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Interesting Example of how the bubble bursts

Here’s a very interesting anecdote that describes how an ‘asset bubble’
builds up and what are its consequences.

Read it even if it confuses you a bit…things will be clear as you reach the end….

ANECDOTE –

Once there was a little island country. The land of this country was the
tiny island itself. The total money in circulation was 2 dollar as there
were only two pieces of 1 dollar coins circulating around.

1) There were 3 citizens living on this island country. A owned the land. B
and C each owned 1 dollar.

2) B decided to purchase the land from A for 1 dollar. So, A and C now each
own 1 dollar while B owned a piece of land that is worth 1 dollar.

The net asset of the country = 3 dollar.

3) C thought that since there is only one piece of land in the country and
land is non produceable asset, its value must definitely go up. So, he
borrowed 1 dollar from A and together with his own 1 dollar, he bought the
land from B for 2 dollar.

A has a loan to C of 1 dollar, so his net asset is 1 dollar.

B sold his land and got 2 dollar, so his net asset is 2 dollar.

C owned the piece of land worth 2 dollar but with his 1 dollar debt to A,
his net asset is 1 dollar.

The net asset of the country = 4 dollar.

4) A saw that the land he once owned has risen in value. He regretted
selling it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollar
from B and and acquired the land back from C for 3 dollar. The payment is by
2 dollar cash (which he borrowed) and cancellation of the 1 dollar loan to
C.
As a result, A now owned a piece of land that is worth 3 dollar. But since
he owed B 2 dollar, his net asset is 1 dollar.

B loaned 2 dollar to A. So his net asset is 2 dollar.

C now has the 2 coins. His net asset is also 2 dollar.

The net asset of the country = 5 dollar. A bubble is building up.

(5) B saw that the value of land kept rising. He also wanted to own the
land. So he bought the land from A for 4 dollar. The payment is by borrowing
2 dollar from C and cancellation of his 2 dollar loan to A.

As a result, A has got his debt cleared and he got the 2 coins. His net
asset is 2 dollar.

B owned a piece of land that is worth 4 dollar but since he has a debt of 2
dollar with C, his net Asset is 2 dollar.

C loaned 2 dollar to B, so his net asset is 2 dollar.

The net asset of the country = 6 dollar. Even though, the country has only
one piece of land and 2 Dollar in circulation.

(6) Everybody has made money and everybody felt happy and prosperous.

(7) One day an evil wind blowed. An evil thought came to C’s mind. ‘Hey,
what if the land price stop going up, how could B repay my loan. There is
only 2 dollar in circulation, I think after all the land that B owns is
worth at most 1 dollar only.’

A also thought the same.

(8) Nobody wanted to buy land anymore. In the end, A owns the 2 dollar
coins, his net asset is 2 dollar. B owed C 2 dollar and the land he owned
which he thought worth 4 dollar is now 1 dollar. His net asset become -1
dollar.

C has a loan of 2 dollar to B. But it is a bad debt. Although his net asset
is still 2 dollar, his Heart is palpitating.

The net asset of the country = 3 dollar again.

Who has stolen the 3 dollar from the country ?
Of course, before the bubble burst B thought his land worth 4 dollar.
Actually, right before the collapse, the net asset of the country was 6
dollar in paper. his net asset is still 2 dollar, his heart is palpitating.

The net asset of the country = 3 dollar again.

(9) B had no choice but to declare bankruptcy. C as to relinquish his 2
dollar bad debt to B but in return he acquired the land which is worth 1
dollar now.

A owns the 2 coins, his net asset is 2 dollar. B is bankrupt, his net asset
is 0 dollar. ( B lost everything ) C got no choice but end up with a land
worth only 1 dollar (C lost one dollar) The net asset of the country = 3
dollar.

************ ****End of the story******* ********* ********* **

There is however a redistribution of wealth.

A is the winner, B is the loser, C is lucky that he is spared.

A few points worth noting –

(1) When a bubble is building up, the debt of individual in a country to one
another is also building up.

(2) This story of the island is a close system whereby there is no other
country and hence no foreign debt. The worth of the asset can only be
calculated using the island’s own currency. Hence, there is no net loss.

