The world's standards by 2002

By Paul Pacter

In Brief

More than Just Harmonization

International accounting standards that provide a common accounting language are gaining in importance as global investing and lending has grown enormously. In fact, the European Union and many individual countries and companies look to standards developed by the International Accounting Standards Committee (IASC). Notable exceptions are Japan, the United Kingdom, and the U.S.

IASC is on target to meet its part of a bargain with the International Organization of Securities Commissions (IOSCO) to complete a core set of accounting standards in 1998. The goal is to have such standards in place for use in cross border capital raising and listing purposes in all global markets. Such core standards will require approval by IOSCO and, if found to be acceptable for U.S. markets, ultimately the SEC. The author estimates that the SEC will accept all or most of such standards for use by foreign issuers in U.S. markets by the year 2002.

Projects that are now on IASC's agenda, and others it may consider, are listed in the exhibits.

At a conference on international accounting standards (IAS) in Washington a year ago, the day's speakers were asked when standards developed by the International Accounting Standards Committee (IASC) will be acceptable for foreign securities issuers in the U.S. without reconciliation to U.S. GAAP. Panelists included an FASB member, someone from the SEC chief accountant's office, three Big Six partners (including an IASC board member), someone from industry, and me.

Several were noncommittal or cautious: "years down the road," "many hurdles," and so on. Others were more definite: "at least 10 years" and an even longer "20 years." My turn came. Five years, I blurted out, meaning at least all regulatory approvals in place by July 1, 2002. I summarized my reasoning--benefits to investors, benefits to companies, and benefits to the U.S. capital markets.

Well, it's now a year later and I am sticking with my prediction for 2002.

IASC is on target to meet its part of a bargain with the International Organization of Securities Commissions (IOSCO) to complete a core set of accounting standards in 1998--standards that produce reliable, high quality information; standards that are bolstered by a program of interpretations in response to problems or divergences in applying them in practice; and standards that can be rigorously enforced.

Why Not Just National Accounting Standards?

The answer to that question is simple. Investors and lenders have gone global. Financial reports must be written in a common accounting language that is understood globally. That means defining assets and liabilities and measuring profits and losses the same way across political boundaries.

American investors have gone global in a big way. Just since 1991, holdings of non-U.S. equities by U.S. residents increased from $200 billion to well over $1 trillion. Seven years ago, foreign equities accounted for about six percent of individuals' holdings. It's over 10% today.

The trend toward foreign investment is expected to continue. Studies anticipate that as the foreign percentage of the equity portfolio increases from today's 10% to 20, 30, and even 35%, portfolio risk declines while the average annual return increases. Rational investors simply cannot walk away from reduced risk coupled with higher return.

It is not surprising, then, that nearly 1,000 of the 13,000 companies now registered with the SEC are foreign companies. And most of those 1,000 are huge multinationals. Nor is it surprising that international equity issuances in the U.S. grew at a 26% annual rate from 1991 to 1997. In 1997, foreign registrants raised $28 billion in U.S. capital markets--16 times the 1990 level. Meanwhile, there are several thousand more large foreign companies--ones of New York Stock Exchange size and quality--that have yet to tap into the American capital markets.

This opportunity has not gone unnoticed on Capitol Hill. In legislation passed in 1996, Congress recognized that "a high-quality comprehensive set of generally accepted international accounting standards would greatly facilitate international financing activities and, most significantly, would enhance the ability of foreign corporations to access and list in the United States markets."

What's Happening in Other Countries?

The trend toward cross border investing and financing is not unique to the U.S. The European Union (EU) started out as a way to achieve a single economic trading market. Harmonized accounting has been an EU objective since its inception. It's in their directives (laws). Over the years, the EU has debated different ways to achieve that goal. As recently as 1995, it considered setting up its own accounting board. But it concluded that IASC is the best way to move forward. As a matter of policy, the EU has associated itself with the efforts of IASC and IOSCO toward international harmonization of accounting standards.

A follow-up 1996 EU report concluded that, with minor exceptions, the EU's accounting directives do not prevent companies from using IAS. In a 1997 speech, EU Commissioner Mario Monti said that, if necessary, the commission should consider amendments to the directives to avoid conflicts with IAS.

