ACCG835

International Accounting

Week 12

International Convergence of Accounting

 Definition

• Harmonization relates to the process of reduction of

contradictory accounting rules in order to reach a
better international comparability of financial
statements.

• International convergence is a process that eventually

results in the adoption of the International Financial
Reporting Standards.

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 Definition …

a. What is the difference between accounting harmonization and

convergence?

The degree of variation in accounting practices………

No Convergence Convergence
Harmonization

b. Why is there an emphasis on ‘convergence’ now, rather than on

‘harmonization’?

The current move is to have ‘a single set of high quality standard’ that is
accepted globally.

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Forms of Harmonization/Convergence

Highest
Adoption of IFRSs in their entirety
Convergence
of standards

Adoption of IFRSs selectively or with a time

lag
Compatibility
of standards
Adoption of IFRSs with amendments and
additions to bring them in line with the local
environment

Continuation with the local accounting Harmonization

standards, but in harmony with the IFRSs process

Continuation with the local accounting

standards or countries without a set of
prescribed accounting standards Lowest

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 Cont…

There are institutional differences among nations such as in

infrastructure, culture, legal requirements, and socioeconomic and
political systems. Therefore, certain amendments are required when
adopting the IFRSs.

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 History of IASB

• On 2 July 1973, the accounting profession achieved its aim, and

formulated a body known as the International Accounting
Standards Committee (IASC) now known as International
Accounting Standards Board (IASB).

• This body was established, together with International

Federation of Accountants (IFAC) to promote worldwide
improvement and harmonization of accounting and auditing
standards.

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 Structure of IASB – “Due Process”

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 Mission Statement of IASB

Our mission is to develop IFRS Standards that bring transparency, accountability and
efficiency to financial markets around the world. Our work serves the public interest
by fostering trust, growth and long-term financial stability in the global economy.
• IFRS Standards bring transparency by enhancing the international comparability and quality
of financial information, enabling investors and other market participants to make informed
economic decisions.
• IFRS Standards strengthen accountability by reducing the information gap between the
providers of capital and the people to whom they have entrusted their money. Our
Standards provide information that is needed to hold management to account. As a source of
globally comparable information, IFRS Standards are also of vital importance to regulators
around the world.
• IFRS Standards contribute to economic efficiency by helping investors to identify
opportunities and risks across the world, thus improving capital allocation. For businesses,
the use of a single, trusted accounting language lowers the cost of capital and reduces
international reporting costs.

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What are the factors contributing to the growth of international
accounting?

* International Financial Markets

* Multinational corporate strategies
* Business Services
* Economic & political interdependence
* New technologies
* International agencies
* Etc

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 Benefits

The benefits of global financial reporting framework are numerous and include:
• Greater comparability of financial information for investors;
• Greater willingness on the part of Investors to invest across borders;
• Lower cost of capital;
• More efficient allocation of resources;
• Higher economic growth;
• Attract international investors;
• Enable transfer of staff and also job opportunities will be created;
• Regulatory agencies will find their supervisory and enforcement roles eased;
and
• Enable the adopting countries’ accounting profession to emulate well-
established professional standards of behaviour and conduct and to legitimize
its status as a full-fledged member of the international community.

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 Major Obstacles

• Understanding the meaning of International Convergence;

• Translation of the International Standards;
• Complexity and structure of the International Standards;
• Frequency, volume and complexity of changes to the International Standards;
• Potential knowledge shortfall;
• Implications of endorsement of IFRSs;
• Length and complexity of the International Standards;
• Cost of compliance with IFRSs versus benefits obtained; (especially for SMEs)
• Inconsistent application of the International Standards;
• Perceived focus on large-entity issues; and
• Lack of sufficient small- and medium-sized entity and accounting firm
representation on the international standard-setting boards.

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 Use of IFRSs

Many countries have either adopted IFRSs in their entirety, base their
national standards on IFRSs, or allow the use of IFRSs. A cartographic
exercise is currently underway to map all countries with respect to
their position on IFRS.

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 Examples

• European Union
The European Union has adopted IFRSs in 2005 for entities with cross-border
business activities preparing consolidated group accounts.

• IASB-FASB Convergence
In October 2002, the IASB and US Financial Accounting Standards Board
embarked on a joint programme to converge US and international accounting
standards to the maximum extent possible.

• Use of IFRSs in Asia-Pacific Countries

Asia-Pacific countries are taking a variety of approaches toward convergence of
GAAP for domestic companies with IFRSs.

