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Accounting for the rest of us: Capturing important truths about business organizations

Accounting standard setter and reformer Sir David Tweedie discusses the importance to national economies of global standards of corporate reporting and valuation. He also explains the challenges to having such common standards adopted by individual nation states. Presented by Eric van Bemmel.

“There is a different philosophy if you like between IFRS and U.S. GAAP and that is the question of principles versus rules.  IFRS is 2500 pages, U.S. GAAP is about 17,500, and they go into a lot more detail.“ — Sir David Tweedie




Sir David Tweedie
Sir David Tweedie

Sir David was educated at Edinburgh University (BCom 1966, PhD 1969) and qualified as a Scottish Chartered Accountant in 1972. After teaching at Edinburgh University he became Technical Director of the Institute of Chartered Accountants of Scotland (ICAS) in 1978. In 1982 he was appointed national technical partner of Thomson McLintock & Co and later of KPMG.

In 1990 he became the Chairman of the UK Accounting Standards Board (ASB) and in January 2001 was appointed the first Chairman of the International Accounting Standards Board (IASB). He then led the Board for ten years, retiring in June 2011.

He is a Fellow of the Judge Business School at Cambridge University and a visiting Professor of Accounting in the Management School at Edinburgh University. He has received honorary degrees from nine British Universities.

He was knighted in 1994 and has been presented with a number of awards from the Accounting Profession. He was inducted into the Accounting Hall of Fame in 2013.

Sir David became President of the Institute of Chartered Accountants of Scotland in April 2012 (until April 2013) and Chairman of the International Valuation Standards Council (IVSC) in October 2012.

He chairs the Royal Household Audit Committee for the Sovereign Grant and is also Chairman of the Board of Trustees of the Scottish Charities, Leuchie House and the ICAS Foundation.'

Credits

Presenter: Eric van Bemmel
Producers: Kelvin Param, Eric van Bemmel
Audio Engineers: Gavin Nebauer
Voiceover: Nerissa Hannink
Series Creators: Eric van Bemmel and Kelvin Param

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VOICEOVER

This is Up Close, the research talk show from the University of Melbourne, Australia. 


ERIC VAN BEMMEL

I'm Eric van Bemmel.  Thanks for joining us.  When we think of accounting and accountants, it's easy to fall prey to the stereotyped pop culture imagery of impersonal men in grey suits crunching numbers on behalf of those who do the important and exciting work.  Well, it turns out the research doesn't bear out the stereotypes and the work of accounting at levels big and small involves capturing important truths about organisations and communicating them to the rest of us.  Many of our decisions in the commercial world are underpinned by the work of accountants to generate accurate representations of those parties we transact with, and the accounting industry itself is anything but staid.  There are heated philosophical differences in how to report a firm's financial standing, for example.  There are serious disagreements about what can be defined as an asset or a liability. 

And then there are questions around accounting's role at times of financial crisis, for example the 1997 Asian Financial Crisis, more recently the 2008 Global Financial Crisis, and in signature corporate fraud cases such as the Enron scandal of 2001.  There we saw accounting's dark side.  To tell us where the world of accounting is heading and why we should take note, we're joined on Up Close by world-renowned accounting standards guru and advocate Sir David Tweedie, a household name in the households of accountants, Sir David was for a decade, until 2011, Chairman of the International Accounting Standards Board and is the 90th member of the Accounting Hall of Fame.  In September 2012 he was appointed Chairman of the Board of Trustees of the International Valuation Standards Council.  Sir David Tweedie is in Melbourne as a guest of CPA Australia and the University of Melbourne's Department of Accounting.  Sir David, welcome to Up Close. 


SIR DAVID TWEEDIE

Nice to be here. 


ERIC VAN BEMMEL

Now, David, I've heard it said that accounting is the conscience of the business world.  What does that mean?


