Master of ceremonies
Ladies and gentlemen
Thank you for inviting me to address you this evening as we witness the changing of the guard. This is a truly wonderful occasion focused on two outstanding individuals. Outgoing president Ignatius Sehoole has served South African Institute of Chartered Accountants (SAICA), the profession and South Africa with distinction. His passion for the profession saw many of us cajoled into bringing issues to the fore, whether for Thuthuka or International Federation of Accountants (IFAC) or just a mere consultation on the issues of SAICA. I suspect this will not be the last I hear from him and you should probably expect the same. I wish to express my sincere appreciation to him for his dedication, consistency and of course, his passion.
Let me also take this opportunity to welcome the new President, Matsobane Matlwa. As you are no doubt aware, I have had the privilege of working with Mr Matlwa at close quarters during his tenure at South African Revenue Service (SARS). It was a clever decision to have “stolen” him from SARS and SAICA is indeed fortunate to have him at the helm. I am however worried that you have converted the “gamekeeper” into being the President of the poachers association. I know that he will serve this institution with dedication and commitment.
I do not often get invited to these grand occasions. In fact, the last time I had the privilege of addressing this forum was almost exactly seven years ago. The world then was still reeling from the 11 September attacks. Moreover, the accounting profession was under severe pressure, with tough questions being asked about the role of auditors in spectacular corporate collapses such as Enron and Worldcom in the United States and the billions of dollars that needed to be written off from Gazprom in Russia. This, of course, led to the demise of Arthur Andersen. But the real pressure was around what the auditors saw and did and whether they provided the necessary comfort to shareholders. None of the large firms were spared this huge embarrassment.
We also took stock of our own situation. Seven years ago I asked this forum to consider ten tough questions whose replies would impact on the future of this profession. It is not necessary to restate those questions here, suffice to say that it is worth referring back to them occasionally. I also invited the institute to join the Ministry of Finance in setting up a task team to explore these matters. The Auditing Professions Act was consequently developed and passed and the Independent Regulatory Board for Auditors (IRBA) was born. So, how much else has changed?
The world is a very different place today. And within this, let nobody say that accounting is a dull profession. The past eighteen months have catapulted the profession onto centre stage once again. It has been a period of great turmoil for anyone involved in the financial services industry. A United States Treasury official was caught off-guard when he revealed that “regulators live for crises like these, it sure beats ticking boxes.” I am not so sure about that. I have certainly lost some sleep and so have many of you. Nevertheless, it is certainly one of the most intellectually stimulating times to be a policymaker, a regulator or even an armchair observer of the world.
Let us pause for a moment and reflect on economic developments since 2002. The commodity super-cycle saw oil prices increase 625 percent from below US $20 to a peak of US $147 per barrel. Gold increased by 273 percent, peaking above US $1 000 per ounce and platinum reached US $ 2251 per ounce, a rise of 377 percent.
According to the International Monetary Fund (IMF), food prices more than doubled and metals increased by 562%. Global growth averaged an unprecedented 4,65% annually between 2003 and 2007 and global inflation averaged 3,7% over the same period. Many emerging economies, including South Africa, posted a fiscal surplus. The good news just kept getting better. United State (US) house prices increased 71% between 2002 and 2006, and doubled in the United Kingdom (UK) over the same period. Cheap money, easy credit and low interest rates resulted in mortgage lending being extended to what has been referred to as “ninja” borrowers no income, no job or assets. Over a trillion dollars was channelled into the US sub-prime market. This was followed by a host of complex financial instruments entering the global market, which polluted much of the financial system.
Crises like these have a way of focusing the mind. It has made us question our beliefs about how economies work, and re-examine the principles underlying the way we do business. The accounting profession has not been spared in this regard; you may remember that it was not too long ago that the blame for the entire financial crisis was (quite unfairly) apportioned to the accounting profession, over the technical intricacies of mark to market accounting.
The crisis in brief
Columnist Matthew Lynn offers an interesting analysis of the crisis (Business Report, 21 May 2009). He writes:
“The crisis that has rolled through the global economy has plenty of causes, many of them hard to understand. The bonus system in banks played a part. So did the way central banks ran monetary policy and rating agencies measured risk. The trade imbalance between China and the rest of the world and the vast quantities of capital that had to be recycled as a result may have been the root of the problem. Lap dancers and cocaine dealers did not really have much to do with it, even if they are more fun to read about. That matters. It is important to get the facts right about the credit crunch because if we don’t, we will all end up making the same mistakes all over again.”
