Archive for November, 2009

Last Thursday evening I had the distinct pleasure to be invited as a delegate to the World Economic Summit held at a private farmhouse in a secluded section of Newtown, Connecticut.  

Delegates from far and wide, and from many disciplines, attended the event.  The atmosphere was cordial, but with a certain seriousness in the air.  

The session started with a searing review of the always problematic Hungarian banking sector.  The representative from the sector asserted they had taken the usual austerity measures, but to everyone’s dismay, the sector looked bloated as usual.  

At first the delegates believed the sector to be “too big to fail” but after some heated discussions in the plenary session it was unanimously agreed that the sector had actually ceased to function many years ago.  Nonetheless the delegates expressed their continuing affinity for this sector during the remainder of the evening.    

The Portuguese delegate gave a report on bankruptcy and insolvency.  After questioning some of the representative’s travel expenses, a resolution was passed declaring that “bankruptcy is good.”  The Portuguese representative received many inquires during sidebar discussions on how one could actually become employed at a bankrupt firm.  

A special emissary from the agricultural industry was on hand to present some of the challenges of that industry and its importance to the sustainability of the food supply.  Much was gathered by the attendees during his presentation.  As a first time attendee, this representative seemed taken aback at times by the candor of the sessions, but later proved he could singlehandedly become the life of the party.  

I had a private discussion with the Italian delegate, who gave a sobering review of the energy and financial services markets.  His comments were tempered by his view that current energy issues are caused by mismanagement rather than an intrinsic supply problem.  It did not go unnoticed that he peppered his comments on energy consumption with periodic glances toward the Hungarian banking representative.    

Observer status was granted to a University of Connecticut student who took the discussions in stride, albeit at times with some concern.  His company was thoroughly enjoyed by the delegates as his enthusiasm reminded them of fleeting days of their youth.  

All of this was presided over by the Master of Ceremonies, a stately gentleman who ensured the delegates were well taken care of and that they continued to focus on the business at hand.  Periodically the MC would weigh in with a sage comment to solve some of the thornier issues that came up. 

At this point some may be wondering, “What the heck is talking about?”  “We didn’t hear about any “world summit” in Newtown!” 

There wasn’t one.  

What I was describing was a periodic get together of friends.  All I did was formalize the language used to describe the events of that evening.  All of the conversations described above actually did take place and the people attending really did express the very salient points outlined above.  

So why go through the trouble?  Why not just say that we had a night out with some old buddies? 

My friends, is anything we write about at the Recon without deeper meaning? 

Just two days ago the World Economic Forum finished their “Second Summit on the Global Agenda.”  This conference was attended by over 700 experts and thought leaders from business, academia, civil society and government.  

I have been watching these summits and forums for years now.  They are all billed as momentous events attended by the leaders of humanity itself.  Who can forget the flashy pictures of CEOs, politicians and Nobel winning professors in Davos smiling at the cameras as they enter and exit the conference.  

When looking at the output of these summits; however, it’s so hard not to be underwhelmed.  Let’s take a look at some of the “incisive” quotes from the conclusion of this latest summit in Dubai: 

“It’s very clear that one of the things which is going to determine whether we succeed or fail is our ability to develop new technologies, and to utilize those new technologies to the best of our ability.”  

You mean technology is a factor in success?  Who would have thought…. 

“There was an agreement that the risks, vulnerabilities and failures [that the crisis revealed] are not a one-off phenomenon, but a wake-up call,” “Risk is the new normal.” 

We were always fearful of the day when risk would become part of life.  How we long for the days of no risks!  Well, at least we still have a systemic lack of accountability to fall back on…. 

“This has been an extraordinary opportunity to take stock of the state of educational opportunity all over the world and to develop a strategy to make sure that we prepare students all over the world to have 21st Century skills.” 

What are these 21^st Century skills?  Computers…agriculture… or whatever is “hot” in California at the moment?

These conferences don’t really say much for many reasons, but one of the primary reasons is lack of candor.  

Candor? 

Yes, the ability to express, without reservation, what the true problems and issues are and to propose solutions that will mitigate the problems, without any preconceived ideas about what the solutions “should be.” 

