In 1957, the Treaty of Rome established the European Community. It is stated in this treaty that to reach an economic level playing field within the Community, harmonization of accounting across all Member States is necessary.
For many years, the European Commission pursued that goal through the implementation of the Fourth (Council of the EC, 1978) and Seventh (Council of the EC, 1983) EC Directives into national law of all Member States. The objectives of these accounting Directives were comparability and equivalence of financial information rather than uniformity (Haller, 2002). The Directives aimed at a minimum level of harmonization but contained numerous options that hindered comparability. Indeed, national accounting standards across all Member States were still very different, and the issue of harmonizing accounting was a highly political task, with national strongholds not facilitating the process. In many continental European accounting systems, individual accounts have almost exclusively the purpose to determine taxable income and distributable profits and the Directives have switched the aim of accounting towards providing useful financial information for the business community. Even though achieving a satisfactory level of comparability was difficult, their impact was huge since over 2 million companies have had to change and converge their methods of publishing, presenting and auditing financial statements as a result (Haller, 2002).
The economical and political context changed in the 1990s and this further increased the need for internationally accepted accounting standards. A satisfactory level of comparability and equivalence had not yet been reached and the growing importance of capital markets as well as the introduction of a common currency, the Euro, pushed the Commission to prepare an action plan. This action plan led to the approval in June 2002 by the Council of Ministers of what is called the "IAS Regulation", requiring all EU listed companies to prepare their consolidated financial statements in accordance with International Financial Reporting Standards (IFRS) by 2005. IFRS are prepared by the International Accounting Standards Board (IASB), a private organization based in London, that took over the work of its predecessor, the International Accounting Standards Committee (IASC). The IASB also adopted the body of standards issued by the IASC, namely the International Accounting Standards (IAS).
It was expected that benefits resulting from high-quality accounting standards would be such as greater access to capital, and increased cross-border listings and investment opportunities (Gornik-Tomaszewski, 2005).
A number of studies suggest that accounting is influenced by its environment (Hopwood, 1991); such factors of influence are the capital market, the role of finance, the impact of the accounting profession as well as the role of the State, commercial and tax law (Delvaille et al., 2005). These factors play an important role in explaining differences in national accounting frameworks and allow the distinction between the Continental Europe group (such as France or Germany) and the Anglo-Saxon group (UK). The Anglo-Saxon group bears the influence of the capital markets and shareholders, whilst the Continental Europe group is characterized by a legal and tax orientation, as well as creditor protection (Nobes and Parker, 2003).
Therefore, the aim of this essay is to look at the different factors and influences that have led to the milestone that is the IAS regulation, to then examine the convergence efforts of two countries, France and the UK. Since France and the UK are respectively examples of a Continental European country and an Anglo-Saxon country, it will be interesting to look at their different strategies towards convergence with IFRS as well as the changes IFRS will likely bring about.
The Directives have provided the basis for the preparation of individual and consolidated accounts of companies operating within the European Union. The Fourth Directive (1978) was aimed at harmonizing the national laws with regard to the accounting regulation of companies. It requires all limited liability companies to prepare annual accounts, which reflect a 'true and fair view' of their financial position, assets/liabilities and profit/loss. It has format and valuation requirements.
The Seventh Directive (1983) deals with consolidated accounts and requires parent companies to prepare, in addition to individual accounts, consolidated accounts and a consolidated annual report. Annual accounts must then be audited and published together with the annual report and the audit report (Haller, 2002).
Behind these Directives was the desire to facilitate cross-border transactions and multiple listings. However, the accounting traditions of the different Member States resulted in the Directives incorporating numerous options as to format, valuation or recognition. In part because of that, a new approach was needed to reach the desired levels of comparability and equivalence of financial information.
