Global Comparability in Financial Reporting: What, Why, How, and When?

1. Global Comparability in Financial Reporting: What, Why, How, and When? Mary E. Barth Stanford University May 2012

2. What is comparability? 2 • Comparability is the qualitative characteristic of financial reporting information that enables users to identify and understand similarities in, and differences among, items • Makes financial reporting information more useful because the information can be compared to similar information about other entities or the same entity at a different time • Does not relate to a single item; comparability requires at least two items

3. What is not comparability? 3 • Comparability is not consistency • Consistency refers to the use of the same methods for the same items; comparability is the goal, consistency helps achieve that goal • Comparability is not uniformity • For information to be comparable, like things must look alike and different things look different; uniformity can make unlike things look alike • Some degree of comparability can be achieved by faithful representation

4. Comparability: Why? 4 • To meet the objective of financial reporting • Provide financial information about the entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity • Decisions to buy, sell, or hold equity and debt require allocation of capital, and financial reporting is aimed at those who cannot demand the information they need • Thus, comparability in financial reporting across entities and over time is important

5. Comparability: How? • Vision for International Financial Reporting Standards (IFRS) 5 …one single set of high quality global standards... ...used on the global capital markets.

6. Comparability: How? 6 • Global standards improve functioning of global capital markets • Increase • Comparability • Quality of information • Decrease • Costs of preparing financial statements • Information risk and cost of capital • Impossible to achieve comparability without using the same set of standards

7. Comparability: How? 7 • Requirements in standards also matter • Framework considers financial statement elements (e.g., assets) item by item • Aim is to provide investors with comparable information about the entity’s assets and claims against those assets; profit or loss is change in the assets and claims • Comparability results from portraying those elements in the same way • Recognize the same (sub)set of assets and liabilities • Measure them in the same way

8. Recognition 8 • Does recognizing same (sub)set of assets and liabilities always achieve comparability? • What if different assets and liabilities are important for some firms versus others, e.g., knowledge-based entities versus durable manufacturers versus insurers? • What if some assets—e.g., intangibles—or particular types of claims—e.g., claims with uncertain outcomes—are omitted? • Unrecognized assets and liabilities have direct consequences for comparability of profit or loss because profit or loss is changes in the amounts associated with recognized assets and liabilities

9. Measurement Same asset measured same way 9 • Does measuring same assets in same way always achieve comparability? • Modified historical cost? • Same asset purchased at different times has different measure • More differences emerge, e.g., if asset is impaired or is part of fair value hedge • Fair value? • Price that would be obtained to sell and asset or transfer a liability between market participants at the measurement date • Has potential to achieve comparability • A concern is effects of discretion in estimating fair value • Something else? What?

10. Measurement Same asset measured same way 10 A, B, and C each own one share of common stock in Entity Z. Acquisition cost is 20 for A, 40 for B, and 60 for C. The current fair value is 45. Are the financial statements of A, B, and C comparable if each measures its investment at cost? What if each measures its investment at fair value? What if each measures the investment at cost, and discloses the fair value? Example is from 2011 FASB/IASB Financial Reporting Issues Conference

11. Measurement Different assets measured different ways 11 • Can we achieve comparability if we measure different assets of the entity in different ways? • Financial assets at fair value and property, plant and equipment at modified historical cost? • Impair accounts receivable for incurred credit losses, property, plant and equipment to recoverable amount, and inventory to lower of cost or fair value less costs to sell? • Long-term debt at amortized cost and derivative liabilities at fair value? • … (many measurement methods are used in financial reporting today)

12. Measurement Different assets measured different ways 12 A: accounts receivable is measured at fair value and property, plant, and equipment is measured at modified historical cost. All in $US. B: all are measured at fair value. Cash is in $US, accounts receivable is in Euros, and property, plant, and equipment is in CHF. What do the 3,000 for A and B represent? Are they comparable to each other? To anything? Example is from 2011 FASB/IASB Financial Reporting Issues Conference

13. Measurement Same asset measured different ways 13 • Can we achieve comparability if we measure the same asset in different ways—either for same entity or different entities? • Computers as inventory versus equipment? • Warranty obligations relating to sales of goods versus insurance? • Real estate as investment property versus property, plant and equipment? • Gain or loss on an item designated as hedged in a fair value hedge, versus one that is not designated? • Optional revaluation, fair value, hedge accounting…

14. Measurement Same asset measured different ways 14 A and B each buy a piece of construction equipment for $200,000. A classifies equipment as inventory and B classifies it as equipment. Six months later, both still own the equipment. C holds it in inventory and B has depreciated it (it is available for use, but has not been used). A and B dispose of the equipment for a gain. A displays the gain as revenue and expense. B displays the gain net. In each case, are the financial statements of A and B comparable? Example is from 2011 FASB/IASB Financial Reporting Issues Conference

15. Measurement Same asset measured different ways 15 • Bank A and Bank B each buy US Treasury securities at a cost of $1 million. The fair value is $1.2 million. • Bank A classifies the securities as trading (or fair value through profit or loss) and recognizes $1.2 million in assets and a gain of $0.2 million • Bank B classifies the securities as held to maturity (or amortized cost) and recognizes $1.0 million in assets and no gain or loss • Are the financial statements of A and B comparable? Example is from 2011 FASB/IASB Financial Reporting Issues Conference

16. Does “use” affect economics? 16 • A key question is whether two assets that seem the same are economically the same if they are used differently? • If so, what are the differences that should be reflected in the accounting? • We have been doing this for a long time in financial reporting without articulating why • Does this notion also apply to financial assets and liabilities? • IFRS 13 Fair Value Measurement has concluded “no”

17. Does business model matter? 17 • Does different “use” depend on the entity’s “business model”? • Frameworkhas no concepts about role of business model in financial reporting • What is a business model? • What is the definition? • Does business model differ from intent? • Is an entity’s business model verifiable? Auditable? • Why and how should business model or intent affect financial reporting?

