On the global acceptance of ias/ifrs accounting standards: the logic and implications of the principles-based system

J. Account. Public Policy 27 (2008) 455–461 On the global acceptance of IAS/IFRS accounting standards:The logic and implications of the principles-based system q IE Business School, Calle Pinar, 15-1B, 28006 Madrid, Spain The widespread acceptance of International Accounting Standards (IAS)/International Financial Reporting Standards (IFRS) makes it timely to examine their technical determinants as well as their implications for the accounting profession and the process of accounting harmonization. In this respect, we suggest that the principles-based approach to the standards and its inner flexibilityenables the application of IAS/IFRS to countries with diverseaccounting traditions and varying institutional conditions. Further-more, the principles-based approach involves major changes in theexpertise held by accountants and, hence, in their educationalbackground, training programs, and in the organizational and busi-ness models of accounting firms. Finally, we submit that the stan-dards set by the IAS/IFRS constitute a step forward in the process ofaccounting harmonization, although there is still far to go in thecomparability of accounting measures across countries andregions.
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The harmonization of accounting standards has made considerable progress within a relatively short period of time (In 1993, Daimler Benz AG aimed to list on theNew York Stock Exchange (NYSE); hence, it needed to reconcile its financial statements to complywith US Generally Accepted Accounting Principles (US GAAP). Under German GAAP, the firm had re-ported a net income of 615 million Deutschmarks (DM) for the 1992 year, which turned into a net loss We are grateful to Luis Fernández-Revuelta and Mikel Tapia for their helpful comments on earlier drafts of this paper. This project is partially funded by the Spanish Ministry of Education’s research Grant # SEJ2007-67582-C02-01.
* Corresponding author. Tel.: +34 91 568 96 00; fax: +34 91 561 09 30.
E-mail addresses: (S. Carmona), (M. Trombetta).
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doi:10.1016/j.jaccpubpol.2008.09.003 S. Carmona, M. Trombetta / J. Account. Public Policy 27 (2008) 455–461 of DM1, 839 million under US GAAP (see also On November 15, 2007, the US Securitiesand Exchange Commission (SEC) allowed the operation of foreign private firms using InternationalFinancial Reporting on the NYSE without first reconciling their financial statements to USGAAP. The financial press enthusiastically greeted this move; on November 19, 2007, the Financial Timeswrote: ‘‘The goal of a single worldwide accounting language has long been a dream. Today it is fastbecoming a reality—and the pace is picking up.” A number of forces have driven acceptance towards a common set of accounting standards. Pro- cesses of political integration, exemplified by the European Union, as well as the globalization of finan-cial markets and firms’ operations in different jurisdictions are among the driving forces ; see also In the global arena, the stock of foreign direct investment increasedfrom US$1.7 trillion in 1990 to US$6.6 trillion in 2001 (Nevertheless, these forcesdo not suffice in explaining how accounting standards have gained widespread acceptance. Arguably,harmonized accounting standards need to meet some technical features to enable acceptance bycountries with diverse cultures and reporting traditions. In the current article, we examine the logicof IAS/IFRS that facilitated its widespread acceptance and adoption in more than 100 countries, as wellas the implications of these standards for the accounting and auditing professions. Furthermore, wediscuss the extent to which the adoption of IAS/IFRS accounting standards have driven convergenceand, hence, removed substantial reporting and measurement differences across countries.
2. Principles-based vs. rules-based systems A distinctive feature of the IAS/IFRS standards is that they are ‘‘principles-based” instead of ‘‘rules- based”. As noted by ‘‘. . .rules include specific criteria, ‘bright line’ thresholds,examples, scope restrictions, exceptions, subsequent precedents, implementation guidance, etc.” Incontrast, ‘‘principles-based” standards refer to fundamental understandings that inform transactionsand economic events. Under a principles-based system, these understandings dominate any other ruleestablished in the standard. In the case of consolidation, for example, IAS 27 states that full consoli-dation should be enforced whenever a firm exerts ‘‘control” over another firm. As a governing measureof consolidation, the ‘‘principles-based” notion of control, IAS 27, par. 4, states: ‘‘. . .the power to gov-ern the financial and operating policies of an entity so as to obtain benefits from its activities”. In turn,this superimposes any specific rule, such as the percentage of voting rights owned by the controllingcompany vis-à-vis the controlled firm. If a firm actually exerts control over another company, the‘‘principles-based” system establishes that full consolidation should be undertaken, no matter howsuch control is executed (e.g., board interlocks).
