International accounting – Lectures 4, 5,6

Chapter 2. Financial reporting of large (listed) entities: economic context, implications for
accounting, accounting models

Preamble

- users of accounting information:

- objectives of financial reporting:

- accounting models (systems):

2.1. The economic environment of listed companies

Increasing need for raising capital led to an increasing number of listed companies (i.e. whose
shares are publicly traded). The size of most MNEs is such that they need to raise external finance
and hence to be incorporated companies listed on stock exchanges.
Globalization led to an increased number of multinational companies and companies listed on
stock exchanges in a different country than the one of origin of the entity. Such a listing is
justified either by: the desire to attract extra investors and widen the pool of shareholders
(especially for those entities based in small countries of origin), a reduced cost of financing, a
desire to raise the entity’s profile (in a foreign country) among potential customers, employees,
regulators etc. Of course, as well as potential benefits, there are also costs, such as the cost of
initially satisfying accounting and other requirements and then providing extra information
compared to domestic requirements, mandatory requirements of reconciliation between different
rules, onerous auditing and corporate governance requirements.

Several statistics are significant here regarding late evolutions:

- the history of the stock exchanges1: in the 1300s – Venetians start trading securities from other
governments; 1531 Antwerp (Belgium) promissory notes and bonds (no real stocks at that time);
in the 1600a, Dutch, British and French investments in East Indies companies (limited liability
companies, dividends, joint stock companies); 1773 – LSE; after 19 years – NYSE (but the first
SE in US was in Philadelphia); globalization (NYSE merged with Euronext in 2007, and with
Deutsche Borse in 2011).
- a rough 20 to 25% of companies listed on major exchanges are foreign listers;
- according to La Porta et al. (1999), 36% of companies in 27 countries (not including China,
India and Eastern Europe) were widely held in the mid-1990s’;
- some large companies are now reducing the number of exchanges on which they are listed on;
for example, Volvo (Swedish car company) was listed in 1935 on the Stockholm Stock Exchange,
in 2005 was listed on 5 foreign exchanges, but remained only on one in 2007; Norsk Hydro
(Norwegian power) listed on 7 foreign exchanges in 2000, but on only 4 in 2007 and 2 currently
(Oslo and London).

2.2 Accounting issues and accounting models

- different rules lead to increasing costs of reconciliations and presentation of financial statements
under these rules;
- the split between owners and managers leads to a greater need for publicly available and
independently audited financial statements;

1
The birth of Stock Exchanges, http://www.investopedia.com/articles/07/stock-exchange-
history.asp#axzz1ba9cGOZG.

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 International accounting – Lectures 4, 5,6
- issues related to acting in a complex economic and legal environment (foreign currency,
complex activities, mergers etc.);
- US GAAP were the “accounting language of capital markets” until 2000s; recently there is an
increase in the IFRS application (see tutorial 2 – IASB – IOSCO relationship).
- European companies listed in an EU securities market, including banks and insurance
companies, are required to prepare their consolidated financial statements in accordance with
IFRSs starting with financial statements for financial year 2005 onwards (IAS Regulation -
1606/2002/EC, issued in June of 2002). The goal of the Regulation is to eliminate barriers to
cross-border trading in securities by ensuring that company accounts throughout the EU are
reliable, transparent, and comparable. Member States have the option of extending the
requirements of the Regulation to unlisted companies and to the production of individual
accounts. The next table gives an impression of the EU member states decisions:

- require IFRSs for unlisted Cyprus, Estonia, Bulgaria, Belgium (credit institutions), Greece,
companies in consolidated Ireland, Malta, Poland (banks), Portugal (banks), Romania
accounts (credit and banks), Slovakia, Slovenia (credit and banks), Spain
(if there is a listed entity in the group)
- permit IFRSs for unlisted Austria, Belgium, Bulgaria, the Czech Republic, Estonia,
companies in consolidated Germany, Hungary, Italy, Latvia, Luxembourg, Ireland,
accounts Norway, Iceland, Denmark, Finland, France, the Netherlands,
Romania, Spain, UK
- require IFRSs in Bulgaria, Estonia, Greece, Czech Republic, Malta, Latvia,
unconsolidated financial Slovakia, Portugal, Italy, Cyprus, Romania
statements of listed entities
- permit IFRSs in Finland, Ireland, Luxembourg, Poland, Netherlands, Norway,
unconsolidated financial Portugal, Slovakia, Slovenia, UK
statements of listed entities
- require IFRSs in financial Cyprus, Malta, Bulgaria (without SMEs), Estonia (banks),
statements of unlisted Greece (banks), Italy (some), Poland (banks), Portugal (banks),
companies Romania (banks), Slovakia, Slovenia (banks)
- permit IFRSs in financial Denmark, Greece, UK, Iceland, Norway, Slovenia, Poland
statements of unlisted (some), Portugal (some), Slovakia (some), Italy (some), Malta,
companies the Netherlands, Estonia, Finland, Greece (some), Bulgaria
(Source: http://www.iasplus.com/en/jurisdictions/binary/europe/1007ias-use-of-options.pdf; for
more recent information http://www.iasplus.com/en/resources/ifrs-topics/use-of-ifrs)

- SEC decides in 2007 to give up requiring the reconciliation between IFRS and US GAAP to
listers already applying IFRS (a possible application of IFRS is envisaged in the US);

Example 1

The auditors’ opinion on GlaxoSmithKline’s consolidated statements reads as follows:

„In our opinion:
- the group financial statements give a true and fair view, in accordance with IFRSs as adopted
by the European Union, of the state of the Group’s affairs as at 31st December and of its profit
and cash flows for the year then ended;
- the Group financial statements have been properly prepared in accordance with the Companies
Act 1985 and Article 4 of the IAS Regulation.

Separate opinion in relation to IFRSs

As explained in Note 1 to the group financial statements, the group in addition to complying with
its legal obligation to comply with the IFRSs as adopted by the EU, has also complied with the
IFRSs as issued by the IASB. In our opinion, the group financial statements give a true and fair

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 International accounting – Lectures 4, 5,6
view, in accordance with IFRSs, of the state of the Group’s affairs as at 31st December and of its
profit and cash flows for the year then ended.
Comment this audit opinion.

Example 2

Philips is listed on NYSE and Euronext in Amsterdam. In 2002, it adopted US GAAP as primary
accounting standards. To meet Dutch legal requirements the Company reconciles from US GAAP
into Dutch GAAP and provides this additional information in the annual report. The company’s
peer group used at that moment as primary GAAP: US GAAP (Emerson Electric, Hitachi,
Matsushita, Sanyo, Sony, Toshiba, Tyco); IAS (Nokia), Swedish (Electrolux, Ericsson), Korean
(Samsung, LG Electronics), Japanese (Sharp, Mitsubishi). In 2005, to continue comparability,
both with the peer group and over time,
Philips will maintain US GAAP as primary accounting standard, but additional IFRS information
will be provided as supplemental information in the annual report. Starting 2009, Philips uses
IFRSs as primary GAAP. What do you think motivated the company’s choice of GAAPs over
time?

- IFRS have undergone transformations in the last 10 years (Chapter 2) and are accepted (in
various manners) in different countries and on various capital markets (Chapter 4).

2.3. The US model (US GAAP)

- common characteristics with the UK model: origins; classification in one group (though
debatable); founders of accountancy firms; separation of reporting rules from tax rules;
- still, differences exist between the two models (US accounting is rule-based);
- IFRS are influenced by both US and UK models;
- it is vital to understand that only a small minority of US companies (about 14,000) are
SEC-registered and have to obey SEC’s accounting and auditing rules. Other companies have no
compulsory audit or published financial reporting, although many companies are required to
publish audited accounts by their shareholders or lenders. A company must register with the SEC
if it wants to become listed; once registered (and only), it has to publish financial statements, file
reports, have CPA audits, follow the Regulations of the SEC, and comply with GAAP;
- originally, GAAP meant what it said (a set of high-level principles endorsed by respectable
companies and auditors); however, from the 1930s onwards, rules have gradually been written
down  GAAP is now a large body of instructions, not ‘generally-accepted’ but written down by
bodies approved by the SEC, and not ‘principles’ but detailed rules;
- originally, accounting standard-setting was made by the profession, with similarities with the
UK system (laissez faire spirit), but the stock exchange involved in this process after 1929. SEC
(created in 1934) started to be involved in accounting standard setting, accounting being a field
virtually unregulated until then. A body was created in this aim, and given several
transformations, the current body (FASB) is in place from 1973. FASB is a private sector
organization with the role to establish standard of financial reporting (7 members); due process
(task force of experts  literature review  discussion published  public hearing  ED 
ultimately publication); SEC maintains a supervisory role; other influential parties are academics,
users of financial statements, preparers, the Congress.

