Ranjit Lall
Department of Government, Harvard University, Cambridge, MA, USA
2014
https://scholar.harvard.edu/files/ranjitlall/files/lall_rg_2015.pdf
5. Global financial reporting standards
The second test case for TEN theory is the IASB, the transnational regulatory regime responsible for developing financial reporting standards for companies across the globe. Financial reporting standards specify how assets, liabilities, income, expenses, and other transactions and events should be defined and recorded in corporate financial statements. These standards create financial statements that contain comprehensive, transparent, and comparable information about companies’ financial positions. In doing so, they facilitate investment and trade, as well as shaping business incentives in areas as diverse as executive compensation, corporate financing, mergers and acquisitions, and research and development. In short, they “affect all sectors of the economy and are central to the stability of a country’s financial system” (Büthe & Mattli 2011, p. 1).
Naturally, the harmonization of financial reporting standards has yielded considerable economic benefits for firms and investors around the world. These benefits, however, have not been distributed evenly. Auditing firms in Anglo-Saxon countries have consistently succeeded in ensuring that global standards reflect the emphasis of their domestic accounting systems on measuring transactions at “fair value” – that is, current market prices. The global regulatory shift toward fair value accounting has, in turn, provided these firms with lucrative opportunities to expand their market share in regions that had previously recorded most transactions at historical cost, such as continental Europe.17 By contrast, firms in the latter regions, whose national accounting standards diverge from those adopted by the IASB, have been forced to pay considerable “switching costs” in order to comply with global rules. In addition to learning how to interpret information reported under the new rules, they have had to invest large sums overhauling their accounting systems and recalibrating lending agreements, compensation schemes, and investment plans. In short, the global harmonization of accounting standards has created clear winners and losers.
What explains these uneven distributional effects? Realists emphasize the magnitude of Anglo-Saxon nations’capital markets, which has enabled them to pressure access-seeking foreign firms into adopting their domestic standards (Simmons 2001). Yet in terms of size, capital markets in Anglo-Saxon countries have been matched – and on some measures exceeded– by those in continental Europe for several years.18 Neo-Marxists would highlight the structural and ideological influence wielded by global auditing firms based in Anglo-Saxon countries. While more promising, however, this explanation has major shortcomings. First, as auditors provide (substitutable) services, rather than investing or lending, they can inflict only limited economic damage on governments that refuse to adopt their favored rules. Second, even if exit threats were effective at the national level, they would not be credible at the global level: as of 2010, more than 120 countries had adopted the IASB’s International Financial Reporting Standards (IFRS). Finally, neoliberalism does not have clear implications for the debate between fair value and historical cost accounting. As discussed shortly, Anglo-Saxon firms’ strategy for influencing IFRS relied less on indoctrinating the IASB with a particular economic philosophy than convincing it to delegate key tasks to them at the crucial agenda-setting and planning stages of the standardization process.
As this suggests, a more persuasive explanation for the distributional effects of global accounting standards lies in the ability of Anglo-Saxon auditors to consistently secure first-mover position in IASB negotiations. The source of this advantage can be traced back to the very first incarnation of the IASB, the Accountants International Study Group (AISG), a forum of British, American, and Canadian standard-setters established in 1966 to examine differences between national accounting rules. As rulemaking had traditionally been delegated to the accountancy profession in Anglo-Saxon countries, the AISG was mostly comprised of professional auditors. In 1973, the AISG invited standard-setters from six other countries to join it in establishing the International Accounting Standards Committee (IASC) – the IASB’s predecessor – which explicitly aimed to develop global standards. Despite its enlarged membership, the IASC was equally dominated by Anglo-Saxon firms, in particular the Big Six of Arthur Andersen, Coopers & Lybrand, Deloitte & Touche, Ernst & Young, Peat Marwick Mitchell, and Price Waterhouse. No fewer than eight of the IASC’s 12 chairmen were partners in one of the Big Six. In addition, “[t]he greater part of the IASC’s experts that took part in the steering committees and on the IASC’s staff as project managers had their ordinary employment at one of the six major accounting firms” (Hallström 2004, p. 92).
