International accounting – Lecture 6

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Chapter 2. Financial reporting of large (listed) entities: economic context, implications for

accounting, accounting models

2.4. IFRS – context, evolution, perspectives

- IFRSs comprise 13 IFRSs, 29 IASs, 16 IFRICs and 8 SICs, along with the conceptual

framework;

- the framework applicable nowadays dates from 1989; however, there is a common project with FASB to revise the framework (first phase completed and published) (Tutorial 4);

- IASC’s strategy in terms of international acceptance is well described by Chairman Kirkpatrick

in 1986: ‘‘I would say that harmonization means compatibility today. Tomorrow it means comparability. The day after tomorrow, conformity”

1;

- harmonization is a process through which different national rules, sometimes divergent, are

improved and made comparable. Recently, the term has been replaced with convergence, used especially to describe IASB’s process to eliminate the differences between national standards and

IFRS and to avoid future differences;

- IASB’s legitimacy increased, since more and more countries realized or intend to realize total or

partial convergence with IFRS. - IFRS are in a continuous modernization process, especially after 2001, process in which the

IASB – FASB convergence plan played a key role.

The convergence process

- examples of standards issued by IASB influenced by FASB: IFRS 5 (2004), IFRS 8 (2006), IAS

23 revised (2007), IFRS 13 (2011); - examples of standards issued by FASB influenced by IASB: SFAS 154 (2005) accounting

policies, SFAS 159 (2007) (Fair value option).

- common projects (some delayed) (framework, presentation of financial statements, leases,

revenues recognition) - benefits of the convergence process:

“Convergence offers substantial benefits to large companies and their shareholders, financial professionals, regulators, and investors, locally and internationally. Large companies would benefit greatly. Currently, over half of Fortune 500 companies are dealing with subsidiaries using IFRS. A large portion of companies with foreign subsidiaries encounter IFRS. Many competitors of U.S. companies already are reporting under IFRS. A large segment of U.S. companies are already familiar with international standards (SEC 2007b). Convergence would produce efficiencies, simplification, and cost savings in those companies. It would eliminate dual reporting. United Technologies, a $50 billion global company, say they need to address IFRS to aggressively address their competition (SEC 2007b). It would eliminate costly reconciliations (KPMG 2008a) and will enhance U.S. global competition (SEC 2007b). Firms who convert should have easier access to foreign markets (Nicolaisen 2005). Financial professionals and regulators are the second group to suggest benefits. Professionals and regulators would deal with a single set of standards (SEC 2007a). There would be a bilateral reduction of differences in accounting standards between countries, and more transparent financial statements (Nicolaisen 2005). Global financial statements would be comparable and convergence would enable the international regulatory community to bilaterally reduce differences, work together, and create stronger standards (SEC 2007b). Investors would also benefit from convergence. Convergence would enable companies to expand capital markets across borders. It will encourage strong, stable, and liquid capital markets. It will increase investor confidence and produce greater global acceptance of company financial statements (SEC 2007b). There are also a number of costs associated with convergence, since the standards are different. United Technologies estimates

1 Botzem and Quack (2009), pag. 143

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that switching to IFRS will cost them two to three years of effort and 5 percent of revenue. They will need to map a new system of accounts and capture transitional differences. There are also fewer bright lines to guide policy. In addition, adopting IFRS would affect their tax bill. For example, they value inventories using LIFO, which is not accepted under IFRS. Switching to FIFO would require them to write a large check to the IRS (SEC 2007b).”2

Q1: Discuss the benefits of the convergence process, and the intentions of various stakeholders involved.

IFRS application

- over 100 countries require or allow IFRS application, using various strategies (adoption, endorsement, convergence). Research suggests that there are differences in the manner in which

IFRS are applied:

1) Kvaal and Nobes (2009)3 propose some hypothesis based on the previous national regulations:

- entities in Spain are more inclined to present an income statement by nature;

- entities from UK are more inclined to present a balance sheet showing net assets;

- entities from UK are more inclined than others to use fair values;

- German entities are more inclined to use weighted average cost, while UK entities are more inclined to use FIFO.

2) Chen et al. (2010)4 identifies an increase in the quality of the accounting information in

Europe, but the quality level is not the same in EU countries. The institutional context (users,

politics, auditors, capital market) is important.

3) Example – the application of IAS 40 in EU

5

The authors of this study analyzed the model used for the measurement of investment property by

125 European listed companies (15 countries). Their results show that the factors affecting the

choice of a certain model are: prior accounting standards, the auditor (Big 4 or not), the commitment to increase transparency and the characteristics of their market.

Country Firms IAS 40 Pre-IFRS domestic GAAP

Cost Fair value

Cost Revaluated PPE Notes

Austria 5 1 4 x x

Belgium 9 1 8 x x x Revaluations allowed under

certain circumstances

Denmark 4 0 4 x Revaluation is required

Finland 4 0 4 x

France 16 9 7 x x Revaluation is permitted, but

rare in practice

Germany 13 8 5 x x

Greece 1 0 1 x

Italy 5 3 2 x While depreciation is not

mandatory, fair value is

2 Thomas, J. (2009) Convergence: Businesses and business schools prepare for IFRS, Issues in accounting

education, vol. 24, no. 3: 369-376. 3 Kvaal, E., Nobes, C. (2009) International differences in IFRS policy choice, working paper, Electronic

copy available at: http://ssrn.com/abstract=1466693 4 Chen, H., Tang, Q., Jiang, Y., Lin, Z. (2010) The role of IFRS in accounting quality: Evidence from the

