The Impact of IFRS in Transparency Manuel Arranz October 15, 2007

A few words about Transparency in financial reporting Contents A few words about Transparency in financial reporting Prehistory of financial reporting: the situation before IFRS Why IFRS?: The European case How does IFRS help to improve Transparency?

A few words about Transparency in financial reporting

Also transparent means easily seen through, recognized, or detected. A general definition Transparency or transparence is the quality or state of being transparent, transmitting rays of light through its substance so that bodies situated beyond or behind can be distinctly seen. Also transparent means easily seen through, recognized, or detected.

A definition closer to financial reporting In financial reporting, transparency commonly refers to the disclosure of financial information in a manner that an user of such financial information can see what it is behind the figures presented by management. Transparency is commonly associated to terms like: useful, timely, reliable, comparable and consistent.

One main reason: the users’ process of making economic decisions. Why Transparency? Diverse potential users of financial information: shareholders, suppliers, financial entities, Internal Revenue Services, financial analysts, etc. One main reason: the users’ process of making economic decisions. Lack of Transparency implies potential errors in such process. Transparency is one of the key pillars in Stock Exchange Markets.

Prehistory of Financial Reporting: the situation before IFRS

Let’s return to the 90’s for a while Main markets: One clear leader: USA A couple of significant markets: London, Frankfurt, Tokyo,.. Many small markets in Europe, Asia, Latin America,… Financial reporting: US GAAP in USA Local GAAP in the rest of countries IAS (former IFRS) applied only in limited situations

US GAAP IAS Local GAAP Private standards setters: FASB, EITF, AICPA GAAP in the 90’s US GAAP Private standards setters: FASB, EITF, AICPA Complex rules, but still understood IAS Private standards setter: IASC General principles, optional methods Local GAAP Mix of principle-based and rule-based Huge diversity

Peak and then drop in Stock Markets Financial scandals in US What happened around 2000? Technological boom: high tech companies, internet, telecom, .com, software companies, biotech, etc. Peak and then drop in Stock Markets Financial scandals in US Demand for new rules and disclosures Investors Politicians Regulators Financial analysts

Major development of US GAAP What happened around 2000? Major development of US GAAP Revenue Recognition (SAB 101) Derivatives (SFAS 133) Business combinations, goodwill and intangible assets (SFAS 141 and 142) FIN 46(R) Improvement of disclosures Creation of IASB and IFRS and revision of IAS Globalization of markets – need for a unique reporting language

Why IFRS?: the European case

USA: Europe Complaints about complexity OF US GAAP Who needed IFRS? USA: Complaints about complexity OF US GAAP Sarbanes-Oxley Act appointed SEC for GAAP: US GAAP was renewed, but FASB had to converge with IASB A process of simplification was required Europe Political and economical convergence: EUROPE needed an unique language

Why IFRS? When was adopted? First steps Political reasons Not US GAAP Not a Local GAAP within EU …only one suitable option. Economic reasons When was adopted? Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the application of International Accounting Standards

How did EU adopt it? –Preamble of the EU Law The Lisbon European Council of 23 and 24 March 2000 emphasized the need to accelerate completion of the internal market for financial services, set the deadline of 2005 to implement the Commission's Financial Services Action Plan and urged that steps be taken to enhance the comparability of financial statements prepared by publicly traded companies. (2) In order to contribute to a better functioning of the internal market, publicly traded companies must be required to apply a single set of high quality international accounting standards for the preparation of their consolidated financial statements. Furthermore, it is important that the financial reporting standards applied by Community companies participating in financial markets are accepted internationally and are truly global standards. This implies an increasing convergence of accounting standards currently used internationally with the ultimate objective of achieving a single set of global accounting standards.

How did EU adopt it? –Preamble of the EU Law (4) This Regulation aims at contributing to the efficient and cost-effective functioning of the capital market. The protection of investors and the maintenance of confidence in the financial markets is also an important aspect of the completion of the internal market in this area. This Regulation reinforces the freedom of movement of capital in the internal market and helps to enable Community companies to compete on an equal footing for financial resources available in the Community capital markets, as well as in world capital markets. (5) It is important for the competitiveness of Community capital markets to achieve convergence of the standards used in Europe for preparing financial statements, with international accounting standards that can be used globally, for cross-border transactions or listing anywhere in the world.

However, what IFRS are accepted by EU? Article 3 Adoption and use of international accounting standards 1. In accordance with the procedure laid down in Article 6(2), the Commission shall decide on the applicability within the Community of international accounting standards. 2. The international accounting standards can only be adopted if: - they are not contrary to the principle set out in Article 2(3) of Directive 78/660/EEC and in Article 16(3) of Directive 83/349/EEC and are conducive to the European public good and, - they meet the criteria of understandability, relevance, reliability and comparability required of the financial information needed for making economic decisions and assessing the stewardship of management. PROCESS OF ENDORSEMENT BY EU

How does IFRS help to improve Transparency?

Directive 2004/109/EC: Transparency for EU Efficient, transparent and integrated securities markets contribute to a genuine single market in the Community Foster growth and job creation by better allocation of capital and by reducing costs. The disclosure of accurate, comprehensive and timely information about security issuers builds sustained investor confidence and allows an informed assessment of their business performance and assets. This enhances both investor protection and market efficiency.

Periodic information Annual financial report 4 months after year end. Transparency for EU Periodic information Annual financial report 4 months after year end. It will comprise: Audited financial statements Management report Management representations Half-yearly financial report and interim management statements Notice of acquisition or disposal of major holdings Major related parties’ transactions

IASB is not a political organization Transparency in IFRS IASB is not a political organization IFRS are especially designed for public companies Objective and qualitative characteristics consistent with European Union’s goals Principles-based set of pronouncements Easy to implement in the short term

Classifications in balance sheet and statement of income Some examples Classifications in balance sheet and statement of income Accounting policies and management estimates Revenue recognition Financial instruments, derivatives and hedging Consolidation procedures Impairment policies

Disclosures: Segment reporting Employees’ benefits Income Tax Some examples Disclosures: Segment reporting Employees’ benefits Income Tax Long-term debt and other commitments Off-balance-sheet arrangements Contingencies Purchase Price Allocation Related parties

Main challenges: convergence with US GAAP Memorandum of Understanding (Feb. 2006): roadmap for 2006-2008. Short convergence projects: Government grants (IASB) Joint ventures (IASB) Impairment (joint) Income Tax (joint) Investment properties (FASB) Research and development (FASB) Subsequent events (FASB) Other projects

Main challenges: different interpretations IAS 8, par. 10: “In the absence of a Standard or an Interpretation that specifically applies to a transaction, other event or condition, management shall use its judgment in developing and applying an accounting policy that results in information that is: relevant to the economic decision-making needs of users; and reliable, in that the financial statements: represent faithfully the financial position, financial performance and cash flows of the entity; reflect the economic substance of transactions, other events and conditions, and not merely the legal form; are neutral, i.e., free from bias; are prudent; and are complete in all material respects.”

Main challenges: different interpretations IAS 8, par. 11 In making the judgment described in paragraph 10, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.

Main challenges: different interpretations IAS 8, par. 12 In making the judgment described in paragraph 10, management may also consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards, other accounting literature and accepted industry practices, to the extent that these do not conflict with the sources in paragraph 11.

IFRS guarantees Transparency because of: : CONCLUSIONS IFRS guarantees Transparency because of: : Its objectives Its quality characteristics It is a principle-based framework The process of setting standards is public and based on consensus It has been positively tested in Europe We need to continue working on: Convergence Consistency in the applications