Principles-based systems thus issue generic accounting standards. As opposed to rules-based sys- tems, accounting standards of the principles persuasion do not address every controversial issue athand but keep considerable ambiguity about such major processes as record keeping and measure-ment. The broad nature of IAS/IFRS, for example, explains why they do not adopt a position with re-spect to accounting for sales incentives. Consequently, IAS/IFRS leaves it up to firms to make anyaccounting choice that does not contravene the principles established in the standards; the accountingchoices regarding the recognition of actuarial gains and losses provide a useful example in this regard.
According to IAS 19 Employee Benefits, the adoption of the corridor approach can smooth actuarialgains and losses; the results affect net income for the part that exceeds the ‘‘corridor” of plus or minus10% of the maximum between the Projected Benefit Obligation and the Fair Value of the assets of theplan. Alternatively, the income statement can directly recognize the gains and losses. As a third choice,actuarial gains and losses can be recognized fully and immediately into equity and, hence, withoutaffecting the income statement. The IAS 16 Property, Plant and Equipment equally enable differentaccounting choices such as the cost method and the revaluation method for the accounting of tangibleassets.
1 The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS). During the period 1973–2000, the International Accounting Standards Committee (IASC), the predecessor to the IASB, issued these asInternational Accounting Standards (IAS). Importantly, the IASB recognizes standards issued by the IASC.
S. Carmona, M. Trombetta / J. Account. Public Policy 27 (2008) 455–461 The IAS/IFRS standards have gained global acceptance and implementation. Countries using rules- based systems (e.g., Germany) as well as those employing principles-based systems (e.g., the UnitedKingdom) apply IAS/IFRS standards. At the same time, common law countries (e.g., Australia andNew Zealand) and those with a civil-law tradition (e.g., Italy and Spain) also implement these stan-dards. Moreover, countries with diverse national cultures equally apply the standards set by theIAS/IFRS (). This global acceptance of IAS/IFRS, we argue, largely rests on its princi-ples-based nature as well as on its driving notions of openness and flexibility. These ideas are instru-mental in accommodating diverse institutional settings and traditions under a common set ofstandards. However, in principles-based systems rules are necessary to provide the principles witha structure ().
Analytical research also provides some interesting insights into the debate on strict (rules-based) vs. flexible (principles-based) regulatory regimes (From an analytical pointof view, the superiority of stricter regimes is hardly unequivocal. shows that set-tings exist where stricter regimes perform worse than their more flexible counterparts do. Intuitively,a strict regulatory regime imposes uniformity of treatment on a variety of firms operating under quitedifferent circumstances. This uniformity involves an informational cost because it reduces the amountof information that the observation of different accounting policy choices can extract. Investors canthen learn about a firm from their observations of the company’s choices on issues such as the treat-ment of actuarial gains and losses of a pension plan under IAS 19.
The implementation of IAS/IFRS across countries and regions has some additional implications. In the current paper, we comment on the effect on the accounting and auditing professions. Furthermore,we discuss the extent to which the application of IAS/IFRS in different jurisdictions results in financialstatements with uniform properties. In turn, we embed this discussion in the steady trend towardsbusiness globalization, an issue that affects both auditors and their clients.
3. The accounting and auditing professions under IAS/IFRS Under a rules-based system, accountants obtain access to detailed implementation guidance. Argu- ably, specific rules considerably reduce uncertainty from the accountant’s role, which ultimately re-sults in a mechanical application of the specific rules established in the standards. To some extent,the commonly held view of the accounting profession as ‘‘dull” has its roots in these mechanicalunderstandings of the accounting process. In countries with a rules-based accounting system, theadoption of the IAS/IFRS standards brings about a different mindset that sharply contrasts with theprior national, regulatory setting. In particular, the principles-based nature of IAS/IFRS standardsand the related notions of openness and flexibility exert a lasting effect on the educational backgroundand professional skills of accountants and auditors.
The adoption of IAS/IFRS requires accountants to possess a solid knowledge of business and eco- nomics. In this respect, accountants should grasp a comprehensive understanding of the businessand economic fundamentals of transactions and events before deciding on its accounting treatment.