Already, two European countries--France and Germany--are developing legislation to allow not only foreign but also domestic companies to use IAS in their consolidated financial statements. Italy and Belgium are developing similar laws, and other EU member states are expected to do the same. Swiss multinationals are permitted to use IAS for domestic reporting purposes, and most do.

The completion of the Uruguay round of GATT talks, leading to creation of the World Trade Organization, is helping to globalize markets, including capital markets. In a statement, issued at the WTO's ministerial meeting in Singapore in December 1996, WTO announced its support for IASC.

Last year the Arab Society of Certified Accountants, comprising 22 Arab nations, signed a declaration supporting IAS as the national accounting standards in all its member countries. "We are confident," their announcement said, "that IASC standards will enhance the economic strength of a region that has significant commercial and industrial sectors."

Australia has adopted a policy of harmonizing its standards with IAS by the end of 1998, so that complying with Australian standards will mean automatic compliance with IASC standards. Canada is debating a similar approach. The chairman of the new Malaysian Accounting Standards Board recently said that his board will "pursue a policy of harmonization of Malaysian accounting standards with the standards issued by the IASC."

In Africa, many countries use IAS directly or as the basis for their national accounting standards. Just a few months ago, for example, Kenya announced that it would cease developing national standards and turn, instead, to IAS. In 1993, the South African Accounting Practices Board decided that its statements of generally accepted accounting practice should be based on IAS.

A number of former Soviet Union countries have adopted IAS as their national accounting standards, including Moldova and Kazakhstan. Ukraine and others are considering similar legislation.

Many major stock exchanges around the world accept financial statements of foreign listed companies that are prepared on the basis of IAS without reconciliation, including the London, Frankfurt, Zurich, Luxembourg, Thailand, Hong Kong, Amsterdam, Rome, and Malaysia stock exchanges.

A Few Important Holdouts

Japan. Japanese accounting standards are set by the government--the Ministry of Finance--which also has tax collection and macroeconomic planning responsibilities. So it is not surprising that Japanese accounting has sometimes been politicized. Several years ago, when the Japanese banking crisis first emerged, what did the government do? It told banks they needn't recognize additional provisions for loan losses because people might lose confidence in the banking system. And what has the Japanese government done this year in the face of the Asian financial crash? It proposed a law to allow financial institutions optionally to revalue their land properties, apparently to boost equity ratios. Who needs real capital infusions when simple bookkeeping can do the trick?

I admire Iwao Tomita, founder of Tohmatsu & Co. (part of Deloitte Touche Tohmatsu worldwide) for speaking out (Accounting Today, February 9­22, 1998):

No matter how critical I am, I have so far gotten no response from the Ministry of Finance... if Japan does not adopt international accounting standards, investors will not feel comfortable investing in Japan.

United Kingdom. The U.K. Accounting Standards Board has announced a policy of trying to make its standards consistent with those of IASC. If it concludes, however, that the U.K. national standard is better, it will retain the national standard but commit to reconsideration after the IASC standard has been tested in practice in other countries for perhaps three to five years. IASC's new standards on income taxes and pensions may well turn out to be cases in point.

Meanwhile, foreign companies listed on the London Stock Exchange (LSE) are allowed to prepare their financial statements with IAS without reconciling to U.K. GAAP. Here are some statistics, from the LSE web site, that just about knocked my British colleagues at IASC out of their chairs:

At the end of 1996 there were 2,171 listed U.K. companies on the London Stock Exchange's main market. The equity capital of these companies had a total market value of £1,011.7 billion. There were also 533 international companies listed on the exchange with a total market value of £2,258.1 billion.

About 70% of the market value of LSE companies comes from foreign issuers! Surely that speaks volumes about the need for global accounting standards.

United States. The U.S. accounting literature is the most comprehensive and arguably the best in the world. American investors are the most informed, and the American capital markets the broadest and deepest anywhere. Although American accounting standards are established for the most part in the private sector, they get their authority primarily by operation of Federal securities laws and state CPA licensing laws.

The U.S. Securities and Exchange Commission will have to decide whether to allow companies to use IASC standards in the U.S. At the moment, foreign securities issuers must either use U.S. GAAP or reconcile their financial statements to U.S. GAAP. For most companies, the number of reconciling items is surprisingly few. Principal among them tend to be pension cost measurement; accruals of other employee benefits; deferred income taxes; merger accounting; goodwill, research, and development costs; investments; and fixed asset revaluations. Differences for pensions, employee benefits, and taxes are likely to be minimized in the future as a result of recent IASC standards. IASC has current projects in most of the other areas, though not asset revaluations.

