Some obstacles to global financial reporting comparability and convergence at a high level of quality part 4

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

part 4

2. Convergence

Let’s talk about convergence.

‘Convergence’ is a term that gained currency in our field in the late 1990s. The earlier term was ‘harmonization’, which was used during the first quarter-century of the International Accounting Standards Committee (IASC), beginning in 1973. Today, the IASB, the FASB, and other national standard setters regularly use the term convergence, which means the increasing compatibility of their respective standards at a high level of quality.4 Of great importance today is the ongoing convergence between the IASB and the FASB because of the great significance of the US capital market to the future of IFRS. I will have something to say about that in Section 2.5.

2.1. Problems of interpretation

There are problems of interpretation, because interpretations are necessary to the effective application of the standards and therefore to the achievement of comparability. The IASB has created the International Financial Reporting Interpretations Committee (IFRIC), a body that proposes official interpretations subject to approval by the IASB. But then there are the regulators which conceivably could issue their own interpretations, making the application and implementation of IFRS different in one country than another.

To counter a state-by-state approach to interpreting IFRS, CESR, working together with the European Commission, is trying to promote coordination among regulators in Europe. IOSCO is doing the same around the world, trying to coordinate the work of the national regulators.

There are no international, or pan-European, regulators of the securities markets. There are national regulators only. So, without the efforts of coordinating bodies such as CESR and IOSCO, we could well be confronted with different interpretations in one country than another. Yet the Australian Securities and Investments Commission (ASIC) has formed a Financial Reporting Panel to give advice on contested interpretations of IFRS as between ASIC and companies it regulates, which could potentially be a source of Australian-only interpretations.

2.2. Problems of language

Language could be a problem when translating IFRS from English. As an example, when the Fourth Directive was approved in 1978 by the European Economic Community (EEC), as the EU was then known, it included the all-encompassing requirement that the accounts give a ‘true and fair view’, which was a British concept, and it was translated into the languages of all of the EEC countries into the closest equivalents to a ‘true and fair view’.5 But the concern was not just the accuracy of the translations. It was more a matter, in each of the other countries, of whether accountants and finance directors understood the concept. It was a totally new concept, only partially understood or not understood at all in most European countries. In some countries, it seems to have been ignored altogether, while in others attempts seem to have been made to follow it. Yet perhaps the only country in which it really has been followed is the UK.

Thus, if one takes a concept embedded in the accounting traditions in one country but that has never been known or applied in another, even if it is translated as accurately as practicable into the language of the second country, the concept may not be understood. The words may be understood, but the concept may not be understood. The same may be so, at least for a time, for elements of IFRS, which represent new concepts, or which address problems that have rarely if ever occurred in many national cultures even though the words are being translated into their national language.

2.3. Problems of terminology

As an example of different national interpretations placed on common terminology, an interesting question surrounds the term probability. The words ‘probability’ and ‘probable’ appear many times in IFRS, but do they mean a 60%, 80%, or 90% likelihood? The Germans may make a conservative estimate of probability, while others may adopt a lower, or less strict, percentage as the equivalent of probability.6 What is meant by ‘probability’ or ‘probable’? ‘More likely than not’? These terms can be defined or interpreted differently from country to country and therefore can impair international convergence and comparability.

2.4. Adjusted earnings measures

An interesting practice that has recently been brought to light, which can dilute convergence, is the practice by many European companies to go over the heads of the IASB to adopt novel measures of profitability for the edification of financial statement readers. The Ernst & Young study referred to earlier, which studied 65 European company annual reports for 2005, found that nearly a third of the companies reported an ‘alternative earnings per share’, including in its numerator an adjusted earnings measure, which in the USA we call ‘pro-forma earnings’. These are measures of earnings that, in the main, have had the effects of certain one time charges removed, thus producing a smoother year-to-year trend. The Chairman of the IASB, Sir David Tweedie, calls these adjusted measures ‘earnings before the bad stuff’. The companies add back restructuring costs, the cost of litigation settlements, and impairment losses, and they eliminate the losses and gains on the disposal of fixed assets (see IFRS: Observations on the Implementation of IFRS, 2006, p. 13).

These companies have devised a ‘bottom line’ which they regard as an estimate of long-term earnings. Such an adjusted measure is not disallowed by IFRS. Of the companies in the Ernst & Young study adopting this reporting practice, most were UK and French companies.

