Inadequacy of National Accounting Standards for Financial Information Users - Coursework Example

Title: Inadequacy of Natonal Accounting Standards for financial information users Name Class Unit Table of Contents Table of Contents 2 1.0 Introduction 3 2.0 Diversity in National Accounting Standards 4 2.1 Capital allocation 4 2.2 Country based diversity 5 2.3 Differences in balance sheets 5 2.4 Level of Accounting Standards 5 2.5 Legal system Impacts on National Accounting Standards 6 2.6 Taxation impacts 6 2.7 Income Smoothening Impacts 7 2.8 Goodwill diversity 8 2.9 Diversity based on level of Economic Development 8 3.0 MNC and diversity in National Accounting Standards 9 3.1 Capital markets 10 3.2 Comparability 11 4.0 Differing quality of National Accounting Standards 12 5.0 Differing Corporate financing 13 6.0 Diversity in State roles 14 7.0 Religious Impacts 14 8.0 Financial analysts 15 9.0 Cultural Impacts 16 10.0 Contradicting treatment of transactions 16 11.0 Harmonisation 17 Conclusion 18 References: 19 1.0 Introduction The use of national accounting standards has become inadequate for most users of financial information. Some of the factors that have contributed to this are the globalisation of trade, business and capital market, which have greatly affected accounting. Capital markets have become interconnected and investors are looking for investment opportunities globally. The use of national standards in global accounting settings is no longer a viable option. Over time, there has been an increase in cross border transactions (Duhovnik, 2003, p.73). For a long time, financial reporting has been guided by national standards. Each country has their national standards which govern their financial information. National standards have been influenced by various factors which include; political, economic, education and the capital markets (Fontes, Rodrigues & Craig, 2005, p. 420). The cultural environment has also played a role in standards setting philosophy (Oppermann, 2001, p. 32). Due to inadequacies brought about by national accounting standards in globalised world, there has been an increase in the call for harmonisation of national accounting practices leading to introduction of International Financial Reporting Standards (IFRS) (Duhovnik, 2003, p.73). This report will discuss why the ever increasing globalisation of trade, businesses and capital markets means that financial statements prepared under national accounting standards are becoming inadequate for most users of financial information. This will be achieved by analysing the problems brought about by diversity in national standards, factors leading to diversity in national standards, and the call for harmonisation of accounting standards. 2.0 Diversity in National Accounting Standards Globalisation of the capital formation has led to the need for globalised financial reporting. This is due to the fact that investors are in different countries (Radebaugh, Gray, Black, 2006, p.37). This leads to difficulties due to different sets of financial accounting standards. Different accounting reporting types lead to additional cost, especially in multinational firms. This requires the work of a regulatory committee to come up with a consistent measure to base their regulatory services. Factors influencing accounting standards are; the nature of the political system, economic development stage, state of accounting education. Other factors identified as causing diversity in accounting systems are; legal system, taxation, financial providers, the level of inflation and the economic and political ties (Duhovnik, 2003, p.76). 2.1 Capital allocation Having differences in national accounting hinders efficient capital allocation which leads to additional risk and costs to investors. When there are different sets of standards, coming up with comprehensive revenue and net profit figures become a complex task (Saudagaran, 2001, p.37). For example, a person evaluating shares from companies located in different countries may find it difficult to harmonise the findings. A famous example of conflicts of national standards is the Daimler Benz case. The company switched from the German accounting principles to the US GAAP for them to get secondary listing in New York. The company profit of 600 million Deutschmarks which had been recorded using German GAAP (General Accepted Accounting Practice) turned into a loss of 2 billion Deutschmarks through the use of US GAAP to report (Hitz et al., 2012, p.235). This was a major challenge to financial analysts. 2.2 Country based diversity There exist a lot of differences in the way different items are treated in accounting based on country’s standards. In the United States, firms cannot report the cost of properties at a cost higher than their historical prices. In the European Union, companies can report their properties based on the market value. In Japan, the research and development costs are reported as incurred expenses while in Canada and France, they are treated as an asset. Chinese firms use direct methods to come up with their financial statements of cash flow while in the United States, indirect method is preferred (Hitz, Ernstberger & Stich, 2012, p.236). 2.3 Differences in balance sheets The use of different accounting standards leads to differences in balance sheets and income statements. For instance, a South Korean telecommunication firm came up with the differences that exist between the US and South Korea accounting rules. Using the South Korea GAAP accounting principles, SK telecom was able to report net income of 1,056 billion KRW. Through the use of the US GAAP standards, the company would have reported KRW 1,357 billion. This is 28% higher than through the use of Korean standards (Fontes et al., 2005). This is an example of accounting standards diversity which leads to problems in financial reporting under a global economy. 