Turning back to our own little summit in Newtown, why was it so easy for the attendees to express the true state of affairs and offer a specific plausible solution..or to simply state that the issue could not be solved at the present time? 

They live in the real world.  

Each of the people sitting around the bar in Newtown is responsible for running a business, managing a portfolio or executing a fiduciary responsibility of some kind.  To perform these functions successfully you cannot be vague, continually state the obvious, or attempt to put in place solutions that sound nice but are unworkable.  

The guys in that room get up every morning, put in a hard day’s work, help people out and solve problems.  

Then they go home and …. put in a hard night’s work, helping people out and solving problems.  

So how did we end that night Newtown?

 I guess I left out the most important part of any world summit, the “Conference Declaration” at the end of the event that is covered by the press and broadcast throughout the world.  

Ours was much simpler.  I can’t remember who called this out to me as I was leaving but as I was walking outside someone said, “Your ugly, take care and call me if you need anything.”  

Have a great Thanksgiving!

Michael Bechara, CPA

Managing Director

Granite Consulting Group Inc.

mbechara@consultgranite.com

www.consultgranite.com

I remember long ago when I was in high school there was a kid with a big mouth.  I’ll call him Larry. 

These were the days when understanding macro economics was not cool.  I was in auto shop class at the time and dead set on becoming an auto mechanic.  An inexperienced kid, I had not yet discovered the seductive allure of finance and economics.  

Larry was one of those guys that was skilled at hurling insults at people. He was average in size, but certainly no brute.  I remember distinctly one particular day, in the school cafeteria, he began to hassle one of the football players.  A linebacker as I recall. 

Larry went on and on with the usual litany of insults.  He degraded the other guy’s clothes, his car and his girlfriend.  As human nature took over, the other kids began to gather round to witness, and hopefully participate, in another human’s agony.  

As Larry intensified his attacks, he saw that some of the prettier girls had arrived to witness his show.  I guess that’s what prompted him to go for it.     

Larry decided to cross the Rubicon. 

“And your mother is so……” 

It happened so quick that for a moment I didn’t understand why Larry’s sneakers were suspended just below the ceiling.  

In one fluid motion, the big linebacker had picked up Larry’s chair (with Larry still sitting in it) raised it above his head and slammed it to the floor (again with Larry still sitting in it).

There was Larry, sitting in his chair facing the ceiling, like an astronaut ready to blast off.  The linebacker’s foot was placed lovingly on Larry’s neck.  

As the crowd looked on, I don’t think many of them realized that with a bit more pressure the linebacker could have snapped Larry’s neck. 

 Larry would have made a great monetary official.  

At the current moment many in the media and government are telling the Chinese that they may have to live with low interest rates and a weak dollar.  Of course, China being the largest holder of US Treasuries, tends to be somewhat interested in the status of the dollar.  

Just to recap, since the US Government spends much more than it collects in taxes, it has to make up the difference by borrowing.  Since we have negligible amount of savings, it must borrow this money from foreigners.  Enter the Chinese.  

Taking this a step further, it also means that the various stimulus programs and bailouts are effectively being paid for by China.  Cash for clunkers, extended unemployment benefits, et al.  China is a major component of our economic policy.  

But there is wrinkle to the story.  If China were to dump their US Treasury holdings they could effectively collapse the Treasury market.  

Given all of this, is it wise to be telling the Chinese that we are going to spend, spend, and spend and keep interest rates below the rate of inflation?  In addition, are we being too foolish by saying that the Chinese need to just get used to this behavior and “live with it?” 

Clearly we have a policy in this country of trying to stimulate our economy through Keynesian type spending and stimulus.  For the reasons mentioned above, we need to borrow money from the Chinese to keep doing this.   We are unsure how the current bluster of words contributes to this goal.  

But let’s get right to the heart of the matter.  Let’s smack the elephant in the room right between the eyes. 

Will we ever pay all of this money back?  Will Chinese ever recover their principal?  

We don’t know, but it’s not far from reality to contemplate a sovereign default by the US at this point.  

