Get the answer of: Why do Accounting Practices Differ throughout the World?
Exhibit 11.1 presents the 2005 consolidated balance sheet for Jardine Matheson, a diversified company incorporated in Bermuda with significant holdings in Asia. A quick examination of this statement reveals several format and terminology differences compared with what is usually found in the balance sheets of U.S.-based companies. The company classifies assets as current and noncurrent but lists them in reverse order of liquidity starting with intangibles. Likewise, it lists long-term liabilities before current liabilities, both of which are reported below shareholders’ equity.
Fixed assets are referred to as tangible assets, receivables are called debtors, and inventories are reported as stocks and work in progress. Cash and cash equivalents are called bank balances and other liquid funds. Accounts payable are referred to as creditors, and provisions, found in both long-term and current liabilities, are estimated obligations related to things such as warranties and restructuring plans.
Share capital reflects the par value of common stock and share premium shows the paid-in capital in excess of par value. Retained earnings are not reported separately but are included in revenue and other reserves. One of the other reserves is related to the revaluation of assets, which is an unacceptable practice in the United States. Treasury stock is aptly called own shares held.
Exhibit 11.2 presents the 2005 consolidated income statement for the Dutch company Heineken N.V., the producer of one of the most popular brands of beer in the world. Inspection of this statement reveals a significant difference in format compared with the format normally found in the United States.
U.S. companies typically report operating expenses on the income statement according to their function, as follows:
Less- Cost of goods sold
Equals- Gross profit
Less- Selling costs
Less- Administrative costs
Equals- Operating profit
This format combines manufacturing costs (materials and supplies, labor costs, and overhead) and reports them as cost of goods sold. Selling costs and administrative costs (which also consist of supplies, labor costs, and overhead) are reported separately from cost of goods sold. Gross profit is reported as the difference between sales and cost of goods sold.
Heineken does not report operating expenses on the basis of their function but on the basis of their nature. Materials costs are reported as raw material, consumables and services, labor costs are reported as personnel expenses, and overhead is reported in the line item amortization and depreciation. Each of these line items includes amounts that cut across functional areas. Personnel expenses, for example, includes the wages, salaries, and benefits paid to employees involved in manufacturing, selling, and administration.
As a result, cost of goods sold is not reported as a separate amount and therefore gross profit cannot be calculated. The nature of expenses format used by Heineken in preparing its income statement is the format traditionally used in continental European countries. Today, however, it is common to find companies in the Netherlands, Germany, and other European countries using the function of expenses (or cost of sales) format familiar in the United States.
Exhibit 11.3 presents the 2005 consolidated income statement for Cemex, S.A. de C.V, a large Mexican-based cement manufacturer with operations in many countries. Like most U.S. companies, Cemex uses the function of expense format to report operating income. The next section of the income statement in which Cemex reports its comprehensive financing result, however, is unique to Mexico.
The net comprehensive financing result combines the nominal amounts of financial (interest) expense and financial (interest) income, the net foreign exchange gain or loss related to foreign currency transactions, and the net purchasing power gain or loss resulting from inflation.
The net comprehensive financing result provides a measure of the true cost of financing after considering inflation and foreign exchange rate fluctuations. Mexico is one of the few countries in the world in which companies must adjust their accounts for inflation. The balance sheet reports fixed assets, inventories, and stockholders’ equity accounts at their historical cost adjusted for changes in the purchasing power of the Mexican peso.
The heading on Cemex’s income statement indicates that amounts are expressed in millions of constant Mexican pesos as of December 31, 2005. This means that all amounts in the income statement, including those related to 2004 and 2003, have been restated in terms of the peso’s purchasing power at December 31, 2005. As a result, the amount reported as 2004 net sales in the 2005 annual report, for example, is different from the amount reported as 2004 net sales in the 2004 annual report.
The reflection of the effects of inflation in the financial statements is one of the most significant differences between Mexican GAAP and U.S. GAAP, but a number of other differences also exist. Because its common stock is listed on the New York Stock Exchange, Cemex is required to be registered and file financial statements with the U.S. Securities and Exchange Commission (SEC).