2.4 Level of Accounting Standards In developing and designing the accounting system, the quality of accounting education and profession matters a lot. Therefore, when the level of accounting education and its level is low and poor as well as accounting system, the form of reporting is affected. The accounting reporting quality is affected by level of their education. This affects the form of reporting on financial documents. The manner in which a country values their accounting system will determine their reporting (Oppermann, 2001, p.26). Thus, a financial analyst looking at documents from different countries may be affected by variations caused by level of education and the quality of the profession in diverse countries. 2.5 Legal system Impacts on National Accounting Standards Countries use both common law and codified Roman law. Common law is found in the English speaking countries and originated from England. In most non English speaking countries, codified Roman law is used (Fontes et al., 2005, p.423). Code law involves corporation laws which have the legal parameters which help in governing businesses. Through corporation law, it has set the financial statements which have to be published in a given format. Accounting law is debated and passed by the country legislature. In countries which have their accounting laws legislated, there is little influence from the accounting professionals. In some countries where there is a common law, accounting professionals are able to establish specific laws. Where there are code laws, their accounting laws are general (McCombie & Hemant, 2005, p.158). They lack much detail and offer little guidance in several areas. This is seen in countries such as Germany where the accounting laws do not give information on lease, cash flow and foreign currency transitions (Hitz et al., 2012, p.235). This leads to differing national accounting systems which cannot be applied in an international context. 2.6 Taxation impacts Countries deal with taxation in their financial reporting differently. Some countries use financial statements as a basis for their taxation (Joos & Lang, 1994, p.149). In other countries, financial statements are adjusted for the purpose of tax. They are submitted separately to the reports that are to be given stockholders. This has led differences in accounting incomes for firms in different countries. For example, a company in Germany is likely to report a lower income when compared to a company in USA (Hitz et al., 2012, p.236). In countries where there is high inflation, they find it necessary to use accounting rules that lead to adjustment of historical costs based on inflation. This has been applied in most of the Latin American companies due to high inflation. Where there is double or triple inflation, historical costs lose meaning. This factor led to Latin America countries becoming distinguished from other countries. Through economic and political ties, there has been conveying of accounting rules from one country to another (Saudagaran, 2004, p.35). This was especially the case during colonisation. 2.7 Income Smoothening Impacts Managers prefer to smooth income patterns through a pattern that provides a steady predictable yearly increase (Fontes et al., 2005, p. 417). When the income pattern is volatile, it suggests that the company has high operational risks and this reduces investors’ confidence. Smooth income implies that there is less risk and investor confidence is high. The GAAP income smoothening provisions vary based on the countries. In countries such as US, GAAP allows little flexibility in income smoothening. This is different in countries such as Germany and Switzerland. The GAAP in these countries have flexibility which managers’ takes advantage of, and some of the countries may use GAAP provisions to ensure that there is confidence in the national economy. The use of these provisions may mislead the financial statements users despite being a legitimate practice (McCombie & Hemant, 2005, p.157). In some countries, some items are kept secret depending on their national accounting standards. 2.8 Goodwill diversity Another issue with the financial statement users is the existing diversity in goodwill. This is due to fact that there exists a difference in whether the purchased goodwill is supposed to be part of the balance sheet and whether it should be amortized (Bennett et al., 2006, p. 192). Capitalisation without amortization implies that goodwill should be treated as an asset with indefinite value. This makes it to remain on the balance sheet. If it is considered under capitalisation with amortization, it is considered as an asset which has a finite value. The shorter life it has, the greater the write-off. It can also be considered as an immediate write-off. Under this case, it is written off to equity, which leaves the company’s annual income unaffected. Accounting for goodwill is highly affected by tax. For example, in the UK, goodwill amortization is not tax deductible but it is deductible in Canada and Germany. This affects global competitiveness (Williams et al., 2009, p.36). For a company that is able to eliminate goodwill amortization from its income statements, it will have higher net earnings during reporting than one that does not eliminate. This affects users of the financial records. 2.9 Diversity based on level of Economic Development The level of sophiscation of country’s accounting system is based on the country’s economic development. The currency in the developed world is stable and there is low inflation in comparison with the developing countries. In poor countries, their securities are poorly developed. The political system may be unstable in some countries and stable in others (Joos &Lang, 1994, p. 150). It can therefore be observed that the accounting system of a developed country will differ from that of developing countries. This makes it hard to compare the accounting reports from developed and developing countries. Legal traditions are also very vital in influencing security regulations in different countries. It is important to note that securities have a great influence on accounting. For example, securities define investor’s protection. In US and UK, their accounting principles have an aim of enhancing investor protection (Georgiou, 2010, p.106). In most countries, there are the interests of the constituencies which matter more than that of the investors. Some countries have intense enforcement on accounting intensity than others. This makes it hard to for financial information users to utilise reports made under different national standards. 