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Ekonomi, Kommunikation och IT
Camilla Svensson 870702-5063
National differences in financial reporting and the process towards harmonization
International Financial Accounting
7,5hp
Term:HT 2009
Contents
1Introduction and question of issue
2Theory
2.1Causes of international differences
2.1.1External environment and culture
2.1.2Legal systems
2.1.3Provision of finance
2.1.4Taxation
2.2Most important differences in financial reporting
2.2.1Shareholder orientation
2.2.2Fairness
2.2.3Conservatism and accruals
2.2.4Uniformity, accounting plans and formats
2.2.5Consolidated accounts
2.2.6Deferred taxation
2.3Harmonization
2.3.1Reasons for harmonization
2.3.2Obstacles of harmonization
2.3.3EU directives
2.3.4IASB
2.3.5FASB
2.3.6The Conceptual Framework
3Discussion and conclusion
1
1Introduction and question of issue
In 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 company. 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 havechosen to write about why different accounting systems exist and how the accounting systems differ from each other. I will also write about whya harmonization process is wanted but also is difficult to reach.
2Theory
In this chapter are firstly the causes of the international differences and the existing differences 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.
2.1Causes of international differences
Many researches and a lot of teaching have been done about international differences in financial reporting, particularly since the 1980s onwards and in this part focus on the most important causes of the international differences (Nobes 2006).
2.1.1External environment and culture
There 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 values 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 following four basic dimensions of culture based on a study of over 100000 IBM employees in 39 countries (Alexander et al. 2009).
Individualism versus collectivism: Individualism represents a society where people are expected only to watch out for themselves and their closest family. Collectivism represents a society 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 allow the power to be spread unequally in institutions and organizations. In large power distance the people think that it is okay that there is a hierarchical order which means that everybody 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 different 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).
2.1.2Legal systems
Two 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 Empireand is distinctly legalistic which means that it is based on obliged and written law. The common law system emanates 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 organizations 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 accounting 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).
2.1.3Provision of finance
When 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 onequity 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 orientation. The financial statements have a creditor orientationin 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).
2.1.4Taxation
The 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).
2.2Most 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 systemsin this part. They are brought up as separate items but they are connected to each other (Alexander et al. 2009).
2.2.1Shareholder 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 countries 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 information. 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 several 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 effectivenessto existing 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).
2.2.2Fairness
A 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 contract. When the focus is fairness and the country has a strong shareholder orientation the company 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).
2.2.3Conservatism and accruals
The 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 shareholder orientation where the financial information is more accrual. These two types of valuation methods lead to a different way of accounting practices and valuation rules. When a conservative accounting is used it often reports lower profits than if accrual accounting is being used (Alexander et al. 2009).
2.2.4Uniformity, accounting plans and formats
The 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 detailed (Alexander et al. 2009).
2.2.5Consolidated accounts
The 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).
2.2.6Deferred taxation
There 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 accounting income and tax income the practice of recording and compute deferred taxes is quite new (Alexander et al. 2009).
2.3Harmonization
There 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 because of the deep-rooted causes of the international differences that has been discussed earlier. 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 inflexible 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:
- Standardization with rules that are uniform and with no chance to choose. FASB applies this model.
- Equal rules with notes. EU applies this model.
- Choice alternatives where wanted alternative has been indicated. IASB has applied this model.[1]
Harmonization
Choice alternativesEqual rules Standardization
(Figure 1. Model from Gunnar Rimmel, lecture 090929, Karlstads Universitet)
2.3.1Reasons for harmonization
The 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 harmonization. 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 intergovernmental transnational bodies, as EU, are involved in protecting investors in their spheres of influence. If foreign shares are quoted on the domestic stock exchange of an investor, the company 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 shareholder 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 harmonized methods were in use for evaluation of business, performance and basis for investments. It would also bring big value to decision makers that need facts based on understandable 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 accounting 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 governments 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 international credit grantors do also find it difficult with the comparison between different countries and many organizations would benefit from greater international comparability of company information(Nobes & Parker 2000).
2.3.2Obstacles of harmonization
There 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 information 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).