In either case, it does not strike us as smart to rub these facts in the face of Chinese leaders.  Even if we were planning to default on the debt, is it wise to telegraph this move?  Even if we don’t care what they think about our spending, would it be astute to tell them this? 

So what ended up happening to Larry?

 The high school storm troopers were called in and pulled the linebacker off of Larry’s neck.  Larry arose with a sick sort of look on his face and hobbled off to the principal’s office for his debriefing.  

It’s funny but Larry was so much quieter after that little episode. 

Have a great week, 

Michael Bechara, CPA

Managing Director

Granite Consulting Group Inc.

mbechara@consultgranite.com

www.consultgranite.com

This week we have a guest column from Dan Helming.  Dan has been gracious enough to comment on many of our posts throughout the past few months.  While Dan often has a different viewpoint than the Recon, we thought we would mix things up a bit by including some of his thoughts.  

Enjoy!

Overreaches and Their Implications

by Dan Helming

I was thinking about what happens with the overreach effect.  This is what happens when reactions to one scenario eventually go overboard and become an overreach, causing another reaction.  

George W. Bush just made his debut as a motivational speaker.  And it brought up the discussions as to what his legacy will be.  The opinions are naturally still pretty much divided, as divided as the world has become.  It reminds me of the rumored story in the 80’s of what the Chinese official thought about the American revolution when he said, “Too soon to tell.”  I’m trying not to reveal any horse I have in this discussion, because I am trying to cite the deeper meaning in that people have said that GWB’s greatest legacy may be… that he brought us the President we have today. 

The overreach effect has shown itself in American politics over the last 30 years, for better or for worse.  Perception of Vietnam and the Democrats gave us Nixon, even though the public seemed to want no part of him 8 years before.  Perception of Nixon and Ford gave us Carter.  Carter gave us Reagan.  Bush I gave us Clinton.  Clinton gave us Bush II.  Bush II has given us Obama. 

In public accounting and internal control, we have seen something similar to an overreach effect.  Twenty-five years ago, Internal Control Questionnaires were used to perform detailed “compliance” testing, to reduce risk for the substantive year-end auditing.  Answering a few internal control questions doesn’t seem very detailed….and it wasn’t.  Since that time, firms have gone from performing little “compliance testing” to performing Sarbanes-Oxley for public companies.  And perhaps, because of overreach, we may be due to switch back again. 

In those days, there wasn’t separate IT auditing; rather the regular auditors were trained in the basics of computers etc. and asked the questions.  

But asking those questions to that level of detail was perceived to be an overreach, so we got the Treadway Commission giving us the COSO framework for Internal Control in the 80’s.  And as best as I can tell, though it wasn’t the intention, that activity released us from a requirement to do any detailed internal control testing at all, because that is about when we stopped.  Since then, COSO was revived as the basis for Sarbanes-Oxley, so we see that differently today. 

IT groups formed in private entities around the increasing importance of computing in general and IT financial reporting in particular.  Then, the more expensive accounting and IT consulting was to these IT groups, rather than to the accounting groups.  So the IT consulting groups as part of the Big 8/6 firms separated and made more money. 

To keep pace in the partnerships, the accounting groups tried to do more and allow more, and even when faced with unacceptable situations, refused to resign more and tried to save cost with 100% substantive audits.  

Internal control in many cases was ignored under an assumption that “we assumed maximum risk”.  Think of the import of that statement.  You are an audit firm and you are testing whether the financial statements are correct, but you are not testing internal control because you are “assuming maximum risk.”  What could happen that could mess up your process, anyway?  The answer is, EVERYTHING that doesn’t have to do with a balance that can be audited substantively at year-end.  This was finally realized in 2008 when 10 SAS’s were revised to eliminate the acceptability of using this assumption… 

Needless to say, this period also gave us Enron, Tyco, WorldCom and other accounting disasters.  So the firms had overreached. 

Then Sarbanes-Oxley came along and required that the consulting firms be separated from the accounting firms, and they required that the internal controls processes be documented and tested, and major gaps resolved, costing firms from 1 to 5% of their revenue.  