2.5. The role of the SEC

We now turn to the SEC.

The cooperation of the SEC is central to the success of the IASB’s aim to secure the acceptability of its standards in all of the major capital markets. One of the goals of convergence has been to persuade the SEC to respect IFRS as the equivalent of US GAAP. It is hugely important to the IASB to get the SEC on board in support of IFRS so that there will no longer be the need for foreign registrants in US capital markets to reconcile IFRS to US GAAP. In order to determine whether overseas companies were fully adhering to the spirit and letter of IFRS, the SEC looked forward to receiving the first batch of IFRS financial statements for 2005.

Expecting some 300 foreign companies publicly traded in the USA to be filing their IFRS financial statements for 2005, the SEC was taken aback when it received only about 40 financial statements where both the company and auditor affirmed compliance with IFRS as published by the IASB. This shortfall troubled the SEC, as it had expected to be able to examine a ‘critical mass’ of IFRS financial statements to ascertain whether companies were indeed complying fully with all of the IASB’s standards and interpretations.

The SEC’s staff reviewed the 2005 IFRS financial statements, and, as usual, they raised questions about companies’ interpretations, application, and implementation of IFRS. The SEC wrote ‘deficiency letters’ to the finance directors of companies in those countries, some of whom reacted quite negatively, because they had not received such strong letters before from a securities market regulator (see Sukhraj, 2006). They believed that the SEC was imposing its own interpretations of IFRS.8 Yet the SEC had been sending similarly strong letters to US-based companies in regard to US GAAP for many years.

In 2006, the SEC agreed with CESR on a work plan to coordinate with European securities market regulators.9 Accordingly, it has communicated with regulators such as the Financial Services Authority in the UK or Consob in Italy in order to share experiences at a general level. Only where the SEC has questioned the accounting used by a foreign registrant and has learned that the regulator in the country where the registrant is based has taken a different position than the SEC’s, will the SEC discuss the specific company’s accounting with the regulator. Once the SEC has become fully apprised of the other regulator’s view, and if there remains a difference of opinion that cannot be resolved, it will declare its own norm on the issue and order a restatement. This could mean that, as a practical matter, the SEC’s interpretations of IFRS may become ‘de facto’ interpretations around the world because of some of the 300 IFRS-eligible multinationals publicly traded in US securities markets and therefore subject to the supervision of the SEC.10 This is a sizeable bloc of important companies, a circumstance which animates a great deal of concern both in Europe and at the IASB over the potential impact of the SEC, a kind of ‘extra-territorial sovereignty’.

In 2005, the SEC agreed a ‘road map’ with the EU to set in place a definitive process for dropping its reconciliation requirement for foreign companies adopting IFRS (see Nicolaisen, 2005).11 In June 2007, the SEC formally proposed a rule ‘to accept financial statements prepared in accordance with the English language version of IFRS as published by the IASB without reconciliation to US GAAP’.12 If the SEC’s rule is eventually issued, which is highly likely, it is expected to apply to foreign companies’ 2008 financial statements.

Another specification by the SEC in its rule proposal is that, ‘in order to be eligible to omit the reconciliation, [a company] would be required, in a prominent footnote to its financial statements, to state unreservedly and explicitly that its financial statements are in compliance with IFRS as published by the IASB.

In addition, in its report, the independent auditor must opine similarly on whether those financial statements comply with IFRS as published by the IASB.’13 Clearly, the SEC wants to see a literal affirmation by both companies and auditors of adherence to the IASB’s standards and interpretations.

