Commissions(IOSCO)consideredguidancefor accountingfor financialinstruments

essential
andrequested theInternational
Accounting
Standards
Commission (IASC)to
includea financialinstrumentsstandard
amongthecorestandardsbeingprepared in
expectationOfendorsement by IOSCOfor bycompanies in cross-border
listings.
IASBcreatedIAS 39 basedon the FASBstandardsrelating to financial instruments
(FAS114,115,133and 140)asan interimstandard.notingthatfurtherdevelopment
Of IAS 39 would be required."
Followingtheannouncement
in 2002thatinternationalaccountingstandards(LAS)
would be adopted in Europe. much greater attention was focused on the content Of
international standards. Ell-listed companies, which had previously followed national
G.•VXP,would now be required to follow IAS at least for consolidated accounts. In the
areaOffinancialinstruments.theaccountingchangewaspotentiallydramatic Generally,
companies used historical cost accounting for financial instruments, showing them at
cost or amortised cost. and including gains in the income statement only Whenthey
were realised. In relation to financial assetsand liabilities. companies had considerable
discretionaboutwhengainsand losseswererecordedin income.IAS39 would require
companies to include unrealised gains and losses on certain financial instruments in
income when they occurred (not when they were realised), thus restricting companies'
choices about the timing of recognition Ofgains and losseson some instruments.
The reaction to IAS 39 among some European companies was extremely negative.
The idea Of including unrealised gains and losses in income was not popular in some
countries, such as France and Germany, where accounting practice was essentially
conservative. Of the historical cost principle the norm and upward revaluation of
assets or liabilities not widely practised." Companies objected to possible subjectivity
introduced into accounting measurement and expected volatility in reported earnings,
as well as the costsincurred in meeting the requirements. Further, bank representatives
argued that they would be forced to follow accounting rules (such as those proposed
for hedge accounting) which did not reflect the underlying reality Of their business,
making accounting information less,rather than more, useful for decision making"
The [ASB gave careful consideration to the issues raised by stakeholdevs. In December
2003 it amended the 2002 exposure draft after an extensive due process which included
numerous board meetings, discussion Of the exposure draft With constituent groups in
nine roundtable meetings, receiving and evaluating more than 270 comment letters
and discussing the topic with advisory committees and national standard setters from
around the world:" At the sametime. financial statement preparers,notably the large
French and German banks. were lobbying hard through all possible means to avoid
the adoption Of IAS 39. efforts directed at the IASB were made by companies,
individuals and their representative bodies such as professional associations, industry
representative groups, national standard setters and European representative bodies
including FEEand EFRAG.44 The ultimate lobbying activity was obsewed: a letter from
the French president. JacquesChirac. to the Fxropean Commission (EC) president
which objected to measurement of derivatives at fair value and claimed that the IA-SB
standard would have 'nefarious consequencesfor financial stability'
The IASB responded as best it could to these concerns, but was committed to
a standard based on the principle of recognition and measurement of financial
instruments at fair value Thus. IAS 39 was included in the standards submitted to
the Accounting Regulatory Committee (ARC) for endorsement prior to adoption by
the EC ARC endorsed all the [ASB standards. but excluded certain provisions
contained in IAS 39.46 Iltese related to the Of fair value measurement and to
hedging. Companies were not required to comply with thesesections of IAS 39 when

CHAPTER 3 to 67
 preparingaccountsin accordance
with IASIIFRS
from2005.Thus,thelobbyingactivities
Ofeconomicallypowerful and politically well-connectedgroupssucceededin dictating
the content of an accountingstandard.One of the issuesof the •carveout' hasbeen
resolved, while the other remains."
TheARCsdecisionwascriticisedby parties sawthecreationOf'EuropeanIAS as
abackwardstep,awayfromthegoalOfharmonisedfinancialreporting.•I-heuK standard
Setters
did notagree
WiththeARCdecision.
andencourageduK companies tocomplywith
the full hedgingrequirementsOfIAS39.u Thepolitical controversyin relation to IAS39
has not decreasedwith the passageOftime-"Itie financial crisis,which beganin 2007—08
resulted in the IASBamending LAS39 (and IFRS7 FinancialInstruments:Disclosures)to
allow companiesthe choiceof reclassifying financialinstrumentsfrom categories
where fair value measurementappliesto categoriesWhereitems are measuredbasedon
amortised cost.The board defended the changeswhich were made without due process
consultation,in the light Ofrequestsfrom EIJleadersand financeministersand that the
factthat theaccountingchoicewasavailableundetLISGAAP.4'Boththeoryin action3.2
andcasestudy3.2address
issuesrelatingto regulationandaccountingstandards.
Illey
allow furtherexplorationof theroleof fairvalueaccountingin theglobalfinancialcrisis.