(3) An overdamped system is assumed when the bubble burst, meaning the
land’s value did not go down to below 1 dollar.

(4) When the bubble burst, the fellow with cash is the winner. The fellows
having the land or extending loan to others are the loser. The asset could
shrink or in worst case, they go bankrupt.

(5) If there is another citizen D either holding a dollar or another piece
of land but refrain to take part in the game. At the end of the day, he will
neither win nor lose. But he will see the value of his money or land go up
and down like a see saw.

(6) When the bubble was in the growing phase, everybody made money.

(7) If you are smart and know that you are living in a growing bubble, it is
worthwhile to borrow money (like A ) and take part in the game. But you must
know when you should change everything back to cash.

(8) Instead of land, the above applies to stocks as well.

(9) The actual worth of land or stocks depend largely on psychology.

(10) If the world market values petrol at USD140 a barrel today and later values it USD 100 some few months / years later (when electric cars alternate fuel automobiles come into play?) – there is surely some bubble that is going to burst!

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Global Meltdown

 

Date : Wednesday, October 08, 2008

As I write this, I am witnessing the most amazing collapse of the global markets with the indices across the globe coming crashing down.

Let us have a look at the developments that have taken place in the last 24 hours:

1.      Global Central Banks lower rates by 50 basis points.

2.      FED, ECB, BoE, Central Bank of China lowered their rates by 50 basis points.

3.      India had taken this step yesterday itself

4.      Global growth estimates for 2009 cut to 3% as against 3.9% projected earlier

5.      India growth estimates lowered to 6.9% as against 8% projected earlier

6.      Indian Market closes 700 points down breaks 11000 barrier

7.      Dow opens 200 points lower; European markets also down.

8.      IMF has clearly indicated that developed economies are either in or are entering a recession.

9.      IMF – Global outlook subject to considerable downside risks

10. UK banks have kept $50bn on call should the banks need them

11. UK feels that 50bn is not enough but is enough to keep UK out of recession.

 

The above developments clearly indicate the fact that the market is firmly in a vice like bear grip and it would take more than rate cuts to revive the markets. The market is now driven by fear psychosis coupled with dried up liquidity. It is now only a matter of time that panic sets in and people troop in herds to sell their stock as if there will be no tomorrow.

 

IMF’s view that most developed economies are either in or entering a recession phase is not very inaccurate. I fully endorse the view – and the worst is yet to come. Amidst the brohua of the stock markets no one is really paying any attention to the real estate and the credit cards segment – I think the next downward wave would come from these two sectors. Even the IT sector would witness some major downsizing. Recession in Europe and US is definitely going to impact the topline and the bottomline of the infotech company.

 

I have always been forecasting a global meltdown – particularly in the financial sector. The financial sector has been in a fragile zone for quite some time now and it was only natural that a small push in a pressure point would result in the whole market come tumbling down. This push has now come in the form of collapse of Lehman brothers which set off a series of chain reaction having impact across markets.

 

I have always been against the BPO culture and now more so. With a global recession in the offing the BPO segment is likely to witness a shakeout and the impact of this shakeout will leave a huge and ugly wound on the employment market and this would is going to take one helluva time to heal. We are going to be stranded with thousands of telephone operators with no specific professional or technical skill.

 

Like Shahrukh said in Om Shanti Om – “Jao mat dost – show abhi baaki hai” – The fun has just begun – so sit back, relax and don’t touch the remote (and more importantly don’t touch any stocks).

So much for E&Y professionalism

Read this article – looks interesting:

Accounting for the auditors Prem Sikka 

In the current financial turmoil, companies are falling like ninepins. 
Lehman Brothers is in administration. Northern Rock, Fannie Mae and 
Freddie Mac have been bailed out and the list of vulnerable banks is 
growing. Bear Stearns and Merrill Lynch have been sold at knockdown 
prices and HBOS has merged with Lloyds TSB. Governments are pouring vast 
amounts of money to bail out financial institutions. Amidst the mayhem, 
we need to ask questions about the role of auditors, who have been paid 
millions of pounds to give opinions on company financial statements. Yet 
companies are sinking within weeks of getting a clean bill of health. 

