Welcome to my weblog, www.alokeghosh.com. Via this personal blog, I am sharing pertinent issues, current topics, and policy matters in the fields of auditing, financial reporting, and corporate finance with relevance for auditors, hedge fund and mutual fund managers, controllers and CFOs of public companies. The targeted audience includes my current and past students, colleagues from academia and practice, and anyone else fascinated by the crossroads of auditing, accounting and finance. Because my academic training and professional experience overlaps these three interconnected business fields, my commentaries/ideas/claims are often a distinctive outcome of a triangular subject-matter lens rather than a specialized subject-matter lens.by
New York City or the “Big Apple” is the financial capital of the world—the city that never sleeps. Walk down the streets of Broadway, and you can hear someone humming the tune “New York, New York” immortalized by Liza Minnelli and Frank Sinatra. With access to Central Park, I believe a more appropriate label for New York City is the “Garden of Eden.” The trees in this Garden sustain life, support knowledge, and generate forbidden fruits. One serpentine bite of the forbidden apple and we are at the cross roads with Genesis!
Why was New York City baptized as the “Big Apple?”
In the early 1920s, “Big Apple” was a nickname for large monetary awards associated with horse racing contests, many of which were organized in and around New York City. The name was commercialized by prominent writers from the New York Morning Telegraph reporting on the City’s horse-racing. Because the city hosted important races, rewards associated with the races were substantial, which may explain the term Big Apple.
Big Apple was subsequently adopted by the City’s jazz musicians. An old saying in show business was “there are many apples on the tree, but only one Big Apple.” New York City being the premier place for jazz musicians to perform made it customary to designate New York City as the Big Apple.
The City in 1971 started a campaign to increase tourism and officially adopted the nickname Big Apple. The campaign featured red apples as reminder of the bright and cheery side of the City, in stark contrast to the common belief that New York City was dark and dangerous. Since then, New York City has officially been designated as the Big Apple.
What if a bite of the Big Apple eludes you? There is a solution to this biblical dilemma—own a piece of Steve Jobs’ Apple. Apple Inc. designs and manufactures computer hardware, software and other consumer electronics. The company is best known for its Macintosh personal computer line, iTunes media application, the iPod personal music player, and the iPhone.
The original logo of the company, which portrays a man sitting under an apple tree, draws on the Newtonian inspiration from a falling apple. Subsequently, Apple redesigned its logo depicting a bite of an apple. I believe the bite taken out of the Apple represents the story of Adam and Eve from the Garden of Eden with apple representing knowledge.
- Holy Cash Cow
The company today is a colossal holy cash-cow. Based on data from the most recent financial statements, i.e., April 2017, the company has a cash balance including short term marketable securities of around $67 billion. If you add long-term marketable securities, the balance increases to nearly $260 billion, which is larger than the GDP of Greece!
What is the genesis of the cash balance? iSimple, high margins. The company’s gross profit margin is around 40%, which means for every $1 of sales, the company generates 40 cents of profit after deducting the cost of sales. The operating margins are equally staggeringly high (around 27%). Even after netting out all operating costs, the company generates $27 of profits for every $100 of sales. The sales for the first quarter of 2017 alone was $52 billion, a mind- blowing number.
- Investments and Acquisitions
Apple is all about organic growth. The company is very frugal with its investments and acquisitions. Much of the excess cash is heavily invested in marketable securities (parking the cash and generating returns on those dollars). Its corporate investments, i.e, purchase of other companies or fixed assets, is rather modest at less than 5% of total assets.
- Giving Back
What does the company do with its surplus cash balance? It pays dividend and buys back its own stock. Over the 6-months period ending April 2017, the company paid $6 billion as dividend. Over the same period, it repurchased $18 billion of its common stock. Thus, the cash returned to its shareholders was around $24 billion over a period of six months only.
No wonder shareholders are elated and appear flying on Elon Musk’s spaceship to the red planet. Over just under a year, the stock price of the company has increased from around $93 to $155, which translates into a 67% annual return. No legal business in the world can come close to generating these holy numbers.
If you cannot get a bite of the Big Apple, I suggest you consider a bite of the Apple company. Apple’s history is being cooked with a hint of exotic spices by its own “Cook.” The taste is simply divine.
May 16, 2017
CEOs of for-profit companies are paid handsomely for their nifty management skills and for creating shareholder value. According to Associated Press study, the median annual CEO pay for S&P 500 companies in 2016 was $11 million (average pay was even higher at $14 million). When compared to the value created by these companies, the pay appears economically insignificant and immaterial. In 2016 alone, nearly $1.5 trillion of shareholder wealth was created by the S&P 500 companies.
What about the pay of the top bosses in nonprofit organizations like academic institutions? Much less. The average pay of a University President is less than $0.5 million. Therefore, S&P-500 CEOs get about 30 times more than a typical University-CEO.
