Chapter 3: International Convergence of Financial Reporting

International Accounting Standard-setting Evolution of IASC and IASB shows international accounting standard-setting in the private sector: With the support of the accounting bodies, standard-setters, capital market regulators, government authorities, and financial statement preparers Harmonization allows countries to have different standards as long as they do not conflict

International Accounting Standard-setting Accounting harmonization considered in two ways Harmonization of accounting regulations or standards Harmonization of accounting practices

International Accounting Standard-setting Other factors leading to non comparable accounting numbers despite similar accounting standards Quality of audits Enforcement mechanisms Culture legal requirements Socioeconomic and political systems International convergence of accounting standards refers to both a goal and the process adopted to achieve it

Harmonization and Convergence Reduction of alternatives while maintaining a high degree of flexibility in accounting practices Convergence Enforcement of single set of accepted standards by several regulatory bodies

Harmonization Can be considered in two ways Harmonization of accounting regulations and standards Harmonization of accounting practice Ultimate goal of international harmonization efforts Harmonization of standards may or may not result in harmonization of practice Different from standardization Standardization involves using the same standards in different countries Allows for different standards in different countries as long as they do not conflict

Arguments for Convergence Facilitate better comparability of financial statements Easier evaluation of companies Facilitate international mergers and acquisitions Reduce financial reporting costs Cost-listing would allow access to less expensive capital Reduce investor uncertainty and the cost of capital

Arguments for Convergence Reduce cost of preparing worldwide consolidated financial statements Simplify auditing Easy transfer of accounting staff internationally Raise the quality level of accounting practices internationally Increase credibility of financial information Enable developing countries to adopt a ready-made set of high-quality standards with minimum cost and effort

Arguments against Convergence Significant differences in existing standards Enormous political cost of eliminating differences Nationalism and traditions Arriving at universally accepted principles is difficult Need for common standards is not universally accepted Well-developed global capital market exists already May cause standards overload Differences in accounting across countries might be necessary

Harmonization Efforts Several organizations were involved at global and regional levels International Organization of Securities Commissions (IOSCO) International Federation of Accountants (IFAC) European Union (EU) International Forum on Accountancy Development (IFAD) International Accounting Standards Committee (IASC) International Accounting Standard Board (IASB)

International Organization of Securities Commissions (IOSCO) Established in 1974 Initially limited its membership to regulatory agencies in America Opened membership to agencies in other parts of the world in 1986 Aims at ensuring a better regulation of markets on both domestic and international levels Works to facilitate cross-border securities offering and listings by multinational issuers Advocates the adoption of a set of high-quality accounting standards

International Federation of Accountants (IFAC) Established in October1977 at 11th World Congress of Accountants in Munich Promotes adherence to high-quality professional standards of auditing, ethics, education, and training Launched International Forum on Accountancy Development (IFAD) to Enhance the accounting profession in emerging nations Promote transparent financial reporting Established the Forum of Firms with an aim of Protecting the interests of cross-border investors Promoting international flows of capital

European Union (EU) Founded in March 1957 with the signing of the Treaty of Rome by six European nations Issued two directives aimed at harmonizing accounting Fourth Directive: Dealt with valuation rules, disclosure requirements, and the format of financial statements Established the true and fair view principle Provided considerable flexibility Allowed countries to choose from among acceptable alternatives Opened the door for non comparability in financial statements Seventh Directive: Dealt with consolidated financial statements

European Union (EU) Directives helped reduce differences in financial statements Complete comparability was not achieved European Commission decided not to issue additional accounting directives Associated itself with efforts undertaken by the IASC toward a broader international harmonization of accounting standards

International Forum on Accountancy Development (IFAD) Mission was to improve the market security and transparency, and financial stability on a global basis Assists in defining expectations from accountancy profession Encourages governments to focus on the needs of developing economies in transition Harness funds and expertise to build accounting and auditing capacity in developing countries

International Accounting Standards Committee (IASC) Established in 1973 by leading professional accounting bodies in 10 countries Broad objective of formulating international accounting standards Harmonization efforts evolved in three mail phases Lowest-common-denominator approach Issuance of 26 generic International Accounting Standards Comparability project Publication of Framework for the Preparation and Presentation of Financial Statements Comparability of Financial Statements Project IOSCO agreement

International Accounting Standards Board (IASB) Replaced IASC in 2001 IFRS Foundation appoints board of 16 members 13 full and 3 part-time Board approves standards, exposure drafts, and interpretations Shift in emphasis from harmonization to global standard-setting or convergence Main aim is to develop a set of high-quality financial reporting standards for global use

EXHIBIT 3.2—The Structure of the IASB

Principles-Based Approach to International Financial Reporting Standards IASB follows a principles-based approach to standard setting vs a rules-based approach Standards establish general principles for recognition, measurements, and reporting requirements for transactions Limits guidance and encourages professional judgment in applying general principles to entities or industries