The genesis of the current crisis lies in the long period that we now refer to as “the nice” the Non-Inflationary Continuous Expansion. Globally, it lasted from roughly the beginning of 2002 to the end of 2007. This period of rapid expansion of the global economy was primarily driven by sustained inflows of capital from the developing world into the developed world. South Africa has experienced a slightly longer Non-Inflationary Continuous Expansion (NICE); we have grown consistently since 1998, with the first relatively mild downturn experienced late last year.
Over time, structural imbalances emerged, warning us that this could not last forever. At the peak of the boom in 2007, China was running a current account surplus equal to US$371,8 billion, or over 11 percent of its Gross Domestic Products (GDP), rising to US$426,1 billion in 2008. This surplus was almost entirely due to the insatiable appetite of consumers in developed countries, particularly the United States. Nothing seemed to slow their appetite for more goods, more food, more toys or more widgets. In 2007 alone, the United States imported approximately $321,5 billion in products in 2007 from China and exported only $65,2 billion to the country.
The current account surpluses in China and other emerging markets created a global glut of capital, which allowed an environment of artificially low interest rates, leading to overly cheap money. When something is too cheap and too easy to obtain, you very quickly forget what it is worth and as a consequence of this cheap money, financial institutions mis-priced risk. This allowed rapid credit extension to risky, sub-prime households. Another related consequence was the sharp rise in the value of assets, as more and more capital chased fewer and fewer investment goods.
Many attempted to fool themselves into believing that this boom was different and could last forever. It was a “structural shift”, brought about due to the industrialisation of China and the development of innovative financial instruments, which could spread risk in a way that would benefit everyone.
This time was not different. It never is different. The NICE boom could not be sustained. The stress first emerged in the banking sector, banks discovered that they had lent this cheap money to people that could not repay it, even at very low interest rates. They thought they had cleverly evaded this problem by securitising this debt; but we all know that the bankers discovered that they had not been quite as clever as they thought. This house of cards, built on dodgy securitised assets with strange sounding names, very soon collapsed. Within months, we were staring down the barrel of a global financial crisis.
There are many pieces of this puzzle, telling us there is still more to come. A report released in March this year, entitled “sold out, how Wall Street and Washington Betrayed America” details how the financial sector spent more than US $5 billion on political influence. The 231 page report show that from 1998 to 2008, Wall Street investment firms, commercial banks, hedge funds, real estate companies and insurance conglomerates made US $1,7 billion in political contributions and spent a further US $3,4 billion on lobbyists aimed at undercutting federal regulation. The report documents in detail twelve deregulatory steps that together led to the financial meltdown. From 1998 to 2008, accounting firms spent US $68 million on campaign contributions and US $ 115 million on lobbying.
We are only now beginning to understand the complexity of what happened in the past 18 months. We understand that regulatory failure was a common denominator. We need to act swiftly to correct the weaknesses in our overall regulatory system, strengthen our economies, and try our very best to get out of the downturn as quickly as possible.
Implications for the accounting profession
I have been fortunate enough to participate in many of the debates and discussions that have taken place in many forums the future of capitalism series in the Financial Times, our Cabinet meetings, the G20 meetings of finance ministers and central bank governors and of course, my dinner table.
I would like to share with you what those discussions and debates have yielded for all of us, but in particular for those of you involved in the accounting profession.
Firstly, we have learnt that the world needs good regulations and good regulators. The period of deregulation has come to an end. No longer can we rely on enlightened self-interest to regulate global markets.
Of course, we should be careful not to shift to the other extreme, where we tie up companies in so much regulation that they can barely function perhaps the Sarbanes-Oxley Act of July 2002 appeared to introduce such strictures. But clearly we do need what President Barack Obama has called “supervision by the grown-ups.”
This re-affirms the need in this world for the professional auditor. Just when we thought that auditors were dull, unnecessary, and simply a hindrance, we have discovered the crucial role that your profession must and should play in our global economy. In my 2002 address, I questioned the fact that we rely almost entirely on self-regulation in the accounting profession. Attempts to toughen accounting and ethical standards do not easily win acceptance; industry groups very easily lobby for rules that protect them and help them appear more profitable. SAICA should fight against such efforts. The integrity of the auditing profession and the Chartered Accountants South Africa designation relies on your ability to check the accounts of firms independently.
