Why IASs Reflect Economic Reality

Vladimir Vorushkin

Introduction

In their case for Russia’s move to International Accounting Standards (IAS), many foreign experts often claim that, unlike Russian accounting standards (RAS), IASs reflect economic reality. However, some Russian accountants might say that it is not apparent a priori which accounting system (i.e. RAS or IAS) better reflects real economic events. This article sets out specific reasons why the latter view is mistaken. In particular, it investigates how cross-country differences in legal systems and the demand for accounting information, differences in legal protection for external shareholders, and differences in the degree of tax conformity affect the relation between financial accounting earnings and economic reality that underlies those earnings. A special focus will be made on how well a measure of aggregate financial accounting performance (in particular, return on assets) reflects real economic activity at the macro-economic level (as measured by economic indicators such as GDP and GNP) in five industrialized countries with different accounting principles: France, Germany, Japan, the UK and the US. These five countries have been chosen for this study because they represent the principal types of accounting standard setting regimes throughout the world, and they are highly influential in the development of IASs. In addition, UK and US GAAP have some differences from IASs but are based upon the same principles, because they are reporting to external investors. Japanese, German and French accounting traditions, like the one in Russia, historically have been creditor-oriented. Accordingly, the differences with IAS are larger.

Institutional factors

To begin with, differences in countries financial accounting standards in many ways reflect underlying differences in political influences on accounting, which gives rise to «stakeholder» (code-law) and «shareholder» (common-law) models of corporate governance.

Under the stakeholder model reflected in code-law countries (e.g., France, Germany, Japan and Russia), governments (with representation from major political groups such as labor unions, banks and business associations) establish and enforce national accounting standards. Under this system accounting income is viewed as a ‘pie’ to be divided up among the enterprise’s various stakeholders (government, managers, creditors, employees and shareholders). Therefore the demand for accounting income is strongly influenced by the payout preferences of these groups. These groups of stakeholders have incentives to reduce the volatility of accounting earnings. For example, the government prefers to have stable tax receipts, employees prefer stable profit-sharing plan contributions, and banks prefer stable income for regulatory reasons. Consequently, code-law accounting gives management more flexibility in smoothing reported accounting earnings. Also, because of the political influence of each stakeholder group and each stakeholder group’s representation in corporate governance, problems of information asymmetry can be solved through insider communication.

In contrast, under the shareholder model reflected in common-law countries (e.g., the UK and the US), accounting standards such as UK and US GAAP and IASs are developed by the private sector accounting profession, although government regulatory agencies can have considerable influence on this process. Payouts to stakeholders are closely linked to underlying earnings, and stakeholders (other than managers) have less direct influence in corporate decisions and hence less access to inside information about the enterprise. Thus, in the shareholder model the primary purpose of accounting earnings is to meet the market demand for true and fair accounting information to solve information asymmetry problems between managers and shareholders. Since shareholders and creditors operate at greater «arm’s length» from managers, they demand accounting information that reflects the company’s economic performance on a timely basis. Therefore managers in common-law countries have less ‘accounting flexibility’ in exercising discretion in reported earnings than managers in code-law countries. For example, certain accounting practices that can be used to smooth income in code-law countries are not allowed in common-law accounting1 . As a result, accounting earnings in common-law countries are expected to have a higher association with economic reality than those in code-law countries.

A second factor that needs consideration is how well a country’s legal system protects outside investors. Differences in the nature and effectiveness of financial accounting systems across countries can be traced in part to differences in investor protection, as reflected by legal rules and the quality of their enforcement. If a country has strong shareholder protection, investors will be more willing to enter the equity market, the equity market will be large, and the firms will raise much more of their outside capital through equity. An important aspect of shareholder protection is providing meaningful and timely information to shareholders about the firm’s economic performance. When firms have large and diverse groups of external shareholders, a cost-effective way to provide this information is through financial accounting. This benefits not only corporate goverance within an enterprise but also society as a whole as the entire system is more transparent. Thus, financial accounting earnings in countries with strong shareholder legal protection (such as the UK and the USA) are expected to be highly correlated with economic reality.