Accountants draw [he line at regulating

by Patrick Durkin
Theglobalaccounting
standards
setterhasdeien&ditsroleinthefinancialcrisisandblamed
prudentialregulatorsfor lax rulesthat banksto makerisky dole out excessive
bonuses and pay too much in divicEnds_
Membersof theInternationalAccountingStandards
Board,visitingSydneyyesterday,also
&fended fair-valueaccountinæwhich bankshavecriticisedfor exacebatingthe crisisby
forcing themto recordmassivewrite-downsin assetvalues.
"We arenot setup to be frwused financialstability,"board StQhenCooper
said."ThereareOtherIpru&ntial regulauyslwhoarealreadysetup to dothat.buttheydon't
Want to do it.
"It æemscrazyto that are usto sanethingwe arepamly not
equipped to do.—
TheIASBwill preent itsviewsto G-20rneeting world leadersin Londonnextmonth
andwill urgeleaders puttheonusforoversightOibankson prudentialregulators.
"Theregulatorshouldbefocusedon notallowingbanksto paydividendsanddo share
buybacksif thatisgoingtoputthebankindanga,ratherthantryingtochangetie profitthat
is reported," Mr Cooper said.
TheIASBsaidthepd'lems Withfair-valueaccounting— themethodof valuingassetsat
market value rather than historical cost — becauseit was adopted Widely enough
and should be applied to all financial instrurrrnts.
Themajorinvestment
banksapplythe toOnly60percentto80percentOifinancial
instrumentson their balance and major retail banksapply it to as little as 10 per
cent to 20 per Cent.
"Peopleareaskingusto takea haircutto fairvalue '*her Whentimesare
goodandincreasethefairvaluewhentinps arebad,' Mr Coopersaid.
"Buttodecidebyhowmuchyouhaircutandby howmuchyouincrease,
youhavetobe
close to the banks and the markets. Ttk banking regulator hasthat closeness:
IASBmemkkrWarrenMacGregorsaidthe bankingindustryshouldkeepan additional
capital buffer to protectagainstcatastr%lhes,asinsur«s did.
He alsosaidAustraliancompanz shouldreFX»rt quarterly.asin the US,ratherthan twice
a year,to ensurethetirnelydisclcsure
of assetprices•ii needfortinrly infr»rmation
is
clearly there.•

PART
 The IASBwill IÖ•,• the G-20 to ensue the uS towardsadq)ting international
accounting standards. If the US fails to adopt the standards,there will an increased risk
regulatoryarbitrage:convanies k»king gapsto deermine bestjurisdiction ior them
to report in.

I. The article refersto a view circulating at the time, that fair value accounting contributed
to the 'global financial crisis' October the near collapse oi many banks
caused capital flows to dry up and share prices to fall dramatically). How could fair value
accounting exacerbatetik financial crisis?
2. Why the IASBmember refuseto rspatsibility for the financial crisis?
3. The IASBconsidersadoptionoi ASB standardsin the USAto be essential.Explainwhy it
holds this view. TOwhat ext«tt the IASWsposition reflect self-interest?

Intangible assets
adoption Of IAS 38 IntangibleAssetsin Australia also illustrates the role Ofpolitics in
the standardssetting process.The AASBhad not issuedaspecificstandardon accounting
for intangibles, having withdrawn its draft in 1992 due to lack Ofconsensuson
the subject-50Many methods for valuing intangibles assetshad developedand Australian
companies used a variety of methods_St LAS38 (issued by the [ASB in 1998 and revised
in March 2004) required methods Of accounting that were significantly different from
those adopted by some Australian companies For internally generated
intangibles cannot be recognised and intangible assetswithout an active market cannot
be revalued.Australian companies with substantial intangible assetsin either Of these
categories lobbied the IASB, the AASB and the federal government for relief from
the IAS 38 requirements based on the impact that they would have on companies'
financial statements." •Itie AASBrequestedthat Australian companiß be permitted to
carry forward existing intangible assetvalues from January2005. However, the IASB
declined their request.The AASBwas unable to negotiate With the IASB to achieve an
outcome that was considered important by some Australian companies, The result
shows the relative power of the AASBand IASBand highlights the limited ability Ofthe
AASB to influence the IASB. It also illustrates the IASB's need to be seen to be a strong
independent standard setter. The Australian government chose not to intelvene in
the processOf adopting IAS 38, despite company requestsfor it to do Transferring
a fundamental aspect of standard setting offshore (to the IASB in lßndon) allows the
governmentto referto globalmarketforcesdemandinginternationalcomparabilityand
givesit a justification to Stayout Ofthe standardsetting process.It alsohighlights the loss
of influence of the corporate sector Overthe standard setting process.

THE REGULATORY FRAMEWORK

FOR FINANCIAL REPORTING
In the preceding discussion.we have referredto many parties With an active role within
the financial reporting environment. They include the preparersof the financial reports
(company directors and their executives and managers) and a company's external
auditors as well as the rule-makers,such as private sector groups, stock exchangesand
governmentsand their agencies. activitiesof thesepartiesWill be influenced by
the environment in which financial reportirw takes place; that is, its legal, economic

CHAPTER3 to 69
 politicalandsocialsetting. specificenvironmental
fraturesof thefinancialreporting
environmentmakeup Whatcan be calledthe regulatoryframeworkOf financial
reporting.While regulatoryframeworks
varybetweencounuies,they often have
common elements.We outline theseelementsbelow 10provide an overviewOf the
regulatory
framework
forfinancialreporting(thatis.aproformaregulatory
framework)
and to demonstratehow theelementsOftheregulatoryframeworkinfluencethe output
Of the financialreportingprocess— the financialstatements. elementsof the
regulatory framework which we discussare:
• statutory requirements
• corporate governance
• auditors and oversight
• independent enforcementbcxlies.