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 IASB Chronology
1974 Agreement to establish IASC signed by representatives of the professional
accountancy bodies in Australia, Canada, France, Germany, Japan, Mexico,
Netherlands, United Kingdom/Ireland, and United States. Steering committees
appointed for IASC’s first three projects.

1975 First final IAS published: IAS 1 (1975), Disclosure of Accounting Policies, and
IAS 2 (1975), Valuation and Presentation of Inventories in the Context of the
Historical Cost System.

1994 Establishment of IASC Advisory Council approved, with responsibilities for

oversight and finances.

1995 European Commission supports the agreement between IASC and

International Organization of Securities Commissions (IOSCO) to complete core
standards and concludes that IAS should be followed by European Union
multinationals.
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 IASB Chronology Cont…

1996 US SEC announces its support of the IASC’s objective to develop, as

expeditiously as possible, accounting standards that could be used for
preparing financial statements used in cross-border offerings.

1997 Standing interpretations Committee (SIC) is formed. 12 voting members.

Mission to develop interpretations of IAS for final approval by the IASC.

2000 IOSCO recommends that its members allow multinational issues to use IASC
standards in cross-boarder offerings and listings.

2001 Members and new name of IASB announced.

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 IASB Chronology Cont…

2002 SIC is renamed as the International Financial Reporting Interpretations

Committee (IFRIC) with a mandate not only to interpret existing IASs and IFRSs
but also to provide timely guidance on matters not addressed in an IAS and IFRSs.

2003 First final IFRS and first IFRIC draft Interpretation published.

2004 First IASB discussion paper and first final IFRIC Interpretation. IFRSs 2
through 6 are published.

2005-11 The US FASB and IASB have begun a number of new joint agenda projects,
including their conceptual frameworks for financial accounting and reporting.

2015- US FASB and IASB convergence seems to have substantially stalled.

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Special international issue – recent financial
crises
• Since the 1990s one particular issue has galvanised
international concerns over financial reporting –
malfeasance crises.
• Enron episode 2001 – might be termed ‘first financial crisis’
• Global Financial crisis 2008-9, might be termed ‘second
financial crisis.’
• In reality these two are closely related.

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 First crisis: Enron Corporation
• Enron grew rapidly to become America's 7th largest
company.
• 21,000 staff in 40 countries
• Originally (early 1990s) owned large energy assets
• Early activities “honest” trading, then in mid-1990’s started
to report fictitious revenues to inflate the share price
• Bought and sold energy assets to other companies (Special
Purpose Entities) controlled but not majority owned by
Enron
• Normally, inter-company sales would be removed from
financial reports by “consolidation”
 First crisis: Enron Corporation
• Basics of consolidation:
• 1. Combine net assets and profits of group companies
• 2. Remove those profits due to inter-company transactions
• 3. Report only adjusted total of group profit
• US consolidation rules – based on “ownership”
• Australian, UK, IFRS etc consolidation rules: based on “control” i.e.
which can be obtained with < 50% ownership.
• US subsidiaries owned > 50% are consolidated, not otherwise
unless caught by (vastly complicated) exception rules
• Enron abuses complicated exception rules to evade consolidation
 First crisis: Enron Corporation
• Complexity of financial instruments also used to disguise
fictitious revenue
• By 2000 Enron owned few physical assets and mostly
reported profits based on trading of financial instruments
(e.g. futures contracts) to deliver energy products. Many of
these products did not really exist.
• Billions of dollars of non-existent revenue reported by
Enron in late 1990s.
• Enron’s accounting so complicated that securities advisors
did not discover the “missing” assets until 2001
• Numerous other corporations with similar accounting
malfeasance followed Enron, some US, some European and
elsewhere: Parmalat, Sunbeam, Worldcom, etc.
First crisis: Enron Corporation

• Excerpts from film ‘The Smartest Guys in the Room’, HDNet Films,
Alex Gibney director.

• Note: in the film all fair value accounting is called ‘mark-to-market.’

