Measuring Accounting Harmonization

7/30/2019 Measuring Accounting Harmonization

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ACC 808 Measuring International Accounting Harmonisation. Imad Alsuwaih

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University of Newcastle upon Tyne

Department of Accounting and Finance

I nternational F inancial Analysis

Measur ing I nternational Accounting Harmonisation

between

Large Companies from France, Germany and the UK

Supervised by Dr Simon Pallet

Prepared by Imad Alsuwaih

September 2002


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Acknowledgment

I am most grateful to all those who have supported me dur ing

my research and provided assistance to al low me to complete

my cour se.

Special thanks to:

Simon Pallet (Newcastle University-UK)

Don Hermann (Oregon State University-USA)

Wayne Thomas (Oregon State University-USA)

I an Dobbs (Newcastle University-UK)

And my dear parents in Tr ipoli -L ibya

From: I mad Alsuwaih

Newcastle upon Tyne

6 September 2002


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Abstract

The measurement of harmonisation is dependent upon, and therefore affected by, the

importance of accounting and various international attitudes towards harmonised

accounting. Through the analysis of various areas of harmonisation this study aims to

measure harmonisation between large companies located in France, Germany and the

UK.

The methodology adopted in this study has previously been used by several authors,

such as, Emenyonu and Gray (1992) and Hermann and Thomas (1995). However, a

more diverse range of accounting practices has been used to measure accounting

harmonisation for the purposes of this study. These practices have been sub-divided

into those regulated by the Fourth European Directive and those not regulated by the

Directive.

Within this study a comparison of my results to those of EGs enables the process of

harmonisation in the context of common practices between the two studies to be

measured. Results of the current study indicate a high level of harmony can be found

in many accounting practices, despite accusations that the Fourth European Directive

has failed to meet its aim for harmonisation. The study also shows that the accounting

reporting in these three countries are affected by five main regulations: German

GAAP, French GAAP, UK GAAP, US GAAP and the IASs.

As most studies in this area do not provide an explanation of the methodology

adopted, a modest addition to the literature has been included in this study which

provides a clear explanation of the methodology used.


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TABLE OF CONTENTS PAGE NO.

ACKNOWLEDGEMENT II

ABSTRACT III

TABLE OF CONTENTS IV

LIST OF TABLES VI

CHAPTER 1

1.1INTRODUCTION 1

1.2DEFINITIONS 2

CHAPTER 2

2.1 FACTORS DIFFERENTIATE ACCOUNTING SYSTEMS

2.1.1. THE LEGAL SYSTEM 4

2.1.2. METHODS OF FINANCE 4

2.1.3. THE ROLE OF TAXATION 5

2.1.4. THE ACCOUNTING PROFESSION 5

2.2 STANDARD SETTING IN THE THREE COUNTRIES

2.2.1. UK 6

2.2.2. FRANCE 7

2.2.3. GERMANY 8

2.3. RELATED ACCOUNTING RULES IN DIFFERENT REGULATIONS

2.3.1. STOCK VALUATION 9

2.3.2. DEPRECIATION 11

2.3.3. TREATMENT OF GOODWILL 13

2.3.4. R&D 15

2.3.5. FIXED ASSETS VALUATION 16

2.3.6. DEFERRED TAXATION 17

2.3.7. CURRENCY TRANSLATION 19

2.3.8. BORROWING COSTS 20

2.3.9. LEASES 20

CHAPTER 3

3.1 REVIEW OF EXTANT LITERATURE

3.1.1. LITERATURE REVIEW BY TAY AND PARKER 24

3.1.2. MORE STUDIES 28


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3.2 METHODOLOGY 35

3.2.1. STATISTICAL ANALYSIS 36

3.2.1.1. INDICES 36

3.2.1.2. CHI-SQUARE TEST 42

3.2.2. MULTIPLE REGRESSION 46

3.2.3. MEASUREMENT PRACTICES 47

3.2.4. HYPOTHESIS 48

3.2.5. PROBLEMS OF NON-DISCLOSURE 49

CHAPTER 4

4.1 PRESENTATION OF RESULTS 50

4.1.1. STOCK VALUATION 50

4.1.2. DEPRECIATION 51

4.1.3. TREATMENT OF GOODWILL 53

4.1.4. AMORTISATION OF GOODWILL 54

4.1.5. R&D 55

4.1.6. FIXED ASSETS VALUATION 56

4.1.7. DEFERRED TAXATION 57

4.1.8. CURRENCY TRANSLATION 59

4.1.9. BORROWING COSTS 60

4.1.10. LEASES 61

4.2 DISCUSSION AND COMPARISON WITH EG 62

4.2.1. COMPARISON WITH EGS RESULTS

4.2.2. OTHER ACCOUNTING ISSUES 63

4.2.3. BICOUNTRY I-INDICES 64

4.2.4. DIFFERENCES FROM EG 65

4.3 CONCLUSION 67

APPENDICES

APPENDIX-1-FRENCH COMPANIES 70

APPENDIX-2-UK COMPANIES 71

APPENDIX-3-GERMAN COMPANIES 72

APPENDIX-4-I-INDEX BETWEEN MY STUDY AND EGS (CHART) 73

APPENDIX-5-2X BETWEEN MY STUDY AND EGS (CHART) 74

List of references 75


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List of Tables

Table 1. Regulations comparison 23

Table 2. Studies Reviewed by TP 27

Table 3. Stock valuation 50

Table 4. Depreciation............................................................................................... 52

Table 5. Treatment of Goodwill 53

Table 6. Period of Amortisation 55

Table 7. Research and Development Costs.............................................................. 56

Table 8. Fixed Assets Valuation .............................................................................. 57

Table 9. Deferred Taxation ...................................................................................... 58

Table 10. Translation of Financial Statements of Foreign Subsidiaries .................. 59

Table 11. Results of HTs study 60

Table 12 Capitalisation of borrowing costs ............................................................ 60

Table 13. Leases: ..................................................................................................... 61

Table 14. Comparison with EGs: ........................................................................... 62

Table 15. issues out of the 4th D scope: ................................................................... 62

Table 16.Bicountry I indices 64


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Chapter 1

I ntroduction and defi ni tions

1.1 Introduc t ion

Measuring harmonisation is a subject which attracted the attention of many

researchers in the last two decades as the importance of international harmonisation

has increased over time. This importance emerged from the changes in the form of

stock markets across the globe. These markets have become more international, and

large numbers of multinational companies have become inter-listed on more than one

stock market. Another factor is the existence of international investors either

individuals or corporations, both trying to find the most profitable and most secure

investments and to benefit from the free business situation in the developed countries

(comparing with business closely controlled by government in the developing

countries). The European Union as well has a big interest in international accounting

harmonisation, where one of its main goals in the treaty of Rome 1957 is to guarantee

freedom of capital movement across its member states. All this factors increased the

attention paid to international comparability between the financial reports produced

by the companies which might attract investments at an international level. This

increasing importance of international harmonisation made the measuring process

inevitable. Therefore a methodology for measuring harmonisation has evolved, and

different techniques have been developed. This study is aims to use some of this

methodology in measuring harmonisation between three countries of the European

Union, France, Germany and the UK. These countries are chosen because in addition

to the Netherlands they are described as vital countries for the process of international

harmonisation (Nobes 1996). Moreover, Germany and the UK represent the origins of

the two opposed primary accounting philosophies worldwide, the Anglo-Saxon and


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the Continental models. Historically the first model has focused on shareholders

working within the frame of the true and fair view; whereas the German (Continental)

model has focused on debt holders, and prudence is characterised by strong links

between financial and tax reporting. The Anglo-Saxon model has had a strong

influence on accounting in countries which were colonised by the UK, whereas the

Continental model has influenced most of Continental Europe, Japan and the

countries colonised by Germany and France, as France was traditionally closer to

Germany; nevertheless it appears that it has shifted now towards the Anglo-Saxon

model. Therefore studying these countries might provide insight into the situation of

accounting practices in other countries (see Joos and Lang 1995). However, the

Netherlands is excluded from this study as the researcher aims to compare his results

with the results of Emenyonu and Gray (1992), which does not include the

Netherlands. The difference between the level of harmony measured in this study and

the one measured by EG will be the measurement of harmonisation as a process.

