The introduction of International Accounting Standards in Europe: Implications for international convergence

Abstract

This paper describes several implementation effects associated with the mandated adoption of international financial reporting standards promulgated by the International Accounting Standards Board in the European Union, including a possible increased demand for detailed implementation guidance and for a single European securities regulator. The paper also discusses the mandated adoption as a research setting for considering the relative influences of standards versus incentives as determinants of financial reporting outcomes, and describes two standard setting challenges that may become more pronounced as a result of the mandated adoption.

Acknowledgements

The views expressed in this paper are the author's own, and do not represent positions of the Financial Accounting Standards Board. Positions of the Financial Accounting Standards Board are arrived at only after extensive due process and deliberation. Jennifer Francis, Begoña Giner and William Rees are thanked for helpful comments.

Notes

¹This agreement can be found at the FASB's website (www.fasb.org). For convenience, this discussion refers to IASB and FASB activities to converge IFRS and US GAAP as ‘international convergence’.

²Member states of the European Union are permitted to decide whether the requirement will apply to nonlisted enterprises and to provide an exemption, until 2007, for enterprises that are listed in both the European Union and in another non-European Union jurisdiction (such as the USA) and that are following another internationally recognized set of accounting standards (such as US GAAP). As a practical matter, therefore, the application of IFRS by certain European enterprises that are listed in the USA and that report using US GAAP will be delayed.

³This discussion is not intended to provide an exhaustive enumeration of the financial reporting implications of the 2005 European IFRS adoption; my focus is necessarily selective. In addition, I do not touch on the numerous auditing implications of the 2005 adoption.  

⁴At various times in the past, the International Accounting Standards Committee (IASC), predecessor to the IASB, listed on its website companies referring to their use of IAS. As of early 1998, for example, over 400 companies were listed; of these approximately 182 could be identified as European. At the current time, IASplus, a website maintained by Deloitte, provides a list that summarizes, by country, the use of IFRS for reporting by domestic listed companies in their consolidated reports (www.iasplus.com/country). This list indicates whether IFRS is permitted, not permitted or required for domestic listed companies. For example, the list shows that IFRS are currently permitted for Belgian or German listed companies but will be required in 2005, and that IFRS are not currently permitted for French, UK or Irish listed companies but will be required in 2005.

⁵Additional details about the due process procedures and rules of the FASB and EITF can be found at the FASB's website (www.fasb.org); additional details about the due process procedures and rules of the IASB and the IFRIC can be found at the IASB's website (www.iasb.org.uk).

⁶The importance of maintaining a distinction between standard setting and enforcement has been emphasized by, for example, the Financial Accounting Standards Committee of the American Accounting Association (1999, p. 451) and the Fédération des Experts Comptables Européens (2003). Neither the FASB nor the IASB has any enforcement powers.

⁷CESR Standard No 1, Financial Information – Enforcement of Standards of Financial Information, lays out certain governing principles, and clarifies that the intent is convergence or harmonization of practices, not the creation of a pan-European securities regulator. Within Standard No. 1, Principle 20, Coordination in Enforcement, states that in order to promote harmonization of enforcement practices, both ex ante and ex post coordination of enforcement decisions on the application of IFRS will take place. The explanatory material to the Principle clarifies that ‘Decisions of national enforcers reflect the judgment of the enforcer on the compliance of the financial information with the reporting framework. Exchange of information among enforcers prior to the decision … is limited by technical feasibility, time and confidentiality constraints.’ The entire Standard is available at the website of the Committee of European Securities Regulators (www.cesr-eu.org).

⁸Another key element of that assurance, not considered in this discussion, is high quality audits performed using a common set of auditing standards.

⁹In terms of legal differences, research has documented substantial differences in legal approaches to investor and creditor protection across jurisdictions, including several European Union jurisdictions; see, for example, La Porta et al. (1998). In terms of cultural differences, Licht (2003) draws on psychology research dealing with cultural orientations and cognitive styles to describe difficulties in adopting corporate governance approaches imported from other jurisdictions.

¹⁰Because this discussion paper is not intended to be a review of the literature, I reference specific published and unpublished papers only as illustrative examples. I make no attempt to be inclusive of all papers on a given topic or to summarize the findings of the papers used as examples.

¹¹Ball et al. draw three inferences that are likely to be of interest to those who examine the costs and benefits of the 2005 European Union implementation of IFRS. First, jurisdiction-specific characterizations of accounting should include both the formal standards and the institutional influences on preparers' decisions. Second, attempts to increase financial reporting quality will reap greater improvements from changing incentives than from mandating (presumably higher quality) accounting rules. Third, jurisdiction-specific patterns of incentives limit the extent to which comparability can be achieved by imposing a common set of accounting standards.

¹²Morck et al.'s analyses are based on 1995 data from Datastream. They use stock return synchronicity (the extent to which stock prices move up or down together) as an inverse indicator of the extent to which firm-specific information is capitalized into stock prices. Absent the capitalization of firm-specific information, stock returns will not capture economic income. Given the substantial economic and regulatory changes in the world since 1995, it is possible that an updated study would reach different conclusions.

¹³See, for example, Schipper and Vincent's (2003) discussion of alternative approaches to defining and measuring earnings quality and Francis et al. (2004) for evidence that both earnings persistence and measures of accruals quality developed by Dechow and Dichev (2002) capture aspects of earnings quality that are rationally priced by investors.

¹⁴More recent data (as of 2002) on the number of listed firms on exchanges belonging to the World Federation of Exchanges (WFE) are available in the WFE Annual Statistical Report 2002. These data indicate that the number of listed firms is, in general, increasing on many exchanges. The report is available at: http://www.world-exchanges.org/WFE/home

¹⁵The financial reporting incentives associated with concentrated ownership should vary depending on the nature of the ultimate owner. As noted by La Porta et al. (1999, p. 476), ‘State control … is a form of concentrated ownership in which the State uses firms to pursue political objectives, while the public pays for the losses.’ In contrast, family/individual control or control by another business enterprise would not offer this incentive or opportunity.

¹⁶Another element of that definition, not considered in this discussion, derives from criteria for asset derecognition and liability extinguishment – when should an asset or liability be removed from a reporting entity's balance sheet?

¹⁷For example, Bill Gates is identified as the controlling shareholder of Microsoft with (at the time of the study) just under 24% ownership.

¹⁸More specifically, IAS 27, paragraph 12 states that control exists when one entity has a majority of voting power, the ability to appoint or remove a majority of the governing board, the power to cast the majority of votes at meetings of the governing board, or ‘the power to govern the financial and operating policies of the enterprise under a statute or agreement’.

¹⁹The accounting for such entities under US GAAP is governed by FASB Interpretation 46R, Consolidation of Variable Interest Entities, An Interpretation of ARB No. 51, revised December 2003. The IASB's guidance is found in Interpretation 12 of the Standing Interpretations Committee (SIC), Consolidation – Special Purpose Entities.

²⁰This information is taken from the IASB's project summary, revised as of 1 March 2004; available at: www.iasb.org.uk

²¹For example, depreciation allocates the transaction amount associated with acquisition of a fixed asset to accounting periods during the asset's service life.

²²An independent investigation of alleged faulty accounting at The Federal Home Loan Mortgage Corporation (‘Freddie Mac’) in the USA concluded that the alleged accounting errors resulted in part from a lack of accounting expertise among the firm's accountants. The investigation concluded that the alleged accounting errors ‘often result[ed] from judgments and decisions by employees who lacked the expertise to appreciate the significance, gravity of, or rigor required by, the accounting decisions they were making’ (Baker Botts LLP, report dated 22 July 2003, p. 5).