Current Accounting Issue No. 1: Germany-Leases by Stephen L. Larson January 11, 2014

Development of Germany’s Accounting System

In 1992, many key individuals in the U.S. including the former chairman of the Securities and Exchange Commission (SEC), Richard Breeden, believed that German accounting rules were deficient and did not provide the necessary disclosures about business operations as the German’s approach focused on compliance with tax and creditor regulations and not on a true and fair view of corporate results (Harris, Lang, & Mőller, 1994). Prior to the 1930’s, neither the U.S. nor Germany had developed uniform accounting principles, required audits, or established educational or licensing requirements for accountants (Fear & Kobrak, 2006). And before 1914, research indicates that American accounting practices were shoddy compared to those accounting practices of Germany (Fear &

Kobrak, 2006). How had this occurred? Why did German accounting go from superior to inferior since the basic economic events that lead to change and the business risks which threaten the continuance of an organization’s life are universally true? These events and risks result from environmental changes, economic crisis, and entrepreneurial decisions taken all over the world on a daily basis. What differs on the global stage are the philosophies and mechanisms entrenched in the national concept of corporate governance. German corporate governance is highly influenced by internal reporting duties rather than the need to publicly disclose information to absentee owners (Wustemann, 2004).

Years prior to the First World War, Germany enacted legislation to require German companies to publish financial statements to shareholders and created some accounting standards for those public financial reports. Additionally, these regulations mandated oversight by supervisory boards for the purpose of avoiding frauds. In the U.S., during the same timeframe, accounting organizations, independent of government, began to push for stronger involvement in creation of accounting standards (Fear & Kobrak, 2006).

After World War I, the U.S. becomes the dominate financial power in the world and corporate ownership expanded to absentee investors while Germany was impacted by its defeat, rebuilt through debt financing, experienced political disruptions, and hyperinflation. The stock market crash of 1929 resulted in the development of mandatory audits for both countries and establishment of accounting standards. In the U.S., the financing of corporate growth through equity transactions focused attention on the need of the shareholder, the development of agency theory, and the creation of professional-based accounting standards. In Germany, regulators began to develop the required accounting standards with focus on protection of the creditors rather than shareholders. The reason was that at this point, banks and other financing institutions were the primary financiers of German business. Another factor to the growth of government control in Germany was the Nazi regime. Their anti-capitalistic views and negative position towards shareholders provided emphasis in limiting the distribution of information. This

Current Accounting Issue No. 1: Germany-Leases by Stephen L. Larson January 11, 2014

resulted in German accountants turning their attention to control issues rather than transparency (Fear & Kobrak, 2006).

As the concept of widespread ownership grew in the U.S., the dispersion of owners made it difficult for owners to be intimately involved in the businesses which they owned. Accounting and reporting concepts therefore, had to overcome the loss of knowledge through lack of participation. Not so with German companies. Ownership was generally concentrated among a few and the parties providing the financing (banks) were actively involved in the business. Disclosure of information was not necessary as the interested parties were already well informed (Fear & Kobrak, 2006). Consequently, German accountants were organized to increase the power of the government whereas in the U.S., accountants took on the role of developing information for the shareholder.

It wasn’t until 1985 that German law and tax rules began to focus on reporting of financial results. However, the primary rule making responsibility for accounting standards continued to remain with the government and focus continued on prudence and creditor protection combined with calculations of tax liabilities.

Impact of Lease Accounting on German Companies’ Financial Statements

Prior to acceptance of international accounting standards (IAS), Germany

followed the German Commercial Code (HGB) as well as U.S. GAAP. International financial reporting standards (IFRS) were adopted in 2005 (as noted by Deloitte in its publication titled IAS Plus) and added to the list of accounting standards German companies were authorized to use. Today, German companies can choose any of the three accounting standards based on the purpose for which the financial reports are to be used and to whom the accounting information is to be provided. Accordingly, German companies, as it relates to the treatment of leases, can use IAS 17 for reporting purposes to the European Union, Statement of Financial Accounting Standards (SFAS) 13 for reporting to U.S. capital markets, and HGB rules for reporting in compliance with German regulatory requirements (Fuelbier, Lirio Silva, & Pferdehirt, 2006), (PWC, 2010).

Accounting for leases is similar in both SFAS 13 and IAS 17. However, HGB accounting for leases does not include any guidance for classification--finance or operating. HGB does provide minimal guidance as to capitalization and depreciation whereas IFRS and U.S. GAAP go into greater depth as to determination of the amount to be capitalized (PWC, 2010).

Unique Aspects of Germany’s Accounting Practices

The accounting in Germany is very conservative, influenced by tax avoidance

strategies, lacks detailed disclosures, and oftentimes allows management to create hidden reserves (Leuz & Wüstemann, 2003). A country’s accounting system represents its needs, philosophies, and approaches to corporate governance. Germany is no exception. Because of the extensive private information channels (insider management involvement by third parties) in Germany, public financial statements are not an important aspect of corporate governance nor is the reporting of performance. Because of this aspect of business within the German society, outside investors are not as informed about

Current Accounting Issue No. 1: Germany-Leases by Stephen L. Larson January 11, 2014

operational results as in the U.S. (Leuz & Wüstemann, 2003). The reason for such an environment is that German companies operate in a code-based country with debt being the primary financing tool rather than equity which is the case in the U.S. The emphasis of the code (regulatory focus) is prudence and creditor protection resulting in limiting payouts to shareholders (Leuz & Wüstemann, 2003). Relationships with financing institutions are such that they are often members of the Board and are actively involved with the operations of the company. Consequently, corporate governance is in the hands of those most at risk and who have access to insider information. The need for additional disclosures to outside parties is minimal so the role of accounting has evolved not to distribute information to the public but to expedite relationship-based financing and to provide internal managerial and cost accounting information (Fear & Kobrak, 2006). Given these attributes of the German financial system, the primary parties involved with the organization don’t need public information (Leuz & Wüstemann, 2003).

Because of the need to protect the creditor, the legal system of Germany evolved into viewing German accounting principles as legal concepts subject to legislation. Accounting decisions made in court cases become generally accepted accounting principles unlike in the U.S. where court case assess the reasonableness of application of an accounting principle (Leuz & Wüstemann, 2003). In 1998, legislation was enacted to allow German firms to follow IAS or other national accounting systems. This action by the German government left intact German GAAP while allowing IAS thus providing for the continuance of the concepts of prudence and creditor protection but complying with the movement towards a global accounting standard. The result will be a dual reporting state where IAS will be followed to meet the demands of global capital markets and German GAAP will be required for reporting to regulatory bodies within the country.

Current Accounting Issue No. 1: Germany-Leases by Stephen L. Larson January 11, 2014

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Leuz, C., & Wüstemann, J. (2003). The role of accounting in the german financial

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