Ever since the 1998 collapse of Long Term Capital Management (LTCM) and 
its rescue by the US Federal Reserve, it has been acknowledged that 
derivatives are very difficult to value. In this case Nobel prize 
winners in economics could not work out the value of such financial 
instruments. Derivatives are central to the demise of Lehman. Its annual 
accounts mention derivatives contracts with a face value of $738bn and 
fair value of $36.8bn. 

Lehman Brothers, incorporated in the tax haven of Delaware, was audited 
by the New York office of Ernst & Young. On January 28 2008, the firm 
gave a clean bill of health to Lehman accounts for the year to November 
30 2007. The auditor’s report (page 75 of the accounts) says, “Our audit 
included obtaining an understanding of internal control over financial 
reporting, assessing the risk that a material weakness exists, testing 
and evaluating the design and operating effectiveness of internal 
control based on the assessed risk, and performing such other procedures 
as we considered necessary in the circumstances”. Lehman Brothers filed 
quarterly accounts with the SEC for the period of May 31 2008 and on 
July 10 2008 and these (see page 52) too received a clean bill of 
health. Despite the deepening financial crisis, auditors did not express 
any reservations about the value of the derivatives or any scenarios 
under which company may be unable to honour its obligations. Just two 
months later, Lehman collapsed. 

During 2007, Ernst & Young collected fees (see page 43) of $31,307,000 
from Lehman Brothers, compared to $29,451,000 for 2006. The fees for 
2005 and 2004 were $25,324,000 and $24,748,000 respectively. Over the 
last four years, Ernst & Young collected over $110m in fees, of which 
nearly $14m is for advice on tax and other consultancy services. 

The scale of fees raises questions about auditor independence. By 
providing other services auditors begin to perform quasi management 
functions and cannot objectively evaluate the outcome of the 
transactions they themselves have helped to create. The fee of $110m for 
the New York office of Ernst & Young is likely to be significant in 
influencing the financial rewards of local partners and managers. The 
fee dependency exerts pressure on auditors to acquiesce with management. 
Such concerns were raised during the demise of WorldCom, Maxwell, Enron 
and more recently in the insolvency examiner’s report on the collapse of 
New Century. 

Audit opinions are akin to financial mirages. In recent weeks, within a 
short period of receiving clean bills of health Bear Stearns, Carlyle 
Capital Corporation and Thornburg Mortgage hit the financial buffers, 
closely followed by Lehman Brothers. 

Time and time again it has been shown that the basic audit model is 
faulty. Private sector auditors cannot be independent of the companies 
that they audit. This fundamental faultline has not been addressed by 
the post Enron reforms. In addition, the ex-post financial audits are 
too late and cannot alert financial regulators of problems. The 
financial regulators have a wider remit and are also concerned with the 
financial health of the whole system. These shortcomings were recognised 
after the 1929 stock market crash. The draft legislation that created 
the SEC in the 1930s contained a provision making the SEC the auditor 
for public companies, but under pressure from corporate interests, 
legislation was diluted. 

It is time to go back to the future and ensure that audits of major 
companies, at least banks and financial institutions, are carried out 
directly by the regulators. These audits should be on a real-time basis. 
Audits by regulators have the advantage of independence and can address 
regulatory issues. Accounting firms and companies used to softer audits 
will no doubt fight tooth-and-nail to retain their privileges, but we 
can’t continue to indulge accounting firms and pay billions to rescue 
banks. guardian.co.uk ) Guardian News and Media Limited 2008

Another Scheme change by ICAI

Hi all,

The following article has appeared in The Hindu and authored by Sivakumar which I am reproducing here which says that the Institute vide its notification dated September 1, 2008 has again changed the scheme of articleship training – I am not too sure about the detailed working of the scheme as I am not able to locate the notification in the ICAI site. I am anyway reproducing the article for whatever it is worth:

Accounting technicians in ICAI’s new scheme 

R. Sivakumar

The entry requirements for articleship training in the chartered accountancy course were not tinkered with from 1949 to 1992 (except for a few years). This was mainly because the articleship was open only to graduates.

