International accounting Chapter 2: Causes and examples of international differences

Learning objective: discuss the degree to which international cultural differences might explain accounting differences; outline the two main types of legal system to be found in the Western world and how these are related to accounting differences; explain how the predominant methods of financing of companies can differ internationally and how this may affect the purpose and nature of accounting; illustrate the linkages between taxation and financial reporting, and show how these are stronger in some countries than in others; outline the relationships between international accounting variations and differences in the accountancy profession;

.. Learning objective: synthesize all the above relationships to begin to explain international differences in financial reporting; outline various ways in which accounting under German national rules is more conservative than that under UK rules; explain the difference between a provision and a reserve, and show how the definition of provision is wider in some countries than in others; outline the main valuation bases used for assets in major countries; and summarize the international differences in formats of financial statements.

Why should we want to know how and why accounting develops?

DEVELOPMENT factors have a significant influence on accounting development. 1. Culture 2. Legal System. 3. Sources of Finance. 4. Taxation. 5. Political and Economic Ties 6. Inflation 7. Level of Economic Development 8. Educational Level

Culture Culture in any country contains the most basic values that an individual may hold. It affects the way that individuals would like their society to be structured and how they interact with its substructure. Accounting may be seen as one of those substructures.

Culture (1) individualism versus collectivism, (2) Large versus small power distance, (3)Strong versus weak uncertainty avoidance, and (4) Masculinity versus femininity.

framework linking culture and accounting. Professionalism vs. statutory control Uniformity vs. flexibility Conservatism vs. optimism Secrecy vs. transparency

Countries differences The picture shows clear ‘Arab’ and ‘Anglo’ clusters, but less cohesive clusters in East Asia or among ‘Latin’ countries. Chand et al. (2012) show how different cultures in the same country can affect accounting judgements; they study Australian students with Chinese backgrounds and those with Anglo-Celtic backgrounds.

Legal Systems: Common Law vs. Code Law Accounting The main difference between the two systems is that in common law countries, case law — in the form of published judicial opinions — is of primary importance, whereas in civil law systems, codified statutes predominate. 

Legal Systems: Common Law vs. Code Law Accounting For example, that companies in common law countries have higher levels of disclosures. Bushman and Piotroski (2006) examine the greater incentives to report losses quickly in common law countries

Legal Systems: Common Law vs. Code Law Accounting common law countries is characterized as oriented toward “fair presentation,” transparency and full disclosure, and a separation between financial and tax accounting. Stock markets dominate as a source of finance, and financial reporting is aimed at the information needs of outside investors. Setting accounting standards tends to be a private sector activity, and the accounting profession plays an important role. Common law accounting is often called “Anglo-Saxon,” “British-American,” or “micro based.”

.. Legal Systems: Common Law vs. Code Law Accounting code law countries is characterized as legalistic in orientation, opaque with low disclosure, and an alignment between financial and tax accounting. Banks or governments (“insiders”) dominate as a source of finance, and financial reporting is aimed at creditor protection. Setting accounting standards tends to be a public sector activity, with relatively less influence by the accounting profession.

Providers of finance A proposed grouping of countries into types by financial system has been formalized by Zysman (1983) as follows: ● capital market systems (e.g. United Kingdom, United States); ● credit-based governmental systems (e.g. France, Japan); ● credit-based financial institution systems (e.g. Germany).

Taxation the tax/reporting connection, and the treatment of deferred tax. For example, for tax purposes, impairments are only allowed if they are expected to be long lasting. Also, long-term provisions should be discounted.

Taxation Without disconnection, companies could choose their taxable income by choosing whether to use IFRS or domestic accounting rules. Differences between a company’s tax base and its financial reporting lead to the accounting topic of deferred tax.

Other external influences Economic ties financial crises, Enron, black Monday The adoption of, or convergence with, the standards of IASB. For example, the EU has made these standards compulsory for the consolidated statements of listed companies. The level of inflation. In most of continental Europe and Japan, accounting has been the servant of the state (e.g. for tax collection). In the Anglo-Saxon world, theory was traditionally of little importance in accounting practice

The profession The lack of a substantial body of private shareholders and public companies in some countries means that the need for auditors is much smaller than it is in the United Kingdom or the United States.

