international accounting chapter 1

Financial Reporting in the Global Arena

By: Sommer Kaleohano-Knittleand Patricia Hardy

Number of non-U.S. companies listed on the NYSE increasing◦ 1986: 59 companies◦ 2007: 421 companies

Similarly other stock exchanges have seen an increase in foreign firms◦ London Stock Exchange: 719◦ NASDAQ: 307◦ Singapore Stock Exchange: 290◦ Mexican Exchange: 242◦ Luxemborg Stock Exchange: 227◦ Euronext Exchange: 225

Importance of International Accounting

Illustrates the dramatic pace of globalization

Points to the need for capital investors to have an understanding of the accounting concepts of international companies◦ Important when investing in companies listed on

domestic stock exchanges◦ Increases their ability to make informed financing

and investment decisions 10 factors that shape accounting

Importance of International Accounting

Nature of Capital Markets

Equity-Oriented Debt-Oriented

U.S. and Canada Primary source of capital

is the stock market Cosmetic Difference

◦ Companies invest a lot in their annual reports and other financial communications to investors

◦ Treat annual report as a marketing tool to attract investors

◦ Use annual reports to portray a positive image

Most other countries Primary source of capital

is bank financing Cosmetic Difference

◦ Annual reports are matter-of-fact and to the point

◦ Banks do not basis lending decisions on cosmetics

◦ Little reason to spend large amounts of money and time on production of annual reports


Equity-Oriented Debt-Oriented

Substance Difference◦ Try to make accounting

numbers as positive as possible Capital markets punish

companies that report poor performance

◦ Bias to report well to stockholders

Companies: Bank of America

Substance Difference◦ Tendency to underreport

earnings◦ Relates to the type of

reporting regime◦ Financial statements in

international companies will show different earnings in U.S. versus other countries

Companies: BNP Paribas

Level of sophistication◦ Accounting has to keep up with finance in terms

of drafting rules for new financial instruments U.S. and Wall Street

Highly complex and innovative financial instruments Financial reporting is continuously changing to keep up

Simple capital markets and financial instruments Less need for accounting to constantly change


Level of globalization◦ Varies with the type of foreign firms entering the

market Entering firms have high level of financial reporting

and disclosure standards Raises the general level of reporting in that country Example: U.S. firms listing on the London Stock

Exchange Entering firms have a lower reporting requirements

Not much impact on financial practices in that country Example: Indonesian firms listing on the Australian Stock

Exchange


Dual set of rules for financial and tax reporting◦ Independent set of rules for each type of

reporting◦ “Financial reporting schizophrenia”

Normal for companies to show high levels of profitability on financial reports while not looking as profitable on tax filings

Allows companies to report optimistic earnings to their stockholders while avoiding possible tax liabilities

Perfectly legal

Type of Reporting Regime

Single reporting system◦ As mentioned before, debt-oriented companies

have a tendency to underreport earnings Use the same reporting system for financial and tax

purposes If these companies inflate earnings in financial

reporting, they face paying higher taxes

Type of Reporting Regime

Economically advanced countries◦ Large and complex companies such as

corporations Sell hundreds of products Employ thousands of people Do business in multiple countries

◦ Accounting rules are detailed and complex Emerging economies

◦ Small, simple and usually family owned businesses

◦ Accounting rules are not as complex

Size and Complexity of Business Entities

Type of Legal System

Code Law Common Law

Also called civilian law Characterized as

mandating acceptable behavior

Accounting is regulated through an accounting code that is highly detailed, procedural and set by legislature◦ Emphasis on protecting

creditors

Legalistic Deters undesirable

behaviors Accounting regulations

are set on a piecemeal bases◦ Set by private standard-

setting body◦ Emphasis is to present a

true and fair picture to shareholders

◦ Research shows that financial reporting is more transparent

Type of Legal System

Code Law Common Law

Less market oriented and rely on private information

Countries have adopted common law where governments generally established and enforced accounting rules

Examples: BNP Paribas

Viewed as being more adaptive and innovative in terms of financial reporting

Where international accounting standards are rooted

Examples: Bank of America

Factors affecting enforcement◦ Political system and leadership

Example: Asian financial crisis Investors believed companies were in compliance with

reporting requirements when they were not and therefore suffered losses when true financial position was disclosed

Shows a lack of willingness to enforce the rules

◦ Lack of resources Countries may adopt accounting standards but lack

the resources to implement and enforce them

Type of Enforcement of Regulations

High level of enforcement◦ Accounting practices are largely in compliance

with the requirements◦ Example: U.S.