In 1992, the Foundation course was introduced which saw many talented youngsters successfully completing the chartered accountancy course.

However, many of the firms had their own reservations about the maturity of the entrants. To address this as well as the uniformity of the entrants, the ICAI, in 2002, decided to allow articleship only for students passing the PE-II course.

This decision of the ICAI frustrated both the entrants as well as chartered accountant firms, as the course got automatically extended to at least five years and firms suffered for want of entrants. Following another review in 2006, the course was thrown open to the students passing the CPT exam along with Plus 2.

The outcome is that today more than a lakh of students have successfully completed the CPT, but the main problem is that many of them are not able to do their graduation and some are unable to obtain articleship. In fact, some of them have been doing the so-called ‘dummy’ articleship.

The IPCC  

The ICAI has now proposed to amend the regulations (Notification dated September 1, 2008) so that henceforth to do articleship the candidate has to pass both the CPT and Group I of the proposed Integrated Professional Competence Course (IPCC) .

This course has three levels — Group I, Accounting Technician (optional) and Group II. A candidate enrolled for the IPCC shall be eligible to three years articleship on passing the Group I or Accounting Technician level.

The regulation is silent about the number of papers and the details of the syllabus of these Groups and that of Accounting Technician course.

A reading of the regulation indicates that it is nothing but a throw back to the erstwhile Foundation or PE-I examination. Quite ironically the regulation has been notified along with the proposed Accounting Technician course but a candidate passing Group II of the proposed IPCC course is not permitted to register for articleship.

The articleship period in effect is reduced to three years but the minimum time for completing the course will be four years as against the existing three-and-a-half years.

Destabilising effect 

As early as 1959, the stalwarts of the profession had clearly foreseen that the chartered accountancy course would be more apt and suitable for graduates as they would have the required aptitude and maturity.

Compared to the initial four decades, wherein much changes were not effected, the ICAI has been changing the curriculum quite often in the last two decades, more so in the last decade.

These changes have a destabilising effect on the profession.

There is no point in trying to unnecessarily compare the profession with that of engineering, medicine, and so on.

The problem lies more clearly on the overall structure of the profession with specific reference to practicalities, methodology of the examination and evaluation. It is time the ICAI looked into these aspects.

More confusion and More chaos for the students – Enjoy !!!! – Srinivasan

Lehman collapses – AIG on the way

Lehman Bros folds up like a pack of cards

Humpty Dumpty sat on a Wall

Humpty dumpty had a great fall,

All the Kings horses and all the Kings men

Couldn’t put Humpty together again”

Well, Well, Well… all is not well on the investment banking side isnt it? Lehman bro has folded up, AIG is extending the begging bowl to the FED,  Goldman Sach’s scrip prices is scraping the bottom with its Q3 results diving down by 70%. This comes as no surprise to me for I had predicted this as early as March 08  in this blog referring to the fact that DBS Singapore had already informed its traders to curtail positions with Lehman Bros. I once again tell the young (wet behind the ears) professional who thought getting a job in one of these firms was the ultimate nirvana – welcome to the real world where everything that glitters is not gold. These professionals who have taken huge loans to fund their fancy cars and fancy apartments are now on the streets and their bargaining power has reduced substantially. (Incidentally Lehman Bro has already handed over the pink slips to its employees in Mumbai – Refer today’s economic times where it says that employees of their worli office have been told to pack their belongings). RBI has already barred Lehman’s Indian arm from remitting money to its parent – same action has been taken by Japan too. Another banking group that i am extremely bearish is on is ICICI (yes our own ICICI) – the kind of hits they have been taking on their balance sheet is not funny. In the last episode where the banks locked horns with their customer on FX derivative losses – it was the bank which took the largest hit .. and now with Lehman Bro folding up it is estimated that it will have to take a $28 mn hit (Source ET – today instant).

Another sector that will face turbulent times ahead is the BPO / KPO sector. These sectors have a direct corelation with the wellbeing of their so called big principals. Lehman Bro collapse is reportedly cost 2200 BPO employees their jobs. With downsizing a reality in the US BPO / KPO employees are also likely to feel the heat – like I have been saying always – we will be left with thousands of telephone operators – who dont have any additional skillset or degrees – coz these foolish youngsters made the cardinal sin of giving up their education for the lure of immediate money that these BPO’s offered – Well guys – time to pay up for your sins !!!!

