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Fakulteten för Ekonomi, Kommunikation och IT

Camilla Svensson 870702-5063

National differences in financial reporting and the process towards harmonization

International Financial Accounting7,5hp

Term: HT 2009

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Contents1 Introduction and question of issue......................................................................................22 Theory.................................................................................................................................2

2.1 Causes of international differences..............................................................................22.1.1 External environment and culture.........................................................................22.1.2 Legal systems........................................................................................................32.1.3 Provision of finance..............................................................................................32.1.4 Taxation................................................................................................................4

2.2 Most important differences in financial reporting........................................................42.2.1 Shareholder orientation.........................................................................................42.2.2 Fairness.................................................................................................................42.2.3 Conservatism and accruals....................................................................................52.2.4 Uniformity, accounting plans and formats............................................................52.2.5 Consolidated accounts..........................................................................................52.2.6 Deferred taxation..................................................................................................5

2.3 Harmonization..............................................................................................................52.3.1 Reasons for harmonization...................................................................................62.3.2 Obstacles of harmonization...................................................................................72.3.3 EU directives.........................................................................................................72.3.4 IASB.....................................................................................................................82.3.5 FASB.....................................................................................................................82.3.6 The Conceptual Framework..................................................................................8

3 Discussion and conclusion................................................................................................10

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1 Introduction and question of issueIn the beginning of financial reporting, it was mostly internal reporting. Since the early 1800s more and more companies ended up in financial problems and it became necessary to separate management and capital supply. It was not enough with only private capital to finance all of the business activities, so they had to collect capital from different people outside the com-pany. This development caused a change in the financial reporting from internal to a wider external reporting. Standard setters and accounting bodies choose dissimilar alternatives for recognition, measurement and presentation in their financial reports because of the different characteristics in different countries. They have simply chosen the alternative that best fitted their national environments (Alexander et al. 2009). These differences can be a problem for those who work and use the published financial statements and organizations around the world are trying to harmonize accounting (Nobes & Parker 2000).

The process towards harmonization has increased a lot in recent years and now days do all quoted companies in EU using IAS for their consolidated financial statements. There is also an active process between IASB and FASB to reach a convergence (Alexander et al. 2009). These fast changes about accounting are the reason why I have chosen to write about why dif-ferent accounting systems exist and how the accounting systems differ from each other. I will also write about why a harmonization process is wanted but also is difficult to reach.

2 TheoryIn this chapter are firstly the causes of the international differences and the existing differ-ences being explained. After that are the reasons and obstacles with harmonization described. This chapter also describes different accounting standard setters and in the last part of this chapter is the convergence project being discussed.

2.1 Causes of international differencesMany researches and a lot of teaching have been done about international differences in finan-cial reporting, particularly since the 1980s onwards and in this part focus on the most impor-tant causes of the international differences (Nobes 2006).

2.1.1 External environment and cultureThere are cultural differences between nations and they have become a significant influence factor on disclosure and reporting behavior with consideration to financial statements (Alexander et al. 2009). In every country the culture consists of peoples most important val-ues and it have an effect on the way that people want their society to be structured (Nobes & Parker 2000). People have created principles or laws which are a societies norms or customs. These norms or customs does eventually become social institutions that are different between one group to another. They are affected by geographic areas and other features that either is original or that comes from other groups (Marrero et al. 2007).

Hofstede is one of the most important researches on cultural differences and he defined fol-lowing four basic dimensions of culture based on a study of over 100 000 IBM employees in 39 countries (Alexander et al. 2009).

Individualism versus collectivism: Individualism represents a society where people are ex-pected only to watch out for themselves and their closest family. Collectivism represents a so-

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ciety where people expect their relatives or other in-group to look after them in return of total loyalty. The problem with this dimension is the level of independence that a society has among the individuals (Alexander et al. 2009).

Large versus small power distance: Power distance stands for how the people in a society al-low the power to be spread unequally in institutions and organizations. In large power dis-tance the people think that it is okay that there is a hierarchical order which means that every-body has a special place and that place needs no further vindication. The main problem with this dimension is how the society takes care of differences among people when it comes up (Alexander et al. 2009).