Statutory requirements
Thekeyparticipants
in theproductionOffinancialreportsarecorporate
directors(and
their executives
andmanagers) and auditors.Msewherein this book,we
have that therearemanymotivationsfor managersto voluntarilyprovide
financial information and to have that information independentlyverified through
the audit process.Now we turn to the role Of Statutoryrequirernentsas an incentive
to producefinancial statementsand havethem audited. In many countriescompany
law mandates that directors provide audited accounts." Ihus a primary influence on
directorsand auditorsisthe needto fulfil Statutoryreportingrequirements,ascontained
in companylaw.On theonehand,companylawwill likelymandatebasicrequirements
relating to which reportsare 10be preparedand their frequencyOf preparation.But it
mayalsoincludeparticularrequirements
relatingto theinformationto beincluded;for
example,
in Australia
companies
mustdisclose
informationabouttheirenvironmental
performance.
In someiurisdictions,notablytheunited States.reportingrequirements
arederivedpredominantly
fromsecurities
marketlawratherthancompanylaw.S•
Additional financial reporting requirementsare derived from specific accounting
standards and in many jurisdictions these standardshave the force Of law. For
aarnple,listedcompanies
in theEuropean
Unionthatprepareconsolidated
financial
statements
arerequiredby law to useLASB standardsadoptedby the ELI.In Australia,
companylaw requiresall reportingentitiesto follow legallyendorsedIASB•based
accounting standards.Tuation law is another Statutory influence on financial
accountingin manycountries,notably thosefollowing a Frenchor Germanaccounting
tradition. In thesecountries, for single entity reportin& the financial accounting rules
are the sameas tax rules." Company law. in turn. forms part Of a wider legal system,
which is likely to includewaysof monitoring complianceWith Statutoryrequirements.
Forexample.the FEEreportsthat manyFau•opean countrieshavea body responsible
for checkingICHIgement
Ofaccounts.In addition.thejudicialsystemprovidessanctions
andpenaltiesthatpromotecomplianceWithcompanylaw*

Corporate governance
AnotherimportantelementWithina countrysregulatoryframeworkis the systemof
corporategovernance.
Davistakesa broadviewOfcorporategovernanceandstatesthat
it refersto 'the structures.processesand institutionswithin and around organizations
that allcrcatepower and resource control among participants'.57Some corporate
governance
practicesarederivedfrom lawswhichrequiredirectorsto carryOutspecific
actions in relation the management for their companies. For example, requirements

70 PART1 Accountingtheory
 to hold meetingswith shareholdersand to disclosemattersof interestsuchasdirectors'
remunerationand related party transactionsare basiccorporategovemancematters
which may be coveredby company law.SS
However,a regulatoryframework may contain additional corporategovernance
guidanceand rules, arising from both private sector voluntary recommendations
and stock exchangelisting rules.Corporategovernanceguidancemay take the form
Of voluntary best practicerecommendations,
which encourage
directorsto adopt
appropriate governance mechanisms, to best suit the situation Of their individual
company. Both supranational and national bodies haveproducedcorporategovernance
recommendatiol& The International FederationOf Accountants(IFAC) guidelines are
an exampleOf the former and corporategovemancecodesissuedin the United Kingdom
and AustraliaareexamplesOfthelatter-S'Governancerequirementsrelatingto financial
reporting canbeenforcedby the stockexchangesor the gcwernmentbody responsiblefor
enforcementOf financialreportingrequirements.Forexample.in theUnited Kingdom
andAustralia,therespectivestockexchangesrecommendcomplianceWiththecorporate
governancecodes and require companies not in compliance to provide explanations
Ofthe reasonsfor non-compliance.theso-called•if not. why not' rule. lit] directiveson
corporate governancecanbe enforcedthrough memberstates'legalsystems.

Auditors and oversight

In many countries auditors perform a vitally important function in providing assurance
aboutthequality Ofinformation providedby companiesin their financialstatements_t-•
It is common for the auditing profession to be regulated in someway. •Ilie most basic
form of regulationof theprofessionis limiting Ofmembershipto personswith particular
qualifications and experienceand requiring registrationto practise.Other forms Of
regulation involve requiring membership Of a professional body and commitment to
an ethical code Of conduct. professional bodies may also sanction members in breach
Of their rules."
Many Of these forms Of regulation are self-imposed a profession may agree
to follow a body Of rulesto maintain its privilegedposition and to protectits right to
practise as a profession. For example. private sector self-regulation Of the accounting
professionis an earlyform of auditor oversight.In the past.professionalbodieshave
taken their role Of oversightOf the profession seriously.devoting considerableresources
to developing standards for professional conduct at a national and international level.
Many national bodies representing auditors have voluntarily adopted international
standards Of auditing (ISA) as an indication of their commitment to providing a high-
quality serviceand demonstratingbehaviourappropriateto membersOfa profession.
Self-regulation Of the auditing profession has been widely obsecved,but there are
some notable examples where regulation was from early times the responsibility
Of Stateauthorities. For example.in Franceand Italy regulationOf auditors was the
responsibility of their respective independent enforcement bodies (the securities
market regulators, Autorité des Marches Financiers or AMF in France and Commissione
Nazionale per le Societae la BorsaOr Consob in Italy). In the caseOf the AMF and its
predecessorOrganisation Commission des Operations de Bourse(COB), the regulator
Works closely With the Compagnie Nationale des Commissaires aux Comptes or CNCC,
the body representing the auditing profession in the processof carrying out oversight
of auditors' activities.
The location Ofresponsibilityfor auditor oversightwith a body, ratherthan
allowing self-regulation, provides (at least in theory) for more independent regulation.
The choiceOf a statutoryregulatorrather than self-regulationmay reflecteconomicor

CHAPTE
R 3 Applying to accounting
 politicaldifferences
in approachestomanagement Ofcapitalmarkets.Forexample. until
2005theUnitedKingdomhada traditionof self-regulation
Ofauditors,
consistentwith a culturalpositionof minimisinginterventionin theoperationOfthe
capitalmarket.StatutoryregulationOfauditorsis consistentWitha morecentralised,
interventionistapproach(0 regulationOfbusinessobservedin Franceand Italy.62In
recentyears,manycountrieshaveintroducedStatutorybodiesresponsiblefor auditor
oversight, as discussedin the final section Of this chapter.