One cannot discuss the subject of harmonisation without to mention the crucial rule of

the IASB, which has been trying to produce a uniform framework for international

accounting. In this study, my intention is to focus on the subject of measuring

harmonisation rather than discussing harmonisation concepts and the role of IASB.

However, the conclusion of this study may cast light on the importance of IASB.

1-2 Definit i on s

Since there have been many studies which concentrated on the subject of accounting

harmonisation, there have been many definitions given to the terminology related. For

the purpose of this study, some of these definitions will be provided. Tay and Parker

(1990) presented these definitions: harmonisation (a process) is a movement away


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from total diversity of practice. Harmony (a state) is therefore indicated by a

clustering of companies around one or few of the available methods. Standardisation

(a process) is a movement towards uniformity (a state). It includes the clustering

associated with harmony and reduction in the number of available methods.

Moreover TP (1992) in their reply to van der Tas (1992), stated that standardisation is

associated with reduction of exclusion of choice, whereas harmonisation is associated

with the degree of flexibility and some choice.

Harmonisation and standardisation exist at the levels of regulations and practice. The

former can be referred to as formal harmonisation de jure, whereas the second is

referred to as material harmonisation de facto. This paper is confined to measuring

material harmonisation.


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Chapter 2

Dif ferent account in g system s and dif ferent regulat ions

2.1 Factors d if ferent iate acco unt in g sy stems

In the area of international accounting, there have been some efforts to determine the

factors which may cause differences in financial reporting systems across countries.

Nobes (2000) suggests seven principal causes of difference, which provide a useful

framework for analysing the three countries under review. Four of these factors are

more important than others and this review concentrates upon them.

2.1.1. The leg al system

France and Germany, like much of continental Europe, have legal systems based on

Roman Law. This type of legal system requires detailed codification of rules covering

all eventualities. Thus accounting and financial regulation in these two countries is

largely a part of law, instead of being a professional discipline in its own right. Such a

system by its very nature is difficult to change (Watts, 1996). The UK (excluding

Scotland), on the other hand, has a legal system based on Common Law. In such a

system, statute law provides a framework which is followed by judgements based on

the findings of individual cases. Thus in countries such as France and Germany,

company laws and commercial codes contain detailed rules for accounting and

financial reporting. This has made accounting practices strongly tied to government

regulations and to be restricted in different accounting areas. On the other hand,

accounting in the UK is practiced independently from laws. In the UK the Company

Act regulates many accounting issues. However, it leaves a large area for profession

and judgements to take place in the frame of the true and fair view.


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2.1.2. Methods of fin ance

Where companies raise their capital is considered to be an influence on the nature and

quality of financial reporting Patterns of financing are different in each of France,

Germany and the UK. In France, for example, a significant proportion of companies

capital has been provided by the state or banks; whereas German companies are

substantially financed by banks and providers of loan capital. UK companies, on the

other hand, are largely financed by shareholders. This is reflected in an active stock

exchange. In a country like the UK with a major tradition of private shareholders,

audited information is required to a large extent as these shareholders do not have

access to detailed internal information. Moreover, there will be a strong need to seek

advice from financial analysts. The majority of investors in the UK are financial

Institutions, which are short-term investors. Therefore they need high degree of

disclosure and rely on the approach of true and fair view. All this has led accounting

in the UK to be more transparent than in the Continental Europe. In the case of

Germany and France, the major shareholders are able to access internal information

and have less need for transparency. Banks and providers of loan capital are also

more likely to favour a conservative view of accounting (J Watts, 1996).the different

pattern of ownership in these countries produces different views about shareholders

equity and the treatment of distributable earnings. However, in the move towards one

European market, laws in France and Germany related to disclosure issues have been

developed since the Sixties.

2.1.3. The ro le of taxation

Taxation is a significant effectual factor in determining the type of financial reporting

in a country. In countries such as Germany and France, tax laws regulate for

accounting practices. Thus, the accounts for shareholders and the commercial


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accounts are to a large extent similar to the tax accounts. In the UK, on the other hand,

by the time taxation became important, financial reporting and auditing were already

well established. Such a divorce between accounting reporting and taxation reporting

in the UK has created the issue of deferred taxation, which is not a significant issue in

either France or Germany (J Watts, 1996). Still it is not the case for Group accounting

in France and Germany. In France for example, group accounts are separately

regulated from individuals accounting, whereas in Germany group accounting is

generally based on US GAAP and the IASs. Therefore deferred taxation is also an

important issue for the large French and German companies. From another point of

view, the tax based accounting lead to conservative tendency in reporting profits.

Moreover, it is less likely to show true and fair view, because of the concentration on

the compliance with tax rules and producing lower figures of profits.

2.1.4. The account ing pro fession

Factors such as, number of private shareholders and number of public companies are

likely to create the need for a large number of accountants and auditors These factors

can be considered responsible for the massive number of professionals in the UK,

which is larger than the number of accounting and auditing professionals in the whole

continental Europe. However, one should notice that many of them work in other

fields than professional practice. The size of profession and the authority delegated to

it by governments affect the standard setting process. In the UK the ASC which

comprised part-time representatives has ruled the accounting practices for long time

before it was replaced by ASB. However, even in countries where governments are

setting accounting rules, professionals still may affect the standard setting process by

acting as advisors to the government (Roberts et al., 1998). This factor can be related

to the legal system factor mentioned above. In countries such as the UK, un-detailed


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rules activate the process of producing accounting standards and relative

recommendations.

2.2 Standard sett ing in the three coun tr ies1

To complete the background about the accounting practices in France, Germany and

The UK, it is necessary to explain at least in short about the mechanism of standard

setting in the three countries.

2.2.1. UKStandard setting: In 1970 the Accounting Standards Steering Committee was

established by the Institute of Chartered Accountants in England and Wales (ICAEW).

In 1976 it was reformed as the Accounting Standard Committee (ASC). Over a period

of approximately 14 years the ASC issued 22 Statements of Standard Accounting

Practice (SSAP). ASC was accused of being slow and too willing to compromise.

Moreover, there has been increasing complexity of accounting issues. Subsequently,

there has been pressure to find more highly developed standard setter. In 1990 the

pressure produced a new body which is the Financial Reporting Council (FRC). The

FRC, comprise the Accounting Standards Board (ASB) which is considered to be the

successor of ASC, the Financial Reporting Review Panel (FRRP) and the Urgent

Issues Task Force(UITF). The FRRP is for investigating the requirements of the

Companies Act and that financial statements show a true and fair view; whereas the

UITF prevents and treats any misinterpretation of the FRSs. Most of the UK listed

companies if not all, tend to follow the FRSs, unless there is a lack of regulation for a

certain accounting variable. In such case an IAS or a FASB would be practiced.

1The main resource for this section is (Deloitte 2000a & Deloitte 2000b)


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The companies Act: the Companies Act of 1985 was amended by the Companies Act

of 1989 to introduce a definition of accounting standards; alongside with a

requirement for companies over a certain size to disclose their compliance with

accounting standards. Auditors in the UK are obliged by the law to regard to

2.2.2. France

Standards setting: standards in France are complied with by the power of law as they

are part from basic business law. There are different resources for accounting

regulation:

European Directives.