18. Comparability: What does research say? 18 • Global financial reporting with greater comparability can be beneficial… • To investors • Lower costs of comparing cross-border investment opportunities • Higher quality accounting information • To firms • Lower cost of capital • Increase cross-border investing • But, benefits are tempered by cross-country differences in implementation, incentives, and enforcement

19. C.S. Armstrong, M.E. Barth, A.D. Jagolinzer and E.J. Riedl The Accounting Review 2010 19 Market Reaction to the Adoption of IFRS in Europe

20. IFRS adoption in Europe 20 • Motivating questions • Did investors perceive net benefits to adoption of IFRS in Europe? • Comparability or increased quality? • Research questions • Did European market react positively (negatively) to events that increased (decreased) likelihood of IFRS adoption? • Were there differences across firms depending on information environment?

21. IFRS adoption in Europe 21

22. IFRS adoption in Europe 22 • Overall positive reaction to IFRS adoption • Investors perceive net benefits to adoption • Incrementally positive for firms with lower pre-adoption information quality and higher information asymmetry; incrementally negative in code law countries • Investors perceive increased quality benefits, but concerned about enforcement • Positive for high information quality firms • Investors perceive comparability benefits

23. M.E. Barth, W.R. Landsman, M. Lang, and C. Williams Journal of Accounting and Economics 2012 forthcoming 23 Are International Accounting Standards-based and US GAAP-based Accounting Amounts Comparable?

24. Comparability of IFRS and US GAAP reporting 24 • Motivating questions • Is comparability with US GAAP reporting higher after IFRS firms adopt IFRS? • Does comparability differ across firms or time? • Research questions • Are accounting system and value relevance comparability higher after IFRS firms adopt IFRS? • Are there differences for voluntary/mandatory adopters, firms from common/code law and high/low enforcement countries, and in more recent years? • Are earnings smoothing, accrual quality, and timeliness of earnings sources of increases in comparability?

25. Comparability of IFRS and US GAAP reporting 25 • Research design • Firms adopting IFRS from 1995 to 2006 and US firms • IFRS firms from 27 countries • Economic outcomes: stock price and stock return • Accounting amounts: earnings and equity book value • Accounting system comparability • Difference between predicted economic outcomes resulting from applying US GAAP and IFRS pricing multiples to each firm’s accounting amounts • Value relevance comparability • Difference between explanatory powers of accounting amounts for economic outcomes • Metrics for earnings smoothing, accrual quality, and timeliness of earnings from prior literature

26. Comparability of IFRS and US GAAP reporting 26 • Findings • Comparability higher after firms adopt IFRS • Both types of comparability are higher for IFRS • Firms that adopted IFRS mandatorily, firms from common law legal origin and high enforcement countries, and in more recent years • US firms have higher value relevance, but value relevance is comparable for firms from common law and high enforcement countries • Earnings smoothing, accrual quality, and earnings timeliness all potential sources of comparability

27. Comparability: When? 27 • This is the big question • Widespread IFRS adoption and more consistency in implementation and enforcement • Most countries are now part of the IFRS family • Last big holdout is the US • Thus, there has been progress on using the same standards dimension of comparability • But, more needs to be done • Need for all entities to apply all standards, word for word

28. Comparability: When? 28 • Need to ensure requirements in standards achieve comparability • Standard setting is slow and evolutionary • Changing standards takes time, even if we all agree • But, we do not. There are many unresolved questions • What are “like things”? • Does use of an asset change its economics? • What measurements should we use and why? • What information do investors need and, thus, should financial statements portray? • Need to be willing to accept change

29. A word about the US 29 • Pre 2001 US actively involved in IASC • 2001 US played key role in setting up IASB • 2007 non-US registrants can use IFRS without reconciliation to US GAAP • IFRS as issued by IASB—no modifications • 2008 “Roadmap” for possible adoption of single set of global standards • 2010 confirmed commitment to single set of standards and issued SEC staff “Work Plan”

30. A word about the US 30 • May 2011 “Exploring a Possible Method of Incorporation” • “Condorsement” framework • Convergence: country maintains its local standards, but over time modifies those standards to be more like IFRS • Endorsement: involves incorporating individual IFRS into its existing local standards • Not fundamentally different from other countries’ processes • We are awaiting the SEC’s next move • Comparability is key to the SEC’s decision—it is the main justification for moving to IFRS

31. Concluding remarks 31 Comparability in financial reporting is key to promoting efficient allocation of capital Adoption and consistent implementation of IFRS is crucial, necessary first step Often overlooked second necessary step is need to improve the requirements in the standards to truly achieve comparability Progress in last ten years was breathtaking We can do better, but we are getting closer!!

32. Thank you! 32