The influence of major accountancy firms in the IASC expanded yet further in 1993 with the establishment of the Group of Four plus One (G4+1), a forum for discussing major standardization projects comprising standard-setters from Australia, Canada, the UK, and the US (plus an observer from the IASC). Between 1994 and 2000, the G4+1 evolved from “think tank” to “embryonic standard-setter,” publishing 12 papers – many of which resembled fully-fledged standards – that guided the IASC’s work on a variety of complex accounting topics (Street 2006, p. 116). As we will see in the following subsections, these papers also played a crucial role in the development of IFRS.
Following the IASC’s decision to restructure itself in 1998–a move aimed at enhancing its ability to develop high-quality global standards – G4+1 standard-setters exploited their collective bargaining power to ensure that members of the new regime would be selected solely on the basis of technical accounting expertise, an asset highly concentrated in Anglo-Saxon auditing firms. Consequently, no fewer than eight of the IASB’s 14 original membershad been previously employed by one of the Big Six – a majority large enough to approve the adoption of a global standard under the board’s new constitution. Four of these eight members had also participated in G4+1 meetings, including the group’s first chairman Sir David Tweedie, a former KPMG partner and head of the British Accounting Standards Board (ASB), who served as chairman of the IASB from its establishment in April 2001 until June 2011.
Accountancy firms were also strongly represented in the IASB’s auxiliary bodies. All of the Big Four auditors that have dominated global accounting since the early 2000s – Deloitte, PricewaterhouseCoopers (PwC), Ernst & Young, and KMPG – were members of both the International Financial Reporting Interpretations Committee (IFRIC),which issues authoritative guidance on conflicting interpretations of IFRS, and the Standards Advisory Council (SAC), the IASB’s advisory body.19
The concentration of technical expertise in Anglo-Saxon auditors has opened up several avenues for informal interaction between these firms and the IASB. Board members hold regular off-the-record consultations with the firms’ specialized IFRS teams, using them as a“sounding board” for new projects.20 After projects are approved, theseteams are often delegated the further task of drafting, editing, and proofreading the text of discussion papers and IFRS. Anglo-Saxon auditors also form the core of the “Expert Advisory Panels” frequently convened by the IASB to assess whether additional regulatory guidance is needed in a given area of accounting.21 Perhaps most importantly, these firms provide a large proportion of the IASB’s technical staff through an institutionalized secondment system. Under this system, firms pay for senior managers to work at the IASB as “Practice Fellows” for a period of one to two years. Although nominally independent, secondees have strong incentives to promote their employers’ preferences in IASB working groups and steering committees.22
In the remainder of this section, I examine how membership in the IASB’s exclusive ISN has enabled Anglo-Saxon auditing firms to shape three of most important standards adopted by the IASB during the past decade: IFRS 9 Financial Instruments, IFRS 3 Share-Based Payment, and IFRS 2 Business Combinations. The main findings are summarized in Table 2.
Table 2
5.1. Financial instruments
Since its establishment, the vast majority of the IASB’s work has been devoted to revising International Accounting Standards (IAS) inherited from the IASC. Perhaps the fiercest distributional battle over the revision of an existing standard concerned IAS 39, which dealt with the measurement and recognition of financial instruments. The first attempt to develop a standard governing financial instruments was made in the late 1990s. Under pressure to finalize a set of “core standards” in order to gain the endorsement of the International Organization of Securities Commissions (IOSCO), the IASC had hastily adopted an interim financial instruments standard – IAS 39 – under which some financial instruments were measured at fair value while others were measured at historical cost (IASC 1998).
