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O2: oxygen of publicity: the accountancy profession has been the subject of especially intense public scrutiny over the past 12 months--for all the wrong reasons. Ruth Prickett delivers her financial review of the year and asks the experts what the prospects are for global economic thaw in 2003. (Cover Feature Annual Review).

It's hard to think of any industry which could argue convincingly that the past year has been the best of times--in fact, many could complain that it's been the worst of times. One thing that 2002 has not been, however, is dull.

On the world scene, honours for the most exciting stories must go to the dramatic collapses of Enron (January), followed by WorldCom (June). That these companies should announce huge losses was startling enough, but the fact that they had been concealing them through fraudulent accounting caused an international outcry. Next to lose its head in the furore was Andersen, a break-up almost more shocking for many accountants than the fraud revelations themselves.

The WorldCom saga rumbles on. In November the US Securities and Exchange Commission announced that the telecoms firm had admitted concealing $9 billion in expenses--more than double the original sum revealed in the summer--and converting them into false profits. Soon after that revelation, Harvey Pitt, the commission's chairman, resigned amid criticism over his management of the crisis.

These scandals triggered debates worldwide on corporate governance and transparency, strengthened calls for the adoption of international accounting standards and weakened faith in US Gaap. While government committees and business leaders discuss the possibility of tighter regulation, firms are facing demands from fund managers, investors, employees and campaigning bodies for more reliable data. Some doubt whether it will be possible to provide genuinely transparent information, but most accept that they must be seen to be doing what they can to reassure key stakeholders.

The collapses have increased public concern about the role of directors and how they axe rewarded. The accountability, independence and qualifications of non-execs have also come under the spotlight. These issues, of course, have gone hand in hand with falling share prices and perennial complaints that directors receive disproportionately large sums while staff are laid off and investor returns decline.

While Enron and WorldCom did not cause the general decrease in share prices, they certainly worsened the existing downward trend. Many people blame the terrorist attacks of 11 September 200l and uncertainty about a future war with Iraq, but others insist that the current depression is a normal cyclical correction of overpriced stocks and overcapacity in the markets.

"Enron had a depressing effect on shares, especially in the US, but it probably means that they are now down to a realistic level, having been overpriced for years," says John Holdsworth, head of macroeconomics at PwC. "Even at the start of the year we thought prices were still too high, so the events at WorldCom probably knocked them down to fair values faster than we expected.

"Contrary to some predictions, 11 September didn't push the US into recession. It actually helped the recovery to go faster in the short term because the government cut interest rates and raised spending, so consumers went back to the shops quickly--although this petered out after six months."

While he agrees that uncertainty about war in Iraq may be depressing some sectors, Holdsworth thinks that a quick, successful war for the US could actually improve its economy. A longer conflict would have more varied effects, especially if it spread to other parts of the Middle East and affected oil prices. "Generally, wars are not bad for economies. They have a sectoral effect, so they are bad for airlines, but good for the defence industry," he says. "A prolonged war, however, would affect the US debt and the economy."

Bruce Russell, head of fund management and research for Barclays Private Clients, believes that the downturn is a direct consequence of economic trends stemming back to the mid 1990s. He argues that large US companies were advised by their banks and consultants to increase their gearing and buy back shares, thus paying bigger dividends to managers who owned stock options.

"It was sold as a way to improve business performance and translated into a stronger share price. This is fine until the music stops-when the debt starts to be felt," Russell says. "In 1999-2000 share prices became very overvalued and raising finance was cheap, so businesses could invest far more."

This, he adds, is why there is now massive overcapacity in most markets. In the 1990s firms maintained prices but increased volumes. Now that demand has fallen, firms have to boost volumes in order to survive. "It's a vicious circle," he says. Car manufacturers, for example, need to boost sales volumes, yet have reached a point in the US where there are 1.05 cars per driver and 2.01 per household.

Current figures suggest that the economy has passed its lowest point, but Russell warns that the recovery is likely to be slow. The first half of 2002 saw a general improvement and raised hopes, but this stalled in the summer. The sharp decline in share prices and activity has been matched by an increase in financing costs since companies were hit by falling bond yields and spread assets.

Low interest rates mean that consumer spending has remained buoyant and, in the UK, the housing market is still strong, but this is now starting to tail off. Experts warn that property prices may stagnate or fall, and much consumer spending has been based on credit. The good news for the UK economy is that government spending has risen sharply for the first time in a decade. This, Russell hopes, will prove to be a vital stabiliser.

Holdsworth agrees. "Spending on areas such as the NHS and education is locked in for the next three years," he says. "The unrest among public servants such as firefighters is a problem for the government but not for the economy, which will benefit whether the money goes into pay or into infrastructure."