SIR DAVID TWEEDIE

Well, the business world operates on capital and if you're going to give capital to a company you want to make sure you're going to get your money back.  You want to make sure it's being looked after properly.  You want to make sure that, is this the company I should invest in or should it be the one next door.  And so what happens is the company has to report on what's going on.  The accountant's job is firstly to do that report on what's going on.  The accountant's job is firstly to do that reporting internally in the company but secondly, the auditor has to look at it and say yes, that's exactly what happened and that's the best we can do as far as the economics are concerned.  If it wasn't for that, the capital markets wouldn't exist. 


ERIC VAN BEMMEL

It's in the interests of the counter party but also in the public interest.


SIR DAVID TWEEDIE

Absolutely in the public interest.  And it was quite interesting, you mentioned Enron in your introduction.  After Enron there were several companies got into trouble and there was a question mark over the auditors.  This was Arthur Andersen sadly and the firm disappeared shortly afterwards.  But it was interesting watching the reaction in the stock market.  Suddenly people thought we can't trust the auditors and the stock market in America just tumbled.  And once the lack of trust is there the capital system is really in trouble because people are reluctant to invest, they don't know if they're going to get their money back, they don't know if people are telling lies in the accounts, they don't think the auditors are checking up properly and that caused a major problem in American accounting.


ERIC VAN BEMMEL

The ones we entrusted to tell us the truth were not telling us the truth in that moment.


SIR DAVID TWEEDIE

That's exactly it.


ERIC VAN BEMMEL

So there's that level of accountability as part of the accounting process.  Now, the role of accounting in the modern day business corporation has a couple of core components here.  There's managerial accounting, which is information - usually internal things like salary costs, profit targets, generally for internal consumption, if I understand.  But then there's financial accounting which is what we're I guess mainly concerned with in this discussion, the information that companies make available to outsiders where they capture important truths about a firm.  Who are those outsiders?


SIR DAVID TWEEDIE

Well, the outsiders are the investors mainly, and that could be the major pension funds, insurance companies, private investors like you and me.  These are the people who give their money up, and they give it in return for dividends, they want to make sure that they are going to get dividends, they want to make sure they're going to get their money back.  So that's the prime side of financial accounting.  Managerial accounting on the other side is where the accountant tries to show what are the best areas to invest in as far as the company is concerned, are they doing the right things?  Let me give you an example. 

When I was a young accountant, even before I qualified, in Glasgow, one of my first jobs in charge was of a little textile company; father and son, ran this company, they made a living - eked a living I should say.  They'd had the same profit, which was pretty low, for years after years after years.  And I went in all bright-eyed and bushy-tailed and did the accounts and suddenly the profit was about seven or eight times more than it had ever been before.  And my first reaction was a sinking feeling, I've got this wrong, and so I checked all the various things that accountants would check, have I got the inventory right, have I made sure I've got all the liabilities and assets there; seemed to have.  And I had to ring the partner up in the firm and say there's something wrong, I don't understand this. 

So we went and investigated the company, and it was very simple, they made two products.  One had a very small margin and the other had a nice big profit on it, but they only made a tiny amount from the one with the big profit.  They ran short of materials for the one with the small margin, they were forced to make the one with the big margin, and they made huge profits.  They thought I was brilliant telling them that, and my reaction was why didn't we tell them that years before?  There was a small company, they had no accountants working for them, but that's what accounting can do.  That transformed these two men's lives. 

And you can actually change companies, you can tell them don't do that, you're doing the wrong thing, but that's where you should be.  So management accounting is more inside, looking for opportunities, telling them the right thing, recording the costs, are you making something that you can't sell at that cost and so on.  So two different functions but ultimately the financial accountant measures the product of what the managerial accountants come out with.


ERIC VAN BEMMEL

In that case you just mentioned, it sounds as though there's almost a strategic planning role for the accountant.


SIR DAVID TWEEDIE

Yes.  In the major companies they have an army of management accountants who are doing that sort of thing.  In the smaller companies, like the two-man business that I've just spoken about, then you often find it's the auditor.  He comes in, he looks at it; he's the only contact they have with accounting.  What he could do, as my firm had done for years, was just tick the books and say yes, that's what happened.  On this particular occasion we went in and said why did that happen, and that's a role the accountants could play - could and should play.  When I was President of the Scottish Institutes of Accountants we were telling the small accountants, just look at your clients; is there something you can do to help them?  Because that actually - the small companies are the engine of growth.  A lot of growth comes from these smaller companies and accountants can do a lot to help that. 