Strong versus weak uncertainty avoidance: Uncertainty avoidance is how uncertainty and vagueness affects the feeling of uncomfortable of the peoples in the society. When a society has strong uncertainty avoidance the members of the society do not tolerate people with dif-ferent behavior and ideas. But when a society has weak uncertainty avoidance the members have a more peaceful feeling and different people are more easily tolerated (Alexander et al. 2009).

Masculinity verses femininity: Masculinity stands for accomplishment, material success and great courage. Femininity is the opposite and stands for humility, relationships and to take care of the weak (Alexander et al. 2009).

2.1.2 Legal systemsTwo types of legal systems have been developed over the years; the common law system and the code law system. The code law system emanates from Roman Empire and is distinctly le-galistic which means that it is based on obliged and written law. The common law system em-anates from England and it is found in many other countries. The written law has only had a limited influence on this legal system and instead, it has grown case by case. It is qualified or-ganizations of the private sector that does the accounting regulation in common law countries and the accounting rules are not part of the law (Smith 2006).

The company law is very detailed in code law countries and accounting standard are regularly incorporate in the company law. It is the government that has the responsibility of the ac-counting regulation in code law countries and that leads to that the financial reporting often is condensed to a minimum defined by the detailed set of legal rules (Alexander et al. 2009).

2.1.3 Provision of financeWhen companies had to get extra capital to finance expansion they reacted in different ways in different countries. In countries like France and Germany banks became the most important supplier of additional resources. In these countries the companies was more dependent on debt to provide capital for their activities than on equity. In other countries, like USA and UK, the companies got the extra finance from shareholders. In these countries the companies was more dependent on equity for the finance of their activities and a lively stock exchange was and still is in attendance (Alexander et al. 2009).

In countries where companies are mostly financed with equity financial statements will have an investor or shareholder direction. Because of that the financial statements must give the kind of information that will make it possible for a conceivable shareholder to make the best investment choice. This kind of information is called “high-quality” accounting information. Empirical research has pointed out that when countries have a strong capital market influence, then it is a higher quality of accounting earnings compared to countries with creditor orienta-

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tion. The financial statements have a creditor orientation in those countries where companies rely more on debt financing. This means that information given by the annual accounts must be valuable to form an opinion of whether a company is able to pay back its debt or not. It is important to remember these kinds of differences in financial statements when companies from different countries are being compared to each other for financial analysis purposes (Alexander et al. 2009).

2.1.4 TaxationThe fiscal authorities use information given in the financial statements in order to find out the taxable income in countries like Sweden and Germany. In several countries in Europe you only need to pay tax on expenses if they are also documented in the profit and loss account. This means that it is in these countries the financial reporting turn out to be tax influenced. The connection between taxation and financial reporting is frequently found in countries where they do not have a clear investor approach in their financial reporting direction. In other countries, like USA and UK, the connection between taxation and financial reporting is a lot weaker and they have separate accounts or other accounts for tax purposes (Alexander et al. 2009).

2.2 Most important differences in financial reporting

Accounting reacts to its environment and that’s why different environments make different accounting systems, but similar environments make similar accounting systems. We focus on these differences in accounting systems in this part. They are brought up as separate items but they are connected to each other (Alexander et al. 2009).

2.2.1 Shareholder orientation The shareholder orientation affects how the financial statements are designed (Nobes & Parker 2000). It is important that published financial information is of high-quality in coun-tries where they have a widespread ownership. It is important because existing and potential shareholders do not have access to internal information but they need to know the financial situation about the company where they might want to invest or increase their investments. In other countries the provider of finance (creditors/insiders) has the power to get access to the internal information and thereby it is not as important for revelation in the published informa-tion. There are more things that affect the valuation and one of them is if the company has debt or equity orientation. In debt oriented countries the financial information has to give sev-eral types of stakeholders such as creditors and the government the information they need to take the right decisions. In other countries, where the companies are financed with equity, the financial information should inform about the business performance and effectiveness to ex-isting and potential shareholders. The dept versus equity orientation lies at the source of the different reporting and principles that will be explain next (Alexander et al. 2009).

