13 Financial Reporting M

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LO3: Evaluate financial reporting standards and theoretical models andconceptsLO4: Evaluate international differences in financial reporting Summary â??The
information in financial statements has to be communicated clearly and
effectively to help investors make investment decisions�Hans Hoogervorst Chairman of the International Accounting Standards Board Refer
to the attached Case study 1 and 2; â??Fonterra Co-operative Group
Limitedâ? and â??International differences before IFRSâ? Critically evaluate
the application of IFRS in application to specific countries and
differences in financial reporting based on models and theories.Your report should include the following; Explain the benefits of International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS).Evaluate the models of financial reporting and auditing.Evaluate the differences in importance of financial reporting across different countries.Critically
evaluate financial reporting and auditing through the coherent
application of theories and models to support judgements and
conclusions.Critically evaluate the factors that influence international differences in financial reporting. You
have to read the (case 1 and case 2pdf file ) and answer all the
question from the case study . assignment should be 1800 word


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2. International differences before IFRS
One of the problems in identifying reasons for accounting
differences, and then classifying accounting systems into
groups, is a lack of clarity about what is being examined or
classified. This report discusses accounting practices,
using â??accountingâ?? to mean published financial reporting.
In some jurisdictions, the rules of financial reporting may
be identical or very similar to the practices, but sometimes
a company may depart from rules or may have to make
choices in the absence of rules. So, it seems more
pertinent to discuss actual practices rather than formal
The academic literature3 offers a large number of possible
reasons for international differences in accounting. The
explanation can be dramatically simplified by suggesting a
single main factor: how companies are financed. This
factor has two dimensions, as shown in Table 2.1.
Another difficulty concerns the word â??systemâ??. It sometimes
includes entities such as regulatory agencies, whereas
other uses of the term refer to a corpus of accounting rules
or practices. This report follows the latter usage; that is, an
â??accounting systemâ?? is a set of practices used in a
published annual report. Although this is a narrow
definition, these practices will reflect the wider context in
which that accounting system operates. Yet another issue
is whether to separate disclosure from measurement
practices. It seems appropriate to include the presence or
absence of certain key disclosures (eg earnings per share,
cash flow statements) as elements of an accounting
A further issue is to determine whose accounting practices
are being examined. In general, this report will discuss
listed companies, because their accounting is easy to
inspect and can benefit from international harmonisation.
A related point is that all the researchers2 classify
countries. A country can have more than one system â?? one
for companies with publicly traded securities and another
for small private companies.
In addition, a countryâ??s accounting system may change
dramatically; for example as a result of economic or
political revolutions (eg China, Russia, Poland). In addition,
accounting in a country can change quite significantly as a
result of new laws (eg in Spain from the late 1980s, as a
consequence of EU Directives). Lastly, companies in two
countries (eg the UK and Ireland) can use extremely
similar accounting practices (ie perhaps the same
The detailed elements of accounting practice can differ so
much from one company to another that the number of
different sets of practices is effectively infinite. A certain
degree of variation among company practices may be
allowed, however, without having to abandon the idea that
the companies are all using the same system.
2. Such as: Nair and Frank (1980); Nobes (1983); Doupnik and Salter
â??Insidersâ?? are investors (in equity or debt) who have
long-term relationships with the company. They can
appoint board members, or may have special access to
information. Examples are: family members (even in large
listed companies, eg Fiat); banks (as big lenders or as
major equity holders, eg Daimler); and governments (eg
By contrast, â??outsidersâ?? are the millions of shareholders
who have small percentages of shares or listed debt.
Included in this group are large shareholders (eg pension
funds in the US or UK) as long as they have no privileged
access to company information (because, for example, that
would break insider-dealing laws in the country
Examples of the financing systems are as follows.
r System I (credit/insiders) is associated with several
continental European countries in the 19th and 20 th
r System II (credit/outsiders) might be rare, but there is
a vast amount of listed debt on the New York Stock
r System III (equity/insiders), elements of which are seen
in Japan.
r System IV (equity/outsiders) is the full-blown
capitalism of New York and London. China has moved
towards System IV but the State (an insider) still holds
much equity.