Foreign registrants must file their annual report with the SEC on Form 20-F. The financial statements included in Form 20-F may be prepared in accordance with a foreign GAAP, but the SEC requires income and stockholders’ equity reported under foreign GAAP to be reconciled to U.S. GAAP. Cemex’s 2005 reconciliation of net income to U.S. GAAP is in Exhibit 11.4.
This reconciliation provides insight into the major differences in accounting principles between the United States and Mexico. Some of the accounting differences resulting in the largest adjustments are amortization of goodwill, hedge accounting, derivative instruments, and inflation adjustment of fixed assets.
Note that net income under U.S. GAAP exceeds net income under Mexican GAAP in 2003 and 2004, but the opposite is true in 2005. The difference in net income in 2004 is highly material; Cemex’s net income under US. GAAP that year is 32.5 percent higher than its net income under Mexican GAAP.
Although it is generally assumed that accounting diversity results in significant differences in the measurement of income and equity across countries, until the 1990s there was very little systematic empirical documentation of the effect that these differences have on published financial statements.
In 1993, the SEC published a survey that examined the U.S. GAAP reconciliations made by 444 foreign entities from 36 countries. The results of that survey indicate that approximately two-thirds of the foreign companies showed material differences between net income and owners’ equity reported on the basis of home GAAP and U.S. GAAP.
United States Securities and Exchange Commission, Survey of Financial Statement Reconciliations by Foreign Registrants.
Of those with material differences, net income would have been lower under U.S. GAAP for about two-thirds of the companies (higher using US. GAAP for about one-third). Similar results were found with regard to owners’ equity. At the extremes, income was 29 times higher under U.S. GAAP for one foreign entity, and 178 times higher using British GAAP for another entity. In addition, the study found that significant differences are spread relatively evenly across countries.
In other words, material differences are as likely to exist for a British or Canadian company as for a company in South America, Asia, or Continental Europe:
Focusing on the U.S. GAAP reconciliations of British companies, a separate study found that all 39 companies examined reported material differences in income or equity. More than 90 percent reported lower income under U.S. GAAP and approximately 60 percent reported higher equity.
The average difference in income, even after including those with higher U.S. GAAP income, was a 42 percent reduction in income when reconciling to U.S. GAAP. It is clear that differences in accounting principles can have a material impact on amounts reported in financial statements.
In 1998, Nobes developed a simplified model of the reasons for international accounting diversity that has only two explanatory factors:
(1) National culture, including institutional structures, and
(2) The nature of a country’s financing system.
Nobes argued that differences in the purpose for financial reporting across countries is the major reason for international differences in financial reporting and that the most relevant factor in determining the purpose of financial reporting is the nature of a country’s financing system. Specifically, whether or not a country has a strong equity financing system with large numbers of outside shareholders determines the type of financial reporting system a country uses.
Nobes divided financial reporting systems into two classes, A and B. Countries with a strong equity-outsider financing system use a Class A accounting system and countries with a weak equity-outsider financing system have a Class B system. Class A accounting is less conservative, provides more disclosure, and does not follow tax rules. Class B accounting is more conservative and disclosure is not as extensive and more closely follows tax rules.
Nobes stated that a country’s culture determines the nature of its financing system. He assumed (without explaining how) that some cultures lead to strong equity-outsider financing systems and other cultures lead to weak equity-outsider financing systems.
His model of reasons for international accounting differences is summarized as follows:
Many countries in the developing world are culturally dominated by another country, often as a result of European colonialism. Nobes argued that culturally dominated countries use the accounting system of their dominating country regardless of the nature of the equity financing system. This explains, for example, why the African nation of Malawi, a former British colony, uses a Class A accounting system even though it has a weak equity-outsider financing system.
Nobes’s classification is consistent with the findings of a study in which data on 100 accounting practices in 50 countries were analyzed using the statistical procedure of hierarchical cluster analysis.” The results of this procedure (see Exhibit 11.6) produced two large clusters of countries composed of several smaller clusters. The two clusters in what is referred to as the micro class of accounting system consist primarily of countries that at some point in their history were part of the British Empire.
In contrast, no English-speaking countries are in the macro class clusters. The two classes of accounting reflected in Exhibit 11.6 differed significantly on 66 of the 100 financial reporting practices examined. The micro class countries generally indicated requiring more disclosures than the macro class countries, and a much larger percentage of macro countries indicated that accounting practice adhered to tax requirements.