Low level of enforcement◦ Businesses exhibit very little compliance with

regulations

Type of Enforcement of Regulations

Historical-cost model ◦ Economic transactions are recorded at values on

the date of the transaction◦ Dominant basis of accounting in most countries◦ Countries that have been able to hold inflation

steady use this model Based on the fact that inflation does not seriously

impact them United States and United Kingdom

Inflation-adjusted model◦ Countries that have suffered high levels of

inflation Bolivia and Mexico

Rate of Inflation

Countries have adopted the accounting regime of other countries both voluntarily and involuntarily

Colonization◦ When colonized for an extended period of time,

countries usually used the accounting system of the colonial power Example: Countries of British Commonwealth use

same accounting system as Britain. Philippines based on accounting in the U.S.

Political and Economic Ties

Post-independence◦ Countries have a choice on their accounting

method Some have chosen to continue using the accounting

method of the colonial power Others have chosen to replace their old method with

a different one Also has the potential to influence

accounting development◦ Geographic proximity (U.S. and Canada)◦ Economic alliances (EU and NAFTA)

If countries use the same methods of accounting, it often decreases costs of doing business

Political and Economic Ties

Stature of Accounting Profession

Code Law Common Law

France and Germany Less stature and

power Government takes the

lead role in regulating the profession

U.S. and Canada Held in high esteem Largely self-regulating

and plays a major role in setting accounting and auditing standards

Large role in establishing educational and licensing requirements

Influences the quality of financial statements

Strong accounting profession◦ Audit reports are more respected as independent

and reliable Weak accounting profession

◦ Quality of financial statements is questioned◦ Auditor independence and stature is questioned

Likely to influence the size of accounting profession◦ Strong stature = more accountants◦ Weak stature = less accountants

Stature of Accounting Profession

“A coherent system of interrelated objectives and fundamentals that can lead to consistent standards that prescribes the nature, function, and limits of financial accounting and financial statements” (FASB)

Associated with countries that embrace a micro-user oriented accounting system

Accounting in countries that have developed or adopted a conceptual framework are more similar than countries that do not have a conceptual framework

Existence of a Conceptual Framework

Factors affecting education are level of economic development, the political and economic ties with other countries and the stature of the accounting profession

Countries that hold the accounting profession in high regard have accounting programs at the undergraduate, graduate and doctorate degree levels

In other countries accounting education is weak because accounting is often equated with bookkeeping and viewed as a vocation rather than profession◦ Accounting education isn’t available at universities◦ Affects the accounting profession as a whole

Quality of Accounting Education

Diverse Roles of Accounting in Countries Primary role of accounting varies in different

countries◦ Affects orientation and information content of financial

statements◦ Influences how accounting reports are interpreted and

used Domestic capital markets can have an impact

on the development of accounting in countries◦ Demands arising from capital markets provide

rationale for adopting particular forms of accounting◦ Accounting perceived as a prerequisite for the growth

of domestic capital markets

Financial Reporting Central to process of allocating financial

resources in capital markets In non-securities sector, important basis for

decisions of financial institutions Essential for oversight and supervision of

banks and other financial institutions Financial institutions usually required to

submit financial statements to government agencies (and, in some countries, publish in major newspapers) as part of discharging their accountability requirements

Financial Reporting Regulatory requirements for banks and

other financial institutions often based on accounting information furnished by these enterprises

Financial crises in emerging capital markets◦ E.g., Argentina, Brazil, Indonesia, Malaysia, Russia

U.S. subprime mortgage collapse in 2008 Causes?

