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June 2005 Edition ---- to page back through Previous Editions click here

We consider again the superfluous financial transactions undertaken by Transpower, the NZ government owned corporation which operates the country's arterial electricity network.

The matter seems to be being pursued by the newspaper The Press and Sue Newberry of Canterbury University. Her colleague Allan Robb seems to have dropped out of the pursuit.

This site has criticised Robb and Newberry for unjustified comments to mitigate the effects of matters they have uncovered. Perhaps Dr Newberry has taken this on board since she seems not to be conceding the benefit of all doubt and more, this time.

Having (justifiably) gone out on a limb Dr Newberry has had her reliability questioned by the Minister of Finance. When one is working in the dark it is probably necessary to engage in a degree of speculation. The speculation can often get a response and so dredge up more information to help complete the puzzle as has been happening.

Two sets of transactions are at the forefront of the controversy, at buy-back deal in the 2004 financial year and a loan deal in the 2003 year which we will discuss first.

In the loan deal Transpower borrowed over $700m and invested $500m of the proceeds with a group of financial institutions who undertook to service their portion of the loan directly. The borrowing and investing was arranged for Transpower as one deal and as a result Transpower apparently claim to have achieved a very low rate of interest.

Suggestions were made that this low interest rate was achieved because the deal allowed parties to it to avoid New Zealand income in some unfair manner. Transpower responded to these suggestions by way of a public statement, quoting their treasurer John Bishop, dated 7 June 2005 in which they reject any suggestion that deal had reduced the NZ tax take. The statement is available at http://www.transpower.co.nz/?id=5482 Justaccounting is inclined the accept the assertions made in this regard, except that it implies that Transpower knows the NZ tax affairs of all the parties to the deal and hence is in a position to make the claim that tax take had not been reduced. It is most unlikely that they have free access to all such records. The expression "as far as we are aware" or similar should have been included.

That completes our comments concerning tax. But the statement and the deal it refers to raises many more accounting issues of concern.

The first is a claim that the transaction allowed Transpower to reduce its borrowing costs. The only factor indicating that could be the case is that by borrowing $700m instead of the $200m it needed would attract more big investors and the arranging costs per dollar borrowed would be less. But $200m is already quite big, and the more one lends to the same source the greater would be the risk per dollar lent. And the arranging cost of course would be a lot less if there had been no onlending to a variety of borrowers.

People suggesting a reduced tax take were probably surprised at the low interest rate that Transpower is paying on its $200m borrowing. This can probably be explained by two factors. First Transpower physical assets provide a critical ongoing service and hence can provide the finest of security for a loan. This is enhanced by the readiness shown by NZ Governments to bail out entities deemed to be important to the country such as Air New Zealand and, on two occasions, the Bank of New Zealand. Good security commands low interest rates and Transpower can probably offer better security than any bank or finance institution.

Secondly, and this is where bad accounting comes into play, the financial institutions have probably paid a margin to Transpower for using its security for their borrowing and this margin has been converted by the "arranger" into a reduction on what rate Transpower pays on its $200m borrowing.

Effectively at the same time as borrowing the $200m, Transpower has gone into the finance business. Any revenue received from that business (ie the onlending) has little or nothing to do with its $200m borrowing for its core business and should not be treated as a reduction in the interest rate it has borrowed at. The financial accounts of Transpower need to show this. It does not seem plausible that a sufficiently better interest rate can be obtained from borrowing $700m rather that $200m to justify an onlending arrangement and all the security considerations which that entails.

While it might be reasonable for individual persons to entrust any well known financial institution with their savings, that does not necessarily apply to multimillion dollar investments made in such an institution by a large corporation. In the event of default by such an institution, governments will move fast to protect or replenish the savings and investments of the everyday public. Large investors will probably be treated much less favouably. They will be expected to have taken greater care about who they have invested with. Proper investing is a serious and difficult business when hundreds of millions of dollars are involved. It cannot just be left to an "arranger".

Whether income gained (via interest reductions received) from such onlending is a contribution to profit is doubtful, Transpower has given up borrowing power on its fixed assets and now has a risk on the investment with institutions to live with. Although the risk might not be high by normal standards they are high by Transpower standards and arguably provision should be made for an eventual default by one or more of these institutions obliging Transpower to take over loan servicing.

A second disturbing accounting issue is that of debt defeasance employed in the Annual Accounts of Transpower in respect of this loan. The principle behind this practice is that if an investment parcel and a borrowings parcel of an accounting entity can be relied upon to offset one another in terms of servicing and eventual repayment, the accounts can be simplified by omitting both parcels and mentioning them only as a contingent liability. The problem with this is deciding what is an acceptable degree of reliance that the investment will not go bad and liability for the loan go back to the entity. ie where does one draw the line. Transpower prides itself on maintaining a debt to assets ratio of about 50%. Its 2004 annual accounts show assets of 2.2 billion and liabilities of 1.2 billion or about 51%. If the 0.5b defeasance is added to both the figures are 2.7b and 1.7b or about 63%. These ratios are meaningless if there are not clear rules about what assets can be relied upon and what can't and it is rather impossible to evaluate such assets and draw a line. Perhaps the investor has security over the onlent funds but this is not clear. All sorts of receivables could be teed up to pay all sorts of payables direct and so allow both the paired items to drop out of the balance sheet and distort the ratios under the defeasance principle. The practice should be stopped and also investigated for legality with action taken if it is not legal.