Examples of political lobbying2:

1) Business combinations (1968-1970): at that time, regulation was made by the Accounting
Principles Board (APB); the APB was forced by the US industry and the government to issue a

2
Nobes and Parker (2008), pages 213 and 222.

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 International accounting – Lectures 4, 5,6
highly compromised standard on BC. While the government approved of the elimination of the
“pooling of interests” method (the APB’s intent), industry heavily opposed. Industry has
published a number of articles ‘forcing’ companies to place pressure on their auditors (Big 8 at
that time) which each had a partner serving on the APB  rejection of the elimination;

2) Business combinations (1996-2001): the issue became topical again after the 1990 (SEC
wanted the FASB to tackle ‘pooling of interests’ vs. ‘purchase’ accounting for BC). The issue
was added on the FASB’s agenda in 1996. The Body issued an ED in 1999 proposing the
elimination of the ‘pooling’ method, reducing the maximum useful life for amortizing goodwill
and other intangibles from 40 to 20 years (harmonization with IAS 22 revised in 1993 at that
time). Congress members have conducted hearings of the FASB chairman, and put force on him
(‘the purchase method requires goodwill be written down over time, even though, in any
successful merger, we expect the value of that goodwill to rise and not to decline’)  the FASB
reconsidered its position and issued a new ED proposing goodwill be reviewed periodically for
impairment (SFAS 142 finally included this treatment).

- the role of the capital market in the US was unique. “This road to accounting intervention was
singular as governments used mostly company law to regulate accounting. That the US regulation
in accounting took the route via capital markets is more a historical accident than a careful
consideration: the financial crisis happened across the globe, but nowhere else was regulation
extended to capital markets.”3 SEC also has a very important enforcement role (SEC reviewed
4485 financial reports in 2006 leading to 914 investigations), which makes it one of the most
stable institution of accounting regulation and enforcement. The model of the capital market’s
involvement in accounting standard setting is recently globally expanded (IASB-IOSCO
agreements). SEC has to authority to prescribe the methods to be followed in the accounts and
reports to be filed, and the relationship with FASB is not delegation4: “In meeting this statutory
responsibility effectively, in recognition of the expertise, energy and resources of the accounting
profession, and without abdicating its responsibilities, the Commission has historically looked to
the standard setting bodies designated by the profession to provide leadership in establishing
accounting principles” (SEC, 1973) and “the Commission has determined that the FASB has the
capacity to assist the Commission […] the standards set by the FASB are recognized as generally
accepted” (SEC, 2003).
- auditing is playing an important role in US, external verification of accounts being a common
practice among listed firms before the federal securities legislation made auditing mandatory
(90% of NYSE-listed entities published audited reports before it became a requirement).
- the frauds in 2001 and 2002 (Enron and Arthur Andersen etc.) led to “the crisis of the most
advanced reporting system in the world”. The result is Sarbanes-Oxley Act (2002) imposing
additional rules to auditors, managers, and even FASB. This law is considered the most drastic
since SEC was created.

„Andersen, Enron's auditors, fared even worse. They were caught up in the US rule-based
accounting system that encourages companies to ask 'Where does it say we can't do this'. This led
them to gain large consulting fees in working out how clients could get around the rules.
Andersen was blamed for not properly auditing the accounts; for shredding evidence of its
interactions with Enron; and for taking more money in consulting fees than auditing and
therefore of being corrupt. With its reputation destroyed, the firm ceased to be economically
viable. All this happened before Andersen had a chance to defend itself against its accusers. As a
result of Enron there have been the biggest changes to company rules in the US since the 1929