The Art of Presidential Pay
The highest paid academic top gun was not from an Ivy League institution but a leader of an arts college in Georgia. According to the Wall Street Journal, in 2014, Paula Wallace, the president of the Savannah College of Art and Design (say what?), earned a whopping $9.6 million in 2014. That is, the pay was about 20 times a traditional academic presidential pay.
Ms. Wallace earned a base salary of $859,000 and a bonus of $1 million. In addition, the board/trustees of Savannah College of Art and Design voted to pay Ms. Wallace supplementary deferred compensation of $7.5 million as a cumulative reward for her prior 14 years of service (this is in addition to the annual salary she drew over the past 14 years).
Deferred compensation refers to the portion of an employee’s compensation that is set aside to be paid at a later date in the form of retirement plans or pension plans. In most cases, taxes on deferred compensation are delayed until income is paid. In common parlance, deferred compensation is the ability to provide for a “highly prosperous retired life” by leveraging current position and power.
Stellar Savanah College
Ms. Wallace is one of the founders of the college. Her achievements include overseeing enrollment growth, and the expansion of academic majors and branch campuses. According to a consulting firm retained by the arts college in Georgia to approve presidential pay, “the compensation is fitting given her four decades of contribution towards the success of the institution.”
Tuition, fees, and living expenses can exceed $50,000 a year. Students at this institution collectively received about $115 million in federal student loans. Among nonprofit art and music colleges, students of Savannah College of Art and Design rank among the top quartile for graduation rates and earnings. About two-thirds of full-time students graduate within six years, and their students receiving financial aid reported median earnings of roughly $35,000 a decade after entering.
Scarcely stellar when you consider that a representative student can potential rack-up federal loans of up to $250,000 to get this coveted arts and design degree from Georgia.
Raymond Cotton, a lawyer who advises university boards on presidential pay, called Ms. Wallace’s compensation “..such an outlier in the world of higher education; it’s really incredible.”
Benchmark: Harvard’s Presidential Pay
How does this pay compare to the Presidential pay at country’s leading academic institution with a largest endowment?
Harvard University’s President, Drew Faust, earned a $811,000 salary and received a meagre total compensation package worth $1.2 million.
Nonprofit organizations are organized for a public or mutual benefit other than generating profit for owners or investors. Because a nonprofit company’s intent is to increase the welfare of society, the government sponsors those objectives by defraying some of the nonprofit’s costs by exempting nonprofit organizations from paying taxes.
If Presidential Pay at academic institutions mimic CEO-pay at S&P 500 companies because academic institutions draw inspiration from for-profit companies, why the big need for subsidy from the federal and state government?
Midnight in the Garden of Good and Evil!
Chatham; April 17, 2017by
Romania and Chad are two “sovereign, independent, unitary and indivisible” National States. Separated from each other by the Mediterranean Sea and by the adjoining countries including Serbia, Bulgaria, Macedonia, Greece, and Libya, the two countries are most diverse in their economic, social-political, ethnic, religious and racial backgrounds. Yet, the pennant, the umbilical cord bonding the two countries, is identical. Their tri-color flags are indistinguishable!
Imagine, the two countries locked in a competitive sporting duel and you are passionately waving the blue-yellow-red tri-color cheering one country! It may become hard to assess your preferred country.
Design of Flags
Vexillography deals with the art and practice of designing national flags. A casual inspection of the national flags highlights common underlying attributes unifying most national flag designs;
- All national flags are rectangular, except for the flag of Nepal
- Except for Nepal, the width is taller than the height for all national flags
- Only the national flags of Switzerland and Vatican City are exact squares
- All national flags are either identical or mirrored, except for the flag of Paraguay
- All national flags consist of at least two different colors
- It is common for many flags to feature national symbols, such as coats of arms
Convention for Adoption
The national flag is often, but not always, mentioned or described in a country’s constitution. Its detailed description may be delegated to a flag law passed by the legislative, or even secondary legislation or in monarchies a decree. For most countries, the date of flag adoption is apparent. For others, the task of determining the exact date may be more complex because of unknown or disputed design changes, regime changes, or other geographical changes.
According to the office of the U.N., “…it is up to Member States to select their own flags,” which means there is no internationally recognized governing body delegated with the task of approving and supervising the issuance of flags.
Therefore, it should not come as a complete surprise that two or more countries may have twin sibling flags.
Romanian Tri-Color National Pride
It is historically well-established that dissidents in Romania from 1800s began waving the blue-yellow-red tricolor during protests. Subsequently, a series of monarchical governments used versions of this symbol. In 1949, when the Communists took control of Romania, they tweaked the flag by adding a star, several chaffs of wheat, mountains, trees, a sunrise, and a power line, which was the enforced “Romanian coat of arms.”