◦ Lack of financial reporting transparency and inconsistent application of auditing standards

Financial Reporting Accounting reports relevant to investors’

buy and sell decisions on corporate securities◦ Evident every time the stock price of a company

drops precipitously when questions arise about the reliability of its financial reporting

Crucial policy matter for less-developed countries (LDCs) aiming to attract capital to develop their economies

Regulation of Financial Reporting Consensus that financial accounting

important for efficient operation of capital markets has permeated policy making

International level ◦ International Accounting Standards Board (IASB)◦ International Organization of Securities

Commissions (IOSCO) Ensures adequate supply of reliable and relevant

financial information necessary for cross-border financial transactions

Multilateral lending institutions◦ International Monetary Fund (IMF)◦ World Bank◦ Asian Development Bank (ADB)

Forefront of recommending to LDCs the need to ensure a robust accounting system to enhance the development of their financial systems

Regulation of Financial Reporting

Policy Choices in AccountingHierarchy of Accounting Polices

Element of Accounting Accounting Policy Issues

Broad aims of financial accounting

•What should be the aim of financial accounting in terms of the user orientation of the accounts?•What should be the role of financial accounting in regard to capital markets, fiscal (tax) policy, and macroeconomic planning policy?

Institutional setting for accounting regulation

•Which approach(es) to formulating accounting regulation should be adopted?•Which approach(es) to enforcing accounting regulation should be used?

Hierarchy of Accounting Policies

Element of Accounting Accounting Policy Issues

Specific accounting rules and requirements

•Which specific disclosure and measurement rules should be adopted and to whom should these rules apply?

Corporate accounting practices •Which specific disclosure and measurement methods will be used in presenting the company’s accounts?

Policy Choices in Accounting

Relative scope and importance of policy decisions increases as one climbs the accounting policy hierarchy

Decisions regarding broad aims of accounting◦ Profound and long-term impact on institutional

basis, specific accounting rules, and corporate accounting practices in a country


Policy Choices in Accounting Broad aims of accounting

◦ Private-sector users (i.e., individual and institutional participants in capital markets

◦ Public-sector users (i.e., government ministries and agencies responsible for tax collection or economic planning)

Countries can be compared based on relative importance attached to particular roles of accounting in society

Policy Choices in Accounting• Macro-user oriented

◦ Intended users: government agencies—particularly tax and economic planning agencies

◦ Goals and role of accounting: guard against loss of assets, contribute to enterprise stability and continuity

◦ Conditions: Significant role of institutional creditors Conservative accounting methods Neutrality in accounting procedures subordinate to goal

of deliberately influencing the behavior of enterprise agents towards certain pre-defined goals

◦ Countries: France, Germany, Sweden, Japan

Marco-user oriented◦ Conservative accounting methods prevent

management from distributing dividends perceived to be detrimental to creditors, and provide rock-bottom asset values that do not overstate the security potential of assets in case of liquidation

◦ Requirements of government agencies and employees (including management) are ranked of the same, if not greater, importance as capital providers

◦ Enterprise viewed as helping to guarantee long-term, if not lifetime, employment and contributing towards national economic goals


Policy Choices in Accounting Micro-user oriented

◦ Intended users: Diverse set of capital providers◦ Goals and role of accounting: Provide “true

and fair” or “fairly presented” financial statements (reflect economic substance rather than the legal form of transactions), provide reliable benchmark for evaluating management performance

◦ Conditions: Neutral and unbiased accounting methods

Until collapse of Soviet Union, could observe specific role of accounting in planned economies with communist system of government◦ Private property and investment were frowned

upon, so government typically only direct stakeholder in economic entities

◦ Since no external stakeholders and few competitive markets for goods and services, there was no real concern with traditional measures of performance such as profitability or cost of containment


◦ Main role of accounting—to facilitate the economic plans under which the government would set priorities and targets at the national level, which would translate to production goals and quotas at the individual factory level

◦ Accounting used almost entirely to collect data to prepare national statistics and to determine whether the government’s economic targets had been achieved


One school of thought—deliberate efforts towards accounting harmonization can reduce gap regarding broad aims of countries◦ Even in EU, where greatest visible effort towards

attaining regional accounting harmony has been made, there remain substantial differences in terms of broad aims of accounting and, consequently, methods and practices among countries

◦ Evidence suggests that accounting differences are perpetuated by underlying differences in these countries’ capital markets United Kingdom and U.S. have long tradition of active

securities markets, however, Germany and France have, until now, relied on bank finance as a source of industrial capital


Effects of Diversity on Capital Markets Rationale to reduce global diversity

◦ Reduction of costs imposed by diversity◦ If accounting diversity presents a barrier to the

free flow of capital across borders, then reducing or removing this barrier should help direct capital to the most efficient users (and uses) globally

