Interpreting the European Union’s IFRS Endorsement Criteria: The Case of IFRS 9

Abstract

EU Regulation requires that any international accounting standards (International Financial Reporting Standards, IFRS) and interpretations (IFRIC) pronounced by the International Accounting Standards Board (IASB) meet three sets of criteria before they become binding for EU-based companies: a ‘true and fair view’ criterion, a list of qualitative criteria, and a ‘European public good’ criterion. During the endorsement process, EU institutions evaluate each standard or interpretation’s compliance with these three criteria. Nevertheless, despite plenty of past endorsement decisions, there is still disagreement about a unanimous interpretation of the criteria in the literature. In this study, we interpret all three criteria against the background of European accounting law and academic accounting research. Then, the paper illustrates for the case of the new IFRS 9 standard on accounting for financial instruments how these criteria can be applied in the endorsement practice. We conclude that the standard cannot reasonably be rejected on grounds of the IAS Regulation. We also explain that the vagueness of the endorsement criteria and the inherent discretion in the eventual endorsement decision help maintain the EU’s political influence on the IASB’s standard-setting ex ante.

Keywords:

• European Union
• IFRS
• endorsement
• true and fair view
• European public good
• bank accounting

JEL classification:

• K22
• M41
• M48

Acknowledgements

An extended version of the study was prepared in October 2015 for the Directorate-General for Internal Policies of the European Union at the request of the European Parliament’s Committee on Economic and Monetary Affairs (IP/A/ECON/IC/2015-154, http://www.europarl.europa.eu/RegData/etudes/STUD/2015/563460/IPOL_STU(2015)563460_EN.pdf). Copyright of this study remains with the European Parliament. We thank an anonymous referee, David Alexander, Paul André (the editor), Günther Gebhardt, Niclas Hellmann, Stephanie Honnefelder, Doris Kolassa, Chris Nobes, Maddy Trimble, Peter Walton, and (in particular) Stephen Zeff for many helpful comments.

Disclosure Statement

No potential conflict of interest was reported by the authors.

Notes

1 For an overview of the EU’s endorsement process, see Botzem (2015, p. 27, Figure 5). The latest update on IFRS and interpretations pending endorsement and past endorsement decisions are provided in EFRAG’s ‘EU endorsement status report’ at: http://www.efrag.org/Endorsement.

2 The two Directives that the IAS Regulation 1606/2002 continues to refer to (Directive 78/660/EEC and Directive 83/349/EEC) have been replaced by the Accounting Directive 2013/34/EU. However, the wording of the TFV principle remained unchanged in Article 4 of the new Accounting Directive 2013/34/EU. In the following, we refer to all three Directives as ‘the Accounting Directives’ in their respective context. See Appendix 1 for the corresponding legal texts on the endorsement criteria.

3 These are the EFRAG, the European Commission, the Accounting Regulatory Committee (ARC), the Council, and the European Parliament.

4 See http://ec.europa.eu/finance/accounting/ias/index_en.htm.

5 See http://ec.europa.eu/finance/company-reporting/ifrs-financial-statements/index_en.htm for the EU’s underlying objectives of IFRS adoption.

6 See, for example, the discussion and proposal on reforming the current endorsement process in the Maystadt Report (2013).

7 The Maystadt Report proposes that the activities of EU institutions be bundled and coordinated by one institution alone (e.g. EFRAG) to further enhance the EU’s influence over the IASB’s standard-setting; see Maystadt (2013).

8 For details on the steps in the due process, corresponding feedback and board deliberations in the process replacing IAS 39 by IFRS 9, see http://www.ifrs.org/current-projects/iasb-projects/financial-instruments-a-replacement-of-ias-39-financial-instruments-recognitio/Pages/Financial-Instruments-Replacement-of-IAS-39.aspx.

9 The stakes are likely to be lower in case of an IFRIC interpretation on a specific technical issue.

10 While some jurisdictions have already endorsed IFRS 9 (e.g. Canada, see http://www.osfi-bsif.gc.ca/eng/fi-if/rg-ro/gdn-ort/adv-prv/Pages/freifrs9.aspx), in others, new IFRS will automatically become legally binding. Our observation is that many jurisdictions are closely following, if not awaiting, the EU’s endorsement decision.