Public-sector money is already making itself felt in areas that are struggling, such as technology and software. Richard Pierce, director of software provider PS Financials, says his company is seeing a huge increase in tendering from local authorities, museums and development agencies seeking new systems.

But increased public spending is not happening in key EU economies. "France, Germany and Italy are in danger of entering a real deflationary period. They are hampered by EU rules on spending and borrowing," Russell says. Since the UK's biggest trading partner is Europe, this is more bad news for British manufacturers. Even financial services, traditionally a pillar of the UK economy, cannot rest on its laurels. Insurance is having a particularly tough time. While it can benefit from increased concern about risk, natural disasters and terrorism, the industry has also seen a rise in expenditure and the old problem of asbestosis is becoming a major issue again.

In the SME sector the business stock is still falling by about 10,000 to 15,000 firms each quarter, although the number of start-ups was the highest for several years in the third quarter of 2002, according to Russell's colleague, Richard Roberts, head of SME research at Barclays Business Banking. He expects the number of closures to fall further during 2003 so that stock starts rising again by the end of the year, but he warns that this kind of confidence is fragile. "You only need a few people to hesitate to throw all forecasts off," he warns. "A few negative articles in the FT or another business scandal will set it back."

Unlike the situation in the 1980s, however, Roberts says that most SMEs are not deeply in debt. "In the next 18 months we expect to see loan demand to grow, but that's fund investment, not distress borrowing," he says. The underlying strength of the sector, he argues, means that it will see a reasonable rate of growth in 2003, which will increase in 2004.

"It looks as if we've been through the bottom, but we still face serous threats from overcapacity and unconfident consumers," Russell says. "Changes are happening, but firms will struggle to make big profits, so why should investors rush in and pay high prices?" But, while he thinks the UK is unlikely to see big stock market rises in 2003, there are grounds for optimism. A review of Barclays gilt equity studies dating back to 1900 shows that one in seven three-year periods have been consecutive periods of negative growth, so the past three years have not been as unusual as some people might think. More encouragingly, after every one of these three-year periods, investors more than made their money back in the following three years.

At present, however, most fund managers would be happy with a small but sustained improvement in returns. "Institutional investors say stock markets are undervalued and interest rates will fall, which are positive signs. But we may be facing a weakened nominal sales environment, which would make the market look worse," says David Bowers, chief global investment strategist at Merrill Lynch and author of its October fund manager survey.

Bowers' research found that the percentage of respondents expecting a stronger global economy fell from 48 per cent in September to 37 per cent in October. While institutional investors still preferred emerging markets to US equities, there was better news for the UK, where equities were seen to give the best quality of earnings. Investors' favourite sectors were consumer staples and pharmaceuticals, while their least favourite were utilities and telecoms.

Not surprisingly, falling equities have led investors to look at alternatives such as hedge funds, private equity/venture capital and managed futures funds. "Some of the greatest growth in demand for hedge funds has been in Europe, where the market has quadrupled to $64 billion since 1999, creating a significant alternative to US hedge funds," says Phil Sieg, global head of segments at Merrill Lynch's International Private Client Group. International investors are also increasingly buying US treasury bonds, which are seen as a safe bet.

One major area of equity risk that has been exposed this year is that of company pension schemes. The new reporting procedures required under FRS17 opened a huge can of worms when it revealed the true extent of many companies' liabilities. Boots pulled out of equities altogether and reinvested in bonds, and the newspapers were full of stories about firms dosing their final-salary schemes.

In October, pensions consultancy UBSL revealed that FTSE 100 companies' pension schemes had lost 63 billion [pounds sterling] since the start of the year, taking their overall pension fund deficits by 30 September to 59 billion [pounds sterling]--a shortfall equivalent to the market capitalisation of the bottom-30 companies in the index. "Unions and employees fighting to keep their final-salary pension schemes may find themselves fighting a losing battle when the full-year disclosures are made early in 2003," says Rob Dales, director at UBSL, but he adds that it's unlikely that many other firms will follow Boots' lead and pull out of equities.

"It's swings and roundabouts. If you get locked into bonds, you discount liabilities in exchange for a constant return," he says. "Boots had a surplus, so this move didn't send up its costs. Many other firms will want to remove volatility but won't want to incur these costs, so they will hope to ride out the stock-market dip."

The problem is that liabilities are continuing to rise, so assets will have to increase considerably to make up the difference.

Although the shortfalls came as a shock to most companies, which had been happy to rely on unrealistically low figures if it kept their costs down, Dales points out that the headlines were not the whole story. "Most FDs say: `This is a line in the sand; it doesn't change my firms' contribution to its pension fund.' This is true, but they will face pressure from trustees, analysts and members of their boards to get rid of deficits," he says. "For example, if Diageo has a 950 million [pounds sterling] shortfall it's not going to put all that cash in now, but the liability may still be there next year and the year after that."

