America vs. Europe. The battle between accounting standard setters

Chapter 1 History FASB / IASB

“The formation of the International Accounting Standards Committee (IASC) in 1973 was the organized accountancy profession’s most important and enduring response to the growing internationalization of capital markets following the Second World War.” (Camfferman & Zeff, 2007, p. 1)

In this chapter I would like to say a few words on the history and rise of the FASB and IASB, the reasoning on why we needed standard setters, and still need them today and the main missions of the FASB and IASB. I think this is useful for this research to gain a better understanding of the organizations and from what viewpoint they do their work. This will also add more insight in the convergence process, by knowing where both standard setters came from and how they work.

1.1 The International Accounting Standards Board (IASB).

Before 1973, when the IASC and the FASB were founded, the accounting practice differed significantly around the world. From the 1960s on internationalism became an important issue on the agenda of companies and countries. This internationalism also had a big influence on the accountancy profession. The profession leaders of that time stated that, with this internationalism in mind, cooperation among accountancy bodies was a necessary step to take in the process of narrowing international differences in the accounting practice.

From the late 1960s onwards there were moves towards establishing a worldwide organization to represent accounting bodies. First of all the Accountants International Study Group was founded in 1966. The study group publications were not intended as binding on anyone, so this had hardly any influence on the accounting practice. Therefore the next logical step was to form an accounting body that had greater authority.

This next step would be taken in 1972 at the Tenth International Congress of Accountants held in Sydney in September of that year. This congress was, in hindsight, the birthplace of the International Accounting Standards Committee (IASC). At a second meeting in London in December 1972, the proposal came to form the IASC. After a couple of meetings, the agreement to establish an International Accounting Standards Committee was signed on the 28th of June 1973 and the same day the IASC held its first meeting. All the institutes that were approached in 1973 to join the IASC, came with a positive reaction on the formation. This was mostly because of the flattering thought, or the assumption, of being included among the leading countries (Camfferman and Zeff, 2007; Pacter, 2005).

The objective of the newly formed IASC was:

“to formulate and publish in the public interest, basic standards to be observed in the presentation of audited accounts and financial statements and to promote their worldwide acceptance.” (International Accounting Standards Committee Foundation, 2009)

Since the founding of the IASC, their underlying mission was more or less to get such an acceptation of their standards, and becoming such an authority in the accounting profession as the FASB was at that time. The process of getting their standards accepted in the US was a process involving a couple of small steps. Before 1982 there was a requirement made by the SEC for foreign private issuers. They had to disclose narrative information in their periodic reports about differences between foreign accounting principles and U.S. GAAP. If practicable, these differences should be quantified. The SEC had required a full reconciliation, when foreign private issuers offered documents. In 1982 the SEC adopted a separate set of registration statement forms for foreign private issuers. This adoption of the SEC created what became known as the reconciliation requirements, as they were known until 2007 (Nicolaisen, 2005). In the years following 1982 up to present, the pressure to relax or remove the reconciliation requirement for non-U.S. companies grew bigger and bigger. This has become reality in 2007. On 15 November 2007, the SEC voted for the allowance of private issuers to prepare their financial statements using IFRS without reconciling them to US GAAP. (SEC, 2007; Erchinger and Melcher, 2007).

The last major change happened in 2001. On April first 2001 the Trustees brought a new structure into effect. The new organization is called the IASB. With this new organization there also came a new mission. The mission of the IASB is, as mentioned on their website:

“To provide the world’s integrating capital markets with a common language for financial reporting.”

With the IASB instead of the IASC, there came a new wind through the standardsetting. The IASB started off with the making and issuing of IFRSs. IFRSs are based on the IASs, as created by the IASC, and go further than those in respect to international convergence (Tweedie and Seidenstein, 2005). IFRS became mandatory in the European Union in 2005(Vergoossen en van der Wel, 2002; Tweedie, 2005).

To sum up all the above: Until a couple of years ago the organization, at the time called the International Accounting Standards Committee (IASC), was just a collector of local accounting standards, rather than itself now, a setter of world-wide standards. At the turn of the millennium the IASC was restructured. Like the FASB, the IASB is now itself a standard-setter. Only one difference is that the IASB’s mission is not limited to any particular country, group of countries, or continents. The IASB is quite successful in reaching their target of global accounting standards. More than one hundred countries have allowed or even required the use of International Financial Reporting Standards (IFRS). Even the United States permitted foreign issuers to prepare financial statements in accordance with IFRS.

