CPA 2014 conference - paper reference number CPA2014-187

Accounting Manipulation in Australian Banking and Financial Organizations

Kazi Islam*

Lecturer in Accounting, CQUniversity, Australia

Dr. Mohamed Omran

Associate Professor of Accounting, Gulf University for Science & Technology, Kuwait

Dr Mahmud Hossain

Professor of Accounting, CQUniversity, Australia

Contact Address:

Kazi Islam

Lecturer in Accounting, CQUniversity, Australia

Building 19, Room 3.23

Bruce Highway, Rockhampton, Qld 4702

Phone: 61 7 4930 9555 (office)

Email: k.islam@cqu.edu.au or, ksi72000@yahoo.com.au

* This paper is a part of the PhD work of Kazi Saidul Islam (Kazi Islam) who provides thanks to Dr Mohamed Omran, Professor Mahmud Hossain, Professor Sheikh Rahman, Mr Lawson Smith, Dr Jane Andrew, Dr Kathie Cooper, and Dr Martin Turner for their suggestions at various stages.

Accounting manipulation in Australian banking and financial organizations

ABSTRACT

This study examines the circumstances of accounting manipulation in Australia during the period 1998-2010. The theoretical framework of this study is premised on the fraud triangle theory. The analysis and interpretation of findings are based on twoAustralia banking and financial institutions, namely Heath International Holdings Limited and Allco Finance Group Limited. The study obtained data from companies’ annual reports, related investigation reports and other public documents. The study finds that accounting manipulation is an intentional activity engendered by individuals’ subjective use, misinterpretation or violation of accounting standards. It arises from multiple realities constructed by the interaction of social-psychological factors encapsulated in the fraud triangle theory. Accounting issues, incentive factors, dysfunctional corporate governance, lax external oversight by the auditors and regulators, and behavioural issues are found to be the key factors that fit in the fraud triangle theory. The study has policy impactions for the company managers, directors, regulators, educators, and researchers.

Key terms: Accounting manipulation, corporate governance, independence, oversight, fraud triangle, Australia.

ii

Accounting manipulation in Australian

banking and financial organizations

1. Introduction

The pejorative term accounting manipulation is understood to encompass and describe the miscellaneous array of intentional malpractices in corporate financial reporting. In reality, accounting manipulation is undertaken by responsible individuals in the companies with the ultimate objective of providing misleading and/or deceptive information to the intended recipients and users of that information. Self-interests of the persons responsible for providing information and the lack of accountability of the persons charged with internal governance and external oversight are widely accused of as the perceived causes of accounting manipulation (Rezaee, 2005; Watts, 2006; Lee et al., 2008; Ball, 2009).

Accounting manipulation, whether periodic or continuous, may eventually cause the unexpected, sudden failure of an organisationwith significant adverse impacts upon and repercussions for its stakeholders, the domestic economy and society more broadly.During the period 2001-2010, the corporate sectors of some western economies (e.g. the USA, UK and Australia) suffered unprecedented failures, thereby inflicting not insignificant shocks on their respective economies. In this way, in 2001 the Australian economy – and its accompanying political governance system – suffered from the cumulative failures of HIH, Ansett, OneTel and Harris Scarfe. This era was followed by the regulatory reforms including exposure of the ASX Corporate Governance Principles and Recommendations in 2003, the Corporate Law Economic Reform Program (CLERP) 9 Act of 2004 and the new set of accounting standards mandatorily applicable from 1 January 2005.Australian economy was further perturbed by the failures of ABC Learning Centres, the Allco Finance Group (AFG), Babcock and Brown and Storm Financial during 2007-2010.

Positivist research in accounting continues to uncover the incentives and opportunities of earnings manipulation (see Healy & Wahlen, 1999; Dechow & Skinner, 2000; Efendi et al., 2007; Files et al., 2009; Dechow et al., 2011; Feng et al., 2011). These studies consider many companies to test hypotheses in explaining the dominant factors of earnings manipulation. Their research approach is well encouraged by the business schools and academic journals (Mouck, 2004; Parker, 2005). In practice, individual companies may face unique circumstances of accounting manipulation. Owing to the lack of case studies, a holistic explanation of the circumstances of both earnings and balance sheet manipulation in the individual companies in Australia appears crucial. Therefore, this study selects two cases, Heath International Holdings Limited (HIH Limited) and Allco Finance Group Limited (AFG Limited), to analyse and interpret the circumstances of accounting manipulation prior to and after the regulatory reforms. HIH Limited was Australia’s second largest insurance company when it collapsed in 2001 with far-reaching impacts on its employees, shareholders and society at large (Parker, 2005). The collapse of HIH Limited was so significant that the Australian Government set up the HIH Royal Commission which reported in three volumes in 2003 on the causes of the failure of HIH Limited, the nature of accounting manipulation and recommendations for regulatory reforms. AFG Limited was a major Australian investment bank when it collapsed in 2008 during the global financial crisis (GFC) amidst allegations of accounting manipulation.

The remainder of this paperis structured in 4 sections. Section 2 provides an overview of the two selected companies. Section 3 outlines the theoretical framework and research

3

methods. Section 4 analyses and evaluates the circumstances of accounting manipulation. Section 5 concludes this paper. 2. An overview of HIH Limited and AFG Limited

HIH Limited had its origins in MW Payne Liability Agencies Pty Ltd, which was established in 1968 by two promoters (directors), Ray Williams and Michael Payne, to underwrite the insurance business. Over the subsequent decades, the company diversified its underwriting business into property, plant and equipment insurance plus commercial professional liability. Eventually it became CE HIH Limited in 1989 (HIH Royal Commission, 2003, vol. 1, p.51). In 1992, HIH Limited was listed on the Australian Stock Exchange (ASX) and subsequently operated in 16 countries (Lee et al., 2008). Its operating profit attributable to shareholders for the 12 months ended 30 June 1996 was $59.2 million, which increased to $78.3 million in 1997, but significantly decreased to $37.5 million in 1998 (HIH Limited, Annual Report, 2000). For the first time, the company then incurred a loss - $39.8 million - in 1999. In 2000, the company returned to profitability, with a profit of $18.4 million and as at 30 June 2000 had assets of $8.3 billion and liabilities of $7.3 billion (HIH Limited Annual Report, 2000). HIH Limited went into provisional liquidation on 15 March 2001 with an estimated deficiency of $3.6 - $5.3 billion (HIH Royal Commission, 2003).

AFG Limited was an Australian based investment bank that commenced operations in 1979 primarily to organise leveraged leases for plant and equipment. With a merger with Record Investments Limited in 2006, the new group was listed on the ASX on 1 July 2006 with a market capitalisation of approximately $3 billion (AFG Limited, Annual Report, 2006). AFG then diversified its financial services for aviation, shipping, rail, infrastructure, property, and financial assets (AFG Limited, Annual Report, 2007). Its net revenue increased by 60% to $546.0 million in 2007 (compared to 2006 pro-forma net revenue), net profit after tax increased by 41% to $201.3 million (compared to 2006 pro-forma net profit after taxes) and earnings per share on a normalised basis increased in 2007 by more than 28% (AFG Limited, Annual Report, 2007). In 2008, AFG had revenues of $1.3 billion, but sustained a net loss of $1.7 billion while it had assets of $7.4 billion and liabilities of $6.9 billion (AFG Limited, Annual Report, 2008). AFG went into liquidation in November 2008 with an overall deficit of $1.1 billion.

3. Theoretical framework and research method

This study takes a holistic view to analyse the overall circumstances of accounting manipulation. The fraud triangle theory which originates from sociology literature (Cressy, 1953) has been used in this study to explain accounting manipulation in Australia. This theory assumes that the factors of accounting manipulation or fraudulent financial reporting fall under three categories: (i) incentives and pressure; (ii) opportunities, and (ii) rationalizations/attitude. A basic premise of this theory is that the three components of fraud do not work in isolation, rather they are interrelated.

The auditing standards, such as ASA 240 (AUASB, 2006) adopted in Australia and SAS 99 (AICPA, 2002) developed in the USA are based on the fraud triangle theory. All these standards now have the forces of law. Further, academic studies have used fraud triangle theory to explain fraudulent financial reporting (see Albrecht et al., 2004, 2008; Rezaee, 2005; Choo & Tan, 2007; Wilks & Zimbelman, 2004; Hogan et al., 2008; Srivastava et al., 2009; Hammersley, 2011; Bens et al., 2012; Brody et al., 2012). The incentives and pressures that represent the first component of the fraud triangle theory are discussed in

4

this paper taking into account overall economic and industry conditions, entity conditions, executives’ remuneration, and analysts’ expectations of earnings or pressures from the credit/rating agencies.The opportunities of accounting manipulation are examined in view of subjectivity in accounting standards or violation of the standards and regulations, board independence, financial expertise and internal control. Any conflicting interests of external auditors or their negligent oversight may also create accounting manipulation opportunities. Ineffective enforcements by securities or financial regulators may also be responsible for accounting manipulation. Rationalization is typically understood as verbalisation or arrogant attitude coupled with dishonest behaviour.

For data, the study relieson annual reports of the companies, investigation reports, court hearings and judgments, and other public documents including media articles. The method of analysis of data is interpretive-social constructivist which is driven by a philosophical belief of subjective realities.

4. Analysis and interpretation of findings

4.1 Incentives and pressures for manipulation

Macro-economic and industry conditions

At the time of the HIH collapse, overall economic conditions were deteriorating, as was apparent from the number of corporate collapses that occurred in Australia and elsewhere. Six months before Enron’s collapse in late 2001, there were a number of high profile corporate collapses in Australia, including national retailer Harris Scarfe (placed in receivership in April 2001), high profile telecommunications company One.Tel (suspended share trading and appointed an administrator in May 2001), one of the two the major domestic airlines in Australia, Ansett (in September 2001), and Australian mining company Pasminco (went into voluntary administration in September 2001) (Robins, 2006; Parker, 2005, p.384). The high profile collapses in Australia during 2000-2002 somewhat replicated corporate failures in the 1960-1980s period by Reid Murray, H.G. Palmer, Stanhill, Cambridge Credit, Adsteam, the Hooker Corporation, Westmex, Qintex and the Bond Corporation (Clarke et al., 2003). In addition to such traumatic 2001 corporate collapses, worsening economic and trading conditions for the insurance industry were noted in the Final Report of the HIH Royal Commission:

By the mid-1990s the general insurance cycle in Australia was close to its peak … On the stock market, the insurance index outperformed the all ordinaries index and the banking index in that year. Thereafter the cycle turned down. Low interest rates and a reduction in investment returns, coupled with a general cut in premium rates because of competition, hit the sector’s profitability. By the end of 1998 profit falls and some losses were being reported across the sector. The situation was aggravated by unusually large losses on underwriting: in the year ended December 1998 the industry reported its highest ever underwriting loss – nearly 40 percent higher than any underwriting result in the previous 20 years. (HIH Royal Commission, 2003, vol. 1, p.66)

While the downturn in the insurance industry had led to various mergers, the following emerging factors also had the potential to destabilise the industry (HIH Royal Commission, 2003, vol.1):

The traditional boundaries between banking and insurance were blurring, paving the way for increased competition in the insurance sector by the major banks.

5

Advances in technology were leading to major changes across the whole financial sector.

Public liability insurance, workers compensation and professional liability insurance classes were generally under-reserved across the industry.

Economic and industry conditions prevalent in Australia and overseas in the last years of the 1990s and in the early years of the 2000s comprised the adverse external environment which confronted the corporate world during this period.

Another round of corporate meltdown began in the second half of the 2000-2010 decade. During 2007-2010, the Australian and global economy witnessed the severe impact of the global financial crisis with market downturns, earnings volatility, excessive leverage, a liquidity crisis and job cuts. Australia’s economic conditions remained quite buoyant during this period and sustained a much lower shock than the US and European economies. Nonetheless, ASIC relying upon its assessment of market conditions estimated that approximately $73 billion was lost in value as a result of corporate and investment product collapses from 1 January 2008 to 31 May 2009 (ASIC, 2009). The failures of ABC Learning Centres, AWB, Storm Financial, Opes Prime, Babcock and Brown, and Clive Peters during 2007-2010, indicate how the financial and non-financial sectors in Australia were severely affected by the GFC. As the GFC continued to unfold, more corporate failures occurred in the Australian economy. The ongoing GFC as well as volatile economic and industry conditions may have had contagion effects on the failure of AFG in 2008 (ASIC, 2009). AFG’s administrator McGrathNicol held the view that the main factors contributing to failures of various leading companies during the GFC were mostly sourced in the substantial deterioration in debt and equity markets that occurred (McGrathNicol, 2009).

Entity conditions

Earnings growth and profitability

Typically, net profit and earnings growth are widely considered key factors in determining the level of profitability, earnings per share and share price over time. All these factors indicate whether a company can satisfy earnings expectations of executives, investors, analysts and other market participants.