The case of the investment made by Pirelli in Telecom Italia helps to illustrate this point. In 2001, Pir-elli subscribed to 60% of a firm called Olimpia. At the same time, Olimpia had bought 27% of Olivetti,which in turn owned 55% of Telecom Italia. A mechanistic application of the 20–50% ‘‘rule” would statethat Pirelli should fully consolidate Olimpia. According to this reasoning, Olimpia was required to re-port the investment in Olivetti under the equity method whilst Olivetti needed to consolidate TelecomItalia fully. Nonetheless, a close inspection of Pirelli Consolidated accounts for the year 2001 revealedthat the Chairman of Pirelli at the time was also the Chairman of Olimpia, the Deputy Chairman andManaging Director of Olivetti and the Chairman of Telecom Italia. Moreover, the Deputy Chairman ofOlimpia was also the Deputy Chairman of Olivetti and the Deputy Chairman of Telecom Italia. Withthis information in hand, can we still defend why we should not fully consolidate Telecom Italia’sfinancial statements into Pirelli’s accounts? A principles-based approach would draw on the notionof control as the dominating principle. This is the notion adopted in IAS 27, which would considerTelecom Italia as a subsidiary of Pirelli and consequently would call for full consolidation. However,the only way to reach this conclusion and correctly apply IAS 27 is by conducting a thorough S. Carmona, M. Trombetta / J. Account. Public Policy 27 (2008) 455–461 examination of the economics and business essence of the relationships between Pirelli, Olimpia, Oliv-etti and Telecom Italia. As noted, the mere reliance on the percentage of shareholding does not bringabout such a conclusion.
Principles-based systems feature professional judgment as a distinctive element of the accounting process (). Under these systems, accountants are required to make a considerable num-ber of estimates for which they are responsible. In addition to technical skills, the accountant’s roleinvolves some ethical and legal implications that are barely discernible under a rules-based system.
In turn, these changes affect the role of auditors, who should not merely report formal complianceof a firm’s financial statements with a set of rules. Under a principles-based system, auditors needto grasp a proper understanding of the extent to which a firm properly applies the standards set bythe IAS/IFRS. This understanding, we contend, requires an informed judgment about the businessand financial situation of the firm. In some countries, this will ultimately involve substantial changesin the training and educational programs of accountants and auditors, especially in those jurisdictionswhere there is no accounting profession and/or auditing is perceived as an ‘‘activity” and thereby lacksprofessional status (e.g., Spain; see ).
Moreover, the worldwide introduction of IAS/IFRS creates important implications for the market for audit services. One of the reasons used to explain the progressive concentration in this marketis that only large audit firms can provide international corporations with the expertise needed to con-solidate accounts produced under many different sets of national standards. Paradoxically, the harmo-nization of accounting standards worldwide through IAS/IFRS could have important effects on themarket prospects of second-tier accounting firms. This is a direct consequence of the complexity ofthe reconciliation process from a subsidiary’s home standards to the parent’s home standards. Thisharmonization process will also put to test the true ‘‘global” nature of the Big-4 audit firms. The com-munication between national partners and global teams in Big-4 audit firms will then probablystrengthen the organizational links between local practices and international headquarters.
The principles-based system featured by IAS/IFRS has been instrumental in the global acceptance of the accounting standards. However, the extent to which the application of IAS/IFRS enhances theinternational convergence of accounting practices remains outstanding. In this respect, empirical re-search has distinguished between the voluntary adoption of IAS/IFRS within the European Union be-fore 2005 and their mandatory adoption after 2005.
Research examining voluntary adoption is mounting (see for an excel- lent review). Accordingly, we focus on those studies that are particularly significant for the purposes ofthis paper. In this respect, distinguished between firms that voluntarily appliedIAS/IFRS into serious and label adopters. The distinction captured the idea that some adopters seriouslymodify their financial reporting strategy after adoption (serious), whereas others use the flexibility ofIAS/IFRS standards to keep on using their usual financial reporting strategy under the new interna-tional label (label). find that the positive effects of adoption are more pronouncedfor serious adopters than label adopters. When the two groups of adopters are pooled together, theaverage effects of adoption become modest. In a related vein, investigated the ef-fects of voluntary adoption of IAS/IFRS on various measures of accounting quality. They found thatadoption significantly improved accounting quality by reducing earnings management and enhancedboth the value relevance of accounting numbers and the timeliness of loss recognition. In spite of this,they also suggested that the results could be partly attributed to differences in firms’ incentives, aswell as the varying economic environments of the sample firms.