In a recent research report titled Apples to Apples, Morgan Stanley Dean Witter's equity research group considered the question: How close are IAS and U.S. GAAP? The group's conclusion:

The answer depends on what benchmark you use; spelling out all the differences would require a textbook. FASB has identified 255 differences, although many investors would find most of them meaningless. For reflecting economic substance in most industries, IAS is easily of comparable quality to U.S. GAAP, if auditors do their jobs. Yet, as a rulebook, IAS is definitely less detailed than U.S. GAAP.

Incentives for Companies

Investors are not the only ones to gain from global accounting standards. There are big incentives for companies as well. Most obvious is the savings from not having to keep records in accordance with multiple sets of accounting rules. But the benefits are much more fundamental and financially rewarding in terms of access to capital markets, information credibility and understandability, and lowered capital costs.

Wouldn't it have been fun to have been a fly on the wall in the office of the lawyers who were counseling Daimler Benz in its pioneering 1993 U.S. stock sale? After just having told German investors the company had made a profit of DM 615 million, management had to turn around and tell U.S. investors the company suffered a loss of DM 1,839 million. Was 1992 a good year for Daimler Benz, or a bad year? Surely the capital markets wondered what was going on. Uncertainty increases risk. Investors demand a higher return (cost of capital) in higher risk situations.

Thousands of large companies around the world have voluntarily adopted IASC standards. Why? Here are excerpts from two 1997 annual reports:

* Bayer AG's said IAS "provides investors and the financial world with a reliable basis for evaluating our company and its performance."

* Union Bank of Switzerland's--the bank switched to IAS for the first time in 1997--said: "By so doing, we bring greater transparency, furnish additional information, and simplify international comparisons."

The benefits to investors, to companies, and to capital markets of adopting IASC accounting standards are compelling.

What Are the Core Standards?

Where does IASC stand in its program to develop a comprehensive set of accounting standards that are worthy of recognition by IOSCO and its members? I think it is very close--just one standard to go, financial instruments recognition and measurement. Once that is buttoned up, IASC will proudly turn the package over to IOSCO for its review.

IOSCO is the worldwide association of securities commissions--the SEC in the U.S. and over 100 of its counterparts. In 1993, IASC and IOSCO reached agreement on "the necessary components of a reasonably complete set of accounting standards (core standards) that would comprise a comprehensive body of principles for enterprises undertaking cross-border offerings and listings."

In July 1995, IOSCO announced the following:

The [IASC] board has developed a work plan that the technical committee agrees will result, upon successful completion, in IAS comprising a comprehensive core set of standards. Completion of comprehensive core standards that are acceptable to the [IOSCO] technical committee will allow the technical committee to recommend endorsement of IAS for cross border capital raising and listing purposes in all global markets. IOSCO has already endorsed IAS 7, Cash Flow Statements, and has indicated to the IASC that 14 of the existing international accounting standards do not require additional improvement, providing that the other core standards are successfully completed.

Is IOSCO Endorsement Pretty Much a Sure Thing?

Definitely not. IOSCO has defined the minimum core set of standards, spelled out specific accounting issues to be addressed, and publicly announced its support of the IASC. However, the IASC's work product will be judged on its own merits. IOSCO's evaluation will begin with detailed review by an IOSCO committee called Working Party No. 1. That group focuses on multinational accounting and disclosure issues. SEC staff people are members.

Working Party No. 1 will make a recommendation regarding endorsement to IOSCO's technical committee. The technical committee is composed of 16 regulatory agencies, including the SEC, from countries with the world's largest securities markets. Its policy is to make decisions unanimously or not at all.

Technical committee endorsement would then trigger consideration of the IASC core standards at national levels, including SEC examination in the U.S.

If IOSCO Says Yes, Can the SEC Say No?