3
Zimmermann, J., Werner, J.R., Volmer, P.B. (2008) Global governance in accounting. Rebalancing public
power and private commitment, Palgrave Macmillan, pag. 29.
4
Zeff, S. (2010) A comment on ‘delegation’, Accounting in Europe, vol. 7: 123-125

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 International accounting – Lectures 4, 5,6
crash. CEOs must now testify to the accuracy of the accounts and auditors are effectively banned
from consulting to clients.”5

- the American system is described as being rules-based:

“According to a widely-held view, U.S. accounting standards are more rules-based than
principles-based. This observation stems in large part from the emphasis put on two aspects of
the wording of the typical attestation statement: ‘the financial statements present fairly, in all
material respects, the financial position of X Company as of Date, and the results of its
operations and its cash flows for the year then ended in conformity with generally accepted
accounting principles [GAAP]”6.

According to FASB, the complexity of standards results from the Board having to make
compromises with presumably powerful interest groups that prevented it from implementing its
desired principles. In addition, the FASB (and its predecessors) have developed rules-based
standards to meet the demand of major constituents, particularly management and auditors, who
want a clear answer to each and every perceivable accounting issue. The litigious situation in the
United States (and increasingly in other countries) means that the risk of law suits based on
alleged wrong accounting is high and gives accountants a strong incentive to ask for rules they
can adhere to in case of a costly law suit.7 However, the Enron case led to an analysis of the
American system and to a strategy towards principles:

“Unfortunately, experience demonstrates that rules-based standards often provide a roadmap to

avoidance of the accounting objectives inherent in the standards. Internal inconsistencies,
exceptions and bright-line tests reward those willing to engineer their way around the intent of
the standards. This can result in financial reporting that is not representationally faithful to the
underlying economic substance of transactions and events. In a rules-based system, financial
reporting may well come to be seen as an act of compliance rather than an act of communication.
Moreover, it can create a cycle of ever-increasing complexity, as financial engineering and
implementation guidance vie to keep up with one another (SEC, 2003.)”8

Financial statements
- the SEC requires a number of reports at various frequencies; public companies must follow SEC
rules, which typically require balance sheets for the two most recent years, while all other
statements must cover the three-year period ended on the balance sheet date;
- in 2002, the US Congress passed the Sarbanes-Oxley Act that requires senior management to
certify the reliability of the financial statements and imposes greater independence requirements
on auditors;
- there are three main annual financial statements for a US corporation: the balance sheet (named
balance sheet, statement of financial position or statement of financial condition), the income
statement (named statement operations statement, income statement or earnings statement) and
the statement of cash flows. Details regarding “other comprehensive income” are required since
1997; of course, notes are published;
- no general requirement within US GAAP to prepare the balance sheet and income statement in
accordance with a specific layout; still, the SEC imposes various requirements (for example, that
SEC registrants present expenses based on function (for example, cost of sales, administrative);
- various differences in terminology should be acknowledged between US, UK and IFRS
languages:

5
What can we learn from the Enron affair?, http://www.lums.lancs.ac.uk/news/2545/2002-12-18/
6
Benston, G.J., Bromwich, M., Wagenhofer, A. (2006) Principles versus rules-based accounting standards:
The FASB’s standards setting strategy, Abacus, vol. 42: 165-188, pag. 165.
7
Idem.
8
Idem, p. 169.

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 International accounting – Lectures 4, 5,6
US IFRS UK
Income Profit Profit
Sales Revenue Turnover
Income statement Income statement Profit and loss account
Capital lease Finance lease Finance lease
Real estate Land Land
Inventories Inventories Stocks
Stock Shares Shares
PPE PPE Tangible fixed assets
Treasury stock Treasury shares Own shares
Accounts payable Payables Creditors
Accounts receivable Receivables Debtors
Common stock Ordinary shares Ordinary shares
Allowance Impairment Provision
Reserve (for pensions) Provision Provision
Shareholders’ equity Equity Shareholders’ funds
Par value Par value Nominal value

Accounting principles and policies9

Tangible (long-lived) assets
- long-standing adherence to historical cost  FS carry PPE at cost (revaluations forbidden);
- mandatory capitalization of borrowing costs into the cost of assets built for its own use (also
mandatory in IAS 23 for financial years started in 2009);
- usually straight-line depreciation; yet, accelerated methods allowed (reducing balance, SYD);
- no separate accounting for investment property (is accounted for as held for use or held for sale)
(FASB is considering to require fair value measurement for investment property);
- recent impairment rules: if indications, an asset must be tested for impairment (comparison
between its carrying amount and the sum of expected CF from the use and sale of the asset,
undiscounted; the impairment loss cannot be reversed).

