The Growth of International Accounting
About This Chapter
The basic process of accounting, known as double entry bookkeeping can be traced back for many centuries. The first formal book of instruction on the use of this method appeared in 1494 (Pacioli). An explanation of the history can be found in Sangster (2016). Every organization now keeps some form of financial records. Even with the smallest business, the owners, the tax authorities and possibly the bank, will want to know its financial performance and its financial strengths and weaknesses.
When we consider large companies, particularly those with shares publicly traded on a stock exchange, there will be national legislation compelling them to disclose financial information publicly. Companies comply by issuing a document that will contain financial statements and other corporate information. There may even be the requirement for limited financial information to be published half-yearly or quarterly.
The annual documents are lengthy, usually more than 200 pages. They include the financial statements and accompanying Notes required by accounting standards. This takes up roughly 50 pages. There will also be information required by government legislation and that which the company decides to include, such as product details. Over recent years there have been moves in many countries for companies to provide information on various topics that come loosely under the general heading of “Corporate Governance.” The main headings you may find that make up the total contents of present “Annual Report and Accounts” document are:
Strategic Report
Governance Report
Corporate Social Responsibility
Management Report
Report of the Chairman
Financial Statements (or Annual Report and Accounts)
One can obtain a company’s annual report and accounts by contacting them. You will also find that most companies have a website and you can download the annual report and accounts for several years. Take care! The sheer volume of the information available can be intimidating, with financial information being only one part of it.
Legislation is necessary to ensure that companies are properly run but is a very unwieldy system for determining the detailed financial information companies should disclose in the annual report and accounts. Another process is required. In this chapter, we discuss the development of regulations in the form of national accounting standards. We identify the limitations of such an approach and explain the birth of international accounting standards and the development of international financial reporting standards.
Many countries now use international financial reporting standards including Australia, Canada and all member states of the European Union. One country that started to converge its own standards with international accounting standards was the U.S. We describe that process as well as the reasons that full convergence did not take place.
Problems with National Accounting
On a personal basis, most of us do some simple form of accounting. We need to ensure that we do not spend more money than we possess or we can borrow. We keep a record of how much money we have in the bank and we may have to decide whether we need a loan and, if so, whether we can pay it back.
The owners and managers of a business need to conduct more detailed accounting. They require financial information to make decisions and monitor business activities. They may also have to keep shareholders and other lenders informed. There may be various groups of people and individuals, not employed by the company, who require financial information or are legally entitled to receive it. The purpose of financial accounting is to provide that information. The larger the business, the more complex the accounting system will be.
In most countries there are usually regulations that specify the types of organizations that must produce financial information. This regulation may be part of the law of the country, but is usually in the form of accounting standards, also known as financial reporting standards. These are issued usually by a professional accounting body, or some organization specifically established for the purpose within that country.
Accounting standards are concerned with specific economic transactions, arrangements and events conducted by a business. For example, you will have one standard that is concerned only with identifying and measuring the revenue that a company receives. Another standard will set out the procedures for purchasing buildings and machinery. Other standards apply to such topics as accounting for valuing goods you have in stock and recording transactions in a foreign currency.
A standard usually focuses on the following three topics:
- 1.Recognition. This specifies the transactions and events that should to be incorporated into the financial statements. The Chief Executive having a heart attack may be interesting and impact the share price of the company, but it is not shown on the financial statements. The factory burning down will be.
- 2.Measurement. The method used to determine the financial value of transactions and events. This can be tricky. Everything a company does has to be converted into financial measures. With many items there are no problems, but we need to know how entities do their calculations and to have confidence in their methods. Accounting standards provide this reliability. With some transactions and events there must be estimations and we will discuss these when we consider the individual standards.
- 3.Disclosure. Companies do not “open their books” to anybody who asks. Not only are there concerns over privacy, but the volume of information is huge. Information must be extracted and disclosed in a useful way. There is a standard that specifies the content and structure of the main financial statements. We explain these statements in detail in the following chapters.
In early times there were no accounting standards. Companies decided themselves how to account for their activities and, frequently, would not give investors and lenders a complete picture. Not surprisingly, shareholders relying on this financial information could “scarcely avoid arriving at erroneous conclusions” (Naylor 1960). To protect those who use the financial statements of companies for investment decisions, many countries began to develop their own accounting standards. Frequently, it was an organization of professional accountants in a particular country that began to recommend to its members how to account for financial transactions and activities.