In the 1990s, the international context changed and this had an influence on EU accounting policy. Cross-border merger and acquisitions and foreign direct investments increased substantially. In addition, there was greater trade and investment liberalization, deregulation, technological innovation, privatization as well as more favourable tax rules (OECD, 2000, Van Hulle, 2004). Thus, the capital demand of EU companies was often greater than the domestic capital supply, further increasing the need to secure capital in foreign or cross-border markets. Capital markets were growing in importance and many companies had to prepare a second set of financial statements (in addition to their national requirements) in accordance with either IAS or US GAAP. But 'parallel reporting', as it is called, was burdensome and costly and led to confusions, such as Daimler/Benz not knowing whether it had made a profit or a loss (Van Hulle, 2004). There is a rationale behind parallel reporting; indeed, the US capital market was very important to many global players that sought to raise capital, or increase their visibility; using US GAAP also allowed companies to have a better benchmark basis to compare their financial positions with their international competitors (Haller, 2002). It was realized that national accounting standards, as derived from the Accounting Directives were not enough to satisfy the needs of investors who were increasingly asking for high-quality financial information.
Also, the introduction of the Euro as a single common currency in the EU accelerated the integration of capital markets and reduced transaction costs as well as currency risks. This was a necessary step towards 'optimum functioning of capital allocation mechanisms within the European Economy' (Gornik-Tomaszewski, 2005), but the EU financial market was not efficient, competitive or fast enough. This was even more detrimental as equity securities were gaining in importance.
In the search for a new accounting strategy, several possibilities were envisaged:
None of these options appeared satisfying enough. The Commission wanted a solution that would be flexible, and that would involve as little new legislation or amendments to existing legislation. Implementing the Directives was hard, and rather than reducing the number of options they contained, cooperation with the IASC was seen as a way to prevent US GAAP from dominating (Zeff, 1998). Putting its weight behind the IASC would have avoided duplication of the harmonization efforts, and it allowed using the existing treatments on issues that were not covered by the Directives, such as leases, or pensions. There was thus a strong preference for IAS rather than US GAAP, as the European Commission had no influence whatsoever on US GAAP, and as it was not necessarily deemed suitable to the European market. In addition, the SEC would have had too much power. The Commission therefore took an observer seat on the Board in 1990 and joined the IASC's Consultative Group.
Later in 1990, the Accounting Advisory Forum was created. It consisted of accounting standard-setting bodies, the accounting profession, some academics and organizations of users and preparers of financial statements. Its role was to advise the Commission on technical issues that had not been treated in the Directives, and to provide guidance in future debates on accounting harmonization (Van Hulle, 2004, Gornik-Tomaszewski, 2005).
In the mean time, IASCO (an international federation of securities regulators), which includes the SEC, suggested getting rid of some of the too many IAS options. It was hoped that this could lead to the elimination of the required reconciliation with US GAAP (Zeff, 1998, Gornik-Tomaszewski, 2005). A project called the "Comparability and Improvement project" was thus launched and 20 standards were revised, but this was not enough to IOSCO, which expanded the list with 24 standards. This is when the IASC and the IOSCO entered into an agreement (1995) to create a "comprehensive core set of high-quality standards for cross-border listing on securities exchanges". Even though the project did not fulfill all expectations as members of the IOSCO were still given the right to require reconciliation, it did a great deal to improve IAS by reducing a number of differences between IAS and US GAAP (IOSCO, 2000, Gornik-Tomaszewski, 2005).
Finally, in 1995, the Commission published a Communication that suggested putting its full weight behind the IASC and said that it was abandoning any consideration of a European accounting standard-setting body. It specified that global players in Europe should be allowed to prepare only one set on financial statements, (preferably) in accordance with IAS.
The Commission knew that preparing financial statements in accordance with IAS would require distinguishing between annual and consolidated accounts, and that this would create some difficulties, especially for those companies in Member States where there was a close linkage between taxation and accounting profit. It was however argued that in most cases, consolidated accounts are not the basis on which taxable profit or distributable income is determined (Van Hulle, 2004).
The 1995 Communication " Accounting Harmonization: A New Strategy vis-à-vis International harmonization" was mostly concerned with decreasing comparability, in part due to too many options, unaddressed issues, and different interpretations of the Directives' principles.