2.2.2 FairnessA fair picture of the financial situation is the purpose in common law countries and in some countries this is called the “true and fair view” concept. The opposite of fairness is legality and in code law countries financial reporting is focused on legal demands and tax laws. The differences between the two concepts can be explained by how they take care of a lease con-tract. When the focus is fairness and the country has a strong shareholder orientation the com-pany is not the real owner of the asset but it is still accounted for the lease in the balance sheet. In other countries where the focus is on legality, an asset is not accounted in the balance sheet if the company uses it but is not the real owner of it. This variation can have a big effect on the debt/equity percentage of companies (Alexander et al. 2009).

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2.2.3 Conservatism and accrualsThe valuation rules is more conservative in countries where the financial information is more creditor oriented and used for tax purposes, in contrary to countries where they have a share-holder orientation where the financial information is more accrual. These two types of valua-tion methods lead to a different way of accounting practices and valuation rules. When a con-servative accounting is used it often reports lower profits than if accrual accounting is being used (Alexander et al. 2009).

2.2.4 Uniformity, accounting plans and formatsThe regulator thinks it is important with uniformity in code law countries. Fulfillment of a comprehensive set of balance sheet and profit/loss result based on officially approved plans for accounting is a base for improved standardization. When it is the government that does the regulation the layout of the balance sheet, profit and loss accounts and notes is a lot more de-tailed (Alexander et al. 2009).

2.2.5 Consolidated accountsThe commonness of consolidation has been very different between the countries (Nobes & Parker 2000). The practice of plans and published consolidated financial statements came a lot earlier in countries where they had a strong shareholder orientation. In other countries where they were more creditor oriented, and usually also code law countries, consolidation was decided by law (Alexander et al. 2009). In the United States they have used consolidation at least as far back as the 1890s and it was commonly used in the early 1920s. Despite from UK and Netherland, consolidation is anyhow quite new or so far very unusual. Now when the majority of the developed countries ask for consolidation the interesting variation are in the description of subsidiaries and associates and how goodwill and other technical issues is being handled (Nobes & Parker 2000).

2.2.6 Deferred taxationThere are countries where there are no straight connection between accounting income and tax income and their practice of recording deferred taxes on the balance sheet is deep-rooted and common practice. In other countries where there are a strong connection between ac-counting income and tax income the practice of recording and compute deferred taxes is quite new (Alexander et al. 2009).

2.3 HarmonizationThere are a lot of accounting differences between countries. Many people want to decrease these differences and even eliminate them if it is possible. But it is not an easy process be-cause of the deep-rooted causes of the international differences that has been discussed ear-lier. Many attempts have been made to reach a harmonization and EU has made one of the most significant attempts (Alexander et al. 2009).

It might be easy to mix up harmonization and standardization but harmonization is a process that increases the comparability of accounting practices by setting bounds to their level of variation. Standardization on the other hand appears to imply the imposition of a more inflexi-ble and thin set of rules (Alexander et al. 2009).

Harmonization could be either on de jure-level which is rules and regulation, or on de facto-level which is how accounting is used in practice by companies. There are three strategies about harmonization on de jure-level and they are:

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1. Standardization with rules that are uniform and with no chance to choose. FASB ap-plies this model.

2. Equal rules with notes. EU applies this model. 3. Choice alternatives where wanted alternative has been indicated. IASB has applied

this model.1

Harmonization

Choice alternatives Equal rules Standardization

(Figure 1. Model from Gunnar Rimmel, lecture 090929, Karlstads Universitet)

2.3.1 Reasons for harmonizationThe financial statements in one country are used by people in many other countries and that is why national accounting standards should be able to also apply internationally. It is those who regulate, prepare and use financial statements that mainly demand international harmoniza-tion. Investors and financial analysts have to be capable of understanding financial statements from companies in foreign countries where they might want to buy shares. They have to be certain that statements from different countries can be trusted and that they are comparable with each other, or at least show the level of differences. That’s why different intergovern-mental transnational bodies, as EU, are involved in protecting investors in their spheres of in-fluence. If foreign shares are quoted on the domestic stock exchange of an investor, the com-pany might have to provide financial statements that are consistent with domestic practice. It would be easier for these companies if the international differences were reduced (Nobes & Parker 2000). Researchers assert that if the financial reporting is being more harmonized and converge to only one system, it should be towards the common law system because it is share-holder oriented and the shareholders gets a more and more important role for the companies (Buchanan 2003).

