Brian Gaynor: An amulet for bewitched accounts

Accounting scandals in the United States are grabbing headlines throughout the world. The ripple effect is being felt in New Zealand as investors worry about similar catastrophes occurring here.

The simple answer is that we had our scandals after the 1987 crash and most New Zealand companies are relatively clean. But there is a guideline that enables shareholders to determine whether a company's accounting policies should be scrutinised more carefully.

This is called the Inland Revenue Department's guideline for sharemarket investors.

Every listed company has two sets of accounts, one for the IRD and another for shareholders. The object of the IRD accounts is to produce figures that comply with tax standards and for the company to pay no more tax than is absolutely necessary.

The object of the public accounts is to give a true and fair view of the financial position of the company and to comply with generally accepted accounting practice.

The two sets of figures should be fairly similar but a gap develops between them under certain circumstances. These include:

* In buoyant sharemarket conditions companies come under pressure to meet profit expectations and inflate their reported earnings relative to the IRD figures.

* Companies look for ways to boost their reported numbers when they have a high level of debt and are under pressure from bankers and shareholders.

In theory, tax returns are scrutinised by the IRD, and auditors are guardians of published figures. Auditors have come under fierce attack in the United States because they compromised their role by becoming too dependent on non-audit work from client companies. Investors have lost confidence in auditors and taxation accounts are now considered to be more accurate because they are closely scrutinised by taxation inspectors.

New Zealand auditors have also become far too reliant on non-audit income and opened themselves to similar criticism. The 22 companies in this survey paid $205.8 million to auditors in the past five years and 62 per cent, or $127.6 million, was for non-audit work.

Companies do not publish taxation accounts but shareholders can determine their actual tax position, as compared with their accounting treatment of tax, from published accounts.

The first column shows the published pre-tax earnings of 22 large companies for the five-year period, 1997 to 2001. Air New Zealand and Natural Gas numbers are for the 1996 to 2000 period because large losses in 2001 would distort their figures; Fletcher Challenge is for the same period because it ceased to exist after 2000; and Brierley Investments is for 1995 to 1999, its last five years in New Zealand.

The second column shows actual tax paid as per the statement of cash flows, not the figure in the earnings statement. Tax payments should represent 33 per cent of pre-tax earnings in the taxation accounts because Sir Roger Douglas abolished all company tax breaks in the 1980s.

The third column is the rate of tax paid to published pre-tax earnings and the final two columns show the total fees paid to auditors and the percentage of these fees that was for non-audit work.

The list has been ranked on the basis of the third column, the tax rate. The accounting policies of companies at the top end of the list should be closely examined as their published earnings are substantially higher than the numbers in their taxation accounts.

Tranz Rail, which is at the top of the list, had a net tax refund of $2 million in the 1997-2001 period. This suggests that it had a small loss in its taxation accounts compared with published pre-tax earnings of $207 million.

The group has capitalised costs that have been charged against revenue in its taxation accounts and it has had higher depreciation charges in its tax accounts than its published figures.

On Tuesday, Tranz Rail will outline accounting policy changes and release three-year financial forecasts. The company has a great opportunity to recover market confidence but will it have the courage to go far enough?

Management needs to bite the bullet on two major leasing arrangements. The company is taking a net profit of $59.2 million on the sale and lease back of rolling stock over a 12-year period, yet it will be required to make a penalty payment of US$9 million if it does not repurchase the assets, as seems likely, at the end of the lease.

The Aratere ferry was sold for US$55 million ($113.5 million) in December 1998 and Tranz Rail is taking a net profit of $30.6 million over the 12 years of the lease-back arrangement. At the end of the lease, Tranz Rail has an irrevocable commitment to buy back the Aratere for approximately $100 million, depending on the US$/NZ$ exchange rate at the time.

Tranz Rail should also announce on Tuesday that its auditors, KPMG, will not undertake any more non-audit work for the company. KPMG was paid $16.6 million for non-audit work in the 1997-2001 period, $10.7 million of which was capitalised, and investors cannot be expected to have full confidence in a company if its auditors receive huge payments for non-audit work.

Not surprisingly, Brierley Investments and Fletcher Challenge fill the next two places. Both companies tried to convince investors that they had conservative accounting policies but reality finally caught up with them. Fletcher Challenge's two auditors, PricewaterhouseCoopers and KPMG, were paid a staggering $41 million for non-audit work in the five years prior to the group's demise.

Airline companies' accounting policies are contentious because they usually have large off-balance-sheet assets and different aircraft depreciation rates for the taxation and published accounts. Air New Zealand is going through a honeymoon period following its recapitalisation and major board and management changes. The carrier's short-term shareprice performance will be determined by its operating performance, not accounting policies.

UnitedNetworks, TrustPower and several other electricity companies are using far higher depreciation charges in their taxation accounts than their published figures. The utilities argue that this situation prevails in other countries and investors have been fairly relaxed with this approach.

There is little doubt that Telecom adopted a fairly aggressive approach towards the capitalisation of costs while under American control. Concerns have also been expressed over its accounting for the Southern Cross Cable and several joint ventures, particularly with Microsoft. However, Telecom's tax paid rate is above 20 per cent and its accounting concerns are minor, particularly when compared with the troubled telcos in the northern hemisphere.

Carter Holt is at the opposite end of the table to Tranz Rail because of tax paid on profits from the sale of its Chilean assets, while reporting an operating loss at the same time. This has distorted its tax-paid rate in the table.

Shareholders can feel relatively safe with companies that have a tax-paid rate in excess of 25 per cent. For those with a tax rate of 30 per cent or more the earnings figures in the published accounts should be similar to their IRD numbers.

There is no foolproof way of identifying companies that should be scrutinised for suspect accounting but a comparison between the published and taxation accounts is a useful start. Investors should examine the accounting standards of a consistent tax paid rate below 25 per cent.

But the most important message from this survey is that payments for non-audit work have become ridiculously high and have compromised the independence of auditors. The seven companies with a tax-paid rate below 25 per cent are particularly open to question because they paid $90.9 million for non-audit work whereas the 15 companies above the 25 per cent threshold paid out $36.7 million.

Investors will have complete confidence in the accuracy of published figures only when auditors are barred from doing almost all non-audit work.

* bgaynor@xtra.co.nz