IASC Conceptual framework

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Ludwig Erhard Lectures 2004 1

Chapter 4: The objective of international

harmonisation: value relevance or accountability?

Introduction

Many scholars take it for granted that the objective of international harmonisation is

to improve the informational efficiency of foreign stock markets. As Hopwood said,

in most international accounting research, The user perspective is taken to be one of

such obviousness that it requires no appeal to conventionally accepted evidence

(1994, p.249). By user-perspective Hopwood means the decision-relevance or

informational perspective which, as we saw in chapter three, says that the aim of

accounting is to help investors value companies. In this chapter we appeal to

conventionally accepted evidence to ask, why do the capital markets want harmonised

accounting? It is not sufficient to simply assume that this is the aim of international

accounting, any more than we can just assume that domestic investors want value-

relevant accounting information. As Holthausen and Watts say,

standard-setting inferences based on a theory that assumes standard setters

consider a high association with stock values a desirable attribute for

accounting earnings are not likely to be useful if the evidence suggests

standard setters do not consider stock valuation association an important

attribute. Simple assertions by authors that standard setters should consider

that attribute desirable are not sufficient for scientific research (2001, p.4).

While there are important differences in international financial reporting, theirsignificance for users in share valuation is debatable. Many observers believe

accounting differences create a Tower of Babel . However, there is extensive

evidence that the capital markets of developed economies are informationally

efficient (e.g., Choi and Levich, 1990, pp.23-25; Alford, 1993, pp.184, 196). In other

words, accounting differences have not caused domestic investors any insurmountable

problems in valuing shares sufficiently accurately to prevent abnormal transfers of

wealth from trading on past prices (weak-form efficiency), publicly available

accounting information (semi-strong), or even inside information (strong-form). Non-

Anglo Saxon capital markets have lower liquidity and public disclosure standards, but

we must remember that poor public disclosure does not necessarily impede the flow

of information into stock prices, since the information flow can occur instead via thetrading of informed insiders (Ball, Kothari and Robin, 2000, p.48). US investors

behave as though they believe foreign stock markets are efficient. As Lochner, a SEC

commissioner, pointed out, the failure of most non-US companies to use US GAAP

has not deterred U.S. investors from purchasing foreign securities (1991, p.108).

The problem for those who allege that IAS are a pre-requisite to a well-developed

global securities market is that a well-developed capital market exists already. It has

evolved without uniform accounting standards (Goeltz, 1991, p.86).

To explain the objective of international harmonisation we must distinguish between

informational efficiency and allocational efficiency, that is, between the fair pricefor a financial security and its maximum value. A securities market is efficient if




information is widely and cheaply available to investors and all relevant and

ascertainable information is already reflected in security prices (Brealey and Myers,

1984, p.266). The chapter argues that the problem for international investors is not

whether the market price for foreign securities is fair, but whether the expected

returns are as high as possible. As Choi and Levich point out, the international capital

market efficiency of interest to policy makers includes not just confidence in theaccuracy of relative share values, but the confidence to form fully diversified global

portfolios:

Not withstanding this rosy appraisal of international capital markets, two

questions are of concern to policy makers. First, would a common,

harmonized accounting system provide more useful information to market

participants than the diverse systems now in place? Second, even though

financial markets may appear efficient, do diverse accounting systems act as a

nontariff barrier, affecting the capital market decisions of investors and

issuers? (Choi and Levich, 1990, p.34).

The fundamental question is whether, based on their analyses, foreign investors are

confident enough to participate in international markets to the extent required to hold

well-diversified portfolios (Choi and Levich, 1990, p.22). Even though there is clear

evidence that market prices reflect available information [this] does not address the

question of how costly it is for investors to process diverse accounting information

(Choi and Levich, 1990, p.22). We saw in chapter 1 that international diversification

by US and UK investors is below its apparently optimal level. This is consistent with

the hypothesis that without IAS international investors do not expect the returns from

additional investment in foreign securities to cover the increased information

processing costs they would incur to hold foreign management accountable for therate of return on capital.

If the international capital markets are informationally efficient, accounting is

useful to investors only as a means of holding management accountable. Only if

investors have confidence that the accounts objectively measure management s

performance are there no accounting barriers to investors allocating their capital to

those firms delivering the highest rates of returns on capital. In this sense, we can

agree with Saudagaran and Meek that

The primary economic rationale in favor of harmonization is that major

differences in accounting practices act as a barrier to capital flowing to the

most efficient uses. Investors are more likely to direct their capital to the most

efficient and productive companies globally if they are able to understand

their accounting numbers (and so, presumably, their economic reality) (1997,

p.137).

The most efficient and productive companies are those with the highest rates of

return on capital. This, we shall argue, is the economic reality of concern to

international investors.

By contrast, the information efficiency objective assumes harmonising accountingaround the Anglo-Saxon model will give investors more value-relevant information,




that is, information with more predictive ability , to increase capital market

efficiency.1

As we saw in chapter 3, the basis of the IASC[ s] conceptual

framework is the value relevance of financial reports (Ali and Hwang, 2000, p.3).

The dominant view is that the objective is to improve the efficiency with which the

markets operate by reducing the diversity that exists among the bases on which

financial accounts are prepared in various countries (Bayless, 1996, p.76; see also,Zarzeski, 1996, p.18). As Arthur Wyatt, former director of the IASC, put it,

Comparable financial information assists in the quality of the financial

analysis and thereby should increase the efficiency of capital markets. . One

can build a strong case that financial data, presented on a comparable basis

across countries - with the same degree of credibility as local data possesses -

will increase the efficiency of investment analysis (1991, p.13.9).

To prove that informational efficiency is the real aim of harmonisation, its advocates

must show us, first, that the primary function of accounting in the Anglo-Saxon

capital markets is to help investors value securities.2 In other words, they would have

to show us that Anglo-Saxon accounting plays a major role in security valuation by

providing investors with information having significant predictive-ability or value-

relevance . Second, they would have to show us that restating foreign accounts using

Anglo-Saxon methods improves their value-relevance. We first show that extensive

research has established neither proposition. Then we look at the evidence supporting

the accountability objective of harmonisation.

The value-relevance of accounting

During the 1970s and 1980s scholars attempted to verify the decision-usefulness viewof accounting by establishing a statistical link between economic returns and

accounting earnings, usually called the information content or value-relevance of

accounting. Initially they had little success. Early studies of the information content

of earnings usually found only weak links between earnings and returns, with R2

statistics typically ranging from 2 per cent to 10 per cent (Pope and Rees, 1992,

p.337). Stimulated by Ohlson s work the inclusion of the book value of equity in the

regression equations increased these embarrassingly low R2

statistics (Strong and

Walker, 1993, p.385). Nevertheless, we will see this research has not established

value-relevance as the primary function of accounting, and we conclude, therefore,

that it provides no support for the market efficiency objective of harmonisation.