Table 1: HIH Limited’s net profit to shareholders ($ million)Reporting periods Net profit to shareholders

January to December 1997 (12 months) 61.8January to December 1998 (12 months) 37.6January to June 1999 (6 months) (58.8)January 1998 to June 1999 (18 months) (21.2)July 1999 to June 2000 (12 months) 18.4

Source: HIH Limited, Annual Reports, 1997-2000

In the years ending 31 December 1995 to 1997, HIH reported consistently growing operating profit after extraordinary items and income tax (HIH Royal Commission, 2003, vol. 1, p.xviii). From 1997, HIH Limited’s financial performance was affected by earnings volatility. As evident in Table 1 above, HIH Limited’s net profits attributable to shareholders dropped from $61.8 million in 1997 to $37.6 million for the 1998 calendar year. With approval from ASIC, HIH changed its financial year from January-December to July-June, from 1998. Accordingly, its net loss for six months to June 1999 was $58.8 million and net loss for eighteen months from January 1998 to June 1999 was $21.2

6

million. Then surprisingly, the company recorded a net profit attributable to shareholders of $18.4 million for the 12 months ended 30 June 2000.

Table 2: Revised earnings with growth and profitability in HIH Limited($ million, other than ratios and percentages)

Year Net income after tax (1996: $59.2) Profitability ratios EPS(in cents)12 months

ended June 30Amount ($) Change ($) Growth (%) ROE ROA1

1997 78.3 19.1 32.3% 16.3% --- 25.61998 37.5 (40.8) (52.1%) 6.5% --- 9.91999 (39.8) (77.3) (206.1%) (5.0%) --- (0.4)2000 18.4 58.2 146.2% 2.0% --- (0.6)

Source: HIH Limited, Annual Report, 1997-2000

HIH Limited’s 2000 annual report disclosed a revised summary of the company’s net profit attributable to shareholders for the financial year to June each year (Table 2). Accordingly, HIH Limited’s net income after tax to June was $59.2 million in 1997, $78.3 million in 1997, and $37.5 million in 1998. Its net loss for the twelve months to June 1999 was $39.8 million which was almost double the net loss of $21.2 million for eighteen months to June 1999. With the revised earnings numbers, HIH Limited’s net income growth (net profit attributable to shareholders for 12 months ended in 30 June) was up 32.3% in 1997 then down 52.1% in 1998 and down a further 206.1% in 1999 (see Table 2). Then in 2000, HIH Limited had an unexpected profit of $18.4 million - net income growth of 146.2%. HIH Limited declared a dividend in 1999 and 2000 by exhausting retained earnings (HIH Royal Commission, 2003). HIH Limited’s net income volatility had effects on return on equity (ROE) and earnings per share (EPS). Its ROE in 1997 was 16.3% and then declined to 6.5% in 1998. It fell further to a negative 5.0% in 1999. Then in 2000, the company rebounded with a positive ROE of 2%.

There had been a sharp decline in earnings per share from 25.6 cents in 1997 to 9.9 cents in 1998. Earnings per share numbers appeared negative with 0.4 and 0.6 cents in 1999 and 2000 respectively. It is apparent that the company reported fictitious earnings numbers in 2000. Despite the net profit of $18.4 million with net income growth of 146.2% in 2000, its EPS was a negative 0.6 cents - the lowest ever. The HIH Royal Commission questioned the veracity of HIH Limited’s earnings volatility as follows.

For the 18 months to June 1999 there was a loss of $21.2 million. In the year ending 30 June 2000 the group returned to profit, but only to the extent of $18.4 million. It is my opinion that, were it not for questionable accounting treatment of some transactions, the loss in 1999 would have been greater and the profit in 2000 would have been a loss. In both 1999 and 2000 the company declared a dividend but in doing so exhausted its store of retained profits. (HIH Royal Commission, 2003, vol. 1, p.xviii)

In light of the significant deterioration in HIH Limited’s profitability and capital base during 2000 and the resultant deterioration in the share price caused by (i) market difficulties in the UK and the USA, and (ii) losses from the acquisition of FAI2 (HIH Royal Commission, 2003, vol. 1., p.60), the subsequent sections reveal how the use and abuse of 1 As there were revisions in the earnings numbers based in the changes in financial year, ROE ratios were

taken from the 2000 annual report. Return on assets (ROA) ratios have not been calculated owing to unavailability of data related to total assets for each financial year ended in June.

2 FAI was an Australian based insurance company which also had operations in a number of Asian and Pacific general insurance markets. Being acquired in early 1999 for a total consideration of about $300 million, FAI became a wholly-owned subsidiary of HIH Limited (HIHRC, 2003, vol. 1& 2).

7

reinsurance and under-provisioning by the misapplication of accounting standards, contributed to an understatement of losses in 1999 and overstatement of profits in 2000.

In a similar vein, AFG Limited was subject to dramatic earnings volatility between 2006 and 2008. As reported in the June 2005-2007 annual reports, its 2005 net income was $61.8 million.

Table 3: Earnings growth & profitability of AFG ($ million, other than ratios & percentage)

Year Net income after tax (2005: $61.8) Profitability ratios EPS(in cents)12 months

ended June 30Amount ($) Change ($) Growth

%ROE

%ROA

%2006 96.9 35.1 56.8% 16.05% 7.41% 49.4*2007 211.7 114.8 118.5% 9.95% 2.25% 63.92008 (1,731.6) (1,943.3) (917.9%) (319.16%) (23.27%) (485.5)

Source: AFG Limited, Annual Reports, 2006-2008.

As revealed in Table 3 above, AFG Limited’s net income (profit) after tax rose to $96.9 million (a 56.8% increase) in 2006; then it grew further by 118.5% to $211.7 million in 2007. But despite net earnings after tax having significantly increased in 2007 and earnings per share increased from 49.4 cents in 2006 to 63.9 cents in 2007, the profitability ratios fell drastically in 2007. One likely explanation is that AFG Limited could increase net profit in 2007 by 118.5 % because of the merger with Record, whilst its return on equity and return on assets declined in 2007 by more than 6% and 5% respectively owing to an increase in equity and assets of the group. But the following year 2008 proved a fatally stressful year for the newly merged AFG Limited-Record firms, due to an enormous net loss after tax of $1.7 billion, which comprised a nine-fold decline in earnings performance with accompanying revelations of negative earnings growth, profitability and EPS. To be sure, AFG Limited’s $1.7 billion loss for 2007-2008 was one of the largest in Australian corporate history (The Australian, November 5, 2008). According to the administrator’s report to creditors, required pursuant to Section 493A of the Corporations Act 2001, the key causes of AFG Limited’s ultimately fatal under-performance in 2008 were as follows (McGrathNicol, March 6, 2009):

Losses of $139 million on equity accounted investments

An increase in financing costs of $94 million

Asset impairment charges of $1.6 billion.

It is noteworthy that despite severe earnings volatility in 2007 and 2008, AFG Limited was not accused of income smoothing, but rather of balance sheet disclosure problems. A scrutiny of its disclosure practices reveals AFG Limited’s efforts to report better earnings numbers in the financial years prior to its collapse. Firstly, AFG Limited’s basic EPS of 49.6 cents and diluted EPS of 47.6 cents for the financial year to 30 June 2006 were restated as 47.6 and 47.3 cents respectively in 2007. The market participants’ (e.g. investors, and analysts) perception of the group’s earnings capability for 2006 may have remained unchanged until an explanatory restatement was provided in the 2007 annual report. As articulated by the efficient market hypothesis, investors and other market participants react to information when it is released by a company. Secondly, AFG Limited acquired goodwill and intangibles because of acquisitions and the merger with Record Investments Ltd on 1 July 2006. According to the GAAPs, both goodwill and intangibles are subject to judgements and impairment every year. As extracted from the annual reports, AFG Limited’s impairment losses were $26.4 million and $1.6 billion for the years to 30

8

June 2007 and 2008 respectively. In both these years, AFG Limited encountered difficulties caused by deteriorating asset values. However, its 2007 impairment losses did not include any impairment charges for goodwill. Conversely, AFG Limited’s management justified inclusion of goodwill impairment charges of $885.1 million in $1.6 billion total impairment losses for the year ended 30 June 2008. If goodwill impairment losses had instead been charged and reported for the year ended 30 June 2007, the net profit could have been a loss. As reported by Verrender (2010, 23 March), it has also emerged that in its dying days, AFG Limited sold some assets to entities (related parties) within the group, not for cash but to book earnings and signal profitability.

Solvency issues (leverage and liquidity)

HIH Limited’s overall leverage was critical to running as a going concern.

Table 4: Leverage of HIH Limited ($ million, other than percentages)Year Assets Financing assets

Assets Liabilities Equity Assets to equity

Financed by equity

Financed by debt

As on 31 Dec 1997 3,986.7 3,426.4 560.3 7.1x 14.1% 85.9%As on 30 June 1999Restated on 30 June 2000

7,725.48,051.1

6779.07,104.1

946.4946.4

8.2x8.2x

12.2%12.2%

87.8%87.8%

As on 30 June 2000 8,327.1 7,388.0 939.1 8.9x 11.2% 88.8%Source: HIH Limited, Annual Reports, 1997-2000

As shown in Table 4 above, HIH Limited’s leverage ratio in 1997 was 7.1x which increased to 8.2x in 1999 and to 8.9x in 2000 (Table 4). Otherwise stated, HIH Limited had only $1 of equity every year when it needed $7.1 to $8.9 to finance its assets between 1997 and 2000. Consequently, HIH Limited had to depend on debt for financing 85.9% to 88.8% of assets.

Table 5: Liquidity ratio of HIH Limited ($ million, other than percentages)Year Current assets Current liabilities Current ratioAs on 31 Dec 1997 1849.1 1594.9 1.16:1As on 30 June 1999Restated on 30 June 2000

3596.83750.5

3289.13,262.8

1.09:11.15:1

As on 30 June 2000 3,450.5 3,026.3 1.14:1Source: HIH Limited, Annual Reports, 1997-2000

As detailed in Table 5, HIH Limited’s liquidity fell to critical, unstable levels. It had just over $1 in current assets to pay current liabilities of $1. Given this precarious liquidity position and without the requisite capital base to endure cyclical downturns, HIH Limited had to maintain a resilient balance sheet in addition to delivering a satisfactory return on equity to shareholders (HIH Royal Commission, 2003). HIH Limited’s assets and liabilities increased in 1999 due primarily to the acquisitions of FAI, Great States, Cotesworth Group and associated Lloyd's Syndicates (Annual Report, 1999). HIH Limited also restated its June 1999 assets and liabilities on 30 June 2000. Its liquidity increased to 1.15:1 from the previously stated 1.09:1.

Table 6 below depicts how AFG Limited’s leverage ratio during 2005-2007 ranged between 1.8x and 3.9x and hence was not as excessive as that in HIH Limited.However, it is understandable that AFG Limited’s leverage increased annually, becoming excessive prior to collapse.

Table 6: Leverage of AFG Limited ($ million, other than percentages)

9

Period Assets Financing assetsAssets Liabilities Equity Assets to

equity Assets financed

by equityAssets financed

by debt2005 810.06 358.53 451.54 1.8x 55.7% 44.3%2006 1,308.88 704.74 604.14 2.2x 46.2% 53.8%2007 8,583.66 6,381.38 2,202.28 3.9x 25.7% 74.3%2008 7,478.76 6,933.48 545.28 13.7x 7.3% 92.7%

Source: AFG Limited, Annual Reports, 2006-2008

In 2008, when AFG Limited needed $13.7, its equity could provide finance support of $1 only. Given its parlous equity base as revealed in Table 6, AFG Limited was under pressure to increasingly depend on debt financing, which increased from 74.3% in 2007 to 92.7% in 2008. The major portion of its debt was short-term. This created liquidity problems (working capital crisis) in 2007 and 2008. As a result, AFG Limited chose to miscategoriseitems if assets and liabilities in its balance sheet, thereby obscuring the true state of its solvency problems. Extracting information from AFG’s management, AFG Limited’s administrator subsequently re-estimated AFG Limited’s current assets at $3.4 billion against $4.7 billion current liabilities in 2008. The result was that, the group had a working capital deficiency of $1.3 billion which represented a current ratio of less than $1 in 2008 (McGrathNicol, 2009). Its excessive dependence on externally sourced debt combined with its liquidity crisis were fatally exacerbated, when Australia’s biggest margin lenders removed AFG from their margin lending stock list (see Jimenez, 2008, February 02). Reported that:

Two of its four margin lenders sold their security – about half APT’s Allco holdings – while the remaining two, including National Australia Bank, are in negotiations with APT over a standstill agreement that would protect both parties from crystallising more fire sale losses by offloading the remaining shares in the current environment. (Bartholomeusz, 2008, February 22)

Cash flows

Cash flows arguably provide a better indicator than accrual based accounting of a company’s ability to sustain its overall activities (Hertenstein & McKinnon, 1997). Table 7 reveals that HIH Limited’s overall net cash flows were negative in two out of three years.

