Chapter Eleven

1. Chapter Eleven Worldwide Accounting Diversity and International Standards

2. Examples of International Accounting Diversity German companies amortize goodwill as a reduction of owners’ equity. Dutch companies report assets at current replacement cost. Canada and France allow capitalization of R&D costs.

3. Magnitude of Accounting Diversity Results of a 1993 SEC survey on the significance of the differences between GAAP and non-GAAP countries. 2/3 of foreign companies report material differences when compared to GAAP. A separate study showed that the average income would have been reduced 42% if reconciled to US GAAP Material differences are spread relatively evenly across countries.

4. Reasons for Accounting Diversity Legal System Tax Regimes Political and Economic Ties Culture Financial Providers Inflation All these interact!!!

5. Legal System • Common Law • Found primarily in English-speaking countries • Limited statutory law • Importance of courts establishing precedents • Accounting profession plays a large role in standard setting and tends to be independent • Standards tend to be detailled • Roman (Codified) Law • Based primarily on statute rather than precedent • Corporation laws tend to establish parameters and stipulate nature of financial statements • Accounting profession tends to have little influence on standard setting and is frequently an adjunct of the legal system • Accounting law tends to be lacking in detail • Sharia (Islamic Law) • Based on interpretation of the Quran • Interest is not permitted • Accounting law is determined by religious authorities

6. Tax Regimes • Some countries use financial statements as basis for taxation (single system) • Some countries adjust financial statements for tax purposes and require separate submission of tax returns (dual system)

7. Financial Providers • Family members • Less pressure for public accountability • Banks • Focus on solvency and liquidity (balance sheet emphasis) • Tendency to conservatism in relation to assets • Governments • Shareholders • Focus on profitability (income statement emphasis) • Higher demand for outside disclosure • Other creditors

8. Inflation • High inflation tends to reduce historical cost accounting’s value • Accounting focus is on adjusting values to current or market value • Creditors tend to suffer under highly inflationary economies

9. Political and Economic Ties • Accounting methods are readily conveyed from one country to another, either by trade or conquest • Britain’s former colonies throughout the world, such as Australia and Canada, tend towards “common law” systems • Former French colonies, such as Senegal and Congo, base their accounting standards on “codified law” • Japan has an SEC and a variety of American aspects to its accounting as a result of its occupation following WWII

10. Culture • The various factors explaining accounting diversity are highly correlated, and there are many similarities in accounting “culture”: • Common law countries tend to separate financial and tax accounting, and frequently rely primarily on capital markets as sources of capital • Code law countries frequently link tax and financial accounting, require less detailed public disclosure and often rely more on banks as a source of financing. In turn, these countries tend to have banking representatives on corporate boards of directors

11. Problem Subs use local standards in preparing financial statements. To gain access to a country’s capital market, financial statements must be in accordance with local standards. Statements are simply not comparable. Solution The parent must adjust the subs’ statements to be in accord with GAAP. The parent must restate their own statements in accord with local standards. Statements must be re-stated in common standards. Problems Caused By Diverse Accounting Standards

12. Accounting Clusters • The Mueller classification scheme identifies four major accounting models: • British-American • Continental • South American • Mixed economy • Nobes’ micro-based/macro-based model.

13. Hypothetical Classification of Accounting Systems Exh. 11.3

14. International Harmonization • The process of reducing differences in financial reporting practices across countries is called “harmonization.” • Arguments in favor of harmonization include: • Improved comparability aids capital globalization • Reduced cost of producing financial statement information • Easier to shift accounting staff worldwide • Simplified auditing

15. International Harmonization • Arguments opposing harmonization: • Magnitude of current differences is an immense obstacle • High political cost • Nationalism • Unnecessary (a thriving global capital market already exists) • Existing differences might be “appropriate and necessary”

16. International Harmonization • Major Harmonization Efforts include: • European Union (EU) • The Fourth Directive (1978) • The Seventh Directive (1983) • International Accounting Standards Board (IASB) • International Organization of Securities Commissions (IOSCO)

17. European Union • 1957 – European Economic Community (now called European Union) established free trade among member countries. • EU issues “Directives” to assist with harmonizing accounting across member countries • 1978 – 4th Directive deals with valuation • 1983 – 7th Directive deals with preparation of consolidated financial statements.