Value relevance research starts from the tautology that the market value of a firm s

equity is the sum of the book value3

of its net assets plus the present value of its

expected residual income . Residual income is the excess earnings over the required

return on its net assets. The economic value of expected residual earnings is what

accountants call internal goodwill. Value-relevance research exploits this tautology

1 Note that market efficiency does not mean that the market has perfect forecasting ability, only that

prices reflect all available information (Brealey and Myers, 1984, p.271).2

We saw in chapter 3 that the IASC s Framework for the Preparation and Presentation of FinancialStatements assumes this is the aim of accounting. 3 From the traditional perspective, book value is replacement cost.




to re-write the dividend valuation model using accounting numbers. The dividend

valuation model is:

Pt = R- Et[dt+ ]=1

Pt = share price at time t. R = 1 + required return on equity.

dt+ = the dividend to be paid at year-end t + .

Et[.] = expectations at year-end t.

To re-write this equation with accounting numbers, we define earnings as the annual

clean surplus . This means earnings equals all changes in the book value of equity

(other than capital injections and distributions) including all movements of reserves

(e.g., foreign currency translation differences, asset revaluations, goodwill write-offs):

xt = yt - yt-1 + dt

xt = earnings in the year end t.

yt = book value of equity capital at year-end t.

yt-1 = book value of equity capital at year-end t-1.

dt = the dividend paid at year-end t.

We define residual income for year t as earnings for year t less a capital charge based

on the opening book value of equity:

xta

= xt - (R - 1) yt-1

xta = yt + dt - Ryt-1

dt = Ryt-1 + xta - yt

All this says is that dividends equals the normal increase in equity (i.e., normal

income) plus the abnormal or residual income less the closing equity. Substituting

this expression for dividends in the dividend valuation model produces:

Pt = yt + Et[xat+ ]R

-

=1

This says the market value of a firm is the sum of the book value of its equity and the

present value of expected clean surplus residual income.

Thus, if the market knows the book value of equity and can forecast expected

earnings and, therefore, the clean surplus residual income, it can deduce the expected

dividends and value the firm whatever methods of accounting management uses.

Consider the following example:4

A company raises £1m cash in equity at the end of t = 0.

The company immediately communicates to the market the expectation that this £1m will

all be used to buy inventory during year 1:

4 From Rees (1995, pp.230-231).




The company will sell half of the inventory in year 1 for £0.6m;

The company will sell half of the inventory in year 2 for £0.6m

It will earn no other income and pay no taxes.

It will distribute all cash balances at the year end.

Assuming a cost of capital of 10%, according to the dividend capitalisation model the value of the firmat t0 is:

P0 = £0.6m/1.1 + £0.6m/[1.1]2

= £1.0413m.

We can derive this valuation from the forecast accounts based on the forecast events regardless of the

methods used. Consider the following three accounting bases:

1. Historical cost accounting where the closing stock at the end of year 1 = £0.5m.

2. Valuing closing stock at zero at the end of year 1.

3. Valuing closing stock at £2m at the end of year 1.

1. Stock @ t=1 = £0.5m:

Cash Inventory Equity

------------------------------------------------------------------

£m £m £m

Initial capital +1.0 -1.0

Purchases -1.0 +1.0

Sales +0.6 -0.6

Cost of sales -0.5 +0.5

Profit/Dividends -0.1 +0.1

Dividends/cash -0.5 +0.5

------------------------------------------------------------------

BS end 1 0.0 0.5 0.5

==================================================================

Sales +0.6 -0.6



Dividends/cash -0.5 +0.5

------------------------------------------------------------------

BS end 2 0.0 0.0 0.0

==================================================================

According to the accounting valuation model:

Pt = yt + Et[xat+ ]R-

=1

£0.1m - [£1m x 0.1] £0.1m - [£0.5m x 0.1]

= £1m + ------------------- + ---------------------

1.1 1.12

= £1.0413.

2. Stock @ t=1 = £0.0m:


-------------------------------------------------------------------

£m £m £m


Purchases -1.0 +1.0

Sales +0.6 -0.6


Dividends -0.6 +0.6

-------------------------------------------------------------------

BS end 1 0.0 0.0 0.0

===================================================================

Sales +0.6 -0.6

Cost of sales 0.0 +0.0


-------------------------------------------------------------------




BS end 2 0.0 0.0 0.0

====================================================================

-£0.4m - [£1m x 0.1] £0.6m - [£0.0m x 0.1]

£1m + ------------------- + ---------------------

1.1 1.12

= £1.0413.

3. Stock @ t=1 = £2.0m:


--------------------------------------------------------------------

£m £m £m


Purchases -1.0 +1.0

Sales +0.6 -0.6

Revaluation +1.0 -1.0

Dividends -0.6 +0.6

--------------------------------------------------------------------

BS end 1 0.0 +2.0 -2.0

====================================================================

Sales +0.6 -0.6

Cost of sales 2.0 +2.0 Profit/Dividends -0.6 +0.6

--------------------------------------------------------------------

BS end 2 0.0 0.0 0.0

====================================================================

£1.6m - [£1m x 0.1] -£1.4m - [£2.0m x 0.1]

£1m + ------------------- + ----------------------

1.1 1.12

= £1.0413.

Many researchers have estimated Ohlson s model in the following forms to assess the

value relevance of accounting :

Either,

Pt = a0 + a1b j,t + a2x j,t + , jt

Or, a statistically more valid formulation (Brown et al. 1999),5 as

x j,t x j,t

Rj,t = a0 + a1 ------- + a2 ------- + , jt p j,t-1 p j,t-1

Where:

Pt = share price at time t.

a0 = the intercept.

a1, a2 = regression coefficients.

b j,t = the book value of the equity of firm j at time t.

x j,t = reported earnings of firm j at time t.

x j,t = the change in the reported earnings of firm j from time t -1 to t.

, jt = an error term.

5

Regressions of the levels of prices against levels of the book value of equity and earnings can lead tospuriously high R-squares because companies with large nominal share values tend also to have large

values for the book values of equity and earnings per share.




Researchers usually take the regression R2

as a measure of the value relevance of

the accounting numbers. On this basis, research in the US and Europe shows that

this relation is weak, suggesting that reported earnings do not provide good summary

measures of the value-relevant events that have been incorporated in stock prices

during the reporting period [as] R-squares are relatively low (Dumontier and

Raffournier, 2002, p.131), usually in the range 20% to 30% for US and non-UScompanies (e.g., Ali and Hwang, 2000, Table 3, p.12).