Alternatively, if the country has strong creditor protection (Germany and Russia, to some extent) but weak shareholder protection, investors are more likely to deposit money in banks than to invest in the equity market (either directly in shares or indirectly via funds). As a result, the country is likely to have an extensive banking investment system but a relatively small equity market, and banks will be the major capital providers. In such an environment, because a few large banks can satisfy most capital needs, a cost-effective way to disclose information to investors is through private contacts. Therefore, financial accounting earnings in these countries are expected to be less highly correlated with economic reality.

In this context, it should be noted that Germany is now transforming itself rapidly into the Anglo-Saxon model. The reason is that the German industry including the banks saw that with the unity of Germany, and with the opening to the East, an enormous amount of capital would be required. Thus they had to provide Anglo-Saxon type information. In addition, by providing the markets with the information they require, the cost of capital is reduced. So society as a whole benefits because capital is more efficiently used (and can be seen to be used).

The third factor is whether a country’s capital market is bank-oriented or market-oriented. In bank-oriented systems (e.g., Japan, France, Germany and Russia), businesses generally have very close ties to their banks, which supply most of their capital needs. Since banks have long-term debt and equity holdings, they also have direct access to company information, thus reducing the demand for published financial statements. Market-oriented systems (the UK and the US), on the other hand, contain numerous diverse investors without direct access to company information. Therefore, investors are likely to rely heavily on financial accounting disclosures to obtain information to be used in security valuation and monitoring management. As stated above, if a few large banks are the major suppliers of capital in a country, financial accounting earnings are less highly associated with underlying economic activity.

A fourth factor is the level of alignment between financial reporting rules and tax accounting rules within a country. Companies have strong incentives to minimize taxes, and if financial and tax accounting must conform, tax considerations may dominate other considerations. For example, under the Russian Government Resolution #552 that is superior to MinFin’s PBUs, enterprises must use statutory depreciation rates for fixed assets and charge general & administrative expenses to production costs for tax purposes. Therefore, Russian accountants prefer to comply with this Resolution and consider it too burdensome to simultaneously follow PBUs on Fixed Assets and Inventories which establish IAS-compliant accounting treatments. In Germany and France, tax considerations force enterprises to use accelerated depreciation and rapid asset write-offs. In both cases, financial accounting income does not reflect underlying economic performance. If financial accounting and tax accounting are separated (as in the UK and the US), firms are able to simultaneously use financial reporting rules to meet the information needs of investors and tax accounting rules to minimize payments to the government. This means that to a large extent reported accounting income of UK and US companies is not affected by tax considerations.

A special note should be given to Japan. Although Japan is technically a code-law country, Japanese financial accounting combines both German and US traditions and is moving away from a «legal» approach to a more ‘economic’ approach (i.e. towards IAS). This is partly due to the fact that the economic crisis in Japan has been made worse by the rigidity of the system, stemming in part from a failure to account properly for the extensive cross holdings and in part from other elements in the lack of transparency. In the first half of the 20th century, accounting thinking in Japan reflected German influences whereas in the second half, US ideas were pervasive. Accounting standards are based on both the Commercial Code and the Securities and Exchange Law, and while the former is creditor-oriented, the latter is shareholder-oriented. In areas that are not explicitly regulated by codified laws, accounting principles are established through business practices and promulgated by the Business Accounting Deliberation Council of the Ministry of Finance. Due to the increasing adoption of US standards, Japanese small investors enjoy an information advantage over their German and Russian counterparts, but the information asymmetries between corporate insiders and small investors are still higher in Japan than in the US.

Like Germany, financial accounting must conform to tax accounting in Japan. However, unlike Germany, taxable income in Japan is based largely on financial accounting rules contained in the Commercial Code, except in cases where the Code does not prescribe an accounting treatment. Therefore, the effect of tax considerations on financial accounting in Japan is less than that in Germany.

Given the above facts, we can assume that the correlation between the financial accounting measure of performance and real economic activity in Japan is higher than that in Germany and France but slightly lower than that in the UK and the US.