ERIC VAN BEMMEL

Certainly value add. 


SIR DAVID TWEEDIE

Value add. 


ERIC VAN BEMMEL

David, how has accounting changed through history?  I guess I should ask how old it is first of all, but then has it evolved?


SIR DAVID TWEEDIE

Yes.  It goes way back to the Italians at the Renaissance, Pacioli, 14th, 15th centuries.  He developed - the insiders would know what I'm talking about - the double-entry system.  That is still with us.  It's the basis of accounting ever since.  Where accounting has changed is 40 years ago when I first became an accountant there were no accounting standards.  So accounting was to say well, what do we normally do in this situation, and if you got something that was a bit unusual then you had a little team of accountants, and we'd debate it and then come up with an answer.  The trouble was we started finding many, many ways for accounting for exactly the same thing and the effect on the profit and balance sheets were huge. 

So, somebody said there's a million ways you can put together accepted practices and get a fair presentation.  Well, that's a wide range of variation you could get in profits and so on.  And so,  gradually the view came we'll have to standardise these things so let's pick what people think are the best method.  Now, there can be lots of arguments over best methods.  So the UK didn't even have accounting standards until the 1970s; America had them before that.  But then we had a situation, we had British standards, we had American standards, Aussie standards, everyone had their standards.  And that made sense because in Australia you got the money from the stock exchange here.  So Australia decided what it wanted to know as far as accounting was concerned, the same thing in the UK. 

Then from 1975 onwards globalisation started coming so Aussie companies would go to the London Stock Exchange, they'd go to New York, and having different accounting was an impediment because if I asked our listeners do you understand Indian accounting, do you understand Latvian accounting, the answer is almost certainly no, and if you can invest in say an Indian company and there's their accounts, you won't say well, these aren't necessarily U.S. GAAP, these are Indian accounting, what's the differences.  You've got to spend a lot of time trying to find out the differences, have you got all the nuances. 

So gradually a view came we should all the same thing.  Why don't we just pick the best one and do it?  That's really what led to international standards, triggered by the Asian Financial Crisis.  And in that, you had companies in Asia that looked all right under local national standards and suddenly they went bust, and a lot of the finance was short term and it was just pulled out.  A lot of investors in America just pulled out.  So investment ground to a halt; that affected employment; that affected growth. 

So you had a situation where the only way they could fix it was to go for a set of accepted standards, which were international, and that's eventually what led to the International Accounting Standards Board being set up, to do that.  The Americans were very good because some of them thought well, shall we just make the US standards the international standards.  It was the Securities and Exchange Commission and the Financial Accounting Standards Board said no, no, American standards are written for America, not internationally, but you want something like them internationally and that's really where we got to.  And then of course we've tried to put the two of them together. 


ERIC VAN BEMMEL

So in the European Union for example you've got the International Financial Reporting Standards, and that covers some - what, over 100 countries - is that right - that subscribe to these standards?


SIR DAVID TWEEDIE

Well, in Europe it's about 30, but Europe decided very quickly after the International Accounting Standards Board was created in 2001 that Europe was going to switch to international standards.  And that made sense because you can't have a single market with 20 odd countries all doing different things.  And a month later Australia came in and then New Zealand and then South Africa and then Hong Kong it was basically Europe and the Commonwealth. 


ERIC VAN BEMMEL

But the US remains outside?


SIR DAVID TWEEDIE

The US remains outside.  What we did was, after Enron there was a lot of angst in America about their accounting.  Now, Enron, while there was some bad accounting, it was mainly poor auditing, bad corporate governance and fraud, you know there was little tweaks in accounting that could be fixed, but it led to a situation whereby the US said well, let's look at what other people are doing, and we were the prime candidates.  And at the same time, one of our board members, Bob Herz left us to become Chairman of the American Standards Board.  Bob is an internationalist; he didn't particularly want to leave but this was a bigger duty for him.  We are great friends, we've worked together for a long time and we decided what we should do is put the two together as best we can. 

