IAS – the only real contender
As recently as 10 years ago, harmonisation of accounting standards in Europe, let alone the rest of the world, seemed a distant dream. The detailed accounting requirements in some European countries were as diverse and distinctive as the countries themselves and many countries were prepared to fight hard to defend their own generally accepted accounting principles (GAAP) – it was a matter of national pride, tradition and sovereignty.
Most European territories have had their own comprehensive accounting requirements for many decades. Finding a path towards one common approach was never going to be an easy task. With the formation and development of the Common Market, Europe began the difficult task of moving in the same direction. But progress was slow, and often any development seemed to achieve little real harmonisation.
At the beginning of the new Millennium, the picture has changed dramatically and pragmatism is making headway against nationalism. Today, the world-wide impetus for harmonisation of accounting is emanating strongly from Europe. It is a force that the rest of the world cannot afford to ignore.
Early harmonization
The journey towards European harmonisation began with the introduction of the 4th and 7th European Company Law Directives – widely known as the European Directives – which dictate the range of allowable accounting policies for companies in European Union countries. (Banks and insurance companies have their own specific Directives as they are regarded as special accounting cases).
The Directives were introduced in the late 1970s and early 1980s and underpin accounting practices across Europe. In practice, however, the degree of harmonisation they could achieve was, in the EC«s own words, »base level«. To be effective at a national level, the Directives» had to be transferred to national company law, a process that requires intensive due process and is, in all countries, time consuming and slow. The Directives also allowed sufficient interpretation to encourage continuing differences between national GAAP in different European countries.
After 15 years under the Directives, real harmonisation still seemed a long way off. The GAAP 2000 survey carried out by the big firms shows that there are still very significant differences between national GAAPs, as well as between national GAAP and IAS. In addition, a PricewaterhouseCoopers survey carried out in late 2000 confirmed that the vast majority (68%) of over 700 listed companies in the European Union and Switzerland were still using one of 16 different national GAAPs. However, a new trend was apparent with 19% of chief financial officers (CFOs) questioned using IAS and, worryingly for some Europeans, a further 8% were already using US GAAP. Germany, for instance, allows companies to use US GAAP or IAS for their group accounts as long as they also comply with the European Directives.
Fundamental differences
In fact, some European multinationals have been reconciling to US GAAP for years in order to gain a US stock exchange listing. This practice has highlighted some enormous differences between the accounting regimes of different continents, as Daimler-Benz famously discovered in the mid-1990s when it reported a healthy profit under German GAAP and a huge loss under US GAAP during the same financial year. By the late 1990s there was a real possibility that US GAAP could become a widely used accounting language in Europe.
In 1995, the European Commission made its first announcement that it intended to encourage the use of a single body of accounting standards in Europe. That set of standards, it was assumed, would be International Accounting Standards. But while the announcement was generally welcomed, progress towards practical application of the proposals remained slow.
A few countries recognised the benefits of allowing the use of IAS so that companies could have internationally comparable results. Four countries in the European Union – Austria, Belgium, Finland and Germany have so far allowed their multinational companies to use IAS for domestic reporting instead of national GAAP. Companies elsewhere in the EU can choose to use IAS for their own internal financial reporting purposes or to present additional IAS data when they are seeking funds from international capital markets. But this is an extra cost if they are also required to file accounts in accordance with their national rules.
The forces of change
New developments, however, soon gave European harmonisation renewed urgency. First of all, a viable body of international standards was at last emerging with the resurgence of the International Accounting Standards Committee. The IASC made an historic agreement with the International Organisation of Securities Commissions (IOSCO) in 1995 and when it delivered its promised core standards in late 1999, IOSCO endorsed them for use on member stock exchanges and the IASC's future as the accepted world-wide standard setter seemed certain. The subsequent restructuring into the International Accounting Standards Board (IASB), an independent foundation run by trustees and consisting of full-time standard setters, has reinforced its position.
More importantly, the IASB's objectives and mandate shed light on the real motive behind the restructuring – global harmonisation in one way or another. Seven members of the new board have specific liaison roles with national standard setters and the grand idea is that many standards will be developed in partnership and introduced into IAS and national GAAP simultaneously. At last, the prospect of acceptable world-wide standards is a reality.
The European Commission, along with much of the rest of the world, now sees a respected and independent international standard setting process in place. But that factor alone did not begin the rush towards IAS adoption. The trigger for a sudden change came with the Portuguese presidency of the European Union in 2000. Discussions about an Action Plan for Financial Services and Financial Markets confirmed the strategy for a single European capital market, with one set of rules for companies listing on a European stock exchange. Within this initiative, a vital step in integrating Europe's financial markets is the production of easily comparable statements of company results.
The same period saw another event put pressure on the EC to take decisive action on IAS. Ironically, that event was the approval in November 1998 of the IASC's most unpopular standard, IAS 39 (Financial Instruments), which is applicable this year. That standard introduced fair value reporting for many financial assets and required some fair value changes to be taken to the income statement. IAS 39 created a particular problem in Europe because it directly contradicted the Directives, which rely heavily on historical cost accounting and do not allow fair value gains in the income statement.