11 See, for example, Ordelheide’s (1993) discussion on whether the percentage-of-completion method in long-term production is in accordance with the 4th Company Law Directive.

12 For example, Ordelheide (1993, p. 83) argues that ‘if it is one’s opinion that the valuation principles of Art. 31 are characterized by a certain degree of prudent income determination – and this seems conceivable – one has to accept a similar prudent solution in order to reduce open areas and ambiguities’.

13 See also the European Commission’s (1998) Interpretative Communication providing clarification of Article 2(5) of the 4th Company Law Directive: ‘In the interest of harmonisation, Member States may not use the last sentence of Article 2(5) in order to introduce an accounting rule of a general nature which is contrary to provisions of the Directive, nor can they use this sentence to create additional options allowing for accounting treatments which are not in conformity with the Directive’.

14 Note that while there are many ECJ rulings that refer to the Accounting Directive’s TFV criterion, it is consensus in the academic literature that it was and still is the Tomberger case that shaped the ECJ’s interpretation of the criterion. In fact, more-recent cases, such as GIMLE SA (Case C-322/12) or Texdata Software GmbH (Case C-418/11), heavily rely on the TFV interpretation in the Tomberger case (see the references in the more-recent verdicts). All related verdicts can be retrieved via InfoCuria – Case-law of the Court of Justice at: http://curia.europa.eu/juris/recherche.jsf?cid=238754.

15 In other words, ‘The gateway of Art. 2 (5) seems to narrow for all derivations of British accounting from the accounting principles and rules of the Fourth Directive’ (Ordelheide, 1993, pp. 83–84); see also European Commission (1998).

16 See ECJ, Case C-234/94, p. I-3133, para. 15.

17 See, for example, their Endorsement Advice on IFRS 9, para. 4, in EFRAG (2015a). This test is likely to be a response to demand from particularly vocal stakeholders who placed specific emphasis on ‘prudence’ and actively lobbied the EU institutions that were involved in the endorsement process (e.g. the UK Local Authority Pension Fund Forum (LAPFF)). For an example, see the introductory statement by Haaker (2015) in the public hearing on IFRS 9 in the European Parliament (note that the other three experts in the hearing did not mention ‘prudence’ in their introductory statements), see: http://www.europarl.europa.eu/committees/en/econ/events-hearings.html?id=20151201CHE00081.

18 See, for example, different reports on the effects of accounting rules on the financial crisis: International Monetary Fund (2008); De Larosière et al. (2009, para. 73–79); Marteau and Morand (2010); Bieg et al. (2008).

19 See Bank for International Settlements (2015) for a comprehensive literature review. A 2008 SEC report on ‘Mark-to-Market Accounting’ commissioned by the US Congress came to a similar conclusion; see SEC (2008) and also https://www.sec.gov/spotlight/fairvalue.htm.

20 Prudence is often defined as ‘caution in conditions of uncertainty’ (see, e.g. EFRAG, 2015b, para. 209). Conservatism has historically meant not overstating assets and revenues, and not understating liabilities and expenses.

21 A reason for this finding could be that the exercise of prudence allows the creation of hidden reserves or excessive provisions by holding back profits in one year that may lead to their release in a subsequent period (either automatically because the accruals reverse (e.g. Dechow, 1994) or by intentional selling of undervalued assets and the reporting of exaggerated results).

22 However, we predict that under IFRS 9, the ‘contractual cash flow characteristics test’ will likely lead to more classifications into measurement categories outside cost than the business model test.

23 In a sense, the wording seems to comply with the conceptual idea of the ‘Abkopplungsthese’ discussed in the German literature since the 1970s (e.g. Moxter, 1979; Ordelheide, 1993).

24 Barth (2007, p. 9): ‘Understandability is the quality of information that enables users who have a reasonable knowledge of business and economic activities and financial reporting, and who study the information with reasonable diligence, to comprehend its meaning’; see also IASB (2015a, para. 2.33–35) and EFRAG (2015b, para. 191).