EU, Journal of International Financial Management and Accounting, vol. 21, no. 3: 220- 278. 5 Sellhorn & Riedl (2008) – Choosing cost versus fair value – international evidence from the European

real estate industry upon adoption of IFRS, EAA Congress

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prohibited

Netherlands 6 1 5 x x Disclosure of fair value

Norway 3 0 3 x x

Poland 2 0 2 x x x

Spain 1 0 1 x x

Sweden 11 0 11 x x Disclosure of fair value

Switzerland 5 0 5 x x x

UK 40 0 40 x

Total 125 23 102

Q2. Which do you think are the factors leading to different IFRS practice? What do you think the implications of such a different practice are? Q3. Which are the sources (related to IFRS) for these differences? Issues related to the IFRS application

- benefits and effects Previous studies suggest that benefits are related to increased trust of users, increased

comparability, increased transparency (on past performance and risk), another perception on the

value of entities (IFRS are closer to internal reporting) (PWC 2006, 187 investors in 7 countries). Also, studies indicate that IFRS are related to a decreased degree of prudence, increased volatility

of results, an integration of financial reporting and managerial accounting (with impacts upon the

organization of the accounting system of the company).

- compliance and enforcement There are differences between countries in terms of the compliance and enforcement levels.

“Scandinavian and Anglo-Saxon companies display above-average compliance, whereas companies from Middle-Eastern Europe display below-average compliance. In-depth

investigations indicate that the strength of countries’ enforcement systems, the importance of the

national stock market as well as cultural factors are associated with compliance”6.

“Enforcement of financial reporting rules can be seen as a three-part process: (i) effective company control systems and management dedicated to good reporting, (ii) independent auditors who are expert in the rules, and (iii) an oversight mechanism with sufficient expertise and power to achieve effective enforcement.”7 “Even if it is possible to craft a single set of high-quality standards, can they be consistently enforced? […] A common accounting system needs a common enforcement system. Having the most intelligently crafted rules means nothing if companies feel they can simply ignore them without fear of any meaningful consequence. Yet there is no global enforcement mechanism.”8 “There are considerable challenges to be faced in the effective enforcement of IFRS in Europe. The structure and organisation of entities responsible for the oversight of financial reporting requirements differ between EU countries, with both public and private sector bodies being used. Furthermore, some countries have no institutional oversight of financial reporting (FEE, 2001a, p. 10). The EU Regulation mandating the use of IFRS stipulates that member states are required to take appropriate measures to ensure compliance with IFRS (European Commission [EC], 2002, n.16). Consequently EU countries are presently evaluating existing enforcement strategies

6 Glaum et al. (2012) Compliance with IFRS 3 and IAS 36 required disclosures across 17 European

countries: company and country level determinants, Accounting and Business Research, in press. 7 Brown, P., Tarca, A. (2005) A commentary on issues relating to the enforcement of IFRS in the EU,

European Accounting Review, vol. 14, no. 1: 181-212 8 Reilly, D. (2011) Commentary: Convergence Flaws, Accounting Horizons, vol. 23, no.4: 873-877

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and proposals to introduce enforcement bodies. When examining the bodies concerned with accounting regulation, it is necessary to distinguish between rule-makers and rule-enforcers. Some bodies (e.g. the IASB) confine themselves to rule-making, others (e.g. the COB) specialise in enforcement, but some are involved in both (e.g. the SEC). In addition, we use the term ‘enforcement body’ to refer to national institutional oversight mechanisms, including both review panels and stock exchange regulators.9 Q4. What it is understood by enforcement? Name a few enforcement mechanisms. How the level of enforcement influences the level of compliance?

- the political lobbying over IASB Considering the so-called ‘economic consequences’ of accounting standards, those with a vested

interest intervene by writing letters, comments, overt or covert threats, attacks at the setter’s

reputation or independence, powers or existence, withdrawals of funding etc.

Examples10

- elimination of LIFO in 1992: delegations of countries (Germany, Italy, Japan and South Korea)

where it could be used for tax purposes opposed. LIFO was then finally eliminated in 2003; - in 2001, IASB begins working at a standard related to employee stock options; it proposed that

share options be expensed in each period in which employee services were performed. Even

before IASB had even composed the exposure draft, 15 European companies (amongst which Nokia, Lafarge, Nestle, Saint-Gobain, Pirelli, ING etc.) complained (probably concerted) about

them being placed in a competitive disadvantage compared with companies applying US GAAP.

Still, IFRS 2 was issued in 2004, endorsed by the EC in 2005, while FASB had issued SFAS 123 revised to converge with IFRS 2 (with opposition from the congress);

- IAS 39 in EU – the loudest complaint came from especially French banks, that the standard

would afflict them with unacceptable earnings volatility and require they change their risk

management practices to their disadvantage. In July 2003, President J. Chirac even wrote to Commission President Romano Prodi that the proposed standard would have ‘disastrous

consequences for financial stability’. In 2004 the Commission endorsed IAS 39 but with two

carve-outs: full fair value of some liabilities and portfolio hedging on core deposits. In 2005 the IASB amended IAS 39 to eliminate the fair value option, thus solving the first carve-out. The

second still remains.

Exercises and questions

1. Provide examples of treatments in IFRS which may be applied differently in the UK and Italy.

2. Which IASs/IFRSs do you believe to be the most difficult to be applied by European

continental companies? Please explain.

3. Which do you believe to be effective ways to reduce differences in IFRS practice around the

world?

4. How successful is IASC/IASB as a standard-setter?

9 Brown and Tarca (2005). 10 Nobes and Parker (2008), pages 224-227.