However, even these correlations do not prove that the release of accounting numbers

themselves causes any changes in forecast earnings and hence share prices. As

accounting numbers reflect real world events, correlations between accounting and

share prices could reflect the correlation between share prices and the underlying real

world events which accounting reports reflect. But, if (as in our example) the market

can forecast the real world events underlying its forecast of the accounts, including

the dividend, why would it bother to use the accounts to value the firm as it could do

so directly? As Walker concludes,

Potentially the most destructive criticism of the Ohlson approach is that it

does not explain why firms bother to report earnings and book values in the

first place. Ever since Beaver and Demski s (1979) seminal paper, this line of

criticism has dogged all approaches to financial accounting based on notions

of income measurement. In particular, [that] neo-classical economics has

failed to develop a theory of income measurement in which there is an

endogenous demand for some form of income measurement (1997, pp.352,

342).

Beaver and Demski restated the well-known fact that income measurement only hasan unambiguous interpretation as an increment to economic value in a wholly

unrealistic certain world with perfect and complete markets. In the real world of

uncertainty and imperfect and incomplete markets the case for accrual accounting to

improve the predictive abilities of investors is unclear. In the real world, to forecast

dividends and value shares investors need information about the real world, in

particular management s state-contingent production plans . They must combine

their knowledge of management s plans with other information to form beliefs about

future states of the world and their implications for the dividends expected from

particular firms. It is unclear whether, or if so how, accrual accounting provides this

information (Beaver and Demski, 1979, pp.43-45). Although Ohlson claims to

integrate the income measurement approach that assumes that investors use

accounting information to value companies with the information perspective that says

that accounting provides data about the real world that investors use for valuation, in

fact, as Walker says, The Ohlson models assume that accounting numbers reflect an

underlying reality that is directly observed by the market (1997, p.352). As

Dumontier and Raffornier say,

association studies do not infer any causal connection between accounting

figures and stock prices. They do not even presume that market participants

use accounting data in their valuation process. They only posit that if

accounting data are good summary measures of the events incorporated in




security prices, they are value-relevant because their use might provide a value

of the firm that is close to its market value (2002, p.128).

In short, Ohlson s model tells us nothing about the role of accounting in the real

world, only that it is to some extent correlated with share prices. Not surprisingly, the

huge value-relevant literature has made virtually no contribution to setting accountingstandards. Holthausen and Watts are scathing in their criticism of this literature:

Barth et al summarize what the have learned from the research on the value

relevance of fair value as the basis of accounting. They conclude that various

fair value estimates of pension assets and liabilities and fair values of debt

securities, equity securities, bank loans, derivatives, non-financial intangible

assets (R&D, capitalized software, advertising, brands, patents and goodwill)

and tangible long-lived assets are value relevant. They also conclude that

some estimates are not value relevant. These conclusions amount to the

finding that the literature has documented that the listed items are correlated

with equity values than other items. However, it is difficult to derive

standard-setting inferences from these findings without descriptive theories of

accounting and standard setting to interpret them (2001, p.65).6

To write helpful standards we must understand accounting and its role. As Walker

concludes,

what we really want to know is why do we have financial reporting systems

that supply measures of income (earnings) and value (book value)? Perhaps

one cannot hope to explain the basic features of the financial reporting unless

one starts from the proposition that that capitalist owners value measures of return on capital (Walker, 1997, p.352).

In traditional accounting, capitalist owners value the accounting rate of return because

it provides an objective basis for holding management accountable for the rate of

return on capital. As we shall see, research on the usefulness of accounting to the

international capital markets is consistent with the accountability hypothesis.

First, however, we show that although there is some evidence that Anglo-Saxon

accounting has more value-relevance within Anglo-Saxon capital markets than

foreign GAAP has in foreign capital markets (Ali and Hwang, 2000), there is little

evidence that the value relevance of their accounts to Anglo-Saxon investors wouldincrease if foreign firms used Anglo-Saxon GAAP. This undermines the hypothesis

that investors demand international harmonisation to improve the value relevance of

non-Anglo Saxon GAAP and thereby increase the informational efficiency of the

international capital markets (hereafter, the efficiency hypothesis ).

The value-relevance of non-Anglo-Saxon GAAP

6 Barth et al (2001) is a reply to Watts in the same issue of the journal. They admit that Because

usefulness is not a well-defined concept in accounting research, value relevance studies typically donot and are not designed to assess the usefulness of accounting amounts , and that Academic

researchers are the intended consumers of value relevance research (pp.78-79)!




If Anglo-Saxon GAAP has predictive-ability we should expect the accounts of foreign

firms that report using non-Anglo Saxon GAAP would consistently have significantly

less value-relevance than Anglo-Saxon restatements. The SEC s 20-F requirement

that to have their shares traded in the US foreign firms must restate their accounts to

US GAAP provides a test of the likely value-relevance of internationally harmonised

accounts. Several studies have investigated whether US GAAP restatement releaseshave value-relevance. Saudagaran and Meek summarise the results:

(1) non-US GAAP accounting information has value relevance; (2)

restatement information seems to have some (though not overwhelming) value

relevance, but evidence on the general direction of relevance is mixed; (3)

such value relevance as exists seems to vary by country of domicile, or

perhaps system of accounting. In other words, the restatement may be more

important for some countries than it is for others (1997, p.152).

Bhusan and Lessard (1992) surveyed the opinions of US and UK international

investment fund managers. They found that while professional investors thought

international harmonisation useful , it was not essential as they relied on local

accounts and local valuation.

Meek (1993) examined 26 firms from five countries. He found no significant

relationship between the equivalent 20-F earnings and security prices. He concluded

the market had already impounded the information contained in the 20-F

reconciliation before the company released them (usually three months after the

foreign earning announcement). Amir et al (1993) studied 101 firms from 20

countries. They observed that 20-F earnings and shareholders equity reconciliations

were not value relevant even for specific items (e.g., goodwill, asset revaluations, andtaxes). Amir et al question the relevance of 20-F reconciliations as they argue a

careful investigator could reconstruct US GAAP for themselves. Consistent with this,

McQueen s (1993) analysis suggests that levels of both [foreign] reported earnings

and foreign earnings reconciled to a US GAAP basis are significantly associated with

securities returns (Choi and Levich, 1997, p.6.15), but the relationships were small

and not robust (Pownall and Schipper, 1999, p.266).

