Chapter 9

Financial Reporting – Evolution of

Global Standards
 Objectives

By the end of the chapter, you should be able to:

• describe the UK, US and IASB standard setting bodies;
• critically discuss the arguments for and against standards;
• describe the reasons for differences in financial reporting;
• describe the work of international bodies in harmonising
and standardising financial reporting;
• explain the impact on financial reporting of changing to
IFRS;
• critically evaluate the progress being made towards a
single set of global international standards;
Why are FRSs needed?
• Accounting numbers are important when
making contracts. Eg.
– Management and directors' pay is often related to the firm's
performance.
– The required performance may not be achieved under one
method of producing accounting reports, but it could be
under an alternative method.
• With no restraints on the methods used to
produce the report, these methods can be
changed to suit the desired performance
requirements.
Role of accounting numbers in defining contractual
entitlements – temptation to manage the numbers
If there is a risk that earnings will not grow at a rate attractive
to directors THEN there is a temptation to take measures
not in the interest of the shareholders.
Typical measures include:
• Deferring discretionary expenditure, for example research,
advertising, training expenditure
• Deferring amortisation, for example making optimistic sales
projections in order to classify research as development
expenditure which can be capitalised and
• Reclassifying deteriorating current assets as fixed assets to
avoid the need to recognise a loss under the lower of cost and
net realisable value rule applicable to current assets.
Role of accounting numbers in defining contractual
entitlements – temptation to manage the numbers
Mandatory standards defining the way in which
accounting numbers are measured and presented in
financial statements would restrict management’s ability
to adopt measures such as those listed above.
This affects wealth distribution within the firm.
For example, IF managers cannot delay the amortisation of
development expenditure, THEN bonuses related to profit will be
lower and there will effectively have been a transfer of wealth from
managers to shareholders.
 Shareholders are in the dark

• Shareholders are usually unaware that financial

statements are inaccurate.
• Only aware in restricted circumstances
• When a third party has a vested interest in revealing adverse
facts following a takeover, or
• When a company falls into the hands of an administrator,
inspector or liquidator, whose duty it is to enquire and
report on shortcomings in the management of a company.
• The GEC/AEI scandal (p.212) showed that financial
reports prepared from the same basic information
could disclosed materially different results – ranging
from a profit forecast of £10 million to a loss of £4.5m
in this example.
GEC takeover of AEI in 1967 – reasons for
difference
• Two possible reasons for the difference:
• Either the facts have changed or
• The judgements made by the directors have changed
• In this case, it seems there was a change in the facts
• a post-acquisition closure of an AEI factory explained £5
million of the £14.5 million difference between the
forecast profit and the actual loss
• Also, a change in judgement
• The remaining £9.5 million arose because of differences in
judgement. For example, the new directors took a different
view of the value of stock and work-in-progress.
Public view of the accounting profession
following these cases

• Known that accountancy is not an exact science

• BUT not realised how much latitude there was for
companies to produce vastly different results
based on the same transactions
• Given that the auditors were perfectly happy to
sign that accounts showing either a £10m profit or
a £4.5m loss were true and fair, the public felt the
need for action if investors were to have any trust
in the figures that were being published.
 Arguments in support of standards

Comparability
• Need to make valid inter-company comparisons of
performance and trends
• Investors must be supplied with relevant and reliable
data that have been standardised
• Comparisons are distorted if companies are permitted
to select accounting policies with the intention of
disguising changes in performance and trends.
 Arguments in support of standards
(Continued)
Credibility
• Credibility lost if companies selected different
accounting policies for similar events
• Uniformity essential if reports are to disclose a
true and fair view
• However, not intended to be a comprehensive
code of rigid rules
• Not to supersede informed judgement in
determining what was a true and fair view.
 Arguments in support of standards
(Continued)
Influence
• The process has stimulated the development of a
conceptual framework
• For example, the leasing standard considered the
commercial substance of a transaction rather than simply
the legal position
• In the 1970s, no clear statement of accounting principles
other than that accounts should be prudent, be consistent,
follow accrual accounting procedures and be based on the
initial assumption that the business would remain a going
concern
• By 1994, the ASB had produced its exposure drafts of
Statement of Accounting Principles, which appeared in
final form in December 1999.
 Arguments against standards

Adverse allocative effects

• Could occur if standard setters did not take account
of the economic consequences flowing from the
standards they issued. For example,
• Additional costs could be imposed on preparers
• Suboptimal managerial decisions might be taken to
avoid any reduction in reported earnings.
Arguments against standards (Continued)

Consensus-seeking
• Can lead to the issuing of standards that are over-
influenced by those with easiest access to the
standard setters as the subject matter becomes more
complex, for example capital instruments
• ASB attempting to minimise such influences by
basing its standards on the Statement of Principles,
but is the Statement of Principles too general?
Arguments against standards (Continued)