To ensure that any long-term solution reflected its preferences for a full fair value approach, the G4+1 established an independent committee – the Joint Working Group of Standard Setters (JWG) – to develop a permanent version of IAS 39. Despite including a handful of standard-setters from continental Europe, the JWG was dominated by large accountancy firms: more than half of the JWG’s 20 members – including both its chairman and project manager –were current or former employees of the Big Four. 23
As expected, the JWG’s draft permanent standard, outlined in a lengthy report published in December 2000, permitted the “measurement of virtually all financial instruments at fair value” (JWS 2000, p. i).
Following the transition to the IASB in 2001, major accountancy firms had little difficulty ensuring that the JWG’s draft standard became the basis for proposed revisions to IAS 39. Indeed, the IASB’s official project manager for amendments to IAS 39 – Sandra Thompson, a former project director at the UK ASB – was herself a key contributor to the JWG’s draft standard (JWG 2000, p. 300). Furthermore, three of the JWG’s most senior members– Tricia O’Malley, Tatsumi Yamada, and James Leisenring – were now members of the IASB. Most stakeholders only became aware that the IASB had adopted the JWG’s suggestions following the publication of the first exposure draft for amendments to IAS 39 in June 2002. The 337-page draft, which had taken officials more than a year to write,allowed entities “to measure any financial asset or financial liability at fair value” (IASB 2002a, p. 130).
Unsurprisingly, the proposal encountered stiff resistance from continental European stakeholders – in particular banks – who had traditionally measured financial instruments at historical cost. The French Banking Federation (FBF), for instance, denounced the full fair value approach as “dangerous” and “self-defeating,” predicting that it would result in “an increase, not economically justified, of the volatility of the balance sheet and profit and loss account, which produces inaccurate information in the financial statement” (FBF 2002, p. 1). As opposition mounted, in July 2003 French president Jacques Chirac took the unprecedented step of writing to EC president Romano Prodi to warn him of the proposal’s “nefarious consequences for financial stability” (Dombeyet al. 2003).
Yet even high-level political intervention could not alter the IASB’s trajectory, and only minor changes were made to the original draft over the following two years. As the European Commissioner for Internal Market and Services later admitted, “The banks [in Europe] . . . engaged in discussion on the issue far too late” (Bolkestein 2004).24
Unable to defend their interests in IASB negotiations, European banks persuaded the EC to “carve out” the full fair value option from the 2004 Commission Regulation translating IAS 39 into EU law – a move condemned by businesses for jeopardizing harmonization efforts (EC 2004). Under pressure to abolish the exception, one year later the EC adopted a slightly modified version of IAS 39 published by the IASB in 2005 that continued to allow fair value measurement in most circumstances (EC 2005).25
Controversy over IAS 39 was reignited during the global financial crisis, in which fair value accounting was widely regarded as having exacerbated illiquidity in securities markets. In March 2009, the G20 Working Group on Enhancing Sound Regulation and Strengthening Transparency emphasized the need to “dampen the adverse dynamics associated with fair value accounting,” a message echoed in the G20 leaders’ recommendation in April to “improve standards for the valuation of financial instruments” (G20 2009, p. 5; G20 Working Group 1 2009,p. iii). Yet one year earlier – in a discussion paper drafted in part by auditing firms – the IASB had already concluded that “[f]air value seems to be the only measure that is appropriate for all types of financial instruments” (IASB 2008, p. 4).26 Subsequent amendments to IAS 39 consequently contained no further restrictions on the use of fair value measurement.27 To the contrary, the first part of IAS 39’s successor standard IFRS 9, which was issued by the IASB in November 2009, expanded the application of fair value by requiring new types of embedded derivatives and financial liabilities to be valued at market prices (IASB 2009). EC officials, who were said to be “furious” that they had not been given deserved weight in negotiations, refused to endorse IFRS 9 until the remaining parts of the standard had been finalized.