This was the terminology in the early 2000s.
• Later than the film, mid-late 2000s, fair value accounting terms were
refined as mark-to-model version, (management estimates of profit
using estimates of the future, used by Enron) and mark-to-market
version (profit measured by stock exchange prices of today).
 Between Enron and Global (2nd) Financial Crisis

• Enron disaster in 2001 changes the debate about acceptance of

IAS.
• US GAAP suddenly seen as seriously flawed.
• Balance of political power shifted dramatically to IASB.
• IASB offers itself as the world's vehicle for accounting reforms.
• SEC recommends return to "principles-based" standards. Major
political back down.
• Will the US be able to let go of rules-based framework?
• Example, no sign yet of principles-based consolidations.
• BUT, IFRS also has a lot of rules based material – this debate never
really went anywhere.

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 Between Enron and Global (2nd) Financial Crisis

• Aftermath of Enron also contributed to the second recent crisis, the

GFC.
• Though not widely recognised in 2001, by the mid-2000s, ‘fair value
accounting’ was blamed for the Enron collapse.
• Enron accountants had used an early, crude form of FVA, ‘mark-to-
model’ to measure financial assets. These measurements were done
with ‘management estimates’ of revenues that ‘might’ happen in the
future.
• In the film on Enron, ‘Smartest guys in the room’ all FVA is called ‘mark-
to-market.’ Later, commentators would distinguish mark-to-market from
mark-to-model FVA. In fact Enron’s accounting was mark-to-model.
• After Enron, the FASB (and then the IASB) sought to toughen FVA with
updated FVA, based not on estimates of the future but on verifiable
market trading prices of the moment.

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FAIR VALUE ACCOUNTING
1. Mark-to-Model version
Calculated by management estimates of the future
Used by Enron 1990s-2001
Restricted by standard setters 2006-9
Use relaxed by standard setters after GFC

2. Mark-to-Market version
Calculated by quotes from actual stock market prices of
the present
Emphasised by standard setters 2006-9
Use downplayed after GFC

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 Build-up to global crisis of 2008-9

Alan Greenspan, deregulation guru

and Fed Reserve Chairman, 1990s-
2000s.

Gathering speed in the 1990’s, the new political and economic

fashion was ‘deregulation.’

Activities that previously had been illegal or the preserve of regulated

insurance companies, became unregulated and the new main activity
of investment banks.

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Congress allows ‘monetised assets’ and spin-off
products such as quasi-insurance ‘credit default
swaps’ to be traded on stock exchanges.

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Traders sold trillions of dollars worth of (mostly
speculative) real estate backed derivatives
around the world

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Fair value accounting was pivotal in enabling immediate
profits to be booked on these derivatives trades.

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The new mark-to-market FVA was intended to fix Enron-like mark-to-model
problems; but instead the new regime coincided with rising interest rates and
over-priced securities e.g. backed by over-valued real estate…
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When house prices collapsed, mark-to-market
required securities to be valued at price of the
moment and not anticipate a future recovery. 31
“Valuing assets at market value causes wild swings in prices.
When everyone wants the asset, the value on the balance
sheet zooms up! But when no one wants it the asset price is
punished beyond reason” (Brownell, 2008, p.1)

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Banks claimed that the FVA mark-to-market pricing
was unrealistic and caused the frozen securities
market and potential large scale collapse of banks.

This was followed by ….

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34
FVA proponents replied that the over-priced securities
were to blame, not FVA. This argument was lost,
politically, as banks waged a publicity war via politicians.
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The commentariat saw the banks as
cynical and too close to the government

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Large portions of the public thought the
same …

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US Congress however ignored the public and took the side of
the banks.

Congress even organised a special hearing, during which FVA

was condemned by nearly all Congressional members.

Democratic party representative Barney Frank was the chairman.

Previously, Frank was a famous

‘left-wing’ politician. Now he
supported the investment banks,
who paid donations to the political
parties.

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By mid-2009, the FASB and the IASB were forced to revise their accounting
standards …

Mark-to-market was reduced and Mark-to-model was again easily enabled,

even though this technique had been a proven failure under Enron.

Since 2009 there have been complaints that companies are again
manipulating their profits and balance sheets via FVA. Example, in the
Greek financial crisis, billions of dollars of lost capital have not been
reported under mark-to-model FVA.

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The original problem during the GFC – the huge amount of trading in
derivatives – was never really addressed in 2009, instead the quick fix was to
modify FVA, reduce interest rates and stimulate the world economies.

Some say that FVA measured derivatives could collapse again with some
different trigger. In 2018 about $700 trillion worth of derivatives (mainly used
for speculation) hangs over the world ‘like the sword of Damocles’ waiting for
some trigger to cause another collapse.

Does any version of FVA really work?

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