25 In addition, it is unclear how such an evaluation should address the evolution in complexity of the underlying economic transactions over time. For example, in the case of financial instruments and innovations in financial engineering, one can observe an ‘Arms Race’ between accounting standard setters and preparers over a period of decades; see Dye, Glover, and Sunder (2015).

26 See Barth (2007, p. 9): ‘Relevant information is capable of making a difference to a financial statement user’s decisions. Relevant information has predictive value, i.e., it helps users to evaluate the potential effects of past, present, or future transactions or other events on future cash flows, and confirmatory value, i.e., it helps to confirm or correct their previous evaluations’; see also IASB (2015a, para. 2.6–7) and EFRAG (2015b, para. 7).

27 For example, Gassen (2008, p. 6) points out that value relevance ‘targets the alignment between accounting and market information per se, without addressing the question whether accounting information is (potentially) useful to market participants in valuation-related decisions or whether it merely constitutes an echo of information from more timely sources which were already impounded into prices’.

28 See IASB (2010, QC26): ‘Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and the related probabilities can also be verified’.

29 Camfferman and Zeff (2015) concluded that it was the Americans, specifically the FASB, who drove the term ‘reliability’ out of the two boards’ Conceptual Frameworks in 2010. The FASB was also responsible for excising the references to prudence and stewardship in the CF. See pp. 361–362, where FASB senior staff member Todd Johnson argued that many had misinterpreted reliability to mean precision, and thus, it stood in the way of the FASB requiring greater use of fair value measurements.

30 EFRAG (2015b, para. 128): ‘Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully what it either purports to represent or could reasonably be expected to represent, and is complete within the bounds of materiality and cost’. Para. 129: ‘There are a number of aspects to the notion of reliability: freedom from material error and bias, faithful representation, and completeness’.

31 See Schipper (2003, p. 62): ‘similar things are accounted for the same way, either across firms or over time’. Her definition includes consistency but does not explicitly state the ‘difference’ component; see also EFRAG (2015b, para. 152).

32 See Barth (2007, p. 9): Consistency ‘refers to the use of the same accounting policies, either from period to period within an entity or in a single period across entities’; see also IASB (2015a, para. 2.25).

33 Recent research by Chen, Miao, and Shevlin (2015) has suggested a novel measure of disclosure quality based on the disaggregation of accounting data.

34 See De Franco et al. (2011), Barth et al. (2012), and Yip and Young (2012, p. 1769). The concepts they use to operationalise ‘comparability’ are ‘similarity of accounting functions’, ‘accounting system comparability’, ‘value relevance comparability’, and the ‘degree of information transfer, as measured by the association between the earnings surprise of an announcing firm and the contemporaneous stock price movements of other firms’.

35 Note that comparability is distinct from uniformity, as there could be circumstances where one accounting option would suit the underlying economics better than the alternative. Similarly, the use of managerial discretion seems unavoidable no matter how narrowly a standard is framed.

36 Note that the intention behind the IASB’s revision of its conceptual framework is to reduce this conflict by exclusively focusing on external users of accounting information. The objective has resulted in the removal of ‘stewardship’ as a purpose and the verbal downgrade of ‘prudence’ in the qualitative characteristics of the exposure draft.

37 Alexander (2006, p. 71) goes further, arguing that ‘The phrase was presumably inserted by politicians, for politicians’. This critique is repeated in Alexander and Eberhartinger (2010, p. 57): ‘It is particularly noteworthy that the criterion singled out for emphasis [the European public good] is, as stated above, undefinable, completely unmeasurable and nothing to do with accounting’.

38 On 18 June 2015, the European Commission (2015) issued a staff working document on the evaluation of the IAS Regulation, providing a summary of the process and output. Further extensive reviews have been conducted recently after 10 years of IFRS usage; see, for example, ICAEW (2015) and De George, Li, and Shivakumar (2016) and the empirical evidence in, for example, Barth, Landsman, and Lang (2008), Barth et al. (2012), Daske et al. (2008, 2013), and Christensen et al. (2013).