5.2. Share-based payment
Timely participation by accountancy firms played an equally important role in shaping the IASB’s treatment of share-based payment transactions – that is, transactions in which payment takes the form of granted shares, share options, or share appreciation rights. Traditionally, few accounting systems provided guidance on such transactions, allowing businesses to keep expensive employee share plans out of their financial statements. In the late 1990s, major auditing firms convened a working group under the auspices of the G4+1 to explore the possibility of harmonizing accounting rules on share-based payment. The working group was headed by two project directors at the UK ASB with close links to the auditing firms: Kimberley Crook, a secondee from the London branch of PwC; and Kathryn Cearns, a former employee of Ernst & Whinney (later Ernst & Young). The main conclusions of the working group, which were published in an IASC discussion paper in July 2000, were that: (i) share-based payment transactions should be recognized in financial statements; and (ii) the “appropriate measurement basis for such transactions is the fair value of the shares or options issued” (IASC 2000, p. 7).
Following the release of the report, share-based payment quickly found its way to the top of the newly established IASB’s agenda. In a now familiar pattern, the IASB selected former PwC employee Kimberley Crook – the principal author of the G4+1 discussion paper – to lead its standardization project on share-based payment. Unsurprisingly, the lengthy exposure draft for the new standard, which was circulated for comment in November 2002 following several months of technical work, embraced both of Crook’s earlier recommendations. As the draft’s introduction states, “The objective of [the draft standard] is to ensure that an entity recognizes all share-based payment trans-actions in its financial statements, measured at fair value, so as to provide high quality, transparency, and compatible information to users of financial instruments” (IASB 2002b, p. 16).
While receiving strong support from large auditing firms, the exposure draft provoked a furious reaction from businesses across Europe (see PwC 2003). The European Financial Reporting Advisory Group (EFRAG), a private-sector organization established in 2001 to provide advice to the EC on the technical quality of IFRS, emphasized the“great concern among our constituents that all share purchase plans would be automatically scoped in by the proposed standard,” and argued that the blanket application of fair value to shared-based payment transactions was “too restrictive” (EFRAG 2003, pp. 2–3). The European Employee Stock Options Coalition (EESOC) was even more critical, arguing that the draft “is inconsistent, technically flawed, leaves some important implementation questions unanswered and would, if adopted, impair the credibility of reported numbers by reducing comparability and introducing an opacity to the accounts” (EESOC 2003, p.1). As with IAS 39, however, these objections were submitted too late for the IASB to consider relinquishing its extensive earlier work on the proposal. In November 2004, the exposure draft was adopted virtually unchanged as IFRS 2 Share-based Payment (IASB 2004a).
5.3. Business combinations
The development of global accounting rules governing business combinations (mergers and acquisitions) provides a further example of the success of auditing firms in obtaining their favored distributional outcomes by securing first-mover advantage in the standard-setting process. In the late 1970s, accountancy firms persuaded the IASC to establish a steering committee under the chairmanship of John Bishop, a partner in the Australian branch of Peat Marwick Mitchell (later KPMG), to assess the scope for reconciling national accounting rules on business combinations. These firms were particularly keen to rein in the use of the pooling-of-interests method of accounting for acquisitions, which requires that two businesses’ assets and liabilities are combined at their book values following an acquisition.28 Under their favored option – the purchase method – balance sheets are amalgamated at market values.
The standard that emerged from the committee’s deliberations in June 1983, IAS 22, clearly reflected preferences of accountancy firms: the purchase method was required for the vast majority of business combinations, with pooling-of-interests accounting allowed only in “rare circumstances” (IASC 1983).
During the 1990s, businesses began to circumvent IAS 22’s restrictions on the use of pooling-of-interests accounting, which typically “allowed a wide range for interpretation” (Camfferman & Zeff 2006, p. 137). In the US, for instance, the share of mergers and acquisitions transactions recorded using the pooling-of-interests method soared from two percent in 1992 to 31 percent in 1998 (Boegler & Lewis 1998). In response, accountancy firms assembled a working group of senior accountants from G4+1 standard-setters to draft a comprehensive set of revisions for IAS 22. The working group’s main recommendation for revising IAS 22, published in a G4+1 discussion paper in December 1998, was that the pooling-of-interests method should be eliminated entirely. All business combinations, in other words, should be accounted for using the purchase method (G4+1 1998).