Leases (example of SOF)

- accounting requirements dealing with leasing arrangements began in 1949 (initially, they
required the lessee only to disclose the amounts and timing of payments, and assess whether the
asset might be capitalized);
- traditionally either capital lease (‘sale-purchase’ of assets) or operating lease; the practical line
is arbitrary (75% of useful life or 90% of the asset value) (different than IFRS treatment);
- common project with IASB (convergence) on leases;

Intangible assets
- general requirements similar to PPE;
- set-up costs are not capitalizable; R&D are not capitalizable (except for computer software) 
US GAAP are more conservative than IFRS.

Inventories
- ‘lower of cost and market’; ‘market’ is usually RC in the US, and NRV in IFRS and UK; once
reduced from cost to market, the impairment cannot be reversed (unlike IFRS or UK);
- allows LIFO for inventories valuation; LIFO was originally allowed for tax purposes to act as a
relief from taxation when prices rise; tax rules require companies to use LIFO for the published
income statements if it is used for tax purposes. US GAAP require companies to disclose which
method is being used, and the SEC requires its registrant companies that use LIFO to disclose in
the notes what would the value of inventories have been using FIFO (for example, GM would

9
Nobes şi Parker (2008) and Ernst & Young (2011) – US GAAP vs. IFRS – the basics.

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 International accounting – Lectures 4, 5,6
have reported a $m 1,508 adjustment (+) if it would have used FIFO, i.e. an 11% increase; while
Caterpillar would have increased its inventories by 38% = $m 2,403, both for 2006)  impact
upon liquidity, net assets, gearing etc.

Provisions
- they are usually not discounted (under IAS 37, provisions should be recorded at the estimated
amount to settle or transfer the obligation taking into consideration the time value of money);
- measurement – ‘most likely outcome within range’ should be accrued; when no one outcome is
more likely than the others, the minimum amount in the range of outcomes should be accrued
(under IAS 37, ‘best estimate’ of obligation should be accrued. For a large population of items
being measured, such as warranty costs, best estimate is typically expected value, although mid-
point in the range may also be used when any point in a continuous range is as likely as another.
Best estimate for a single obligation may be the most likely outcome, although other possible
outcomes should still be considered).

Examples and questions

1. Present at least three issues specific to the economic context of large listed entities, with
accounting consequences.

2. Which of the following is false regarding the US GAAP:

a) LIFO is allowed;
b) impairment’s reversal is allowed;
c) there is no layout for the financial statements;
d) the type of a lease contract is determined based on rules and not on principles.

3. In US GAAP inventories are measured using the principle of lower of cost and market, by
market understanding replacement cost with a floor (NRV less normal profit margin) and a
ceiling (NRV).
On December 31 an entity had an inventory of five different types of airplane parts:
Parts Cost NRV Replacement cost NRV less net profit margin
1 10.000 20.000 15.000 12.000
2 20.000 19.000 18.000 17.000
3 5.000 3.000 4.000 2.000
4 8.000 15.000 12.000 11.000
5 15.000 12.000 9.000 11.000

As of December 31 next year the entity still had the same five parts in inventory:
Parts Cost NRV Replacement cost NRV less net profit margin
1 10.000 21.000 16.000 13.000
2 20.000 20.000 19.000 18.000
3 5.000 4.000 5.000 3.000
4 8.000 16.000 11.000 12.000
5 15.000 14.000 10.000 12.000
a) Discuss the practice of measurement at a minimum of two values and discuss the consequences
on the accounting information.
b) Compute the inventories’ value under IFRS and US GAAP.
c) Is the IFRS requirement an indication that under IFRS fair value is reported?
d) What are the reasons that one might support or oppose reversals?
e) Do you believe that entities should be allowed/required/forbidden to reverse prior write-
downs? Explain.

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