Dales predicts that there will be few further final-salary scheme closures, but he points out that pensions remain a huge issue. "So far, not many people have retired on money-purchase schemes. They get their annual statements and don't read them, so they don't realise the problems and how poorly they compare with their final-salary equivalents," he says.

The government is also likely to come under pressure to protect employees whose firms close their pension schemes or go bankrupt, taking the pension scheme with them. "If a company is solvent there is a minimum that must be paid, but if it's broke there's nothing that can be done," Dales says. "This tends to hit local headlines, rather than national ones, since most of the firms going bust are smaller, but nationally it is a huge problem."

The ongoing fiasco at Equitable Life, which closed its doors to new business in 2001 and continues to struggle, has highlighted the problem of what happens to members if their provider goes under. While Dales expects more legislation on pensions, he thinks the government will try not to be too prescriptive. "If it sticks to its plans it will announce new regulations next year, but the issue is not going to go away and firms should prepare for further changes," he advises.

All the media focus on pensions over the past year has also worried analysts, who previously took little notice of firms' pension funds. This has put the issue firmly in the arena of business risk and means that companies should be looking closely at how they communicate pension details to the markets as well as to their employees. The shift is typical of the way in which many organisational processes are being pulled together and recognised as part of a wider risk management strategy, according to Richard Waterer, managing consultant at risk consultancy Marsh.

The transparency issue is hardly new to firms such as Shell and BP, which are well aware of how environmental concerns affect their businesses. But this message is now spreading far wider. "Employers have hired brand managers to create brand equity for years, but they rarely looked at protecting this equity against adverse publicity. Now, however, reputation is becoming a number-one issue," Waterer says. "Firms are realising that risk management can be applied to all processes, not only insurance or IT."

Another key area is continuity management--which has been seen as increasingly important since 11 September 2001. "The attack on the World Trade Center was a wake-up call to lots of companies," Waterer says. "Most were already involved in business continuity, but at an operational level. They hadn't considered the overall impact on the whole business."

Waterer says that three main areas have emerged as crucial: the effect on people and need for communication; the need to identify what makes the organisation tick, rather than planning for specific crises; and continuity management in the supply chain. Business continuity is now seen as so vital that it is often a prerequisite for insurance policies--an issue that is particularly important given that some firms have seen their employers' liability insurance premiums rise by 100 per cent.

Ironically, considering how technology shares have slumped, IT is likely to play an important part in collating and communicating information and providing transparency. "Investment in software packages has generally collapsed, but one area where it hasn't is the one under the FD's nose: financial controls," says Jonny Cheetham, operations director at software provider Cartesis. One beneficial result of the Enron affair, he argues, is that it may increase awareness of the need for international accounting standards.

"In the case of XBRL, it's nice to think that firms could report the sensitivity of their prediction figures to market risk so investors can balance risk more effectively and understand the issues," Cheetham says.

Richard Pierce agrees, but doubts whether XBRL will improve the quality of information provided. "XBRL speeds up information, but it doesn't make figures more reliable or more trusted," he says.

Pierce points out that demand for consultants has dropped dramatically, partly because of cost and partly because the fall of Andersen undermined trust. Firms are relying more on in-house knowledge to identify their requirements before approaching software companies. This is yet another example of the desire to cut out the middle man--to save money and because scandals have damaged trust in intermediaries that rely on past reputation rather than personal contacts. Similarly, airlines are seeing customers defect to budget operators that allow them to book tickets, cars and hotels on-line. Retailers are still doing well, but it's significant that Ebay, the on-line boot fair, is going from strength to strength. Customers are prepared to trust, it seems, but they want access to all the information they need to make decisions for themselves. It remains to be seen whether this trend will survive the recovery.


"In the 1990s companies maintained prices and increased volumes, but now that prices are falling they are desperate to maintain volumes despite weakening demand. It's a vicious circle."

Bruce Russell, head of fund management and research, Barclays Private Clients

"Accounting for pensions has always been very subjective. The problems have always been there, but they haven't been seen. Firms always worked out pensions at the lowest reasonable rate. No one thought anything of it--boards were happy, analysts were happy and the finance people believed the actuaries' assumptions."

Rob Dales, director, UBSL

"After 9-11, one of the biggest changes to many organisations was improvements to communication chains. It's no good having separate systems in another office for an emergency if there are no people to staff it."

Richard Waterer, managing consultant Marsh

"This time last year we thought we were going bust. No one was paying and clients were cancelling contracts all over the place. Now we've never been busier: there's lots of expansion and start-ups, mainly among low-cost airlines."

Ian Clement, senior associate, Aviation Solutions

"There has been a dramatic fall in the number of firms using consultants, partly because it's the easiest thing to cut and partly because the Andersen collapse shattered the image of consultants' independence and integrity."