The implications of IAS 39 were immense. Any European territory that wanted to continue to require or permit IAS, or indeed US GAAP (FAS 133 is similar to IAS 39), could not because their accounts would not comply with the Directives. Europe was faced with a clear choice: depart from IAS or change the Directives. The EC opted to change the Directives and in May this year, the European Parliament approved changes to the 4th Directive to enable companies and banks in the EU to follow the controversial IAS 39. Under the amendment, member states may permit all or some categories of companies to value specified financial instruments at fair value.
The magnitude of this change cannot be underestimated. It is the first time that European company law has been altered to comply with IAS – an important signal to the rest of the world.
Decisive action required
These combined forces – the improved viability of IAS and the Action Plan – were enough to persuade the European Commission that it was time to make a decisive move. In May 2000, it announced plans to require all European listed companies to use IAS that has been checked for suitability in their consolidated accounts by 2005 – a move that will affect 6,700 companies, including some banks and insurance companies. The EC also proposed that member states should be given the option of extending the ruling to unlisted companies and individual accounts.
The EC's decision to require the use of IAS is a landmark. The proposal gained strong support almost immediately. A survey published by PricewaterhouseCoopers showed that 79% of European CFOs supported the plan and 75% said that they would consider adopting IAS ahead of the 2005 deadline.
In July 2000, the EU finance ministers approved the EC«s plans and urged the EU executive to hand in a legislative proposal that would enable the recognition of international standards »as soon as possible". In February this year, the draft regulation was produced and will have its first reading in the European Parliament this September. The regulation, which will be immediately binding in all member states, could be adopted as early as February next year, though it is likely to take a little longer.
As part of the move towards IAS, the EC was also keen to ensure that the new standards would have legal certainty in Europe. Thus an endorsement mechanism for the standards was proposed that would allow the EC to work with the private sector in assessing the technical quality of existing and new standards.
That endorsement mechanism recently became more of a reality. As promised, it is a two-tier system. The Accounting Regulatory Committee, chaired by the EC, operates at a political level. The private-sector European Financial Reporting Advisory Group (EFRAG) and its supervisory board are funded by a mixture of business, the accounting profession and the «users» of accounts. EFRAG itself largely consists of European standard setters, preparers and the accounting profession and will provide the technical expertise, acting as technical liaison between the IASB and the EC and «vetting» the standards before they are adopted in Europe. Its supervisory body is drawn from the wider professions and includes three PwC partners as members.
Exponential growth in IAS
In spite of some concerns about how the endorsement mechanism will operate and some noisy resistance to the adoption of more fair values, the underlying forces driving Europe towards IAS are strong. Europe is sending a signal to the rest of the world that it is behind IAS and moving quickly to adopt the standards on a widespread basis. But Europe is not alone. Already, there are many countries outside Europe that base their standards on IAS and some, such as Singapore, are using IAS unchanged but with delayed implementation. Others, such as Australia, are converging their national standards with IAS so, for example, compliance with Australian GAAP will be little different to IAS.
By 2005, the number of listed companies in full compliance with IAS will have grown exponentially. And when many of the largest multinationals in the Asia Pacific and all of Europe«s big multinationals are complying with IAS, ignoring these standards simply won»t be an option – analysts, investors, stakeholders and companies everywhere will need to understand them.
The faster Europe and others move towards IAS, the greater the pressure on the rest of the world to harmonise standards so that financial information in, say, Europe is directly comparable with financial reporting in the Americas or the Asia Pacific. All national standards may not have exactly the same words, but harmonisation should mean that they do have the same end result. Those of us in Europe are more convinced than ever that IAS will become the universal common language for financial reporting, and that the new IASB structure will ensure that the standards are of a very high quality.
As the quality and consistency of IAS is ensured, the objections of the US Securities and Exchange Commission and others to the standards without supplementary reconciliations are likely to reduce and, at the right moment, should be challenged. European companies will be less willing to go to the expense and effort of reconciling their accounts to US GAAP, for instance, if they are already using a high quality, internationally recognised set of standards. With the rapid development of capital markets in Europe and elsewhere, it may also be easier for companies to find sufficient capital outside the US and this could have an impact on US investors. The regional use of IAS in Europe also raises the possibility of companies from outside the region finding themselves at a competitive disadvantage if they are still using a national GAAP because it is likely to be less well understood by analysts, investors and other stakeholders.
The US has much to contribute to this debate. If the profession across the world works as a partnership, we can learn to forget the differences in our accounting histories. If we work together, a single international set of financial reporting standards can become a driving force behind easy access to all of the world's capital markets.
Ian Wright leads the Global Corporate Reporting Group at PricewaterhouseCoopers.
He can be contacted by phone +44 (207) 804 3300 or e-mail ian.d.wright@uk.pwcglobal.com