18. European Union – Unaddressed Differences Between Countries Lease Accounting Income Taxes Accounting Changes Long-term Construction Contracts Foreign Currency Translation Contingencies

19. International Accounting Standards Board (IASB) • International Accounting Standards Committee established in 1973 • IASB superseded IASC in April 2001 • Includes over 140 accounting bodies, representing over 100 nations. • The U.S. is represented by the AICPA and IMA • Standards produced by a 14-member board. • Requires 11 of 14 members to issue a standard. • 36 International Accounting Standards (IAS’s) and International Financial Reporting Standards (IFRS’s) issued as of January 2005.

20. International Accounting Standards Board • Consists of 14 members • Technical competence is the most important selection criterion • 12 members are full-time, 2 are part-time • Full-time members required to sever former employment relationships and may not hold positions that would call their economic independence into question • 7 full-time members have formal liaison responsibilities with national standard setters • Required member backgrounds: • At least five must have practiced auditing • Three must have prepared financial statements • Three must have been statement users • One must be an academic

21. International Financial Reporting Standards (IFRSs) • In April 2001, the IASB adopted all of the IASs, and announced that its standards would be called “International Financial Reporting Standards” (IFRSs) • The IASB has sole responsibility for establishing IFRSs • As of 1 January 2005, there were 36 IASs and IFRSs • These can be thought of as “IASB GAAP” • IASB has no enforcement authority!!

22. Examples of IFRS Application IFRS Required: Belgium, France, Ireland Italy, Norway IFIF IFRS Required for Some: China, Romania, Russia IFRS Not Permitted: United States, Canada, India, Japan IFRS Permitted: Bermuda, Switzerland, Turkey, Uruguay

23. Norwalk Agreement: FASB-IASB Convergence • In Norwalk, Connecticut, a joint meeting of FASB and IASB was held in September 2002 • The “Norwalk Agreement” states that the two bodies will “use their best efforts” to: • Make existing financial reporting standards compatible “as soon as is practicable” and • Coordinate efforts to “ensure that once achieved, compatibility is maintained”

24. FASB-IASB Convergence • FASB initiatives include • Short-term convergence project • Joint projects • Longer-term convergence research • Liaison IASB member at FASB offices • Monitoring of IASB projects • Explicit consideration of convergence potential in FASB agenda decisions

25. FASB’s Short-term Convergence Project • Intended to remove individual accounting differences between IFRSs and US GAAP that are not covered in broader projects and “for which a high quality solution appears to be achievable in a short period of time.”

26. FASB’s Short-term Convergence Project (continued) • Inventory Costs • SFAS 151 issued in December 2004 to converge with IASB’s current period expensing of • Idle facility expenses • Excessive spoilage • Double freight • Re-handling costs • Asset exchanges • SFAS 153 issued in December 2004 to eliminate APB Opinion 29 exception to the rule of fair value measurement for nonmonetary exchanges of similar assets • Accounting changes • An Exposure Draft was issued in December 2003 proposing that retrospective applications of new accounting principles would replace current reporting • Earnings per share • An Exposure Draft was issued in December 2003 that would enhance comparability

27. FASB-IASB Joint Projects • Business Combinations • Performance Reporting • Issues Include: • Should a single statement of comprehensive income be required? • Should direct method be required for reporting cash flows from operations? • How many years of comparative data should be included in financial statements? • Revenue Recognition – Single Standard • Common Conceptual Framework

28. Current Differences Between IFRSs and US GAAP Recognition Presentation and Dislosure Measurement

29. Examples of Differences Between IFRSs and US GAAP - Recognition • Recognition Differences (mainly relating to “whether,” “how,” and “when” an item is recognized) • Research and Development • Gains on Sale and Leaseback Transactions • Past Service Costs Related to Vested Pension Benefits • Deferred Tax Assets • Purchased In-process R&D • Negative Goodwill

