Ask the Finance Expert: Finance Questions and Answers
Why can quantitative easing not be used to pay off the government's budget deficit? Why would one worry about the 'markets', regarding the budget deficit in the UK? The markets are ultimately a human phenomenon which depends on physical location and state issued currency to work.
The way QE2 works for the Fed is that the Fed buys a variety of US government bonds in the market. These are bonds that have already been issued and have been bought by US banks. All that happens here is that the Fed electronically credits the accounts these banks have with the Fed, thus inflating the bank's account by the amount of the bond. What is then supposed to happen is that the bank lends around 9 times that amount to private citizens and businesses, thus pumping credit into the economy.
What has been happening in reality is that banks have simply used the Fed's purchases to shore up their capital reserves and very little has passed to the economy. The Fed then holds an ever increasing amount of government debt on its books. Note, this debt has not gone away, or been "repaid", it has simply transferred to the Fed, which printed money (electronically) to pay for it.
It should be clear from this that QE2 has not in any sense acted as a way of repaying US debt. What it does do is to expand the US money base, or it would if the banks passed the money on in 9x worth of credit (this is how banks really do create money from nothing, by lending $90 new for every $10 they hold). This in turn leads to a rise in prices, following the law that more money in circulation chasing the same amount of goods bids up prices.
So ultimately, QE2 is seen as inflationary (it has the potential to increase prices), which means the government debt diminishes in real terms. But the government is not printing money to pay itself with. That would be like you writing out a cheque to clear your overdraft on the same account. Life, or at least double entry book-keeping, doesn't work that way...
If you are asking why the government can't simply roll the printing presses and pay all its creditors with the new money, the answer is that the value of the money it was printing would drop even faster than it was rolling the presses, leading you straight to a Weimar Republic or Zimbabwean world where the paper is worth more than the zeros printed on it...
Response by Anthony Harrington, award-winning journalist and QFINANCE blogger.
What is the reason for double taxing interest on debt in the concept of EVA?
The EVA calculation starts with operating income. This profit figure can be pre-tax or post-tax, according to taste. Operating income net of tax is called Net Operating Profit after Tax (NOPAT). Capital charges are then subtracted from NOPAT to arrive at EVA. Capital charges equal the cost of capital (for both debt and equity), multiplied by invested capital. A common approach to determining the cost of capital is to use the formula for the weighted-average cost of capital, otherwise known as WACC. WACC is based on the cost of debt and the cost of equity, weighted for their relative proportions in the company's capital structure. However, the cost of debt needs to be adjusted for the tax savings that arise from the deductibility of interest payments. So the interest cost is not double counted. In fact, the tax benefit (= interest expense * the marginal tax rate) has the effect of increasing EVA.
Response by S. David Young, Professor of Accounting and Control at INSEAD (France and Singapore).
I read in your SOX information that companies are supposed to make public disclosures of "material weaknesses" in the quarter they were identified as well as report them to the audit committee. I have been watching a company for a couple months and feel they have a couple of "material weaknesses" that they have had knowledge of for some time. What's the best way to check and see if they have reported these?
Finding Sarbanes-Oxley (SOX) Internal Control Disclosures
SOX-related disclosures are required in quarterly reports (SEC Form 10Q) and annual reports (SEC Form 10K) of publicly-traded companies. Within quarterly reports, the disclosures appear in Part I, Item 4 "Controls and Procedures" and in the "Certifications Persuant to Section 302 of the Sarbanes-Oxley Act" provided by the CEO and CFO, which are attached to the reports as exhibit items. Within the annual report, the disclosures appear in "Management's Report on Internal Control over Financial Reporting" and the "Report of the Independent Registered Public Accounting Firm."
Disclosure and Assessment Requirements
SOX and related SEC guidance require two types of assessments: 1) Quarterly assessment of "Disclosure controls and procedures" under SOX Section 302; and 2) Annual assessment of "Internal control over financial reporting" (ICFR) under Section 404. For further information, see Section II. C-E of the SEC August 2003 "Final Rule: Management's Report on Internal Control over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports-Release 33-8238 and 34-47986."
The SEC expects management's annual assessment to be more robust than the limited quarterly assessment, which is focused on key risk areas and major control changes. The classification of internal control problems ("deficiencies") as material weaknesses is complicated and requires significant judgment. In practice, companies typically disclose material weaknesses in the annual report, after completing the more comprehensive annual Section 404 evaluation. Progress towards fixing the problem is documented in quarterly and annual reports thereafter. In the absence of a significant financial restatement announced publicly, look to a company's next annual report for disclosure of a new material weakness.
SOX is an accounting standard, not a risk management standard
Since SOX is focused on whether the financial statements are accurate or not, a firm experiencing large losses due to bad business decisions is not required to report a material weakness. For example, large U.S. banks did not report material weaknesses, despite massive losses from risky borrowing and lending decisions.
By David A. Doney, CPA CIA
Will Islamic Finance become mainstream in the next five years?
Islamic finance has not escaped the financial crisis unscathed, whose ramifications have been amplified by the recent controversy surrounding the debt restructuring of Dubai World in tandem with a generally diminished investor confidence in the Gulf region. Tremors in the sukuk market serve as poignant reminders of the many governance issues that have beset financial innovation in Islamic finance. In particular, the Nakheel case in late 2009 has fuelled groundswell concern about the interaction of shari'ah compliance and commonly accepted principles of investor protection and bankruptcy workouts.
The potential of litigation following the announcement of a debt standstill on the Nakheel sukuk illustrated the importance of recognizing whether Islamic law governs sukuk by substance or form. If shari'ah compliance were treated as matter of form – and the jurisdiction of UAE courts over the issuer suggests that this would have been the case – then the opinion of shari'ah courts could potentially override the opinion of commercial courts on perfected security interest (or agency agreements) as defined by commercial law. Such legal uncertainty has been accompanied by considerable heterogeneity of scholastic opinion, which continues to hamper the creation of a consistent regulatory framework and corporate governance principles.
Going forward, the current controversy will raise expectations of legal governance in shari'ah-compliant instruments as key requirement for the general acceptance of Islamic finance. The Nakheel bond issue was the first real test case for shari'ah compliant bonds, and this episode will hopefully spur greater legal certainty, transparency and a more robust sukuk infrastructure. The fundamental factors support a strong recovery of sukuk markets, but without resolving these teething issues, Islamic capital markets will not reach a critical mass.
by Andreas Jobst, Economist, IMF, USA.
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