With the change of the IASC to the IASB, the mission changed as well. The IASC was trying to harmonize the national GAAPs of the nine founding countries, where now the IASB is trying to converge their own IASs and IFRSs with the standards set by the FASB. The ultimate goal of this convergence is:

“a single set of global accounting standards.“ (Pacter, 2005)

One might even say convergence is the cornerstone in the mission of the IASB (Camfferman, 2010).

1.2 The FASB

The very first start of American accounting regulation came in 1917. The Federal Reserve Board (FRB) attempted to establish guidelines for financial reporting with its publication of the bulletin “Uniform Accounting”. This bulletin was issued due to concerns regarding the corporate reporting standards. There was a lack of uniformity and reliability with the reporting of these companies. The FRB’s concern was not taken seriously though. The 1920s were a period of “economic exuberance”. People had confidence in the market and everyone was happy. But reality hit when the Down Jones Industrial Average fell drastically during the market crash that preceded the Great Depression.

In 1934 there an agreement was reached between committees of the New York

Stock Exchange and the American Institute of Certified Public Accountants (AICPA). In this agreement there were five general guidelines for financial reporting. These were:

1. revenue should not be recognized until a sale is made, and current period expenses should not be deferred in anticipation of sales;
2. expenses should be deducted from income in measuring earnings, not
charged to capital surplus;
3. after an acquisition, dividends paid by a subsidiary to its new parent out of prior earnings are a return of capital, not income to the parent;
4. dividends on treasury stock should not be treated as income;
5. receivables from officers and employees should not be included in trade receivables.

This agreement followed Franklin D. Roosevelt’s New Deal, which was issued on the 7th of May 1933. This New Deal’s legislation included the Securities Act of 1933. This act stated:

“independent public accountants must audit the financial statements of publicly traded companies.”

This created a foundation upon which the Federal Accounting Standards Board (FASB) would be established forty years later.

The Securities and Exchange Act in 1934 introduced the Securities and Exchange Commission (SEC) to the world (Tucker, 2002). This act transferred authority to administer the 1933 Act requirements from the Federal Trade Commission to the SEC. The SEC was created with hopes of regaining public trust in financial reporting. The SEC was to determine the form and content of financial statements issued by those publicly held companies large enough to be required to register with the SEC. In 1938 though, the SEC voted to rely on the public accounting profession to lead in developing standards in the private sector, while the SEC retained an oversight function and final authority. The SEC decided this private sector body should be the AICPA. The Committee on Accounting Procedure (CAP) of the AICPA was charged with identifying acceptable accounting practices.

The CAP disbanded in 1959 because of discomfort with the lack of specificity in its work. The CAP was replaced by the Accounting Principles Board (APB), a second committee of the AICPA. There was a lot of criticism on the APB. They were said to concentrate on “firefighting” and ignoring “fundamentals”. Another point of criticism was the fact that the APB was “ able as a part-time, volunteer body, to act quickly enough to keep up with developments in the marketplace.” Due to all this criticism there was a conference in 1971 of a handful of leaders in the public accounting profession. They discussed possible solutions for the problems that were encountered. Two study groups, the True blood Committee and the Wheat Committee, were established to research objectives and the establishment of accounting principles. In 1972 the Wheat Committee published their report which recommended a new and independent structure for standard setting. The structure included the Financial Accounting Foundation (FAF), the Financial Accounting Standards Advisory Council (FASAC), and the FASB (Tucker, 2002).

In March 1973 the seven members of the FASB were introduced. Since 1978, following a recommendation by the Foundation Trustees, the FASB opened its meetings to the public (Fleckner, 2008; Tucker, 2002). Since then on the FASB has issued their accounting standards regularly.

To recap what is said before, the American regulation in the accounting sector started off in 1917. The FRB tried to establish guidelines for financial reporting, which were issued on the basis of concern regarding the corporate reporting standards. With these concerns not taken seriously everything went on as before, until the Great Depression set in. Since then accounting regulations in America have taken a new spin. In 1934 the AICPA set five general guidelines for reporting. Also the SEC was introduced, which got all authority on the basis of accounting regulation. Then as a result of criticism, the Trueblood Committee and the Wheat Committee had a look at what should be changed in the organization to get it on track again. A new structure was recommended, out of which the FASB resulted. In

March 1973 the FASB was founded. It still is the accounting standard setter in America today.