Independent enforcement bodies

A studyby the FEEincludesan independentenforcement body aspartOfthe overall
systemfor enforcementof financialreportingrequirements.63 roleOfsucha body
in the regulationof financialrepottingis to promotecompliancewith theregulations
governingthe productionOf financialstatements,
whicharecontainedin law.and
accounungstandards.
AnindeiEndentenforcement
bodyis anextensionOflodgement
supervision,
abasicpartOftheregulatory
framework.
Whilemanycountries
haveabody
responsible
forlodgementsupervision.
settingupanindependent
enforcement
bodyis
a morerecentevent.linked to theadoptionOfIFRSin 2005.Because
Ofthe importance
Ofcomprehensive
andconsistent
applicationOfIFRSin achievingthe goalsOfIFRS
adoption,eachELImemberStatewasrequiredto setup an independentenforcement
body.TheCommitteeof EuropeanSecuritiesRegulators
(CESR)reportedthatby 2006,
20 of the 27 ELImemberStateshad setup an enforcementmechanismthat met,at least
in part.therequirements
laid downbyCESRstandards
for enforcement"
AsecuritiesmarketregulatoristhemostcommonlyObserved
form for an independent
enforcementbody. Examplesincludethe AMF in France.the Consobin Italy, the
Autoriteit FinancieleMarkten(or AFM,financial MarketAuthority) in the Netherlands,
the SecuritiesExchangeCommissionin the united Statesand ASICin Australia.
Independentenforcementbodiesmayhaveextensive dutiesandpowersin relationto
theregulation
ofsecurities
markets,
whichextendfarbeyondthemonitoringoffinancial
reporting.Nevertheless,
suchbodiescanbeveryactivein enforcingfinancialreporting
requirements
containedin lawandaccounting
standards. SECisanotableexample
Of an active market regulator,which is involved in setting accountingrequirements
(eitherdirectlyorthroughadelegated
committee.
FASB),
providinginterpretation
advice
andtaking legalactionagainstfirmsfor non-compliance."•Iheoryin action3.3explores
the role of both the FASBand the SECin relation to the issue Of backdating Of stock
optionsin theUnitedStatesWeconsidertheextentto WhichFASBand/ortheSECcan
beconsideredresponsiblewhenthereis non-compliancewith anaccountingstandard.

EnforcingrequirementsOfaccountingstandards

Executive in U.S. convicted for backdating share options

by EricDashandMatt Richtel
NewYork:US. scoreda guiltyverdictin thefirstogiionsbackdatingCaseto goto
trial,securinga convicticvnthatisexpectedto emboldenthemto pursuesimilarcases.
Jurorsin US. DistrictCourtin SanFrancisco Tuesday convicteda iorrnerchief Of
3rtxadeCommunications Systems.Cr.ry Reyes, 44,on 10countsofccnspiracy fraud.
Theverdictendedafive-weektrial inwhich Reyeswasaccusedof intentionallychangingthe
grantdatesforhundredsoi stockC5)tion
awardswithout the toinvestors.
Sentencing isscheduledforNov.21.UnderU.S.sentencing
guidelines,
Reyes couldface
upto20yearsinprisonforthe eriouschargøaswellaspaymillionsofdollarsinfines.

72 PART 1 Acco..mting theory

 Theverdictsentshock
waves
through
Silicon
Valley lawoffices
around
theCountry
arerg»resenting
dozensof companiesandexecutives in widespread lal.
In the wake Oi intensemediaattention,regulatorscrackeddown on more than 00 com•
paniesovertheunlikelycoinci&nceOfstcx•k t*ing grantedagainandagainto
executives
and datewhenthesharepricewaslow—atacticthatguaranteed
the maxirnumprofit whenthe cvtions were laterturned into cash.
Backdating
isillegalif thecompany prcvcrlyaccn_Jnt
forthediscounted
grantsas
an expense.
The U.S. and ExchangeCulunission eventually investigatedabout 140
panies in connecticmwith the practice, and filed chargesagainstat least fwe

Yet lawyas have argu«f that these caseswere more winnable as civil rather than
criminal courts where the burden of proof is much greater.
Most of the backdatingcases,including the one againstReyes, on proving that the
defendantsknowingly manipulat«i an option grarudate to defraudinvestors.
But thatclaim can be obscuredby the complexityof accountingissues.While lawyerson
both side acknowledgethat thesecasesare difficult win, the Brocadedecision indicates
that a guilty verdict is possible.
"It emboldensthemin bringing cases,banI don't think it rneanstheywill bring bushels
o' these cases." SeanO Shea. a criminal defense lawyer in New York, said of prosecutors.
"They will bring the strongßt Of those whee can show evil in trying to conceal
information frorn shareholders. •
Mark Zauderer, a trial lawyer in New York. said: •Defense lawyers are going to be keenly
aware that where there is evidence Ofmisleading documents. it will difficult to rely on the
&fense that nobody knew it was illegal.
"Betterto truthfullythatis qustiMable thanto riskmisr"øenting
the facts, • he said.
In the Brocade case, prmecutors evi&nce that Reyes intentionally misled
shareholderswith a "systemicpracticeo' cherry-pickingstock prices-to build in gains
employees.
During the trial, a formerfurnan tßtified that Reyø told her that the
practice was illegal if you don't get caught.'
Prosecutorsalso said that Reyesdenied backdating stcrk q*ions Whenhe was
by investigators about the pattern Of favorable grant dats.
The lawyer for Reyes,Richard Marmaro, portrayal his client as a hard-working technology
cornpanyexecutivewho did traffic in the accountingarcanaof stockoption grants.
Brocade, the defenseargued, offered the low-priced gramsas a way of attracting ernployæs
as the dot.com boorn created an intense battle to hire tal«'t.
t 8 2007