As a consequence, the Contact Committee was established in 1996, following the endorsement of the Communication by the Council of Ministers, with the duty of 'facilitating the harmonized application of the Directives as well as providing advice for the Commission and examining the conformity of IAS (issued at the end of 1995) with the directives'. The Committee concluded at first that there were no major incompatibility between IAS and the Directives. This somewhat came as a surprise as the objectives and principles of the IAS and the Directives were different. However, such a conclusion was possible as the Committee focused on consolidated accounts, and because both IAS and the Directives contained many options. It must be kept in mind, that conformity with the directives does not necessarily mean conformity with the different national standards, indeed, some options that could have been chosen by national standard-setters might not have been permitted under IAS (Contact Committee on the Accounting Directives, 1996). But in 1998, a second report showed that there were some important incompatibilities between existing IAS and the Directives. The concepts of realization, prudence, and fair value accounting versus historical cost accounting were amongst the biggest problems. It was thus suggested that the Directives be amended (Gornik-Tomaszewski, 2005).
Following the 1995 Communication, 7 Member States (Austria, Belgium, Finland, France, Germany, Italy and Luxembourg) adopted measures or legislation that allowed listed companies to prepare their consolidated financial statements in accordance with IAS (or US GAAP) (Van Hulle, 2004).
To allow EU companies and citizens to fully benefit from the introduction of the Euro, and because of the growing importance of capital markets for corporate financing, the Commission published in 1999 its Financial Services Action Plan (FSAP). The FSAP was later endorsed at the Lisbon European Council in 2000 and contained some forty measures. It had three main objectives: " a single wholesale market, an open and secure retail market, and state-of-the-art prudential rules and supervision" (FSAP Guide, 2003). It proposed that all EU listed companies report under the same framework, with the aim of allowing EU companies to use the same set of financial statements for listing purposes throughout the world. The framework had to be aimed at investors' needs, rather than those of the legal authorities for example (Cairns, 2003).
But at that time, comparability was still far from satisfying, with national standards still very different, and a lack of enforcement; it was not uncommon for companies listed at the same exchange to report under different standards (Van Hulle, 2004).
As a consequence, a second Communication was published in 2000, "EU Financial Reporting Strategy: The Way Forward". Its aim was to enhance the comparability of financial statements (once again). It emphasized the need for transparent, objective, understandable and enforceable financial reporting standards. In this Communication, the Commission stated that it would submit legislation to make mandatory for all listed EU companies to prepare consolidated financial statements in accordance with IFRS, and this by 2005. This involved a two-tier endorsement mechanism to make sure that the IAS were in conformity with the Directives (Cairns, 1997, Haller, 2002). Some other proposals that were made included allowing the Member States to extend the application of IAS to unlisted companies and individual accounts, modernizing the Accounting Directives, and setting a proper enforcement infrastructure.
At the same time, mainly due to great pressures from the capital markets, the IASC went through a major restructuring that led to the creation of the IASB. The IASB was modeled after the Financial Accounting Standards Board (FASB) in the United States, and was mandated to produce a single set of high-quality enforceable and understandable IFRS.
We have set out the main socio-economical and political factors that preceded the IAS Regulation, let us now look at its implementation.
The European Parliament endorsed the IAS Regulation on the Application of International Accounting Standards in March 2002. Using a regulation over a directive was a carefully thought choice made by the Commission. Indeed, the advantage of a regulation is that it is applicable directly in all Member States, without requiring transposition into national law. This was a drastic measure, motivated both by time constraints and the willingness to prevent any national "adaptation" that would have hindered the harmonization process (Van Hulle, 2004).
The Regulation covers all companies with securities admitted to trading on a regulated market in the EU, including banks and companies (Member states can extend this to unlisted companies and unconsolidated statements) (EC, 2002b). These companies must now prepare their consolidated financial statements in accordance with IFRS. An important point raised by Van Hulle is that foreign companies listed on EU markets are not required to reconcile to or apply IAS. This has to be understood as part of the EU policy aiming at opening up the US market to EU companies. Indeed, EU companies should then be able to be listed on US capital markets without having to reconcile with US GAAP. Related to that, the IAS Regulation included the option for companies whose shares are listed in a non-member state and that use internationally accepted accounting standards other than IFRS to postpone the requirement to adopt IFRS to 2007. As Bromwich puts it, this curiously seems to imply that it is considered easier to change from national GAAP to IFRS than from US GAAP (Bromwich, 2003).