1.3 What is Convergence

As already mentioned before at the end of chapter 1.1 the ultimate goal of convergence is to come to a single set of accounting standards. A single set that is applicable worldwide. In order to come to a single set of standards there has to be determined what convergence exactly is. Convergence is defined in the dictionary as:

“to come together and unite in a common interest or focus”

By using this definition of the word convergence, the process the FASB and IASB have started comes more into perspective (Payne and Ranagan, 2008). The convergence of the FASB and the IASB can be phrased like:

The FASB and the IASB are trying to come together and unite to create a set of accounting standards that is worldwide applicable, which will lead to better understanding and comparability.

Convergence can come in a couple of different ways. Payne and Ranagan (2008), identify five major degrees or levels of convergence. These are: (1) Adoption, (2) Convergence, (3) Harmonization, (4) Adaption, and (5) Informed deliberation.

The first identified degree or level of convergence was adoption. To adopt means:

“… to accept formally and put into effect.”

So adopting would mean that either the FASB or the IASB formally accepts the standards of the other party and puts them into effect. This means that the standards of the other party will be applicable in your area as well. This is the highest degree of convergence there is.

The second degree in convergence is convergence. This word is defined as already mentioned before as:

“to come together and unite in a common interest or focus”

In an ideal scenario, complete convergence would result in a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the world’s capital markets and other users make economic decisions (Fleckner, 2008; Payne and Ranagan, 2008). The difference between adoption and convergence lies in the fact that adoption generally involves accepting standards that have been developed and putting them into practice, where convergence requires starting with standards that have been put into practice and gradually make them uniform (Payne and Ranagan, 2008). So, adoption is accepting already existing standards and going with them, where convergence is starting off with the already existing standards and step by step transforming them to make them uniform with the other set of standards.

The third degree of convergence is harmonization. Harmonization is:

“to bring into consonance or accord”

The difference between harmonization and convergence lies in the fact that convergence involves working together with other standard-setters, while harmonization involves working individually to bring one’s standards in line with either international accounting standards or an alternative best practice (Payne and Ranagan, 2008).

The fourth degree of convergence is adaption. Adaption is;

“to make fit (as for a specific or new use or situation) often by modification”

In the light of the convergence process this would mean that adaption occurs when a country modifies the original IFRSs to fit a perceived need or difference in its particular country.

The fifth and last degree of convergence as identified by Payne and Ranagan (2008) is Informed Deliberation. Informed Deliberation is:

“a commitment by the standard-setter to consider the work of other standard-setters but not to be constrained in developing the best standard.”

Informed deliberation involves an active effort to review international standards and standards of other domains and countries when developing standards for similar issues (Payne and Ranagan, 2008).

1.4 The rise of the convergence process

In this paragraph I would like to say a few words on convergence. First of all, what is convergence? This will be followed upon by the discussion of the convergence process over time. This paragraph ends with the discussion around the convergence process today.

1.4.1 The rise of the convergence Process (1960’s – 2001)

The state of convergence as we have today is a result of roughly three big steps in the history of the standard setters. The convergence process is a process that started off before the founding of the IASC, in my view. A first sign of convergence can be seen in the 1960s. As already mentioned in 1.1, internationalism became a hot topic at that time. Therefore, the profession leaders in accounting thought cooperation among accountancy bodies would be important in narrowing international differences (Camfferman and Zeff, 2007). The fact that the profession leaders thought of international cooperation, shows a first effort in bringing the accounting world together.

With the founding of the FASB and, more importantly, the IASC, in 1973, the convergence process became a bigger topic. The IASC fought for worldwide acceptation of their standards and becoming such an authority in the accounting profession as the FASB was. This meant that more and more effort was put into getting the IASs accepted in the US. And with a lot of effort the IASC got what it was fighting for at the end of the 1990s (Camfferman, 2010). This meant a second and big step in the convergence process.