As is customary in a communist regime, the input of the native Romanian citizens was not deemed as being necessary! All was well with the flagging spirits until 1989, when during the revolution at Timișoara, Romanian dissidents quite understandably began ripping and tearing out the communist symbols from their flag. For a few revolutionary months, Romania’s de facto flag was the blue-yellow-red tricolor with a big hole in the middle.
Finally, by a decree-Law, on 27 December 1989, the National Salvation Front and of the territorial councils of the National Salvation Front declared that “the national flag is the traditional tricolor of Romania, with the colors laid out vertically, in the following order, starting from the flagpole: blue, yellow, red”.
Chad Tri-Color National Pride
Chad, a country in North Africa, gained its independence from France on August 11, 1960. The country officially adopted its flag on November 6, 1959. It combines two colors from the French Tricolore (red and blue), and two Pan African colors (red and yellow). Blue represents the sky, hope and agricultural strength of the southern part of the country. Yellow is representative of the country’s northern desert and the sun. Red represents prosperity, unity and the blood shed for independence.
Lennin to Lennon
In essence, Chad and Romania have had identical flags since 1989. Chad government has been protesting to the U.N. declaring that two countries cannot have the same flag. Yet, for the moment, Romania appears unperturbed by this trivial practical resemblance.
You can almost hear the epic Lennon song in the background
“Imagine there’s no countries, It isn’t hard to do, And no religion too
Imagine all the people living life in peace, you…”
March 23, 2017by
Giddy up! At more than 21,000, the Dow Jones Industrial Index has soared by 1,200 points or about 13% since January 2017. If you consider the run-up since February 2016, the stock market has delivered a staggering return of about 30%. The stock market has been on the best winning streak in 25 years.
One fundamental reason for the stock market rally is linked to the growth of Exchange Traded Funds, or ETFs, as retail investors have poured in $124 billion into this type of an investment vehicle in 2017 alone.
State Street Corp.’s SPDR S&P 500 ETF is the market’s oldest, largest and the most-traded security in the world.
Love Thy ETF
Introduced in 1993, ETFs, or Exchange Traded Funds, trade on an exchange like stocks. An ETF is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike actively traded mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold.
ETFs typically have lower fees than mutual funds, making them an attractive alternative for individual investors. Shareholders do not have any direct claim on the underlying investments in the fund, instead, they indirectly own these assets.
According to research firm XTF, there are around 1,800 ETF investment vehicles holding stock worth more than $2.7 trillion. There are no SEC rules governing ETFs which means ETFs are regulated via mutual fund regulation. Just three firms
— BlackRock Inc.
— State Street Corp.’s State Street Global Advisors
— Vanguard Group
manage 80% of ETF assets.
ETF vs Actively Managed Funds
- ETFs try to track the performance of a particular market benchmark, or “index,” as closely as possible. In contrast, Actively Managed Funds (AMFs) try to outperform their benchmarks and peer group average.
- ETFs buy all (or a representative sample) of the securities in the benchmark, while AMFs combine research, forecasting, and experience/expertise of a portfolio manager or management team.
- Index funds tend to be more tax-efficient and have lower expense ratios than actively managed funds because they trade less frequently than AMFs.
- Although AMFs attempt to beat the market, quite often they may also miss their targets which results in losses for the funds’ investors. In contrast, ETFs are only undertaking the underlying risk of the market benchmark.
- Most importantly, AMFs typically charge between five and twenty-five times what ETFs charge their investors.
Not surprisingly, the pace of ETF inflows bodes negative news for asset managers. Investors have started pulling their investments from AMFs to ETFs. The largest providers of ETFs have started reducing management fees to attract even more funds. The average annual fee of ETFs bought this year is only $23 for every $10,000 invested, sharply lower than last year. Some ultralow-cost iShares Core funds cost as little as $4 a year for a $10,000 investment, which is can be about 1/25th fraction of the fees charged by most mutual funds.
Given the low-cost structure of ETFs and the raging bull market, $7.5 billion has moved into the iShares Core S&P 500 ETF and $5.4 billion into the Vanguard S&P 500 ETF in January 2017 alone!
Hamiltonian Hip Hop and ETFs
Lately, the US stock market has generated staggering returns unmatched by almost any other country. Take for instance the returns generated from an investment in S&P 500 stocks in the last eight years.
- 2009 26%
- 2010 15%
- 2011 2%
- 2012 16%
- 2013 32%
- 2014 14%
- 2015 1%
- 2016 12%
If you invested in the S&P 500 from 1928 to 2014, the per annum compound rate of return was 9.8%. Thus, if you invested $100 in 1928, your nest egg would become $346,261 in 2014.