Code de Commerce (including general accounting obligations for all

commercial entities and general rules for consolidated accounts).

Regulatory texts such as decrees and regulations (regulations are now

issued by the CRCsee below).

Jurisprudence.

Guidance, interpretations and recommendations (issued by CNCC and

OEC for all companies, and by the COB for listed companies).

In 1998 CRC was formed for approving the new accounting standards. Accounting

standards are proposed by the Conseil National de la Comptabilit (CNC), and

reviewedby the CRC before issuance. For interpretation of existing standard the

Comit dUrgence du CNC (Urgent Issues Committee), is comprised of a limited

number of CNC members.

According the French Code de Commerce, the companies listed on the French stock

exchange are permitted to prepare their financial statements using the IAS. However,

French companies still have to prepare their financial statements under French GAAP

as the CRC has not yet endorsed the requirements for adopting this option.


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2.2.3. Germany

Standards setting: German companies are required to prepare their financial

statements according to German GAAP by the force of the Commercial Code (HGB).

In 1998 the German Accounting Standards Committee (GASC) was set by the

German government to accomplish the following tasks:

Developing accounting standards for listed companies consolidated financial

statements

Advising the German Ministry of Justice on new legislation concerning

accounting standards

Link with international standard setters and to represent Germany in

international accounting committees.

The GASC since it was set has issued a number of accounting standards with the

name Deutsch Rechnungslegungs Standards (DRS). Moreover, since 1998 four laws

have been introduced which have significantly affected the process of bringing

German accounting practices to a divergence with the IASs.

However, the listed German companies are divided in three categories in terms of the

accounting practices the embrace: following German GAAP, IASs and US GAAP in

case they are listed on the American stock exchanges.

2.3 The rules relat ing to the tested accou nt ing variables in

dif ferent regulat ions2

Most of the accounting variables which are subject to this study are regulated in the

systems of the UK, France, Germany, IASB, the USA and the Fourth European

Directive, which is included in Companies Law of the three countries. One might ask

2For France, Germany and the UK, the main information resource is (report of Deloitte & Touche

2000a & 2000b)- For the US and IASs the main resource is (PricewaterhouseCoopers 2002)


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why we should be interested in IASs and US GAAP. The answer is that the German

companies which are a part of our sample are following either, German GAAP, IASs

or US GAAP, in case where they are listed on American stock exchanges. Thus the

following part illustrates the most important points these regulation tell about the

accounting variables which we are interested in, taken in account that these

regulations are guided in many areas by the Fourth European Directive.

2.3.1. Stock Valu ation

UK In general, stock valuation in the UK is regulated by SSAP 9 and Sch 4 CA

1985. According to SSAP 9 stocks must be valued at the lower of cost and net

realisable value (sale proceeds less all further costs to bring the inventories to

completion). Cost can be of production or purchase and must include all expenses

incurred in the normal course of business in bringing the product to its present

location or condition. According to the Companies Act the cost of borrowing capital

which is used to produce an asset can be capitalised and added to the cost of that asset.

Although SSAP-9 requires following the principle of the lower of cost and net

realisable value, the Companies Act does allow stocks to be valued at current value

and in certain industries (such as commodity brokers and plantation companies) at

market value. For the determination of stock cost, various methods are permitted

under UK GAAP such as the weighted average, first in first out (FIFO) and Unit cost.

However, last in first out (LIFO) is not considered to be acceptable.

FranceAs in the UK, French GAAP requires that stocks must be valued at the

lower of cost and net realisable value which is calculated at same way as in the UK.

Expenditures included in the cost of stocks are rather similar to the ones under the UK

and the German GAAP.


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Cost flow methods allowed under the French regulations comprise FIFO, unit cost

and weighted average. The LIFO method, however, is just allowed for the

consolidated accounts. Conventions which regulate stock valuation in France include

(Code de Commerce, Art. L123-18 al 3), (Decree of 23 March 1967, Art. D 248-8c),

(PCG art 321-3; PCG art 333-1, 321-3) and (Decree of 23 March 1967, Art. D248-8d).

Germany According to the German Commercial Code (HGB) stocks must be

valued at the lower of cost and either of net realisable value, market value,

replacement value or another permitted value permitted by tax rules. Unlike the UK

rules the German rules do not permit stocks to be carried at a value which surpasses

cost.The HGB states some guidelines about what might be included in the cost of an

asset such as the interest on loan capital used to finance the production of that asset.

To determine the cost of stocks both LIFO and the weighted Average are permitted

for tax purposes. However, FIFO is not allowed for tax purposes unless it is consistent

with the real pattern of consumption. Some of the conventions regulate stock

valuation in Germany are; ( 253 (3), 254 HGB), ( 280 HGB), ( 255 (2) HGB) and

(255 (3) HGB)

IASsSimilarly to the UK GAAP and French GAAP, under the IAS stocks are

carried out at the lower of cost and net realisable value. However, all of cost flow

assumptions FIFO, LIFO and weighted average are allowed under the IASs.

USA under US GAAP stocks must be valued at the lower of cost and market

value. Market valued is defined as being current replacement cost subject to an upper

limit of net realisable value and a lower limit of net realisable value less a normal

profit margin3. For cost determination LIFO is widely used for tax benefits gained

from following this method; nevertheless FIFO and weighted average are both

3PricewaterhouseCoopers 2000


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acceptable. Whereas under both UK GAAP and the IASs allocation of fixed

production overheads is based on normal capacity, under US GAAP some idle

capacity costs may be allocated to inventory costs.

The Four th Directive:in its article 39 the Fourth Directive states that stock

should be valued at the lower of cost and market value or another lower value

attributed to them at the balance sheet date. However, for cost determination, article

40 allows any of the recognised cost flow methods including FIFO, LIFO and the

weighted average.

2.3.2. Depr eciati on

UKIn general, under UK GAAP depreciation is to bring down net book value to

the estimated residual value over the assets useful economic life. Different

depreciation methods are acceptable in the UK including straight-line and the

reducing balance. Unlike France and Germany, the capital allowances (equivalent to

depreciation rates in other countries) given by tax authorities are completely

independent from the accounting practices.

FranceIndividual companies accounts in France are usually tax driven. Thus

the depreciation charge is based on advantageous rules and options. For the purpose

of taxes, the reducing balance method and accelerated tax depreciation may be used in

the statutory accounts. Although for consolidated accounts, different depreciation

methods are permitted, the straight-line method is widely used. Tax laws determine

the rates for depreciation; nevertheless companies are not obliged to use them as long

as the rates used by them are not 20% above the ones determined by the Tax

authorities. Similarly to the UK the estimate of the economic useful life of fixed

assets can be revised and changed.


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Germany As in France, depreciation in Germany is tax driven and rates are

determined by the Tax authorities. Different depreciation methods are accepted by

these authorities including the reducing balance method, accelerated depreciation and

the half year simplification rule. The reducing-balance method is commonly used for

movable fixed assets in the first years after acquisition in order to achieve the

maximum possible tax benefits. Then it is common to switch to the straight-line

method, if this method results in a higher depreciation, in order to maintain tax

deductions at their highest possible level (KPMG 2001)4. Depreciation calculated for

individual accounts is accepted to be included in group accounts; nevertheless it is

also permissible to correct the tax-driven values when preparing group accounts

(Ordelhide and KPMG 2001).