3.0 MNC and diversity in National Accounting Standards Accounting diversity leads to a lot of problems to the users of financial information. Companies with foreign operations experience consolidation of their financial statements (Penman, 2007, p.31). This can be well explained using a company such as Toyota. Toyota has operations in more than 50 countries worldwide. Each of the subsidiaries incorporated in the country of operation will require having its financial statements which are based on the laws of country of operation (Fontes et al., 2005, p.418). Most of local accounting standards require the company to keep its financial books in the local currency and use the local principles of accounting. This implies that Toyota Motors in Japan will prepare their financial statements in Japanese yen and Toyota motors in Mexico will prepare them using Mexican Pesos. This will happen in all their countries of operation. To come up with a consolidated financial statement in US, and change the local currency into US dollars, the company will be required to translate the financial statements from all foreign operation into US GAAP (Penman, 2007, p.32). This leads to Toyota being required to have professionals who have expertise in more than one country’s accounting standards. Multinationals have been facing problems based on foreign currency exchange in their reporting. There have been issues related to fluctuations of currency between transaction period and reporting. There have been issues which are related to depreciable assets. This involves determining the depreciation rate in a fluctuating exchange. This leads to an issue on how to use national accounting standards to eliminate these issues (Williams et al., 2009, p.27). The use of national accounting standards thus presents a problem when dealing with transactions that involve more than one currency. With globalisation, there have been operations of Multinational corporations (MNCs) in different countries. These companies operate under diverse national accounting standards. Using the national standards, it becomes hard to compare the companies reporting in different countries. This is due to the diversity in legal and political environments (Saudagaran, 2004, p.31). For the financial information users, national standards provide a hindrance to compare companies working in different environments. Accounting reporting under their national accounting system becomes inapplicable in international capital markets. The documents are also interpreted differently by directors from different countries. This makes it hard for MNCs to compare their financial records (Duhovnik, 2003, p.63). The lack of a common position in accounting makes MNCs to face difficulties when comparing and interpreting financial records. This is due to fact that the records are based on different national standards. 3.1 Capital markets For financial information users, gaining access to foreign capital markets is a major issue. When a company wants to buy or borrow stock in another country, they are supposed to prepare financial reports based on the country where they want to obtain stock (Bennett et al., 2006, p. 193). For a foreign firm to have their stock traded in US, they have to prepare financial statements based on US GAAP. This leads to additional costs. When Daimler Benz was listed on the NYSE in 1993, they had to spend almost $60 million to conform with US GAAP. The cost of US $ 15- 20 million was expected to be incurred yearly (Alfredson et al., 2005, p.34). Foreign companies which have not adopted international standards continue to incur high costs to come up with US GAAP information. 3.2 Comparability Another issue users of financial information face is the comparability of the financial statements in different countries. To make investment or lending decisions, an analysis of foreign financial statements is needed (Williams et al., 2009, p.19). This is greatly affected by the diversity of accounting standards. With the increase in mutual funds being invested in foreign companies, this is a major issue. Making a decision on which firm to invest in is made complicated by the differing accounting rules used by foreign companies. For example, it is very hard for an investor to compare the financial position of companies based in different countries. For example, it can be difficult to compare financial performance of Ford (US), Toyota (Japan) and Volkswagen (Germany) due to different accounting standards (McCombie & Hemant, 2005, p. 160). This requires investors to either have knowledge on different accounting standards or take greater risks. When a corporation is making a huge financial acquisition decision, comparability of the financial statements has a great effect. This was the case that foreign investors in Eastern Europe faced after the fall of the Berlin wall in 1989 (Bennett, et al., 2006, p.190). Western firms were involved in the acquisition of companies which became privatised in the former communist bloc. Under communism, the accounting standards were very different from those of the western countries. This made financial statements worthless in determining the attractive targets. This led to the use of international accounting firms to convert the financial statements. The reason for this was based on the fact that accounting in the communist countries firms was very different compared to western countries (West, 2003, p.31). Communist firms made financial statements with the aim of giving the government information on a central economic plan. This was in contrast with the western countries where financial statements were used in making decisions on investments and lending. 