In the U.S. the Securities and Exchange Commission (SEC) was established in 1934 by the Securities Exchange Act to remedy the poor corporate financial information that was available (Galbraith 2009). In 1973, The Financial Accounting Standards Board was established and is accountable to the SEC for setting accounting regulations. These were first issued as Statements of Financial Accounting Standards, and since 2009 there has been an online Accounting Standards Codification (ASC) in the U.S.
Accounting Standard Updates (ASUs) are issued to amend the codification. Updates are published for all authoritative U.S. GAAP released by the FASB, regardless of the form in which such guidance may have been issued prior to release of the FASB codification. Updates will also be issued for amendments to the SEC content in the FASB codification, as well as for editorial changes.
Other countries also have established their own methods requiring companies to provide publicly financial information. Unfortunately, the accounting techniques and methods of accounting can have strong national characteristics. In other words, one could not compare the information in the financial statements of companies in the U.S. with those in the U.K. or Japan, or any other country because they had different methods for recognizing, measuring and disclosing financial transactions and events.
Much has been written on the reasons for countries having different financial accounting and reporting regulations (Frank 1979; Mueller 1967; Nair and Frank 1980; Nobes 1983). The main reasons would appear to be:
- 1.The different sources of external financing for companies. In some countries, companies rely on financing from wealthy private individuals. In other countries there is a stock exchange where a company can list its shares.
- 2.The legal system in the country will reflect the values and procedures within that country including financial accounting.
- 3.The types of business organizations and ownership differ.
- 4.The culture of the country will influence the approach to regulating corporate activities.
Although national regulations for financial accounting greatly improved financial reporting in one country, there were substantial problems at the international level. If you wanted to do business, buy shares, or make loans with a company in another country you could not refer to their nationally produced financial statements, unless you “translated” them to your own methods.
When countries use different accounting standards to regulate the financial statements of companies operating within their borders, there is difficulty in comparing a company in one country with one in another country. As businesses and investors have become more international in their activities, this has caused problems.
To compare the financial statements of a foreign company to that of a U.S. company, the financial statements had to be redrawn according to the U.S. method of accounting to give the “profit or loss” according to U.S. regulations. This was not only a laborious task, but the amount of profit shown under the two different country systems could vary considerably. The worrying question was “Which one is the correct figure?”
The Start of International Accounting
After the Second World War, international trade began to increase. Companies were buying and selling in different parts of the world, and investors and lenders of finance were also taking an international approach. The problem of being unable to compare financial statements drawn up under different national procedures was a major obstacle to an increase in international activity. Some form of action was required.
In 1973 the national accountancy bodies, not governments, from Australia, Canada, France, Germany, Mexico, the Netherlands, the United Kingdom, Ireland, and the United States met and agreed to form the International Accounting Standards Committee (IASC). This was to be based in London, U.K. with the task of establishing international accounting standards. These would be used by companies, whatever their country of origin.
Unfortunately, progress was slow. The (IASC) was a private sector, non-governmental organization. It received modest funding and had only a part-time body of standard-setters who met 3 or 4 times annually to agree on a uniform way of accounting.
In its early years, with scarce resources and little power, the IASC concentrated mainly on the harmonization of financial reporting on a worldwide basis. It issued its first International Accounting Standard, IAS 1 Disclosure of Accounting Policies, in January 1975 and in October 1975 issued IAS 2 Inventories. This standard, although it has been amended, is still in force.
There were external factors that assisted the work of the IASC. Many emerging economies were attempting to establish themselves in international trade. The IASC offered a way for following an appropriate and acceptable accounting regime. A company’s financial statements could be understood by interested parties in other countries.
A second factor assisting the IASC was the increased involvement from several organizations in developing international business activities. The European Union (EU) for many years had been seeking accounting harmonization throughout the EU. This was achieved by issuing “Directives” that were binding to all member states. Towards the end of the 1980s, the European Commission gave increasing support to the efforts of the IASC.
Although the IASC made progress, it was under resourced. It was heavily reliant on the support of national accounting bodies as well as other parties who sometimes argued for international standards that best met their own national interests. The aim was international accounting regulations, but the question was whether the IASC could achieve that aim. Either a complete overhaul of all aspects of the IASC was required or a new body must be formed. The latter was the course of action chosen.