As the financing system in a country evolves from weak equity to strong equity, Nobes suggests that the accounting system also evolves in the direction of Class A accounting. He cites China as an example of a country in which this is already taking place. Nobes also argues that individual companies with strong equity-outsider financing attempt to use Class A accounting even if they are located in a Class B accounting system country; some evidence suggests that this also has occurred.
To enhance companies’ ability to compete in attracting international equity investment, several European countries (with weak equity-outsider financing and Class B accounting systems) developed a two-tiered financial reporting system in the late 1990s.
Austria, France, Germany, Italy, and Switzerland gave stock exchange-listed companies the option to use International Financial Reporting Standards (IFRSs) (a Class A accounting system) in preparing their consolidated financial statements. Large numbers of German and Swiss multinational companies (including Deutsche Bank, Bayer, and Nestle), in particular, took advantage of this option. Other companies continued to use local GAAP.
The desire for companies to be competitive in the international capital market led the European Union in 2005 to require all publicly traded companies to use IFRSs in preparing their consolidated financial statements. As time passes, it will be interesting to see whether adoption of a Class A accounting system results in a stronger equity-outsider financing system within the countries composing the European Union.
Because of the problems associated with worldwide accounting diversity, attempts to reduce accounting differences across countries known as harmonization have been ongoing for more than three decades. The ultimate goal of harmonization is to have all companies around the world follow one set of international accounting standards.
Proponents of accounting harmonization argue that worldwide comparability of financial statements is necessary for the globalization of capital markets. Financial statement comparability would make it easier for investors to evaluate potential investments in foreign securities and thereby take advantage of the risk reduction possible through international diversification. It also would simplify multinational companies’ evaluation of possible foreign takeover targets.
From the securities issuer side, harmonization could allow companies to gain access to all worldwide capital markets with one set of financial statements. This would allow companies to lower their cost of capital and would make it easier for foreign investors to acquire the company’s stock.
One set of universally accepted accounting standards would reduce the cost of preparing worldwide consolidated financial statements and would simplify the auditing of these statements. Multinational companies would find it easier to transfer accounting staff to other countries. This would be true for the international auditing firms as well.
One obstacle to harmonization is the magnitude of the differences between countries and the fact that the political cost of eliminating those differences could be quite high. As Dennis Beresford, former chairman of the FASB, stated, “High on almost everybody’s list of obstacles is nationalism.
Whether out of deep-seated tradition, indifference born of economic power, or resistance to intrusion of foreign influence, some say that national entities will not bow to any international body.” Arriving at principles that satisfy all parties involved throughout the world seems an almost Herculean task.
Harmonization is difficult to achieve, and the need for such standards is not universally accepted. As Richard Karl Goeltz stated, “Full harmonization of international accounting standards is probably neither practical nor truly valuable. It is not clear whether significant benefits would be derived in fact.
A well-developed global capital market exists already. It has evolved without uniform accounting standards.” Opponents of harmonization argue that it is unnecessary to force all companies worldwide to follow a common set of rules. The international capital market will force companies that benefit from accessing the market to provide the required accounting information without harmonization.
Another argument against harmonization is that because of different environmental influences, differences in accounting across countries might be appropriate and necessary. For example, countries at different stages of economic development or that rely on different sources of financing perhaps should have differently oriented accounting systems.
Regardless of the arguments against harmonization, substantial effort to reduce differences in accounting practice and to develop a set of international accounting standards has been ongoing for several decades.
While numerous organizations have been involved in the international harmonization of financial reporting the two most important players in this effort have been the European Union on a regional basis and the International Accounting Standards Board on a global basis.
The major objective embodied in the Treaty of Rome that created the European Economic Community in 1957 (now called the European Union) was the establishment of free movement of persons, goods and services, and capital across member countries. To achieve a common capital market, the European Union (EU) has attempted to harmonize financial reporting practices within the community. To do this, the EU issues directives that must be incorporated into the laws of member nations.
Two directives have helped harmonize accounting. The Fourth Directive, issued in 1978, deals with valuation rules, disclosure requirements, and the format of financial statements. The Seventh Directive, issued in 1983, relates to the preparation of consolidated financial statements.
The Seventh Directive requires companies to prepare consolidated financial statements and outlines the procedures for their preparation. This directive has significantly impacted European accounting because consolidations were previously uncommon on the Continent.