Rupee Dollar Action:

Rupee has been battered to 47 to a $ (it was Rs.44.5 to a $ on Sept 9th) . Overnight call money rate has shot upto 16% (this was ruling in the band of 6-8% for over a year now). So the RBI is stepping in to supply rupees to lower the banks rupee borrowing cost. RBI has increased the interest rates on NRI deposits by 50 basis points – this will have the impact of attracting more dollar deposits and thereby increasing the dollar supply. The RBI has also stated in a release that it will sell dollars to meet any demand supply gap – so the target of RBI seems to be to increase dollar supply and easy out the call markets.

Borrowing on Repos:

Normally the banks can borrow from RBI against securities by pledging its securities only if it has securities in excess of 25% of net deposits. However now RBI has allowed banks to borrow against securities even if their holdings is just 25% (upto a maximum of 1%) .. which means banks holding just 25% SLR can use 1% of the same to borrow in repos .. this will result in their SLR coming down to 24%. RBI has clarified that it will not charge any penalty for the SLR slipping below 25%. This move will prompt banks to borrow more from RBI thereby easing pressure on the call markets.

Over and above this banks can now borrow twice a day from RBI’s repo window @ 9%.

Conclusion:

Interesting (though not pleasant for those in the financial services sector) times ahead … It would be very interesting to watch RBI’s move to combat inflation, Re/$ pressure and interest rates. Keepwatching this space for more…. 

Post Script: It is rumored that Warren Buffet has refused to bail out Lehman Bros.

Some relevant tax issues

For assessment of income, a notice is issued seeking the taxpayer to produce
the necessary details for examination of the statements filed and income
admitted by him. Technically, a notice must be served on the taxpayer as if it
were a summons issued by a court under the Code of Civil Procedure, 1908.

In CIT vs Inderpal Malhotra (171 Taxman 359) a notice under Section
143 (2) was issued by means of registered post on the last day of the period of
limitation. The law says that the notice under Section 143(2) is required to be
served within 12 months from the end of the month in which the return was filed.
The court held that the statute has used the word ‘served’ in Section 143(2)
and, hence, mere dispatch or issue of notice before the prescribed time is not
sufficient compliance of the legal requirement.

Accordingly, the notice dispatched by registered post on the last of the
limitation time was held as inadequate for seeking compliance from the assessee
and, hence, the decision went in the assessee’s favour.

Tribunal subordinate to HC

In the hierarchy of appellate authorities, the Tribunal is the final
fact-finding authority. However, in respect of questions of law, both the
taxpayer and the Revenue can transverse beyond the Tribunal, to the High Court
and thereafter to the Supreme Court.

In National Textile Corporation Ltd vs CIT (171 Taxman 339), it was
observed by the court that the tribunal is subordinate to the High Court and
hence has to follow the decision of the jurisdictional High Court without making
any comment on the said decision or ignoring it on any grounds except those
which are well-recognised. It referred to a catena of cases in which there have
been deviations from binding decisions of superior authority and held that the
tribunal cannot ignore the decision of the jurisdictional High Court and give a
contrary decision.

Modvat credit

Where the taxpayer acquires a plant and machinery and pays excise duty on
such acquisition, he can claim credit in respect of such duty against duty
payable on goods manufactured by him. Whether the duty credit, which is eligible
for such adjustment, is chargeable to tax as income was the issue in CIT vs
Jay Bee Industries (171 Taxman 386)
.

The court held that merely because the Modvat credit is irreversible would
not mean that it is an income to be taxed. Following the precedent of the apex
court in the CIT vs Indo Nippon Chemicals Co Ltd (130 Taxman 179) case,
it held that the Modvat credit eligible for adjustment against duty payable is
not chargeable as income.

Estimate of stock on survey

During the course of survey by the income-tax authorities, the value of stock
in the premises surveyed is compared with the books of account to detect and tax
the unaccounted stocks as income. Such stock valuation is a matter of conjecture
in most of the cases.