The third major thing in the convergence process happened in 2001. The big change in this year was the foundation of the IASB. And with the IASC turning into the IASB, a new wind came through the standard setting. IASB introduced IFRS. IFRSs are based in IASs and go further in respect to international convergence. Also the fact that IFRSs became mandatory in the European Union in 2005 added weight to these new standards (Tweedie and Seidenstein, 2005). IFRSs are the third big step in the convergence process. With the IASB not needing to be concerned about acceptation in the US of their standards, the focus today lies completely on convergence with US GAAP, with the ultimate goal being:

“a single set of global accounting standards.“ (Pacter, 2005)

1.4.2 The convergence process today.

Convergence is one of the core concepts of the “new” IASB. Where the IASC had the goal of getting their standards accepted by the SEC, the IASB has this acceptation, and aims on convergence. Convergence has to improve both existing financial reporting and consistency across borders (Camfferman, 2010; SEC, 2007).

Of course convergence cannot be reached if only one Board is taking the effort to think about global standards. The FASB and the SEC had participated in and supported the former IASC’s work in coming to the goal of global standards. But with this participation and effort there never really came a universal action that led to international standards.

However, a combination of factors has led to what is now a focused effort aimed at convergence of U.S. GAAP and IFRSs. Firstly there always had been pressure of the SEC to relax or remove the reconciliation requirement for non-U.S. companies. This has become reality in 2007. On 15 November 2007, the SEC voted for the allowance of private issuers to prepare their financial statements using IFRS without reconciling them to US GAAP. (SEC, 2007; Erchinger and Melcher, 2007). Secondly the “new” IASB is an international body insulated from national political pressures, committed to a rigorous due process and established with a similar structure as the FASB. The creation of the IASB gave encouragement to the SEC and FASB to see the IASB as a viable and credible partner. Thirdly, the initial work program of the IASB laid the groundwork for a serious initiative to eliminate the differences, mainly between U.S. GAAP and IASs/IFRSs. Lastly, in the aftermath of Enron, the United States became more receptive to non-U.S. approaches to accounting.

All these factors then led to an environment in which both the FASB and IASB could commence work on eliminating differences between U.S. GAAP and IFRSs. In 2002 this led to a joint meeting in September. As a result of this meeting, the FASB and the IASB published a memorandum of understanding, known today as the Norwalk Agreement. In this Memorandum of Understanding (2002) both Boards agree to:

1. Undertake a short-term project aimed at removing a variety of individual differences between U.S. GAAP and IFRSs;
2. Remove other differences between IFRSs and U.S. GAAP that will remain on January 1, 2005, through coordination of their future work programs; that is through mutual undertaking of discrete, substantial projects which both
Boards would address currently;
3. Continue progress on the joint projects that are currently undertaking;
4. Encourage their respective interpretative bodies to coordinate their activities.

This Norwalk Agreement marked the first time an actual joint strategy was put in place to eliminate differences between U.S. GAAP and IFRSs. Therefore this Norwalk Agreement is the first visible evidence to the public that, since the founding of the IASC and thereafter the transformation into the IASB, both the Boards are trying to come together and set one set of international standards (Tweedie and Seidenstein, 2005).

It can be stated that the Norwalk Agreement is there as a result of some heavy accounting scandals in the US. Where before 2001 the FASB was very skeptical about the convergence process, the Enron scandal and the WorldCom scandal had led to a change in mentality at the FASB. The FASB realized that they could learn something from the IASB and their way of standard-setting (Camfferman, 2010).

There have been two “updates” on the Memorandum of Understanding 2002, the Norwalk Agreement. A Memorandum of Understanding has been issued in 2006 and in 2009. In these agreements both the FASB and the IASB acknowledge their joint work on converging their standards. Since the first Memorandum of Understanding there are joint projects and joint agenda points between the FASB and the IASB. This indicates that both the standard-setters are working together in thinking about how to handle the challenges of financial accounting today (FASB and IASB, 2002; FASB and IASB, 2006; FASB and IASB, 2009; Herz and Petrone, 2005).