So in 2002 we made an agreement called the Norwalk Agreement that narrowed the differences.  And how did we go about it?  Well, if you used IFRS and you listed in New York, you had to reconcile to US standards, U.S. GAAP.  So it was quite easy because all we had to was go down these reconciliations and say where are the big differences because they were standing out in these things.  And we decided well, let's pick them off one at a time, and what we'll do is, here's a difference, let's look at the two sets of standards; is the American one better or is the international one better, and whichever had the weaker standard just took the other one.  We agreed, don't improve the other one.  Just take it; we haven't got time to improve it. 


ERIC VAN BEMMEL

Cherry-pick from each?


SIR DAVID TWEEDIE

Cherry-pick from each.  Take the best ones from each, but don't try and play around with it because that will mean another convergence problem because you'll be different.  So we'll bring the two standards together and it will strengthen the weaker one by taking the stronger.  So that went on until about 2006 and we probably changed about half a dozen each, and people gradually got fed up with all the change and they said we're still having to do this reconciliation and we don't like it.  Perhaps we should make the Americans reconcile when they invest in Europe or come to the European stock exchanges.  And that seemed to be a real backward step. 

And the SEC stepped in and with the European Commission and the American standard setters and ourselves, we agreed to set out a program and it was based on the fact that well, you don't have to have word-for-word the same standards; if the principles are the same, that's fine.  But there are certain areas where the standards are either outdated or they're too convoluted; don't try and get a converged convoluted, outdated standard, both of us should write a new one together.  So they listed out 10 major areas, so we just concentrated on that for about five years.  After about a year the Americans said well, we can see you're making progress, the reconciliation went, and then the clear goal was to mush them all together and then came the Global Financial Crisis and held it up. 


ERIC VAN BEMMEL

Right, but that's still an ongoing process?


SIR DAVID TWEEDIE

Still an ongoing process.  It stalled a bit.  People matter; Bob and I, we were passionate about it.  The newcomers, they weren't there at the beginning, but I think they're still keen on it, but the US have had a lot of opposition from say the Midwest, there's no international companies or they don't trade internationally, why should we change, and if you change - I always call the three C's, first change itself, then there's the cost of change and the one that matters is loss of control, because you give up American sovereignty to an international body.  That was a big sticking point for many Americans.  I think it's going to happen. 

When you look at the world, as you mentioned, 130 odd countries use it.  India is coming in 2016, you've got Canada uses it, Mexico and Latin America use it; all Europe uses it.  Asia is predominantly IFRS.  Three-quarters of the G20 countries are IFRS.  The majority of the world's 500 biggest companies are IFRS.  Twenty per cent of the Japanese stock market is IFRS.  People listing - companies from overseas and going into the United States use IFRS.  So it's coming.  The U.S. GAAP is going to become a minority sport.  But the US isn't ready yet. 


ERIC VAN BEMMEL

And the U.S. GAAP, just for listeners who don't know, GAAP is the Generally Accepted Accounting Principles. 


SIR DAVID TWEEDIE

That's right, the American standards. 


ERIC VAN BEMMEL

Versus the IFRS, the International Financial Reporting Standards.


SIR DAVID TWEEDIE

That's exactly it, Eric.  So it will happen.  I think probably the first move is that perhaps American companies will be given an option to move to IFRS.  And I think you'll get things like the automobile industry, which is competing against other international companies using IFRS so where's the comparisons?  Companies I think that trade with others using IFRS or compete with others using IFRS will be one of the first to change.  So I think the Americans will come, and the world needs them because you can have international standards without America; you can't have global standards without them, and we need their intellectual expertise.  They're a great profession of good accountants.


