Major International Differences in Financial Reporting

1. Major International Differences in Financial Reporting Chapter 3 ACC 4305

2. Accounting Formats Differences in Financial Reporting

3. Accounting Formats • Display order of the accounting elements • Linked to the existence of a regulation • And to the targeted audience (shareholders’ orientation) • Shape (configuration) of the balance sheet

4. Analysis of Annual Reports Should Include Four Questions Regarding Format • At what level is the company reporting? • In the UK and the USA, consolidated accounts have been the rule for many years • Some countries still provide separate statements for parent and subsidiaries • Which statements are present? • What is the flow of the statements? • Reading from top to bottom, which items are first and which last? • Is there any netting or subtotals as we go along?

5. A Comparison of Reporting for Three Major Corporations

6. A Comparison of Reporting for Three Major Corporations

7. Uniformity and Accounting Plans • Uniformity of reporting can be required in: • Formats of financial statements • Accounting principles • Disclosure requirements • But accounting plans may vary from one country to another

8. Fairness Differences in Financial Reporting

9. Fairness • Some accounting regulations require fairness in financial reporting • UK was one of the first EU country to require fairness • Fairness means faithfulness to economic reality, i.e. financial reports do not « mask » economic events • Problem of substance over form • Do you grant some flexibility to present a fair view? • Or do you regulate the form of financial reports, at the risk of twisting economic realities?

10. Example of a Fairness Issue • Airlines companies typically own the airplanes they operate • This means that airlines companies are capital-intensive and show high fixed assets (as a % of total assets) • Some companies started to lease airplanes

11. Example of a Fairness Issue • Leases are equivalent to renting a capital good • Typically, they are not capitalized – since there is no ownership, there is no assets – only an expense charged to the Income Statement every period • US accountants considered this practice as unfair, and mis-representing the capital intensive nature of activities of airline companies • Statement passed to capitalize certain leases

12. Substance over Form • US accountants: Initiated the trend toward preferring substance over form • Fairness is defined by GAAP and the general framework for accounting • In Europe, fairness is theoretically an over-ridding concept • Replacement cost accounting in the Netherlands • Stems from a fairness concern (true representation of value) • Germany • Preference for following legal requirements, independently of fairness issues

13. Fairness and Perfect Information Reporting

14. Enron Mark to Market of Investments in derivatives “Mark to Enron” (Bonus inflation) Hiding liabilities and losses in “Special Purpose Entities” Off balance sheet

15. Conservatism Differences in Financial Reporting

16. Conservatism and Accruals • Conservatism is another adversary to fairness • Important differences in reporting result from a more or less conservatism in analysis • Notion of « prudence » in the UK, • “Principe de prudence” in French Accounting • Note: these differences can be observed nationally between private and government businesses

17. Conservatism • Accountants “anticipate no profit, but anticipate all losses” • FASB Statement No.2: • Conservatism is “a prudent reaction to uncertainty to try to ensure that uncertainties and risks inherent in business situations are adequately considered” (FASB, 1980, p. 10) • APB Statement No.4 • describes conservatism as a preference for possible error in measurement to be in the direction of understatement rather than overstatement of net income and net assets (AICPA, 1970)

18. Example of Divergences in Conservatism • Should R&D expenses be capitalized? • Okay in certain conditions in UK accounting standards • In the past, never in US accounting • Should a forecasted loss on work in progress inventory be recognised? • Yes in French accounting • No in US accounting

19. Conservatism • Continental Europe tends to be most conservative • A lot of research on conservatism • Use of conservatism index (Gray, 1980) RA = adjusted earnings under the GAAP of the country being used as a standard RD = disclosed earnings under the national GAAP of the country whose conservatism is being assessed |RA| = the absolute value of adjusted earnings under the GAAP of the country being used as the standard

20. Conservatism Index

21. The Impact of Conservatism

22. Provisions and Reserves Differences in Financial Reporting

23. Provisions • Terminology can be confusing • Make sure to differentiate: • Provision • A liability of uncertain timing and amount • An allowance • against the value of an asset

24. Provisions in French Accounting • En comptabilité, la provision est la constatation d'une moins-value probable sur un élément d'actif ou d'une augmentation du passif dit « exigible ». • Cette notion ne doit pas être confondue avec celle d'amortissement, qui correspond à une dépréciation d'une autre nature (la perte est irréversible et est liée au temps, à l'usure, à l'obsolescence) • La dépréciation doit être nettement précisée quant à sa nature ou son objet et elle doit être évaluée avec une approximation suffisante. Elle doit être probable et pas seulement éventuelle. Cette probabilité doit être la conséquence d'un événement survenu au cours de l'exercice. www.wikipedia.fr

25. French vs. US Provisions Allowances Provisions US Provisions pour risques et charges Provisions pour dépréciation FR

26. Provisions in Moroccan Accounting • There are three types of provisions: • « Provisions pour dépréciations » • They are acknowledgements of the decrease in value of assets • That is, the value of an asset is lower than its recorded value, or than its net value • These are “allowances” in US accounting!