In October 2002, as part of the so-called Norwalk Agreement to promote convergence between US generally accepted accounting principles (GAAP) and IFRS, the IASB embarked on a joint project with the Financial Accounting Standards Board (FASB) to develop a successor standard to IAS 22. The IASB–FASB exposure draft for the new standard (ED3), published in December 2002, incorporated the G4+1’s recommendation almost word-for-word, proposing “to eliminate the use of the pooling-of-interests method and require all business combinations within its scope to be accounted for by applying the purchase method” (IASB 2002c, p. 5). This move had been strongly advocated by the FASB, which had followed other G4+1 standard-setting bodies in abolishing pooling-of-interests accounting at the domestic level in June 2001. As the Financial Times noted at the time, it was clear that companies in continental Europe, where the pooling-of-interests method was still widely used, would be “hardest hit” by the new rules (Smy 2002).
Once again, support for the retention of the pooling-of-interests method from European stakeholders was expressed only after the release of the IASB’s exposure draft, a relatively late stage in the standardization process. The European Roundtable of Industrialists (ERT), which represents the interests of around 50 major European multi-national companies, criticized the draft as “arbitrary” and “inappropriate,” arguing that “the cost of acquisition has to be retained because it is the best way to measure the net assets acquired” (ERT 2003, pp. 1–2). Mazars, a French accountancy firm, expressed a similar view, arguing that in the case of mergers between similarly sized companies “the purchase method [does not give] a true and fair view of the economic substance of the new entity resulting from the combination” (Mazars 2003, p. 5). Other European stakeholders, such as the French bank BNP Paribas, missed the deadline for submitting comments altogether. Consequently, in March 2004 the exposure draft was adopted by the IASB with minimal changes as IFRS 3 Business Combinations (IASB 2004b).
Notes:
17 Despite traditionally conducting much of their business in the US, as of 2012 the Big Four derived the largest share of their global revenues – 43 percent on average – from Europe (Big4.com 2013, p. 2).
18 According to recent IMF data, the value of bonds, equities, and bank assets is almost $20 trillion higher in the EU than in the US (International Monetary Fund 2012, appendix p. 11).
19 The Big Six became the Big Four following the merger of Coopers & Lybrand with Price Waterhouse to form PwC in 1998 and the collapse of Arthur Andersen in the wake of the Enron scandal in 2002.
20 These discussions are also an important source of information about the IASB’s agenda for auditing firms. As one partner of a Big Four firm revealed: “Although the IASB eventually publishes its agenda, we usually learn about new standardization projects in advance through private discussions with board members and staff.” Author’s interview with Deloitte partner, London, August 2012.
21 Author’s interview with KPMG partner A, London, August 2012.
22 Author’s interview with KPMG partner B, London, August 2012.
23 Interestingly, a further two members – Patricia Stebbens and Shigeo Ogi – would be made partners at the Big Four shortly after the JWG’s disbandment.
24 Representatives of EU member states, such as the German state secretary for economics Caio Koch-Weser, also lamented that Chirac’s intervention came “too late” to alter the IASB’s decision (Dombey 2003).
25 Specifically, it allows firms to use fair value when there is an “accounting mismatch” between the measurement of assets and liabilities and when financial instruments are managed in accordance with a documented risk management strategy (IASB2005).
26 Author’s interview with KPMG partner A, London, August 2012.
27 In October 2008, however, the IASB issued amendments to IAS 39 allowing firms to temporarily reclassify instruments outof the fair value category in “rare circumstances,” such as the ongoing turmoil (IASB 2008, p. 5).
28 The book value of an asset is its historical cost minus any depreciation, amortization, or impairment costs made against it
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