Alford, et al (1993) compared the information content and timeliness of accounting

earnings in 17 countries using the US as the benchmark. They do find differences,

but some of them are inconsistent with the market efficiency hypothesis. Their

finding that the information content and timeliness of accounts to the capital marketsin Denmark, Germany, Italy, Singapore and Sweden, was either less timely or less

value relevant than US GAAP earnings is consistent with the efficiency hypothesis.

However, they also find that accounts in Australia, France, Netherlands, and the UK

are more informative and timely accounts than US companies, which is highly

unlikely. Given the size, liquidity, extensive requirements for timely disclosures

effectively policed by the SEC this result would puzzle many US observers (at least),

and is not explained by the authors . In addition, data questions, such as whether

earnings is defined consistently across sample countries, also obscure the results.

Cautious interpretations are in order (1997, p.149). Significantly, the results for

Belgium, Canada, Hong Kong, Ireland, Norway, South Africa and Switzerland arenot conclusive (Alford, et al, 1993, p.213). That is, it was not possible to conclude




that these countries systems of accounting were or were not more or less value

relevant than US GAAP.

Harris, Lang and Moller (1994) compared the correlations between accounting

earnings and stockholders equity to share prices and returns using Ohlson s approach

for German and US companies on their home stock exchanges. These researchersfind the explanatory power (R

2) of earnings for stock market returns is similar for

both German and US companies (around 10%). Harris, Lang and Moller conclude,

contrary to the notion that accounting data are essentially meaningless for German

corporations that these data are associated with stock price levels and returns.

Further, the explanatory power of earnings for returns in Germany is comparable to

that in the United States, which suggests that German earnings are not as garbled as is

often perceived. However, the explanatory power of shareholder s equity for price is

significantly lower in German than in the United States (1994, p.207). The

conclusion that German stockholders equity is significantly less correlated with

returns than US stockholders equity is consistent with the efficient markets objective.

However, they also found that the market valued German earnings at a higher

multiple than US earnings, as an efficient capital market should given the

conservative nature of German accounting. Saudagaran and Meek conclude:

Arguably, the most surprising aspect of these results is that German GAAP

earnings are just as value relevant as U.S. GAAP earnings. Differences

between the two countries in the importance of capital markets as a source of

finance, the fundamental purpose of accounting, and particularly German

income smoothing practices would lead one to expect lower explanatory

power for German companies (1997, p.149).

In other words, this finding is inconsistent with the efficient markets objective. Also

inconsistent is the finding of Joos and Lang (1994) who found that while UK

accounting is more investor-oriented than France or Germany their R-squares were

higher than those for the UK. Also inconsistent with the efficient market objective is

the conclusion of Hall, Hamao and Harris (1994) that over the period they studied

(1980s) there is little evidence of any relation between market returns and accounting

earnings in Japan, even though the Japanese capital markets were informationally

efficient over this period. Clearly, as they conclude, investors in Japanese capital

markets relied heavily on other , non-accounting, information in valuing Japanese

securities. However, first, it is not clear that investors elsewhere rely on accounting

information most of which the market anticipates, or they are reacting to the realworld data they reflect. Second, investors in all capital markets rely heavily on non-

accounting data (Dumontier and Raffournier, 2002, pp.137-139).

Understanding the role of accounting in market valuation in any country depends

crucially on that nation s institutional framework, involving the purpose and practice

of accounting and the capital market microstructure (Saudagaran and Meek, 1997,

p.149). In other words, it is necessary to understand how the market makers obtain

the information they use to value shares. As these sources differ across countries, not

surprisingly the associations between market returns and accounting, its value

relevance, differ systematically across countries according to institutional differences,particularly the differences between the market or shareholder-focused economies




and the Continental or code-law or bank-dominated economies (Pownall and

Schipper, 1999, p.272; Ali and Hwang, 2000). In market systems, with numerous

investors with no direct access to value relevant information, investors rely heavily on

financial accounting disclosures. In bank-oriented systems, by contrast, banks are

insiders with direct access to value relevant information (e.g., Berglof, 1990). Not

surprisingly, therefore, Ali and Hwang find,

Using financial accounting data from manufacturing firms in 16 countries for

1986-1995, that the value relevance of financial reports is lower for

countries where the financial systems are bank oriented rather than market

oriented; where accounting practices follow the Continental model as opposed

to the British-American model; where tax rules have a greater influence on

financial accounting measures; and where spending on auditing services is

relatively low (2000, p.20).7

Thus, even the remarkable case of Japan provides no grounds for harmonisation in the

name of improving capital market efficiency. Studies have repeatedly found the

Japanese capital market is efficient.

Bandyopadhyay et al (1994) study 20-F reconciliations from a sample of Canadian

firms. They found no evidence that the reconciliations were value relevant in the US.

Harris, a leading researcher in value-relevance, admitted in an open forum discussion

of allowing foreign access to US capital markets on the basis of IAS, the evidence

was inconclusive. [W]e have not been able to isolate a market reaction on an

aggregate basis to the release of the 20F disclosures given that other accounting

information exists (Bayless, 1996, p.91). For example, Frost and Pownall s study of

Smithkline Beecham plc (SK) found that U.S. investors do not appear to be confusedby U.S./U.K. GAAP differences, and in fact use information about U.K. GAAP

earnings in their valuations of SK (1996, p.38). Chan and Seow (1996) studied 45

firms 20-F adjustments and found better associations between foreign GAAP and

market returns than US GAAP. In contrast, Barth and Clinch s (1996) find a negative

relationship with market returns, for Canadian reconciliations, and a positive

relationship for changes in reconciliations. Their results differ year by year.

Gornik -Tomaszewski and Rozen conclude U.S. capital market participants are able

to interpret foreign GAAP earnings and promptly infer from them U.S. GAAP

earnings (1999, p.550). This, as they say,

may be interpreted as empirical evidence of semi-strong efficiency of capital

markets in an international context. [M]arket participants have apparently

developed a coping mechanism in dealing with accounting diversity. They

seem to utilize other sources of information, such as previous years

reconciliations and interim reports (Gornik-Tomaszewski and Rozen, 1999,

pp.550-551).

7 Ali and Hwang find that these factors are all closely related, with only one underlying construct, but

they were unable to label the construct (2000, p.2). In chapter five we label the underlying constructcapital market orientation , the extent to which the capital markets dominate industrial and

commercial enterprise.




Davis-Friday and Rivera (2000) assess the relationship between market prices and

Mexican and US GAAP earnings and equity. They find no significant relationship

between the [Mexican] ADR price and net income and equity reconciliations from

Mexican to US GAAP. [Their] results call into question once again the validity and

usefulness of the SEC s required reconciliations to US GAAP (Davis-Friday and

Rivera, 2000, p.113). Their results also call into question the efficient marketobjective.