The Fourth Directive provides considerable flexibility with dozens of provisions beginning with the expression “member states may require or permit companies to”; these allow countries to choose from among acceptable alternatives. One manifestation of this flexibility is that Dutch and British law allow companies to write up assets to higher market values, but in Germany this is strictly forbidden. Notwithstanding this flexibility, implementation of the directives into local law caused extensive change in accounting practice in several countries.
The Fourth and Seventh Directives did not create complete harmonization within the European Union. As an illustration of the effects of differing principles within the EU, the profits of one case study company were measured in European currency units (ECUs) using the accounting principles of various member states.
The results are almost startling:
Part of the difference in profit across EU countries results from several important topics not being covered in the directives including lease accounting, foreign currency translation, accounting changes, contingencies, income taxes, and long-term construction contracts. In 1990, the EU Commission indicated that there would be no further accounting directives. Instead, the Commission indicated in 1995 that it would associate the EU with efforts undertaken by the International Accounting Standards Committee toward a broader international harmonization of accounting standards.
In hopes of eliminating the diversity of principles used throughout the world, the International Accounting Standards Committee (IASC) was formed in June 1973 by accountancy bodies in Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom and Ireland, and the United States. The IASC operated until April 1, 2001, when it was succeeded by the International Accounting Standards Board (IASB).
Based in London, the IASC’s primary objective was to develop international accounting standards (IASs). The IASC had no power to require the use of its standards, but member accountancy bodies pledged to work toward adoption of IASs in their countries. IASs were approved by a board consisting of representatives from 14 countries. The part-time board members normally met only three times a year for three or four days. The publication of a final IAS required approval of at least 11 of the 14 board members.
Early IASs tended to follow a lowest common denominator approach and often allowed at least two methods for dealing with a particular accounting issue. For example, IAS 2, originally issued in 1975, allowed the use of specific identification, FIFO, LIFO, average cost, and the base stock method for valuing inventories, effectively sanctioning most of the alternative methods in worldwide use.
For the same reason, the IASC initially allowed both the traditional U.S. treatment of expensing goodwill over a period of up to 40 years and the U.K. approach of writing off goodwill directly to stockholders’ equity. Although perhaps necessary from a political perspective, such compromise brought the IASC under heavy criticism.
In 1987, the International Organization of Securities Commissions (IOSCO) became a member of the IASC’s Consultative Group. IOSCO is composed of the stock exchange regulators in more than 100 countries, including the U.S. SEC. As one of its objectives, IOSCO works to facilitate cross-border securities offerings and listings by multinational issuers.
To this end, IOSCO has supported the IASC’s efforts at developing IASs that foreign issuers could use in lieu of local accounting standards when entering capital markets outside of their home country. “This could mean, for example, that if a French company has a simultaneous stock offering in the United States, Canada, and Japan, financial statements prepared in accordance with international standards could be used in all three nations.”
IOSCO supported the IASC’s Comparability Project (begun in 1987), “to eliminate most of the choices of accounting treatment currently permitted under International Accounting Standards.” As a result of the Comparability Project, 10 revised IASs were approved in 1993 to become effective in 1995. In 1993, IOSCO and the IASC agreed upon a list of “core” standards to use in financial statements of companies involved in cross-border securities offerings and listings. Upon their completion, IOSCO agreed to evaluate the core standards for possible endorsement for cross-border listing purposes.
The IASC accelerated its pace of standards development, issuing or revising 16 standards in the period 1997-1998. With the publication of IAS 39 in December 1998, the IASC completed its work program to develop the core set of standards. In 2000, IOSCO’s Technical Committee recommended that securities regulators permit foreign issuers to use IASC standards to gain access to a country’s capital market as an alternative to using local standards.
A Principles-Based Approach to Standard Setting:
The IASB has taken a principles-based approach to establishing accounting standards rather than the so-called rules-based approach followed by the FASB in the United States. Principles- based standards focus on providing general principles for the recognition and measurement of a specific item with a limited amount of guidance; they avoid the use of “bright-line” tests. Application of principles-based standards requires a greater degree of professional judgment than does application of rules-based standards.
