Some obstacles to global financial reporting comparability and convergence at a high level of quality part 2

Some obstacles to global financial reporting comparability and convergence at a high level of quality

part 2

1.2. Accounting culture

Now we turn to the accounting culture. The impact on accounting of the cultural value of fixating on the minimisation of the income tax burden played a significant role in the choice of financial reporting practices in many continental European countries until recent times, yet it may linger for years to come. A contemporary example is that asset impairment losses are tax deductible in Germany but not in the UK (Nobes, 2006, p. 235). Would that influence a company in the UK not to recognize an impairment loss, using its judgment appropriately, as opposed to a German company that might like the tax deduction and therefore may be willing to show the loss in its financial statements? In this respect, the tax mentality could continue to have an influence.2 Traditionally in those countries, companies were focused on reducing taxable income and therefore took advantage of options to report a lower accounting income. Such choices leading to a conservative result may still be those that were made when taxation was linked to financial reporting. Yet they are no longer relevant for today’s consolidated financial statements.

How long will it be before this mentality changes, when executives come round to believe that the lower accounting income option is not necessarily the best option, that the proper option should be the one that reflects the company’s economic reality?

For another example, consider the use of percentage of completion accounting, or stages of completion accounting, for long-term construction contracts. Until recent times in some countries, percentage of completion accounting was not used, because no company wanted to be taxed any earlier than it had to be. Therefore, companies would wait until the contract was well along or actually completed before recognizing revenue. Now, however, taxes are not an issue in the preparation of the company’s primary (i.e. consolidated) statements, but the company’s management may still be reluctant to adopt the stages of completion approach because of the traditional way of thinking about financial reporting in its country. This manner of thinking is likely to change gradually with the passage of time.

Then there is the matter of increasing complexity in company financial reporting. In particular, prior to 2005, company financial statements, especially those in Europe, were less detailed and therefore less daunting to read and digest. A recent study by the global firm of Ernst & Young of 65 European companies using IFRS in 2005 reported that there are now some 2000 disclosure requirements, which was about twice the number under UK and Australian GAAP and four times the number under French GAAP (IFRS: Observations on the Implementation of IFRS, 2006, p. 14).

The European companies’ financial statements studied by Ernst & Young were 20–30% longer than the financial statements for the same companies in 2004. The standards, too, are growing in length. The textual content of IAS and IFRS in 2006 consumed approximately 2300 pages. In 2000, it extended to only 1200 pages (IFRS: Observations on the Implementation of IFRS, 2006, p. 14). The issue of principles vs rules has been raised as to whether IAS/IFRS are inexorably, inevitably, moving in the direction of more rules and away from a focus mainly on principles, as reflected in the increasing length and greater detail of the IASB’s pronouncements, including the basis for conclusions and the implementation guidance which regularly accompany the standards.

1.3. Auditing culture

Then we may enquire into the auditing culture.

There is a different auditing culture among countries even though, apart from the USA, auditing and assurance standards are issued by a single body at the international level. In some European countries, for example, there has been an inclination of the auditor not to issue a qualified report if the company’s financial statements departed from national accounting standards. I saw instances in the 1990s where the external auditor, aware that the company was not following the statutory accounting and disclosure requirements, did not issue a qualification even when the difference was material. In some countries, apparently, the external auditor is more ‘flexible’ in such matters. Cairns (2001) found that companies and their auditors often did not draw attention to departures from IAS when the company asserted that it was adhering to IAS (chaps. 15–16).

There are, to be sure, countries where auditors have given a qualification because the company was, in one or more material respects, not following national standards or IAS. Yet, in other national settings, no qualification was given because there may have been a sensitivity, or anxiety, over an auditor publicly questioning a major company for its choice of financial reporting methods.

This reflects a different mentality, a different auditing culture, across countries and therefore could lead to a diminution in comparability, especially if a company knows that it can depart from IFRS without having to suffer an auditor’s qualification. Because of differences in auditing culture, companies may be more willing to depart from the IASB’s standards and interpretations in certain countries than in others.