Table 2.1: Financing systems
Dominant investors
Strong credit
Strong equity
3. Choi and Mueller (1992) ch.2; Radebaugh et al. (2006) ch.3; Belkaoui
(1995) ch.2; Nobes and Parker (2010) ch.1.
There are two caveats to this.
r Countries might have more than one of the four
systems; for example, System IV (equity/outsiders) for
big companies and System I (credit/insiders) for small
ones. This report concentrates on the bulk of a
countryâ??s economic activity; for the US and the UK, for
example, that means listed companies.
r Countries change over time, but accounting might
change more slowly and will be influenced by the past.
Some simple measures of equity market size are given in
Table 2.2. Listed companies and equity markets are
obviously much less important in Italy and Germany than
they are in the UK and the US.
The starkest contrast is between System I and System IV.
Concentrating on these, the following are relevant points.
r In a country (or in a sector of a country) dominated by
equity/outsiders (System IV), there will be a demand
for detailed, audited, frequent, published accounting
r The conceptual frameworks of the IASB and of
standard setters in Australia, Canada, the UK and the
US state that the purpose of financial reporting is
primarily to enable investors to make economic
decisions. This is clearly a System IV orientation.
Table 2.2: The strength of equity markets, 2009
Domestic listed
companies per
million of
Equity market
capitalisation as %
of GDP
United States
United Kingdom
Source: Nobes and Parker (2010: 33)
r In a country (or in a sector of a country) dominated by
credit/insiders (System I), there will be no such
demand for investor-oriented reporting. For such
countries, in the absence of an outsider purpose,
accounting will serve its traditional purposes:
calculating prudently distributable profit and
calculating taxable income. System I purposes are legal
in nature and relate to single entities, therefore the
detail of accounting tends to be controlled by the State
and will concentrate on unconsolidated statements. By
contrast, in equity/outsider (System IV) countries, the
detail of accounting will be controlled by bodies
connected to accountants or stock markets.
The two classes of accounting that result have the features
listed in Table 2.3. These features are found in the
following cases. All the features of Class A in Table 2.3
were found in the national practices of Australia, the UK
and the US. All the features of Class B are found in the
unconsolidated statements of companies (even large ones)
prepared under the national accounting rules of France,
Germany or Italy.
Table 2.3: Examples of features of the two accounting
Class A
Class B
Depreciation and
pension expenses
Accounting practice Accounting practice
differs from tax rules follows tax rules
Percentage of
completion method
Completed contract
Unsettled currency
Taken to income
Deferred or not
Legal reserves
Not found
Income statement
Expenses recorded
by function (eg cost
of sales)
Expenses recorded
by nature (eg total
Cash flow
Not required, found
only sporadically
Earnings per share
Required by listed
Not required, found
only sporadically
There are various explanations as to why other important
factors are less useful in explaining the main A/B split
between the classes of accounting.
International differences in tax are of limited relevance in
causing the A/B split of Table 2.3 because Class A is
supposed to be unaffected by tax issues. There are some
exceptions, such as the use of LIFO in the US for reporting
purposes, in order to be allowed to use LIFO for tax.
System IV financing causes Class A accounting, which is
not designed to serve tax purposes. So, tax itself does not
explain why a country is in Class A or Class B. Of course,
within a set of countries that use Class B accounting,
differences in tax are likely to be a major cause of
differences in accounting.
International differences in legal systems are also of only
limited relevance in causing the A/B split. Class A seems
to be associated with common law countries, and Class B
with Roman (codified) law countries, but there is not a
perfect correlation. In addition, IFRS was adopted in some
Roman law countries in the 1990s for the consolidated
statements of listed companies. The EU (a very Roman law
organisation) has adopted IFRS for this purpose.
Nonetheless, the national legal system still affects
monitoring and enforcement of accounting.