In 1992, the three standard setting bodies of Canada, the United Kingdom, and the United States met to discuss ways for making greater progress. Australia and New Zealand later joined the working group, and this became the group known as the G4+1.
In January 2001, it was agreed that G4+1 group would disband and a newly constructed organization, the International Accounting Standards Board would replace the IASC. The IASB, with a highly experienced accountant, David Tweedie, as its Chair was established in April 2001. It had more substantial financial support than the IASC and a reorganized structure.
The IASB kept several of the IASs issued by the IASC and commenced issuing its own standards entitled International Financial Reporting Standards (IFRSs) starting with IFRS First-time Adoption of International Financial Reporting Standards followed by IFRS 2 Share-based Payments.
The numbering of individual standards is somewhat confusing. The present position is that the IASC issued 41 standards between 1975 and 2000. The standards were numbered consecutively starting with number 1. Each standard also had a descriptive title, for example, IAS 7 Cash Flow Statements. Most of the IASC standards are still in effect.
When the IASB took over from the IASC it “adopted” the IASs still in force and started to issue its own standards. These are named International Financial Reporting Standards (IFRSs). Once again, these standards are numbered consecutively, starting with number 1 and have a descriptive title, for example, IFRS 7 Financial Instruments: Disclosures.
When referring to all the standards that have been issued, we generally use the term international standards. It is essential, however, to use correctly the term IAS or IFRS when referring to a specific standard, for example, IAS 2 Inventories or IFRS 2 Share-Based Payment.
The Spread of Internationalization
The pressure for international accounting standards arose from the need for comparable financial statements. The financial reports of all companies would be prepared according to the same principles. Ideally, all companies would use the same accounting standards in their financial reports.
Several countries have adopted international accounting standards. This does not necessarily mean that those countries require all companies within its borders to comply with them. Normally, it is only major companies listed on its national stock exchange that must do so. Usually smaller companies will follow the national regulations for financial reporting or, if there are none, they will comply with the IFRS for SMEs Standard. SME refers to small and medium sized enterprises.
The SME is a small Standard of ~250 pages. It concentrates on the presumed information needs of lenders, creditors and other users of smaller entities. It is assumed that these groups are most interested in information about cash flows, liquidity and solvency. We do not discuss IFRS for SMEs in this book.
Even where a country claims it “uses” international accounting, caution must be applied when examining the financial statements of companies within that country (Zeff and Nobes 2010). The reasons are that some countries may:
- •claim to have adopted international standards. If so, it is highly likely that the standards will apply only to certain organizations, that is, the large listed companies.
- •endorse international standards. Usually, they will have their own standard setting process. The international standard will be examined and, if it is considered suitable, it will form part of national regulations. However, the country may require further disclosures or make some changes in the requirements.
- •adapt international standards. In other words, they use the international standard as a basis but amend it to meet their particular needs.
Even where a country has adopted fully an international standard, political, legislation, tax regulations and other pressures can lead to differences. New standards generally are in force on the date of annual periods beginning on or after January 1, but early applications are normally permitted. The result is that two different versions can be in force at the same time depending on the implementation year chosen by a particular country compared to the choice by another country.
Year ends of companies can also differ. Some may find that a new standard becomes applicable in their financial year. Others, with an earlier year-end date, will not have to comply with the IFRS until the following year’s financial statements. In some countries, for example, Australia and the United Kingdom, corporate accounting periods do not necessarily end on December 31. In other countries, that may be the usual year-end date for all companies registered in that country.
Caution must also be used in assessing the extent of adoption. In a comparison of India and China, the authors concluded that accounting estimates in India are useful in predicting future earnings and cash flows, but accounting estimates in China are not. They conclude that accounting quality varies with accounting systems and legal enforcement. Accounting standards in China and India are converging to IFRS, but both countries have not fully implemented IFRS (Eng and Vichitsarawong 2017).
The U.S. and International Accounting
The U.S. was at the original 1973 meeting that launched the IASC. It was not until 1988, after the IASC had issued nearly 30 separate standards, that the FASB (Financial Accounting Standards Board) declared that it would support the development of superior international standards and these would replace national standards.