Testing of assumptions

The fact that IASs which show considerable similarities with UK and US GAAP reflect economic reality better than Japanese, French, German and Russian accounting standards can be best illustrated by examining correlation coefficients of aggregate return on assets (ROA) and a measure of underlying economic activity in a particular country. The average ROA2 is used as the accounting measure for the following reasons. Firstly, ROA is widely used as a general measure of business performance. It also plays a central role in issues such as anti-trust cases, internal resource allocation, corporate restructuring decisions, managerial compensation schemes, and valuation of closely held companies. Secondly, ROA is less affected by the firm’s capital structure than other general accounting performance measurements, such as return on equity. If return on equity is used, any differences in capital structure across countries or any changes in capital structure over time will result in differences in the accounting measure of performance. Since Japanese, French and German firms are more highly leveraged than UK and US companies, return on equity would not be a comparable measure across the sample firms.

The economic growth rate, which is defined as the percentage change in real GDP, is used as a measure of economic reality. GDP is chosen because it is the most comprehensive measure of a country’s economic activity and because it is not accounting-based3 .

The relation between ROA and the economic growth rate can be briefly described as follows. When the economy is expanding (i.e. GDP is increasing), demand may exceed supply, and selling prices and volumes may adjust more quickly that production costs because many production costs are fixed. Thus, revenues should increase faster than costs and corporate earnings should increase by a larger proportion than production. Companies may increase production capacity (labor and capital) to satisfy increased demand in good economic years. However, they are more likely to hire additional labor to satisfy increased demand first because an increase in labor (a variable cost) is less risky than an increase in capital (a fixed cost). Thus, assets are likely to increase at a smaller rate than production. Based on this assumption, earnings should increase at a higher rate than assets, and ROA is more likely to be high in a good economic year. For similar reasons, ROA is more likely to be low in a bad economic year. In summary, if ROA measured by a particular accounting system reflects economic activity in a timely manner, it should be positively related to the economic growth rate.

Correlation coefficients between ROA and the economic growth rate using GDP are presented in Table 1 below. All the accounting data on a sample of French, German, Japanese, UK and US firms have been collected from Standard & Poor’s Global Vantage database from 1983 through 1999. The data on real GDP have been obtained from Main Economic Indicators, which is published by the Statistics Directorate of the Organization for Economic Co-operation and Development. The high correlations for the UK and the US relative to France and Germany are consistent with the above assumptions.

Table 1

Source: S&P and OECD

There are many factors that may cause a low correlation between aggregate ROA and the economic growth rate even if ROA captures the underlying economic activity of the firm. One factor is that many sample firms are multinationals, and hence their ROAs are based on the performance of both domestic and foreign operations. The economic growth rate, however, is calculated based on GDP that does not account for products and services generated out of the country. If the performance of foreign subsidiaries of sample firms affects these firms’ ROA but is not recognized in GDP, the correlation between ROA and the economic growth rate may be low. To address this issue, the economic growth rate based on real GNP rather than GDP needs to be calculated4 . Correlations between ROA and the economic growth rate using GNP are reported in Table 2 below. The results are similar to those in Table 1.

Table 2

Source: S&P and OECD

As these tests demonstrate, the correlation coefficients for the US and the UK are significantly higher that those for France and Germany.

Conclusion

These results provide evidence that the correlation between financial accounting earnings and real economic activity in a country is related in predictable ways to the legal and economic systems that underlie financial accounting standard setting and the demand for financial accounting standards. The high association for the UK and the US and the low association for France and Germany are consistent with assumptions that accounting earnings in common-law countries better reflect underlying economic events. The same statement is likely to apply to full comparisons on an IAS basis when the figures become available, since they are based on the same principles as UK and US GAAP standards.

Vladimir Vorushkin is ICAR’s Financial Analyst and Translations Manager. This article is based on some of the research for his Ph.D. dissertation entitled «Move to IASs as a Factor of Russia’s Integration into the World Economy» at the International Marketing & International Management Department, MSLU.

The Trustees of the IASB have decided that in future the accounting standards issued will be called «International Financial Reporting Standards (IFRS)». This name will apply to all new standards, with the title for earlier standards «International Accounting Standards (IAS)» gradually being phased out.