Accounting Standards - Essay Example

Convergence of Accounting Standards Business firms publish their company's profitability and financial condition in their various financial and economic reports annually or quarterly. Investors and creditors around the world base their investment decisions in the capital markets in these reports. So, these reports need to be meaningful, transparent and comparable in their content. Since 2001-2002, several US and other countries' corporate accounting scandals have shaken the confidence of the investors on the financial reporting process and it has reflected in the market value if corporate equity securities. The world markets are increasingly converging due to globalization, and there is a constant flow of investments from one part of the world to another. The use of different accounting standards in a highly globalized world has hampered the flow of investment across borders, which drags the world economic growth and security valuations in its turn. As a result there has been a move among the regulatory bodies to converge the accounting standards globally, and steps have been taken towards this aim. Sir David Tweedie, The Chairman of IASB, says that research shows that if companies are familiar with a country's accounting standards, then they would invest more there than if they are unfamiliar with it. Any company entering another country's market has to learn its accounting principles and even then they remain concerned that they may have overlooked at some points. This increases the risk premium and cost of capital, as well as the interest charged on it. This might lead to a company cutting its investment, thus cutting employment and hence cutting its growth. Hence, a common set of international accounting standards becomes very important. (Heffes, Apr 2006) A global set of principles based accounting standards is the final goal of this international convergence in accounting standards. For this purpose the International Accounting Standards Board (IASB) was constituted from the erstwhile International Accounting Standards Committee (IASC) in 2001, to develop high quality common accounting standards for use in the world's capital markets. The IASB has embarked on the project to bring the world's accounting standards closer to a common standard. Of these, the most important is the Financial Accounting Standards Board (FASB) of the United States. There has been a marked difference in the accounting standards of FASB and that proposed by IASB. The latter is propagating a principles-based accounting standard, while the former has been following a rule-based accounting standard. A lot of effort has gone into bringing the FASB to the IASB's line of thinking. And a lot of progress is being made. The UK accounting standards have traditionally been principles based and so have not had much disagreement with the efforts to converge with an international accounting standard, which is based on principles. In this paper we analyze the convergence projects undertaken between the IASB and the FASB, and the UK accounting standards and the International Accounting standards. History The FASB is the private sector standard-setting body in the USA. It was established in the year 1972. The standards that FASB sets put recognition, measurement and disclosure principles to be at the heart of preparing the financial statements. The IASB was created when the erstwhile IASC was restructured. The IASB was delegated the responsibility of producing a single set of high quality, understandable and enforceable IFRS's and to encourage convergence on these standards. The first step taken towards convergence between FASB and IASB accounting principles was the Norwalk Agreement, which discussed how the two bodies could work together to "get rid of the reconciliation between US GAAP and International standards." The second step has been the European Union adopting International Financial Reporting Standards (IFRS), which has meant a 100 or more countries adopting it. (Heffes, Apr 2006) In 2002, the EU approved a regulation, which required all EU listed companies to prepare their statements in accordance with IFRSs. After this announcement the IASB undertook three projects. The first set of projects involved an international convergence of accounting standards. For this purpose, the Board works with other standard setting bodies in the world, of which FASB is the most important and influential. The Board looks for the best principles in standards all around the world and builds a body of standards, which constitute the "highest common denominator" of financial reporting. The first project in convergence included four projects: business combinations (Phase I); insurance contracts, performance reporting, and share-based payments. The board is presently working on three projects: Business Combinations (Phase II); Financial Performance Reporting; and Revenue Recognition. Accounting for stock-based compensation is a major issue of convergence. (Gornik-Tomaszewski, Sylwia, and Victoria Shoaf, Apr 2004) The second set of projects that the board set on involves assistance with the application of IFRSs. And the third set of projects aims to improve the basic International Accounting Standards (IASs). On DEC 15, 2003, the FASB issued four Exposure Drafts, where it adopted the IASB solutions, marking a real step on convergence of standards. The American accounting authorities have exerted a crucial hold on the convergence projects undertaken by IASB. This is because of their strong capital markets and a high confidence in the rules of US GAAP prior to the corporate scandals of 2001-02. The companies in Europe have been very interested in accessing the American markets, so US rules have predominated. But after the corporate scandals, the confidence of US authorities in US GAAP has slipped. Although US GAAP and IUFRS are based on the same Fair Value Accounting Model, but there are important differences. The Core Standards project of IASC was one of the examples of the influence of SEC over the international accounting rules. The SEC says, "the current standard setting process is too cumbersome and slow. much of the recent FASB guidance is rule based and focuses on a check-in-the-box mentality that inhibits transparency. Much of the recent FASB guidance is too complex." ("The Roles of the SEC and The FASB in establishing GAAP," May 2002) It feels that the FASB has been evolving the system of standard setting through a series of projects. These projects have mainly included the consolidation of financial instruments and accounting for financial instruments at fair value. The SEC has felt that such sweeping changes 'sapped' the resources of FASB, and it lead to it ignoring setting guidance on issues which involve Revenue Recognition and Consolidation of Special purpose entities. Much of the standard setting body recognizes that where there is too much divergence on certain issues, it is better to frame new principles and standard, rather than trying to converge them. The IASB has identified 11 such standards. ("The Roles of the SEC and The FASB in establishing GAAP," May 2002) Objections to Convergence There have objections from various quarters on the issue of the convergence of accounting standards, into a common set of standards for the whole world. Some critics have expressed their apprehensions about its application. They believe that the Regulator is responsible to a large number of