illustrated Columbia Encyclopedia
Columbia University Press
New York
1969

Towards the end of the 1920s, the stock market was on a joy
ride.  The thinking was that there has never been a better time
to invest.  Financial statements of many corporations brought
tears of joy to one’s eyes.  They were not printed on pink paper,
but, oh, everything was so rosy.  In time it was realized that
they should have been printed on red paper, for there was so much
red ink behind the stated figures.

There were too many factors behind the great depression, one
of them was that the auditing methodology of those days was
flawed.  Two examples follow.

Auditors accepted the receivables figure on nothing more
than the verification of supporting documents.  They accepted the
inventory figure by referring to back-up invoices, establishing
reasonability via calculating applicable ratios, and discussions
with management.  They were in effect largely accepting these
critical figures sight unseen.

After the market crashed in 1929, the financial world came
to realize the hollowness of many so-called blue chip companies.
Window dressing and outright fraud was behind many of the figures
reported on their financial statements.  Were the auditors asleep
at the switch?  Indeed they were.  The profession was to learn
lessons that were never forgotten.

The audit methodology from that day on included, among other
things, an independent confirmation of the receivables and a
physical verification of the inventory.

On a test basis (and with an eye on materiality) you write
to the customers of your client and ask them to confirm the
receivable figure.  The answer comes to the CPA office and not to
the client!  (The idea is to ascertain that these clients really
exist).  All other procedures such as verifying supporting
invoices are still carried out.

Back in those heroic days, near empty warehouses were
sometimes behind a reported inventory figure of million of
dollars.  Therefore, now, on a test basis, auditors carry out
their own count.  They do not merely count, they check the goods
to determine that they are in a good state, that they are not
obsolete, and so on.  Again all other necessary procedures are
still carried out.

What follows may be considered by some of you as snooze
material.  But remember this, the job you hold, the bank(s) you
trust with your money, the funds you invest, the pension
(including government pensions) you will rely on when you retire,
the taxes you pay, what the government does with your taxes, and
a host of other financial duties that affect you directly or
indirectly are carried out or monitored (audited) by your
friendly CPA (CA or CGA in Canada).  You want him or her to be
sharp.  And you want to be wide awake while you read what will
follow.  I have tried to make it interesting, but there is only
so much you can do with accounting!  (There are so many engaging
programs on TV on issues affecting doctors and lawyers, but have
you seen a program regarding dramatic events unfolding in a CPA
office?!)

What do auditors do?

Auditors express an opinion on the financial statements.
What this means in simple terms is that the figures reported on
the statements are checked back to the ledgers and to a sample of
the supporting documentation.  As well, a variety of ratios are
calculated to determine the reasonability of the reported
figures.  Finally, as discussed above, a confirmation of the
accounts receivables and a physical verification of the inventory
take place.  Many additional procedures are carried out, they
will vary according to the nature of the entity being audited.

Auditors will have numerous discussions with the staff and
with management.  Management will explain the estimates,
assumptions, and interpretations made, and the auditors will
decide on the reasonableness of the explanations offered.

Once the audit is completed, and the auditors and management
agree on all material items, the auditors will issue an
unqualified opinion (a clean bill of health).  Needless to say,
there is rarely, at the onset, a meeting of minds between
management and the auditors.  There is a give and take process
that goes on until both parties reach a compromise they can live
with.

If management and the auditors cannot agree, or if the
auditors have encountered problems regarding a material item(s),
the auditors will issue a qualified opinion; for instance they
may say in their report that the inventory should be valued at
$xxx instead of the amount reported on the financial statements,
and they will explain how they have arrived at their valuation.

In more extreme cases, they will issue an adverse opinion,
or a denial of opinion, if the financial statements do not
reflect the true financial status of the corporation, or if they
were unable to conduct a proper audit because adequate records
were not kept.

While the auditors report to shareholders, there are third
parties who have a stake in the financial affairs of the
corporation; examples:  bondholders, banks, and major suppliers.
Can all concerned have peace of mind once the auditors have
issued an unqualified opinion?  Not exactly!  There are three
problem areas I want to address.