Questions
Accountingstandardsrecpirethat.in certaincircurnstancß,companiesrecordanexpensefor
stock options grant«i to employees.
I. DO you consider that the C'*rvany Broca& with the
requirement to record an expense for stock cotims?
2. Who benefitsfrom the 'backdating'Of cpti0ns? is harmed?
3. If options can be backdated, hasthe standardsetting board (in United States,the FASB)
been effective in the role of prunulgating acccn•ntingr%ulations?
4. What is the role Of the SECin relation to the Of accounting practice?

In some countries the stock exchange takes the role Of market regulator. For example,
stock exchanges are (or have been) involved in monitoring financial reporting in
Switzerland, Swedenand Norway. Another form of independent enforcement body is a

CHAPTER3 Applyi ng to regulation 73

 reviewpanel.suchas the united Kingdom'sfinancial ReportingReviewpanel (FRRP).
FRRPwasformed in 1991with powerto investigatemattersrelatingto financial
reportingbroughtto its attention.•lite FRRPwassetup asa privatesectortrustand
comprisesmembersOf the businesscommunity.•nu,s. it is a Structurethat involves
the privatesectorin regulation.which is viewedby manyasan effectivealternative
approachto regulation.67Anotherapproachwastakenby Germanyfollowing adoption
Of IFRS.They set up a Bvo-tier enforcementsystem,comprising a review panel
(Deutche Prüfstellefür Rechnungslegun&i.e. the Ihnancial Reporting Enforcement
panel or FREP),which reports to a governmentdepartment (Bundesanstaltfur
Finanzdienstleistungsaußicht
or BaFin.i.e. the FederalInstitute for the Oversightof
Financial Services).
Another part of the regulatory framework which arises becauseOf widespread
adoptionof IFRSis a Systemto coordinateenforcementA supranationalorganisation,
theInternationalOrganizationOfSecuritiesCommissions(IOSCO)establisheda system
for participating IOSCOmembersand Otherindependentenforcementorganisations
to share information and consult in order to improve coordination and convergence.
Eachnational regulatorretainsthe ability to dealWithan issuein its Ownright but the
systemaimsto facilitateConsistencyand providea referencepoint for future regulatory
decisions.68At a regional level, CFSRhasset up a coordination mechanism (European
enforcers' coordination sessions or EECS) to maintain a database of enforcement
decisions. The EECS focuses on decisions taken or to be taken by local enforcers and
gives input and feedbackon specificca*S in order to achieveconsisteno' among
European enforcers."

THE INSTITUTIONAL STRUCTURE FOR SETTING

ACCOUNTING AND AUDITING STANDARDS
In Our discussionOf the regulatory franw•workfor financial reporting Wesaw that
financialreportingrequirementsarecommonlyderivedfrom statutelaw andaccounting
standards. In this section, we consider the development Of an international standard
settingbodyand theprocessor settinginternationalaccountingand auditingstandards.

Background
The development Of international accounting standardsbegan formally with the
formation of the International Accounting StandardsCommittee (IASC) in London in
1973. committeecomprisedrepresentatives of professionalaccountingbodiesfrom
nine countries(Atßtralia. Canada.France.Japan.Mexico,the Netherlands,the United
Kingdomand Ireland,the United Statesand WestGermany).mIts aim wasto develop
accountingstandardsfor the privatesectorsuitablefor usein countriesthroughout the
world. Prior to 2005, International Accounting Standards(IAS) were influential in the
following ways.They wereadopted for usein countrieswithout a national standard
setting structure; for example in Papua New Guinea and Indonesia. In Other cases,
they wereused in the developmentof national standards,such as in Singaporeand
Hong Kong. IASwere also usedvoluntarily from the early 1990sin the consolidated
accountsOf companiesfrom countriessuch as Switzerlandand Germany-72In these
countries, national accounting reflected a stakeholder orientation arising from their
code law legal framework and tax-basedaccounting systems.Companies used IRS to
provide additional information for capital market participants in a more transparent
and comparable format.