Table 7: Cash Flows of HIH Limited ($ million, other than percentages) Year Cash flows from different activities Net CF

Operating activities Investing activities Financing activities1997* 166.8 (258.7) (2.6) (94.5)1999** (341.4) 531.4 257.6 447.62000*** (678.3) 543.8 (50.8) (185.3)

Source: *Figures are for the year ended on 31.12.97 (HIH Limited, Annual Report, 1999). **Figures are for 18 months from 1.1.98 to 30.6.99 (HIH Limited, Annual Report, 1999). ***Figures are for the year ended on 30.6.2000 (HIH Limited, Annual Report, 2000).

Although HIH Limited had negative cash flows of $94.5 million for the year ended December 1997, it did not then depend on financing activities as it generated positive cash flows of $166.8 million from operating activities. But its net cash flow position was negative in 1997 mostly because of investing activities. The figures in Table 7 further demonstrate the worrisome state of HIH Limited’s cash flow positions for 1999 and 2000. The company had positive net cash flows of $447.6 million for the 18 months to 30 June 1999. However, this amount was not sourced from operating activities, but rather, from investing activities of $531.4 million and financing activities of $257.6 million. Its operating cash flow position was a negative $341.4 million for this period. The company’s

10

net cash flows from operating activities continued to be negative with $678.3 million for the year ended 30 June 2000 when HIH Limited was unable to generate cash flows from financing activities. At this point, the company totally depended on selling its own assets to reduce negative net cash flows.

The huge volume of negative cash flows from operating activities from 1 January 1998 to 30 June 2000 along with excessive leverage, earnings volatility and negative earnings per share during 1999-2000, signalled HIH Limited’s potential failure in the subsequent periods. The seemingly unavoidable consequence was that HIH Limited became insolvent in March 2001, amidst serious assertions of its unrelenting attempts to hide debts and smooth profits (HIH Royal Commission, 2003).

And similarly, regarding AFG Limited, Table 8 reveals enormous volatility in its net cash flows between 2005 and 2008.

Table 8: Cash Flows of AFG Limited ($ million, other than percentages) Year Cash flows from different activities Net CF

Operating activities Investing activities Financing activities2005 51.30 (371.04) 311.55 (8.19)2006 57.78 (374.94) 323.19 6.032007 237.19 (263.56) 465.01 438.642008 (29.37) (168.83) 154.01 (44.19)

Source: AFG Limited, Annual Reports, 2006-2008

Prior to the merger of Allco Limited with Record Investments Limited in 2006, Allco Limited’s net cash flow position was a negative $8.19 million for 2005. After this merger, AFG Limited’s net cash flow position was positive but insignificant with $6.03 million for 2006, and then net cash flows for 2007 leapt to $438.64 million, some 73 times larger than for 2006. The company’s aggressive expansion and diversification of business activities were supported by increasing cash flows from both operating activities and financing activities between 2005 and 2007. However, AFG Limited ultimately collapsed in August 2008 with negative cash flows from operating activities of $29.37 million and reduced cash flows from financing activities of $465.01 million for 2007 to $154.01 million for 2008.

Executive remunerationThe remuneration packages for executive directors and senior officers in HIH Limited comprised salary, superannuation, performance-based bonus, and long-term incentives, including share ownerships and options (HIH Limited, Annual Report, 1999, 2000).

Table 9: Break-up of executive remuneration in HIH Limited ($ other than percentages)

Year Executives Salary Incentives/options

Other benefits

Total % of salarySalary Others

1999

R R Williams 1,450,188 --------- 10,162 1,460,350 99.3% 0.7%T K Cassidy 906,615 --------- 10,162 916,777 98.9% 2.1%D Fodera 789,708 --------- 10,162 799,870 98.7% 2.3%G O Sturesteps 976,132 --------- 10,162 986,294 99.0% 1.0%H F R Wein 372,431 137,911 7,345 517,687 71.9% 28.1%Total 4,495,074 137,911 47,993 4,680,978 96.0% 4.0%

2000

R R Williams 1,140,625 500,000 7,067 1,647,692 69.2% 30.8%T K Cassidy 664,833 --------- 7,067 671,900 98.9% 1.1%D Fodera 646,602 --------- 30,526 677,128 95.5% 4.5%G O Sturesteps 700,219 ---------- 7,067 707,286 99.0% 1.0%H F R Wein 529,410 118,918 --- 648,328 81.7% 18.3%Total 3,681,689 618,918 51,727 4,352,334 84.6% 15.4%

Source: HIH Limited, Annual Reports, 1997-2000

11

In practice, a differential scale was applied for the payment of remuneration to the top five executives. As shown in Table 9 above, only one of the top five executives – the CEO - received long-term incentives of $137,911 and $118,918, in addition to his regular salary in 1999 and 2000 respectively.

The CEO, Ray Williams, received $500,000 as stock options in 2000. None of the other top executives was granted any performance-based bonus or stock options. In this situation, the salary of the top executives other than that of CEO Ray Williams and HFR Wein comprised between 95.5% and 99.3% of their total remuneration during 1999-2000. Although HIH Limited’s net profit after tax increased from a negative figure (net loss) of $39.8 million in 1999 to a positive figure (net profit) of $18.4 million in 2000 (Table 1), total remuneration of the three executives Cassidy, Fodera and Sturesteps decreased in 2000, while total remuneration of the CEO and HFR Wein increased in 2000 vis-à-vis their total remuneration in 1999. The stock option of $500,000 to the CEO was likely linked to financial performance, a net profit of $18.4 million in 2000. HIH Limited’s net income over the 1997-1999 period declined by 52.1% in 1998 and 206.1% in 1999 (Table 1). The HIH Limited Final Report documented how the salary of CEO Ray Williams increased about 44% from $775,000 to $1.12 million between early 1997 and March 1999 (HIH Royal Commission, 2003, vol. 3, p.284). There was no cogent explanation in the company’s annual reports about increases in CEO remuneration from 1997 to 2000, despite its falling profitability.By contrast, the remuneration policies of AFG Limited were guided by an explicit philosophy to align senior executives’ performance with business performance. This linked the contribution of the senior executives to a remuneration regime, coupling business performance with achievement of individual objectives (AFG Limited, Annual Report, 2007-2008).

As adverted to below, business performance and specific objectives were linked to remuneration policies via a combination of relatively modest base salaries and performance-driven incentive arrangements (AFG Limited, Annual Report, 2007, p.48).

Table10: Break-up (A) of executive remuneration in AFG Limited (Actual $ amount)Year Executives Salary Bonus Shares Options &

rightsRetentionIncentive

Othrs Total

2007

David Clarke 187,415 250,000 141,640 --- --- --- 579,055M Stefanovski 399,818 600,000 2,019,336 82,731 --- 9,900 3,111,815Tim Todd 346,890 450,000 17,728 140,410 --- --- 955,028David Veal 311,431 --- --- 82,731 --- 9,900 404,062John Love 356,577 1000,000 --- --- --- --- 1,356,577Mark Worrall 300,000 500,000 --- 82,731 --- 9,900 892,631Rob Moran 300,000 500,000 --- 82,731 --- 9,900 892,631Total 2,201,431 3,300,000 2,178,704 371,334 --- 39,600 8,191,799

2008

David Clarke 827,235 --- 848,692 319,542 --- --- 1,995,469MStefanovski 436,871 --- 3,781,366 (82,731) --- 763,129 4,898,635Tim Todd 405,387 --- (17,728) (140,410) --- --- 247,249David Veal 389,014 --- --- (13,757) 750,000 --- 1,125,257John Love 326,277 --- --- 27,608 800,000 --- 1,153,885Mark Worrall 350,000 --- --- (13,757) 500,000 --- 836,243Rob Moran 365,909 --- --- (13,757) 650,000 --- 1,002,152Total 3,100,683 --- 4,612,330 (82,738) 2,700,000 763,139 11258891

Source: AFG Limited, Annual Reports, 2007- 2008

12

Table 11: Break-up (B) of executive remuneration in AFG Limited (Actual $m)Executives % of salary including superannuation % of performance related remuneration

2007 2008 Difference 2007 2008 DifferenceDavid Clarke 32.37 41.46 9.09 67.63 58.54 (9.09)

M Stefanovski 13.17 24.50 11.33 86.83 75.50 (11.33)Tim Todd 36.32 0.00 --- 63.68 0.00 ---

David Veal 79.53 34.57 (44.96) 20.47 65.43 44.96John Love 26.29 28.28 1.99 73.71 71.72 (1.99)

Mark Worrall 34.72 41.85 7.13 65.28 58.15 (7.13)Rob Moran 34.72 36.51 1.79 65.28 63.49 (1.79)

Source: AFG Limited, Annual Reports, 2006-2008

Tables 10 and 11 above reveal the remuneration paid to the CEO David Clarke, Deputy CEO Michael Stefanovski, CFO Tim Todd and four other senior executives. Cash bonus, shares, options and rights, retention incentives, and other monetary and nonmonetary benefits were considered as performance related pay. The performance related remuneration of those senior executives ranged between 65% and 87% of their total remuneration in 2007, and 63% to 76% in 2008. The group’s lower earnings performance had direct effects on the reduction in performance related pay in 2008. As detailed in Table 2, AFG Limited’s net income attributable to shareholders increased from $96.9 million in 2006 to $211.7 in 2007, while it sustained a net loss of $1.7 billion in 2008 with resulting decline in EPS from 63.9 cents in 2007 to a negative figure of 485.5 cents in 2008. And relatedly, AFG’s share price experienced a sharp decline from $10.64 on 30 June 2007 to $0.40 on 30 June 2008 (AFG Limited, Annual Report, 2008, p.31)before AFG Limited went into receivership in November 2008. Remarkably, while no one received cash bonus and nonmonetary benefits in 2008, Deputy CEO and CFO executives received retention incentives or other benefits of similar amounts.

Analysts’ expectations

Market analysts had for some time viewed with scepticism the earnings and stock prices of HIH Limited. When not satisfied with HIH Limited’s earnings, their opinions perhaps more accurately tracked the prospects and stock prices of the firm. In 1998, market analysts were divided with respect to their “buy”, “hold” and “sell” opinions, forecasting different prospects for HIH Limited. The Agenewspaper summed up the overall market position by quoting an unnamed analyst:

Rarely do you get such a dichotomy of opinion on a stock between analysts. It makes it really hard for the fund managers to decide what to do. (HIH Royal Commission, 2003, vol. 1, p. 68)

The opinion of market analysts was especially polarised in 1998, due to an adverse conjunction of the release of the poor first half-year results in September 1998 and announcement of the bid for FAI just three weeks later (HIH Royal Commission, 2003, vol. 1, p.68). When the acquisition of FAI was completed, Standard & Poor’s downgraded HIH Limited’s credit rating from “A” to “A-” and at the same time upgraded FAI from “BBB–“to “A-” (HIH Royal Commission, 2003, vol. 1 p.68). Despite this downgrade, some market analysts still took an optimistic view of the enlarged firm’s prospects following the FAI takeover (HIH Royal Commission, 2003, vol. 1, p. 69). That lingering sense of market optimism however, ultimately dissipated:

By mid-1999 a more cautious tone was evident throughout the market as concerns emerged about HIH’s profit for 1998-1999. When a profit result

13

below expectations was confirmed on 25 August, the media coverage was critical. (HIH Royal Commission, 2003, vol. 1, p.69)

Then subsequent events prompted dramatic reactions from market analysts and the media. On a positive note, by the end of October 1999, the analyst Ord Minnett had upgraded its recommendation to shareholders to “accumulate” HIH Limited’s shares, noting confidence in the stock based on an extension of HIH Limited’s alliance with the National Australia Bank. That positive attitude continued when HIH Limited revealed on 25 January 2000 that it expected an improvement in results for the six months to 30 December 1999 (see HIH Royal Commission, 2003, vol. 1, p.70). That favourable media coverage began to fade away more or less permanently from late May 2000, coinciding with a sharp fall in the price of HIH Limited’s shares (HIH Royal Commission, 2003, p.71). A 26 May 2000 article in The Australian entitled “Failing HIH Limited has only itself to blame”, mostly criticised elements of a poorly run business run by an entrenched management team led by Ray Williams, including the failure to extract the potential synergies from HIH Limited’s three acquisitions and the method of under-provisioning. The 1999-2000 full-year results, when released, were well below market analysts’ expectations; and HIH Limited’s shares were suspended from trading for a day on 13 September 2000. Further, as observed in the Royal Commission’s Final Report (HIH Royal Commission, vol. 1, pp.70-73):

Standard and Poor’s revised its credit watch on HIH Limited to ‘negative’.