The IASC welcomed the declaration by the FASB for greater international involvement. This statement of commitment by the world’s largest market was a major shift in the spread of internationalization. The relationship was further strengthened in 1999. The FASB and its oversight body, the Financial Accounting Foundation (FAF) declared their wish for a worldwide single set of high-quality accounting standards. These would be used both for companies within the country and also for those with an international profile.
Further progress towards convergence came in 2002. Robert Herz was appointed the new Chair of the FASB. He was a qualified U.K. Chartered Accountant and brought a greater commitment to convergence. This meshed well with the objectives of the restructured IASB under its Chair, David Tweedie.
Other factors were also operating to make full internationalization appear a probability. The New York Stock Exchange was facing growing competition from markets in other countries. Foreign companies were finding U.S. regulations increasingly onerous. In addition, a succession of financial scandals such as Enron and WorldCom weakened confidence in U.S. financial reporting regulations.
External events were also changing the landscape. Several countries had either adopted international accounting or were planning to do so. The influence of the IASB was growing in strength and this could result in the U.S. becoming isolated unless it took action.
All the indications were that the FASB and the IASB were willing to work together on standard setting. The first major step was the signing of the Norwalk Agreement in 2002, which had the objective of converging U.S. and international standards. The intention was not for the U.S. to adopt international standards set by the IASB. The intention was for the U.S. to retain its own standard setting authority and for the FASB and the IASB to jointly develop and agree on the contents of individual standards.
It was a rocky route towards convergence. It involved identifying standards that both parties agreed were weak and replacing them with high-quality standards, a term that we discuss at the end of this chapter.
There was an international financial crisis in 2007/8 which gave encouragement to the convergence project. It was argued by some politicians that the reason for the crisis was the weak regulations for transactions known as financial instruments. Pressure was put on the FASB and the IASB to produce strong, effective standards for financial instruments. The FASB and the IASB jointly responded positively and this gave new impetus to the convergence project.
In 2010 the SEC published its Strategic Plan for the fiscal years 2010 to 2015. It supported the objective of a single set of high-quality global accounting standards and the work of the FASB and the IASB. Most importantly, it also stated that the decision for incorporating international accounting standards in the U.S. would be made in 2011.
The progress that had been made has been well documented by Kirsch (2012) and one can only conclude that there was insufficient commitment to full convergence. However, the debate on convergence has been focused on the interactions of the FASB, the U.S. standard setter, and the IASB. There are many countries involved in the convergence process and Ruder, Canfield, and Hudson (2005) have argued that the IASB is subject to influence by business interests and that business interest successes in influencing endorsement or adoption of accounting standards are likely to delay or impede convergence.
The End of Convergence
In 2010 it seemed that the convergence project was on a sound course. However, some were expressing the opinion that the convergence project was not a success. There had been examples of standards where the two parties had not been able to reach a full convergence. Although the FASB nor the IASB had not made any public declarations, there was an obvious decline in the U.S. enthusiasm. It was not surprising that in 2014 the FASB argued that the objective for international accounting standards could be achieved in different ways.
The FASB suggested that the original aim of convergence was to develop a unified set of high-quality international standards. This did not necessarily mean that the two parties had to issue a single standard to which they were both committed fully. To achieve converged standards the FASB considered a better route was to work on global issues with the IASB and other countries through membership of the Accounting Standards Advisory Forum (ASAF).
Some interpreted this statement as the FASB not being willing to give up its role as the standard setter in the U.S. and it had limited interest in international developments. Others warmly welcomed the move arguing that the FASB should concentrate on improving the quality of standards in the U.S. They regarded that the convergence project was an expensive waste of time and effort that would not lead to high-quality standards.
This reference to high quality standards raised two related issues that weakened the chance of further convergence between the two bodies. One was concerned with the definition of high quality and the other issue related to the nature of the standard; known as the rules versus principles debate.
Both the FASB and the IASB would claim that they wished to produce high-quality standards. Although there is general agreement that such standards would lead to comparability and transparency with the qualities of relevance and reliability, nobody has been able to define precisely the characteristics of high-quality standards. It was really a case of “we will know it when we see it.”
Another obstacle on the route to convergence was the differences in the rules based versus the principles-based approach to establishing standards and enforcing them. The rules-based approach lays down specific, detailed requirements in a standard to ensure that financial statements do not mislead the users. Most would agree that the FASB inclines towards this method for setting its standards. It can be argued that the rules-based approach may result in financial statements that are consistent with the rules but do not always provide the most reliable and relevant information for users. Strict conformity with the rules may fail to capture fully the complexities of business operations.