Overload
• Too many standards
• Too detailed
• Too general-purpose and fail to recognise the
differences between large and small entities
• Too many standard setters with differing
requirements, for example FASB, IASB, ASB,
national Stock Exchange listing requirements.
 US GAAP

• The USA has the largest economy in the world

• It is an attractive source of capital for foreign
companies
• There has been competition for international
supremacy between US GAAP and IFRSs
• UK and the USA systems of financial reporting have
much in common, BUT
• There are more rules in the USA than in the UK, and
• A greater standardisation and disclosure of information.
 US GAAP (Continued)

Legislation
• No direct equivalent of the UK Companies Acts in the
USA
• The main federal regulation of trade in shares
comprises the Securities Act 1933 and the Securities
Exchange Act 1934. Neither of these includes any
detailed provisions for the form and content of
financial statements
• The Securities and Exchange Commission (SEC) is
responsible for requiring the publication of financial
information for the benefit of shareholders.
 Enforcement – The Sarbanes-Oxley Act
2002 (SOX)

SOX
• Is the result of the Enron and Worldcom frauds.
• CEO’s of public companies directly responsible for
accuracy of the financial reports
• Management required to certify the reports
• Criminal offence to take steps to obstruct
investigations.
 US GAAP – The SEC

• The SEC has the power to dictate the form and

content of reports
• The largest companies whose shares are listed
must register with the SEC and comply with its
regulations
• The SEC monitors the financial reports filed, in great
detail
• The majority of companies fall outside the SEC’s
jurisdiction
• Individual states have the power to introduce their
own legislation to control businesses and even set
taxes.
 US GAAP – Standard setting

FASB
• The Financial Accounting Standards Board (FASB) is
responsible for setting accounting standards in the USA
• Its independence is ensured by limiting the voluntary
contributions to its funding from the various public
accounting firms, industry and other interested parties
• FASB issues the following documents:
• Statements of Financial Accounting Standards, which deal
with specific issues
• Statements of Concepts, which give general information
• Interpretations which clarify existing standards
• Emerging Issues Task Force.
 US GAAP – other mandatory
pronouncements
The APB
The Accounting Principles Board (APB) publishes
Opinions
The AICPA
The American Institute of Certified Public
Accountants (AICPA) publishes Accounting Practice
Bulletins and Opinions
APB and AICPA pronouncements should all be
regarded as mandatory.
 US GAAP – What if no bulletins or
opinions?
• Refer to the
• FASB Technical Bulletins,
• AICPA Industry Audit and Accounting Guidelines
cleared by FASB, and
• AICPA Statements of Position.

• Other AICPA interpretations and implementation

guidelines published by FASB staff may also be
relevant
• Finally, companies should refer to practices that
are widely recognised and prevalent, either
generally or in the industry.
 SEC

• Power to dictate the form and content of reports

• Monitors financial reports.
 Reasons for differences in reporting

• The character of the national legal system

• The way in which industry is financed
• The relationship of the tax and reporting systems
• The influence and status of the accounting
profession
• The extent to which accounting theory is
developed
• Accidents of history
• Language.
 Character of the national legal system

• Legal system based on common law

• Importance of equity

• Legal system based on Roman law

• Importance of codification
 Ways in which industry is financed
Different information needs

• Equity investors
• Objective information for stewardship
• Fair information for investment decision-making
• Reliance on external information

• Loan creditors
• Banks principal lenders and shareholders
• Access to internal information
• Published disclosures less relevant.
 Relationship of the tax and reporting
systems

• Reporting and tax separate

• Separate rules for computing profit for tax
• Financial reporting less prescriptive.
Primacy to taxation rules
- Allowance only if in the financial accounts
- Possible misinterpretation when comparing different
countries
- Example: treatment of depreciation.
 Influence and status of the accounting
profession

• If market-sensitive information has been required

• Reliable and relevant information required
• Growth of established profession and audit
function
• Impact on accounting regulation.
Where there has been less need for market-
sensitive information
- Less need for expertise
- Less need for financial management.
 Accidents of history

• Effect of commercial scandals

• In US led to SEC being set up
• In UK led to publishing accounting standards
• Financial reporting less prescriptive

• Pooling resources

• External pressures
• Joining EU and becoming subject to Directives
• Imposed.
 The European Union

• The European Economic Community established

in 1957 – renamed in 1993 the European Union
(the EU)
• A major aim for financial reports prepared using
common financial reporting standards
• Accounting Directives – Fourth, Seventh and
Eighth Directives.
 The Fourth Directive prescribes

• Annual accounts should comprise statements of

income and financial position with supporting
notes to the accounts
• A choice of formats, for example vertical or
horizontal presentation
• The assets and liabilities to be disclosed
• The valuation rules to be followed, for example
historical cost accounting
• The general principles underlying the valuations.
 The Seventh Directive requires