One should take note of the SEC’s important qualification in its rule proposal: ‘the English language version of IFRS as published by the IASB’. As observed elsewhere in this paper, in the EU and in many other countries that have also signed on to the use of IFRS, companies and auditors refer to endorsed IFRS or to national GAAP, but not to ‘pure’ IFRS, that is, the precise version published by the IASB in the English language. It is interesting that audit firms in the UK now give two opinions on some listed companies’ financial statements: on compliance with ‘IFRS as adopted by the EU’ (required by the IAS regulation of 2002) and on compliance with IFRS. Jurisdictions around the world are reserving to themselves the right to tailor the IASB’s official rendering of IFRS to their own legal and other circumstances, including an accommodation to political pressures (see the next section). One can verily say that, while the IASB was intended to be a retailer of accounting standards, it has become, in large measure, a wholesaler. To address this problem of jurisdictional variations, the IASB decided in July 2007 to expose a proposed revision of IAS 1 to require an entity that ‘is not able to make an explicit and unreserved statement of compliance with IFRSs’ as published by the IASB, to describe each such difference from ‘pure’ IFRS as well as ‘how its reported financial position and performance of the entity would have differed if it had complied with IFRSs’.14 Does this proposal portend the imposition of a kind of ‘qualitative reconciliation requirement’?15 After the SEC drops its reconciliation requirement for foreign companies adopting IFRS, it will be no less of a force in the work of the IASB and IFRIC, and its firmly held views on the proper interpretation, application, and implementation of IFRS will continue to have repercussions overseas. The much stricter regulation of financial reporting in the USA stands in stark contrast to that in virtually all other countries.

There are still options available to IFRS adopters that are not available to companies using US GAAP, such as the revaluation of property, plant, and equipment, the revaluation of investment properties, and the valuation of certain biological assets. In time, these will likely be ironed out in the convergence process. Until they are, it is not clear what disclosures the SEC might impose on foreign companies that adopt these options, giving rise to material differences between US GAAP earnings and IFRS earnings, as well as between other key accounting numbers.

The SEC also announced, in April 2007, that it plans to issue a concept release to explore the possibility of allowing US-based companies to adopt either IFRS or US GAAP after the reconciliation requirement is dropped.16 It approved the concept release unanimously on 25 July 2007, which limits the IFRS option to IFRS as published in English by the IASB.17 A considerable number of US-based multinationals have many overseas subsidiaries that are required to use IFRS, and they would find it much less costly to be able to issue their consolidated statements also in IFRS. One can verily ask if, once the SEC were to allow US-based companies to use either IFRS or US GAAP, what will become of US GAAP and the FASB? That the SEC has no intention of witnessing the disappearance of US GAAP is evidenced by its decision announced on 27 June 2007 to form an Advisory Committee on Improvements to Financial Reporting. The membership of the advisory committee was announced on 31 July 2007 and represents ‘key constituents in our capital markets’.

In the announcement release, SEC Chairman Christopher Cox grandly said that he is counting on the advisory committee to ‘recommend improvements that will keep America’s financial reporting system as the gold standard for the world’.18 One of the major issues it will address is the complexity in US GAAP, which will be a daunting assignment in a country as litigious as the United States.19

2.6. The impact of politics Another issue that one must take into account is politics.

Companies place pressure on the IASB just as they have over the decades on the FASB. It has happened for financial instruments in a big way, coming from the French banks. If powerful companies or banks find that they are unable to persuade the IASB to their side on a pending matter, they will redirect their persuasive efforts towards the European Commission, the Accounting Regulatory Committee (ARC), the European Financial Reporting Advisory Group (EFRAG), the European Central Bank, or the European Parliament.

Both the ARC, which represents the EU’s member states, and EFRAG, whose Technical Expert Group is composed of accounting specialists in the private sector, advise the European Commission on the political and technical acceptability, respectively, of the IASB’s standards and interpretations. A new body was established in 2006 to monitor EFRAG, called the Standards Advice Review Group (SARG), which is intended to satisfy potential critics that EFRAG’s judgements are balanced and objective, whatever that means. SARG could also become the object of political forays.20

There are many places, nationally as well as internationally, to which financial statement preparers can go if they possess considerable political leverage and the determination to use it. In France, the power of the banks was so great that the President of France made a public statement in July 2003 critical of the IASB’s proposed standard, IAS 39, on financial instruments.

There is a differing likelihood of politicking on accounting issues from one country to the next. In the USA, which is known for political activism and confrontation, it is very high. In the Congress, whose members and staff know virtually nothing about the technical aspects of accounting and financial reporting, they nonetheless are aware of which petitioners for relief from proposed accounting standards have contributed money to support their election campaigns. An aggrieved company executive comes in and says: ‘Remember my financial support during your re-election campaign?’ and the member of Congress replies, ‘Yes’, and then the visitor says, ‘Now we need a favour from you. We need you to stop the SEC from enforcing a proposed FASB standard’. While members of Congress cannot prevent the FASB, a private-sector body, from issuing a standard, they can introduce legislation ordering the SEC, a governmental agency, not to require companies to follow the standard if it should be issued. Even a threat of such legislation can be enough to turn the tide. This is effectively a means of stopping the FASB. In the USA, companies have appealed to members of the Congress a number of times on financial reporting matters (on the investment tax credit, on oil and gas accounting, on employee share options, on financial instruments, and on business combinations, among others). If the FASB does not heed companies’ strongly felt criticisms of a proposed standard, it is quite possible for the companies to appeal to one or more members of Congress to achieve their aim.

