David Wood: Learning to balance the good news with the bad

The PM is late in closing the stable door, but is ensuring it stays firmly shut, writes David Wood

SO GORDON Brown has called for caution on off-balance sheet activities and for companies to "put bad assets back on to their balance sheets". Brown is the man who, as Chancellor, presided over and encouraged the expansion of PFI/PPP.

This, of course, is a way of funding public infrastructure projects without the borrowing appearing on the Government's balance sheet – the biggest public sector off-balance sheet exercise of all time.

Why is he saying this now? Well, for many observers, off-balance sheet accounting is where the credit crunch started. It was the repackaging of US sub-prime mortgages with enough prime mortgages to ensure a good credit rating, and selling packages of these assets through off-balance sheet vehicles, which sowed the bitter harvest that the financial markets now reap.

But it was not the off-balance sheet aspect of this which was the problem. It was the fact that having sold off the packages of mortgage assets, neither the resulting owners, nor any of the intermediaries, had any real ability or willingness to manage those mortgage loans and monitor the prospects of them being paid back.

This in turn resulted in the default problems emerging at a very late stage, and by then the scale of the problem was huge.

There is a good point underlying Gordon Brown's comments, however. Clearly, if a company has assets and liabilities, they should be on its balance sheet – and accounting standards have very effectively ensured this over a long time. As with most issues, the problems appear at the margins.

These may reside in special purpose vehicles – separate entities often with no, or only a very tenuous link, to the company – and it may be less than clear whether the sponsoring company has any ownership of such assets and liabilities.

There are many other situations where a liability will not obviously fall to the company. As in many other areas of accounting, judgments are needed as to the likelihood of a liability actually arising and whether to include an amount on balance sheet or just to disclose details in a note.

Some of the recent instances of off-balance sheet liabilities being brought on to balance sheets have been simply for reputational reasons – where banks have decided to honour their perceived duties to their customers but where they were under no obligation to do so. The fact that these banks have 'done the gentlemanly thing' does not mean that the accounting standards are defective or that the bank has done anything wrong.

However, it is right that international accounting standards which address special purpose vehicles are being reviewed and consideration given to improving disclosures about those vehicles which have been left off-balance sheet.

Companies cannot simply set up off-balance sheet vehicles to which they can transfer and 'hide' their riskier investments. Accounting standards in the UK and international standards have been very strict on this point, and, more recently, the US has also closed its loopholes which allowed Enron to conceal millions of dollars of liabilities in off-balance sheet special purpose vehicles.

Gordon Brown is seemingly closing the stable door after the horse has bolted, but he is right to make sure that that door is firmly shut.

While the role of accounting is very important in ensuring visibility and accountability, the role and behaviour of the board and management of a company is critical. It is clear that somewhere in this crisis, some companies' management had few scruples as to what they were packaging and selling, and others did not really understand what they were buying.

David Wood is executive director, technical policy at ICAS