I am reminded of Alan Greenspan’s testimony on the financial crisis last year in October, when he said “those of us, who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself especially, are in a state of shocked disbelief.”
Perhaps we were naïve to think that bankers were only interested in the common good. To our shocked disbelief, we have discovered that the average big company (or say the average global multinational bank) is quite happy to play at hocus-pocus accounting, creating off-balance sheet vehicles to hide odious losses, artificially boosting revenues through selectively and inappropriately applying the rules of valuation, and massaging the treatment of derivatives.
Let us look at each of these issues separately:
- Off-balance sheet vehicles: On Monday this week, the Federal Accounting Standards Board in the United States voted unanimously to change the rules regarding the treatment of off-balance sheet Special Purpose Vehicles. The idea is to ensure that companies bring back onto their balance sheets any entity in which they hold an interest that gives them “control over the most significant activities.” Shareholders, investors and regulators would all welcome improvements to the accounting of off-balance sheet items. The very term “off-balance sheet” suggests that firms wish to hide assets or liabilities.
- Fair-value accounting: I could not do justice to the topic of fair-value accounting in a ten-day workshop, let alone in a dinner speech such as this. But, I am a little alarmed that we seem to be moving in the wrong direction. Currently there is much talk about allowing companies to use “significant judgment” in valuing both assets and impaired investments. We need to go back to basics and rethink how we derive the value of assets on a company’s balance sheet in a way that is consistent, fair and reliable.
- Treatment of derivatives: I wish I understood the Intergovernmental Fiscal Relations System (IFRS) statements relating to the valuation of derivatives. I am sure there are some highly paid specialists in this room that do. But one thing we have realised is that derivatives have the ability to collapse entire firms. Globally and locally, we clearly need a little bit more light on this somewhat obscure area of accounting.
Conclusion
I am railing against the failure of the global economic system, when we in South Africa have missed the worst of the crisis. This is in no small measure due to organisations such as SAICA. It was somewhat heartening to sit in the G20 discussions. One of the key recommendations flowing out of the technical committee is that G20 countries should move swiftly ahead to adopt IFRS and Basel II. Of course, SAICA facilitated that process long ago, particularly on IFRS. I felt quite proud that such a complex process was handled with a minimum of fuss. Well, it seemed like a minimum of fuss from the outside, I am sure that adopting IFRS was not the easiest task for the people here.
It is against this background that I urge the South African Institute to continue engaging with your colleagues at a global level to ensure that our country remains at the cutting edge of reforms to accounting standards. We have been presented with a unique opportunity as a country to participate in shaping the future.
I urge you also to continue with your efforts to maintain the highest standards for the profession in this country. The global financial crisis has indeed shown us how important regulation, oversight and accountability are in an economy.
Let me share a few thoughts with you.
- Firstly, the overstatement of earnings was what led to the South Sea Bubble the world’s first “Enron type scam” in around 1715. This same scam is still being used repeatedly do consider why auditors keep falling for it.
- Secondly, some scams, like the $ 1Billion at the Indian software company discovered in January this year, are so unbelievably crude heaven only knows what the auditors looked for or why they did not bother to call the bank to verify the deposits. Unfortunately, these auditors were senior partners in one of the big four audit houses.
- Thirdly, there is now a much higher level of collaboration between states through the G20 and other forums. Tax havens can no longer offer a hiding place and the cross-border fancy tax evasion schemes will be very soon be uncovered. Too many countries are debt strapped now and need to maximise revenues. So, play by the rules and we will all be better for it.
- Fourthly, if these clever bankers cannot explain to your clients what they’re doing, advise your clients that those bankers probably don’t have the foggiest idea of what they’re talking about. If it sounds too good to be true then it probably is.
I hope that this institute and its members, continues to hold companies accountable to shareholders and outside interest groups, as it clearly is in the interests of all.
I know that I do not get invited to dinner with you often as again this evening, I abuse your hospitality to raise unpleasant issues. So I do not wish to impose, but merely ask to be invited back to share my observations in May of 2016 (after the regulatory seven years) and to reflect on today’s questions.
Thank you.