A famous internal audit professor giving a seminar to my colleagues and I, in an enlightening discussion about the focus of Sox and rules-based frameworks, said in the seminar that an organization looks like “this”, and he formed a triangle with his hands, point up… OK… and he said that how Sarbanes-Oxley tests and what it controls is in a similar shape, and he made the triangle with his hands again.  OK… And then he said, “but where the weakness and the vulnerability and the opportunities for fraud exist are like this”, and he made a triangle again, but unlike the previous two times, the point was faced DOWN.  

What this meant was that the problems occurred at the top, whereas Sarbanes-Oxley tested most heavily at the bottom. 

So in his and, over increasing experience with Sarbanes-Oxley, my opinion, we had an overreach in the direction of what Sarbanes-Oxley was suppose to achieve as well as its cost. 

It’s hard even for me to believe it now, but big firms nursed the heck out of the application of Sarbanes-Oxley.  One firm actually took a job over from us because we didn’t want to run up the job by noting the detail beyond identifying and documenting the points of control.  Someone from the firm insisted to me that my work would be laughed at bu the Big 4 firm, because in our narratives we weren’t naming “the specific individual”,   “the control objective”, and “the written evidence of the control completion” in every commentary.  

I’m talking about the “the controller reviews and approves the A/R Rec” as not being sufficient if I didn’t instead write: “for purposes of the authorization control, the controller reviews that the entries have been footed and tied to the GL by a subordinate, and is evidenced by the Controller initialing the Rec.”  We understood that a Controller that was too busy initialing every reconciliation… was going to not be busy enough reviewing any.  People misinterpreted “a risk-based approach” as meaning that every control that was to be done by the Controller had “risk”. 

Well, for those and other reasons, we lost the job, and that firm got it, causing me to question the objectivity of the individual’s role who had made the comment.  And later in the year, justifying my position, the PCAOB came out with guidance saying that firms in the field were overdoing the work and running up unnecessary cost.  Big 4 firms at that time even started not answering their clients’s financial questions, the firms thinking that they were getting too involved in the making of the books and not detached enough from auditing them.  The PCAOB dismissed that fallacy in their guidance as well, and even issued a new framework for small companies that formally loosened the rules.

So now, Sarbanes-Oxley implementation has been delayed again for small companies, which make up about 40% of all public companies.  And the House’s’s Financial Services Committee is discussing eliminating the whole Sarbanes-Oxley requirement.  The small companies should have been implementing anyway because that was required a few years ago, but the audit requirement was postponed.  Who was the famous man who said, “With no accountability comes no control”?  I noted that as these implementations were going on that 2 disturbing trends came up:  clients were turning for these implementations to 1) their auditors and 2) to relatively cheaper proprietary tools.  Though they are essentially implementing according to the rule, they are probably making less objective and weak internal control risk assessments.  And I personally believe in the Enterprise Risk Management framework, put out by COSO in 2004, that looks at financial risk along with all other risk, on more of a management-level principled-based approach. 

Is eliminating Sarbanes-Oxley just an overreach in the other direction? 

Have you heard the true story about the prescription sleeping pill that works great, but has possible side effects of amnesia and paranoia.  Now there’s something that will keep you awake…

Regards,

Dan Helming

“The smart man learns from the mistakes of others, the average man learns from his own mistakes and the idiot doesn’t learn from either.”   – Syrian Proverb 

Crude oil is an amazing substance.  

It is extremely energy dense, meaning that the energy that can be obtained from a barrel of crude is in excess of the energy that can be obtained from a barrel of almost anything else.  

It is easily stored and does not degrade over time.  You can put crude in an unpressurized tank in the back yard and come back 50 years later and it will still be there and still be ready to refine.  

You can move crude around easily.  You can send it through a pipeline or put it on a ship, airplane or truck.  

Crude oil can be refined to suit the demands of the economy.  A barrel of crude can be refined into various proportions of gasoline, kerosene, diesel, jet fuel, etc.  

Oh and I almost forgot, our entire way of life is based on crude oil.  