Conclusions

There is no case for harmonisation around the Anglo-Saxon model if the purpose is to

improve the informational efficiency of the capital markets. As Choi and Levich

conclude, the conventional wisdom behind the quest for a harmonized set of

international accounting standards appears to be twofold (1997, p.6.23). First, that

mandatory accounting standards are necessary, and second, that harmonisation is a

necessary part of developing large, well-functioning international financial markets

(Choi and Levich, 1997, p.6.23). There is, as they say, empirical evidence that

contradicts both , and at best the capital markets case for harmonization remains an

empirical issue (Choi and Levich, 1997, p.6.23). The best we can say after extensive

empirical research is that The results are mixed, with coefficient estimates and R-

squares varying across empirical specifications, years and sample firms domiciles

(Pownall and Schipper, 1999, p.266). Certainly, as Pownall and Schipper conclude,

the Form 20-F reconciliation literature provides some evidence that for non-U.S.

firms that list in the U.S., both U.S. and non-U.S. GAAP accounting measures are

value-relevant for U.S. (and other) investors (Pownall and Schipper, 1999, p.268).

Therefore, if the objective is value relevance, full harmonisation is not necessarily a

good idea. As Pownall and Schipper put it, the academic research literature poses thefollowing question for securities commissioners and standard setters worldwide:

What is the best way to trade off the comparability benefits and benefits from

economies of oversight and enforcement, obtainable from using a single set of

financial statements worldwide, against the potential noncomparability costs

of inappropriately imposing worldwide standards on events and transactions

that are inherently noncomparable because of cross-jurisdictional institutional

differences? Faced with this cost-benefit trade-off, some regulators and

standard setters may find it preferable to maintain (at least some) country-

specific reporting differences that capture qualitative, institution-driven

differences in similar-seeming events and transactions, coupled withreconciliations for firms wishing to report in several jurisdictions (Pownall

and Schipper, 1999, pp.278-279).

In other words, recent levels of diversity in international accounting are consistent

with an efficient international capital market. How is this possible? From the

traditional perspective the purpose of accounting is to hold management accountable

for the capital they control, not to provide investors with data for economic valuation.

Accounts merely provide investors with a steady state model of the realised surplus

for the period and the capital recoverable. While accounts do contain data that may

be more or less useful in valuing shares, for valuation investors must interpret thisdata in the light of their beliefs and the vast amount of additional and alternative




information available. From this point of view, the existence of capital market

efficiency implies that most differences in international accounts are insignificant for

the purpose of share valuation. That is, international differences in accounting are

either irrelevant, or sophisticated investors can see through them or compensate by

using alternative information to produce share values.

It certain appears to be true that, In shareholder-focused economies (common-law

countries), earnings [or information correlated with earnings] are used by

shareholders to determine share value and compensate managers, while in

stakeholder-focused economies (code-based countries), earnings are used more for

determining current payouts to government (via taxation), to shareholders (via

dividends), and to managers and employees (via wages and bonuses) (Pownall and

Schipper, 1999, p.273). However, it does not follow that code-country stock markets

would be more efficient if its companies used IAS or US GAAP and investors relied

more on these accounts and less on their current sources of value-relevant

information. The fact that investors in shareholder-focused economies make more

use of accounts or information correlated with accounting information to value shares

than investors in code-based economies does not mean share valuation is the purpose

of harmonisation.

If we cannot justify the international harmonisation of accounting in the name of

value-relevance, why are the world s leading stock markets and the IASB determined

it will happen? In what follows we argue the evidence supports the accountability

objective.

Accountability to the international capital markets?

From the accountability perspective the purpose of accounts, whether national or

international, is to motivate management to take decisions in the interests of the

providers of equity.8

As Lowenstein puts it,

The financial disclosure system, while intended to permit investors and

creditors to make rational decisions, and so to make markets fair and efficient,

in fact it has the quite independent effect of forcing managers to confront

disagreeable realities in detail and early on, even when those disclosures may

have no immediate market consequences. [G]ood disclosure has been a

most efficient and effective mechanism for inducing managers to manage

better. Alas, it is an insight that is lost on most financial economists, whoinstead rely on stock prices as the measure of corporate performance (1996,

pp.1335-1336; 1342-1343).

This independent effect , management s accountability for the capital it controls and

the profits or losses it makes, appears to explain the superior statistical performance

of Ohlson s book value model over the earnings models. In traditional accounting net

assets represents the capital estimated to be recoverable. Implicit, therefore, in the

inclusion of an asset on the balance sheet, is the verified estimate that management

8 We assume the providers of credit either share the same interests as equity or are able to look after

their interests where they differ.




will recover the capital and expects to earn at least the required return from its

ordinary operations. This is consistent with Walker s view that

The key to understanding why accounting book values might yield superior

explanatory performance turns on the fact that reported book values reflect the

rational investment choices of firms, and assessments by the firm (and itsaccountants) of capital expenditures that can be booked as assets. A

fundamental feature of accruals accounting is that it classifies expenditures

into revenues and capital. To the extent that the currently booked capital

expenditures have positive net present a truncated equation based on

earnings and book values will tend to produce a better statistical fit than the

truncated dividend series. In other words, accounting numbers provide a

better association with market values because, somehow, managers have been

motivated to adopt investments with value (1997, p.346).

Ohlson s value-relevance approach assumes management makes maximum NPVinvestments. Traditional accounting explains why management maximizes NPV. It

assumes accountability for the rate of return on capital is the purpose of financial

reporting - that is, accountability for the maximum sustainable residual income. If

management maximizes NPV it will maximize sustainable residual income, and vice

versa. Thus, the accountability perspective explains the statistical results of Ohlson s

value relevance approach. It explains why we find reasonably high correlations

between accounting numbers and share prices.

The traditional accountability perspective is also consistent with the findings of other

research on international capital markets and financial reporting. In particular, with

research seeking to explain (a) voluntary disclosure to the international capitalmarkets, (b) listing behaviour, (c) management s behavioural responses to

international diversity in accounting, (d) differences in apparent income smoothing in

different accounting jurisdictions, and (e) emerging evidence of a governance

premium .

(a) Voluntary disclosure:

The importance of accountability to the international capital markets could explain

why those European and Japanese companies who came to these markets to raise

capital in the 1960s and 1970s voluntarily disclosed substantial additional

information. For example, in 1969 Most found that when comparing financial

statements of listed U.S. and European chemical companies, a skilled analyst could

compare their accounts. In 1973 Choi showed that companies that sought to borrow

on the eurobond market adapted their financial reports to best international practice.