39 See the German, French, Italian, and Spanish language versions on EurLex (http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32002R1606): ‘im europäischen öffentlichen Interesse’, ‘l'intérêt public européen’, ‘interesse pubblico europeo’, ‘el interés público europeo’. For a critical discussion on different language used in national implementations and translations of Directive 2013/34/EU, see Alexander (2015).

40 See, for example, Alexander’s (2006) interpretation of Jacques Chirac’s letter to Romano Prodi. See also Ramanna (2013) on IFRS endorsement and carve-outs in other countries around the world. The ICAEW (2012) contemplates in its report on ‘Public Interest’ that ‘there can be a natural suspicion that the phrase may be used as a smokescreen to garner support for something that is actually in the advocate's own interests’. See http://www.icaew.com/en/technical/ethics/the-public-interest.

41 See, for example, the webpage of Sven Giegold (European Greens and Member of ECON Committee of the European Parliament) and his statements on IFRS, http://www.sven-giegold.de/.

42 See the IFRS Foundation’s Mission Statement: ‘Our mission is to develop International Financial Reporting Standards (IFRS) that bring transparency, accountability and efficiency to financial markets around the world. Our work serves the public interest by fostering trust, growth and long-term financial stability in the global economy’. http://www.ifrs.org/About-us/Pages/IFRS-Foundation-and-IASB.aspx; see also IASB (2015b), where the IASB outlines in detail how it proposes to serve the public interest.

43 See the Objectives of the IFRS Foundation’s Constitution, where it states ‘to develop, in the public interest, a single set of high quality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles. These standards should require high quality, transparent and comparable information in financial statements and other financial reporting to help investors, other participants in the world’s capital markets and other users of financial information make economic decisions’ IFRS Foundation (2012).

44 See Schipper (2010) for an excellent summary.

45 The FASB discussed the possible application of cost–benefit analyses to accounting standard setting back in 1991 (see FASB, 1991). See also Zeff’s (1978) early discussion of ‘economic consequences’ arguments.

46 The re-labelling from ‘cost-benefit’ to ‘effects’ analysis in accounting standard setting follows the in-depth analysis of Schipper (2010, p. 316), who suggests that ‘“effects” may result in a better description of the cognitive process actually used by standard setters to weigh the consequences of authoritative guidance’.

47 See Effects Analysis Consultative Group (2014): The core objectives to consider are to improve the quality of financial information (para. 12). According to its objectives, the IASB is de jure not required to consider the broader economic consequences of its standards (para. 13); de facto, however, broad stakeholder participation, the openness of the process, and the incentives of affected parties ensures that those concerns are heard.

48 See also FASB (1978, para. 23): ‘[T]he benefits from financial information are usually difficult or impossible to measure objectively, and the costs often are; different persons will honestly disagree about whether the benefits of the information justify its costs’.

49 The difficulties of conducting quantitative analysis based on comprehensive real-world data are illustrated in the case of IFRS 9 when even the European Systemic Risk Board (ESRB) openly admitted on request of the European Parliament that ‘ESRB has not yet assessed the impact of the new accounting standards on the financial sector as a whole. Draghi explained that this was down to the “poor quality of the data available and uncertainty as to whether – and if so how – capital regulation might change in the light of the new accounting rules”’; see Bouvier (2016).

50 See http://www.accountingfoundation.org/jsp/Foundation/Page/FAFSectionPage&cid=1351027545591. Note that the FAF contributions also cover the expenses of the GASB.

51 See http://www.ifrs.org/About-us/IFRS-Foundation/Oversight/Financing/Pages/Financing.aspx. The budget is in British Pounds; approximate conversion in May 2016.

52 Note that only reviews of upstream cost–benefit analyses are also observable in other public policy areas. See Schipper (2010, fn. 13).

53 See Giner & Arce (2012). They find that standard setters react primarily to conceptual arguments in standard setting debates.