27. Provisions in Moroccan Accounting • There are three types of provisions: • « Provisions pour risques et charges » • These are provisions, i.e. they recognize a potential future liability • Examples: • Provisions for legal disputes • Provisions for warranties extended to customers • Provisions for future losses on long term contracts • Provisions for fines, penalties • Provisions for foreign exchange losses

28. Provisions in Moroccan Accounting • There are three types of provisions: • « Provisions réglementées » • These are provisions (i.e. future liabilities) not accounted in other categories and regulated • Examples: • Industry specific: mines, natural resources management • Acquisition and building of housings

29. Accounting for Provisions • Recording provisions and allowances • Debit an expenses account • Impact on income statement • Examples of Moroccan accounts: • Dotations d’exploitation • Dotations aux provisions pour risques et charges • For an allowance • Credit an asset account • Example: Provisions pour dépréciation des comptes de l’actif circulant • For a provision • Credit a liability account • Example: Provisions durables pour risques et charges

30. Accounting for Provisions • Provisions are re-evaluated on closing dates • They can be increased, decreased, or written-off • Example: for a provision (risk-based) • Credit a revenue account • Example: Reprise provision pour risques et charges • Debit the liability account that was initially debited

31. Example – Bad Debt • 01/01/2006: Credit sale for 10,000 euros to Mr Dupond • The amount is due on June 1st • On June 1st, Mr Dupond defaults on the payment • The accountant considers that the receivable could be received (not lost with certainty) • Use an allowance • On July 1st, Mr Dupond actually pays the bill

32. Example – Bad Debt First Case: No VAT, No use of “Clients Douteux”Account, One customer only

33. Example – Bad Debt + asset + revenue

34. Example – Bad Debt Expense/loss Contra asset

35. Example – Bad Debt Cancel contra asset Restore revenue

36. Example – Bad Debt

37. Example Bad Debt • Customer is unable to pay (Certainty) When the loss/expense actually posted to the Income Statement?

38. Note – Bad Debt Expenses • In practice, accountants try to estimate precisely which portion of the debt will be paid or not

39. CLIENTS CREANCES T.T.C. PROVISIONS AU 31/12/99 ENCAISSEMENTS 2000 OBSERVATIONS A 1897,6 700 680 solde irrécouvrable B 2848,4 800 320 Provision nécessaire : 60% du solde Example – Several Customers • On 31/12/2000, you receive the following table:

40. CLIENTS CREANCES T.T.C PROVISION A CONSTITUER C 2965,00 40% D 4669,6 60% Example – Several Customers • In 2000, the following new customers have become suspicious

41. Example – Several Customers • Client E who owns 1423,20 TTC has filed for bankruptcy • His A/R is irreversibly lost

42. Example – Several Customers

43. The Impact of Provisions • In 2000, Beaufort Accessories in France decided to build a roof for its factory. Work will take place in 2002 and which will cost approximately EUR 300,000. • Under French Accounting, the company can recognize the expense of EUR 100,000 in 2000 for the roof construction as a provision, and then recorded the rest in 2001 and 2002 for EUR 100,000 each.

44. Example Note: Assuming the roof would have been reported as an expense in 2002 – in most cases,it would be depreciated over time

45. The Impact of Provisions

46. Reserves • Reserves are an element of equity • They are set as an appropriation of profit (i.e., retained earnings) • The existence of reserves are linked to regulations (e.g., « Réserves légales ») or to lenient tax regulations (e.g. income smoothing in Germany) • Negative impact on fair reporting • Fund – an asset invested and managed independently • This fund reduces the corresponding provision one would have recorded on the B/S

47. Others Differences in Financial Reporting

48. Valuation Bases • Strict adherence to historical cost • Requires little judgement • Is expected of countries with strict taxation regulations and commercial codes • Use of replacement cost or current value • Requires judgement, and therefore a great amount of flexibility given to accountants • Case of the Netherlands • Middle of the road... • UK accounting

49. Consolidation • The US provided leadership for consolidation accounting, • Followed by the UK • Continental Europe was slow to develop consolidation accounting • More on the consolidation lecture

50. Taxation • Already discussed in chapter 2 • Can have a key impact on reporting practice • Taxation rules: • Are not necessarily consistent between countries • Are often an enemy to fairness, e.g. in Europe, where it takes precedence over a « fair » presentation of economic profit