ERIC VAN BEMMEL

I'm Eric van Bemmel and on Up Close, this episode, we're speaking with leading expert in the world of financial reporting and valuation, Sir David Tweedie, about what accounting means for the rest of us.  Up Close comes to you from the University of Melbourne, Australia. 

David, can we just step back a minute and look at what the differences really are, and some examples of differences between the US say, and the European system, for the non-accountant?  What are we talking about here?  I mean certainly money is money and profit and loss and assets; what's the difference?


SIR DAVID TWEEDIE

Well, we've got different ways of doing certain things; not all that many now, they've been reduced enormously.  There is a different philosophy if you like between IFRS and U.S. GAAP and that is the question of principles versus rules.  IFRS is 2500 pages, U.S. GAAP is about 17,500, and they go into a lot more detail.  Now, you can write an accounting standard which deals with 80 per cent of the issues in probably 10-15 pages.  If you want to go into 95 per cent of the issues you're up to 300.  It's just going down into the weeds that causes the problems.  And the US - Bob often said that he wonders if US accountants can use judgement, because if there's something comes up, what's the answer?  Let's put it up to a group who will come up with an answer.  Whereas IFRS is saying now you've got the principle, just go use your judgement. 


ERIC VAN BEMMEL

So it's a principles-based versus a rules-based - sort of the spirit versus the letter. 


SIR DAVID TWEEDIE

Absolutely.  The American system is principle-based but then you have massive guidance after it whereas we didn't.  Interestingly enough, you hear well, we need all this to protect us from litigation and yet I watched an American litigation lawyer in New York, and he picked up a bit of paper, probably about a metre square, held it up and he said this is a facsimile of the first American Constitution.  On this paper is the American government's relationship with the Federal states, with its citizens and with overseas jurisdictions.  And then he bent down and he picked up seven huge tomes and said, and here are the American Standards on Financial Instruments.  Which do you think I'd rather defend?  He said I can defend a principle but if you missing something on page 11,473 you're dead.  So I don't think it protects them; if they miss it, they're finished. 


ERIC VAN BEMMEL

Now, the IFRS and the GAAP, these are standards, but who actually minds them?  Do governments actually have a view, do they have actual control?


SIR DAVID TWEEDIE

No.  We're based on the American system and in that sense the standard setter is completely independent.  He can do what he likes.  Now, who picks the standard setters?  Well, there was a group of trustees initially picked and they select their successors and they are not allowed to interfere, technically. 


ERIC VAN BEMMEL

Picked by whom?


SIR DAVID TWEEDIE

They were picked originally, as far as the IFRS is concerned, by a group of securities regulators and then left alone.  That was a problem, because in America is was different.  They had the similar system, the Independence Standard Board, the trustees, but above them was the Securities and Exchange Commission keeping an eye on them.  We came under quite a bit of criticism, and it was fair criticism, that we weren't subject to any democratic control.  I quite liked it that way.  Basically you'd get somewhere, like in France they would say we have to fight laws through Parliament whereas you guys just issue a new standard and that's it, every company has got to change to do it. 

So they created a monitoring board consisting of the Chairman of the SEC, the equivalent from Japan, the European Commissioner responsible for the financial reporting area, a couple of other securities regulators, and they just made sure the trustees were appointed properly and they did their job properly.  They too couldn't interfere in the technical matters.  They could ask me to come and speak to them, and which I would, but they couldn't say you've got to do it this way, because I could say no and there wasn't anything they could do about it.


ERIC VAN BEMMEL

Now, you're clearly an advocate for internationalisation of standards, harmonisation across national boundaries.  What about harmonisation across different industry sectors?  I mean certainly different industries must have different accounting needs. 


SIR DAVID TWEEDIE

Well, it's quite interesting, because the latest standard, both boards and the ISB, they've issued a joint standard.  We've had two different types of how do you measure sales and profit and things like that when you sell something.  The Americans had lots of standards; I think they had about 200 dealing with the film industry and so on.  The ISB had two, and ours wasn't detailed enough, theirs was well over-the-top, too detailed.  And what we did, we produced one standard and we scrapped all the others.  What we've basically tried to do is to say here are the principles of how you recognise profit and that should apply to a restaurant or a shipbuilding industry. 