54 A reason may be significant barriers to entry based on required technical expertise.

55 Holger Daske has been representing the International Association of Accounting Educators and Researchers (IAAER) in the IFRS Advisory Council since 2015 (http://www.iaaer.org/). Note that IAAER is a non-profit organization, that is, there is no compensation for Advisory Council members, and academic independence is uncompromised.

56 For example, various stakeholders in the wider non-financial reporting community have presented their views in the past few years’ IFRS Advisory Council Meetings, such as the Global Reporting Initiative (GRI); see http://www.ifrs.org/About-us/IFRS-Advisory-Council/meetings/Pages/IFRS-Advisory-Council-2016.aspx and the meetings of the years before.

57 We note that there can certainly be a role for wider non-financial socio-economic reporting requirements, such as laid down in the Non-financial Reporting Directive 2014/95/EU (amending Directive 2013/34/EU); see http://ec.europa.eu/finance/company-reporting/non-financial_reporting/index_en.htm.

58 Note that Board members who are active academics have fulfilled this role in the past in the FASB and IASB. At the time of writing, IASB Member Dr Chungwoo Suh is a Professor of Accounting at Kookmin University, Seoul.

59 We further observe that the typical older age of IASB board members (who tend to make the board membership the last step in their career prior to retirement) enhances their independence from vested interest groups (e.g. the auditing sector) and limits ‘revolving door’ concerns. However, there are more-frequent job transfers from within the organization of the IFRS foundation at the level of staff involved in standard setting.

60 See Eurostat: http://ec.europa.eu/eurostat/statistics-explained/index.php/The_EU_in_the_world_-_economy_and_finance.

61 The Commission set up the group to (a) evaluate the impact of IFRS within the EU against its original aims, and (b) take into account the recommendations of the Maystadt Report; see: http://ec.europa.eu/finance/accounting/governance/committees/evaluation/index_en.htm.

62 See Effects Analysis Consultative Group (2014, para. 20). For example, EBA notes in their feedback to EFRAG that they are aware of several interactions with the prudential regulatory framework; see feedback letters to the EFRAG Draft endorsement advice.

63 For example, the ECB summarises that ‘Furthermore, the ECB is not aware of any objective reason suggesting that IFRS 9 is not conducive to the European Public Good. On the contrary, some aspects of IFRS 9 may be an improvement from a financial stability perspective’; see feedback letters to the EFRAG Draft endorsement advice; http://www.efrag.org/Front/p328-5-272/IFRS-9---Financial-Instruments.aspx.

64 Similar arguments have been put forward, for instance, in the stock options debate; see, for example, Farber, Johnson, and Petroni (2007).

65 Note that such feedback may or may not be similar to comment letter participation in the IASB’s due process. Current research analysing comment letters to EFRAG illustrates descriptively that the group of respondents is not identical, and therefore, there seem to be idiosyncratic incentives to participate in EFRAG’s call re their endorsement advice, for example, Weiss (2015).

66 See http://www.efrag.org/Front/p328-5-272/IFRS-9---Financial-Instruments.aspx.

67 The two institutions that have concerns are the French Autorité des Normes Comptables (ANC) and the Task Force on Long Term Investment of the Paris Financial Center.

68 Note that the Local Authority Pension Fund Forum, a private-sector lobbying group, has recently commissioned a series of legal opinions by QC George Bompas questioning the UK Financial Reporting Council’s (FRC) working interpretation of TFV; see http://www.lapfforum.org/news/LAPFF-obtains-further-Legal-Opinion-from-George-Bompas-QC. These opinions have been responded to by the legal opinion of QC Martin Moore, commissioned by the FRC; see https://frc.org.uk/News-and-Events/FRC-Press/Press/2013/October/Accounting-standards-are-part-of-legally-binding-c.aspx; see also Nobes (2015).

69 See Onali and Ginesti (2014). Such tests, by design, focus on the effects of a new standard on shareholders only.

70 See Richard (2004) for the case of France, Georgiou and Jack (2011) for Great Britain, and Hoffmann and Detzen (2013) for Germany.

71 See Alexander (2006) for the EU and Zeff (2008) for the US.