IASs and USADepreciation should reflect the consumption pattern of the fixed

asset in a systematic way. Various depreciation methods are permitted under both

IASs and US GAAP, including reducing balance and straight-line. While under UK

GAAP and IASs changes in the depreciation method used or the expected life are

dealt with as changes in accounting estimate, which means they are reflected in the

current and prospective years accounts, under US GAAP these changes are dealt with

as changes in accounting principle and its cumulative effect is treated in the current

years results.

The Fourth Direct iveThe only point mentioned about depreciation in the

Fourth Directive is in article 31, which states that depreciation must be taken in

account whether the result is a profit or a loss.

4A report prepared by KPMG- see references list


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2.3.3. Treatment o f Goodw ill

Generally, goodwill arising on a business combination is calculated as the difference

between the cost of the firm acquired and the fair value of the net identifiable assets

acquired. However, the amount of goodwill calculated under different conventions

may differ because of the difference in requirements for calculating the cost of

acquisition and its allocation to identifiable assets and liabilities required. What

matters here in this research is exploring whether all companies are harmonised in the

respect of capitalising goodwill.

UKbefore FRS10 was issued,although capitalisation of goodwill was permitted

under UK GAAP, the full amount of goodwill used generally to be eliminated against

reserves. For accounting periods ending on or after 20 December 1998, positive

goodwill has been required to be capitalised as an asset with a useful economic life

presumed to be less than 20 years. However, this presumed period is not definite, as it

can be a longer or an indefinite life if the stability of the acquired business can be

demonstrated, and justifies that the economic life is to exceed 20 years, and the

goodwill is capable of continued measurement. Impairment review for goodwill is

required by FRS 11 as amortisation is not compulsory.

France according to Code de Commerce: Art. L123-14; Rg n99-02 ( 212),

goodwill in consolidated accounts arising on acquisition of a company must be

capitalised and shown as an asset within fixed assets; nevertheless, under French

regulations goodwill can be written off, if that provide a true and fair view, this might

means the case where goodwill has no real value. Under French GAAP non-

amortisation of goodwill is permitted, and in French laws there is no requirement for

amortising goodwill in the accounts of individual companies. the period of

amortisation, there is no specific requirement, except that it must be on a reasonable


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basis in the consolidated accounts. Moreover, under French regulations, goodwill

amortisation is not tax deductible.

Germanya definition of goodwill is stated in the convention ( 255 (4) HGB).

As in French law, requirements about goodwill for individual companies are different

from the ones for consolidated accounts. For the purpose of individual companys

financial statements, goodwill can be written off immediately against reserves or

amortised over four years. Another alternative is to amortise it over its estimated

useful life, which is commonly assumed to be fifteen years. Before August 2000

according to the convention ( 309 (1) HGB), goodwill in consolidated accounts was

allowed to be written off against reserves or amortised over four years but after that

date, accounting standard DRS 4 required that maximum useful life of goodwill is 20

years and that the amortised proportions should be taken through the profit and loss

account and no longer be offset against reserves.

IASsaccording to IAS 22 goodwill must be capitalised and amortised over a

period not to exceed 20 years as the one of the UK regulations.

USA goodwill under US GAAP used to be capitalised and amortised over a

period of less than 40 years. However, effective January 1, 2002, SFAS No. 142

eliminates the requirement to amortise goodwill and instead requires periodic testing

of goodwill for impairment. If goodwill is impaired, it must be written down to its

estimated fair value.

The Fourth Direct iveas article 9 from the Directive prescribes the layout of the

balance sheet, this article states that Goodwill acquired for a valuable consideration, is

an element of the intangible fixed assets. Article 4 affirms that capitalised expenses

should be amortised over a maximum period of 5 years. This was followed by article

37 which says that goodwill is a part of those expenses. However, article 37 allows


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companies in member states to amortise goodwill over a period exceeding 5 years and

no longer than the useful economic life of the asset, which must be stated in the notes

to the accounts, with the reasons therefore.

2.3.4. Research and Development Cos ts

UKunder UK GAAP research costs are differentiated from development costs.

Whereas the first must be expensed as incurred, the later may be capitalised provided

that outcome of the project can be measured with reasonable certainty as they are

technically feasible and commercially viable. In other words, costs of development to

be capitalised, must be recoverable and adequate resources must exist. Exception

from this is development costs which are related to contracts with a third party, or the

ones which are incurred while locating and exploiting mineral resources. Nevertheless,

the last practice is rarely chosen.

Franceunlike UK GAAP, French regulations [PCG art 361-2, 361-3] do not

distinguish between research and development costs. However, it allows both of them

to be capitalised under the same conditions UK GAAP requires for capitalising

development costs. Amortisation of capitalised R&D must be charged over a

maximum period of 5 years. Furthermore, unamortized R&D should be deducted

from retained profits before calculation distributable earnings.

Germany according to the convention ( 248 (2) HGB) R & D costs must be

expensed when incurred.

IASssimilarly to UK GAAP, IAS 38 does distinguish between research and

development costs. While the first must be expensed as incurred; the latter must be

capitalised provided met certain criteria built on conservative basis similar to ones of

UK GAAP. Costs of development which written of prior meeting the criteria, may be

capitalised, if the criteria are met later.


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USA with no differentiation between research and development costs and

according to SFAS No. 4, R&D must be expensed when incurred

The Fourth Direct iveresearch and development costs are recognised in article

9 as an element of intangible fixed assets as long as national permits their being

shown as assets. Similarly to the case of goodwill, article 37 refers to article 34 in

amortising R&D costs so that may be amortised within a period of maximum 5 years.

However, it affirms that exception to this period may take place, but it must be

explained in the notes to the accounts.

2.3.5. Fixed A ssets Valuation

In this research attention will be on the valuation of just one part of fixed assets: -

property, plant and equipment. Thus issues about revaluation of investment are

avoided.

UK under UK GAAP, initial measurement of fixed assets is carried out at cost.

However, Companies Act (1985 CA, Sch.4) permits tangible fixed assets to be

revaluated. FRS 15, which is effective for periods ending on or after 23 March 2000,

determines some bases on which revaluation of fixed assets must be carried out.

France fixed assets under the French rules are initially recorded at cost, except

items with value less than FF 2,500 to be expensed. Still revaluation of tangible fixed

assets is permitted in both statutory and consolidated accounts. When revaluation

policy is adopted all relevant asset categories must be revalued; nonetheless intangible

assets and stocks may not be revalued. Although legal revaluation-tax free of tangible

and intangible assets was allowed in the year 1976-1977, surpluses from voluntary

revaluation from 1984 onwards are taxable. Thus revaluation practices are rare in

France and much less common that in the UK. Revaluation is regulated by the

conventions [Code de Commerce, Art. L123-18al.4, PCG art 350-1]


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Germany although revaluation of fixed assets is permitted by the Fourth

European Directive, German regulations do not permit fixed assets to be revalued at

more than original cost as reduced by depreciation.

IASsessentially the base is the historical cost, but revaluation is permitted by IAS

16, which states some conditions under which revaluation must be carried out. On the

other hand, IAS 40 is considered with revaluation of investment property.

USA under the US GAAP no revaluation for PP&D is permitted.

The Fourth Direct ivethroughout section 7 the Directive states the criteria must

be met when companies valuate items in their annual accounts. Article 33, shows that

tangible fixed assets can be revaluated and that inflation must be taken in account.

2.3.6. Deferred Taxation

UK according to SSAP 15, deferred taxation must be provided for timing

differences for which a liability or an asset is probable to crystallise (partial provision),

and that liability method is required. However, in December 2000 FRS 19 was issued

requiring companies to report their deferred taxes in a form of full provision, called

the incremental liability approach. FRS 19 is effective for accounting periods ending

on or after 23 January 2002. By this convention assets and liabilities of deferred taxes

are allowed to be discounted. Under UK GAAP deferred taxation requirements are the

same for consolidated financial statements and single entity accounts.

