1. How to Make Global Reporting Convergence Work Christian Leuz J. Sondheimer Professor of International Economics, Finance & Accounting

2. Slide 2 Global Reporting Convergence Financial crisis has led to a loss of confidence in financial markets −Calls for more and stricter regulation for banks and capital markets −G-20 process is also about leveling the playing field and global convergence of regulation  G-20 Summit (Pittsburgh) charged the IASB and FASB to converge their standards Global convergence in reporting −Well over 100 countries have either moved to IFRS or have decided to require IFRS in the near future −SEC proposed Roadmap to IFRS, which could lead to IFRS adoption by the U.S. in 2014 Harmonization efforts in the EU −EU requires IFRS reporting since Dec 2005 −FSAP: Series of directives to create single market (e.g., TPD)

3. Slide 3 Update on US Decision SEC is expected to make a decision on IFRS adoption by 2011 Recently, SEC floated the idea of “condorsement” −Convergence and endorsement −US would participate in standard setting at IASB and endorse new standards (similar to EU) −Convergence of remaining differences between GAAP and IFRS What are the tradeoffs of IFRS adoption in the US? −Independent research report to the FASB

4. Slide 4 Our FASB report: Main Effects and Tradeoff for US Main impact of IFRS adoption is likely to be on firms’ reporting costs and on the U.S. reporting system Tradeoff between −One-time transition costs for firms and economy −Comparability benefits  Stem from adoption of a single set of standards (restricts the set of permissible treatments)  Modest but accrue over much longer horizon −Recurring cost savings  Accrue mostly to multinational firms  Limited due to the fact that IFRS are generally not used for statutory and tax reporting in many countries Net effect for a given company or the U.S. as a whole is not obvious  there is not a strong case for or against IFRS 4

5. Slide 5 Implications of U.S. Decision for the EU U.S. adoption may have some comparability effects in the EU but they are muted −Most of the comparability effects occurred when European firms adopted IFRS IFRS are less specific than US GAAP −SEC could add specific disclosure requirements or issue guidance on specific standards −These requirements could become a de-facto standard for firms and countries around the world Influence of the EU on IASB is likely to decrease Continued convergence process between IASB and FASB −Further changes for non-US firms 5

6. Slide 6 Will we get convergence of global reporting practices? IFRS are set to become the global accounting language −Accounting standards will likely be the same going forward But it is not clear that we will get convergence of reporting practices? −Implementation, application and enforcement of standards is likely to differ around the world −Firms’ incentives to apply standards differ around the world Reporting quality will not be the same

7. Slide 7 What is the issue? Standards provide plenty of discretion −Firms can legitimately use reporting discretion −Firms can use this discretion to convey private information −But they can also use discretion to obfuscate and hide (e.g., poor economic performance) Given the discretion, accounting standards do not “force” (or constrain) reporting outcomes −Outcomes (e.g., earnings quality) depend on firms’ reporting incentives −Note that this is not just a matter of enforcement Reporting incentives matter even with perfect enforcement (as long as there is discretion)

8. Slide 8 Role of Reporting Incentives Supporting infrastructure and reporting incentives play an important role for reporting practices −There is lots of empirical research that supports this idea Important implications: −A single set of accounting standards by itself does not guarantee the comparability of firms’ reporting practices −Applies within a country and across countries −Again, this is not just a matter of enforcement (but it matters) If convergence is the goal, we also need to focus on: −Countries’ institutional infrastructures −Differences in capital markets and the incentives they create

9. Slide 9 Illustration: IFRS Mandate Local GAAP IFRS Reporting Discretion Firm A Firm B With strong enforcement Reporting quality With weak enforcement

10. Slide 10 Early Evidence in Daske, Hail, Leuz and Verdi (2008) Capital-market effects of IFRS mandate in 26 countries −On average, there are modest liquidity effects (and to a lesser extent valuation and cost of capital benefits) Substantial heterogeneity in the capital-market effects −Effects are stronger in the EU than in the rest of the world −Effects are stronger in countries with stronger legal systems and better reporting quality in the past Cross-sectional results point to the critical role of enforcement and reporting incentives −Countries need a supporting infrastructure

11. Slide 11 Capital-market effects of EU securities regulation: Christensen, Hail & Leuz (2010) Market Abuse Directive (MAD) −Directive against market manipulation and insider trading to ensure investor confidence Transparency Directive (TPD) −Directive to ensure appropriate transparency for investors −Disclosure of accurate and timely information There are prior rules banning insider trading and mandating financial disclosure −MAD and TPD aim at improving implementation and enforcement of securities regulation −Mandate changes to the supervisory structure and public enforcement Directive applies to all member states and it is the same for all countries −There could be differences in the transposition into national law (e.g., penalities) −Supervision and enforcement is local Exploit differences in the implementation and enforcement across countries