74 PART Accounting theory

 Themembers
of theLASC
hailedfromcountries
with arangeof accounting
practices
anddifferentapproaches to settingaccountingstandards.EarlyIASCstandards Often
alloweda choiceOfaccountingpolicyto includethe preferences of variousmember
nations.Duringthe late 1980sthe IASCbeganwork Onthe Improvements Project,to
improvethequalityOfIASandremovemanyoptionaltreatments. TheIOSCO.a body
representingsecuritiesregulatorsthroughout the world. sought a setOf standardswhich
its members could use in cross-border listings. The revised standards Wereendorsed
by IOSCO in 2000, albeit with the proviso that member countries could add further
requirements.72
The latter proiäsion reflectedthe position Of the marketregulatorin
the United States, the SEC. It did not intend to remove the LIS CAAP reconciliation
requirements (the so-called Form 20-F) for companies using [ASC standards and listing
on the more-regulated United States (such as the NYSE NASDAQ and
AMEX)."
Althot• use of IAS throuølout the world was increasing further acceptance
Was limited by the fact the IASC was not an independent standard setting board.
Consequently, it was restructured in 2001 to create the International Accounting
Standards Board (IASB). an independent board based on the Structure Of the Financial
Accounting StandardsBoard (FASB)in the United States.The board comprised fourteen
full-time members,chosenfor their expertiseand experiencein professionalaccounting
and standard setting It was supported by dedicated technical staff, located in London.
The IASC Foundation became the oversight body of the IASB and an interpretations
committee was formed.74 The formation of the IASB saw the disbanding of the G4+1
(a body comprising independent standard setters from Australia. New 7xaIand,
the United Kingdom, the United Statesand the IASC),which was becoming influential
in developing international IASBhas responsibility for updating existing
IAS (which still carry the IAS label) and producing International Financial Reporting
Standards (IFRS).
importanceOfthe activitiesOf the IASBincreaseddramaticallyWith thedecision
in 2002 by the European Commission (EC) to adopt IASBstandards in 2005. The EC
announced that all listed companies in European union (ELI) member countries would
prepare consolidated accounts based on [ASB standards. •this fundamental change was
an important Step promoting the production Of more transparent and comparable
financial information by listed Europeancompanies.It wasprompted by the goal of
developinga single,unifiedcapitalmarketin Fa•rope_
Ilmedecisionprompteda flurry of
activity at the LASBand in ELI member countries first, the IASB was required to produce
a 'stableplatform' of standardsby I March 2004. to be reviewedby the EC'sAccounting
Regulatory Committee (ARC). committee would recommend to the EC whether
the standards should be endorsed for use in EU countries. Thus. the IASB had a heavy
workload and tight timetable as it sought to finalise standards,including demanding
and controversial projects such as accounting for financial instruments. Second,
eachELI membercountry had to preparefor adoption of international standardsby
consideringhow IFRSreporting would integratewith national reporting.For example,
would parent company and private company accountsalso use international standards
or continue to use national GAAP! The setting up of independent national enforcement
bodies,to promotecomplianceWithinternationalstandards,wasalsorequired.75%ird,
the accountingprofession(including externalauditors and public accountants)had
to preparefor IFRSadoption. Ihis in•nlved technicaltraining to acquaint themselves
with standards,which in some caso were markedly different to existing national
GAAP_Companiesalso facedmany challenges.personnelhad to becometechnically
proficient in the standardsand companieshad to reviseaccountingsystemsto record

CHAPTERJ 75
 information required by the new regime. In addition. they had to communicate With
stakeholders such as investors and financiers about how IFRS adoption would impact
on their financial statements.

The IASB and FASBconvergence program

work programOftheIASBwasfurthercomplicatedby theannouncementOftheIASB/
FASBconvergenceprogram,called the Norwalk Agreement,in 20021bThe FASBwas
formed in 1973 and is highly regardedthroughout the world asa leading standardsetter.
'Ille FASBhaspowerdelegatedby theSECto developstandardsfor hnancialreportingfor
listedcompanies. hasproducedseveralaccountingconceptstatements77 anda seriesOf
financial reporting standardsfocusing on providing high quality financial information
which isuseful for decisionmaking.The useof international standardsin the United States
hasbeendiscussedat length.'8Whilesomegroups.suchasthestockexchanges, mounted
argumentsin favourof acceptanceof IASbasedfinancialstatements,the SECuntil 2007
maintained that reconciliation to US GAAP was necessary to ensure a 'level playing
field'. SECissueda concept releasein 2000 which outlined its views about desirable
attributesOfthe financial reporting framework" ntey include high—quality
standards
developedby an independentstandardsetting board. and compliancepromoted by
independent enforcementbodies. With the adoption OfIAS in 2005by many companies,
pressureto allow the OfLASWithout reconciliation (e.g.from EUcompaniescross-listed
in the united States)increased.In 2007, the SECagreedto permit foreign registrantsto file
IFRS accounts with the SECwithout the R»rm 20-F reconciliation. SCThe SEC then began
the processofconsidering whetherdomestic registrantsbe permitted to useIFRSinsteadOf
LISGAAP.81While there aresome supporters for of IFRSin the United Slates,de Lange
and Howieson arguethat political realitiesmean the US is unlikely to give up M)vereignty
over the setting Ofaccounting standards
In the meantime. the IASB/FASBconvergenceprogram has generated considerable
work for both Boards. It complicated the processOf producing the 'stable platform'
Of standard for 2005 as the IASB was working to this aim while at the same time
considering the extent to which standards could be revisedto convergeWith US CAAP.
The convergenceprogram requires the FASBand IASB to identify differences between
their respective standards, to review available solutions and to adopt the better
treatment. In practice, convergenceis a complicated process.Some of the differences
arise becauseOf underlying differences between the two of standards. GARP
have been described as rule-based standards while IAS aim to be principles-based. 83
greaterinvolvement of the United Statesmeansthat international standardsetting
(and, in turn, national standard setting) is now dominated by the FASBand IASB.
The convergenceprocßS can only be a two-way dialogue between the FASBand IASB
becauseOf its inherent difficulties. which would increaseif more parties were involved.
However, the IASB has a policy Of working With national standard setterson projects
where they are able to contribute to the standard setting process." Ilie current liaison
standard settersare national standard setting bodies from Australia, France,Germany,
Japan,New Zealand, the United Kingdom and the united States.They participate in
the IASB'sWork through researchprojects, project teamsand joint projects. •Ibe IASB is
dependent on the contribution of national standard setters,yet it is unclear the extent
to which these bodies will influence the final decisions of the IASB. Since 2005 bodies
from the ELI (such as national standard setting boards and EFRAG) have become more
vocal in the processOf developing accounting standards •Ihe IASB may see itself as
the global standard setter, but for the ELI it is their 'local neighbourhood standard
setter Given that standards have economic consequences.there is vigorous debate