France for single entity accounts, deferred taxes are not required. Yet they are

required to be reported in consolidated accounts using the full provision approach and

the liability method. Deferred taxes assets in both the UK and France, must be

recognised to the extent that recovery is assured beyond a reasonable doubt. Material

about deferred taxation in the French regulations will be found in the provisions [PCG

art 441/14] and [CGI, art. 39-1-5]


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Germany For individual companies financial statements, and according to the

German provision ( 274 (1),(2) HGB and DRS 10), deferred taxes liabilities are

required; whereas deferred taxes assets are optional. On the other hand, for

consolidated accounts both assets and liabilities of deferred taxes are required by the

provision ( 306 HGB) to the extent that they will reverse in the future years (partial

provision). The method required under the German code is the liability method,

although it is not mentioned by name ( 274 (1) and (2) HGB, SABI 3/1988).

IASsIAS-12, which was amended by IAS-10 and IAS-40, requires full provision

for deferred taxes arising from nearly all timing differences calculated at tax rate

expected at time of settlement (liability method).

USA full provision is required under the US GAAP. However, it differs for the

other countries in requiring provision for all deferred tax assets, and then provides

valuation allowance if recovery is less than 50% likely. As explained in the

publication of PricewaterhouseCoopers (2000), it is Recognise in the balance sheet at

full value, but reduce by a valuation allowance if, based on the weight of available

evidence, it is more likely than not that some portion, or all, of the deferred tax asset

will not be realised.

The Fourth Direct iveThe only requirement in the Fourth Directive about

deferred taxation is that they must be disclosed in the balance sheet as a cumulative

amount under a separate item with an appropriate heading (art. 43, par. 11). Neither

the Fourth Directive nor the Seventh Directive contains any requirements in respect of

reporting deferred taxes in full or partial provisions.

2.3.7. Translatio n o f Financ ial Statements o f Foreign

Subsidiar ies

UKUK GAAP distinguishes between independent and dependent subsidiaries,

according to way they are financed or operate in relation to the parent company. The


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current method is used to translate the financial statements of independent

subsidiaries, whereas the temporal method is required for the dependent ones.

However, under UK GAAP, it is permissible to translate the profit and loss account at

either the closing rate or the average rate. For countries with hyperinflation, UK

practitioners may adopt IASs or US GAAP. The case of hyperinflation is regulated by

SSAP 20 and UITF 9. In short they require either the financial statements reflect the

current price level, or using a stable currency as a functional currency.

France under the French GAAP, conditions required in choosing either the

current method or the temporal method, are the same as the ones required under UK

GAAP. Nevertheless, for translating the profit and loss account, just the average rate

for the period is used.

Germanythere is not any specified method required under German GAAP, for

translating financial statements of foreign subsidiaries. Yet, there are some methods

which are recognised in practice, such as the current method, modified current method

and the temporal method. Translation differences are either taken to the reserves or

offset against profit and losses.

IASsas in the UK, the temporal method is required for dependent subsidiaries

and the current method for the independent ones. However, just the average rate is

allowed to translate the profit and loss statement, whereas under UK GAAP closing

rate is permitted. Another difference from the UK is that exchange differences are

taken to equity, as in the UK they are reported in STRGL. (PricewaterhouseCoopers

2000)

USA under US GAAP, requirements of translation are comparable to the ones of

the IASs, except the treatment of statements from countries with hyperinflation.


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The fourth Direct ivetranslation of foreign financial statements is not in the

scope of the fourth Directive. However, the only requirement in the Seventh Directive,

which is concerned with consolidated accounts about this, is to disclose the chosen

policy in the notes to the accounts.

2.3.8. Capital isat ion o f bo rrow ing cos ts

UK according to the Companies Act (1985 CA, Sch. 4), Interest on capital

particularly borrowed to finance producing an asset, can be added to the cost of the

asset to the extent it accrues in the period of production.

Franceunder the provision [PCG art 331-1], as in the UK interest may be

capitalised providing it incurred in period of the asset production and it is on external

borrowings.

Germanysimilarly to the UK and France, it is allowed under the German

regulations to capitalise the interest on the capital used to finance certain assets. (

255 (3) HGB)

IASregulated by IAS 23, interest can be capitalised.

USA US GAAP has a different treatment from the others, as borrowing costs are

required to be capitalised by FAS 34.

The Fourth Direct ive there is no any requirement related to this accounting

variable.

2.3.9. Leases :

UKunder UK GAAP (SSAP 21), a lease should be capitalised and stated as an

asset (finance lease), if it transfers to a large extent all the risks and rewards of

ownership of the asset to the lessee. An asset and a liability should be reported at the

present value of the minimum lease payments. Another case of finance leases is when


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the present value of the minimum lease payments equals 90% or more of the assets

fair value.

Francefor individual companies accounts, all leases are considered to be

operating leases and expensed. On the other hand, for consolidated financial

statements capitalising finance leases is preferred but they are mandatory. Therefore

in case they were considered as operating leases additional information about the

amount may be capitalised must be provided (multiple reporting).

Germanywhereas tax law in Germany distinguish between operating leases and

finance leases; the German commercial law does not distinguish between them. Thus,

definitions in the tax law are used by the companies, to account for finance leases.

This means that leases can be capitalised but in contrast to UK GAAP, the present

value of minimum lease payments is not a criterion for classification of leases.

However, in practice they are frequently not disclosed separately, unless material.

(Deloitte)

IASIAS-17 (revised) has the same requirements as UK GAAP.

USA FAS-13 has similar requirements to those of UK GAAP and IASs.

The Fourth Direct ivethis directive does not provide any guidance in the area

of foreign currency translation. However, the seventh Directive on consolidated

accounts refers to translation methods only in the requirement that the bases of

foreign currency translation be disclosed in the notes to the accounts. Thus in most of

Europe, the choice of method is left to the company (HW, 1995)


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Chapter 3

3.1 Review of extant literature

3.1.1. Literature review b y Parker and Tay

A study by Tay and Parker (1990) might be the most appropriate start for reviewing

the extant literature about measuring harmonisation. TP analysed six important

studies dealing with the measurement of international harmonisation of financial

reporting. The approach used to review the six studies was by analysing the problems

which arise when measuring harmony, harmonisation, uniformity and standardisation.

Seeing that the issues discussed in this analysis are important for this research, I have

chosen to provide a summary of each issue. However, before that we need to know

which studies have been used and criticised in this analysis; thus TPs table, which

was used by them to illustrate the most important information from these studies has

been reproduced as table 2 (p27). The studies reviewed by Tay and Parker in

chronological are: Nair and Frank (1981), Evans and Taylor (1982), McKinnon and

Janell (1984), Doupnik and Taylor (1985), Nobes (1987) and van der Tas (1988).

These authors will be referred to as NF, ET, MJ, DT, N and VDT respectively.

Summary of the main problems associated with measuring harmonisation as

defined by Tay and Parker 1990:

Possible data resources: There are two main types of data resources used in the six

studies; surveys and financial statements. NF, DT and MJ used international surveys

whereas van der Tas used national ones. The international surveys were the ones

prepared by Price Waterhouse, whereas the national surveys used by VDT were

prepared by professional bodies in the Netherlands, the US and the UK. Surveys have

some advantages such as making work easier for researchers, as other people have


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done the tiresome work of collecting the information and put it in a particular form.