A market analyst’s view was reported in the Australian Financial Review for their opinion that: “This is the tip of the iceberg. This business is haemorrhaging”.

Credit Suisse, First Boston and Ord Minnett all downgraded HIH Limited’s shares. Although Ord Minnett later upgraded its recommendation from ‘hold’ to ‘accumulate’ on the strength of the CEO’s resignation on 12 October 2000, market analysts and investors progressively withdrew any residual support for HIH Limited from the end of 2000 until its collapse in March 2001.

AFG Limited had secured its continued existence, relying upon long-term relationships with borrowers, co-investors, asset-managers, commercial banks, stockbrokers and advisors (Annual Report, 2007). Whilst ostensibly recognising the legitimate interests of stakeholders, in reality, as stated earlier, AFG Limited did not disclose a $50 million loan to APT, hid current liabilities of approximately $1.9 billion, did not charge goodwill impairment in 2007 and sold assets to related parties (not for cash). These accounting contrivances were undertaken to improve earnings, risk and solvency (see Tables, 2, 4, 5 and 6). Analysts reacted accordingly. It has been reported that that:

Australia’s top investment analysts should be ashamed of themselves. As of December 2007, five out of seven brokers and banks covering Allco were advising investors to buy; none was saying “sell”. Three months later the shares were practically worthless. (Barry, 2010, May)

In 2008, when AFG Limited’s outlook and performance worsened, the S&P/ASX revised their indices, and deleted AFG from the top 200 (S&P’s, 2008b, September 5). When AFG Limited, Max Securities and Mortgage Trust issued A$535 million medium-term-notes (MTNs), S&P’s Ratings Services provided a CreditWatch on it in negative terms (S&Ps, 2008a, March 26).

14

4.2 Opportunities to carry out manipulation

Accounting issues in HIH Limited

The Royal Commissioner obtained evidence of HIH Limited management’s involvement in questionable accounting entries. He was eventually able to provide a detailed explanation of such accounting manipulation. As Justice Owen explained in his final report, HIH Limited’s “financial statements were distorted by questionable entries, heavy reliance on one-off end-of-year transactions, and aggressive accounting practices” (HIH Royal Commission, 2003, vol. 1, p.xlvi). Westfield (2003a) argues that HIH Limited’s accounting reports concealed potential losses.

Although Table 12 below is not an exhaustive list, it is indicative of the principal accounting standards that were misapplied or misinterpreted to facilitate a misleading perception of HIH Limited’s financial performance and strengths during 1997-2000.

Table 12: Major accounting issues in HIH Limited (1997-2000)Relevant accounting standards effective during 1997-2000

Under-provisioning AASB 1023, Financial reporting of general insurance activitiesRe-insurance AASB 1023, Financial reporting of general insurance activities

AASB 1002, Events occurring after reporting dateDisclosure of intangible assets including goodwill, future income tax benefits, deferred acquisition costs and deferred information technology costs

AASB 1013, Accounting for goodwillAASB 1020, Income taxAASB 1023, Financial reporting of general insurance activities

Accounting policies - going concern issues

AASB 1001, Accounting policies

Related Party disclosures AAS 22 and AASB 1017, Related party disclosuresSources: Based on the Accounting Standards; HIH Limited, Annual Reports, 1997-2000; HIH Royal Commission, 2003

Under-provisioning

It is a stereotypical phenomenon – and hence related accounting practice – in the insurance business that while premium income is received on a regular periodic basis, the payment of claims is typically deferred, i.e., they are made in subsequent accounting periods or years. Because of this technical asymmetry the non-contemporaneity of receipts and payments – a ‘long-tail’ insurer could become technically insolvent but remain operational for a significant period of time (HIH Royal Commission, 2003).

Given this situation, adequate provisioning for future claims and disclosure of relevant information in a timely manner was mandatory to keep investors and other key stakeholders well-informed. As HIH Limited’s provision for outstanding claims was about 50 percent of liabilities on the balance sheet with under-provisioning between $2.6 billion and $4.3 billion, Justice Owen concluded that that the biggest single cause of HIH Limited’s collapse was the failure to provide properly for future claims (HIH Royal Commission, 2003, vol. 1).

Table 13 below presents the estimates of under-provisioning in HIH Limited, C&G, and FAI for 2000. If under-provisioning was re-estimated at $302 million, HIH Limited’s reported reinsurance liability of $4,430 million could have been $4,732 million in the year to 30 June 2000. With a 3 percent further allowance for future handling costs, under-provisioning would be further re-estimated at $444 million.

15

Table 13: Under provisioning in HIH Limited for the year to 30 June 2000 ($m)Valuation of the cases Extent of under-provisioningHIH Limited C&G liability portfolio 84.6HIH Limited C&G professional indemnity portfolio 59.0HIH Limited C&G Workers compensation portfolio 2.8HIH Limited C&G - undiscounted value of builder’s warranty 20.0HIH Limited C&G’s US liability claims 25.0HIH Limited America ( without HIH group $55 million) 72.0 FAI - undiscounted value of builder’s warranty 20.0FAI - doubtful reinsurance recoveries 18.6Total adjustments ($4,732 - $4,430)Further allowance (3%) for future handling costs

302142

Inadequate provision in the financial statements to 30 June 2000

444

Source: Estimates of Slee and Justice Owen as stated in HIH Royal Commission Final Report, 2003, vol. 3, pp.56-57

Since HIH Limited failed to set aside enough provision to cover future insurance claims, this accounting treatment had simultaneous effects on the income statement and balance sheet, because it increased profits in the reporting year(s) and caused a great risk (liability) of non-payment in future years. HIH Limited’s inherent under-provisioning problems compounded over time and became critical when HIH Limited inherited unexpected losses from under-provisioning in FAI. The Royal Commission referred to independent reports about under-provisioning practices in FAI. For example, Swiss Re Insurance Company discussed with the officers of FAI and reported in October 1997 the absence of a methodology for the claims-handing process, problems in claims-reserving guidelines, the absence of a claims manual about basic controls and processes, and the failure to monitor claims below $100,000. Then on behalf of Swiss Re Insurance, in April 1998, General Australia Limited conducted basic due diligence about FAI’s outstanding claims liabilities relating to reinsurance contract and reported that FAI’s “big six” loss reserves were recognised only after receiving a monthly or quarterly statement of account, and hence no case reserves were booked in a timely manner (see HIH Royal Commission, 2003, vol. 2, pp.109-110). In the upshot, the Royal Commissioner made numerous adverse findings about financial reporting issues relating to under-provisioning in FAI, as follows:

The reserving practices within FAI over a long period of time were unsatisfactory giving rise to significant under-reserving from at least 30 June 1997 and possibly before that period. The causes of the under-reserving were multifaceted. They included poor claims management but also deliberate manipulation of claims estimates by management for the purpose of improving reported profit as at various report dates. Further, once the extent of the under-reserving was understood by management, which seems to have occurred in the last quarter of 1997, steps were taken to conceal the under-reserving from the Board, the auditors, the external actuaries and APRA amongst others. The deception continued until shortly after the acquisition of FAI by HIH Limited in the circumstances referred to above. (HIH Royal Commission 2003, vol. 2, p.138)

Before FAI was taken over by HIH Limited, inflicting major financial damage upon it, FAI had a history of accounting malpractices. However, the Royal Commission took the view that opportunities of accounting standard misapplications in FAI and HIH Limited or misinterpretations provided by the management and auditors both occurred due to their intentional malpractice(s) and weaknesses in the principal accounting standard, AASB

16

1023; Financial reporting of general insurance activities. The application of this standard was contentious for various reasons, as follows (HIH Royal Commission, 2003, vol. 1, pp.141-160):

The ‘deferral and matching approach’ to reporting of general insurance transactions under AASB 1023 provided incentives for insurers to under-price their products and hence to ominously understate potential liabilities. According to APRA, it was possible to entirely avoid GPS 210, because it allowed up-front recognition of future claims in the current year rather than allowing the loss to be deferred into future years when the actual claims will arise.

The subjective judgements based on assumptions about present value of the expected future cash flows associated with the claims.

The discounting provisions in relation to calculation of the future cash flows under AASB 1023 in Australia were similar to those in the UK, but different from the related requirements in the USA.

The clash between the Prudential Standard GSP210, Liability valuation for general insurers and AASB 1023 (when read with SAC 4) about the accounting treatment of prudential margins.

The conflicts between AASB 1023 and IASC recommendations as to the value of insurance liabilities (and assets), because, IASC recommended that the value of insurance liabilities (and assets), whether calculated as the entity-specific value or the fair value, should always reflect risk and uncertainty while this practice was not acceptable under AASB 1023.

The concept of a “true and fair” view has always been contestable. The true and fair view of the value of HIH’s liabilities was also troublesome, because this value was calculated based on what knowledgeable and willing parties (HIH Limited and policyholders) would pay to resolve those liabilities (HIH Royal Commission, 2003). Justice Owen’s opinion about this was that, “liabilities should not be valued according to the definition of ‘fair value’ contained in the various IAS standards and in AASB 1033 as “the amount for which a liability could be settled between knowledgeable and willing parties in an arms’ length transaction” (HIH Royal Commission, 2003, vol. 1, p.147). Subsequently, a new standard IAS 139 was issued to better conceptualise fair value. However, this standard also attracted criticism from academics and the accounting profession.

While the above problems variously impacted on the overall financial reporting of HIH group, there arose the quite separate issue about how the principles prescribed in AASB 1023 in regard to recognition of revenue and liabilities, allowed reporting organisations to manipulate profit. The Royal Commission took the following view:

AASB 1023 requires insurers to recognise premium revenue (and reinsurance expenses) in accordance with the pattern of insurance risk under relevant contracts. While the standard does provide guidance as to the interpretation of the statement ‘in accordance with the pattern of the incidence of risk’, it nevertheless allows entities to manipulate the timing of the recognition of premiums. If an entity considered that an insurance (or reinsurance) policy permitted it to recognise all premiums (or reinsurance recoveries) yet delay the recognition of liabilities (or reinsurance premium expenses) then this could result in the recognition of profit being brought forward artificially in the early period of such a contract. (HIH Royal Commission, 2003, vol. 1, p.152)

17

As AASB 1023 inconsistencies provided insurers with the opportunity to under-price products and manipulate accounts for financial reporting purposes, the HIH Royal Commission recommended modifications to this standard. APRA agreed with many of the findings and recommendations of the Royal Commission and suggested removing the opportunities of accounting discretion from this standard. The AASB reissued the standard in July 2004 as AASB 1023 General insurance contracts to incorporate some overdue improvements to accounting for insurance contracts.

Re-insurance

A further quite distinct accounting problem in HIH Limited concerned re-insurance. Owing to a seriously deficient level of reserves in HIH Limited and FAI, HIH Limited management opted for reinsurance, although in reality, reinsurance was shown to consist of sham transactions that were actually loans (Lee et al., 2008, p.701).

And in this respect, the Royal Commission noted that:

The objective was to use reinsurance to off-set any increase in reserves on the balance sheet with a correspondence recovery under a reinsurance contract. The arrangements were structured so as to achieve an accounting treatment that would allow the company to defer to later years expensing the premium paid to obtain the recoveries. (HIH Royal Commission, 2003: vol. 1, p.xxxi)

Therefore, the motivation in HIH Limited for entering into reinsurance arrangements was predominantly earnings manipulation. A variety of abusive and unjustifiable reinsurance programmes (arrangements) impacted on group profit in 1999 and 2000. For example, HIH Limited booked a profit of $92.4 million for June 1999 in relation to so-called reinsurance arrangements with respect to contracts that only commenced on 25 August 1999 (HIH Royal Commission, 2003, vol. 1, p.xxxii). The immediate recognition of income resulting from this type of reinsurance arrangement could not be justified under any accounting standard. In the reporting year to 30 June 2000, there was an instance of a reinsurance arrangement for which the contract was expected to continue for a further period of 2-5 years. Although an external actuary cast doubts about the long-term efficacy of this arrangement, HIH Limited did not disclose it to the auditors and consequently, HIH Limited was able to book an after-tax profit of $84 million (HIH Royal Commission, 2003, vol. 1, p.xxxiii). If this arrangement was disclosed to the auditors or not approved, the Royal Commissioner notes that, HIH Limited’s net profit of $18.4 million for the year to 30 June 2000 could have been a loss of $66 million. With a similar dubious reinsurance arrangement, HIH Limited’s UK branch was able to enhance its balance sheet solvency for UK regulatory purposes (HIH Royal Commission, 2003, vol. 1, p.xxxiii). Moreover, a number of reinsurance arrangements were approved by the auditors despite being somewhat questionable having regard to AASB 1002, Events occurring after balance sheet date(see Table 14).

