Sunday, 26 August 2012

The Beauty of Creative Accounting

The Beauty of Creative Accounting

When an organisation is confronted with a situation that could be misunderstood by shareholders, customers or voters it is essential that the organisation manage the release of that information in a manner that minimises the risk of an overreaction from those shareholders, customers or voters.

The New Zealand Government was recently challenged by this very dilemma. New Zealand’s second most populous City was devasted by the most damaging (per capita) natural disaster in the history of the OECD. Occurring during the depths of the Global Financial Crisis it would have been especially imprudent for the Government to respond with the usual excesses of socialistic generosity towards disadvantaged residential property investors that are characteristic of left wing governments such as Japan and the United States of America under George W. Bush. Such profligate use of taxpayer funds would have placed the New Zealand Governments AA+ credit rating at unacceptable risk. However, with an election looming the Government had to gie the impression of being compassionate and generous whilst actually acting with great fiscal prudence.

New Zealand’s statutory requirement for Government’s to produce “no surprises” budgets means that when the current government commits future governments to spend money those future liabilities must be included in the current accounts as though all of the future commitment had been spent in the current financial year. By contrast, revenues may only be included in the year in which they are actually receipted.

To this end it has indeed been fortuitous that the Government has been operating a natural disaster insurance scheme, the EQC. By adding the liabilities of the Government’s insurer to the Government’s account whilst excluding the insurers invested reserves was able to exaggerate both the Government’s financial assistance and the earthquake’s impact on the Government’s accounts. Thus the 2010/2011 Budget had to include EQC’s claims liability of $3.3bn but could not include any reference to the fact that the EQC held $6bn in reserves to cover these costs as these reserves held in investments, which cannot be counted as revenue until the investments are converted into cash.

Furthermore, the Government estimated that it would face costs of $2.2bn but allowed a contingency for a further $3.3bn of costs to be subsequently identified, thus creating a future liability of up to $5.5bn.  However, this liability would be significantly offset by charging GST on the rebuild of Christchurch but under the “no surprises” accounting regime this revenue cannot be included in the Government accounts until it is actually receipted. Thus the earthquake’s impact on the Government’s accounts was able to reported as a deficit of $8.8bn whereas the actual impact on the Government’s accounts at the end of the reconstruction of Christchurch would actually be between a surplus of $700m and a deficit of $2.2bn.

Thus the Government was able to tell voters that the earthquakes were seriously hurting the nation whilst receiving a generous response from central government, without having to tell lies and with the confidence that the international credit ratings would check the full facts and assess the Governments credit rating based on the longterm fiscal impact.

A year later and the circumstances have become even more convenient for keeping socialist voters satisfied without offending fiscally prudent voters. Independent loss assessors have concluded that EQC’s claims exposure could exceed EQC’s reserves and reinsurance cover by up to $1.5bn. Fortunately, the total estimated cost of reconstructing Christchurch has also increased resulting in a $1.5bn increase in GST levied on the reconstruction. If the EQC loss assessment is pessimistic then the Government could achieve a surplus of $2.2bn. But its maximum deficit would still be $2.2bn.

Unfortunately the summary account released for the $5.5bn Canterbury Earthquake Recovery Fund in Budget 2011/12 indicates that almost $2bn of the unallocated funds have now been mysteriously allocated. Board documents available from the New Zealand Transport Agency reveal that at least $500m of the “other costs” is for road repairs even though traffic using Christchurch City Council owned roads pays sufficient in fuel taxes and road user charges to the Government to meet the road repair costs without requiring taxpayer assistance. Discussion of the following table from Budget 2011/12 with insurance brokers and property developers has led to universal bemusement at the incompetence of Government departments when dealing with skilled negotiators from insurance companies and property development companies and a general consensus that CERA is spending three times more than is reasonable on this EQC de-risking exercise.

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