Choi rationalised this finding by claiming that Increased firm disclosure tends to

improve the subjective probability distributions of a security s expected return

streams in the mind of an individual investor by reducing the uncertainty , that

increased disclosure had value-relevance. However, it is also consistent with the

demand from the international capital markets for increased accountability. In 1976

Barrett examined both the extent of financial statement disclosures, and the

comprehensiveness of the net income figure, for 103 companies in the US, Japan, UK,France, Germany, Sweden and Holland, in 1963 and 1972. The companies chosen




had the largest market capitalisations in their domestic stock markets in 1972. Barratt

studied their English-Language accounts to view the financial reporting practices of

the sample companies through the eyes of an internationally-oriented investor

(Barrett, 1976, p.11). The results were as follows:

Disclosure: Barrett constructed a weighted scoring index for the disclosure of 17items of information (covering financial history, segments, capital expenditure,

depreciation, funds flow, stocks, price-level, marketable securities, currency

translation, tax, margins):

Average Disclosure Indices

1963 1972

US 53 72UK 48 73Japan 41 56Sweden 29 58Holland 43 57Germany 40 52

France 24 44 All Companies 41 59

Source: Barrett (1976), p.15.

Barrett s work showed that US companies were better on operating details and UK

companies were better on segmental data and capital expenditure plans.9

Comprehensiveness: Barrett measured this as (a) the extent of consolidation and (b)

the comprehensiveness of income statement for 1963 and 1972:

% Companies Consolidating All Significant Subsidiaries

1963 1972 US 67 87UK 100 100Japan 42 64Sweden 71 93Holland 88 100Germany 20 86France 0 50 All Companies 54 83

Source: Barrett (1976), p.17.

In 1972 only US companies made significant use of equity accounting, although the

average percentage of companies reporting equity in associates had increased from9% in 1963 to 34% in 1972 (Barrett, 1976, p.18).

Inclusiveness of Net Income: In 1963 53% of companies passed all non-

capital items (e.g., accrued liabilities, extraordinary items) through the income

statement. In 1972 61% did. Only the US had 100% in both years, and the

UK provided sufficient supplementary data to achieve similar results. When

supplementary disclosures were included, 62% of companies provided a

comprehensive net income figure in 1963, and 66% in 1972.

9 Note that the authors did not consider alternative sources of information (e.g. the detailed individual

French company accounts produced according to the Plan Comptable) in scoring the disclosures.




Barrett concluded:

While the overall level of financial disclosure steadily improved throughout

the 1963 to 1973 period, there was still a wide variance between the overall

level of disclosure of American and British firms on the one hand, and the

firms from the other five countries. In addition,...the American and Britishfirm s financial statements were considerably more comprehensive.... These

results were certainly consistent with the general belief that there is a link

between the quality of financial reporting practice and the degree of efficiency

of national equity markets (1976, p.24).

These results are also consistent with the hypothesis that while all these national

equity markets were efficient , whereas the American and British firms were fully

accountable to their capital markets, the firms of the other countries were not.

Meek and Gray (1989) studied 28 Continental European firms listed on the London

Stock Exchange, who exceeded its disclosure requirements through a wide range of

voluntary disclosures. Choi and Levich say, These results suggest that firms have

found it in their interest to provide additional accounting disclosures in the hope of

improving their share prices, reducing the cost of their funds, and competing with

other firms for capital in the international market (1997, p.6.14). However, it does

not automatically follow that these benefits to firms accrue from the improved value-

relevance of their accounts. While not probed by these researchers, this evidence is

also consistent with the hypothesis that the benefits from additional disclosure arise

from the increased accountability they signal to the market. As Saudagaran and Meek

say, an unresearched question is, for example, whether, and if so how, restatement

disclosures affect the way companies are managed. For example, there is anecdotalevidence that Daimler-Benz changed its management practices in response to

reporting U.S. GAAP earnings (Saudagaran and Meek, 1997, p.153).

(b) Listing behaviour:

The research of Biddle and Saudagaran (1991), Saudagaran and Biddle (1992, 1995)

on the listing choices of 450 firms from eight countries provides further evidence

consistent with the accountability objective. Their evidence is consistent with the

explanation that over the 1980s and early 1990s the required levels of disclosure of

foreign stock exchanges compared to their domestic disclosures strongly influenced

firms who choose to obtain a listing on a foreign stock exchange. These studies foundthat, after taking other factors into account, companies were indifferent across

exchanges with levels of disclosure that were less than domestic levels.10

However,

companies were progressively less likely to list on exchanges with higher disclosure

levels.11

Scholars usually rationalise this behaviour as an aversion by some firms to

the large expenses required in foreign listings requiring greater disclosures.

10 Firm size, foreign sales, foreign investment, and foreign employees, industry, geographic location,

exports, importance of domestic stock market as a proportion of GDP. 11 While Gray and Roberts (1997) study of listing decisions into London in 1994 questions the

generality of this finding, their companies were not typical of all foreign companies. Those listingtended to be large, came from countries with relatively important stock markets and had high needs for

capital as measured by the level of domestic investment over the country of origin s GNP.




However, it is also consistent with the hypothesis that the major cost for

management is the increased accountability entailed.

For example, as Saudagaran and Biddle note, Managements in certain countries such

as Germany and Japan strongly oppose quarterly reporting on philosophical grounds,

arguing that it adversely affects their ability to take actions that are in the long terminterests of their firms (1992, p.373). These countries have therefore largely avoided

listing in the US. From the accountability perspective, management should take

decisions in the long-term interests of investors, to produce the maximum sustainable

return on capital, not in the interests of their firms! Glaum and Mandler (1996) give

us evidence consistent with the accountability view in their survey of the opinions of

the senior management of top listed German companies and German university

professors about the desirability of adopting 13 accounting US regulations. In general

these US regulations would have shifted German accounting towards traditional

Anglo-Saxon accounting. Glaum and Mandler found:

almost every single US-GAAP regulation was opposed by the corporate

managers. The professors assessment were more differentiated . A second,

related, observation is equally striking: all suggestions for the adaptation of

German accounting to current US-practices were judged less favorably by the

managers than by the professors (1996, p.226).

Their explanation for this difference is consistent with German managers not wanting

to face increased accountability to shareholders:

One purpose of financial accounting is to oblige management to render an

account at regular intervals to the owners of the company with regard to thefinancial results of their decision-making. [C]urrent German accounting

rules leave management wide discretion for accounting policy and, in

particular, for the smoothing of profits. The differing attitudes of managers

and professors may be explained, at least partly, by the managers negative

attitude towards closer scrutiny of their decision-making by the capital

markets (Glaum and Mandler, 1996, p.226).