30. Examples of Differences Between IFRSs and US GAAP - Measurement • Measurement Differences Result from • Different Methods of measurement • While both value inventory using lower of cost or market (LCM) techniques, “market” is measured differently • Replacement cost in US • Net realizable value for IFRS • Alternatives allowed by one set of standards but not the other • LIFO allowed in US, but not by IFRS • IFRS required ‘benchmarking’ of borrowing, which expenses these costs immediately. US GAAP requires capitalization of interest on certain self-constructed assets • IAS 16, Property, Plant and Equipment

31. Examples of Differences Between IFRSs and US GAAP – Presentation and Disclosure • Certain types of extraordinary gains and losses under US GAAP are not allowed under IFRS • US GAAP is less restrictive on the definition of “discontinued operations” • Segment Disclosure • US GAAP requires management approach • IAS 14 requires disclosures for both industry and geographic segments, but one is given primacy. Geographic segments tend to be regions rather than individual countries

32. The IOSCO Agreement International Organization of Securities Commissions (IOSCO) In 1987, partnered with the IASC’s Comparability Project. Helped to rewrite IAS’s to eliminate unnecessary alternatives. The goal is to help make it easier for foreign companies to use IAS’s when reporting on different exchanges.

33. Support of Securities Exchange Regulators Since 1994, reconciliation to U.S. GAAP is not required for foreign registrants using IAS’s for: • Statement of cash flows. • Amortization of goodwill. • Translation of financial statements of subsidiaries in highly inflationary economies.

34. Support of Securities Exchange Regulators • In 1996, the FASB compare GAAP to IASC standards. • Significant differences were found.

35. Accounting Environment:United Kingdom • The Companies Acts (1989) • Legal foundation for accounting. • Requires a “true and fair view” of a company’s operating results and financial position. • Professional accountants are called Chartered Accountants. Membership is approaching 200,000. • The Accounting Standards Board (ASB) was established in 1990. • Replaced the Accounting Standards Committee

36. Accounting Environment:Germany • Accounting principles set by the Bundesrat (legislature). • The Third Book of the Commercial Code (Handelsgesetzbuch). • It is generally believed that strict adherence to the law provides a “true and fair view”. • A professional accountant carries the designation “Wirtschaftsprufer”. • Requires passing an exam and 6 years of experience. • Profession considered to be quite conservative

37. Accounting Environment:Germany • German accounting is greatly influenced by German banks. • A Statement of Fixed Assets is often produced in addition to the other common statements. • Income Statement is produced in one of two formats: • Cost of Sales Approach • Type-of-Cost Approach • Current and noncurrent designations are generally not used. “Provisions” are estimated, whereas “liabilities” are fixed • Tax conformity principle applies • Notorious for the use of “hidden” reserves

38. Accounting Environment:Japan • Basic accounting principles are set by the government. • Some rules are set by the Japanese Commercial Code. • The Business Accounting Deliberation Council (BADC) provides additional accounting rules in the Financial Accounting Standards for Business Enterprises. • In 2001, the private sector Accounting Standards Board of Japan (ASBJ) was established. Modeled on the FASB, its authority is derived from the BADC.

39. Accounting Environment:Japan • Financial statements required include: • Balance sheet. • Income statement. • Proposal of appropriation of profit or disposition of loss. • Business report. • Extensive cash flow information is required in supplemental disclosures. • Income statement divided into two sections • Ordinary Income • Special Items (not as restrictive as US GAAP’s “extraordinary” items)

40. Summary • Different environmental factors contribute to the current variety of accounting standards in the world • Greater capital globalization has led to pressure for increased harmonization of accounting standards • The IASB, successor to the IASC, produces International Financial Reporting Standards (IFRSs) • The Norwalk Agreement of 2002 is leading the FASB to converge many areas of US GAAP with the IASB’s IFRSs

41. Possible Criticisms • While there is significant pressure to harmonize accounting standards, there is still much opposition to the idea of “one world accounting” WHAT DO YOU THINK?????

42. End of Chapter 11 When the ad said, “Extensive travel,” this isn’t exactly what I expected.