◦ Improve comparability of financial statements, making them easier to use across countries

Effects of Diversity on Capital Markets Diversity in financial reporting rules and

practices and their effects on firms ◦ Effects of differences in disclosure levels on listing

decisions◦ Effects of regulatory differences on user groups◦ Effects of differences in goodwill treatments on

mergers and acquisitions

Effects of Diversity on Capital Markets Debate as to level of disclosure that should

be required by regulators and stock exchanges from foreign firms listing within their jurisdiction◦ Regulators perspective: goal of protecting

domestic investors from potentially misleading financial disclosures by foreign firms must be weighed against demand for increased access to investment opportunities in foreign firms

Effects of Diversity on Capital Markets During 1980’s & 1990’s

◦ Securities and Exchange Commission (SEC) Insisted that foreign firms’ financial statements had to be

reconciled to U.S. GAAP◦ New York Stock Exchange (NYSE)

Argued reconciliation requirement imposed an unnecessary burden on foreign issuers that kept them from listing their securities and adversely affected the U.S. Economy

Argued it deprived U.S. investors of the opportunity to invest in many global blue chip companies and reduced the competitiveness of domestic stock exchanges and securities industries relative to countries where the net regulator burden was less than in the US

Effects of Diversity on Capital Markets Three main issues related to the interaction

between accounting diversity and the increasing globalization of the world’s capital markets◦ 1) Benefits and costs of listing on a foreign stock

exchange◦ 2) Effects of accounting disclosure levels on

foreign listing decisions◦ 3) Accounting policy issues posed by foreign stock

exchange listings and how authorities have responded

Effects of Diversity on Capital Markets Key question: Are choices regarding

alternative foreign stock exchange listings influenced by financial disclosure levels? Yes.

Surveys of Canadian companies listing in the U.S. and United Kingdom◦ Indicated that the financial reporting and

compliance requirements of the SEC to be greatest cost of listing their shares on U.S. stock exchanges*Significant because Canada is very similar to the US

in terms of business environment

Effects of Diversity on Capital Markets Other surveys gauge behavioral effects of

accounting diversity on major categories of capital market participants

Found—accounting differences are important and affect capital market decisions such as:◦ The geographic spread of investments◦ The types of securities selected◦ Assessment of security returns or valuation◦ Information processing costs

Effects of Diversity on Capital Markets Effects of differing rules of goodwill on

merger activity◦ Question: Whether national differences in the

accounting treatment of purchased goodwill were associated with differences in merger premiums offered by non-U.S. acquirers when bidding for U.S. target companies

◦ Found—merger premiums offered by foreign acquires based in countries with more favorable accounting and tax treatments for goodwill than the U.S. to be higher than those offered by U.S. acquirers

Object of classification in international financial reporting is to group countries according to common elements and distinctive characteristics of their financial accounting systems

Benefits of classification: ◦ Identifying similarities and differences has improved

overall understanding◦ Countries comprising of particular group likely to react to

new circumstances in similar ways◦ Countries may anticipate accounting problems and

solutions by looking at experiences of other countries in the same group

Classification of Financial Accounting and Reporting Systems

◦ Countries that lack resources to develop their own accounting standards may identify a group that can serve as a model

◦ Patterns can help organizations such as the IASB in their global harmonization efforts

◦ Financial statement communication problems are more severe when reporting across groups rather than within

Classification of Financial Accounting and Reporting Systems

Global Convergence◦ Convergence of accounting regulations will have a

significant impact on company’s investing, financing and business decisions Example: U.S. GAAP to IFRS

Quality of Financial Reporting in Developed and Emerging Economies◦ Recent economic and financial crises have highlighted

a need for reliable and transparent financial reporting◦ United States Agency for International Development

has been contributing resources to establish accounting and capital marketing regulations in developing countries

Challenges Facing Accounting Globally

Social Responsibility Reporting◦ A consequence of globalization is having stakeholders

all around the world◦ Becoming increasingly important to include reports

regarding the company’s social responsibilities within their operating communities

Financial Reporting in the High Technology Era◦ Is beneficial to investors for having information

available at any time◦ Investors demand timely financial reporting◦ Leading to the hard-copy annual reports becoming

obsolete

Challenges Facing Accounting Globally

international accounting chapter 1

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