Now, there's certain things like long-term contracts there's separate standards for, but what it says is look at the contract that you've got, what are the deliverables you've got to do, how much are they worth within that contract, take the profit as you do them.  So some of them are simple, a restaurant, you have your meal, there's the bill, bang, easy accounting.  Shipbuilding, well, a two-year contract so you have to break up into bits and do it that way.  But we've tried to get one contract, we'll deal with aerospace which will deal with shipbuilding, because ultimately we want to try and make sure that we don't get areas that only the experts know that this is different from that one.  They should broadly have the same principles.  Maybe a bit more guidance on how to do it in a particular industry but it should be the same principles underneath it. 


ERIC VAN BEMMEL

And there's flexibility for new industries that we can't even envision yet. 


SIR DAVID TWEEDIE

Yeah.  Can't even envision.  Software was one, when it started coming up.


ERIC VAN BEMMEL

You mentioned earlier the Enron case that led to the de facto dissolution of one of the very large accounting firms, Arthur Andersen.  You also mentioned the Asian Financial Crisis as being a turning point for change, to harmonise, to internationalise.  And you said that negotiations between the U.S. GAAP and IFRS were stalled by the Global Financial Crisis in 2008.  Speaking about that financial crisis, Steve Forbes, Chairman of Forbes Media, he wrote that mark-to-market accounting was the principal reason that the US financial system itself melted down in 2008.  Now, I want to get your opinion on that, but before you do, tell me what is mark-to-market accounting?

SIR DAVID TWEEDIE

Well, let's say that you buy a share and you pay $5 for it.  Now, the old accounting would keep that $5 in the books and that's how it would be shown.  Fair value would say what's the market price?  So if it went to $7 or it went to $3 that's what would be reflected.  So it's much more volatile.  Using the old methods you would not show any change in the value of that share, you would take a profit when you sold it.  Fair value, or mark-to-market, shows the changes as they happen. 


ERIC VAN BEMMEL

And did that cause the meltdown in the United States?


SIR DAVID TWEEDIE

Well, it's interesting that that question was posed because about four or five weeks after Lehman's I was interviewed in the British Broadcasting Corporation's World Service, and the BBC interviewer, he said, in this crisis, fingers are pointing.  Fingers are pointing at you, you're the man who caused the crisis.  And I said they're right, it was me.  I made banks give up their risk management techniques, I made them give loans to people who had no assets and no income.  I made them take these mortgages and break them into tiny pieces, add them to tiny pieces of thousands of other mortgages, I made them scatter them worldwide.  I made the rating agencies give them AAA ratings, I made people buy them though they hadn't a clue what was inside them.  It was all my fault.  There was a silence, and the interviewer said, for the benefit of overseas listeners that was irony, and that's what happened.  That's what happened. 

If you want to pinpoint what was going on, the banking system had lost it.  They had absolutely lost it.  The growth of the banks was enormous.  In 2000 three British banks, the biggest ones, were about 75 per cent of UK GDP but seven years later they were 200 per cent which was enormous things.  You got to a stage where the equity levels in a bank were down by the time of the crisis to about two per cent; that means banks were 98 per cent borrowed.  Well, you don't have to lose much to lose two percent.  The thing that really upset people was the losses were socialised; you suffered, I suffered.  The gains were privatised.  Bankers did a lot there.  Where were the controls then?  Well, in 10 years the average time a shareholder in a bank kept the shares had gone from three years to three months, by 2007.  So we had quarterly capitalism.  And these people couldn't have cared less, they were in and out.  They were just looking for a quick buck. 