76 PART 1
 inEurope
aboutthecontent
ofIASB
standards
andthedirection
Ofstandard
setting.
as
discussed
previously
in thischapter
in relation
tofinancial
instruments.
Casestudy3.3
provides
anopportunity
toconsider
anumberofimportant developments
relating
to
theadoptionOfinternational
standards
whichbrirwOutkeyissues
arisingfromuseOf
common standards.

Accounting standards for the public sector

As noted above.the IASBsetsstandardsfor the private sector.Different standardscould
applyto thepublicsector,giventhatpublicsectorentitiesmayhavedifferentgoalsand
Objectivesand differentstakeholderscomparedwith privatesectorentities. Individual
countriesmustdecidethe extentto whichIASBstandards
Will be followedby public
Sectorentities.In Australiaand NewZealand.theapproachto datehasbeento pursue
one set of accountingstandards.suitablefor both public and private sectorentities.
Such standards are described as •sector neutral standards'
In Australia the AASBhasa numberof functions.asdescribedbelow by the then
chairman, David Boymal:
• produceaccountingstandardsto befollowed by reportingentities
• produceaccountingstandardsfor the public and not-for-profitsectors
• actively participate in development of international standards
• provide interpretation of accounting standardsto ensure comparability Of financial
reporting by Australian reporting entities
• provide technical support to Australian repre*ntatives on international committees
such as the IPSASB and SACS7
• producestandardsfor privatesectorand not-for-profitentitiesare a key board
function. In addition, the Boardnotesthat it supportsthe B'orkOf the International
Public SectorAccounting StandardsBoard (IPSASB).a committee of the International
Federation
OfAccountants
(IFAC).In 2009.IPSASB
wasinvolvedin developing
a
conceptualframeworkfor public sectoraccounting

International auditing standards

Finally in this chapter, we consider the regulation Of practice and the
developmentOf internationalauditing standards.Historically.auditing was self-
regulated. Several professional accounting societieswere founded in the nineteenth
centuryto promote the professionand to provide training for members. The formation
of thesesocietiesoccurredduringatimewhenCompanies
Actswerebeingpassed
in the
United Kingdom requiring audits and thus generating a significant source Of revenue
for accountants." As Watts and Zimmerman have documented, there is evidence of
auditsin theearlyhistoryof corporations
andthedevelopment
of professional
auditing
reflectedthe developmentof capitalmarkets." authorsconcludethat audits were
demandedto meettheneedsOffinancialstatementusersandcontractingpartiesand
that legislationrequiringauditsmerelycodifiedthebestexistingpractice.
Asdiscussedin chapter2, earlyauditingtheorydevelopmentdocumentedtheprocßs
Ofauditingandthedutiesexpected
Ofauditors.Moregeneraltheoreticaldevelopment
followed which describedand prescribedbestauditingpractice.Thesepracticesbecame
enshrined in auditing standards issued by the profession. In the United States,the
AmericanInstitute of Accountantswasresponsiblefor the first auditing standardsin
1939." In Australia.auditing standardswere issuedby the professionalaccounting
bodies through the AARE.The professionwas responsiblefor maintaining ethical
standards.including di«iplining memberswho did not follow accounting and