In some countries, there may be a deeply held view or value that accounting choice should be responsive to a company’s ‘circumstances’. An interesting question is: how does one define ‘comparability’? There are those who believe, and many have believed this for a long time, that comparability is promoted, or assured, by all companies being required to use the same accounting methods, that is to say, ‘standardisation’ or ‘uniformity’ of method. On the other hand, there are those who argue that there must be some options available to take into consideration differences in ‘circumstances’ among companies or among countries.

An anecdote may be instructive. In the 1950s and 1960s, there was a raging debate in the USA about whether uniformity or flexibility of accounting method better promoted comparability (Uniformity in Financial Accounting, 1965). There were major accounting firms, such as Arthur Andersen, which avowed that, without uniform accounting methods across companies, comparability could not be achieved. Other firms, such as Price Waterhouse, now part of PricewaterhouseCoopers, and Haskins & Sells, now part of Deloitte & Touche, disagreed. They insisted that one must take into consideration the individual ‘circumstances’ of the company when choosing the appropriate accounting method.

Early in the 1960s, I went to an Arthur Andersen partner and asked for his view about companies using either the FIFO or LIFO method for merchandise inventories. He said that it would defeat comparability if one of two companies that were otherwise identical were to use FIFO, while the other used LIFO. Then I asked the same question of a Price Waterhouse partner, after having told him what the Arthur Andersen partner had said, and his reaction was predictable. He replied that there were no two companies that were ‘otherwise identical’, that differences in ‘circumstances’ inevitably exist among companies, which necessarily justify the use of different accounting methods to achieve genuine comparability.

The debate in the USA was never resolved: whether uniformity or flexibility, without options or with options, better produces comparability. The Securities and Exchange Commission (SEC), however, has consistently supported uniformity. This is an unsurprising view for a regulator.

Two examples might serve to illustrate the argument advanced by those who prefer an attentiveness to ‘circumstances’. Think about a company that owns long-lived depreciable assets, most of whose usefulness and benefit comes in their earlier years of life, and it accordingly uses an accelerated method of depreciation,

by which more of the depreciation is recorded in the earlier years and less in the later years, as opposed to the straight-line method. Advocates of an attentiveness to circumstances would argue that the company should not use the straight-line method, because the greater amount of revenue expected from using the depreciable asset is expected in the early years—it will be used more intensively at the onset than at the end. So, allowing companies an option to use either of the two methods makes sense. Yet New Zealand had a requirement in the 1970s that all companies must use the straight-line method, evidently in the belief that the use of one method by all companies would assure comparability.

Suppose, as another example, a company is considering use of the ‘average’ method of computing inventory cost, as opposed to FIFO. This company, let us say, is in the chemicals industry and receives liquid chemicals that are poured into a vat, a big container, and then would be withdrawn following immersion and mixing.

Advocates of flexibility would argue that FIFO does not make much sense for such a company, and perhaps the average method would be more justifiable. On the other hand, if a company manufactures cigarettes and receives tobacco leaf from its suppliers, perhaps FIFO—because of a demonstrable FIFO flow of the raw material—could be more easily defended, and the average method might not make as much sense. Therefore, in the eyes of flexibility advocates, different circumstances, in view of the nature of a company’s operations, might justify one option over another. But others would argue that the existence of options impedes the attainment of comparability. This becomes a philosophical question: what fitting of accounting methods to circumstances promotes genuine comparability?

The question is whether the same method to be used by all companies around the world produces ‘genuine’ comparability or ‘superficial’ comparability. This is a debate that has not been adequately taken up in our literature.

Referring to the simplistic desideratum that ‘like things should look alike, and unlike things should look different’ does not address the essence of the conundrum of accounting comparability and how it is to be achieved.

To Be Continued