Table 14: Reinsurance arrangements in HIH Limited and compliance with standardsReinsurance arrangements

Accounted for as at

Contract entered into

Audit approach

Disclosure problem

Swiss Re insurance 31 Dec 1999 In Jan 2000 Flawed Disregarded AASB1002

Hannover Re insurance (I&II)

30 June 1999 In Aug 1999 Flawed Disregarded AASB1002

Preference shares in FAI

30 June 2000 In Oct 2000 Flawed Disregarded AASB1002

Source: HIH Royal Commission, 2003, vol. 3, p.169

18

There were numerous reinsurance contracts which adversely impacted upon HIH Limited and FAI. Amongst them, three types of reinsurance contracts could be attributed to adjustments to net assets by a reduction of $351 million in total (Table 15).

Table 15: Effects of reinsurance contracts on HIH Ltd consolidated accounts ($ million)Reinsurance arrangement Adjustment date Net assets overstated Profit overstated

Swiss Re insurance 30 June 2000 131.0 131.0Hannover Re insurance (I&II) 30 June 2000 192.0 192.0GCRA and NI contracts (FAI) 30 June 2000 28.1 28.1Total 351.1 351.1

Source: HIH Royal Commission, 2003, vol. 3, p.58

Reliance on intangibles

Another major accounting problem derived from heavy dependence on intangibles. In accounting literature intangibles - especially goodwill - have always been dealt with and reported on a subjective judgement basis. This enables management to obscure the proper disclosure of potentially market-sensitive information.

Table 16: Disclosure of intangibles in HIH Limited financial reports ($ million)Year Goodwill Management rights Total

intangiblesShare holders’

equity(net assets)

At cost

Accumulated amortisation cost

At cost

Accumulated amortisation cost

As on 31 Dec 1997 67.2 (25.1) --- --- 42.1 560.3As on 30 June 1999 392.1 (45.6) --- --- 346.5 946.4As on 30 June 2000 555.9 (80.6) 19.3 (0.2) 494.4 939.1

Source: HIH Limited, Annual Reports, 1996-2000

Table 17: Other components of assets not disclosed as HIH Ltd intangibles ($ million)Year Deferred acquisition costs Future income tax benefits (FITB)

Disclosed as Total Disclosed as Timing diff.

Tax losses

Total

On 31 Dec 1997

Current assets 139.8 Non-current other assets 25.1 28.1 53.2

On 30 June 1999

Current assets 278.3 Non-current other assets 145.2 27.2 172.4

On 30 June 2000

Current assets 304.3 Non-current other assets 91.2 137.2 228.4

Source: HIH Limited, Annual Reports, 1996-2000

HIH Limited’s intangibles abruptly and inexplicably leapt in value from $42 million on 31 December 1997 to $346.5 million on 30 June 1999 and $494.4 million on 30 June 2000 (Table 16). In the first two reporting periods, the group’s intangibles totally relied on goodwill. On 30 June 2000, its intangibles consisted of goodwill and management rights. However, the quantum of management rights was negligible - only $19 million. Therefore, from information disclosed in the financial reports on 30 June 2000, when HIH Limited’s intangibles (494.4 million) were 52.6% of shareholders’ equity ($939.1 million), the amount of HIH Limited’s goodwill ($475.3 million) after amortisation costs alone represented 50.6% of shareholders’ equity (Table 16).

There was a major divergence between what HIH Limited reported and what the HIH Royal Commission considered to be the proper amount and components of the firm’s intangibles. Table 17 shows some components not included in and disclosed as HIH Limited’s intangibles. As understood by the Royal Commissioner, 75% of HIH Limited’s shareholders’ equity would rely on intangibles, if goodwill and management rights along with deferred acquisition costs, deferred information technology costs and future income

19

tax benefits were considered as intangibles (HIH Royal Commission, 2003, vol. 1, pp.xix-xx). As the company’s net tangible asset backing per share of $1.39 at 31 December 1997 fell to only 33 cents by 30 June 2000, the Royal Commissioner noted that, HIH Limited adopted a strategy to show components of intangibles as tangible assets (HIH Royal Commission, 2003, vol. 1, pp.xix-xx).

Concerns about accounting for various intangibles (their subjectivity and legitimacy) were ventilated by the HIH Royal Commissioner Justice Owen, in these terms:

I do not think there can be any real argument that future income tax benefits and deferred information technology cots are tangibles. There is, however, doubt whether deferred acquisition costs–while answering the euphemistic description ‘soft assets’–fall into the same category. (HIH Royal Commission, 2003, vol. 1, p.xix)

This is not to say reliance on intangibles is illegitimate. But the trend is disturbing for at least two reasons. First, the value to be attributed to intangibles is often a matter of judgement and is particularly susceptible to error – witting or unwitting; in the accounting practices of HIH Limited goodwill became something of a repository for the unpleasant and unwanted consequences of poor business judgement. Second, when times get tough it is difficult to convert intangibles to cash; as other sources of cash disappear, the intrinsic value of intangibles is seriously called in question. (HIH Royal Commission, 2003, vol. 1, p.xx)

Further analysis of accounting treatment and disclosure of the various components of HIH’s intangibles follows. Firstly, HIH Limited’s goodwill, comprising substantial portion of intangibles, significantly increased following its FAI acquisition in 1999. Under AASB 1013, Accounting for goodwill, the amount of goodwill was estimated as the excess of the cost of acquisition over net assets. The calculation of goodwill under this standard was criticised for inherent ambiguity. It was rigorously revised as part of the development process of IAS 38, Intangible assets, adopted in Australia as AASB 138 with effect from 1 January 2005. The Royal Commissioner argued that goodwill was defined in AASB 1013 in conceptual terms as future benefits from unidentifiable assets, but in practice, goodwill was typically measured just as a residual amount arising from the excess of the cost of acquisition over net assets of the acquired entity (HIH Royal Commission, 2003, vol.1, p.161). Justice Owen put forward compelling arguments of the difficulties arising out of application of AASB 1013 as follows: (i) there was no guidance as to how an assessment of goodwill (excess of the cost of acquisition over net assets) would present future benefits from unidentifiable assets; and (ii) to increase goodwill, there might be more importance placed on the residual amount and less on considering the manner in which the future benefits from unidentifiable assets were realised (HIH Royal Commission, 2003, vol. 1, p.161).

Secondly, on an application of AASB 1020, Income tax, HIH Limited classified future income tax benefits according to timing differences and incurred tax losses (Table 17). This standard also had specific prescriptions about offsetting future income tax benefits against provisions for deferred income tax. The Royal Commissioner uncovered: (i) a provision for deferred income tax of $131.3 million offset against future income tax benefits relating to tax losses: and (ii) a provision for income tax of $96.7 million offset against future income tax benefits relating to tax losses and timing differences. However,

20

HIH Limited’s financial reports did not disclose any provision for tax or for deferred income tax (HIH Royal Commission, 2003, vol. 3).

Thirdly, during investigations, the Royal Commissioner, Justice Owen, discovered in the audit work papers of Arthur Andersen that deferred IT costs were recognised as assets in December 1998, June 1999 and June 2000 as $30 million, $63 million and $88 million respectively. There was no accounting standard or pronouncement about this item; and likewise, there was no specific disclosure in the financial statements about these numbers (HIH Royal Commission, 2003, vol. 3, pp.115-116). Owing to the lack of information, Table 17 does not include any amount for this item. Arthur Andersen failed to find adequate audit evidence about it – identifying at least $8.6 million as not properly capitalised for this item. The Royal Commissioner opined that such deferred IT costs should have been treated as an operating expense in the consolidated financial statement (HIH Royal Commission, 2003, vol. 3, p.58).

Fourthly, deferred acquisition costs were categorised and disclosed as current assets and the future income tax benefits as non-current other assets, not as intangibles (Table 17). If deferred acquisition costs were treated as an intangible asset rather than as a current asset, HIH Limited’s liquidity position, ceteris paribus, was more critical due to the resultant decrease in current assets against current liabilities. Under AASB 1023, a recoverability assessment was necessary to calculate the recoverable amount of deferred acquisition costs and write down the difference as an expense when its cost was less than the recoverable amount. HIH Limited failed to undertake a recoverability test for reporting at 30 June 1999 and 2000 (HIH Royal Commission, 2003, vol. 3, pp.112-114).

Accounting policies on going concern issues

The contemporary accounting standard AASB 1001, Accounting Policies, had specific requirements for companies to prepare financial reports on a going concern basis. This standard suggests disclosure in notes to the accounts of any issues like risks or uncertainties that affected or had the potential to affect the going concern. HIH’s June 1999 and June 2000 financial reports were prepared on the basis of a going concern assumption. However, accounting policies of HIH Limited did not disclose any statement or explanation of risks and uncertainties in the following circumstances:

HIH Limited had worsening underwriting losses, rising from $33.8 million for the year ending on 31 December 1997 to $173.7 million for 18 months to 30 June 1999 and to $103.5 million for the year to 30 June 2000 (Annual Reports, 1999-2000).

The group heavily relied on intangibles which were difficult to convert to cash in adverse financial conditions (HIH Royal Commission, 2003).

The group’s overall cash flow for the year to 30 June 2000 was a negative $185.3 million which mostly resulted from negative operating cash flow of $678.3 million (Table 7)

It had negative EPS numbers in 1999 and 2000 (Table 2).

Liquidity approached critical levels for the entire 1997-2000 period (Table 5).

Leverage from 7.1x on 31 December 1997 to 8.9x on 30 June 2000 increased dependence on debt financing from 85.9% to 88.8% respectively of total assets (Table 4).

21

Related party disclosures

Related party disclosures have long been considered a significant item in accounting standards. The rationale is that disclosure of related party transactions provide an appreciation of the interest in, and a level of control or influence over, or imposed by, the reporting entity. In Australia, AAS 22 ‘Related party disclosures’ was first issued in 1998 by the Australian Accounting Research Foundation and was subsequently reissued several times. AASB 1017, ‘Related party disclosures’ was issued in 1993 and reissued in 1997 with changes in the requirements for related party disclosures. However, the importance of related party disclosures increased when the fact came to the light that many companies, including Enron, Tyco, Adelphia and HIH Limited that collapsed between 2001 and 2003 had not disclosed adequate information about related party relationships and transactions. As a consequence, AASB 124 ‘Related party disclosures’, equivalent to IAS 24, was issued in 2004 with intense focus on related party disclosures. This standard was reissued and became effective from 2005 as part of the array of Australian equivalents to the International Financial Reporting Standards (IFRS). This standard superseded the previous standards AAS 22 and AASB 1017, but was applicable in consideration of AASB 2 ‘Share-based payment’ and AASB 1046 ‘Director and executive disclosures by disclosing entities’ for prescribing the overall requirements for related party disclosures in Australia (CA Financial Reporting Handbook 2005, p.683). AASB 124 was further reissued in 2009 with modifications in the definition of related party3, but the definition of related party transactions4 remained the same. These salient facts suggest that when HIH Limited collapsed in 2001, there were relevant accounting standards in Australia with regard to related party disclosures.

Table 18 below reveals the related party relationships in HIH Limited and related transactions which were complex. These mostly developed from the connections of Rodney Adler, a director of HIH Limited. The CEO Ray Williams and another director, Fodera, also faced legal charges arising from Rodney Adler’s related party relationships with and direct or indirect influence over FAI, HIH Limited, HIHC, PPE, AEUT and Adler Corporation. Relevantly, he was either a director, shareholder, or in control of a trust.

An issue was a payment of $10 million by an HIH Limited subsidiary to a company of which Rodney Adler was a sole director. By use of a trust mechanism, approximately $4 million was used to acquire HIH Limited shares, venture capital unlisted investments were purchased from another Adler company, and loans were made to entities which were associated with Adler. (PricewaterhouseCoopers, 2011, p.13)

Table 18: Related party relationships/transactions in HIH Limited

3 Under AASB 124 (paragraph 9), a related party is considered as a person (or close member of that person’s family), an entity or the entities including parent entity, subsidiaries, fellow subsidiaries, or associate companies, and even the key management personnel or directors. Since at the centreof the concept of related party is the interest and influence of related parties, this standard assumes that one party controls another or is controlled by the other/s or they have joint controls.

4 AASB 124 (paragraph 9) defines a related party transaction as a transfer of resources, services or obligations between related parties, irrespective of whether a price is charged.

22

Related party relationships Related party transactions/benefits

FAI became a wholly-owned subsidiary of HIH Limited. Rodney Adler was a major shareholder of FAI.

Adler was appointed to the HIH Limited board in April 1999, and was also engaged as a consultant in HIH Limited.

Adler along with other directors received remuneration (compensation)

HIH Limited Casualty and General Insurance Company Ltd (HIHC) was a wholly-owned subsidiary of HIH.

Rodney Adler and Ray Williams, the CEO of HIH Limited, were the directors of HIHC.

Adler was the sole director of another company Pacific Equity Pty Ltd (PPE).

HIHC paid $10 million as loan to PPE.

(PPE and Adler as PPE’s sole director, subsequently used this fund for investments)

Australian Equities Unit Trust (AEUT) was established and PPE became the trustee of AEUT.