However, there are some drawbacks in dealing with surveys as a resource for this

kind of study. One disadvantage is that they have been prepared for other purposes, so

they are not necessarily valid for the purposes of this kind of research. In some cases

surveys are not available in a form suitable for the researchers. This could cause

problems when comparing data from different surveys with each other. Surveys might

not be sufficiently detailed and that might lead to researchers to draw the wrong

conclusions. Moreover there are some inaccuracies in the data given; such as the ones

spotted by Nobes (1981)5 in the PW survey of 1979. There is also the possibility of

misinterpreting data as because of unfamiliarity with accounting systems in the

different countries. The last disadvantage of the surveys is the time lag which can be

found between the periods surveyed and the publication date.

Financial statements: TP describe the data of financial statements as raw. It can be

easily manipulated by researchers. Collecting data from financial statements can also

be tedious and time consuming. Other problems about financial statements are

associated with companies placed in other countries, where it takes long time to get

copies of their financial statements, although nowadays the Internet might provide us

with electronic versions. The annual reports of foreign companies might not be

available in a language the researcher understands. In some cases even if translated

versions are available, they might be abridged or restated in a way which is different

from the original statements.

Operational Definitions: in this part TP indicate that the operationalisation of the

concepts of harmony, harmonisation, uniformity and standardisation is necessarily

linked with the type of data used. The use of data and the categories in which this

5It is a reference for TPs paper, but not a reference for my research.


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data is classified will imply a concept of what is measured. Therefore in some cases

such as in the study of NF (1981) the measured harmonisation might not be consistent

with its definition.

Statistical methods: The methodology used in the six studies reviewed by TP can

be classified into three categories; descriptive statistics, nonparametric statistics and

indices. The first one, descriptive statistics, used to be the most common method

where three of the reviewed studies (N, ET and MJ) employed this kind of method.

This is applied by calculating the number or percentage of companies within the

sample which complied with specified regulations, where the percentage represents

the degree of uniformity. One of the shortcomings of this methodology is that it does

not measure the overall degree of harmony, either between countries or across time.

The second type of type of methodology is the nonparametric test: Two of the studies

used nonparametric tests. NF (1981) used Friedmans ANOVA to deal with the

categories of PW survey, which were given different ranks. On the other hand, using

the same survey data, DT (1985) allocated weights to the different categories, and

ranked the weighted average scores they calculated for the countries surveyed. The

prepared data was tested by employing the Kruskal-Wallis test and Mann-Whitney U

test which was used to examine the significance of the differences between the mean

scores of the E.C. and non-E.C. groups of countries. TP see that this kind of

methodology is appropriate for the purpose of measuring harmonisation. Yet the

concept of what is to be measured must be accurately defined and operationalised,

while data is to be accurately interpreted and categorised.

The last type of methodology is the indices which are discussed later in the

methodology section of this research. In the two following pages, Table 2 illustrates a

summary of the studies reviewed by Tay and Parker:


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In 1988 van der Tas provided his important paper about measuring

harmonisation. The importance of this paper was the newly developed technique for

measuring harmonisation. This paper aimed to determine when and to what extent

harmonisation had taken place at the level of some accounting practices in the UK,

the Netherlands and the USA. Another aim of the paper was to determine the impact

of some organisations such as the ASC, FASB, IASC and the EU on the process of

harmonisation Data for this study was collected from some national surveys, such as

the survey of ICAEW over the period 1968-1981 and some other surveys prepared in

the US and the Netherlands by national institutions. The practices chosen by van der

Tas to be examined in his paper are deferred taxes and investment tax credits. To

measure harmonisation van der Tas presented the Herfindahl index, which was

originally used to measure concentration and monopoly in industries. Two secondary

indices are developed from the H index for the purpose of measuring harmonisation in

the case of multiple reporting; the C index and the I-index. (See p38, p39)6

At the international level van der Tas found disharmonisation had taken place

between the US and the Netherlands, as each of the two countries had concentrated on

a different method. In the USA there had been an increasing application of the flow-

thorough method, while in the Netherlands the deferral method had been the preferred

method. In fact at the end of his study, van der Tas did not relate his results strongly

to the aims he stated at the beginning of the paper, such as measuring the impact of

the organisations mentioned above on the harmonisation process. However, what van

der Tas emphasised and analysed very well is the indices suggested for measuring

harmonisation.

6Details are in the methodology section in my research.


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After about four years in 1992van der Tas provided his second paper which

aimed to measure the degree of harmony of the deferred taxation accounting policies

of 154 European listed companies over the period 1978-1988. Furthermore, this study

explores the impact of the EC harmonisation endeavours in the context of the deferred

taxation issue. The methodology used by van der Tas in this study is developed from

the one he used in 1988. In addition to the C index which is used to measure

harmonisation, van der Tas suggested using multiple regression analysis to measure

the statistical significance of the impact of the ECs efforts (see p 49)7. Furthermore,

van der Tas in this study defended the use of his indices as they were criticised by Tay

and Parker (1990). At the same time he criticised the use of the Chi-square test which

had been suggested by them. Additionally van der Tas rejected the idea that three of

the other studies reviewed in the article of TP; Evans and Taylor (1982), Doupnik and

Taylor (1985) and Nobes (1987a) can be considered as attempts to measure

harmonisation. Van der Tas argues that these studies are measuring the compliance

with or observance of international standards. Furthermore, he is arguing that their

methods are not appropriate for measuring material measurement harmonisation, as

high compliance with the standards does not mean high level of material harmony. To

support his opinion van der Tas, explained that when an IAS allows various methods

and companies apply these methods, the degree of harmony may be low all the

compliance with the IAS is high. On the other hand, when all large companies choose

the same practice, the degree of harmony is high; nonetheless the degree of

compliance with the IASs may be low when that method is not permitted by the IAS.

The researcher indicated that the sample he used was not random and that the results

of his study cannot be regarded as a statistically valid estimate of the degree of

7Methodology section


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harmony of financial reporting. Because he believed that it should be considered as a

demonstration of the application possibilities of the methods of measuring

harmonisation.

3.1.2. More s tudies

During the nineties there were a number of studies which attempted to use different

techniques to measure harmonisation. Some of these studies introduced new

methodology, while some other used previous methods with some adjustments. The

following are a sample of these studies:

Emenyon u and Gray in 1992In this paper EG aimed to measure the level of

harmony in accounting practices between France, Germany and the UK under the

scope of the Fourth European Directive. They used the I-index of van der Tas (1988).

This study is considered to be important for the use of the non-parametric test Chi-

square to determine how significant the differences are in the accounting practices

chosen by a number of the largest companies in the three countries. In fact using this

statistical test was suggested by Tay and Parker in their critical article (1990). EG

chose to examine the methods of treating six accounting issues: Stock valuation,

depreciation, goodwill, fixed assets valuation, R&D and exceptional items, all of

which had been included in the Fourth European Directive. Their general null

hypothesis was that there is no significant difference in any of the methods used by

the companies in their sample to treat the six accounting variables. Data for their

study was obtained from the annual reports of 78 of the largest listed companies on

the stock markets of France, Germany and the UK for the 1989 financial year.

Emenyonu and Gray found that there were very significant differences in the

treatment of stock valuation, goodwill, fixed assets valuation and depreciation.

However, there was no significant difference in the treatment of


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extraordinary/exceptional items and it was not possible to test the treatment of

research and development, because of a lack of disclosure about this item. EG ran bi-

countries tests to get different results. For instance, there was no significant difference

in the stock valuation methods adopted by German and UK companies which means

the significance in the difference was caused by the French companies. The same test

was applied to goodwill treatment and again they found that there was no significant

difference in the German and UK choices. For the harmonisation measurements there

was a very low degree of harmony in the treatment of depreciation, which was

explained by the influence of tax accounting on French and German financial

reporting. A low level in harmony was in the treatment of goodwill was caused by

96% of the UK companies and 75% of the German companies writing off goodwill

immediately against 92% of the French companies amortising it over a period of time.