parties, such as varied sized companies, investors and other stakeholders. So, it is difficult to take decisive action. Also, with each country bringing forth their own legislative and regulatory reforms - an example is Sarbanes Oxley Act of 2002 - it has made matters even more difficult. The critics have also pointed out that local conditions differ from country to country, and so a "one-size-fits-all" kind of standard is ludicrous. They also feel that the costs and inconveniences of the change are immense and perhaps unbearable for the smaller companies and the poorer countries. They have also felt that the consultation period is very short and there is a lack of widespread public debate on these issues. But their detractors and votaries of the change push aside these objections. They say that one has to incur some cost for something better, and to avoid future costs. Another criticism directed at the convergence project is that its revolutionary changes may disrupt the working of the capital markets of some of the countries. However, the argument for convergence says that it is a step towards globalization, which is already accepted by most of the world, and it improves the efficient working of capital markets. So, it should be welcomed. Some critics believe that adopting a uniform set of standards would not mean uniform accounting practices as well. That depends on cultural differences, social factors such as education, attitudes and other factors. These they believe have the capacity to distort the process of convergence. Another issue, which is in contention, is the timing of the convergence projects. The US accounting industry is still trying to deal with the requirements of Sarbanes Oxlay Act. Now, they have to face the new regulatory changes in the accounting standards also. Some believe that it is too much for the accounting industry to handle and might create problems. Another criticism of international standards is that they are lenient and not as detailed. This might create litigation problems later on. Principles versus Rules The convergence process has continued despite continued criticisms. Most of the world feels that the advantages of having a common set of accounting standards for the whole world are much more than any disadvantages. The raging discussion now centers more on whether the new standards should be rule-based like the standards of FASB or whether they should be principles-based on the line of IASB and the UK IAB. There is much more weight towards a simplification of accounting practices and towards an accounting standard which is based on principles. The most important detractor is FASB on account of US being in the stronger position in terms of its capital markets as compared to the rest of the world. The SEC says that most of FASB's standards are rule-based, instead of principles based. This has encouraged a check-in-the-box mentality to financial reporting. Such accounting guidance, which is more rule-based, are accounting for derivatives, employee stock options, and leasing. ("The Roles of the SEC and The FASB in establishing GAAP," May 2002) SEC feels that the ideal accounting standard would be based on principles, which would "reflect the economic substance, not the form, of the transaction." Such standards are less complex and are more responsive to emerging issues. But they also mandate greater discipline from all the parties concerned, such as the corporate world, accounting professionals, private sector setters and SEC. This will move away from check-in-the-box kind of financial reporting, and "it would mitigate the opportunities to financially engineer around the rules." It will also preserve comparability. ("The Roles of the SEC and The FASB in establishing GAAP," May 2002) The FASB has taken steps towards convergence. Its recent moves are: the completion of Phase I, in it FASB has eliminated pooling-of-interests accounting and "enhanced the disclosure requirements relating to goodwill and intangible assets. It has also instituted SFAS No. 106, "Employees' Accounting for Post-Retirement Benefits Other than Pensions." It has made mandatory for the companies to account for their non-pension post-retirement benefits on an accrual basis instead of cash basis. ("The Roles of the SEC and The FASB in establishing GAAP," May 2002) Most countries use principles based standards, but for the US. But William Bratton, professor of Law at Georgetown University Law Center, is supporting rules based standards. Earlier he was a proponent of principles based standards, as he himself says, but later he changed his opinion. He says, that more than the choice of the form of regulation, what is more important is the enforcement environment, which in a self-regulatory system depends on incentives. This leads to a "gaming" of the system. And a system where the context is fit for principles is still at an early stage of development. (Heffes, Aug 2006) Bratton has given two reasons for his viewpoint: he says that there is nothing like a rule-based or principle based regulatory system. They are context-sensitive and derive on principles. When principles are applied repeatedly, they become rules. Secondly, rules-based GAAP did not cause the financial reporting breakdown. They also involved principles based GAAP. So, a deeper look at causes is required. (Heffes, Aug 2006) However, the fact is that rules based system requires extreme detail and is very complex. A principles based approach is likely to be easier to understand, and is "more likely to reflect the economic substance of a transaction, in part, because there will be less opportunity for financial engineering." Less time and effort will be required for its implementation. International convergence will be facilitated. Conclusion Both the FASB and the IASB are now working towards greater convergence of their accounting standards. The IASB is also working towards bringing all the other countries of the world to one common accounting standard. For this it has called for opinion and debates from all corners. It is trying to take the best in every country's accounting policy and include it in the common accounting standard that it is developing. The UK accounting standard is already principles based, and the authorities in UK have already implemented the IFRSs in their corporate sector. The world is now following the steps taken by these two giants in the corporate world. Bibliography . 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Financial Executive 20.8 (Nov 2004): 18(2). British Council Journals Database. Thomson Gale. Heffes, Ellen M. "With convergence closer, IASB chair reflects on progress.(David Tweedie of International Accounting Standards Board)(Interview)." Financial Executive 22.3 (April 2006): 15(3). British Council Journals Database. Thomson Gale. Retrieved 23 Aug 2006. Silliman, Benjamin Rue. "Convergence of accounting standards: a comparative analysis of the U.S. revised standard on share-based payment and the International Accounting Standards Board's IFRS 2. (International Financial Accounting Standards)." Review of Business 26.2 (Spring 2005): 24(7). British Council Journals Database. Thomson Gale. "The Roles of the SEC and The FASB in establishing GAAP." Testimony of Robert K.Herdman,Chief Accountant, US Securities and Exchange Commission.May 14, 2002. Before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Committee on Financial Services U.S. House of Representatives. Read More