Adler Corporation Pty Ltd was another company where Adler was a sole director, and Adler and his wife were the only shareholders.

AEUT issued share units to HIHC at an issue price of $10 million.

AEUT issued share units to Adler Corporation at an issue price of $25,000.

AEUT invested approximately $4 million to acquire HIH Limited shares (earlier purchased by PPE before AEUT trust deed was completed)

AEUT made venture capital unlisted investments (dstore, Planet Soccer and Nomad) from Adler Corporation; and

AEUT provided loans to entities associated with Adler and/Adler Corporation

Source: Prepared based on HIH Royal Commission, 2003; Westfield, 2003b

Accounting standards do not restrict related party transactions, but require adequate disclosures to enable the investors and other users of information to assess the interests and influence of the related party relationships. As reported by the HIH Royal Commission, Rodney Adler had significant interests in HIH Limited’s subsidiary FAI and in other related organisations, but he kept HIH Limited uninformed of these interests. These transactions occurred with no board or member approval and without disclosure; the loans were given without proper documentation or security being sought and the payment was made so that it would not come to the attention of other HIH Limited directors. ASIC ultimately brought an action against Adler for numerous contraventions of the Corporations Act relating to directors’ duties: ASIC v Adler &Ors [2002] NSWSC 171.

Accounting issues in AFG Limited:

Three types of accounting activities provided opportunities for accounting manipulation in AFG Limited: (i) misclassifications of assets and liabilities; (ii) inadequate disclosures about related party transactions; and (iii) impairment of goodwill.

Classification of assets and liabilities

The current and non-current classification of assets and liabilities help calculate relevant financial ratios in order to measure a firm’s working capital sufficiency and ability (liquidity) to meet short-term obligations. It is found in AFG Limited’s annual reports that AFG consolidated balance sheet for the years ended June 2007 and 2008 did not properly

23

classify its assets and liabilities. Even in notes to the accounts, the company did not disclose adequate information about the nature and categories of assets and liabilities.

Owing to misclassifications of the assets and liabilities on the above balance sheets, it would be difficult for the external users of accounting information to:

distinguish current assets from non-current assets

differentiate current liabilities from non-current liabilities

calculate current ratios to assess AFG’s ability to meet the company’s short-term obligations and perform day-to-day operations.

When AFG Limited became insolvent in August 2008, administrators attempted to assess the firm’s obligations to creditors and its ability to meet those obligations. Applying section 436A of the Corporations Act of 2001, when administrators attempted to review current ratio and working capital sufficiency, they found that:

The consolidated financial statements do not clearly delineate current assets from non-current liabilities or current liabilities from non-current liabilities. This has made a review of the balance sheet difficult. (McGrathNicol, 2009, p.12)

After AFG Limited went into liquidation in August 2008, due to serious deficiencies in prior financial reporting, the administrators had to privately elicit substantial further financial information from Allco Limited’s management for the year ending June 2008. Since AFG Limited obscured its critical liquidity position, attributed to $1.3 billion working capital deficiency (excess of current liabilities over current assets), this section’s task is ascertaining if the non-disclosure of current/non-current classification of the items, was allowed under accounting standards or a violation of standards and corporate law.

The international financial reporting standards (IFRSs) along with applicable prior international accounting standards (IASs) adopted in Australia as AASBs, provided mandatory reporting requirements from 1 January 2005 under section 334 of the Corporations Act of 2001. AASB 101, Presentation of financial statements requires classifications of assets and liabilities into current and non-current categories. According to this standard:

[An entity] … shall present current and non-current assets, current and non-current liabilities, as separate classifications on the face of its balance sheet … except when a presentation based on liquidity provides information that is reliable and is more relevant. When that expectation applies, all assets and liabilities shall be presented broadly in order of liability. (AASB, 2007, paragraph 51)

Also with the standard, a liability is to be classified as current when it satisfies the following criteria:

(a) it is expected to be settled in the entity’s normal operating cycle; (b) it is held primarily for the purpose of being traded; (c) it is due to be settled within twelve months after the reporting date; or (d) the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting date (AASB 101, paragraph, 60).

This standard has relevance to other paragraphs that provide an extensive explanation of requirements about the classification of assets and liabilities into current and non-current

24

categories. Even the prior standard, AASB 1040, Statement of financial position had a requirement for the reporting entity to treat current assets and current liabilities separately from non-current assets and non-current liabilities unless assets and liabilities presented in the broader order of liquidity provided more relevant and reliable information (paragraph 5). Therefore, the misclassification of assets and liabilities by AFG Limited, appeared to contravene the relevant accounting standards.

Impairment of goodwill

AFG merged with Record in July 2006. As a result of this business combination, the group acquired approximately $1.1 billion in goodwill (Table 17). In compliance with AASB 3, Business combinations, and AASB 138, Intangible assets, this goodwill figure was disclosed in the balance sheet, separate from intangible assets. However, management applied a subjective judgement to calculation and disclosure of impairment charges for goodwill. As stated previously, AFG’s net loss for the year to June 2008 was $1.7 billion – due mostly to an impairment loss of $1.6 billion. Almost 56% (i.e. $885.1 million) of this impairment loss consisted of the impairment charges for goodwill. Although AFG’s financial catastrophe was attributed to a significant deterioration in debt and equity markets resulting in reducing asset values and increasing cost of debt in the second part of 2007 and throughout 2008 (McGrathNicol, 2009), in 2007, its goodwill was not treated as impaired. This was despite AASB 3 specifically requiring that:

After initial recognition, the acquirer shall measure goodwill acquired in a business combination at cost less any accumulated impairment losses (paragraph 54).

Before the new accounting standards (IFRSs) became effective globally from January 2005, goodwill was amortised annually. The new standard adopted in Australia as AASB 3, Business combinations (paragraph 55) and AASB 136, Impairment of assets (paragraphs 9-10 and 80-89) do not require the acquired goodwill to be amortised annually, but require it to be tested for impairment annually, or more frequently when events or changes in circumstances indicate that it might be impaired.

Related party disclosures

Prior to the collapse of AFG Limited in 2009, AASB 124 Related party disclosures effective from January 2005 along with AASB 2 Share-based payment effective from 2006, prescribed the basic requirements for related party disclosures. Therefore, AASB 124 prior to its revision in 2009 was applicable to AFG Limited to assess related party relationships and make related party disclosures. AASB 124 requires disclosures of key management personnel’s compensation in total and for each of the following five categories: short-term employee benefits, post-employment benefits, other long-term benefits, termination benefits, and share-based payment (paragraph 16). In addition to the requirements in paragraph 16, AASB 124 requires that firms disclose the nature of related party relationships as well as information about the amount of the transactions and the amount of outstanding balances (paragraph 17). The purpose of such disclosure is to provide an understanding of the potential effect of the related party relationship on the financial statements (paragraph 17). AASB 124 further requires that disclosures required by paragraph 17 are to be made separately for the parent, entities with joint control or significant influence over the entity, subsidiaries, joint ventures in which the entity was a venturer, key management personnel of the entity or its parents, and other parties (paragraph 18).

25

Table 19 below reveals a number of AFG related party relationships and transactions that whilst not as diverse as those in HIH Limited, were still complex and questionable. In particular, a number of the related party transactions were driven by the self-interest of directors of AFG or its subsidiaries. For example:

AFG Limited acquired Rubicon where two of AFG Limited’s directors (David Coe and Gordon Fell) had major shareholdings

When some AFG Limited directors were associated with APT, AFG Limited provided a $50 million loan fund to APT to reduce the possibility of margin calls over AFG Limited’s stock owned by APT (see Table 21)

Both Rubicon and RIL Finance were the subsidiaries of AFG Limited and they were in related party relationships.

Table 19: Related party relationships / transactions in AFG LimitedRelated party relationships Related party transactions/benefits

Acquisition of Rubicon by AFG Limited in December 2007.Prior to this acquisition, Rubicon shareholders were Gordon Fell (44.9%), AFG Limited (20.4%), David Coe (19.9%) and Matthew Cooper (14.8%).David Coe and Gordon Fell were AFG Limited’s directors at the time of acquisition of Rubicon.

AFG Limited acquired 79.6% shares in Rubicon that it did not own (an unreasonable director related transaction).

APT (Overseas Holdings No. 1) Pty Ltd was an entity associated with certain directors of AFG Limited.

As per loan agreement on 18 December 2007, AFG Limited agreed to give a loan up to $50 million to APT, but $51.1 million was outstanding on this facility.The loan was advanced to provide APT with funding and sufficient liquidity to ensure that margin loans over AFG Limited stock owned by APT were not called by APT’s margin lenders.

RIL Finance Pty was a subsidiary of AFG Limited.Rubicon was associated with certain directors of AFG Limited.

RIL Finance Pty executed a loan agreement with various Rubicon entities.The loan agreement allowed Rubicon to draw up to $150 million, but $176.5 million was outstanding on this facility.

AFG Limited directors and directors of subsidiaries

Directors of AFG Limited’s did not receive a bonus either in 2007 or 2008, but directors of AFG Limited’s subsidiaries received bonuses, and the payments were likely to be made to the recipients in their capacity as employees of the group.

Source: Prepared based on 439A Report to Creditors (McGrathNicol, 2009) and Media articles

Corporate governance problems

Various reports on corporate governance consider independence of the board and its audit committee as the key to internal control, governance, and integrity in the financial reporting process (see Cadbury Report, 1992; Bosch Report, 1995; Higgs Report, 2003; Smith Report, 2003). Theoretically, independence of the board and its different committees is perceived in view of the ratio of independent non-executive directors to the board and their influence over the executive directors or management in the decision making process. The ASX Corporate Governance Principles 2003 as amended recommend independence of the board and its audit committee subject to the following conditions:

26

The majority of the members of a board are independent non-executive directors, and the chairman of the board and CEO should not be the same person (Recommendation 2.1).

The audit committee consist of at least three members; majority of them being independent; all of them financially are literate, and at least one member have financial expertise (Recommendation 4.2).

These requirements came into effect after the collapse of HIH Limited in 2001. However, had these requirements been incorporated in the regulations, there was no certainty that accounting manipulation would not have occurred. HIH Limited did become insolvent amidst strong allegations of accounting manipulation when its board did not have CEO duality and a majority of the board members (seven out of thirteen in 1999 and five out of seven in 2000) were non-executive directors (HIH Limited, Annual Reports, 1999-2000). Despite this structure, board independence was undermined, because three members in 1999 and two members in 2000 were former partners of Arthur Andersen, and one member’s law firm was engaged by HIH Limited in both years (HIH Limited, Annual Report, 1999-2000). HIH Limited board chairman Geoffrey Cohen was inactive and other non-executive directors were passive in the decision making process, and as a consequence, the CEO Ray Williams was able to assume such a dominant role that there was a culture in the board not to challenge management leadership (HIH Royal Commission, 2003). In particular, information was filtered, that is, not placed before the board unless there was an approval from the CEO. On only a very few occasions the board either rejected or materially changed a proposal put forward by management while on several occasions, the chairman’s request was rejected by the CEO (HIH Royal Commission, 2003). All up, the board was too ready to accept what management was saying without testing the matter with appropriate analysis (HIH Royal Commission, 2003, vol. 1, p.xxv-xxxvi). That lax board oversight, in essence, comprised the failure to check weak management decisions based upon poor quality management information and inadequate accounting systems or a lack of due diligence, which in turn, led to the risk of losses from the UK operations, the US acquisition, and the FAI takeover (HIH Royal Commission, 2003). Given these circumstances, Justice Owen reached the following conclusion (HIH Royal Commission, 2003, vol. 1, p.112):

I am not convinced that a mandatory requirement for boards to have majority of non-executive directors is either necessary or desirable. …. It is customary to speak of ‘independent directors’ but I think this gives the wrong emphasis. What is required is independent judgement. The distinction is subtle but important.

In 1999 and 2000, the HIH Limited audit committee consisted of four members5. As two of them were professional accountants, this committee had financial expertise. But despite being comprised entirely of non-executive members, the audit committee’s independence was questionable, because its two members with financial expertise were the ex-employees of Arthur Andersen (HIH Limited, Annual Reports, 1999-2000).

Similar to HIH Limited, there were internal control and governance issues in AFG Limited when the company obscured liquidity and solvency levels by misclassification of

5 HIH Limited’s audit committee in 1999 and 2000 consisted of non-executive directors including Geoffrey Cohen (board chair, chairman of audit committee and former senior partner of Arthur Andersen), Justin Gardener (former partner of Arthur Andersen), Charles Abbott (lawyer), and Robert Stitt Q.C (lawyer) (HIH Limited, Annual Reports, 1999-2000).