The main conclusion of EGs study was that there were significant differences, and a

lack of harmony which is found by using the I-index. However, there is no benchmark

yet available to test whether the levels of harmonisation measured were acceptable or

not.

Arc her et al in 1995measured harmonisation at the level of both within and

between countries. The countries chosen to be studied were Belgium, France,

Germany, Ireland, Sweden, Switzerland, the Netherlands and the UK; while the

practices examined in their study were the ones of deferred taxes and goodwill.

Although van der Tas had introduced the I-index to measure international

harmonisation and the C index to measure national harmonisation, the authors in this

paper chose to develop new technique using the c index. They decomposed the C

index into two indices; one was to measure comparability within countries; while the

other was to measure comparability between countries. The main purpose of this


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study, as it was stated by the authors, to study the impact of accounting

harmonisation on the financial reporting practices or policy choices of the companies

of our sample was not satisfied at all. Because the concentration in this paper was on

measuring international harmonisation between the samples countries, and nothing

was mentioned about the impact of accounting harmonisation on the financial

practices or policy choices. Data was collected from annual reports of some selected

large companies for the financial years 1986/87 and 1990/91. The researchers found

that there was a little progress in harmonisation at the level of deferred taxation and

consolidated goodwill between the eight countries over the period studied.

In 1995 Hermann and Thom aschose Belgium, Denmark, France, Germany,

Ireland, the Netherlands, Portugal, and the UK to measure harmonisation with respect

to selected accounting practices. These practices were selected according to two main

criteria. First, the policy choices must significantly affect measures of net assets and

profits. Second, the annual reports must contain sufficient disclosure to determine the

policy choices selected. Data examined is taken from the annual reports of 217

companies for the 1992/93 fiscal year. The general hypothesis of this study was that

there are differences in the frequency of accounting measurement policy choices

across the eight countries. However, the authors did not mention the significance of

these differences, although the methodology they chose is to measure significance.

The methodology employed was the same as used by Emenyonu and Gray (1992) (I

index and Chi-square). However, the I index in this study is developed to avoid the

effect of zero in cases where all the companies in a country applied one method (see p

42)8. From the conclusions of this study, we find the highest degree of harmonisation

is identified in the areas of foreign currency translation and stock valuation in addition

8see methodology section


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to the treatment of depreciation after excluding German practices. On the other hand

the accounting for research and development, fixed assets, goodwill and stock costing

is significantly different. Although Hermann and Thomas used the same methodology

used by Emenyonu and Gray before, the number of countries in this paper is larger

and more accounting practices are examined.

Rahman et al in 1996presented their study in which they aimed to measure

formal (de jure) harmonisation, where it was different from the previous studies

which concentrated on material harmonisation (de facto). However, what is measured

in this study is not harmonisation as a process, but just a state of harmony in the

context of the rules and regulations (both disclosure and measurement requirements)

between Australia and New Zealand at 30 October 1993. The methodology of this

study is confined to measuring the significance of the differences in the regulations,

using the statistical test called Mahalanobis distances. The writers suggested that the

results of this study can be used to see how much of the material harmony is

explained by the formal harmony by correlating the distances calculated in their study

with the differences of actual practice. Out from the 59 categories of requirements

tested 38 indicated a distance of 0 to 0.99; whereas 15 indicated a distance of one to

19.99. A distance of over 20 was just in six categories. These distance measures are

comparable to the 2R resulted in regression analysis. However, the authors did not

provide enough information to work as a guidance to show how to interpret these

ranks of distance measures.

In 1999 McLeay et alintroduced another new methodology in the field of

measuring harmonisation. They believed that international harmonisation will occur

by working a way from local regulations where firms would have; a free choice from

a set of international standards and to choose what is suitable to their own


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circumstances without being constrained by national conventions and regulations. In

other words they introduce harmony as the probability that a particular accounting

method will be used in given operating circumstances is identical across all firms in

all countries. Then measuring harmonisation is measuring this probability. Their

methodology was a series of models with different functions such as separating

harmonisation from standardisation; indicating systematic harmonisation (as it is

explained by the authors it is the reduction in disharmony that has occurred during a

period and is attributable to movement within countries towards international norms)

and non-systematic harmonisation. In my opinion, a shortcoming of this study is that

the authors do not provide simple examples to show how these models work. They

just show the results of their study without illustrating how the models were applied.

3.2 Methodology

3.2.1. Data this study aims to measure the material harmonisation (de facto)

between the largest listed companies in Germany, France and the UK; therefore the

most suitable source for data in this case is the annual reports of large companies,

which shows the actual accounting policies practised within these companies. The

annual reports used in this study are for the fiscal year 2001 because they are the most

recent annual reports available for most of the companies studied here. As a matter of

convenience, for the purpose of this study complete versions of annual reports

available on the internet were downloaded. Annual reports as a data resource are

criticised by Tay and Parker (1990) (see p24). The number of companies is 78

(Appendice1, 2, 3), which is equal to the sample used by EG (1992), so comparability

with their results will be reasonable. The companies are the selected from the Worlds


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largest 500 published by the Financial Times 9 . Choosing a sample from largest

companies guarantees benefits which might not be available for medium and small

companies; such as publishing documents in English. Furthermore, these companies

are the most likely to attract international investors for whom international

harmonisation is considered an important issue. Our sample here is not biased by any

sector. It is selected randomly from different sectors avoiding any effect which might

be caused by the nature of sectors on the policy choices made by these companies.

3.2.2. Statis tical analy si sThe methods employed here are two different ones, which have different functions.

These methods are the Chi-square test and the I-index. In this section I explain both of

them, showing the concepts behind them and how they work.

3.2.2.1. Ind ices

Employing Indices for the measurement of harmonisation was pioneered by van der

Tas (1988) where he introduced the Herfindahl index for the purpose of measuring

international harmonisation. To be more precise, what is measured is a state of

harmony at a certain point of time and subsequently harmonisation (the process) will

be computed by the difference between two dates.

3.2.2.1.1. Herfin dahl (H) ind exoriginally is a measurement of concentration

used by economists to measure the level of concentration in an industry and

calculated by summing the squared percentages of market share of all firms in that

industry. Applying this index in the context of financial reporting harmonisation

implies an analogy between the accounting harmonisation and industrial

concentration. Tay and Parker (1990) say that the validity of this analogy must be

discussed. Measuring industrial concentration determines the situation of a market

9annual publication by FT (see references list)


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between the two extremes of monopoly and perfect competition. The match with

monopoly in accounting is when all companies practise the same accounting method

(uniformity), whereas the match perfect competition is where every company is free

to choose a different accounting policy. Tay and Parker see that this situation is not

possible in reality. However, they think that a combination of accounting methods

used for the financial statements as a whole can be the match with a good in a perfect

competition situation- very few companies use identical combinations of accounting

methods). They suggest that some questions need to be answered, such as, when using

the concentration measurement in accounting, what is number of accounting methods

available for each accounting variable? Which ones should be considered (the ones

regulated or all the ones used in practice)?

The Herfindahl (H) index is calculated by weighting the relative frequencies of the

alternative options against each other. This means when the methods chosen by

companies involved concentrate more on one or only a limited number of alternative

methods, the H index will rise. A very small example here might help to show this

idea: Suppose that we have 100 companies and two accounting alternatives A and B.