4.0 Differing quality of National Accounting Standards Lack of quality accounting standards in some countries is another issue that faces financial information users. For example, poor transparency in accounting contributed to the 1997 East Asian financial crisis (Bennett et al., 2006, p.193). There were inadequate financial disclosures that contributed to the crisis. Disclosure in financial accounting determines the risk management. Poor disclosures led to inadequate internal controls and poor management practices that led to banks and corporate being hit by the crisis. Due to the problems that are associated with accounting diversity, there have been a lot of attempts to reduce accounting differences (Williams et al., 2009, p.59). This is through the harmonisation process with an aim of coming up with a common international standard. There is a large difference in the level of details that are reported on different accounting systems. This presents financial information users with a problem as they carry out analysis (Bennett et al., 2006, p. 191). For the US companies, they give few details on their financial statements, but they usually supplement this with notes. This is in contrast with the financial statements provided by countries such as Thailand. There are also issues on differing terminologies used. Most of non-English speaking countries translate their financial statements to English leading to introduction of new terms (McCombie & Hemant, 2005, p. 157). This occurs especially in countries which have unique accounting practices. The amount of information disclosed in financial statements differs based on countries. Laws and regulations determine the amount of disclosure a firm makes (Joos & Lang, 1994, p. 151). There are also voluntary disclosures that a firm makes to help it compete better in international financial markets. Firms in the US make a lot of disclosures compared to others worldwide. There is a wide diversity in disclosures among between different countries. Legal traditions in a given country determine its standards in accounting and this mainly includes common and civil laws. Countries such as UK and US have common laws where accounting standards were obtained by general acceptance of the professionals. In countries with civil laws such as most of the European countries, their accounting system obtains legitimacy by law enactment (Williams et al., 2009, p.39). The legal origin has thus played a big part in diversity. This makes it hard to use national financial standards to give a fair view of business. 5.0 Differing Corporate financing Corporate finance determines the conceptions of the purpose and audience of accounting. Corporate finance is the source of the capital used in funding an enterprise. Capital is composed of debt and equity securities and their combination determines who the accounting is being addressed to (Williams et al., 2009, p.19). The characteristics of corporate finance determine the level of transparency that is given. Different standards have different orientations when reporting. For the Euro-Japanese, there is less transparency as they rely mostly on banks which have power over the corporations. In countries where businesses get their funds through securities, investors use financial reports to gauge the performance of this business. This is due to fact that they have limited access to other information (Gernon & Meek, 2001, p.31). Where a business has gained most of its funding from banks, the reporting is based on the information needs of the creditors. This leads to financial reporting which differs in the details being offered. For the financial information users, this presents a major problem. 6.0 Diversity in State roles The role of the state differs in different countries. In a social democracy, the state has greater influence in accounting. This leads to differences in accounting systems in countries such as France and US. The French accounting system is highly dependent on the state fiscal policies. In countries such as US, their tax accounting and financial accounting are different. Some of the states may prefer to have a form of conservative level in their accounting (Feldman, 2013, p.17). This may differ from other countries where a state does not have the same preferences. This is a challenge that makes it hard to have comparability. 7.0 Religious Impacts Accounting standards are susceptible to the religious status of a country. Western countries standards differ a lot from religious groups such as Islamic values (David, 2005, p.589). There are assumptions that are in place in Muslim countries which cannot be reflected under the accounting systems of western countries. The Muslim faith has an accounting system which focuses on social accountability rather than personal accountability. Full disclosure under Muslim faith implies that all information should be made available to the community based on Islamic law. Business ethics in Muslim countries are based on the practice of Islam. The use of Sharia laws set Muslim financial transactions apart when compared with western practices (Doupnik & Perera, 2009, p.23). In Muslim countries, they prohibit interest. This makes it harder for financial information users to compare statements made under the Islamic countries to those under the western countries. Religion plays a major role in determining the financial information flow like in case of Islamic laws related with banking and related issues which are different from other religion like Christianity countries. 8.0 Financial analysts For the portfolio investors and financial analysts, diversity in international accounting standards affects them considerably. The underwriters have always faced difficulties when using differing national standards. When there is difficulty faced by the investors and financial analysts, problems occur with the financial markets’ efficiency (Godfrey & Chalmers, 2007, p.61). This also reduces returns to the investors. Companies are required to disclose sufficient information so that they can be assessed by the investors on past and future performance (Williams et al., 2009, p.31). The varying accounting disclosures on requirements for listing shares have a significant effect. Investors become more protected when there is no diversity in accounting. For the financial analysis, differing accounting standards affect the accuracy of earnings forecasts. The varying standards make it hard for analysts to come up with a relevant firm valuable. The measurement and disclosure in reporting standards have been a major issue with national accounting standards (Duhovnik, 2003, p.72). For some countries, there is poorer disclosure than others. There is poor information on firms in some of the national standards. For example, it was hard for US financial analysts to forecast for non US firm earnings when using national accounting standards (Williams et al., 2009, p.21). 