A harmonization process is mostly important for the multinational companies even if it also affects companies that do not operate multinational. The preparation and consolidation of the financial statement would be much easier if it was prepared on the same way in the whole world. It would also be easier to make comparable internal information for the appraisal of the performance of subsidiaries that are in different countries. It would be very beneficial if har-monized methods were in use for evaluation of business, performance and basis for invest-ments. It would also bring big value to decision makers that need facts based on understand-able management accounting. A harmonization would also make it easier for multinational companies to move accounting staff between different countries (Nobes & Parker 2000).

The international accounting firms would also get benefits with a more harmonized account-ing practice. Several of their clients have foreign subsidiary or branch and harmonization would make the preparation, consolidation and auditing a lot easier. It is also a lot of difficult work for the tax authorities when they are dealing with foreign incomes by differences in the measurement of profit in different countries. In developing countries would probably the gov-ernments think it would be easier to understand and control the operations of multinational companies with a more harmonized financial reporting. The World Bank and other interna-tional credit grantors do also find it difficult with the comparison between different countries

1 Gunnar Rimmel, lecture 090929, Karlstads Universitet

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and many organizations would benefit from greater international comparability of company information (Nobes & Parker 2000).

2.3.2 Obstacles of harmonizationThere are many obstacles that make the harmonization process quite difficult and the size of the present differences among the accounting practices of different countries is the most basic problem. The common differences between shareholder/fair view presentation and creditor/tax/conservative presentation is another problem that is not easy to overcome without big changes in both law and attitude. But it is not obvious that all differences are supposed to be overcome. If the main reason of financial reporting differ by country it appears logical that the reporting should differ. Companies in several countries anyhow struggle hard to deal with in-formation and financial operations caused by low level of harmonization. The best way maybe is if companies do two different financial statements, one for domestic and the other one for international consumption (Nobes & Parker 2000).

The need for strong professional accountancy bodies in some countries is another obstacle. This implies that anybody, such as The International Accounting Standards Committee (IASC), cannot be effective in all countries when they seek to operate through the private sec-tor. A worldwide enforcement agency could be an alternative solution but it is missing as well. The International Organization of Security Commissions (IOSCO) could be important for listed companies and the European Union could be that kind of agency for one part of the world (Nobes & Parker 2000).

Nationalism is another obstacle and it is because there is unwillingness to cooperate and change the accounting practices against those of other countries (Nobes & Parker 2000). A lot of countries do not want to lose sovereignty and control of their business. The nations are just very protective and they want to maintain their inherent national backgrounds (Marrero 2007). Different language can also be an obstacle. One problem is when people misunderstand each other when one word can have several meanings. It can also be a problem when something is written in an exact way in one language and it cannot be precisely translated so it has to be rewritten and the context might not be the same.2

2.3.3 EU directivesEU uses two main instruments when they try to harmonize company law and accounting. One of the instruments is Directives and it has to be incorporated into the laws of member states. The second instrument is Regulations and they do not need to pass trough national legislatures to become law all over the EU (Nobes & Parker 2000). There are two EU directives that are relating to financial reporting and accounting. The first one is the Forth Company Law Direc-tive of 25 July 1978 and it is related to the yearly accounts of limited companies. The second directive is the Seventh Company Law Directive of 13 June 1983 and it is extending the prin-ciples of the Fourth Directive to the preparation of consolidated accounts (Alexander et al. 2009).

The fourth directive contains both public and private companies in every country inside EU. It also contains how the published financial statements should be formed and requirements to disclosure. The forth directive do not include consolidation so that is comprised in the Sev-enth Directive instead. The Fourth Directive contains the obligation that published accounts must show a true and fair view and this part is very important to the content of the Directive (Nobes & Parker 2000). Since January 1, 2005 must all listed companies in EU publish IAS

2 Arne Fagerström, lecture 091005, Karlstads Universitet

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consolidated financial statements. This is an important step towards international accounting harmonization (Baker & Barbu 2007).