Assume that in period 1, 50% of the companies applied the alternative A and the other

50% applied B. The H index will be: 5.05.05.0 22 H . If in period 2, 75% of the

firms applied method B, whereas 25% applied A, H will be: 22 25.075.0 0.6875.

It is clear from the example that H figure rose, because of more concentration on one

of the methods available.

Van der Tas (1988) found that the H index is unsuitable for multiple reporting (the

situation in which companies provide information that help comparisons with another

accounting policy) because each company can only be assigned to one of the

alternative accounting methods (see van der Tas 1988, p163). To overcome this


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problem he derived the C index and the I-index from the H index. The first is derived

to measure harmonisation within countries (national harmonisation), whereas the

latter (I-index) is derived to measure harmonisation between countries (international

harmonisation). These indices do not measure harmonisation as a process directly;

where they are used to measure levels of harmony at different points of time and

consequently the harmonisation would be the fluctuations in these levels.

3.2.2.1.2. The C indexmeasures the degree of comparability of financial

reports in a country as the ratio of compatible pairs of companies to the number

possible pairings. The compatible pairs are every two companies which follow the

same method or at least provide additional information to enable comparison. Van der

Tas (1992), defending against the criticisms of Tay and Parker (1990), argues that the

C index has three advantages. First, its measurement of the degree of harmony is

directly linked with to comparability; second, its capability with multiple reporting;

and third, its results can be used in an effective significance test to calculate the

significance of movements in the degree of harmony. The C index formula is as

follows:

nn

nai

i

i

C

2

1

2 )(

where:

ia The number of companies applying accounting method i

i The number of alternative accounting methods

n The total number of companies

However, the C index can be related to the H index by using the formula:

n

nHC

/11

/1


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3.2.2.1.3. The I-indexon the other hand is derived from the H index for the

purpose of measuring international harmonisation; it can be calculated by multiplying

the relative application frequency of a method in country A by the relative application

frequency of the same method in country B and subsequently by adding the results of

all alternative methods. In 1995 Archer et al decomposed the C index into two indices

to use at both levels, national and international. However, what we are using here is

the I-index, since it is the same methodology used by Emenyonu and Gray (1992).

The general formula of this index is:

I = ( )......( 21

1

ififif cm

i

) )1/(1 c

Where:

I= I index

fi Relative frequency of method i in country m

c = Number of countries

m = Number of alternative accounting methods

I index is calculated by multiplying across countries the proportion of firms adopting

a specific accounting option followed by summing up all these products for each

accounting method. Hermann and Thomas (1995) indicate that the I-index is not

meant to give a signal of the statistical significance of harmonisation, as it is a scale

upon which to quantify harmonisation for comparative purposes justifying the use of

the Chi-square test.

Van der Tas 1988 applied the I- index to compare accounting policies applied in two

countries. However, he realized that the application to more than two countries will

lead to a very small value of the I-index for the large number of frequencies and

subsequently will lead to a very unequal distribution of the I index over the interval 0-


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1 (the two points of time). Therefore in appendix 2 of his paper, van der Tas

suggested a correction factor )1/(1 m which is the exponent in the formula shown

above. The following is a simple example which will help to understand the way this

index works and to show the effect of the correction factor:

Assume that we are testing the use of two accounting methods 1m and 2m in two

countries 1c and 2c at two points of time 0 and 1. For more explanation assume that

in time 0 all companies in 1c choose the method 1m , while all companies in 2c

choose the method 2m . At time 1 the proportions of companies choosing 1m in the

two countries were 0.75 and 0.35 and the ones choosing 2m was 0.25 and 0.65

respectively.

Country Country

Time 0 1c 2c Time 1 1c 2c

1m 1 0 1m 0.75 0.35

2m 0 1 2m 0.25 0.65

In time 0:

I= 1001 = 0

In time 1:

I= )65.025.0()35.075.0( 0.43

As can be seen above the I index is between 0 and 1, whereas in the first case there is

no in common accounting practices between the two countries and the value is 0.

Complete uniformity would give an index value of 1. The I-index in the example

indicates the level of harmony between 1c and 2c at time 0 and 1. Thus


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harmonisation as a process is measured by the movement from 0 to 0.43 over the

period 0-1.

In the example shown we did not need to use the correction factor we mentioned

above; but if we assume that we have a third country the application of the index will

need the support of this correction factor. Using the previous example suppose that

the proportions of companies in a third country using 1m and 2m are 0.6, 0.4

respectively.

The I-index without correction: I = 4.065.025.06.035.075.0 0.22

The I-index with correction: I= ( 4.065.025.06.035.075.0 ) )13/1( =0.47

As can be seen from this addition to the previous example, excluding the correction

factor changes the value measured from 0.47 to 0.22. As we increase the number of

countries this value decreases because of adding more fractions. Therefore the

correction factor cancels the effect of this mathematical property.

The final problem with the I-index is its sensitivity to zero proportions due to the

multiplication process involved in the calculation of the index. This problem was

recognised by Hermann and Thomas (1995). Thus they suggested a simple

modification for the application of the I-index. This fault in the index and its

treatment can be illustrated through the next hypothetical example:

Assume that there is no company in 3c which follows 1m ; while there is no company

in 1c which follows 2m , whereas in 2c 50% of the companies practise 1m and the

rest practise 2m , in this situation the proportions will be as the following

Country

1c 2c 3c

1m 1 0.5 0

2m 0 0.5 1


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Calculating the I-index in this case gives the following result:

015.0005.01

It is clear that there is a degree of harmony between 1c and 2c . However, I is zero and

that is because of the multiplication property of the zero. Therefore the modification

suggested by Hermann and Thomas is to give the value of 0.99 for the proportion of 1

in the case of the unanimous method, and 0.01 for the proportion of 0 in the case of

non-practiced method (instead of 1 and 0 respectively). Applying this small

adjustment will give the following result:

( 2/1)99.05.001.001.5.099.0 0.00495

(see Hermann and Thomas 1995 for more examples of this).

3.2.2.2 Chi -squ are test:

This test is suitable to test whether data classified into categories will differ in

frequency from each other. For example people may be classified into categories

according to their opinion towards a certain subject e.g. in favour of, indifferent

to, or opposed to. The hypothesis to be tested in this situation is that these

responses differ in frequency. (see Siegel and Castellan 1988).

Application of The Chi-square test for k independent samples:

The Chi-square test can be used to measure the significance of differences among k

independent groups. Siegel and Castellan determined certain steps to be taken to

perform the Chi-square test:

1- arrange the frequencies in an kr contingency table where the kcolumns are

used for the groups (countries in our study) and the r rows for responses

(different accounting policies)


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2- Find out the expected frequency under 0H for each cell of the table. This

expected frequency ijE can be found by the product of the marginal totals

common to the cell and dividing this product by N which is the sum of each of

the marginal totals and represents the total number of independent

observations. (In our case it is the number of companies in a particular country

multiplied by the actual number of companies practicing a particular

accounting policy divided by the total number of companies in all countries).

In fact in the case of our study it can be easier to find the expected frequencies

as the number of companies examined in the three countries is equal. Thus the

ijE can be obtained by dividing the actual number of companies practicing a

certain policy into three equal proportions.

3- Calculate Chi-square statistic 2X and determine the degrees of freedom.

N

E

nX

r

i

k

j ij

ij

1 1

2

2

).1)(1( krdf

4- Determine the significance of 2X by finding the probability of 2X to occur

within dfand compare this by the value of (5%) (using the table of the

Chi-square distribution). So if this value falls in the rejection area (larger than

the critical value of

=0.5 and ).1)(1(

krdf ), the null hypothesis will be

rejected, which means there is a significant difference between the frequencies

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Measuring Accounting Harmonization