A consequence of the Regulation is that if Member States choose to extend it to unlisted companies, then they will not be able to issue any more national standards. However, individual accounts in most cases will continue to be governed by national law as will be seen later on. This is mostly because of the link between taxation and accounting that is still very much anchored in many Member States (Van Hulle, 2004).
A short mention of the endorsement process must now be made. The two-tier endorsement mechanism of IFRS was established in order to correct for any concerns or material deficiencies and to provide for the necessary regulatory oversight in relation to IFRS. Three main "obstacles" must be passed for an IFRS to be endorsed by the EU. It must be "conducive of the European public good" (not very much elaborated on), "not contrary to the true and fair view principle" and "meet the criteria of understandability, relevance, reliability and comparability" (EC, 2002b).
In 2001, the IASB undertook the Improvements project to address potential problems with existing IAS. It was completed in 2003 and eliminated many choices and conceptual inconsistencies. Later that year, the ARC voted in favor of adopting IFRS with two exceptions, IAS 32 'Financial Instruments: Disclosure and Presentation' and IAS 39 'Financial Instruments: Recognition and measurement' (France is mainly responsible for that), the two "carve-outs".
Therefore, by 2005, the Commission had voted to endorse all IAS except the carve-outs. These carve-outs prohibit the use of fair value as it applies to liabilities and allow the use of fair value hedge accounting for interest rate hedges of core deposits on a portfolio basis (Gornik-Tomaszewski, 2005).
In September 2001, the Fourth and Seventh Directives were amended with regard to valuation rules for the annual and consolidated accounts of listed companies, including banks and insurance companies (EC, 2001). This was motivated by the fact that the Accounting Directives played an important role in the mechanism for adopting IFRS. They should thus reflect current accounting developments and not be a break to future developments within IFRS. Also, they had to be modernized to account for unlisted companies, to facilitate any eventual transition to IFRS in the future (EC, 2002a). The amended Directives were then endorsed in 2003.
It would now be interesting to see how different countries, and in particular the UK and France have reacted to the harmonization process of accounting.
Some big global players had not waited for harmonization to start, as their need for capital, desire to benchmark themselves and an increased demand for more comparable financial information had started putting pressures on them long before the 1990s. Companies such as Scottish Power PLC or the Royal Dutch Petroleum Company were listed in the US as early as the 1950s (Haller, 2002). It can be said that they fuelled a de-facto harmonization process. Thus, these big players were then putting pressure on regulatory bodies on a national level as they wanted a de-jure harmonization, which would eliminate some inefficiencies. As a consequence, several Member States had decided to develop national rules, closely following the developments of IAS.
France is an example of a country that changed its national law so that companies may report in accordance to IAS or US GAAP instead of national rules (with detailed prerequisites). The implementation of the IAS Regulation has had profound impacts on the French accounting system. Although the shift to IFRS was expected, it is a quite sudden shift in a Code Law country.
The French accounting model is characterized by a strong influence of tax on annual accounts, an organized and detailed accounting scheme, with a strong analytic emphasis. French public Authorities and the accounting profession have had at mind for at least 50 years that modern accounting principles are necessary. The National Accounting Council, the French standard-setting body, established the Plan Comptable in 1947. The NAC has always tried to set rules by consensus, this can be seen by its wide variety of different stakeholders.
It is important to stress, that unlike in the UK, the organization of accounting is supervised by the State (Evraert, Des Robert, 2007). Following Nobes' classification, it can be said that France is a 'class B' country, where accounting has tended to develop with the aim of catering to the needs of tax authorities and creditors.
Since the mid-1990s, increased transparency of financial information as a result of market pressures has been on the agenda of standard-setters. For example, in 1998, a law was passed by which French listed enterprises were no longer obliged to follow French law for the preparation of their consolidated accounts (IAS, not US GAAP permitted). However, the decree for application was only published in 2005 (Delvaille et al, 2005).