If companies’ attempts to influence the thinking of the IASB do not meet with success with some regularity, it is possible for them and other interested parties (including the European Commission) to try to persuade the trustees overseeing the IASB to approve a broadening in the composition of the former’s membership, thereby bringing in more trustees believed to be sympathetic to their views, or to approve an increase in the majority of votes required by the IASB to approve a standard. Recently, the trustees effectuated both of these changes.

So far, the lion’s share, if not the entirety, of the politicking of the IASB has come from within the European Union and Switzerland. The EU represents a substantial bloc of countries, currently 27, and several other countries (for example, Norway) cooperate with the EU. The EU’s some 8000 listed companies represent more than half of all of the listed companies currently adopting IFRS or IFRS-like standards around the world.

Moreover, the IASB is based in the EU, in London, in close proximity to the seat of the European Commission and EFRAG, in Brussels. Interested parties in the EU seem to regard the IASB as their ‘neighborhood standard setter’. Will the political lobbying which emanates from special interests within the EU be congruent, or clash, with the special interests of important companies and countries based elsewhere in the world? Will such politicking contribute to national GAAPs that differ from IFRS or to ‘IFRS as adopted by the EU’ that differ from ‘pure’ IFRS, which in turn would lead to a dilution in convergence and international comparability?

Politicking within the EU has erected a possible obstacle to the endorsement of IFRS 8, on accounting for operating segments, a standard published by the IASB in November 2006 and which was closely patterned on an FASB standard. The EU’s elaborate endorsement process during 2007 has so far given rise to a non endorsement motion introduced in the European Parliament. As a result, the European Commission has sought responses to a questionnaire on the ‘potential impact’ of the standard and is to report its findings to the Parliament by September 2007.21 The sometimes drawn-out process of endorsement in the EU and in other parts of the world can bring about non-comparability across borders solely because of prolonged time lags in the adoption process. The dissent over IFRS 8 has raised afresh, especially in UK circles, the issue of whether convergence between the IASB and the FASB mainly means importing US GAAP into Europe and therefore whether convergence between the two bodies is a good thing for Europe.22

A current controversial draft standard at the IASB, which has become politically sensitive to many European companies, is a revision of IAS 1, on the presentation of financial statements, which involves the issue that we in the USA call ‘other comprehensive income’, that is, the treatment of unrealised gains and losses on the sale of ‘available for sale’ securities as well as on certain foreign exchange translations, which go into the shareholders’ equity section of the balance sheet instead of into the income statement. The aim of the standard setter is to accord these gains and losses greater prominence and thus display them in a statement that reports on financial performance.

The IASB favoured a single statement, called a ‘Statement of Recognised Income and Expenses’, to report on financial performance. It would be the regular income-statement figures plus or minus all of these unrealised gains and losses, that is, those not yet evidenced by a market transaction, which are currently lodged in the shareholders’ equity section of the balance sheet. But European companies applied pressure on the IASB, arguing that such a presentation would mislead readers into thinking that this combined (‘comprehensive’) measure could be used as the basis for predicting future earnings. The companies persuaded the IASB to allow the combined measure to be placed on a different page than the one on which the traditional earnings appear.

To me, this is a bit ridiculous, as readers are capable of turning the page. But it was important to the companies.

Therefore, in its exposure draft, which was issued in March 2006, the IASB said it would permit companies the choice of reporting these items in one statement or two: a Statement of Recognised Income and Expenses alone, or this statement plus another one, which enables companies to put the second one on a different page, thus, they hope, according it less prominence.23 This kind of pressure on the IASB risks taking a step backward from convergence and comparability.

Comparability would be achieved if all companies were to present only one statement, which is the IASB’s preference. The choice of one presentation vs the other is not one that reflects different circumstances among companies. This is an example of self-interested lobbying that currently confronts the IASB.

To Be Continued