Richard Pierce, director, PS Financials


"You don't need a double dip in the economy; you simply need people talking about a double dip. The question is not whether the recovery will happen, but when."

Richard Roberts, head of SME research, Barclays Business Banking

"Deflationary tendencies, lack of pricing power and excess capacity will combine with weak consumer demand to make top-line growth unlikely."

Bruce Russell, head of fund management and research for Barclays Private Clients

"We are unlikely to see tots more final-salary pension schemes closing--we've had the wave now and anyone else has missed the boat. The future of new pension schemes will depend on the government. Pensions are a big political issue and will become much bigger as more people retire on money-purchase schemes and realise that the amount they'll get is nothing like as much as that delivered by final-salary schemes."

Rob Dales, director, UBSL

"Employers' liability insurance will become the big issue of 2003. It's already hitting some firms, whose premiums have risen by up to 100 per cent."

Richard Waterer, managing consultant, Marsh

"Charter flights in the UK will suffer over the next year. We are likely to see the end of some firms in the package holiday market, because people are going direct to the internet for flights, hotels and car hire, cutting out the middle man. War will be disastrous for large airlines. The price of aviation fuel is also likely to rise and so will insurance costs. Some airlines will go bust."

Ian Clement, senior associate, Aviation Solutions

"The software industry seems to be getting better, but the whole market has gone through a decline in demand. We've had Y2K and EMU, so what next? There's now no urgency to upgrade systems and this is a long-term trend. The future market will be more piecemeal, with phased implementation, so firms can start seeing the benefits sooner."

Richard Pierce, director, PS Financials


Derek Higgs' review of non-executive directors. Expected this December. It is unlikely to recommend new laws, but will probably suggest voluntary measures through the existing corporate governance codes. It is likely to encourage greater openness about appointments, among other crucial issues. The secretary of state for trade and industry, Patricia Hewitt, responded to the interim report produced by the co-ordinating group on audit and accounting issues last summer, but will not publish her final report before the Higgs report emerges.

Ongoing company law review. Proposals are likely to be included in the Companies Act 2003. The steering group delivered its final report in July 2001. A year later, the government issued the Modernising Company Law white paper and consultation closed on 29 November. The key issue is the proposed mandatory operating financial review (OFR). The ASB published a consultation document about the OFR in June 2002.

International Accounting Standards. Regulation requiring consolidated accounts of listed companies in the EU to comply with IFRSs applies from financial years starting 1 January 2005. The intention (as outlined in the recent IASB exposure draft on the first-time application of international financial reporting standards) is that IFRS policies in place on 1 January 2005 should be applied to all periods presented--ie, the comparative data as well. This means that entities which also report in the US will have to present the prior two years' data in IAS format.

For further information on the IASB work programme, visit /0001.asp?s=1580371&sc={A9F7A32B-4F24-4BE2BB3B-F95BAF8A68CC}&n=4091

Environmental tax. Chancellor Gordon Brown has mentioned a possible significant increase in landfill taxes. The current 13-a-tonne [pounds sterling] rate is already scheduled to rise to 14 [pounds sterling] in April, but the government supports environmental groups' views that much steeper rises are needed in future to improve the UK's relatively poor record on recycling. In the medium to long term the climate-change levy, which affects almost all businesses, could evolve into a carbon tax, since the UK must aim to reach the target of 60 per cent reduction in C[O.sub.2] emissions by 2050.

The impact of the Sarbanes-Oxley Act 2002 on firms outside the US. The Securities and Exchange Commission will play a key role in deciding whether the demands of foreign companies for exemptions are met. It is drawing up rules to support the law's general provisions and has a wide-ranging power over potential exceptions to legislation.

Copyright law. The new EU directive takes effect at the end of 2002.

Employment law. The Employment Act was given royal assent in July and is likely to come into force in stages during 2003. It includes issues such as working parent provisions for paternity/maternity leave, flexible working regulations, dispute resolution provisions and tribunal reforms.

The Proceeds of Crime Act and the money-laundering directive. The determination of EU governments to prevent money-laundering has led to the UK Proceeds of Crime Act (in force from December 2002) and the second European money-laundering directive, which will take effect in June 2003. Among other measures, accountants and those giving financial advice could face up to five years' imprisonment for failing to report suspicions of money-laundering. There are also increased requirements to "know your customer" and retain better customer records for longer. A working party including representatives of all the CCAB bodies is currently considering the full implications for accountants and more guidance will be available shortly.

For further information on the money-laundering directive, see page 9.

Danka Starovic, project manager, technical issues, CIMA
COPYRIGHT 2002 Chartered Institute of Management Accountants (CIMA)
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Author:Prickett, Ruth
Publication:Financial Management (UK)
Geographic Code:1USA
Date:Dec 1, 2002
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