Sure they can. Like IOSCO, the SEC will consider the IASC standards independently. Clearly, an IOSCO endorsement of the IASC package would bear on the SEC's decision, particularly since the SEC will have participated in the IOSCO process. The SEC has said that in assessing the acceptability of the core standards when they are completed, the commission will consider whether they--

* constitute a comprehensive basis of accounting,

* are of high quality and result in comparability and transparency and provide for full disclosure, and

* can and will be rigorously interpreted and applied.

In an October 1997 report to Congress, the SEC said its decision whether to propose rule changes will be based on an evaluation of the impact of such changes on capital formation, cost of capital for domestic registrants, and investor protection. In that report, the SEC concluded the following:

The IASC's efforts have already contributed greatly to raising the level of accounting standards worldwide and reducing the number of differences between international standards and accounting principles used in the United States. These and other efforts at the international level are encouraging development of accounting principles that have the needs of investors and capital markets as their primary focus.

While the SEC has not yet announced its review procedure, it will likely begin with a staff assessment followed by a report to the commission. The commission's own study will include a request for public comment before a final decision is made.

Of course, it's not an all-or-nothing decision. Already, the SEC has accepted three IASC standards for use by foreign registrants without reconciliation. One possible outcome of the SEC's review of the IOSCO core standards could be endorsement for use by foreign issuers coupled with a requirement to look to U.S. GAAP if IASC has not addressed a particular matter. Another possibility is that the SEC will exclude one or more IASC standards from its endorsement. In all likelihood, all or many of the disclosures that the SEC now superimposes on FASB standards would also be superimposed on IASC standards.

It is not unreasonable to expect that IOSCO's consideration will take all of 1999 and possibly a bit of 2000. Another year to 18 months seems equally reasonable for the SEC's review. Other national regulators will concurrently be engaged in similar work, and coordination might slow the process down a bit. That brings the process to 2002.

Is There Life After IOSCO?

Assuming all/most/many (reader's choice) national regulators accept IASC's core body of accounting standards for use in their countries, at least by foreign securities issuers and perhaps by domestic issuers as well, what's left on IASC's platter?

For one thing, IASC has some current agenda projects that go beyond the IOSCO core standards. Exhibit 1 summarizes these. A few deserve a bit of commentary.

Agriculture. The World Bank is helping to fund this project. It addresses how to account for changes in assets due to biological transformation (such as the growth of livestock and crops) and aging and maturation processes (such as for wine, cheese, ham, and tobacco). Few national accounting standards exist in this area, which is of particular importance in smaller and developing countries as well as in larger ones.

Financial Instruments. IASC is addressing financial instruments in a series of projects. The first ended in 1995 with publication of IAS 32, Financial Instruments: Disclosure and Presentation. Except for adopting "split accounting" for compound financial instruments (accounting for an equity component such as a convertibility feature separately from the debt component), IAS 32 does not cover recognition and measurement.

Two additional projects, one short term and the other longer term, are now under way. The short-term one involves developing a standard on principles for recognizing and measuring financial instruments, including initial recognition and measurement, derecognition, measurement subsequent to acquisition, and hedge accounting. Because of the urgent need for standards in this area, the board's target for completion of this project is the end of 1998.

The longer-term project entails developing a single, comprehensive standard on all aspects of accounting for financial instruments. With that aim, in November 1997 the IASC Board established a joint working group with national accounting standard-setters from Australia, Canada, France, Germany, Japan, New Zealand, five Nordic countries, the United Kingdom, and the United States. This project will build on a March 1997 IASC Discussion Paper, Accounting for Financial Assets and Financial Liabilities, and the work of national standard-setters. Target date for completion by the working group is the end of 2000, after which each of the individual standard-setters will consider a final pronouncement.

Insurance Accounting. Although IAS 30 deals with disclosures by banks, the insurance project is IASC's first to comprehensively address accounting in a narrowly defined industry.

Performance Reporting. The income statement has long been regarded as a report on a company's operating performance. In measuring performance, unfavorable value changes have been occasionally recognized (such as inventory write-downs, expected losses on contracts, and fixed asset impairments). But by and large, performance reporting has been based on realization in terms of completed sale transactions. Lately, value changes have increasingly been finding their way into financial reporting because that information is meaningful to investment and credit decisions, not to mention sensible business management.