Colonial inheritance is probably the major explanatory
factor for the general system of financial reporting in many
countries outside Europe. For example, it is easy to predict
how accounting will work in Gambia (a former British
colony) compared with neighbouring Senegal (a former
French colony). The same general point applies to
predicting how accounting will work in Singapore or New
Zealand, both of which must be expected to have Britishinfluenced accounting. Colonial inheritance extends to
legal systems and to other background and cultural factors,
and not just to direct imports of accounting. Substantial
capital investment from another country may also lead to
accountants and accounting migrating with the capital.
Another related influence on accounting is invasions, which
may have major effects, as is the case with Japanese,4
French,5 and German6 accounting. When the invader
departs, however, any foreign accounting measures can be
gradually removed if they do not suit the country: Japan
closed down its Securities and Exchange Commission
when the Americans left, whereas France retained its
German-inspired accounting plan in order to aid
reconstruction after the Second World War.
The two-class model outlined in section 2.2 has been
supported in the literature when researchers have
examined accounting practices.7 It can also be seen in
measures of the differences between various national
GAAPs and IFRS. 8 For example, in 2001, there were far
fewer differences between UK GAAP and IFRS than there
were between French or German GAAP and IFRS.
Other empirical studies look at the effects of moving from
national GAAP to IFRS. Some of these look at â??value
relevanceâ??, ie whether IFRS accounting numbers are more
closely related than national GAAP to share price
movements. The evidence9 suggests that there is not much
difference between US GAAP and IFRS for this purpose, but
that IFRS is more value relevant than, for example, German
GAAP. This is consistent with the model proposed here.
Section 2.2â??s simple model of the development of
accounting based on corporate financing can now be
elaborated. This fuller model consists of a number of
linked ideas which will be expressed as propositions. Part
of the model can be shown in simplified form as in Figure
2.1, which amends a diagram suggested by Doupnik and
Salter (1995). The variables have been introduced in the
text above, but now need to be marshalled.
The first variable is a countryâ??s type of legal and
institutional culture, and the second is the strength of its
equity-outsider financing. It can be assumed that some
cultures develop strong equity-outsider markets and
others do not. This is an issue for economic historians and
is not examined in detail in this report. As discussed
earlier, some countries have strong indigenous systems,
whereas others have imported systems that are still
dominated, or at least heavily influenced, from outside.
This dichotomy will be expressed by using the labels SSC
(for self-sufficient financial and legal culture) and DC (for
dominated culture). For example, a DC country whose
colonial inheritance came from a country with one type of
financial culture would tend to have that same financial
culture. This variable could be measured in various ways,
for example by the number of decades since one country
gained political independence from another. Many
developed countries are SSC and many developing
countries are DC, but there are exceptions.
4. Japanâ??s SEC, its structure of Securities Laws and its stock market owed
much to US influence during the occupation following the Second World War.
7. Doupnik and Salter (1993).
5. The distinguishing feature of French accounting, the plan comptable,
was first adopted when France was under German occupation.
8. Ding et al. (2007).
6. The German accounting plan, though copied in France, was abolished
by the occupying Western powers after the Second World War. A version
survived in communist East Germany until reunification.
9. The evidence is summarised by S.J. McLeay in Section 20.5 of C.W.
Nobes and R.H. Parker, Comparative International Accounting, Prentice Hall,
Figure 2.1: Simplified model of reasons for international accounting differences
Financial and legal
culture, including
Strength of equity
outsider financing
As noted above, the second variable is the strength of
equity/outsider financing. For most companies in any
country (insider companies), a controlling stake is in the
hands of a small number of owners. For a comparatively
few companies (outsider companies), control is widely
spread among many â??outsiderâ?? equity-holders. Countries
with strong equity-outsider systems generally have a large
number of outsider companies which may generate most
of a countryâ??s GNP, but some such companies may also
exist in other countries with different systems.
The final variable is the type of financial reporting system
(or, in short, â??accounting systemâ??), introduced earlier as
Class A or Class B. As suggested above, this is the key
driver of the type of accounting that will be needed.