The other aspect I think was a major problem was to make sure they got a good return they tied management incentives to the return on equities.  So if you want high returns you borrow highly, so you have a few shareholders who can take most of the profit, and that's what they did, and that's why they ramped up the debt levels.  The pay of the bank CEOs was phenomenal; in the US it went from something like in the late '80s I think it was about $2.6 million and by the time of the crisis that had gone to $26 million.  In the '80s that $2.6 million, it was about 100 times the average US salary.  By the time of the crisis it was 500 times, and it was based on return on equities.  It had been return on assets they would have only gone up to $3.4 million.  So it was the wrong incentives, they grabbed it, these profits they were making, they either distributed it, put it out in remuneration or bought back shares to reduce their dilution effect.  They did not retain.  And the regulators let them get the gearing down, the amount of equity to two per cent.  They should never have gone that low, and of course the big campaign since then is to get the equity levels up.


ERIC VAN BEMMEL

Basel III and all that. 


SIR DAVID TWEEDIE

Basel III.  Why are they doing that?  Because it was too low. 


ERIC VAN BEMMEL

So not an accounting issue at all, really?


SIR DAVID TWEEDIE

I think it was a regulatory issue.  They should have stepped in earlier and not let this happen.


ERIC VAN BEMMEL

This is Up Close, coming to you from the University of Melbourne, Australia.  I'm Eric van Bemmel.  In this episode we're speaking with world-renowned accounting guru and standards advocate, Sir David Tweedie, about trends and issues in the world of accounting and valuation. 

David, how does valuation tie into this issues, especially post-GFC?


SIR DAVID TWEEDIE

Well, during the crisis I was a member of the Financial Stability Board.  That consisted of the major economies, representatives from the Treasury, the securities regulator and probably the central bank from each of them.  Five weeks after Lehman's when we met, I can honestly say I have never smelt such fear in a room.  There was a real feeling that the whole capitalist system could crash.  There was panic on, markets were tumbling because nobody was buying, people didn't know what to do for fair value so oh here's a sale, but it was a fire sale, someone was desperate, so they grabbed that.  That made it even worse, which is probably the Forbes issue when they talk about what caused it.  It was a reaction to it. 

The Financial Stability Board said well, what are you as accountants doing about it, and I said we're not valuers, we take the values that are there and put them into the accounting but we don't do the values.  What it turned out, nobody was doing them.  So we had to form a committee with Bob Herz and his American board and we got together bankers, auditors, credit rating agency people, regulators, and we came out with how do you deal with illiquid markets, how do you get values in illiquid markets. That worried me, and I thought, what's happening about financial instruments?  So when I was asked to look at the IVSC, I started exploring what's happening about the valuation of financial instruments.  What I discovered really shook me. 

It's not widely-known, but when you get something that isn't straightforward and you can't just pick it off the stock exchange and you have to start estimating what the values are, some of these values have wide variations among the banks.  Now, if that's the case I think we as standard setters, and probably most investors, assume these fair values are pretty accurate and we've got the same numbers.  If you've got wide variations, and I'm talking really wide, then question mark over profit, question mark over balance sheet, question mark over Basel capital requirements, because they're based in these things. 

So the IVSC, what I'd like them to do - and we're getting a roundtable up consisting of regulators, auditors, banks et cetera, and we'll say why are these differences happening, what's causing this?  Is it some of the assumptions, is it some of the models, are they measuring the yield curves at different times like monthly or quarterly and that can create a difference.  What happens when the data runs out, do you just extrapolate or do you say oh, flat-line it.  These all cause differences.  We need to get industry agreement on how this should be done.  We can't have these wide variations with some aggressive valuers and more conservative valuers.  I would suspect if some of the more aggressive valuers, financial institutions, used much more conservative methods they might lose most of their equity, and that's very worrying.  So here comes another crisis if we're not careful. 

One of my main functions - we've got three real ones - I want to see these differences narrowed to acceptable levels.  I don't think they are acceptable at the moment.  That's the first one.  The second item is exactly the same as accounting, why should American valuers do things differently from Aussie valuers or British valuers?  Can't we just agree how to do it and bring the methods together?  So similar to accounting, let's just globalise the valuation methods.  A lot of support of that.  And the third point is, unlike the accounting profession where you have CPAs, you have CAAs, who's a valuer?  I don't know them.  In America for example there are four organisations doing business valuations.  They have five different qualifications, different exams for all of them.  Can we all agree on what the entry requirements should be, the exams, the continuing professional development, the experience you're required, the ethics, the discipline and can we come up with a designation that everybody recognises worldwide?  So you can say this has been done by a qualitied valuer as opposed to a cowboy.  There's cowboys out there at the moment. 