Classification of leases is an accounting issue that demonstrates the difference in the standard-setting approach taken by the IASB and the FASB. The FASB’s SFAS 13, “Accounting for Leases,” requires leases to be classified as either capital or operating. Capital leases are reported on the balance sheet as both an asset and a liability whereas operating leases are not. Criteria for classifying leases are set out in paragraph 7 of the standard, which clearly states “if at its inception, a lease meets one or more of the following four criteria, the lease shall be classified as a capital lease by the lessee. Otherwise it shall be classified as an operating lease.”
The four criteria follow:
1. The lease transfers property ownership to the lessee by the end of the lease term.
2. The lease contains a bargain purchase option.
3. The lease term equals 75 percent or more of the economic life of the leased property.
4. The present value of minimum lease payments is 90 percent or more of the lease property’s fair value.
SFAS 13 is very prescriptive. A lease shall be classified as a capital lease if at least one of four criteria is met, and two of the criteria are based on bright-line thresholds—75 percent or more of the economic life and 90 percent or more of the fair value.
The bright-line tests established in this standard have come under considerable criticism because they give companies the opportunity to engineer lease agreements so as to avoid meeting the tests and thereby to keep leases off the balance sheet. In a Financial Reporting Issues Conference sponsored by the FASB in 1996, SFAS 13 was deemed to be the worst standard in U.S. GAAP.
IAS 17, “Accounting for Leases,” is similar to SFAS 13 in many respects. It also distinguishes between capital (finance) leases and operating leases, but its guidance for classifying leases is much less prescriptive than the U.S. standard.
Clearly, IAS 17’s general principle for classifying leases does not provide sufficient guidance to ensure consistent application across companies. Paragraphs 10 and 11 provide additional guidance that is suggestive rather than prescriptive. These paragraphs describe examples of situations that individually or in combination would normally lead to or could lead to the classifications of a lease as a finance lease. Note that the standard does not indicate that in these situations a lease must be capitalized.
Four of the examples provided in paragraph 10 are similar to the four criteria for lease classification in SFAS 13. However, the IASB standard is careful not to establish bright-line tests. Rather than the 75 percent of economic life rule in US. GAAP, IAS 17 indicates that if the lease term is for the major part of the asset’s economic life, it normally would be classified as a capital lease. In the example relating the present value of minimum lease payments to the fair value of the lease property, a less specific test of at least substantially all is used instead of the FASB’s bright line of 90 percent or more.
Presumably, writing a lease contract whose lease term is only 74 percent of the asset’s economic life and the present value of lease payments is only 89 percent of the asset’s fair value would not in and of itself preclude the lease from being classified as a finance lease under IAS 17, whereas it clearly would not meet the test for capitalization under U.S. GAAP. IAS 17 reiterates in paragraph 10 that “whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract.”
Concerned that the rules-based standards in U.S. GAAP could have contributed to the spate of accounting scandals at U.S. companies, the Sarbanes-Oxley Act of 2002 required the SEC to study the adoption of a principles-based accounting system in the United States. In conducting its study, the SEC evaluated IFRSs but concluded that they did not represent a cohesive set of principles-based standards that could act as a model for the United States.
The SEC report to Congress issued in 2003 stated that “a careful examination of the IFRS shows that many of those standards are more properly described as rules based. Other IFRS could fairly be characterized as principles only because they are overly general.” Principles-only standards do not contain sufficient guidance to ensure relatively consistent application across companies.
Some observers have expressed concern that the FASB-IASB convergence project might result in IASB standards becoming more rules based. In 2003, the IASB issued exposure draft ED 4, “Disposal of Non-current Assets and Presentation of Discount Operations,” intended to converge IFRSs with SFAS 144, the equivalent U.S. standard. Consistent with SFAS 144, the IASB’s exposure draft included a list of criteria for determining when assets are being “held for sale” and therefore must be classified as such on the balance sheet.
In a letter commenting on ED4, representatives from the National Association of German Banks (Bundesverband deutscher Banken) took issue with the fact that the proposed standard included a list of criteria for identifying assets held for sale. According to the authors, such a “list of criteria is at odds with the IAS objective of producing standards based on principles.” Moreover, they argue that “in our view, setting out detailed sets of individual circumstances will result in more, not less, discretionary leeway.”