When the subject of energy comes up most people think only of cars and gasoline.  Anyone who expands the discussion to home heating/cooling is typically thought of as a deep thinker. 

The reality is that everything we depend on for modern life is based on oil. 

Our food is grown using significant inputs of hydrocarbons for the fertilizers, pesticides and machinery.  This food is transported an average of 1,500 miles before it is consumed.  Large scale commercial food production and distribution would not be possible without fossil fuels.  In short, the supermarket would be empty without crude.  

Modern pharmaceuticals would not be possible without petroleum.  Hydrocarbons are used to synthesize many of the life saving drugs we have today.  This simply means that scientists find the hydrocarbon molecule chains very convenient to use as a building block in creating new compounds.  Without petroleum we wouldn’t have modern pharmaceuticals.  

Suburban life does not exist without abundant supplies of crude.  It takes an extraordinary amount of energy to live a suburban lifestyle.  Low density housing, each with its own heating and cooling systems coupled with an extreme dependence on the car create an enormous demand for energy.  Without abundant supplies of crude, many of us would be living in apartment blocks.  

After all this has sunk in, the natural reaction would be to ask, “So how much oil do we have left?”  This topic is open to debate and there are many people who think they know and many others who claim no one knows, but one thing is for sure.  

Oil production is under pressure.  

We know that it’s getting harder and harder to find new oil fields and those that we do find are extraordinarily difficult to extract.  Take the recent discovery of huge new oil field off the coast of Brazil.  According to the New York Times, in order to extract the oil from this field: 

“Engineers will have to drill up to 16,000 feet below the sea floor through salt and rocks, in water depths of up to 10,000 feet, an undertaking that is at the frontier of the industry’s technological ability, according to PFC Energy, a consultancy in Washington. 

In addition, many estimate the extraction project to cost hundreds of billions of dollars and span 50 to 100 years.  

Are the days of cheap abundant energy over? 

Probably. 

Is there an alternative?  

Not really.  

Many people has focused on the so called “Green Technologies” as an alternative to crude, but given what we have described above regarding the many advantageous properties of oil, none of the “Green” alternatives can possibly be a replacement.  Nor can a combination of “Green” technologies replace crude oil.  

So where are we going with this?  Is this a post Halloween scare attempt? 

Not at all.  It’s simply another discussion on business planning.  Consider the following questions: 

• How viable is a 12,000 mile long supply chain with oil at $150?  How about at $200?
• Is your supplier base broad or does it consist entirely of companies located in East Asia? 
• Even if inventory is procured domestically, will a just in time inventory system remain viable given transportation costs and potential disruptions.
• Will this open the door to domestic manufacturing?
• If energy prices become more volatile, oscillating between $70 and $250 per barrel for example, what will that mean for pricing, procurement, cash management, etc.   

Many companies have based their long range business planning on relatively cheap and stable oil supplies.  This is a key assumption.  If energy prices were to become more volatile with a longer term upward trend it would pose an existential threat to many business models.  On the other hand, it may also create an opportunity for many business models long considered not viable. 

In the past 20 to 30 years we have seen a secular trend towards deindustrialization, dependence on imports and larger homes and cars.  This paradigm, of course, depends on cheap and abundant energy.  

Amongst those who are not under the continual influence of psychotropic drugs (again created from hydrocarbons), the debate is no longer if this is sustainable but rather how much longer this can be sustained.    

If our current economic structure cannot be sustained why aren’t we doing something about it?  Isn’t this too obvious?  Why wouldn’t our brilliant economists be warning us about such an epochal shift? 

“Be careful, too, of the so-called science of economics. Economists have been no better in their predictions than cab drivers.”, says Black Swan author Nicolas Taleb.  

The current orthodoxy amongst economists is that things are on their way back to normal.  Normal being defined as the unsustainable pattern outlined above.  

This reminds me distinctly of the assurances made by economists and politicians that everything would shortly go back to normal during the early years of the Great Depression.   

Have a great week, 

Michael Bechara, CPA

Managing Director

Granite Consulting Group Inc.

mbechara@consultgranite.com

www.consultgranite.com