While voluntarily acting as a precursor for adoption of IFRS, France, reformed the NAC, incorporating new technical organizational features and methods, influenced by Anglo-Saxon practice. It created the Comite de la Regulation Comptable, for the future endorsement and implementation of IFRS.
Substantial changes came with the adoption of the 7th Directive. Indeed, it was too permissive, with a large number of options and the UK influence of the concept of 'true and fair view' further increased permissiveness through added mandatory footnote disclosures. It has been argued that the distorting effects conveyed by the legal and taxation system on accounts should not be exaggerated, indeed, the French accounting system has not hindered the development of France as a modern and competitive economy, supported by many national and multinational enterprises (Evraert, des Robert, 2007). The NAC has for several years screened for any discrepancies between IFRS and French Standards, and it has had a strong influence in encouraging France's large companies to adopt IAS in their consolidated accounts.
Following the IAS Regulation, many companies now face changing their accounting model. It is hard to evaluate if the changes that it will bring will outperform the Plan Comptable experience. According to Evraert and Des Robert the main consequences on French accounting were going to be:
French approach is still based upon the civil and commercial code and on the patrimonial nature of accounting; therefore, such principles as 'substance over form' do not seem applicable. This partly explains why IFRS face little prospect to be extended to annual accounts in the near future. The approach of IFRS that shows 'what should be done rather than what must be done' is incompatible with the legal approach of the Plan Comptable. As a result, many practitioners and specialists do not consider that IFRS should be extended to individual accounts, and that especially for SMEs (Evraert, Des Robert, 2005). However, it seems that many differences between French rules and IFRS can be dealt with by convergence, put aside matters relating to tax influence, or some principles and valuation bases.
The large variety of stakeholders has a slowing effect on the transition. Indeed, the Tax Administration has a very strong role to play, and there is no prospect of breaking the link between accounting and taxation, however, the administration is slowly adapting and trying to understand the differences between IFRS and French standards. It seems obvious that financial reporting will end up taking over accounting, but there is no prospect in France, that the connection will be lost with fiscal, commercial and civil law (Evraert, Des Robert, 2005).
On the other hand, the UK financial reporting system has always had a strong market orientation. According to Nobes' classification, the UK is a 'class A' country, "geared towards the needs of equity investors that do not have insider status with the firm" (Gornik-Tomaszewski, Selhorn, 2006).
As opposed to markets developments, accounting developments were late to arrive. It is only after 1970 that the UK implemented mandatory regulation of accounting reports, other than a minimal law. Consolidated statements however appeared well before other countries. Following a series of accounting standards in the 1960s, the Accounting Standards Steering committee was formed (1969) by the Institutes of Chartered Accountants in England and Wales. This was an important decision, as in contrast with France, the State has somewhat decided to let the profession regulate itself (Bromwich et al, 2006). The Accounting Standards Committee was formed in 1976 and promulgated accounting standards (which could be rejected by each of the six professional accountancy bodies). It had however no explicit authority or strong enforcement powers, but did quite well in getting some controversial standards accepted (Bromwich et al, 2006).
The need for a conceptual framework on which accounting standards would be based increased in the late 1980s. That is when the EC Directives introduced detailed accounting reports into UK law. In general, the State left most accounting details to the profession. An overriding requirement, however, was that the financial statements give a 'true and fair view' of the company's state of affairs and its profit or loss. This concept was quite unusual to Continental Europe, where legal rules dominated and the introduction of the Directives changed the 'relatively nonrestrictive approach' of the UK accounting system (Bromwich et al, 2006). As a result, UK accounting practice got slightly closer to Continental Europe approaches, but is still a long way from detailed rules or codes.
The Fourth Directive had the effect of introducing a number of possible formats, which involved much more detailed disclosure than was usual in the UK. It also introduced a number of mandatory principles and valuation rules that eliminated some common practices in the UK. The Seventh Directive, on the other hand, was much influenced by UK practice and did not bring about much change in the UK (Roberts et al, 2008). In a similar way to France, a number of difficult accounting issues were avoided through the permissiveness of the Directives and their numerous options. As Bromwich argues, this contributed to easing acceptance but weakened harmonization.