IFRS and U.S. GAAP are the dominant accounting standards worldwide. In January 2007, a study conducted by the Financial Times determined that U.S. GAAP was used by companies comprising 35 percent of global market capitalization; companies making up 55 percent of global market capitalization were using or planning to use IFRS; and only 10 percent were using some other set of rules for financial reporting purposes.
If the FASB-IASB convergence project progresses to the elimination of substantive differences between the two sets of standards, someday all major companies could use very similar accounting rules. When that day arrives, will the objective of accounting harmonization have been achieved?
Will financial statements truly be comparable across countries? The use of a common set of accounting standards is a necessary but perhaps not a sufficient condition for ensuring worldwide comparability. Several obstacles stand in the way of a common set of standards being interpreted and applied in a consistent manner across all countries.
IFRS are written in English and therefore must be translated into other languages for use by non- English-speaking accountants. The IASB created an official translation process in 1997, and by the end of 2006, IFRS had been translated into more than 30 other languages. Most translations are into European languages because of the European Union’s required usage of IFRS.
However, IFRS also have been translated into Chinese, Japanese, and Arabic. Despite the care the IASB took in the translation process, several research studies suggest that certain English-language expressions used in IFRS are difficult to translate without some distortion of meaning.
In one study, Canadian researchers examined English-speaking and French-speaking students’ interpretations of probability expressions such as probable, not likely, and reasonable assurance used to establish recognition and disclosure thresholds in IASs. English-speaking students’ interpretations of these expressions differed significantly from the interpretations made by French-speaking students of the French-language translation.
In another study, German accountants fluent in English assigned values to both the English original and the German translation of probability expressions used in IFRS. For several expressions, the original and translation were interpreted differently, suggesting that the German translation distorted the original meaning.
As an example, IFRS (and U.S. GAAP) use the term remote that appears particularly difficult to translate in a consistent fashion. IAS 37, “Provisions, Contingent Liabilities and Contingent Assets,” indicates that a contingent liability is disclosed “unless the possibility of an outflow of resources embodying economic benefits is remote”, and IAS 31, “Interests in Joint Ventures,” requires separate disclosure of specific types of contingent liabilities “unless the probability of loss is remote”. It would appear that remote is intended to establish a similar threshold for disclosure in both standards.
French translations of remote in both IAS 31 and IAS 3 7 use the word faible (weak). However, the adjective tres (very) is added to form the expression tres faible in IAS 31. Thus, remote is literally translated as “weak” (faible) in IAS 37 and “very weak” (tres faible) in IAS 31. Preparers of financial statements using the French translation of IFRSs might interpret IAS 31 as establishing a stronger test than IAS 37 for avoiding disclosure.
Translating remote into German presents even greater difficulty. IAS 31 uses the German word unwahrscheinlich (improbable), and IAS 37 uses the phrase äuβerst gering (extremely remote). The German translation of IAS 31 appears to establish a more stringent threshold for nondisclosure of contingent liabilities than does the German translation of IAS 37, and it is questionable whether either threshold is the same as the original in English.
The SEC implicitly acknowledged the potential problem in translating IFRS to other languages in its proposed rule to eliminate the U.S. GAAP reconciliation requirement for foreign registrants. That rule applies only to those foreign companies that prepare financial statements in accordance with the English language version of IFRS.
Even if translating IFRS into languages other than English was not difficult, differences in national culture values could lead to differences in the interpretation and application of IFRS. Gray proposed a model that hypothesizes a relationship between cultural values, accounting values, and the financial reporting rules developed in a country. More recently, Gray’s model was extended to hypothesize that accounting values not only affect a country’s accounting rules but also the manner in which those rules are applied.
This hypothesis has important implications for a world in which countries with different national cultures use the same accounting standards. It implies that for accounting issues in which accountants must use their judgment in applying an accounting principle, culturally based biases could cause accountants in one country to apply the standard differently from accountants in another country.
Several research studies support this hypothesis. For example, one study found that, given the same set of facts, accountants in France and Germany estimated higher amounts of warranty expense than did accountants in the United Kingdom. This result was consistent with differences in the level of the accounting value of conservatism across these countries resulting from differences in their cultural values.
Financial statement users need to be aware that the use of a common set of accounting standards will not lead to complete financial statement comparability across countries. However, a greater degree of comparability will exist than if each country were to continue to use a different set of standards.