The ideas which link these variables can now be brought
together. It is worth repeating the point that more than one
accounting system can be used in any particular country
at any one time, or over time. The model can be expressed
in terms of five propositions (P), which are then explained
and illustrated.
Class of
The dominant accounting system in an SSC country
with a strong equity-outsider system is Class A.
The dominant accounting system in an SSC country
with a weak (or no) equity-outsider system is Class B.
As a country establishes a strong equity-outsider
market, its accounting system moves from Class B
to Class A.
Outsider companies in countries with weak equityoutsider markets will move to Class A accounting.
A DC country has an accounting system imported
from the dominating country, irrespective of the
strength of the DC countryâ??s equity-outsider system.
The analysis here relates to self-sufficient countries (P1
and P2), as illustrated in Figure 2.2. For these countries, it
is suggested that a countryâ??s financing system will have
resulted from its particular type of culture. As suggested
earlier, for the purposes of this report, it is not necessary
to go back that far in the chain in any detail. Let us say
that â??Type 1â?? culture produces strong equity-outsider
financing but â??Type 2â?? culture does not.
Figure 2.2: Application of Figure 2.1 to culturally self-sufficient countries
Country with culture
Type 1
Strong equityoutsider financing
(System IV)
Class A
Accounting for
outside shareholders
Country with culture
Type 2
financing (System I)
Class B
Accounting for tax
and creditors
Figure 2.3 shows some aspects of these ideas. The
continuous arrows are those from Figure 2.2. Arrow (b)
relates to Proposition 3, and Arrow (d) Proposition 4.
Arrows (a) and (c) concern Proposition 5. Some
illustrations of these relationships are given below.
The class into which the predominant accounting system
falls will depend upon the strength of the equity-outsider
market (or on its strength in the past, if there is inertia).
Strong equity-outsider systems will lead to Class A
accounting (containing the features in Table 2.3 on page
10) whereas others will lead to Class B accounting. As
explained earlier, the term â??predominant accounting
systemâ?? refers to the type of system used by enterprises
representing the majority of a countryâ??s economic activity.
For example, small unlisted enterprises in strong equity
market countries might not practise Class A accounting or
indeed any financial reporting at all.
r Arrow (a): New Zealand is a DC country which has
imported British culture and institutions wholesale,
including a strong equity-outsider system and Class A
accounting. Whether Class A accounting in this case
results from the equity market or from direct cultural
pressure is not important to the model; it probably
arises from both.
Proposition 3 is that, if a country with a traditionally weak
equity market gradually develops a strong equity-outsider
system, a change of accounting towards Class A will follow.
Also (P4), in a country with weak equity-outsider markets,
there may be some â??outsider companiesâ?? (as defined
earlier). Commercial pressure will lead these companies
towards Class A accounting, even if the dominant system
in the country is Class B. For such companies, there will be
rewards in terms of lower cost of capital10 from the
production of Class A statements, particularly if there is an
international market in the companyâ??s shares. If legal
constraints hinder movement towards Class A accounting,
then the company can use extra disclosures or
supplementary statements.
r Arrow (b): China is a country that had no equityoutsider tradition but has moved towards such a
system. Class A accounting has followed, for listed
r Arrow (c): Malawi is a DC country with very weak equity
markets but where the accountancy profession has
adopted Class A accounting, consistent with its colonial
inheritance from the UK.
r Arrow (d): the Deutsche Bank, Bayer and Nestlé are
companies from countries with traditionally weak
equity markets. These companies were interested in
world equity-outsider markets, so they adopted Class A
accounting (IFRS) for their consolidated statements in
the 1990s.
Figure 2.3: A proposed model of reasons for international accounting differences
Country with culture
Type 1
Country with culture
Type 2
Class A
accounting for
outside shareholders
Class B
accounting for tax
and creditors
10. It is argued that equity investors and lenders will be persuaded to
provide funds at lower returns to companies using more accepted, familiar
and transparent financial reporting (Botosan 1997).
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