The principles-based approach sets out the general boundaries of the standard’s requirements. It is the preparers and auditors who apply their professional judgment and experience to ensure that the financial statements do not mislead the users. This view was a basis for standard setting in the UK and may have influenced the opinions of the IASB. It can be argued that this approach gives too much scope to preparers and auditors to select various methods for recording accounting transactions and this may not be in the interests of the users.
Undoubtedly, the U.S. put considerable time and energy into the Convergence project. In 2006 a “Road Map” was issued that set out its strategy. The weaker international standards would be replaced by stronger ones and more effort would be given to develop new high-quality standards. In 2008 an update to the 2006 Road Map was issued. A series of priorities and milestones were set out and it was made clear that the U.S. would only adopt international standards if these targets were met.
In 2010 a strategic plan was issued which emphasized the need for high-quality standards. The plan also stated that the decision for the U.S. incorporating international standards would be made in 2011. In 2012 a Joint Progress Report was issued and it was anticipated that the SEC would set out its plans for convergence. It did not do so.
The concerns of the FASB on converging with international standards were set out on FASB’s website in 2014. It was argued that the term “convergence” refers both to the intended goal and the path by which to achieve it. The FASB intended to continue its work on global accounting issues with the IASB. However, for issues of primary interest to stakeholders in the U.S. capital markets, the FASB would make its own decisions.
The announcement by the FASB did not come as a surprise. There were several groups and individuals in the U.S. who were critical of U.S. standards but also did not regard adopting international standards as a worthwhile strategy. They believed international standards were not of “high quality” and argued that practices and standards in the U.S. should be reformed. This would lead to high quality US standards that would be examples for the rest of the world.
There are no indications of the convergence project being revived. It would seem that the FASB and the IASB will retain the responsibility for issuing their own standards. It may be that the two sets of standards will be similar but U.S. GAAP will remain under the control of the SEC and FASB. International standards will remain the domain of the IASB.
However, beginning in fiscal 2007, the U.S. Securities and Exchange Commission (SEC) allowed foreign companies traded on U.S. stock exchanges to report under International Financial Reporting Standards (IFRS) or U.S. Generally Accepted Accounting Principles (U.S. GAAP) so convergence may be resurrected. The similarity of the two sets of standards for sophisticated users of financial statements has already been established. One study (Jategaonkar, Lovata, and Sierra 2014) concluded that the predictive models employed by analysts are equally effective when based on financial results reported under U.S. GAAP or IFRS.
Conclusion
Companies have several groups interested in their financial performance and positions. To meet the needs of the various users, companies provide financial statements. It is essential that those financial statements come under some form of regulation to ensure the reliability and relevance of the information and to enable comparisons over time and with other companies.
To meet these needs, most countries legislation allows for an organization to have the authority to issue financial accounting standards. Companies are required to comply with these standards and the users of the financial statements can have confidence in the information they receive, usually in the form of the annual report and accounts. Companies listed on a stock exchange may also be required to issue half-yearly or even quarterly financial statements.
Over the years it became apparent that countries had different accounting regulations. This made it very difficult to compare the financial performance and position of one company to another in a foreign country. The solution was to develop international standards and the International Accounting Standards Committee was established to carry out this role.
The IASC was successful, but it was considered that a stronger, better financed organization was required, and the International Accounting Standards Board was formed in 2001. A year later the FASB declared a U.S. interest in developing international standards. An agreement was signed and the FASB and the IASB started work on a convergence project intended to achieve a common set of international standards.
Although progress was made, the FASB decided that this was not the best route for establishing international accounting standards or meeting the needs of the U.S. It withdrew from the agreement but has declared its interest in contributing to the development of international standards, but without the convergence relationship with the IASB. The FASB has made it clear that it will retain its authority for the accounting standards used in the U.S.
The standard we discussed in this chapter, International Accounting Standard (IAS) 1, is still in effect. There have been several minor amendments over the years usually caused by a change in another standard. The latest amendment was on October 31, 2018 which amended the term “material.” This comes into effect on January 1, 2020. Our explanation of this term is given in Chapter 2.