9.0 Cultural Impacts There is a link between culture and accounting standards used in a country. Countries differ in their cultural dimension. This makes it hard to apply an accounting system of different countries together due to unifying difficulties. There is a professionalism and statutory control. In countries where there is small power distance, they prefer professionalism hence a feeling for justification of laws and codes. Others which affect the type of financial reporting in a country are: uniformity and flexibility; conservatism and optimism and secrecy and transparency (Gernon & Meek, 2001, p.32). These dimensions determine the type of report that a country has, hence affecting their its applicability. 10.0 Contradicting treatment of transactions The use of different national standards has led to contradictory treatment of similar transactions. This is seen in cases where a lease is treated differently by different accounting standards. When there is a lease agreement, a business may decide to report it as a capital or operating lease. The company adopts the accounting rules which favour them. This leads to a non-uniform approach in dealing with financial accounting. Some of the firms may have an advantage over others based on the accounting system of the country of origin. There is worldwide diversity in accounting and its reporting. In most cases, there is a wide diversity in the national GAAP. When the diversity reaches a point of misinformation, it makes it hard for financial information users to use the financial information (Gernon & Meek, 2001, p.34). Though at domestic level, national accounting standards reduce diversity, they are still a threat to financial information users in international arena. 11.0 Harmonisation Due to inadequacies presented by the national accounting standards to the financial information users, there have been developments of international standards (Schön, 2004, p.433). The financial reporting has evolved to meet the needs of its users. Harmonisation of accounting standards has been a major debate worldwide. Through harmonisation, the global community is treated as a single entity (International Accounting Standards Committee, 2000, p.11). There has been a lot of push for the reporting of finances to be done in a common and understandable manner. There has been push to adopt the international Financial Reporting Standards (Benston, 2006, p.25-51). Most countries have adopted the system to make it easier for financial information users in doing their work. Despite this, achieving global accounting standards is a tough task and there are a lot of problems to tackle for the system to be adopted. Therefore, there is need for harmonizing the standards and systems throughout the world for better accounting results and efficiency. The main aim of standardisation is not elimination of all differences but to reduce contradicting rules. This is to ensure that worldwide differences are eliminated and come up with comparable financial standards (Benston, 2006, p.31). This ensures that there is mutual recognition of the accounting standards irrespective of the country they are prepared in. For example, financial records prepared in Canada can be used in United States. International Accounting Standards Committee (IASB) has been the force behind harmonisation of the accounting standards globally (International Accounting Standards Committee, 2000, p.7). The compliance with the IASB standards is voluntary and hence they cannot be enforced. IFRS are capital market oriented international accounting standards and are the most recent standards released by IASB. With harmonisation, it will be possible to eliminate differences that exist among national accounting standards. This will help financial information users to overcome challenges they face in using the information. Conclusion Increasing globalisation of trade, businesses and capital markets means that financial statements prepared under national accounting standards are becoming inadequate for most users of financial information. Globalisation of the capital formation has led to the need to have globalised financial reporting. Diversity in national accounting standards hinders efficient capital allocation which leads to additional risk and costs to investors. It is important to note that varying financial standards contribute to difficulties in comparing the financial statements from different countries. Diversity in accounting reporting leads to additional costs, especially in MNCs, as they compare reports from different countries. This requires the work of a regulatory committee to come up with a consistent measure to base their regulatory services. Factors leading to differing financial standards in different countries are; the nature of the political system, economic development stage, state of accounting education, the legal system, taxation, financial providers, level of inflation and the economic and political ties. For the financial analysts, their level of accuracy is affected leading to biased reporting. These differences in national accounting standards makes it mandatory for organisations to have two types of reporting based on national and international standards. National standards differ hence it is hard to use reporting based in one country in another country’s context. This has made multinationals to face challenges as they compare accounting reports from different countries. Due to challenges brought about by national accounting standards, there has been a lot of harmonisation using the international accounting standards. 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