Not surprisingly, many major firms did not wish to list in the US under SEC rules.

Also consistent with the accountability objective is Saudagaran and Biddle s finding

that Japanese managements were unhappy about the segment reporting a US listing

would have required. Japanese companies complain that these disclosures put them

at a competitive disadvantage relative to other Japanese companies that are not listed

in the U.S. (Saudagaran and Biddle, 1992, p.373). Competition is essential for

accountability to holders of diversified portfolios. To produce the maximum

sustainable residual income from all companies requires management teams to

compete with other firms to earn abnormal returns. To hold management accountable

for the performance of its segments requires objective and comparable accounting

information relative to its competitors. Clearly, disclosure of segment results could

intensify competition in Japan, could make the management of US listed Japanese




companies more accountable to the product market, but it would certainly make them

more accountable to investors.12

In countries such as Germany and Japan, the law currently sanctions if not encourages

conservative accounting. The statutory audits of Germany and Japan only attest to

conformity with the law. Thus, German and Japanese managers may not have soughta listing in the US or UK because they require auditors to attest whether the

statements are either fair according to US GAAP or are true and fair according to

UK GAAP. Consistent with the accountability objective is the view of Robert

Bayless, chief accountant of the Division of Corporate Finance for the US Securities

and Exchange Commission, who argued for retaining the requirement to translate

foreign accounts to US GAAP or to equivalent IAS. In his view, A particular danger

to an efficient market and to investor confidence in that market could arise if one of

the competing accounting and reporting systems is of lower quality than the other

because it is more susceptible to management s discretionary selection of the methods

and its disclosure rules are less rigorous than the other system (Bayless, et al, 1996,

p.88). This is the real problem with conservative accounting - the discretion it gives

management to manipulate the accounts and thereby become unaccountable to

investors for their performance as accounts are not comparable. As Jim Leisenring

said, This debate is about how much flexibility is acceptable (Bayless, et al, 1996,

p.90).

(c) Management behaviour and accounting diversity:

Choi and Levich (1991, 1996) use the results of opinion surveys to discuss the eff ects

of accounting diversity on the behaviour of major categories of participants in the

international capital market. Choi and Levich find accounting diversity does haveeffects on behaviour. They conducted an opinion survey during 1988 and 1989 of 52

institutional investors, companies, underwriters, regulators, and debt raters. They

found that international accounting diversity was seen as having a detrimental effect

on the ability of participants in the international capital markets to reach their classic

financial objectives - earning the highest risk-adjusted rate of return on their

investments and incurring the lowest cost of capital conditional on the risks of their

strategies (Choi and Levich, 1991, p.7.2). Half of their respondents thought

international diversity affected their capital market decisions . Only 24% of

investors claimed to be able to fully understand international accounting principles

and practices, and said diversity had no effects on their capital market decisions.

More than 50% of them said they had difficulty in comparing internationalaccounts.

13 While most attempted to standardise accounts, this did not eliminate the

problem of diversity. Some imposed a higher risk premium, simply avoided

international investment, or avoided accounting data in their investment decisions

placing more weight on non-accounting information. Those investors with problems

saw international accounting standards as the solution - those in favour thought it

12 Another suggestive example is the frequently cited influence of the U.S. Foreign Corrupt Practices

Act, requiring the disclosure of bribes [?], as a reason for not listing in the US. Many foreign firms

believe that these regulations adversely affect their global competitiveness and contradict established

business practice (Saudagaran and Biddle, 1992, p.114). Not having to report bribes allows

management discretion to consume some of all of these expenses themselves.13 International security underwriters (who often bring new companies to the international markets)

also found diversity troublesome.




would not only make life easier for analysts, but would enlarge investor interests in

international markets (Choi and Levich, 1997, p.6.18). Choi and Levich repeated

their survey in 1996, tailoring it to European investors and companies. While a much

smaller number cited accounting differences and the quality of financial reporting as

significant barriers to pan-European investments, over half said a change in

European accounting reports would make them more likely to consider pan-Europeaninvestments (Choi and Levich, 1997, p.6.19)! How can we explain this apparent

contradiction? Choi and Levich offer two comments from their investor respondents

that are for them very different interpretation[s] of why accounting changes might

matter for investors (1997, p.6.20):

All analysts recognize that earnings figures are manipulated, so they will conduct their

fundamental analysis on a relative basis. Either relative to earlier years, or relative to other

firms in the same country. The desire for accounting standardization is computer driven

growing from a desire to mechanise the analysis of firms (Choi and Levich, 1997, pp.6.19-

20).

Again, [the impact of accounting harmonization] depends on the firm. If Nestle decides to

issue in US GAAP, it will not affect us, since we feel we already know a great deal about

Nestle and the outlook for the firm. On the other hand, if a smaller firm (he mentions one)

makes an accounting change, it could be a signal of a cultural change within the firm. For

small and mid cap firms, this accounting change could be important as a signal (Choi and

Levich, 1997, pp.6.20).

From the accountability perspective we can resolve the apparent contradiction. We

resolve the problem if diversity of accounting was not a critical problem for valuing

European companies and therefore was not a barrier to investment, but, as many

European companies were not accountable to their investors their rate of return on

capital did not justify investing in them. Both comments are consistent with thisinterpretation. The desire to mechanise the comparison of accounts is consistent with

the critical role this plays in holding management accountable for financial

performance. Similarly, the change in culture signalled by the change to Anglo-

Saxon accounting is the improved accountability it affords. As Choi and Levich

comment, whether firms are managed for shareholders or debt holders, whether

firms are managed for profit maximization and wealth maximization or some other

less transparent target (1997, p.6.20), such as balancing stakeholder interests. The

managers of such European companies may well want to change their accounts to

signal their acceptance of primary accountability to shareholders. This could, as Choi

and Levich imply, be costly to these firms as firms cannot alter their accounting

reporting practices for free (1997, p.6.20). The costs of accountability toshareholders they identify could be high, they imply, even though they are

unquantifiable political costs: For many European firms, there is not a tradition of

external, or financial reporting versus tax reporting. A second set of accounting

reports could add a layer of confusion. And some may value secrecy and hold

allegiance to debt holders (1997, p.6.20). As we shall see in the following chapters,

one stakeholder group in particular, the workforce, may well feel confused . That is,

may focus on the higher profits in international accounts described as fair and

ignore the lower, more conservative, profits reported in domestic accounts, the

traditional focus of wage negotiations in these countries.