27

assets and liabilities, failed to disclose significant related party transactions, and applied subjective judgements in regard to impairment of goodwill. With new appointments6 the board was broadened in the year ended June 2007. The expanded board consisted of nine members including five non-executive directors, but just three of these nine members were independent. And board chairman David Coe was himself an AFG Limited executive employee. Board independence was also compromised by self-interest threats arising from related party transactions7 with two members including board chairman David Coe.

In 2008, the size8of the board was reduced to four members, three being independent non-executive directors. However, the resignation of a number of board members was disturbing. According to auditing standard ASA 240, the auditor’s responsibility is to consider fraud in an audit of a financial report, in respect of which high turnover in the senior management positions or those charged with governance, may create an opportunity for misstatements in the financial reports.

The AFG Limited board had an Audit and Compliance Committee (ACC) to liaise between the board and the auditors, and to oversee integrity in the financial reporting process. For the year ended 30 June 2007, the ACC had three independent members including an independent chairman (AFG Limited, Annual Report, 2007). However, upon resignation of the ACC chairman on 25 January 2008, the group did not appoint a new member until the end of June 2008 (Annual Report, 2008). As a result, the ACC was not in compliance with Recommendation 4.2 of the ASX Corporate Governance Principles in failing to have at least three members from 25 January to 30 June 2008.

Also of concern is whether the Audit and Compliance Committee of AFG Limited had sufficient financial expertise9. In the year ended 30 June 2007, two members of the ACC were from engineering and economics background respectively with adequate management experience in different organisations while the third member Rob Mansfield, a qualified accountant (FCA), was replaced by Neil Lewison on 16 August 2006 (AFG Limited, Annual Report, 2007). The board was appreciative of Neil Lewis’s industry experience and professional knowledge that he gained from senior management positions in financial and non-financial organisations. However, the AFG Limited annual reports (June 2007 and 2008) did not disclose anything about his educational qualifications. Therefore, based on available information of ACC members, the committee had lacked technical accounting knowledge (financial expertise) since Mansfield was replaced on 16

6 In 2007, David Clarke was appointed as the CEO and Neil Lewis was appointed as an independent, non-executive director to bring diversity of professional experience in the board (AFG Limited, Annual Report, 2007).

7 AFG Limited acquired Rubicon on 19 December 2007. AFG Limited’s executive chairman DavidCoe and non-executive director Barbara Ward were directors of Rubicon with shareholdings of 19.9 and 44.9 % respectively (Annual Reports, June 2007 and 2008). After acquiring Rubicon, AFG Limited allowed Rubicon to draw a loan up to $150 million (Table 5.21).

8 In late March 2008, AFG Limited accepted resignations of (1) the Executive Chairman David Coe, (2) Chief Operating Officer as well as Deputy Managing Director Michael Stevanski (non-executive director, (3) David Turnbull (executive director), and (4) Gordon Fell (independent non-executive director). After these resignations, the board consisted of four members with (1) David Clarke continuing as CEO, (2) Deputy Chairman Bob Mansfield as independent member and active chairman of the board, and (3) Rod Eddington and Neil Lewis as independent non-executive directors (AFG Limited, Annual Report, June 2008).

9 AFG Limited’s Audit and Compliance Committee (ACC) in 2007 and 2008: (i) Barbara Ward, economics graduate (ACC Chairman), (ii) Rod Eddington, engineering graduate with D.Phil. (Oxon), and (iii) Neil Lewis (education not disclosed) who replaced Bob Mansfield, FCA on 16 August 2006 as a committee member. However, Barbara Ward resigned on 25 January 2008 (AFG Limited, Annual Reports, 2006-2008).

28

August 2006. This might have resulted in the ACC’s failure to properly comprehend the application of accounting standards in regard to classification of assets and liabilities, impairment of goodwill and related party disclosures. And as disclosed in the 2007 and 2008 annual reports, the AFG Limited board had established a Related Party Committee (RPC). The RPC chairman, Bob Mansfield, was an FCA. However, the RPC failed to raise legitimate concerns when significant related party transactions remained undisclosed in the company’s annual reports.

In conclusion, the substantive responsibilities of the AFG Limited board could not be avoided or delegated, irrespective of the ACC and RPC roles, in regard to misclassification of assets and liabilities and non-disclosure of related party transactions. As stated earlier, HIH Limited’s CEO Ray Williams disregarded the concerns of any insider or director about the company’s business judgement and decisions. It is unlikely that nobody raised any issues about an imminent perfect storm in AFG Limited. As reported in The Australian:

Allco’s deputy managing director Michael Stefanovski sent an email to (acting) chairman Bob Mansfield in December 2007 citing a number of issues that were adversely affecting the company. These included market hostility to the $330 million takeover of the Rubicon property group, the prospect of disappointing profit disclosures and concerns about a related-party transaction involving a company owned by Allco executives, Allco Principals Trust (APT). (Moran, 2010b, March 23).

When AFG Limited’s former chief executive David Clarke was asked in the Federal Court about Stefanovski’s concern about a serious contagion risk with APT, leading to financial catastrophe and need for an earnings warning, David Clarke agreed the email was discussed in the board but argued that Stefanovski never recommended issuing such a warning (The Australian, March 23, 2010).

The Corporations Act of 2001 prescribes statutory responsibilities of the board to present a true and fair view of the company’s affairs. Recently, ASIC brought a Federal Court action against Centro Group directors for improper classification of approximately $1.5 billion in borrowings for the year ended 30 June 2007: ASIC v Healey [2011] FCA 717. In his judgment, Justice Middleton did not find that the directors of Centro Group were dishonest. But he expressed the view that directors were deficient in not identifying the debt classification and guarantee issues, not being aware of related accounting principles (standards), and also not having made more detailed inquiries of management and advisors. The 2011 ASIC v Healey judgment requires directors to apply financial literacy or expertise to the business, oversee the level of engagement of management, structure the board and audit committee’s role, and assess the quality of information they receive and provide. Justice Middleton’s judgment confirms the obvious point that having expertise in one area does not release a director from their minimum duty to pay attention to all board-level issues and decisions.

Independence and oversight roles of the external auditors

29

Auditor independence10 is assessed in view of the auditor’s interest, attitude and working conditions which physically and psychologically create a setting for audit engagement and opinion in the audit report. In practice, various threats11 to auditor independence may arise from the interests and working conditions of the auditor, which may reduce the calibre of the auditor’s client risk report and audit opinion.

Arthur Andersen was the auditor of HIH Limited. It consistently regarded HIH Limited as a “maximum risk audit client” (HIH Royal Commission, 2003, vol. 1, p.xlvi). This view of the auditor was grounded in the deteriorating financial conditions of HIH Limited and its corporate governance deficiencies since 1999. The discussion in the previous sections provides evidence of the various forms of accounting manipulation in HIH Limited during this period. However, HIH Limited’s auditor Arthur Andersen always provided an audit report without qualified opinion or emphasis of matter. What caused Arthur Andersen’s silence in not reporting the findings of their analytical procedures12 in relation to HIH Limited’s financial conditions and the company’s ultimate ability to run as a going concern might be due to various implicit deviation from auditor independence (see APES 110, Ramsey Report, 2001).

The material facts suggest at least two types of threats to auditor independence in HIH Limited. Firstly, a familiarity threat was prominent, because three directors (Geoffrey Cohen, Dominic Fodera and Justin Gardener) were the former partners of the accounting firm Arthur Andersen (HIH Royal Commission, 2003, vol. 3, p.86). Secondly, a self-interest threat was created from pressure on Andersen partners to maximise fees from non-audit work (HIH Royal Commission, 2003, vol.1, p.96).

Table 20: Auditor’s (Arthur Andersen) fees in HIH Limited (Actual amount in $)Statutory and advisory services 31 Dec. 1997 30 June 1999 30 June 2000

Audit fees (audit and review of financial reports, and other regulatory audit services)

980,000 2,417,000 1,700,000

Non-audit fees (advisory and taxation services)

436,000 757,000 1,631,000

Total auditor remuneration 1,416,000 3,174,000 3,331,000% of advisory & taxation compliance services 30.8% 23.9% 50.0%

Source: HIH Limited Annual Reports, 1999-2000; HIH Royal Commission, 2003, vol.3, p.86

Table 20 reveals that total fees of Arthur Andersen significantly increased from $1.4 million in 1997 to $3.2 million and $3.3 million in the subsequent two reporting years. The non-audit fees of $1,631,000 comprising 50% of the total fees for the year ended 30 June, 2000 appeared to be 3.7 times higher than the non-audit fees for the year ended 31 December 1997 and 2.2 times higher than that for the reporting year of eighteen months

10 Auditor independence is conceptually categorised as independence in fact and independence in appearance. Independence in fact is known as an unbiased attitude of the auditor during audit while independence in appearance is understood as how users of accounting information perceive and interpret the circumstances that the auditor is not predominantly working as a consultant (an advocate) for fees.

11 APES 110Code of ethical ethics for professional accountants, identifies various threats to auditor independence such as self-interest threat, self-review threat (arising from judgement or advice from previous auditor), advocacy threat, familiarity threat, and intimidation. In the wake of the auditor’s independence issues raised in relation to the companies that failed during 2001-2003, the Corporations Act of 2001 (amended by the CLERP 9 Act of 2004) and APES 110 Code of ethics for professional accountants, have prescribed various safeguards to reduce threats to auditor independence. The recommendations of the Ramsay Report (2001) and HIH Limited Final Report (2003) became the basis of a number of the safeguards prescribed in the CLERP 9 Act of 2004.

12 As per ASA 520 Analytical procedures, analytical procedures are auditor’s assessment of a company comparing its financial conditions with industry average and with previous years’ financial information. Non-financial data are also used to understand and evaluate a company. Analytical procedures are undertaken prior to accepting a client and before forming an audit opinion.

30

ended 30 June 1999. Counter-intuitively, these non-audit fees increased in the years when Arthur Andersen regarded HIH Limited as a maximum risk audit client.

HIH Limited management’s attitude was uncompromisingly hostile to consideration of any qualified audit opinion or emphasis of matter. In March 1999, the HIH Limited’s auditors had a meeting with non-executive directors of the audit committee in the absence of management (HIH Royal Commission, 2003, vol. 1, p.96). An audit engagement partner daringly provided a qualified opinion and sought to progress the implication of this issue in the meeting of non-executive directors of the audit committee. In response, HIH Limited’s CEO Ray Williams became upset and as a result, that audit partner was replaced (Mak et al., 2005). Ultimately, Arthur Andersen did not provide any qualified opinion in the audit report, reflective of its own questionable audit approach: “Andersen’s audit work in relation to the 1999 and 2000 audits was characterised by a lack of sufficient audit evidence to support its conclusions” (HIH Royal Commission, 2003, vol. 3, p.169). According to Justice Owen:

Andersen’s approach to the audit in 1999 and 2000 was insufficiently rigorous to engender in users confidence as to the reliability of HIH Limited’s financial statements. This detracted from the users’ ability to appreciate fully HIH’s true financial position. (HIH Royal Commission, 2003, vol. 1, p.lvii)

KPMG was the auditor of AFG Limited. Its role as an auditor was also questionable. As found in this study, when AFG Limited’s leverage, liquidity and cash flow positions were perilous in the years prior to its collapse, the group attempted to obscure its liquidity and solvency position, by improperly classifying its assets and liabilities. The group also attempted to conceal the true financial condition of the company, or concoct a better position, without charging losses for goodwill impairment in 2007 and without making adequate disclosures for related party transactions. Before providing an unqualified opinion, KPMG should have considered two sets of accounts: (i) non-disclosure of a $50 million loan to a related party; and (ii) $1.9 million of current liabilities shown in the balance sheet as non-current liabilities. Nonetheless, regarding the sources of KPMG’s apparently deficient performance of its AFG Limited auditing duties, this study does not find that there was a familiarity threat to KPMG’s independence. However, an implicit self-interest threat may well have (un) subtly influenced the audit firm’s independent opinion stance during the relevant period.

Table 21: Auditor’s fees in AFG Limited ($)Statutory and advisory services 2006

PWC2007

KPMG2008

KPMGAudit fees (audit and review of financial reports, and other regulatory audit services)

341,195 3,110,076 3,564,215

Non-audit fees (advisory and taxation services) 1,415,500 2,963,942 1,711,604Total auditor remuneration 1,756,695 6,074,018 5,275,819% of advisory & taxation compliance services 80.6% 48.8% 32.4%

Source: AFG Limited Annual Reports, 2007-2008

As shown in Table 21, the total audit fees increased from approximately $1.8 million in 2006 to $6.1 million in 2007 and $5.3 million in 2008. (Annual Reports, 2006-2008). Under the Corporations Act of 2001 as amended by the CLERP 9 Act of 2004, auditors are allowed to provide consultancy services for a maximum period of 10 hours in the current year and 10 hours in the previous year. It is worrisome how and why non-audit fees of

31

AFG Limited’s auditors consisted of 80.6% for the year ended June 2006, 48.8% for 2007 and 32.4% for 2008 respectively of their total remuneration from that company.