ERIC VAN BEMMEL

It took the Global Financial Crisis in a sense to bring this to the fore.  I mean certainly pre-crisis there must have been the valuation industry; how did accountants deal with it then?

SIR DAVID TWEEDIE

Well, I think we just assumed it was all right.  The numbers were there.  Auditors would go in and say well, the assumptions are reasonable, but I don't think it was quite so noticeable.  They seem reasonable but this company's doing it totally differently, and that seems reasonable, so can we just mush them together and try and pick the biggest one?  I think there's a lacuna in the regulation at the moment and it's valuation, and valuation did cause problems in the crisis.  You know, people didn't trust Lehman's valuations; they were much, much higher than other banks.  So we've got to try and get something.  It's very difficult for the prudential regulator, and for the auditor, to say you're too high because the answer is well, where's the benchmark, there isn't one. 


ERIC VAN BEMMEL

Now, in my ignorance I'm still a bit unclear about the difference between a valuer who I imagine is trying to gauge the value of a firm versus an accountant that is still tabulating assets and liabilities and must on some level be gauging the value of the firm. 


SIR DAVID TWEEDIE

Well, valuers, they started by being real estate valuers: how much should I pay for this house?  That gradually came into accounting because we took the values from there.  Then they moved in and a lot of them were accountants who did the next stage, which was business valuation: how much should I pay to buy this company, and what's the assets in that company?  Why am I paying this?  So they would value the individual assets and the overall value of the company.


ERIC VAN BEMMEL

Who would pay the valuers to do their job?


SIR DAVID TWEEDIE

It would be the purchaser.  It would be the company that wanted to buy another one or the real estate purchaser that wanted to do that.  So they're the ones that paid originally.  So a profession of business valuers grew up and a lot of those were accountants, you know, they moved into that area.  Financial instruments: bankers, it's bankers and accountants; it's often astrophysicists, they've got some mathematical models for these things.  The auditor has got to say is it reasonable, and he must struggle with these things.  So what we're trying to do is bring it together, let's get benchmarks and then we can say to someone you're too high, you're way over the top. 


ERIC VAN BEMMEL

David, lastly there are more recent concerns that some people would argue need to be factored in to how we regard a company such as how a company's activities or affecting or harming the natural environment.  Does accounting have a role in, have a methodology for identifying and reporting such things?


SIR DAVID TWEEDIE

It's coming.  In America they have been working on sustainability standards.  There's also the integrated reporting systems, can we get everything in there, not just the financial results but what else they're doing, the damage they might be causing and so on?  There's a lot of work going on that way.  So I suspect the financial reports of companies in 10 years' time will be quite different and much wider I should say than the present ones, which are strictly financial.  It will be also looking at the social aspects and…


ERIC VAN BEMMEL

CO2 emissions on the ledger.


SIR DAVID TWEEDIE

Absolutely.  That's the sort of thing that will be shown and they'll have to do sustainability reports and things like that. 


ERIC VAN BEMMEL

Sir David, thanks for being our guest on Up Close.


SIR DAVID TWEEDIE

My pleasure. 


ERIC VAN BEMMEL

That was Sir David Tweedie, a world-renowned expert in financial reporting and valuation.  A former Chairman of the International Accounting Standards Board, Sir David is currently Chairman of the Board of Trustees of the International Valuation Standards Council.  For a full transcript of this episode and more information on our guest, head to the Up Close website.  Up Close is a production of the University of Melbourne Australia.  This episode was recorded on 14 October 2014 and produced by Kelvin Param and me, Eric van Bemmel.  Audio engineering by Gavin Nebauer.  Up Close is created by me and Kelvin Param.  Thanks for joining us.  Until next time, goodbye.


VOICEOVER

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