Research addressing the mandatory adoption of IAS/IFRS within the European Union after 2005 is at an early stage, given that it is a relatively recent phenomenon. examined theeconomic consequences of mandatory IAS/IFRS adoption in a large sample of firms established in26 different countries. Although adoption did not have seemingly strong effects, the consequenceswere particularly notable, especially in jurisdictions whose domestic GAAP differed from IAS/IFRSstandards. Finally, investigated the unique institutional setting provided S. Carmona, M. Trombetta / J. Account. Public Policy 27 (2008) 455–461 by Germany where firms could voluntarily adopt IAS/IFRS before 2005. This enabled the isolation ofthe incentive effect and its comparison with the mandating of adoption for companies that obviouslydid not have an incentive to do so voluntarily. In this setting, compared theeffects of voluntary vs. mandatory adoption. They found that the economic effects of adoption weresignificant for voluntary adopters but insignificant for forced adopters. These findings question theassumption that mandatory enforcement of IAS/IFRS will result in improvements in accountingquality.
In sum, extant research suggests that financial reporting practices do not necessarily change after mandatory adoption; firms may adopt the ‘‘label” of IAS/IFRS and then use its flexibility to retain exist-ing accounting policies. Consequently, uniformity of accounting treatments is not an automatic out-come of the mandatory adoption of IAS/IFRS. Further, empirical evidence suggests that accountingquality significantly improves in cases of voluntary adoption but does not necessarily improve aftermandatory adoption.
The widespread acceptance of IAS/IFRS requires examination of its technical underpinnings as well as examination of its implications for the accounting profession and the process of accounting harmo-nization at large. In this respect, we argue that the inner flexibility of the principles-based approachenables the application of IAS/IFRS in countries with diverse accounting and institutional environ-ments. Moreover, the principles-based approach brings about a number of fundamental changes inthe backgrounds and skills of accountants and auditors. Notwithstanding our contention that theIAS/IFRS standards constitute a step forward in the process of accounting harmonization, there is stilla long way to go in the comparability of accounting measures across countries and regions.
The IAS/IFRS rely on a principles-based system to set accounting standards. This system, in turn, provides flexibility to render possible the global acceptance of the standards. As noted by some com-mentators, principles-based accounting standards constitute ‘‘the solution” to the problem of account-ing harmonization.In this respect, we suggest that the adoption of a flexible approach by the IASBconstitutes a feasible move towards accounting harmonization. Indeed, this approach has enabled morethan 100 countries to apply IAS/IFRS standards within a relatively short period. In view of the dramaticreconciliation of firm financial statements performed up until quite recently, we could regard this as anew accounting revolution (see In this respect, we focus our discussion on the implica-tions of these changes for fraud deterrence as well as on the differences between domestic standardsand IAS/IFRS.
The inherent flexibility in the principles-based approach could also act as a more effective fraud deterrent. In this respect, empirical research suggests that firms voluntarily adopting IAS/IFRS enhanceaccounting quality, as well as the relevance of accounting numbers, and reduce earnings management(As shown by recent accounting scandals and financial crises, the regulator canhardly anticipate the distinctive features of the evolution of global business. Furthermore, the highlyprescriptive nature of some national standards (e.g., the US) does not provide the best context for theaccounting and audit professions to play an active role in detecting and denouncing these potentiallydisrupting situations (In this respect, former SEC Chairman Roderick , has argued: The fact is that accountants are becoming or have become rule checkers, applying the myriad of FASB pronouncements and clarifications rather than using their judgment as to what is a fair presen-tation of financial statements. The fact is at far too many CEOs regard the annual audit as a commodityrequired by government rather than an exercise that has intrinsic value.
Under a principles-based system, auditors are responsible for providing judgment over the imple- mentation of a broad set of accounting standards rather than following the specific guidance stated ina rules-based system. This approach will have effects on the auditing profession because of the 2 share this position, though qualified in light of their discussion of the asset/liability and revenue/ S. Carmona, M. Trombetta / J. Account. Public Policy 27 (2008) 455–461 possible increase in audit and litigation risks. As pointed out by , it could alsostimulate the creation of a new business model for auditors. According to auditors will now offer a new type of service where the audit report is a complete and argued opinionabout the faithfulness of the financial statements to the intrinsic reality of the activities performed bythe company during the year.