The negligence of the auditor in failing to report about the misclassification of assets and liabilities was taken up by the ASIC and consequently, Mr Whittingham, AFG Limited’s auditor and partner of KPMG, was suspended from the profession for a year (ASIC, Media Release, 2008). When a similar allegation arose against Centro auditors, the Federal Court found the company auditor was negligent in failing to report to the shareholders about misclassification of balance sheet items: ASIC v Healey [2011] FCA 717.

External monitoring and enforcements

A wide range of external bodies and entities comprising government agencies, securities regulators, and specialised control authorities (e.g. the Reserve Bank of Australia for financial institutions and APRA, the prudential authority for insurance companies) have various responsibilities to oversee the governance, operations and performance of a company. As HIH Limited was a listed insurance company, the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commissions (ASIC) were supposed to oversee HIH Limited. However, APRA did not adequately exercise its powers and discharge responsibilities in performing its oversight role over HIH Limited (Parker, 2005). APRA was criticised for not being adequately staffed to identify the weaknesses in the HIH Limited systems (see Kemp, 2001; Elias, 2001; Leung & Cooper, 2005). According to Justice Owen, APRA missed many warning signs about HIH Limited, because “it was so slow to act and make judgements about vital matters (HIH Royal Commission, 2003, vol. 1, p.li). Arguably:

APRA should have intervened to protect policyholders’ interests when the company’s share price fell from $1.05 to 45 cents in September 2000 following the announcement of the $22 million loss in the second half of 1999-2000. Besides being aware of the sliding share price during 1999 and 2000, APRA should also have been alerted by conjecture that HIH would have difficulty in meeting new hurdles. This led to a further shortcoming of regulators in failing to keep the securities market informed. (Mak et al., 2005, p.25)

ASIC’s (non)exercise of its regulatory powers was also quite properly criticised. This regulatory agency was (re)established by the Commonwealth Government via the ASIC Act of 2001, and given a wide, expanded array of statutory powers with the explicit objective of maintaining the confidence of and continue participation by investors in Australia’s financial system. Auditors of the companies registered with ASIC under the Corporations Act of 2001 are required to form an opinion as to whether the audited financial statements comply with the Australian Accounting Standards (AASBs) and exhibit a true and fair view of a company’s performance and financial condition. To discharge the stated responsibilities, it is mandatory for auditors to comply with the Australian Auditing Standards (ASAs) and Professional Conduct Standards. Under section 1292 (1) of the Corporations Act 2001, ASIC can exercise disciplinary and remedial powers if the auditor of a registered company fails to adequately and properly carry out the duties of an auditor.

In relation to the audit of HIH Limited, the Royal Commissioner found that, “ASIC limited its involvement in HIH Limited’s affairs because of a perception that APRA was responsible for and was in fact closely and effectively monitoring the situation” (HIH Royal Commission, 2003, vol., p.liv). Consequently, ASIC’s role was deficient in not enforcing measures to increase board effectiveness and oversee auditor independence

32

issues when HIH Limited was aggressively expanding, without exercising proper business judgement. And despite earnings volatility and/or excessive leverage in this expansionary period, there was no qualified opinion or emphasis of matter in the audit reports. The Royal Commissioner took the view that ASIC’s concerns were largely confined to responding to negative media commentary in the second half of 2000 and monitoring actions in the lead-up period to the liquidation of HIH Limited (HIH Royal Commission, 2003, vol.1).

Unlike ASIC’s sedentary role in the oversight of HIH Limited, ASIC was more proactively concerned about responsibilities and opinions of the auditor KPMG13 in relation to the quality of disclosure in AFG Limited’s yearly financial reports to 30 June 2007. In fact, ASIC conducted an investigation under section 13(1) of the ASIC Act 2001, and uncovered the misclassification of approximately $1.9 billion in interest bearing liabilities (IBLs) as a non-current liability which should have been shown as a current liability. It is mandatory under AASB 101 to properly classify assets and liabilities into current and non-current categories. Therefore, in misclassifying its IBL, AFG Limited blatantly violated Australian accounting standards. The audit firm KPMG, in not providing qualified opinion or emphasis of matter on the misclassification issue, also failed to comply with Australian Auditing Standards as required by section 307 of the Corporations Act 2001 (ASIC, 2010, November, 29). Given this fact, ASIC and AFG Limited’s lead auditor Mr Whittingham reached an enforceable undertaking in 2010 about the proper classification of all AFG Limited’s IBLs (ASIC, 2010, November 29):

sufficient appropriate audit evidence obtained by the auditor audit work was conducted with an attitude of professional scepticism a modified audit opinion was issued due to non-compliance with the accounting

standards there was an adequate understanding of the entity’s internal control environment to

assess risk of material misstatement risk of material misstatement and related disclosures were adequately

assessed adequate consideration was given to materiality and its relationship to audit risk adequate consideration was given to materiality in determining the nature, timing and

extent of audit procedures the audit plan was adequately developed to reduce audit risk.

As detailed in ASIC’s enforceable undertaking in November 2010, KPMG’s lead auditor Christopher Whittingham disagreed with ASIC’s concerns, but recognised their significance, sought explanation from AFG Limited about misclassification of the IBLs, advised AFG Limited to re-issue half yearly financial reports on 27 February 2008, and then issued a modified review report with emphasis on misclassification issues. However, empowered by its enforceable undertaking, ASIC suspended Whittingham from performing any audit duty or function for a period of nine months and a penalty of $10,000 was imposed upon him.

13 As stated in the Enforceable Undertaking (ASIC, 2010, November 29), Christopher Whittingham was an audit partner of KMPG. He held the lead position of an audit team consisting of more than 20 KPMG professionals with approximately 100 KPMG employees atvarious stages, (ii) worked continuously as a registered auditor since 30 December 2002, and (iii) signed the 2007 audit report without providing any qualified opinion on AFG Limited’s financial report for the year to 30 June 2007.

33

4.3 Attitudes/Rationalizations

Rationalization is a process of justifying self-interest. As noted earlier, it typically exhibits an arrogant attitude coupled with dishonest behaviour, provides false hope and shifts the blame for prior failures to others. Rationalization was evident in the HIH Limited collapse. As the Royal Commission duly noted, “there were many aspects in which the governance of HIH Limited was not based on openness, integrity and accountability” (HIH Royal Commission, 2003, vol. 3, p.261). In fact, absolute domination over its weak decision making processes and corporate culture, more or less, compelled HIH Limited’s CEO Ray Williams to rationalize his evident prior managerial incompetence and dubious ethical behaviour. He had created an environment where: (a) the board chairman existed in name only; (b) the board did not have control over decision making processes; and (c) information was filtered and sanitised before becoming available for others. From the commencement of the business until Ray Williams stepped aside in October 2000, “No one rivalled him in terms of authority and influence. The hand and influence of Williams were paramount” (HIH Royal Commission, 2003, vol. 1, xxvii). Rodney Adler, an influential director of HIH Limited, reportedly charged Ray Williams in 2001 as follows (Clarke, 2007, p.445).

You have accumulated around you fantastic, loyal, long-service yes-men, but they are all 1970s type managers with no view of the future.

When HIH Limited was on the verge of collapse in 2000, the board attempted to force CEO Ray Williams to resign and have him exert pressure on director Rodney Adler to do likewise. Both of them rationalized their positions in different ways. For example, in the hour between the audit committee meeting and the full board meeting of 12 September, Williams asked Adler to remain behind in the boardroom and reportedly engaged with him in the following enlightening dialogue, “I’ve offered my resignation and I would like you to resign too” (Westfield, 2003b, p.188). But even at that eleventh hour Adler’s response was uncompromising in a self-interested repudiation of Williams’ request to resign (Westfield, 2003b, p.188):

I have no intention of resigning. I’m a relatively young man, I have a long career ahead of me and it would not look good if I resigned. It’s not in my interest.

Despite having sanctioned accounting manipulations in the context of substantial corporate governance problems, HIH Limited’s CEO Ray Williams still endeavoured to rationalize his own activities and in particular the failure of HIH Limited, as being entirely due to a fiscal-economic down turn, and not because of inept or incompetent decision making. When the company’s liabilities exceeded its assets by an unprecedented $4 billion, HIH Limited’s management continued to give false hope to the market declaring that it held, “substantial reserves to meet policy holders” (Mak et al., 2005, p.27). In 2008, on his release from Sydney’s Silverwater Jail, Ray Williams belatedly apologised to HIH Limited shareholders who lost money in the 2001 failure of HIH Limited. As reported in the media, he apologised in the following somewhat disingenuous terms:

The last thing in the world I would ever have wanted was for HIH to fail, for people to be hurt and for people to suffer financial loss. …. I really am very sorry that occurred. (ABC News, January 14, 2008)

In marked contrast, there were no allegations that the senior management of AFG Limited had an over-bearing, dominant attitude or created a culture of fear to support their

34

activities. However, in defence of their activities, they entirely failed to acknowledge what they ought not to have done, or shifted blame in relation to the group’s performance and reporting. As extracted from the hearings in the Federal Court in Sydney (Moran, 2010a, March 22):

David Clarke, AFG Limited’s managing director, admitted that its business structure was “complex” and “opaque”, but he had been “working hard to address that perception”.

When AFG Limited’s share price fell from $10.45 on 1 August 2007 to $5.44 on 19 December 2007, David Clarke justified this price fall as an outcome of the adverse market sentiment towards the “Macquarie Bank Model” which heavily relied on geared assets.

In relation to AFG Limited’s baseline earnings, when the Court heard about “FIANO exercise” meaning “failure is not an option”, David Clarke argued that he had no objection to “FIANO exercise” but he said, “What I don’t like is the suggestion that this was something out of the ordinary”.

David Coe, AFG Limited’s executive chairman, also justified its stance about a number of transactions. He sent an email to AGF Limited’s managing director David Clarke about discussions held with private equity firm TPG and said ‘the worst decision of my life was not to close out those positions earlier’ ” (Moran, 2010c, March 27). Regarding the Rubicon transaction, he stated that:

I was certainly not attempting to indicate that I -- that AFG Limited would not dump the Rubicon transaction. … On the Rubicon transaction, I make no specific reference to it from an AFG point of view. It was not my position to do that; I hadn’t voted on the transaction. And what I give is my personal view as to the potential for growth should that transaction proceed. (Moran, 2010c, March 27)

Due to the mis-categorisation of liabilities, AFG Limited was able to disguise a current liability of approximately $1.9 billion. ASIC penalised KPMG and imposed restrictions on AFG’s lead auditor, Christopher Whittingham, to work as an auditor. However, KPMG attempted to shift the blame arguing that they depended on managers’ information and this accounting malfeasance did not have any impact on the failure of AFG Limited.

5. Conclusions

The salient finding of this paper is that accounting manipulation in HIH Limited and AFG Limited were more or less caused by similar factors, as encapsulated in the fraud triangle theory. The contemporary global and domestic economic conditions during 1997-2001, entity’s earnings volatility, negative cash flows, liquidity crisis and excessive leverage, all had effects on accounting manipulation and the failure of HIH Limited in 2001. Similarly, external economic and industry conditions during 2007-2008 and company’s earnings volatility, negative cash flows, liquidity crisis, and excessive leverage impacted upon accounting manipulation and the failure of AFG Limited by the end of 2008. The study finds executives remuneration as one of the drivers of accounting manipulation in these companies.

Both companies made opportunistic, subjective use of accounting standards or simply violated them to mask risk, and/or artificially enhance the annual income and window dress balance sheet. Misclassification of assets and liabilities, impairment problems and

35

lack of related party disclosure were the major accounting issues in AFG Limited. Under-provisioning and accounting treatments for intangibles were the most significant accounting problems in HIH Limited. AFG Limited’s audit committee lacked financial expertise and independence in 2008. While HIH Limited’s audit committee had financial expertise, there was a familiarity threat to auditor independence. Overall, weaknesses in the internal control and governance regime were more debilitating in HIH Limited than AFG Limited. Although there was no CEO duality in HIH Limited, its board was passive or ineffective in making business decision. The excessive consultancy fees vis-à-vis regular audit fees paid to the auditors might be one of the reasons for lax oversight by the external auditors of both companies. The external oversight of ASIC and APRA were not effective in performing oversight over the financial reporting of HIH Limited. ASIC’s oversight role regarding external audit in AFG Limited was more effective but not in a timely manner.

AFG Limited’s senior executives and board creatively narrated to rationalize their activities. HIH Limited’s senior executives adopted an assertive, dominating persona, creating an intolerant, oppressive corporate culture. AFG’s CEO David Coe committed suicide. HIH’s CEO Ray Williams eventually publicly apologised. The regulators and standard-setting bodies need to consider the findings of this study in developing future accounting and corporate governance regulations. The business schools should give more emphasis on providing ethical education.

REFERENCES

36