Since the Norwalk Agreement, Memorandum of Understanding 2002, the IASB amended the majority of the standards they inherited from its predecessor. Also they issued several new standards. But not only from the IASB side, there were changes. Also the FASB had convergence related changes in their standards. But this process of convergence does not come all easy. For example there is IAS 39 on Financial Instruments: Recognition and Measurement. This is a standard that is resisted by some parties in Europe, particularly banks. The problem with this standard is the fact that it is not fully endorsed by the EU. The EU carved out two sections of IAS 39, the prohibition on hedge accounting for a bank’s core deposits and the option to measure any financial asset or liability at fair value with value changes recognized in profit and loss (Pacter, 2005). Since the crisis though, the latter option is being enforced by the IASB in October 2008, because of the fact that there was no ‘level playing field’ (Camfferman, 2010).

1.5 Discussion on the convergence process

There are different views on the convergence process between the FASB and the IASB. In this paragraph I will show some arguments for and against the convergence process between the standard setters. Firstly I will sum up the most important challenges and obstacles in the convergence process, secondly arguments against convergence and lastly arguments for convergence.

- Challenges and obstacles to overcome in the convergence process

There are challenges and obstacles in the convergence process mentioned in the literature on this topic. Many challenges lie in the fact that there are differences between IFRS and US GAAP. First of all, there is the principles versus rules debate. In the table at the bottom of this page are three levels of accounting and financial regulation stated. Here type A and type B can be seen as principles based accounting rules and type C as rules-based (Alexander and Jermakowicz, 2006).

illustration not visible in this excerpt

Alexander and Jermakowicz, 2006, p.138

What can be abstracted from the table of Alexander and Jermakowicz is that type A regulations is the basic and fundamental concept of regulations. Type B regulation is a set of motions, conventions or ways of thinking which are to be consistently applied in all possible situations. Type C regulations are more of a very detailed kind of regulation. There is thought of every situation and every exception and there are rules for that. Van der Meulen, Gaeremynk en Willekens (2007) state in their article that IFRS is principle based, and US GAAP rules based. This is acknowledged by van Helleman (2006) and Benston, Bromwich and Wagenhofer (2007). These findings in both articles are pretty much in line with what can be distilled from the table of Alexander and Jermakowicz. The fact that both standard setters make their financial standards on a different basis makes it hard to merge them into one set of standards (Das et al, 2009; Goldberg et al, 2006.).

Another challenge to convergence is the fact that both standard setters have a different cultural background, legal systems and economic systems (Das et al, 2009; Goldberg et al, 2006).

Yet another challenge in the convergence process is a difference in the frameworks of both standard setters. There is a difference in the level of detail. The FASB framework includes more discussion of the underlying logic than the IAS framework, where less guidance is given and more emphasis lies on the interpretation of the standards. Another difference in the frameworks lies in the objectives of the frameworks. The FASB framework states the objectives of financial reporting, where the objectives of financial statements are focused on in the IASC framework. A final difference mentioned in the frameworks are differences in the qualitative characteristics of financial information. There are four qualities that make financial information useful. These are: understandability, relevance, reliability and comparability. The FASB ranks the qualities of relevance and reliability as more important than understandability and comparability. The IASC framework does not rank any of these characteristics higher than another (Malthus, 2004; Goldberg et al, 2006).

There is a resistance or reluctance to change in the United States, which is a big challenge to overcome. Reluctance to change in a process of convergence surely does not help the process to get along (Das et al, 2009; Goldberg et al, 2006).

Then there are a couple of obstacles on the road of convergence. For this topic I used an article of S.A. Zeff, Some obstacles to global financial reporting comparability and convergence at a high level of quality (2007). First, the obstacles mentioned are the problems of interpretation. Interpretations are necessary to the effective application of the standards. There is one official body that proposes interpretations, IFRIC, created by the IASB. But every national regulator could also issue their own interpretations, which could differ from one another, acknowledged by Carr et al. (2001).

Secondly there could be the problem of language. This problem could arise when translating IFRS from English. The problem with translating is that there when translating words are sought which are close equivalents, but the meaning can always differ gradually. This could lead to the situation that some issues or concepts stated in English will not be completely or fully understood in another country.

Then there is the problem of terminology. A word as probability or probable is a very often used word in IFRS, but what does it exactly stand for? There is not an exact number or figure you can translate this word with. Therefore interpretations on basis of probability can differ among the organization that interprets the standard.

