Accounting practices similar to those used by Lehman Brothers to mask bad assets before its collapse are also being adopted by Gulf companies, auditors say. Now regional governments are being urged to clamp down on companies that are misleading investors by keeping assets that could be responsible for losses off their balance sheets.
At the same time, local auditors are facing increased scrutiny after a series of corporate scandals that have hurt investor confidence from Damman to Dubai. Auditors accuse some Gulf companies of flouting book-keeping rules to avoid disclosing transactions involving shares and sukuk, or Islamic bonds, to shareholders. They say stricter enforcement and regulation of transactions should be adopted to prevent a situation in the region similar to the Lehman collapse, which helped trigger the global financial crisis.
"I don't think there are enough safeguards in the region to stop bad practices from happening," said Yusuf Hassan, the UAE-based director of the department of professional practice in the region for the accounting firm KPMG International. "We need more education of entities on the impact of the accounting standards. Safeguards would be good but the auditors have to enforce them from ethical grounds."
An investigation into the collapse of Lehman found it had used an accounting device known as short-term repurchase agreement to give a misleading impression of the company's financial health to investors. A report published this month by the bankruptcy examiner Anton Valukas concluded management at Lehman took advantage of loopholes in "derecognition" accounting rules to move bad assets off its balance sheet.
This allowed the bank to report a less risky cash position. Lehman filed the biggest bankruptcy in US history in September 2008, triggering a freeze in global credit markets. After the financial crisis, concern is building about the accounting standards used by Gulf companies. "In this part of the world, there are many types of arrangements where the derecognition rules come into play," said a GCC accountant who asked to remain anonymous.
"By [flouting] the derecognition rules in various securitisation and repo [repurchase] transactions, entities may also be able to park bad assets off their balance sheet." The accountant noted the example of companies issuing sukuk, which may not transfer all of the downside risk attached to an underlying asset to the bondholder. Neither does that risk appear on the balance sheet of the issuer. Companies can also sell loss-making shares to a related entity, while they hold contracts to buy these shares back at a later date.
"The key question that needs to be asked in such cases is whether there is actually a sale of the asset," the accountant said. "Accounting focuses on substance rather than legal form, and if the substance of the transaction is not a sale, the accounting rules require that these shares not be taken off balance sheet." The practice of not reporting related-party transactions is also more prevalent in the Gulf than in the US, said Sankar Krishnan, the Dubai-based managing director of Alvarez and Marsal, which was the liquidator of Lehman Brothers.
"These transactions need to be really examined by accountants to make sure they don't have any undue exposure to both shareholders," he said. "It's the responsibility of the auditors to point this out and validate the transaction." Accountants say it is the duty of the company to ensure that accounting rules are followed, while regulators need to ensure transactions are monitored and disclosed to enable investors to understand financial risks.
Unlike the US, which has its own corporate accounting rules, most Gulf companies follow the International Financial Reporting Standards (IFRS). "IFRS is a principle-based accounting framework that is sufficiently robust to ensure that assets and liabilities of an entity that have a beneficial interest are recognised and measured in financial statements," said Ashruff Jamall, a partner in financial services in Dubai at PricewaterhouseCoopers.
Although there are differences between IFRS and US regulations, both try to control the issue of moving assets off balance sheets. "There does not seem to be many 'whistle-blowing' mechanisms available in the region," said Mr Hassan. "Currently, the only real safeguard for these types of transactions is the integrity of management and the reporting of dubious accounting treatments by the auditors."