Choi and Lee (1991) and Lee and Choi (1992) find that UK, German and Japanese

companies pay more on average for US acquisitions. They also find a relationship

with these countries more flexible treatments of purchased goodwill compared to the

US where management must capitalise and amortise it over not more than 40 years.

This is particularly the British option of writing off purchased goodwill against

reserves. This allowed British companies to report higher earnings than under USGAAP (Weetman and Gray, 1990), and a higher rate of return on capital (Bryer,

1995). As Choi and Levich say, while there are no economically substantive

differences arising from the British treatment of goodwill, Conventional wisdom

says that differences in accounting treatment for goodwill provide an incentive for

British companies to offer more than U.S. acquirors for a U.S. target because future

earnings need not be reduced by the higher price paid (1997, p.6.15). Conventional

wisdom , the views of most non-academic commentators, was right, and fully

consistent with the accountability perspective. From the traditional viewpoint the

absence of the US requirement to amortise goodwill did give the managers of British

companies a competitive advantage . That is, British managers could pay more for

their US acquisitions because they were not accountable for the cost whereas US

managers were. Choi and Lee s analysis showed that the differing goodwill

accounting treatments does explain the larger British merger premia; that British

managers with the most flexibility, paid the most: higher premiums paid by UK

acquirors do appear to be associated with not having to amortize goodwill to

earnings . As they conclude, consistent with the accountability perspective, This

finding suggests that national differences in accounting do impact managerial

behaviour in the market for corporate control (1997, p.6,16). Choi and Lee repeat

their analysis for German and Japanese companies, also active acquirors of US

companies. Goodwill is deductible from taxable income in Germany and Japan

(unlike the US and UK). For these countries they also found higher merger premiacompared with those paid by US acquirors. Although relative tax benefits partly

accounted for the results, Regression analysis again showed that goodwill

accounting does explain merger premiums (Choi and Levich, 1997, p.6.16).

Germany allowed the most favourable accounting treatment and these companies paid

higher premia than Japanese acquirors.14

(d) Smoothing earnings

As Pownall and Schipper say, a consistent result is earnings of firms in some

countries are smoother than are earnings of firms in other countries (1999, p.276).

They reference evidence showing, for example, that For three-quarters of th[eir]variables, Australian firms standard deviations are the highest of the seven countries

[studied], and Japanese firms standard deviations are the lowest . Another study

finds evidence consistent with both German and French firms managing their

earnings to a greater degree than do U.S. firms (Pownall and Schipper, 1999, p.277).

Other work is consistent with greater earnings management in the UK compared to

the US. These differences are consistent with different levels of accountability

demanded by different accounting systems. Whether the differences result from

differences in rules or differences in the way management operationalises them is, as

14

Dunne and Rollins (1992) and Dunne and Ndubiza (1995) report similar results. See, however, thecriticisms of Nobes and Norton (1997) which are cutting but not fundamental. See the reply in Lee

and Choi (1997).




Pownall and Schipper say, a fruitful area of academic inquiry (1999, p.279). We

look in some detail and differences in rules in following chapters.

(e) The governance premium

If investors do not get objective accounts, we might expect them to nevertheless paymore for companies that guarantee their accountability to shareholders in other ways.

According to research by McKinsey, the consulting firm, the World Bank and the

Institutional Investor magazine, just such a governance premium exists:

Investors will pay large premiums for companies with effective boards of

directors, particularly in countries where financial reporting is poor. [For

example, I]nvestors were prepared to pay premiums of up to 30 per cent for

companies that had a majority of independent outside directors (Financial

Times, June 20 2000).

Investors also favoured companies where directors held significant shareholdings,

paid themselves in share options, and subjected themselves to formal evaluation.

While in the US and UK investors will pay around 18 per cent more than the average

for well governed companies, in Asia and Latin America they will pay much more. In

Indonesia, Venezuela and Colombia they will pay 27 more, and in Thailand and

Malaysia 25 per cent more. As Mr Coombs of McKinsey said:

In Asia and Latin America, where financial reporting is both limited and of

poor quality, investors prefer not to put their trust in figures alone. They

believe their investments will be better protected by well-governed companies

that respect shareholder rights. In Europe and the US, where accountingstandards are higher, the relative performance of corporate governance is

lower (Financial Times June 20 2000).

Consistent with the accountability hypothesis, Classen et al (2002) find that

concentrated control in East Asia diminishes firm value indicating low levels of

accountability, whereas in wealthy Western countries, La Porta et al (2002) find that

firm s with higher concentrations of ownership by controlling owners increased

value. With less accountability, high concentrations of ownership is dangerous to

minorities because management can divert wealth to the owners; with effective

accountability, high concentrations of ownership means the controlling owner s

incentive to increase wealth also benefits the minority.

Conclusions

The evidence available suggests the international harmonisation of accounting is

unnecessary to improve the efficiency of the international capital markets. That is, to

provide international investors with more useful information for investment decision-

making. Choi and Levich say we can safely assume that most managements have

favorable intentions toward shareholders and wealth maximization (1997, p.6.20).

If we can assume this, as firms can choose to provide additional disclosure and

translations to Anglo-Saxon GAAP, it follows that firms that do this have weighed the




additional costs and benefits to investors and that in their particular environments an

optimal level of financial reporting currently exists:

Given that corporate issuers have a natural incentive to provide accounting

information that attracts foreign investors and that both issuers and investors

have developed a variety of mechanisms to facilitate communication, theburden to issuers in having to comply with yet another layer of mandated

accounting and reporting requirements is likely to outweigh the benefits to the

wider market (Choi and Levich, 1997, p.6.24).

However, if the favourable intentions of continental European and Japanese

managements towards shareholders cannot be assumed - the starting point of the

accountability perspective - then it cannot be assumed that the potential costs of

international harmonisation outweigh the potential benefits to international investors.

This, at least, provides a coherent explanation for the unswerving drive of the

international capital markets, the accounting profession and the IASB for IAS.

We argued in this chapter that the evidence is consistent with the accountability

hypothesis. That is, that the purpose of international harmonisation is to improve the

accountability of the managements of firms from countries that allow or promote

conservative accounting - to abolish or significantly reduce the income-smoothing it

currently allows their managements. In chapter 5 we reinforce this conclusion with

evidence that the cause of this difference in international accounting is different

systems of corporate governance . Many argue that the cause of differences in

corporate governance is differences in culture . However, we argue different

systems of corporate governance are the product of differences in the historical

development of the capital markets that create different systems of accountability.

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Documents

IASC Conceptual framework