- Arguments against convergence

There are a couple of arguments brought forward in the literature against the convergence process. One of these arguments is that the adoption of international accounting standards may not be suitable for all developing countries. If developing countries just adopt the accounting standards they will be overwhelmed with, for them, unnecessary complex standards. A problem which follows this issue is the fact that for the application of these international accounting standards you need accounting personnel with sufficient knowledge about these regulations. This requires specific training in these new issues. Some developing countries may not have these opportunities to skill their employees, and therefore implementation of these international accounting standards there will be problematic.

A second argument against convergence is the fact that there will be huge costs and big disruptions in the process of changeover from national standards to the international accounting standards. The changeover costs will include the costs of educating preparers of the financial statements and their auditors about the new standards.

A third, and last mentioned, argument against convergence is the fact that in the process of convergence there is a requirement from every participating country that they surrender their sovereignty over their own financial reporting standards. All over the world countries have developed their own standards in respect with their own national culture, needs and priorities (Malthus, 2004).

- Arguments in favor of convergence

Where there are a couple of arguments against convergence, there are numerous arguments in favor of the convergence process. A first, and widely used, argument in favor of convergence lies in the increasing globalization of the world and the capital markets. There is a huge increase in cross-border transactions (Malthus,2004; Nicolaisen, 2005; Moussa, 2010; Das et al., 2009), and today there is also a large percentage of foreign listers on the stock exchanges around the world (Das et al., 2009), which leads to a conclusion that with more and more cross-border transactions, a set of worldwide standards would be useful. If the world and capital markets are increasingly more coming together, why would the accounting standards stay behind? A single set of worldwide financial accounting standards would enhance the comprehensiveness and comparability of cross-national financial reports, and therewith improve the quality of international financial reporting (Das et al., 2009; Goldberg et al., 2006; Malthus, 2004; Nicolaisen, 2005).This will in turn enhance the confidence in the financial reporting (Nicolaisen, 2005). It would also aid in the functioning and integration of global capital markets, because with the enhanced comparability of financial reports it will be easier for investors comparing companies around the world, and invest in foreign companies (Goldberg et al, 2006; Malthus, 2004;Pacter, 1998).

A second widely used argument is an argument about costs. With one set of financial accounting standards issuance costs for the financial statements would be reduced, since companies which are operating internationally will only have to prepare one financial statement with one set of financial accounting standards, and not multiple financial statements according to different rules (Das et al., 2009; Goldberg et al., 2006;Malthus, 2004;Nicolaisen, 2005; Pacter, 1998).

A third argument for international accounting standards is the rapid development of multinational companies (Moussa, 2010). With different accounting standards it is hard to keep up with these rapid developments. A single set of accounting standards would lead to a more effective and fast reaction on changes in capital markets.

Other arguments mentioned for convergence are the desire to achieve strong, stable and liquid capital markets (Nicolaisen, 2005). A single set of accounting standards would aid in this desire. With one set of financial accounting standards it will be easier and cheaper to implement the standards for countries with limited resources (Malthus, 2004). Also it would be able to do worldwide auditing of financial statements (Goldberg et al, 2006).

Concluding from the arguments mentioned in this chapter we come to the bottom line of this research; Around a (big) change there is always skepticism and criticism.

Moreover, there also is criticism on the convergence process.

1.6 Summary

What we have seen in this chapter is that the FASB and the IASB have completely different backgrounds, despite the fact that they both were founded in 1973. Where the IASB (then called the IASC), had to start off from scratch, the FASB already had 56 years of experience in thinking about accounting regulation, giving them a head

start.

Another important aspect to highlight is that the IASB fought a two-front war. Firstly they had to start and come up with accounting regulations, mostly across Europe, where all the countries separately had their own national regulations. Secondly the IASB had to fight for recognition, not only in Europe, but also from the other standard setting organization, being the FASB (Camfferman, 2010).

Another thing that comes out of this chapter is the fact that there are a lot of different views and therewith arguments in favor of or against the convergence process.

As discussed above, there are a couple of obstacles that need to be resolved to ensure a successful convergence project. But how does all this then relate to the main research question? What I try to examine in this research is whether there is evidence to conclude that the financial accounting standards, after the convergence process, will be more American or more European. Therefore the focus is laid on the one-way convergence standards, because in these standards you see a clear movement towards from one standard setter towards the other.

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