accounting


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The Chicago Tribune recently wrote about how the decision to reduce the expected-return assumption from 7.5% to 7.0% for the Illinois Teachers Retirement System resulted in the governor calling for approximately $400 million in additional taxes.

While the political positioning behind this small move of 0.5 percentage point is fascinating, it more importantly brings to the forefront the issue of how large future obligations are, and why there is a lot of fear and an incentive to hide.

If reducing the expected return assumption from 7.5% to 7.0% results in an additional $400 million- 500 million a year of taxes, then moving the liability discount rate to something closer to a risk-free rate of 3% may imply additional $5 billion in additional contributions (Note: the actual number is likely several times higher than this – see the illustration below for some simplified math).

The dilemma we face is that we have made future promises and don’t have enough money set aside today to pay them. Therefore someone has to make up the shortfall. Instead of trying to determine who makes up the shortfall, we try to bury our heads in the actuarial sand of high expected returns.
But where can Illinois get the additional $5 billion a year? And where can America get the additional $6 trillion?

Investment returns aren’t going to help:

The Teachers Retirement System assumes that investment returns over the long-term will average 7%. With liabilities of $108 billion, and assets of $41 billion, even if investments return 7% per annum, the hole will only continue to grow (see Illustration below). This is why using investment-return expectations to discount liabilities isn’t appropriate.
But investments don’t return 7% year-in, year-out. For simplicity, let’s assume the long-term horizon to be 10 years. Even if there is one year where returns are negative-20%, this results in an asset value that is over $20 billion lower (see illustration below).
When risk-free rates were around 6%-7%, generating 8%-10% expected returns required minimal risk and complexity. However, with risk-free rates at 2%-3%, generating even 7% is a lot harder. While investment teams at pension funds such as Teachers are extremely capable, high expected returns are forcing them to take on additional risk, either in the form of increased leverage or complex investments.

The Rockefeller Institute of Government points out that “taxpayers and citizens may or not want this risk taken on their behalf, but they have little say in the matter. And they have no easy way out: If they want pension funds to take less risk, they’ll have to increase government contributions by even more than contributions have gone up already”.

Inflation may not help either.

Arguments in favor of using higher discount rates tend to revolve around the “artificially low” level of interest rates fueled by central-bank actions, and a belief that discount rates would return to a more “normal” level in the future. However, a return to “normal” is likely to be accompanied by an increase in inflation. For public plans, higher inflation could actually be a problem, as benefits tend to be linked to inflation, and therefore liabilities would likely get larger, not smaller, with inflation.

Therefore, by not putting in the money today, we are effectively making a leveraged bet on the stock market, and hoping it pays off, and praying that inflation stays low.

If average returns are only 6%, state funds in aggregate will run out in 2024. That’s only eight years from now.
And if the bet doesn’t work then who will pick up the pieces?

In 2010, Stanford Prof. Josh Rauh estimated that if state pension funds earned an average return of 8% on their assets, then states would in aggregate run out of funds in 2028. If average returns are only 6%, then state funds in aggregate will run out in 2024. That’s only eight years from now.

According to Rauh, funds would need to earn at least 10% per annum out to 2045 in order to sufficiently meet their obligations.

Higher inflation and lower investment returns would only make this situation worse. Current taxpayers and lawmakers are either unwilling or unable to shoulder the burden, as recent events in Illinois have highlighted.

This then shifts the burden to future taxpayers. As this burden becomes more apparent, Rauh speculates that taxpayers may choose to relocate from states with high unfunded pension liabilities. This would, in his opinion, increase the likelihood of a federal taxpayer bailout. Failing that, states would have to resort to what has so far been unthinkable — cutting benefits. In the absence of a federal bailout or a cut in benefits, it’s likely that municipal-bond holders would have to take a hit, as tax dollars get used to fund pension benefits.

Quantifying the true extent of liabilities is the first step in recognizing the magnitude of the problem; the amounts involved are too large to ignore, and it impacts almost everyone. Hopefully policy makers can make informed decisions before its too late.

If decisions aren’t made, then our only hope is that we earn over 10% investment returns each year. Would you take that bet with your future?

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Global accounting firm PricewaterhouseCoopers is being sued for $5.5 billion (£4 billion) in a Florida court for failing to spot the fraud that led to the sixth largest banking collapse in US history.

Trustees for the Taylor Bean & Whitaker Mortgage Corporation, which went bankrupt in 2009, accused PwC of negligence in their audits of the bank’s parent company, Colonial Bank,according to a report by Courtroom View Network.

Colonial Bank also failed in 2009, costing the Federal Deposit Insurance Corporation more than $4 billion, according to a report by Bloomberg News.

Top executives of TBW faked loan data for seven years starting in 2002, sending information on mortgages that either did not exist or had already been pledged to other investors to Colonial, the parent bank. According to Bloomberg, Colonial had $1.5 billion in non-existent loans on its books by 2007, which helped drive the bank into the ground during the 2008 financial crisis. PwC gave clean audits between 2002 and 2008.

The TBW executives were jailed for the fraud, with former chairman Lee Farkas sentenced to 30 years in prison.

“Year after year, Pricewaterhouse didn’t do their job, they didn’t follow the rules and they failed to detect the fraud,” Steven Thomas, an attorney for the trustee, said in opening statements broadcast on CVN.