Join and celebrate the US goldilocks economy and consider becoming an ETF shareholder.
Vermont, February 10, 2017by
Academic tenure is a contractual right that grants a professor permanent employment or a legal protection against summary dismissal without just cause. Principally, the status of a tenured professor is analogous to a Supreme Court Justice—a lifetime of employment guarantee. Less than one-third of all college and university faculty members are tenured in the US.
Tenure may be revoked if there is evidence of incompetence, unprofessionally behavior, or when an academic department/school is in serious financial difficulty. Nationally, about 2 percent of tenured faculty are dismissed in a typical year.
The notion of academic tenure dates back to the early part of the 20th century when tenure system was erected to protect professors from the abusive power of University Presidents and Trustees who were free to fire professors for their socio-political views. According to NEA, academic freedom via tenure is valuable because professors can then assert their independence. Scholars can challenge conventional wisdom, discuss and debate controversial ideas without having to worry how such exchange may affect their jobs.
- Florida, Missouri, North Dakota, Iowa
Faculty at State College of Florida hired after July 2016 no longer qualify for tenure-like protections. In Missouri, North Dakota and Iowa, Republican lawmakers are introducing bills to eliminate tenure. In North Dakota, the state board of higher education is considering reducing to 90 days from 12 months the amount of time administrators need to give tenured faculty before they can lay them off. The state’s 11-school college and university system is bracing for steep layoffs this year after cutting about 500 full-time positions last year. A Missouri bill would prohibit any public institution of higher education from awarding tenure after Jan. 1, 2018.
While not eliminating the status of tenure, Wisconsin’s state legislators voted in 2015 to weaken state tenure law. Consequently, state universities in Wisconsin had to grapple with sharp reduction in budget (around $250 million) and deal with lower tenure protections. In response to the State law, Wisconsin’s University Board instituted “independent and substantive reviews” of tenured faculty once every five years. Tenured professors who are deemed as lacking in productivity have three to four semesters to improve else their tenure is revoked. The Governor of Wisconsin, Scott Walker, recently declared plans to cut tuition by 5% across all University of Wisconsin System schools while instituting “faculty accountability policy” which aims to monitor the time professors spend in classrooms.
Steep jumps in tuition, students have to accumulate large amount of debt to get quality education, and higher wage inequality may have magnified the scrutiny on the business practices of universities including questioning the concept of permanent employment of professors.
Defense of Tenure
According to NEA, there has been a temporal decline in the proportion of tenured professors. For instance, in 1975, 45% of faculty at public and private schools was tenured or tenure-track, however, by 2014, that number had dramatically declined to 29%.
Defenders of tenure claim that state that disallow granting of tenure will be unable to attract high quality talent. Such states also risk losing valuable grants which is often linked to the human capital and innovative abilities of tenured professors. Another prediction is that salaries are expected to increase dramatically as professors would demand a higher wage rate in the absence of tenure.
Tenure at most prestigious and nationally visible universities is granted after an exhaustive and critical review. The longer the tenure clock, the more stringent is the granting of tenure. Given these parameters, most, if not all, tenured professors are eminent and productive scholars with a shared passion for teaching.
Market theory suggests that, because tenure has endured for more than a century, the benefits must outweigh the costs from having a tenure system. While the experiment of not having a tenure-system is counter-factual in the US, one can draw on the experiences from other countries without a tenure track system. The consensus is that higher education has lagged behind in quality, scientific research and intellectual advancement in countries without a tenure system. More so, countries that have moved to a tenure track system (e.g., schools in mainland China, Hong Kong, Australia, and Europe) have seen a rise in the quality of their advanced level education.
While distinguishing the benefits of tenure, one cannot help underscore that there are some apparent costs including a classic moral hazard problem leading to potential misallocation of resources because of inadequate monitoring.
Future of Academic Justices
Will the US tenure system survive the current predicament? Will tenure endure a refurbishment? Some states have made their decisions. Other states can only resist or follow suit.
Chatham, February 24, 2017by
BT shares, which trade in the US as ADRs (BT Group plc), have declined by more than 45% in less than a year. Around half of that descent was confined to a single day last month (Jan 23) when the company announced accounting improprieties associated with its Italy-based operations. The company also noted that some senior management personnel may have embezzled funds. UK’s parent BT shares have shed more than 8 billion pounds because of this accounting scandal.
Italian prosecutors have initiated their own investigation into BT Italia’s accounting fraud. BT Group Plc has been hit by at least two shareholder lawsuits in the U.S. A number of other US law firms specializing in shareholder class action suits are considering filing lawsuits against the company and senior management.