2.3.4 IASBThe International Accounting Standards Committee (IASC) was founded in 1973 and is the precursor of the International Accounting Standards Board (IASB). IASC gave out accounting standards between the years 1974-2000 and those standards are called IAS. IASB has one of the most important roles when it comes to achieve accounting harmonization and they have worked hard to increase the level of comparability (Barlev & Haddad 2007).

As from 2001 does IASB give out accounting standards that are called International Financial Reporting Standards (IFRS). IASB is a global organization with members from all parts of the world. It is a private organization which is being sponsored by auditors and industry from the whole world. The standards from IASB are being developed so that they can be applied glob-ally. EU has adopted the IAS/IFRS to EU law and the standards have therefore increased from standards to binding law and they have a very strong value as legal status.3 IFRS can be used by commercial, industrial and business reporting entities, whether in the public or the private sectors. The standards should be easy to understand even if you not are an expert.4

When new standards are being developed contributions comes from accounting firms, private financial institutions, companies and other types of organizations. Before a new standard gets compulsory for public companies must the European Commission approve it. EU will also make sure that all member countries have a good supervision and control over the companies so that they apply the standards (Johansson et al., 2004).

IFRS are more and more seen as the package of high-quality accounting standards capital markets worldwide has wanted a long time. A directive from EU in 2005 has resulted in that many of the public traded companies in the member states have taken on the IFRS. At the mo-ment are about 100 countries either obliged or allowed to use IFRS in different levels. One of the causes that have increased the use of IFRS is that many think that the IASBs standards are better because when the standards has developed are the geographically differences being considered. Companies that are adopting IFRS see it as a good way of saving cost when they want entrance to capital markets in other countries. It is due to the fact that it gets easier to compare the financial statements and investors have more faith in global accepted accounting standards (Cabrera 2008).

2.3.5 FASBThe US equivalence to IASB is the Financial Accounting Standards Board (FASB) and it has existed since 1973. The FASB is included in a structure that not is depending on any other business or professional organization. The task of the FASB is to establish and do the stan-dards of financial accounting and reporting better for the guidance and education of the public for all of them that uses the financial information (FASB 2009a). The accounting standards in the US are called Generally Accepted Accounting Principles (GAAP) (Buchanan 2003).

2.3.6 The Conceptual FrameworkSeveral efforts have been made to put together some form of more consistent conceptual framework. The convergence project is between IASB and FASB and they want to develop a better framework that should be a foundation for developing accounting standards for the fu-ture. This framework consists of the already existing IASBs Framework for the Preparation 3 Stefan Olsson, lecture 090911, Karlstads Universitet4 Dominique Rachez, lecture 090915, Karlstads Universitet

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and Presentation of Financial Statements and FASBs Statements of Financial Accounting Concepts (FASB 2009b). The purpose is to find differences between IFRS and US GAAP and discover the best global solutions to these differences. It is also to get rid of many differences between IFRS and US GAAP and work on new rules together which saves money. The idea with the project is to make the financial reports more equal and make it cheaper for compa-nies. 5

5 Gunnar Rimmel, lecture 090929, Karlstads Universitet

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3 Discussion and conclusion

There are many different factors that have influenced the financial reporting. Cultural differ-ence between nations is one of them and it has had an important effect on the reporting behav-ior. One of the most important researches is made by Hofstede and he defined four basic di-mension of culture (Alexander et al. 2009). The Legal system has also affected the financial reporting. Some countries have the common law system which is build on cases, other coun-tries has the code law system which is build on written and obliged law (Smith 2006). In code law countries are the company law very detailed and accounting standards are part of the company law (Alexander et al. 2009).

Even providers of finance have affected the differences in the financial reporting. Some coun-tries are mostly financed with equity from investors or shareholders and their financial state-ment must give a lot of information so that the investors or shareholders can make the best in-vestment choice. Other countries get most of their finance from debt so they have a creditor orientation. Their financial statement has to contain information about the companies opportu-nity to pay back the loan. Taxation is also a reason for differences in the financial reporting. In some countries you only need to pay tax on the expenses that are documented in the profit and loss account and these financial reports are tax influenced. In other countries do they have separate accounts for tax purposes and they have thereby a lot weaker connection between taxation and financial reporting (Alexander et al. 2009).