In 1990, the Accounting Standards Board replaced the ASC, it is more professional and has a similar structure to that of the FASB. The Financial Reporting Council provides guidance to the ASB and ensures its proper funding. Also, the Financial Reporting Review Panel is responsible for investigating reports that may not show a true and fair view.
Let us now focus on the EU influence on UK accounting. It is argued that membership of the EU has had the "most significant inward influence on UK accounting" (Nobes and Parker, 2003). The UK has allowed the option of extending IFRS to individual accounts. But the IAS Regulation has not created as much debate as it has in other countries. Indeed, the ASB had been seeking convergence with IFRS for a long time. One can wonder why there has been relatively low voluntarily take up of IFRS before the IAS Regulation. It has been argued that this can be explained by uncertainties as to the impact on tax liabilities, and on distributable profits. But this must be viewed in the context of a commitment to convergence of UK GAAP and IFRS (UNCTAD, 2008).
Even though UK GAAP and IFRS share more or less the same philosophy, there are still some significant differences between the two, as pointed by Cairns (2003). Main differences have to do with the recognition of all derivatives on the Balance Sheet at fair value, restrictions on the use of hedge accounting, revised accounting for Mergers and Acquisitions (ban of the pooling of interests method), and the amortization of goodwill amongst others. Also, as opposed to IFRS or US GAAP, UK GAAP puts a greater emphasis on "stewardship" ("management's ability to arbitrage input and output markets" (Penman, 2007)). But it must be noted that in most cases, UK companies will find IFRS more flexible than their previous UK GAAP equivalents. It was thought that because UK GAAP and IFRS were quite similar, the convergence would be smooth and not too costly, however, a few issues arose that took a long time to resolve (UNCTAD, 2008). Some examples of technical issues are property plant and equipment, residual values, and financial instruments (perhaps the most challenging issue). There were also project issues, such as the cost of training, the redesigning of software systems, but these are common to most countries.
As far as SMEs are concerned, as opposed to France, it is very likely that the IFRS for SMEs will form the basis of UK GAAP and there is very little doubt that IFRS will one day form the basis of all UK financial reporting.
We have looked at the developments that led to the IAS Regulation. Mostly a capital market based measure, pushed by the desire to establish an efficient European capital market, able to compete internationally; it has achieved a great deal in increasing the comparability of financial statements of listed companies in Europe. The EU, in substance, has delegated the developments of accounting standards to an international private standard-setter, over which it only has a small influence.
It seems right to say that the IAS Regulation is a 'milestone' of global financial reporting. However, its impact is yet to be assessed: we have looked at some of its costs, but its benefits are difficult to determine as of now. Much of its success depends on its consistent implementation and improvements in market efficiency are not obvious. Unfortunately, we have shown that not all countries, due to initial differences in their accounting systems, have reacted in the same way, nor have they all faced the same difficulties in adopting IFRS. By nature, the UK accounting system was closer to IFRS, but it nevertheless had a number of technical and project issues to resolve. On the other hand, France, even though it started early to work on the convergence process, is only focused on listed companies, and there is very little prospect for IFRS to be extended to annual accounts. The link between accounting and taxation will be hard to break, and many practitioners have yet to be convinced as to the eventual superiority of IFRS over the Plan Comptable. Therefore, the NAC will continue to play an important role in setting accounting standards in France, whereas the ASB's future role is not so obvious, as IFRS will likely form the basis of UK financial reporting.
The harmonization efforts in the EU can serve as a good example taken in the greater context of the globalization of capital markets, however, one difference is important, in that the EU has the power to impose standards on its member states, while other countries might want to assess the cost versus benefits of taking such measures. This would not necessarily lead to the adoption of IFRS in these countries.
Finally I would want to add that great efforts have been made towards harmonization of financial reporting, but the only fact that the EU differentiates itself by reporting in accordance to IFRS "as adopted by the EU" is enough to cast doubts as to the future of international harmonization. In addition, the needs of SMEs will have to be better addressed, and this will not prove easy.
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