British Telecommunications (BT)
BT Group plc is a holding company which owns British Telecommunications plc, a British multinational telecommunications services company with head offices in London. The company has operations in around 180 countries. The company’s shares are among the most widely owned stocks in the UK. The ownership of BT shares is widely dispersed ̶ about 700,000 of its 827,000 shareholders own 1,600 or fewer shares of the company.
American depositary receipts (ADRs) were introduced in 1927 as an easier way for U.S. investors to purchase stock in foreign companies. Non-U.S. companies also benefit from ADRs as it makes it easier to attract American investors. ADRs are negotiable certificates issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock traded on a U.S. exchange.
ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas, and holders of ADRs realize any dividends and capital gains in U.S. dollars, but dividend payments in euros are converted to U.S. dollars, net of conversion expenses and foreign taxes. ADRs are listed on either the NYSE, AMEX or Nasdaq but they are also sold OTC.
The fraudulent transactions related to BT-Italy emerged sometime during the summer of 2016 following an internal probe into its Italian business after a “whistleblower” flagged concerns. A whistleblower is an employee who discloses information about illegal acts, mismanagement, abuse of power, or general wrongdoing occurring in the company. If the company is publicly traded and subject to the filing requirements of the Securities and Exchange Commission, whistleblowers are protected by law from retaliation in the US. Some of the major US companies perpetrating accounting fraud were caught and brought to justice by their own employees (e.g., Enron, Freddie Mac, Madoff).
Upon investigation, BT discovered “inappropriate management behavior” within the Italian division. The expected cost of the rent extraction initiated by the Italian subsidiary was estimated to be around £145 million. Sometime in January this year, just days prior to the announcement of the third-quarter results, the company released a statement declaring that, according to an independent investigation by the Big 4 accounting firm KPMG, the losses to BT from the accounting irregularities related to Italian operations were being reassessed at £530m, which is almost 4 times larger than the previously estimated number.
The company suspended several BT Italy’s senior management team. BT has also appointed a new chief executive of BT Italy who took charge of Italy’s operations from Feb. 1.
What remains troubling is why wasn’t the accounting irregularity detected by UK’s parent company much earlier. Nick Rose, the chairman of the BT’s audit committee, flagged internal-control issues in Italy in every annual report since May 2013. Yet, the persistent accounting fraud was not detected until 3 years later. By blaming BT-Italy for all the current problems, the CEO of BT may be attempting to distance the parent company, and himself, from the Italian operations by censuring a few perpetrators.
What is even more worrisome is why didn’t the auditors detect this size of an accounting fraud earlier? Independent auditors are expected to provide an assurance that the financial statement are free of material misstatements. One would agree a misstatement exceeding $600 million is material.
Who was BT’s independent auditor? The answer is PwC, which a Big 4 global accounting giant. PwC has been BT’s auditor for the last 30-year since 1984. It is unclear whether BT intends to end its business relationship with PwC. The big accounting firms are renowned for rendering high audit quality so this type of an accounting fraud is likely to a huge set-back for PwC.
Moody’s has warned it may cut BT’s credit ratings. Analysts are skeptical whether the company can afford to maintain a 10 percent growth in its dividend.
Randoph, February 2, 2017
Beer is the third most consumed drink after water and tea and its production can be traced back 10,000 years. This popular beverage serves as the esprit de corps for almost every human emotion. We drink beer to rejoice, to recollect, to champion ball games, to forget, to relax, or just to get rowdy.
The production of beer is relatively straightforward—some form of starch is converted into alcohol through a fermentation process using yeast. The most common variation of starch used is malted barley, which is dried germinated barley. Hops are added during the brewing process to inject flavor and bitterness to the drink while acting as a natural preservative. Hops are dried flowers from the same family of vines as cannabis so beer may have some medicinal properties as well.
Lager versus Ale
The two overarching beer categories include ales and lagers. The crucial difference between two beer categories is the quality of yeast used in the fermentation which in turn imparts a distinctive character.
Ales are produced using “top-fermenting” yeast strains, which ferment at the top of the fermentation container. Lagers are generated using “bottom-fermenting” yeasts, which ferment at the bottom of a fermentation container. Ales are traditionally fermented at warmer temperatures (55 to 70 degrees Fahrenheit), while lagers are fermented at much cooler temperatures (38 to 50 degrees Fahrenheit). The dissimilar yeast types and the differential temperatures are a key reason why ales are bitter, darker and fruitier and while lagers are less fruity with a refreshingly clean and crisp taste.
The younger sibling Lager is a modern creation with a maturation age less than 300 years. Ale happens to be the older, more traditional and the distinguished sibling.
British East India Company
In the 18th century, British merchants set up East India Company to trade spices, fine cotton and silk from India. Although the British stationed in India may have preferred darker and sweeter ales, the wealthy traders of British East India Company wanted a more refined and lighter/paler version of the traditional ale to accompany their long voyages to India.