• The consolidation of subsidiary undertakings

across national borders, that is worldwide
• Uniform accounting policies to be followed by all
members of the group
• Eliminating inter-company profit and cancelling
inter-company debt.
 The Eighth Directive requires

• Independent audit committees to have one

financial expert as a member
• Audit partners to be rotated every seven years
• The group auditor bears full responsibility for the
audit report.
 The wider reach of IFRS

• Transition to IFRSs occurring in EU and Asian Pacific

Region, but different national editions of IFRSs
appearing
• China - all listed companies in China must comply
with IFRS
• The Australian Accounting Standards Board (AASB)
has issued Australian equivalents (AIFRS) that are
fully compliant with IFRS, but are not identical to IFRS
• This means that Australian companies’ accounts will
be compliant with IFRS, but foreign companies
following IFRS will not necessarily be compliant with
AIFRS.
 The wider reach of IFRS (Continued)

• In New Zealand IFRSs are issued as national

equivalents which introduce specific additional
requirements considered appropriate to the New
Zealand environment
• Singapore seems to have adopted IFRS verbatim in its
local standards, but with some important differences
 The Impact of changing to IFRS

• In some instances the changes have a dramatic effect on

headline figures (e.g. the Dutch company, Wessanen,
reported an increase of over 400% in its net income figure
when the Dutch GAAP accounts were restated under IFRS)
• In other cases, there may be some large adjustments to
individual balances, but the net effect may be less obvious.
The European hotel group, Accor, reported a reduction in
total assets of only 1% when its 2004 balance sheet was
restated from French GAAP to IFRS, but within this, ‘other
receivables and accruals’ had fallen by €294m, a reduction
of over 30% of the previously reported balance.
Total assets = 29,400 - 294 = 29,106 (1% fall)
Other recs. = 980 - 294 = 686 (30% fall)
 The impact of changing to IFRS
(Continued)

• In most countries, earnings and balance sheet

values will be more volatile than in the past
• In certain countries, there will be major changes in
specific components of equity in the year of
transition as particular assets or liabilities may be
recognised differently
• In UK, many companies’ provisions for deferred
tax liabilities increased on revalued properties
• Australian companies have made large
adjustments to their balance sheets through the
de-recognition of intangible assets
 The impact of changing to IFRS
(Continued)

• Accounting for financial instruments has proved

particularly challenging
• In the short term, changes in reported figures can
have important consequences for companies’
contractual obligations (e.g. they may not be able
to maintain the level of liquidity required by their
loan agreements) and their ability to pay dividends
• There may be motivational issues to consider
where staff bonuses have traditionally been based
on reported accounting profit.
Progress towards adoption by the USA of
International standards

• There has been continuous collaboration since the

Norwalk Agreement in 2002 towards the time when
• The US will cease to require companies using IFRS to
lodge reconciliation statements, and
• When it will mandate the use of IFRS by US companies.

• The process
• Started with the Norwalk agreement
• Followed by the IASB carrying out a Convergence
programme and
• Finally joint standards being issued.
 The Norwalk agreement

In 2002, the Financial Accounting Standards Board (FASB)

and the IASB committed to the development of high-quality,
compatible accounting standards that could be used for
both domestic and cross-border financial reporting.
The aim was to:
(i) Make their existing financial reporting standards fully
compatible by undertaking a short-term project aimed at
removing a variety of individual differences between US
GAAP and International Financial Reporting Standards
and
(ii) Remove other differences between IFRSs and US
GAAP through coordination of their future work
programmes by undertaking discrete, substantial projects on
which both Boards would work concurrently.
 The short-term project

• IASB and FASB aimed to remove minor differences by

changing their standards. For example,
• The IASB was to change IAS 11 Construction Contracts,
IAS 12 Income taxes, IAS 14 Segment Reporting, IAS 28
Joint Ventures and
• The FASB was to change Inventory costs, Earnings per
share and Research and Development costs
• By 2008 a number of projects were completed. For
example,
• The FASB adopted the IFRS approach to accounting for
research and development assets acquired in a business
combination (SFAS 141R) and
• The IASB revised its standard on borrowing costs (IAS 23
revised) and segment reporting (IFRS 8).
 Review questions

1. Why is it necessary for financial reporting to be

subject to (a) mandatory control and (b) statutory
control?

1. ‘The most favoured way to reduce information

overload was to have the company filter the
available information set based on users’
specifications of their needs.’ Discuss how this
can be achieved given that users have differing
needs.
 Review questions (Continued)

1. How is it possible to make shareholders aware of

the significance of the exercise of judgement by
directors which can turn profits of £6 million into
losses of £2 million?