PwC argues that well-executed audits do not always catch fraudulent behaviour and that the firm was not the lead auditor for TBW.

Beth Tanis, lawyer for PwC, told the Financial Times: “As the professional audit standards make clear, even a properly designed and executed audit may not detect fraud, especially in instances when there is collusion, fabrication of documents, and the override of controls, as there was at Colonial Bank.”

The case started on August 9 and is expected to last six weeks.

Interesting.

The disclosure on this case will have been significant. Wading through all of the emails, documentation, contracts, etc will have taken a lot of time and effort.

$1.5 Billion is a pretty big number to miss if you are an auditor. Also, given that PwC would have been receiving substantial fees from the client, how hard were they really looking for fraud, especially given that they considered themselves not to be the lead auditor.

15 weeks of retail outflow from equities. Obviously Joe6pac has had enough. While this morning has a flash-crash II potential, who’s to blame him.

The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance.” Cicero, 55 BC

Time to smell the coffee chaps!

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With regard to the maintainance of a balance of payments, if a country wishes to import more, they must export more. If they cannot export more manufactured, semi-manufactured goods or services, then they must export common shares, bonds, and various other securities.

What happens though if the number of notes [fiat currency] is increased by one or both of the contracting [trading] partners?

The prices of the commodities and hence, the balance of payments must adjust. Assume that the US, wanting via WalMart, to import Chinese manufactured goods, refused to increase the notes in circulation. Then, either the price of US exports must drop, or the difference be made up via securities. Now, if the price of US exports drops in relation to Chinese manufactured goods, then a greater quantity of goods will be required to balance the payments. Less goods are available to sell in domestic markets.

That the US tends to produce higher value goods, with higher technology etc, you had the interesting problem of China, a developing economy, not being able to afford US production, and to lower the price might have incurred economic losses.

Increase the notes in circulation. Through this artifice, the balance of payments could be balanced. By increasing the notes in circulation, the goods held for sale, become cheaper, thus a greater volume are demanded.

Paradoxically it was China who increased their note circulation. China printed Yuan in receipt of dollars from their exporters, and purchased with the dollars, US securities. Thus the balance of payments, balanced.

Essentially China entered a credit transaction with the US, foregoing present consumption for future consumption. The products that the Chinese desired, were in point of fact dollars, foreign reserves. The Asian debacle of 1997 and the collapse of the Tiger economies was a currency collapse driven by a lack of foreign reserves against US dollar direct and indirect investments.

Thus, to purchase more dollars, the Chinese had to sell more manufactured items. Thus, drop the price of manufactured goods, or increase the money supply. The money supply was increased, and the purchase of US dollars and assets increased.

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Current economics, assigns a positive credit rating on countries possessing a credit balance of payments. A country with a debit balance of payments by contrast is either unwilling, or, unable, to stabilise the value of it’s money.

The confutation of this assertion lies within Greshams Law which states; that any circulating currency consisting of both “good” and “bad” money (both forms required to be accepted at equal value under legal tender law) quickly becomes dominated by the “bad” money. This is because people spending money will hand over the “bad” coins rather than the “good” ones, keeping the “good” ones for themselves.

The second reason being the Quantity Theory of money, which states; In economics, the quantity theory of money is a theory emphasizing the positive relationship of overall prices or the nominal value of expenditures to the quantity of money. The increase in the quantity of money within the economic system can have two outcomes; increase in output or increase in prices. Theorists assert the latter, arguing that fluctuations of the money supply is more likely to cause changes in the price level as the economic system has reached it’s capacity and cannot facilitate further growth.

Taking money based on Gold [Silver] as the first example. If, imports are favoured over domestic production [for any reason] the outwards flow of money will reduce the quantity of money available for use, viz. in circulation. Thus the demand for money, remaining constant [assumption] the value will rise. This is effect the same as falling commodity prices. Falling commodity prices, encourage exports, thus, money flows back into the country.

In the second example, where a fiat currency predominates, we have a different outcome.

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Is the United States in as dire a position as is commonly claimed? Is China, ready to take it’s place at the head of the table, US hegemony washed up?

The Balance of Payments, seems to confuse, more than elucidate. It is however a simple accounting measure of international flows. Trade between countries, is at it’s base, no different than between two individuals.

The accounting equation:

Assets + Expenses = Liabilities + Equity + Income
Dr…….+…..Dr…………Cr…….+……..Cr….+…Cr

Debits [Dr] = Credits [Cr]
Thus, the export of goods involves the receipt of cash [credit] which represents a claim on on another country [debit] By definition, the Balance of payments must balance, debits must equal credits.

Removing the element of money and time for simplification: if we exchanged 10 Bushels of wheat for one barrel of oil, the Balance of Payments are equal.

Things get increasingly complicated when money, time and services, as opposed to pure commodity products are introduced. One side of the transaction is treated as a Current flow, the other side of the transaction is a Capital flow, arithmetically, Current flows = Capital Flows.

The Current account covers trade in goods and services, income and transfers. Non-mechandise items [services] are known as invisibles. All other flows are recorded in the Capital and financial account. The Capital and Financial accounts include:

*Capital Transfers
*Aquisition/disposal non-produced, non-financial assets [patents etc]

Financial Transfers
*Direct investment
*Portfolio investment
*Other investment

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