To quench the thirst of the industrial revolution, British beer-producers started a new “pale ale” assembly line with a heavy injection of hops to add a bitter counterpoint to the sweetness of the malt. The added advantage of hops was that it also served as a natural preservative, which meant that the pale ale could last the long voyages to India.
As British interests in India grew, so did the beer market in UK. More and more brewers started making “Ales for the Indian Market” or just “India Pale Ale (IPA).” As IPA conquered taste buds in India, it also spread around the world, turning up in America, Australia and South-East Asia.
IPA in the US
Today, IPAs are particularly popular in the US. Craft brewers are increasingly making IPAs as part of their medley. Bars are also happy to stock an assortment of IPAs. Not surprisingly, to satisfy the discerning palate of the consumer, beer producers and suppliers are able to charge a hefty premium for IPAs. Because of the distinct flavor, a unique bitter taste, a discrete sweetness and color, brewers are able to distinguish their products from other beer selections, which allows them to charge a hefty premium for “differentiated products.”
Get ready to recall the spirits of Jack Sparrow from the Indian Ocean and not from the Caribbean. Cheers!
Helsinki, January 15, 2017by
When does a country benefit from trade? Many classical and neo-classical economists claim that countries benefit from “free trade.” Two British economists, Adam Smith and David Ricardo, are credited with developing the idea of free trade in its current form. Advocates of free-trade believe that trade is the singular reason why certain well-known civilizations prospered including Egypt, Greece, Rome, Bengal (East India) and China. Many classical liberals from the 19th and 20th centuries actively sponsored the ideology that free trade promoted peace and not just prosperity.
Countries committed to a free trade policy minimize restrictions on imports from, or exports to, other countries. However, most nations today despite being members of the World Trade Organization (WTO) impose protectionist policies (e.g., tariffs, quotas, taxes, and non-tariff barriers including regulation) with the intention of supporting local employment or limiting entry/exit of certain goods and services. The reality is that most countries do not practice free trade in principle.
When is Trade Beneficial
The major industrial nations, which includes the US and the majority of Western European countries, have benefited from trade because they have pioneered innovative products with high profit margins that are valued globally. Because of access to international markets, which are manifold times larger than their local markets, the benefits of trade have been immeasurably larger for the industrial nations. Encouraging the world to commit to free trade when a nation provides goods that are both profitable to produce and desired by others allows producer-nations to amass wealth because exports exceed imports.
There are at least two fundamental differences in the export lead growth adopted by the US and the approach implemented by the Western European countries including Japan.
- Outsourcing domestic production
The US-based producers have outsourced much their production internationally to exploit differential wage rates and lower their production costs which benefits US shareholders. However, in doing so, substantial jobs are lost to international markets which causes short term economic hardships locally. The economic hardships are more resilient unless displaced workers find alternative employment by relocating or investing in human capital through retraining programs. In sharp contrast, in much of western Europe and Japan, the model has been based almost exclusively on domestic production which implies fewer jobs losses to outsourcing.
The US, which founded the new information-based economy, has been the leader in cutting edge innovation by attracting “global talent.” Because of the attraction of high wages and a realistic opportunity to amass wealth in a relatively short period of time, there has been a large influx of legal migration. The economic prosperity has also been a haven for illegal immigration. As migrants offer comparable or better services at lower wages, one notable side effect of immigration (legal and illegal) is job losses for US citizens. Moreover, in an information-based economy, workers without necessary skills may be unable to harness the benefits from innovation which also adds to economic hardships.
In contrast, Western Europe until recently has been immune to migration problems because of stringent immigration policies and from having smaller territorial borders which are easier to patrol and ward off unwanted inflow of migrants. However, this convenient model has been tested lately. The inclusion of eastern European countries into EU increased the inflow of labor migration into the more prosperous western European economies. The political turmoil in middle east also contributed to both legal and illegal migration. The western European countries are also captive to an additional economic dilemma. Because of an attractive social welfare system, their citizens must pay for non-productive immigrants.
Outcome of the Geo-Political Shifts
A key consequence of the socio-economic shocks is a large wage gap and wealth disparity in industrial nations. In democratic countries, if the gains from production and trade are confined to the elite, the majority of the population are expected to vote opposing the status-quo and elect candidates who promise to usher in changes to existing growth models. Some prominent examples include Brexit decision, the US elections, and the shift in the socio-political debates in France, Germany, Netherlands, Denmark, and Italy (Scandinavian countries and Switzerland are relatively immune because they are not party to the EU block or EU monetary system).
As we continue to reap the benefits from trade and free markets, we are also at the vortex of their detrimental side effects. The recent political dialogue is a reminder that to preserve trade and economic co-operation, the gains from trade must accrue to all strata of society. The alternative is a protectionist and isolationist strategy which may generate near term benefits but may be harmful for a producer nation’s long term economic welfare.