Some examples of differences conservatism, provisions, measurement of assets, and formats of financial statements.

conservatism and accruals Not fully conservative to require the capitalization of some development expenditure as in IAS 38 A similar argument applies to the taking of profit on some unfinished long-term contracts as in IFRS 15. although US accounting practice does not generally allow capitalization of development expenditure, it does require gains to be accounted for on certain unsold investments

conservatism and accruals Davidson and Kohlmeier (1966) and Abel (1969) noted that profit figures would be consistently lower in France, Sweden, Germany and the Netherlands (when use of replacement cost was assumed) if similar companies’ statements were merely adjusted for differences in inventory and depreciation practices from those used in the United States or the United Kingdom.

conservatism and accruals Gray (1980) examined a number of companies from France, Germany and the United Kingdom in the early 1970s in order to produce an index of conservatism. He concluded that ‘French and German companies are significantly more conservative or pessimistic than UK companies

conservatism and accruals Ball et al. (2000) found that continental European companies took longer to recognize losses

conservatism and accruals In France, Germany and Belgium a company is required to appropriate 5 per cent tranches of its annual profit until the statutory reserve reaches 10 per cent of issued share capital (20 per cent in Italy and Spain; 25 per cent in Japan).

Provisions and reserves In American English the word ‘reserve’ means either ‘provision’ or ‘impairment’ in UK English ‘provision’ is used to mean two things: (i) a liability of uncertain timing or amount (e.g. ‘provision for pensions’) and (ii) an allowance against (or impairment of) the value of an asset (e.g. ‘bad debt provision’ or ‘provision for depreciation’).

Provisions and reserves The distinction between provisions and reserves is important for financial reporting because provisions are liabilities recognized by charges against profit, whereas reserves are elements of equity caused by undistributed gains.

Provisions and reserves Tax influence can sometimes have the opposite effect. For example, in many countries, pension expenses are not tax deductible until paid.

Measurement of tangible assets At the other extreme is the Netherlands. Until recently, some Dutch companies (e.g. Philips) published replacement cost financial statements for four decades. Although this remained minority practice, during inflationary periods many Dutch companies have partially or supplementarily used replacement costs.

Measurement of tangible assets Between these two extremes, UK ‘rules’ until the late 1990s allowed a chaotic state of affairs, where some companies revalued, some of the time, using a variety of methods. This was the position for much of the English-speaking world, except that the United States and Canada kept to historical cost (except for financial assets) in the main financial statements because of the influence of the SEC.

Measurement of tangible assets Some countries, notably in South America, have adopted forms of general purchasing power (GPP) adjusted accounting. This has occurred in countries with very high inflation, government/tax controlled accounting, and a paucity of accountants.

Formats of financial statements In some countries, assets are displayed in order of decreasing liquidity (cash first), whereas in other countries there is an increasing order of liquidity (intangible fixed assets come first). The key to predicting is that the decreasing order is used by countries influenced by the United States, and the increasing order is used by countries in the EU.

Formats of financial statements Some combine together all the debits and then all the credits. Such balance sheets are either two- sided (with assets on the left) or in ‘report form’ on a single page (with assets at the top) –

Formats of financial statements Other companies arrange the items in order to calculate totals of net current assets and net assets; this may be called a financial position format. These three shapes (with assets in order of increasing liquidity) are all allowed in the EU. There is no US requirement on the shape of balance sheets.

Formats of financial statements The IFRS on this subject (IAS 1) contains no requirements on formats; neither on the liquidity order nor on the shape. Traditional national practice survives under IFRS. For example, Australian companies still start with cash, whereas German IFRS reporters generally show it as the last asset.

Formats of financial statements The real problem lies in the two ways of combining costs: by nature or by function. The by-nature format combines costs as total purchases, total depreciation, total wages, etc. The by-function format combines costs by stage of production: cost of sales, administrative costs, distribution costs, etc.

Formats of financial statements The by-function format allows the calculation of gross profit for a manufacturing company, whereas the by-nature format does not, because there is no information on the manufacturing wages, depreciation etc. that would be needed for the calculation of cost of sales.