Standard-setters worldwide have struggled with how best to report these nontraditional indicators of performance. A number of them, including FASB and IASC, have shown these items directly in equity, sometimes later recycling them through the income statement and sometimes not. American examples include foreign currency translation gains and losses and unrealized changes in the fair values of nontrading investment securities. IASC examples include fixed asset revaluations and translation gains and losses.

In a recent pronouncement, IASC has taken the further step of requiring companies to report, in a separate new statement of changes in equity, any item of income, expense, gain, or loss that is recognized directly in equity. But IASC stopped short of calling this a second performance statement, though some might view it that way. It is really only a stop-gap solution to the more fundamental question of what is performance and how should accounting report it. That question and its practical ramifications are being addressed in IASC's new performance reporting project.

Potential New Agenda Projects

In setting out their list of core standards, IOSCO developed a second list of projects, called suspense issues. Some of these are small. Others are enormous. Examples cited by IOSCO include LIFO inventories, revenue recognition on real estate sales, fixed asset revaluations, foreign currency translation, and new basis accounting. Suspense issues also include accounting practices in such specialized industries as banking, insurance, transportation, oil and gas, mining, forestry, public utilities, health care, cable television, broadcasting, and motion pictures.

IOSCO has also identified several other potential long-term projects. Three are noted:

* New approaches for lease capitalization by lessees, e.g., all leases with a term over one year or by recording all executory contracts.

* Use of discounting in financial statements generally.

* More definitive guidance in applying notions of probability in accounting.

There is no shortage of projects that could be added to IASC's agenda. Exhibit 2 lists some of them.

Fundamental Issue for IASC's Future

IASC has appointed a study group to think about its future. It will publish some proposals for comment later this year.

The fundamental question facing the group is whether IASC should be a standard-setter or a harmonizer. IASC has slowly been evolving from the latter to the former. A harmonizer approach leaves national accounting standards as the primary accounting literature in a country and national standard-setters with the primary responsibility for developing standards. IASC provides a forum for the debate and, through its standards, narrows the range of options open to the national standards setters.

It is hard to see that as the way of the future. One thing I have learned over almost 25 years working in the accounting standards area is that there is no such thing as accounting truth. Separating right and wrong is much less clear than in a natural science. Of course, accounting alternatives can be tested empirically. Those that can be shown to help investors should win out over those that do not. But in the end, setting accounting standards involves a group of human beings putting their collective wisdom and experience together to make a judgment call.

Inevitably, different groups of wise and experienced humans will reach different judgments. And once a group's answer has been arduously shaped into a national accounting standard--published, taught, learned, applied, interpreted, relied on, and so on--that group and its constituents become protective of its own solution and a bit disdainful, or at least fearful, of alternatives developed by other groups of wise and experienced people.

Harmonization of diverse national standards is fraught with insurmountable obstacles. It is not the way to go into the next century. A single, global set of accounting standards will best serve investors, and realistically it will take a single, supreme standards board to do the job.

That is what professionals who use financial statements have been telling the world. For example, last year Merrill Lynch wrote in its Accounting Bulletin No. 51:

[A]s we wait for IASC to produce its core set of standards and the U.S. SEC to make its decision, all around the world non-U.S. companies, stock exchanges, regulators, and standard-setters are adopting and approving IAS. So, while it would be disappointing if the SEC does not accept the core set of IAS as a group, global investors are already benefiting from the IASC's efforts because the widespread use of IAS has--

* lowered the analytical cost associated with global investing; and

* increased investor interest in non-U.S. stocks.

Lawrence Summers, deputy secretary of the United States Treasury, writing about global financial markets in the Financial Times earlier this year said:

If one were writing a history of the American capital market, it is a fair bet that the single most important innovation shaping that market was the idea of generally accepted accounting principles. We need something similar internationally.

The Morgan Stanley Dean Witter equity research report Apples to Apples, mentioned earlier, put it very simply:

Global investors and companies are impatient for regulators to converge on a global accounting standard. Today, differences in accounting practice can completely obscure comparisons of equity values between countries, between sectors, even between companies in the same industry. Many investors are frustrated, pleading for a single system.

2002 or Just Another Millennium Bug?

So I am sticking with my prediction that regulatory approvals will be in place by 2002 in lots of important countries of the world, including the U.S., to give the green light to the use of international accounting standards, at least by foreign companies whose securities are publicly traded in the U.S. Is that an accurate forecast or just another millennium bug? *