December 31, 2016; 12.02Aby
In the absence of major national banks in New Orleans, regional banks have floated the NOLA (New Orleans, Louisiana) economy. Through its wholly-owned subsidiary First NBC Bank, First NBC Bank Holding Company provides a wide range of financial services in New Orleans, Florida, and Mississippi Gulf Coast with 39 banking offices.
Following Hurricane Katrina, First NBC invested heavily in New Orleans construction projects that included generous tax credits established by federal and state governments. These investments collectively helped propel First NBC to become the city’s largest bank based on assets under the leadership of CEO Ashton Ryan.
Halloween Scare: Stress Test
The Federal Reserve Bank of Atlanta and the Louisiana Office of Financial Institutions informed First NBC on Oct 11 that the bank is under “troubled condition.” As troubled bank, it must seek regulatory approval before adding any new directors or senior executives or changing the responsibilities. The bank is also prohibited from increasing its debt, distributing interest on subordinated debt or paying dividends on its stock.
To add to the stress, the Federal Deposit Insurance Corp. (FDIC) recently declared that First NBC is no longer “well capitalized,” restricting its ability to take on certain deposits and pay interest. First NBC was recently downgraded to junk status by Kroll Bond Rating Agency Inc., which specializes in rating smaller lenders. HoldCo Asset Management, which owns the banks’s debt has shorted the bank’s stock and as a way to hedge its risk against a bank default has also publicly questioned the bank’s accounting policies.
Uncle Sam’s Subsidies: Tax Credits
First NBC invested heavily in New Orleans in construction projects following Katrina and thereby benefited from the generous tax credits from federal and state governments. Because the tax credits received by First NBC were more than the taxes being paid, the bank was able to use the unused portion of the tax credits to reduce future tax payments by offsetting future taxes against the unused portion. For instance, if the government gives a $1,000 tax credit to a single parent for raising a child alone, and the parent must pay $800 as federal income taxes based on his/her income, the parent does not pay any taxes for the current period because the tax credit fully offsets the $800 taxes payable for the current year. More importantly, even after the tax offset, the remaining $200 tax credit balance can be used to reduce future taxes.
Accounting rules allow this $200 future tax benefit to be capitalized (i.e., treated as an asset) and booked as a deferred tax benefit. As of the first quarter of 2015, the bank’s deferred tax assets—the benefits from reduction of future taxes—are $247 million, up from $95.8 million a year earlier.
In 2014, the company reported $28.6 million as income before taxes yet it reported a net income of $55.6 million because it had an income tax benefit of $27 million (instead of having an income tax expense which normally reduces net income).
Mardi Gras Float in Trouble: Recanting Previously Issued Statements
First NBC announced in August 2016 that it expects a delay in filing its 2015 Form 10-K (annual report filing with the SEC) because of restatement of previously issued financial results! The prior results included errors because of the following reasons:
- Use of an inappropriate amortization method in accounting for investments in tax credit (Halloween Hullaballoo)
- Consolidation of certain investments in Federal Low-Income Housing Tax Credit entities because such entities were determined to be variable interest entities in which the Company was the primary beneficiary (Enron Phantom).
- The result of the consolidation has adverse effect on the financials (Hurricane)
Following the error corrections, the 2014 net income was now being restated (or reduced) by 20% ($55.6 million being revised to $44.7 million). Similarly, the 2013 net income was being restated (or reduced) by 18% ($40.9 million being reduced to $33.6 million). Accumulated earnings for 2012 and prior periods was being reduced by 16% from $59.8 million to $50.3 million. The company in its 2015 10-K stated “We determined that we had insufficient qualified personnel at both the executive management and staff levels with appropriate knowledge, experience and training on accounting and reporting matters, which contributed to the material weaknesses that resulted in the restatement, as well as the inability to timely file this report.”
To make matters worse, the bank was in violation of NASDAQ listing rules because it had not filed its 2016 quarterly statements. To avoid delisting from NASDAQ, First NBC submitted a plan to regain compliance with Nasdaq’s listing rules.
In a time-span of less than a year, the stock price of First NBC declined from a high of about $40 to around about $5.30, which is a cyclonic decline of around 86%. More than $600 million in shareholder wealth was destroyed because of the accounting related aggression.
Grateful Dead Sings Aiko Aiko Ande
Ernst & Young (E&Y), a Big 4 auditor with international reputation and stature, has been the independent auditor of First NBC leading up to the 2015 financial statements. First NBC’s restatement is likely to bring considerable negative publicity, media scrutiny and regulatory intervention for E&Y. It will not be surprising to see class action lawsuits initiated by shareholders to recover losses.