All these differences have led to many various accounting systems. Creditor oriented coun-tries are mainly financed by debt and they are characterized by a code law system. The finan-cial reporting in these countries is focused on legality which means that they follow legal de-mands and tax laws. They have more conservative valuation rules and they thereby often re-ports lower profits than if accrual accounting is being used. The regulator in these countries believes that it is important with uniformity and consolidation was introduced by law quite late. Countries that are shareholder oriented are mostly financed by equity and they are influ-enced by a common law system. Their purpose with the financial reporting is a fair picture and they do also have a more accrual accounting. The practice of plan and publish consoli-dated financial statements came quite earlier to these countries (Alexander et al. 2009).

Many want to eliminate or at least decrease these differences and a lot of attempts have been made to reach a harmonization. The main reasons for harmonization is because financial statements from multinational companies are used by people in many countries and that would be a lot easier if it were the same accounting standards everywhere. Investors need to understand the financial information so they know if they want to buy shares. It would also be much easier to prepare and consolidate the financial statement if it were done in the same way globally. Multinational companies would also be able to move accounting staff between dif-ferent countries. The international accounting firms would also get benefits with a more har-monized accounting practice and it would be less work for the tax authorities when they are dealing with foreign incomes (Nobes & Parker 2000).

There are also many problems that make the harmonization process quite difficult. Nobes and Parker (2000) expresses that one of the main problems towards harmonization is the differ-ences between shareholder/fair view presentation and creditor/tax/conservative presentation

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which is a problem that is not easy to overcome without big changes in both law and attitude. Marrero (2007) on the other hand believes that a big problem is that a lot of countries are in-credibly protective and they want to keep their inherent national backgrounds. Fagerström6

thinks that different languages are a problem since people misunderstand each other when one word has several meanings.

EU works for a more harmonized accounting standard and there are two EU directives that are relating to financial reporting and accounting. The Fourth Directive contains information about how the published financial statements should be formed and requirements to disclo-sure. The Seventh Directive includes consolidation (Nobes & Parker 2000). IASB and FASB are working on a convergence project to form a more consistent conceptual framework. They want to develop a framework that should be a foundation for developing accounting standards for the future (FASB 2009b). Rimmel7 says that the purpose is to find out the best global solu-tions to solve the differences between IFRS and US GAAP and make the financial reports more equal.

I think that all these causes of international differences show that the environment has a big impact on how the accounting system has developed. The accounting systems are similar when the surroundings are similar and different surroundings results in different accounting systems. The trend is to get closer to a global harmonization but I believe that national influ-ences even at the moment have a significant function in the quality of the financial reporting. I think that the causes of the international differences that have been brought up earlier in this paper are still important when it comes to the different accounting quality between companies around the world.

I am of the conclusion that it is important with equal accounting standards in the whole world to reach harmonization. So far has EU decided that only listed companies need to publish IAS financial statements that are consolidated. All other countries can use their national standards and I believe that this is an obstacle against harmonization. Another obstacle is that there are countries that don’t want to change their standards into more international and thereby lose their sovereignty and control of their business. IFRS should lead to an increased comparabil-ity but as long as the standards will be interpreted in different ways, there will be diverse ways of accounting, as for example, computing assets and profit.

The goal with the IFRS is that everyone should be able to understand the information but I do not think that is the case. I believe that private investors and others that only has basic knowl-edge about accounting will have to increase their knowledge to be able to understand the addi-tional information that comes with IFRS.

I finally believe that the harmonization is a long-term project. The convergence project be-tween IASB and FASB is in the right way towards it. I do not think that it will be enough with equal accounting standards. One of the most important aspects to reach harmonization is that the standards have to be interpreted in the same way in all countries even if they have differ-ent cultures and traditions.

6 Arne Fagerström, lecture 091005, Karlstads Universitet7 Gunnar Rimmel, lecture 090929, Karlstads Universitet

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