The defeasance principle was apparently employed by the Bank of New Zealand when in 1988 it borrowed a large amount by way of perpetual subordinated notes. From the proceeds the bank bought a zero coupon bond which would grow in value and pay off the notes about 10 years hence. The bond was held by the notes lender as security. Presumably the net amount of liability only was shown in the accounts and probably as a result the two items combined tended to be referred to as "the notes" particularly by the auditors. This allowed the auditors to purport to be confused about the nature of the "notes". First Ms Hickey wrongly decided that a straight line allocation of interest for the 1990 year on the bond was acceptable because a variable interest rate was involved. It was the notes, not the bond, which carried the variable interest rate. Then, when auditing the 1991 year Mr Garty somehow become alerted to the fact that a variable interest rate was not involved and allocation should be made by the Yield to Maturity method. But in his calculations he purported to think that the interest allocated was a charge of interest on the notes and not interest earned on the bond. Perhaps he purported not to know about the bond. As a result he treated the straight line calculations as being an understatement of the bank profits which nicely offset other overstatements on his schedule so that he need take no action. He purported not to have noticed that the BNZ had credited the straight-line interest, not debited it. If the bond and been included as an asset on the balance sheet and not as a deduction from a liability by way of defeasance then the nature of the item requiring the YTM calculation might have been all too obvious and purportation of it being a liability would not have occurred.

Now for a comment or two on the 2004 buy-back deal of Transpower whereby in some respects at least it sold the South Island power grid.

The book value of the assets subject to the buyback and the amount they were "sold" for appears not to have been disclosed in Transpower's 2004 annual accounts, which one would think would be a breach of regulations. The prime other party to the deal is apparently Wachovia Corporation , a large American bank, possibly about the size Enron was. Apparently Wachovia has arranged its affairs so that it has not had to pay income tax for many years. There is nothing really wrong with that but it must be treated with a little more suspicion if it is not normal in that respect. In particular if this bank got into financial difficulties it might be given less opportunities to recover than other banks would get because of a perception that it is not a good corporate citizen. Presumably it does good things for its country in being able to avoid tax but the public might not appreciate this.

Transpower would seem to see the $40m it stands to receive as being money for jam. But it is not all that much on the scale of the South Island grid. Presumably the proceeds of the "sale" have been invested on Transpower's behalf and the proceeds will be used for the eventual buy-back phase which will complete the buy-back. The security of this investment is obviously critical. Again we would contend that the security of any such investment is less than that of the South Island electricity grid and that is the probable reason for the payment.

Exploiting a tax loophole seems to be a justifiable activities these days and would seem to be the only justifiable reason for this buyback. Otherwise the "if it sounds too good to be true it probably is" maxim as constantly espoused by the Securities Commission would apply. In the 1970s the NZ Society of Accountants proclaimed that exploiting tax loopholes was unethical. Whether that was officially withdrawn we are unsure but it does not seem to apply now. We are not convinced that anyone involved in this controversy has verified that an American tax loophole which would justify this payment actually exists. Someone said that when the buy-back was for a long period of time the temporary owner of such assets was allowed to claim depreciation on them for tax purposes. Given that the taxpayer does not have to actually bear the depreciation that is hard to believe, and if the deal is for a long time that means greater risk for Transpower and also means the grid is not available to secure other borrowing such as for the new lines into Auckland.

In general the tax loophole theory is quite vague. The newspaper The Press has had a reporter in the USA investigating the matter. He interviewed an apparent expert on the buybacks who said that the loophole was now closed but the Transpower deal had got through just in time. Again just what proclamation of the tax authority closed the loophole seems unclear. It seems that if people seem to be on the warpath it is best that the alleged loophole be said to be closed. It might invoke the attitude "its all in the past now so lets give it a miss" by the investigators. A "new variation" can be discretely opened up at a later time. One is reminded of the classic statement of the above mentioned Elizabeth Hickey to the Securities Commission in 1993 concerning the acceptability of the zero coupon bond masked as an insurance policy "I believe that this alternative was an accaptable alternative in 1988, I believe it was still an acceptable alternative in 1990 but I believe the people looking at the transaction now in 1993 would not regard the matching as an acceptable alternative and the reason I say this is because of those two papers, the UK paper and the US paper in September and December of 1991 which deal specifically with the transaction as opposed to the references ... made to FAS 5 and FAS 97..."

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