In September 2, 2016, Ernst & Young declined to stand for reappointment as the company’s independent auditor for 2016. Is it a case of too little too late? A restatement is considered an audit failure.
Did E&Y fail the shareholders of First NBC? Only courts and the SEC can render a verdict on this matter. Until then, the accounting profession sings “Aiko Aiko Ande” in Cajun style.
My spy boy saw you spy boy sittin by the bi-yo
My spy boy told your spy boy, Im gonna set you flag on fi-yo.
I said, hey now, hey now, Aiko aiko all day, jockomo feeno na na nay, jockomo feena nay.
My grandma and your grandma were sitting by the fire
Said my grandma to your grandma, gonna get your tail on fire.
Chatham- Helsinki; October 30, 2016
India has become a dominating player in the production of generic-drugs particularly targeting the large U.S. market. Indian drug manufacturers account for 40% of generic drugs sold in the U.S. While most Indian pharmaceutical companies continue to make their money selling inexpensive generic drugs, there is a visible change in their strategy over the last few years. Indian generic-drug manufacturers have started competing intensely to develop their own products through heavy R&D spending and finding solutions to many illnesses and diseases.
Motivated by the desire to produce innovative and patented drugs, Indian pharmaceutical companies have started applying for drug approvals with the U.S. Food and Drug Administration (US-FDA) at an unprecedented rate. Approximately, a third of all FDA applications in the last year were submitted India’s multibillion-dollar pharmaceutical industry. A year ago, the growth in application was only 19% which means the growth rate between the two consecutive years has almost doubled.
Why the Change in Strategy?
Generic drug business (production and sales) entails making money through large volume. Margins are low because there is heavy competition from other generic drug producers. Think of grocery stores as an analogy. In contrast, patented drugs generate high returns for the producer because they are the only producer, i.e., volume is high, and margins are high because they act as a monopolist (sole producer). Think of the diamond business and DeBeers as a parallel.
Medical innovation in drugs requires considerably investments in R&D with initial outlays exceeding millions, and sometimes billions, of dollars. However, following the successful development of a drug, a pharmaceutical company must first procure a patent before the drug can become a commercial product.
The economic idea behind a patent is simple. The government wants the private sector to invest and innovate in the field of medicine and find cure for illnesses. However, because the cost of finding a cure for human ailments can be prohibitively costly, the government offers through a patent a “protection period” for a drug company to sell its drug over a certain period, which is typically 20 years in the U.S.
As a result of the patent, only the pharmaceutical company holding the patent can manufacture the drugs being approved by the FDA. Therefore, in essence the drug manufacturer with a patent is akin to a monopolist, which means it can charge an exorbitant price (think of the recent Mylan case). High prices result in high profits because the cost of production is generally low. The higher profits allow the drug manufacturer to recover the initial investment in R&D and thereafter make a ‘healthy,’ and sometimes super-healthy, return.
Humans benefit, we get to live longer and are able to become more productive, which means that society benefits but all this comes at a step price. Some drugs can cost between $10,000 to $30,000 per dosage (e.g., cure for AIDs or cancer)!
India’s largest drugmaker by sales, Sun Pharmaceutical Industries Ltd., received approval for an eye drop to treat swelling and prevent pain in patients undergoing cataract surgery. In 2014 it received approval for a new injection to treat a rare blood disease known as myelodysplastic syndrome. However, to receive these patent approvals, the company had to invest heavily in R&D. The company’s R&D outlay increased from about $50 in 2011 to about $261 million in 2015, which is more than a 400% increase in a span of 4 years or about 100% annual growth.
Dr. Reddy’s Laboratories, India’s second-largest drugmaker by sales, received FDA approval for a spray for treating a skin condition called plaque psoriasis, as well as an injection for migraine headaches. The company similar increased in R&D from $50 in 2011 to $253 million in 2015, which again translates into a 100% annual growth.
Lupin increased its R&D spending by 17% to $168 million in 2015. The company is developing an injection to treat less common cancers and a nasal spray to better deliver off-patent drugs to treat some types of pulmonary diseases. The company’s U.S.-based laboratories in Florida and New Jersey are also working to improve AllerNaze, according to Wall Street Journal.
Cost versus Benefit
Dr. Reddy’s Lab spent about $25 million in developing its migraine injection and was able to get it from concept to market in less than five years so the gestation period can be long. However, the company predicts that it expects to earn more than $100 million in annual sales from the migraine injection and skin spray.
A 20-year patent period means that the sales over the duration of the patent period would generate about $2 billion sales. The “bottom line,” it pays to invest in R&D for a company and switch from generic production to patented products. But, the company must first succeed in its innovation efforts otherwise all the investment is lost, which is the typical risk associated with R&D investments.
Chatham, Feb. 29, 2016; 11.22Pby