IASB Framework Created to develop accounting standards systematically Framework for Preparation and Presentation of Financial Statement adopted by IASB in 2001 from IASC Scope of Framework Objective of financial statements and underlying assumptions Qualitative characteristics that affect the usefulness of financial statements Definition, recognition, and measurement of the financial statements elements Concepts of capital and capital maintenance

Qualitative Characteristics of Financial Statements Understandability: Understandable to people with reasonable financial knowledge Relevance: Useful for making predictions and confirming existing expectations Affected by nature and materiality of information Reliability: Neutral and represents faithfully what it purports to Reflecting items based on economic substance rather than their legal form Comparabilty

Proposed Changes to existing frameworks by IASB and FASB IASB and FASB will work on existing frameworks to provide basis for developing future standards by boards Phases of project Objectives and qualitative characteristics Elements and recognition Measurement Reporting entity Presentation and disclosure Purpose and status Application to not-for-profits Finalization

Elements of Financial Statements Definition Assets, liabilities, and other financial statement elements are defined Recognition Guidelines as to when to recognize revenues and expenses Measurement Various bases are allowed: historical cost, current cost, realizable value, and present value

The Norwalk Agreement Proposed Changes as per the discussion paper published jointly by two boards: Decision-useful objective encompassing information relevant to assessing stewardship Stakeholder approach (vs. U.S. framework of shareholder approach) — users other than capital providers explicitly acknowledged Asset of an entity would be present economic resource to which, through an enforceable right or other means, entity has access or can limit others’ access Emphasis on principle and guidance development for fair value measurements in IFRS—exit price as measurement base, or, if not—develop additional guidance

Presentation of Financial Statements (IAS 1) Single standard providing guidelines for the presentation of financial statements Guidance areas Purpose of financial statements Components of financial statements Overriding principle of fair presentation Requires the faithful representation of the effects of transactions and events Accounting policies Should be consistent with all IASB standards When specific guidance is lacking, use standards on similar issues, and definitions of the financial statement elements

Presentation of Financial Statements (IAS 1) Basic principles and assumptions Adds to the guidance provided in the Framework Immaterial items should be aggregated Assets and liabilities, and income and expenses should not be offset Structure and content of financial statements Current/noncurrent Items to be included on face of financial statements Items to be disclosed in the notes

First Time Adoptions of IFRS (IFRS 1) Provides guidance to companies that are adopting IFRS for the first time Requires compliance with all effective IFRS at the reporting date of an entity’s first IFRS financial statements Allows exemptions when costs outweigh benefits

The Adoption of IFRS There are a number of ways in which a country might adopt IFRS. 1. Replace national GAAP with IFRS. 2. Require parent companies to use IFRS in preparing consolidated financial statements. 3. Require stock exchange listed companies to use IFRS in preparing consolidated financial statements. 4. Require foreign companies listed on a domestic stock exchange to use IFRS. 5. Require domestic companies listing on a foreign stock exchange to use IFRS.

Use of IFRS Evidence of support for IFRS Adoption by the EU – public companies in the EU were required to begin using IFRS in 2005 IOSCO has endorsed IFRS for cross-listings IFAC G20 accountancy summit in July 2009 issued renewed mandate for adoption of global accounting standards Latest IFAC Global Leadership Survey—emphasized that investors and consumers deserve simpler and more useful information Adoption of IFRS in 2011: Japan, Canada, India, Brazil and Korea

International Convergence Issues The complicated nature of standards such as financial instruments and fair value accounting The tax-driven nature of the national accounting regime Disagreement with significant IFRS, such as financial statements and fair value accounting Insufficient guidance on first time application of IFRS Limited capital markets are less beneficial Investor satisfaction with national accounting standards IFRS difficulties in language translation

IASB/FASB Convergence The Norwalk Agreement reached in 2002 between the IASB and FASB pledged For compatible financial reporting standards Proper coordination of work program to maintain compatibility

IASB/FASB Convergence IASB’s and FASB’s key initiatives in the Norwalk Agreement Joint projects – boards work jointly to address issues (e.g., revenue recognition) Short-term convergence –remove differences between IFRS and U.S. GAAP for issues where convergence is deemed most likely IASB liaison – IASB member in residence at FASB Monitoring IASB projects – FASB monitors IASB projects of most interest Convergence research project – identification of all major differences between IFRS and U.S. GAAP Convergence potential – FASB assesses agenda items for possible cooperation with IASB

IASB/FASB Convergence Following global financial crisis both groups formed Financial Crisis Advisory Group (FCAG) July 2009 FCAG report addresses: Effective financial reporting Limitations of financial reporting Convergence of accounting standards Standard-setting independence and accountability

End of Chapter 3