12. Slide 12 How would we expect the effects to be different across EU countries? Two competing predictions One hypothesis: Countries with weaker prior securities regulation experience bigger effects −Weaker EU countries are “catching up” with stronger countries −Basic idea behind harmonization Alternative hypothesis: −Institutional fit and importance of the directives is different across countries −New directives face the same constraints as past securities regulation (e.g., political resistance) −Regulation is more effective in countries with better institutions, more efficient bureaucracies and a greater ability to implement and enforce policies −Past track record on (securities) regulation is likely informative about the ability and will to put enact and enforce policies that induce or curb certain policies

13. Slide 13 Key findings Significant capital-market benefits from tightening of EU regulation But again considerable heterogeneity in the effects −Countries with a history of higher regulatory quality or stronger prior regimes experience larger effects −Implementation and enforcement matter for regulatory outcomes −Results are not consistent with notion of “catching up” Initial conditions matter  reflect forces in the country −Countries past track record matters when new regulation comes −There is a reason why some countries have weaker regulation −Illustrates the difficulties that EU and global convergence efforts face

14. Slide 14 What explains the differences across countries? Countries do not endow regulators with same powers Some countries set lower penalties −There is huge variation in penalties Countries differ in the extent to which they take enforcement actions Countries pass regulation but do not commit the necessary resources −Staff at securities regulator as a proxy for resources −Some countries exhibit substantial increases in staff

15. Slide 15 New approach to global reporting convergence Status quo: −IFRS are set to become the global accounting language −Considerable heterogeneity in the implementation and enforcement of IFRS −Discretion in IFRS implies that firms’ reporting incentives matter greatly for observed accounting practices Research findings are consistent with the notion of reporting incentives and differences in the implementation of IFRS around the world True reporting convergence requires convergence in countries’ institutional frameworks −Unlikely, in particular, with respect to legal enforcement Global reporting convergence and comparability of practices requires global implementation and enforcement −Focus on those firms for which there is a strong demand for comparable reporting practices

16. Slide 16 Global Player Segment (GPS): Basic idea Voluntary participation to exploits self-selection and need for commitment −Attract firms that have strong reporting incentives in the first place −Segment should be attractive to firms with international shareholder base, that raise finance internationally, and operate in many countries Two additional mechanisms to improve reporting convergence −GPS firms need to be approved by administrating body (e.g., governance requirements) −GPS requirements and enforcement mechanisms improve reporting quality Segment is operated by an supranational body (several options) −IOSCO at the global level; ESMA at the EU level −New body that is part of the IASC Foundation Private contracting solution that does not involve cross-listing −Segment does not create competition for existing exchanges −Firms can concentrate their liquidity and trading in one place and still be part of the segment

17. Slide 17 Global Player Segment (GPS): Requirements GPS firms are required to use IFRS Filings and reporting are reviewed by GPS staff −Comment and review process −GPS staff can request additional information Firms have to satisfy additional disclosures in areas that are closely related to firms’ reporting incentives −Ownership structure −Related-party transactions −Compensation practices −Internal controls and risk management

18. Slide 18 Global Player Segment (GPS): Enforcement Mechanisms Firms have to use an approved GPS auditor −Registration with GPS to assure auditor is qualified −Notification requirements with GPS GPS posts enforcement actions against a firm GPS can drop a firm from the segment Membership agreement grants GPS the right to conduct on-site inspections in certain circumstances In addition, firms could be asked to post a monetary bond up front (e.g., escrow account)

19. Slide 19 Concluding remarks Convergence is easier demanded than achieved Corporate reporting practices are unlikely to converge in the near future GPS as an alternative approach −Align reporting practices for “coalition of the willing” GPS highlights the limits to global reporting convergence and what it might take to achieve it

21. Slide 21 Results in Daske et al. (2008) 21

22. Slide 22 Securities Regulation in the EU

23. Slide 23 Effects of Tighter Securities Regulation When Prior Regulation or Implementation Differs

24. Slide 24 Initial Conditions & Implementation 24

25. Slide 25 Average Staff Changes in High Staff Countries

26. Slide 26 Global Player Segment (GPS): Financing Member firms pay an annual fee −Just having firms pay has obvious limitations Audit firms pay a fee to be approved GPS auditor Exchanges pay a fee as they benefit from GPS certification IASC Foundation could raise funds as the segment contributes to the reputation of IFRS Financial services firms that create products based on GPS firms (e.g., an index) pay royalty fees