The adoption of principles-based IAS/IFRS standards may also bring about organizational conse- quences for accounting firms. Traditionally, firms keep separate the accounting division from the oper-ations division as well as from the public relations/communication divisions. In a ‘‘rule checking”approach, the accountant does not require a deep understanding of the economic and business under-pinnings of the firm’s financial statements. Conversely, under IAS/IFRS ‘‘compliance with the rule” isno longer the case. Consequently, we would expect improvements in the relationships between theoperations and financial reporting divisions of accounting firms. Moreover, accounting choices shouldbe effectively communicated to stakeholders and this process requires close cooperation between theaccounting and public relations divisions of professional services firms. Anecdotal evidence gatheredfrom our own conversations with practitioners and consultants makes us believe that this is a funda-mental challenge posed by the widespread adoption of IAS/IFRS. The rigorous study of these organi-zational implications is worthy of future academic research.
The harmonization process will also benefit from the ‘‘global” nature of both auditors and their cli- ents. Arguably, auditors and clients will drive forward common interpretations and practices aroundthe world. Global clients willing to reduce the steps needed to unify the accounting information pro-duced by local subsidiaries will promote this process. Consequently, global auditors may push forwardharmonization through consistent interpretation to accommodate the needs of global clients. In thismanner, auditors will also be facilitating the global character of business. In turn, the number of globalclients in favor of globally harmonized interpretations will arguably increase and this will enhance thecomparability of financial statements across countries.
The differences between IAS/IFRS and domestic standards may be attributed to the reconfiguration of power among standard setting bodies. This situation largely resembles those recurrently featured inthe process of transnational integration, where national representatives ‘‘. . .retain the ultimate legalclaim to effective supremacy over what occurs within their own territories” (Inthis case, it is not so much a matter of accepting the IAS/IFRS standards, but the rules and normsset by a peer institution established in a different country. Differences between domestic accountingstandards and IAS/IFRS can be explained by absence and divergence Absence is theextent to which the rules regarding certain accounting issues are missing in domestic accounting stan-dards but covered in IAS/IFRS. Divergence applies in circumstances where the rules regarding thesame accounting issue differ in domestic accounting standards and IAS/IFRS. foundthat absence is mainly determined by the importance of the equity market and market concentration,whereas they found a positive association between divergence and the level of economic developmentand the importance of the accounting profession. At the same time, divergence is constrained by theimportance of the equity market. Under these circumstances, suggest that emergingcountries often treat IAS/IFRS as a reference point and a means to upgrade their own accountingsystem.
Emerging economies, though, aim to play an active role in the convergence process ( ). In the case of China, this results in the perception of convergence between Chinese GAAPand IAS/IFRS as a two-way process where each one of the two parties has the right to try and influencethe direction of accounting harmonization (More generally, the adoption of IAS/IFRS by countries with institutional contexts different from those experienced by their Anglo-Saxoncounterparts along the flexibility of the principles-based approach may affect the standard settingprocess in ways that are difficult to predict at the moment. For example, emerging economies lackwell developed markets and this makes it difficult to implement the market based approach to theestimation of fair values, a concept that may involve controversial meanings within institutional con-texts that are remarkably different from those that witnessed the emergence of this notion. Therefore,these countries will likely develop and propose alternatives for this estimation. In this respect, we sub-mit that examination of the implementation of IAS/IFRS in emerging countries might be a potentiallyrelevant research area for scholars interested in international accounting and public policy.
S. Carmona, M. Trombetta / J. Account. Public Policy 27 (2008) 455–461 In sum, we have addressed the principles-based notion underlying IAS/IFRS. This notion, we argue, has enabled the worldwide application of the standards. Furthermore, compliance with the IAS/IFRSinvolves new understandings of the role and background of the accounting and auditing professions,from mechanistic implementation and certification of rules to decisions on the best possible account-ing alternative among those enacted in the standards. In turn, this openness and flexibility poses someproblems for the comparability of accounting figures and measures. At the same time, we submit thatthe inherent flexibility of accounting standards could act as a deterrent to fraud. At the same time, theadoption of IAS/IFRS may have consequences on the organization and business models of accountingand auditing firms. Finally, and notwithstanding our contention that the principles-based approach toaccounting harmonization constituted a plausible route to international convergence, there is a longway to go in the process of cross-national comparability. In addition to problems arising in developingcountries and economies in transition, empirical research addressing developed settings reveals thatthe flexibility of the IAS/IFRS standards may serve the purposes of label adoption ):that is, firms use flexibility to retain their traditional accounting policies.
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