CHAPTER 3 to 77
 auditing standards.However,this form Of regulation wasweakenedif there was no
legal requirement for accountantsto be membersof professional bodies.•Ibe American
Institute OfCPAs(AICPA)begana systemof reviewsin the 1960s.although i' was
voluntary until 1989."
Asnotedpreviously,theaccountingscandalsat EnronandOthercompaniesin theearly
2000scanberegardedasmarketfailuresandappearto havebeenusedasjustificationfor
governmentinterventionin auditingstandardsettingin the UnitedStatesand Australia.
SincethepassageOftheSarbanes-Oxley Act (2002),reviewsOfaudit firrnsin the LIShave
beenconducted by a government body, the Public Company Accounting and Oversight
Board (PCAOB)_The PCAOB is also responsible for setting auditing standards for
the audit Ofpublic companies.In Australia,auditing standardshavehad legal backing
throughtheOrgvrationsAct2001since I July2006following passage OfCLERP9.
Even though auditing standardsare now set by governmentbodies, the early
focus hasbeenmore on rewriting standardsto enable them to be incorporatedinto
legislationthan on changingtheir content. InternationalStandardson Auditing (ISA)
aredevelopedby the International Auditing and AssuranceStandardsBoard (IAASB). In
Australia.the Auditing and AssuranceStandardsBoard(AUASB)rewrotethe previous
set of professional standardsand is directed to ISAasa basefrom which to develop
new Australian standards, With any necessaryamendment-"
The IAASBoperatesunder the auspicesof the IFAC. IFACs areaccounting
organisations and most members Of the IAASB have been practising auditors. This
situation has led some commentators to that the IAASBis •captured' by the auditing
professionin the sameway that professionalaccounting1K'dieshad •captured'the national
auditing standardsetting processbefore the Act in the USand CLERP9 in
Australia.Eventhoughgovernments to havetakencontrol of auditingstandards,
their relianceon the IAASBpotentially underminesgovernmentauthority."
ltA„ASB
appearsto beawareof thethreatto its credibility and powerby its reliance
on professionalaccountantsfor funding and expertise.•me IFACestablishedthe Public
InterestOversightBoard (PIOB) in 2005 With the Objectiveof increasingconfidence
in the standards issuedby the LA-ASB and Other IFAC bodies." Its aim is to ensure that
standards are set in a transparent manner that reflects the public interest. With input
by the public and regulators.and to facilitate audit regulation.As discussedfurther
in chapter14, the future succes of the IMSB relieson successfulenforcementof the
auditing standards and retaining the trust Of the various stakeholders.
Governments appear to believe that accounting and auditing standards matter, and
they have somesupport from researchfor their view. There is evidencethat the strength
Of accounting and auditing standards and the effectivenessOf their enforcement are
factors in the successful development of financial markets around the world. Francis,
Khuranaand Pereiragatheredevidenceon the quality of auditing the strength Of
auditing enforcement.and the quality of accountingstandardsand found that high.
quality accounting and auditing are more likely to exist in corporate governance in
countrieswith stronginvestor protection." Howe.'er,although higher quality accounting
and auditing are also positively associatedwith financial market development in these
countries, the evidence does not support the contention that they are sufficient to
encourage the development Of financial markets without strong investor protection.
One example of how the actions of auditors can impact on individual companies
and on the broader market is addressedin theory in action 3.4. ne article presented
considersthe market impact Ofauditors giving an •emphasisof matter' opinion, which
may be necessaryfor q:jme companies following the 2007—08financial crisis.

78 PART Accrn_jntingtheory
 Many small caps to flashorange
by Damon Kiowy and Patrkk Durkin

Hundreds
Ofsmall
Australian
Securities
Exchange-listed
companies
Willhave half-yearly
S
aCCCwnt
flagged
byauditors
over nextfo-tnight of theymayfailtoStay
in business over the next 12 months.
Theongoing
impactOfthecreditcrisismeans
directors manysrnallCOnpani8
will be
unable
toguarantee
thattheirconvany
will asagoing especially
where
they face rolling over their debt.
Thewarningbydirectors
andacctR•ntants
followsacrackdown
bytheAustralian
Securities
andInvestments
Commissioninsolvent
trading
andcanesasthehalf-year
reporting
seann
drawstoanendoverthenexttwoweeks— whenmanycashstramrdcompanies
tendto
In December.ASICsaid stujuldfocus whether will ranain solvent
giventheirabilitytorefinance
debt,raisefundsandcomplywithlending
covenants.
"Managing bankingcovenants in anenvironrnentwhereass«valuesaredrq»ping
can
beaverydifficultthing.saidJeffLucy,chairman
OftheFinancial
RqmngCouncil
—the
oversight
bodyforaccounting
andauditingstandards
in Australia.
"Fora smallminingccrnpany,
for instance,
a in ccnn»ditypricesleadsyouto
100k
atthecarrying
valueOfmines.
Thisreduceasset
values,
whichthenaffects
banking
WhensigningOffon accounts,auditorsarealsorecpiredto providean assurance
that
companies
will remainsolventoverthenext12months.Wherethereis uncertaintyabout
whether
acompany
cancontinue
asa cmcern,
auditors
arerapiredtoflagtheaccounts
with "an emphasis of matter—.
Thetechnicalacccx•nting
warningisme belowa •qualificatim—,
whichis themost
seriouswarningaboutpotentialirregularitiesin ccrnpanyaccounts.
KPMG's
national
managing
partner.
riskandr.lation, Michael
Coleman,
saidheexpected
to seemoreaccountsflaggedwith an•emphasisof matter*in thecurrentenvironrnentbecause
Ofuncertainty
abouttheirdebtprofile.Butthehighnun&r ofnaggedaccounts
hascreated
alarmamongacccwntantsandregulattysamidconcernsthatinvestors
maymisinterpret
the
findings.
"In thisenvironment.asinvleeventhasachainreaction,
• Lucysaid.•In puttingthe
truth thetable,it canhavea sntmballeffect.Thereneeds to a maturejudgement
applied.Doesit rneanthatwheelsareatnuttofallofRNO.Butrather aqualification,
Whichisaredflashing light.anemphasismatterisreallyanorange
glow.'
Thematterwasdiscussed
atameetingOftheFinancial
Reporting
CouncilinMelbourne
last
weekattended
byMrLucy,Corporate
LawMinisterNickSherry
andthenewchairman oftfr
AustralianAccountingStandardsBoard,3rucePorter.
"It is emphasising
to thereadersthisparticularpoint.it is sayinggoandhavea lookat
this,goandhavearead youfullyunderstand
the because
o/ thisuncertainty:
Mr Portersaid."It issaying isa lackOfevi&ncetosay100 cent(thatthiscompany
will survive), • he said.
2i 20m. p. 9.

Questions
1. Whatdoestheheadlineofthearticle"*an by •smallcap'ard 'flashorange'?
2. Explaintheargumentthatrnerelyby placirwan 'arvhasis Ofmatter'æctionin an audit
you could Start a chain reaction.
3. The article discussesbank covenams— explainthe in-pactof assetvalueson bank
covenantsandthepotentialreg*rcussions a company.

CHAPTER to