Whether such stock valuation might result in concealment penalty is to be
decided based on facts. In SSR Pirodia vs Union of India (171 Taxman
221)
the addition towards excess value of stock found at the time of survey
was sustained but the concealment penalty was set aside by the tribunal as the
addition to income was made on the basis of mere estimate. The further
consequence of prosecution was quashed by the court in view of relief from
concealment penalty granted by the tribunal.

Forfeiture of exemption

Where a charitable trust advances or allows its funds to remain with an
interested person without security or adequate interest, then such trust is not
eligible for exemption contained in Sections 11 and 12 of the Act.

In Kanahya Lal Punj Charitable Trust vs DIT (171 Taxman 134), the assessee
gave advance to a company which had substantial interest in the trust. It was
stated that the advance was towards purchase of land for a school project of the
trust.

The plea of the assessee was taken as an after-thought and the court held
that the income of the trust has been used to the benefit of a person referred
to in Section 13(3) which is one of the disqualifying acts contained in Section
13(1).

Accordingly, the benefit of exemption had to be cancelled to the trust. It
held that the disqualification under Section 13(1)(c) would result in taxation
of entire income of the trust, including voluntary contributions and income from
property held under trust. Such disqualification would saddle the trust to pay
tax on its total income without any exclusion.

However, if the trust for example, does not keep its unspent income in the
approved investments as enumerated in Section 11(5), then only income from such
investments would be subjected to maximum marginal rate of tax and the other
incomes would continue to enjoy the benefit of exemption contained in Sections
11 and 12.

Enhancement of income in appeal

The Commissioner (Appeals) can confirm, reduce, enhance or annul an
assessment order of the AO. The power to enhance the income liable to tax is to
be exercised only after providing an opportunity of hearing to the taxpayer.
However, there is no embargo in sourcing information from the AO while enhancing
the income in an appeal proceeding. It was so held in Goel Die Cast Ltd vs CIT
(171 Taxman 272).

The above has appeared in Hindu and authored by Mr.L.K.Subramani
(The author is an Erode-based chartered
accountant.)

Currency trading launched in India

More than 300 members will be eligible to participate in currency
futures trading on the National Stock Exchange of India on Friday, when
the facility gets flagged off by the Union Finance Minister, Mr P.
Chidambaram, said a top NSE official.

In order to encourage active participation in the Currency
Derivatives segment, the NSE has decided that no transaction charges
will be levied on the trades done in this segment on the exchange from
August 29 till September 30.

However, every trading member participating in currency derivatives
during the above period shall be required to make a lump-sum
contribution of Rs 500 towards an Investor Protection Fund, says an NSE
circular.

Currency futures are standardised foreign exchange contracts traded
on a recognised stock exchange to buy or sell one currency against
another on a specified future date, at a price specified on the
purchase or sale date.

Only US dollar-Indian rupee contracts would be allowed. The contract
size will be of 1,000 US dollars and the tick size (minimum price
fluctuation) will be 0.25 paise.

The prices in currency derivatives segment shall be displayed,
traded and reported up to the fourth decimal place instead of up to
two. For example, Rs 42.50 shall be displayed as Rs 42.5000.


OTC contracts

The trade in currency futures will co-exist with the already
prevalent OTC market for forwards, where the banks and corporates have
been hedging their foreign currency risks so far. The OTC market has an
average daily volume of $34 billion, said the NSE. Unlike OTC contracts
that are bilateral, the exchange-traded currency futures contracts will
be transparent.

Banks are also allowed to become members of the exchange to
participate in currency futures trade. All resident Indians are allowed
to participate in currency futures, only NRIs and FIIs are not eligible
to trade.

All Group 1 securities, bank guarantees, receipts of fixed deposits
will be allowed as collaterals for the margins required to be deposited
by the investors trading in currency futures.


Admission open for Nov ‘2010 exams

Admissions have already opened for Nov 2010 exams. We offer only 45 seats for a batch and admissions have already started filling up with only 10 seats remaining

Batch for May 2010

Classes scheduled to start from February 2009 for May 2010
November 2017
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