Thursday, December 15, 2011

Practice Systems: Fair Presentation vs. Legal Compliance Accounting

Many accounting distinctions at the national level are becoming blurred. There are several reasons for this.The importance of stock markets as a source of finance is growing around the world. Capital is increasingly global, creating pressure for a world standard of corporate reporting. For many companies, global convergence of financial reporting standards will reduce the costs of complying with different accounting rules and may also reduce their costs of capital. The integration of the world’s capital markets is arguably the most important reason why the International Accounting
system for fair presentation versus legal complianceStandards Board has emerged as the focal point for accounting standard setting in Australia, Japan, Europe, Singapore, South Africa, the United States. Stock market development is also a top priority in many countries, especially those emerging from centrally planned to market-oriented economies. Two such countries are the Czech Republic and China, discussed in Chapters 3 and 4, respectively.Dual financial reporting is becoming more common. One set of financial statements complies with local, domestic financial reporting requirements, while the other set uses accounting principles and contains disclosures aimed at international investors. Starting in 2005, all European listed companies were required to adopt.International Financial Reporting Standards in their consolidated financial statements.However, some EU code law countries, such as France and Germany, sanctioned a duality whereby individual company financial statements comply with national legal standards and consolidated financial statements comply with IFRS. In other words, it is necessary to distinguish accounting practice at the national level from that at the transnational levelSome code law countries, in particular Germany and Japan are shifting responsibility for setting accounting standards from the government to independent professional, private-sector groups. This change makes the standard-setting process more like that in common law countries such as Australia, Canada, the United Kingdom, and the United States, and is seen as a way to more actively influence the agenda of the IASB. These points indicate that another framework besides legal systems is needed to classify accounting worldwide.
We believe that a classification based on fair presentation versus legal compliance describes accounting in the world today.25 The distinction between fair presentation and legal compliance has pervasive effects on many accounting issues, such as depreciation, where the expense is determined based on the decline in an asset’s usefulness over its economic useful life (fair presentation) or the amount allowed for tax purposes (legal compliance);leases that are in substance a purchase of property are treated as such (fair presentation) or are treated like regular operating leases (legal compliance); and pensions with costs accrued as earned by employees (fair presentation) or expensed on a pay-as-you-go basis (legal compliance). In addition, the issue of deferred income taxes never arises when tax and financial accounting are the same. Another issue is the use of discretionary reserves to smooth income from one period to the next. Generally, these reserves work the following way. In good years extra expenses are provided for, with the corresponding credit going to a reserve account in shareholders’ equity. In lean years reserves are dissolved to boost income. This process irons out year-to-year fluctuations in income. Because this practice jeopardizes a fair presentation, it is less common under fair presentation and more common under legal compliance. Of course, if such manipulations are fully disclosed, investors can undo the effects on income. This may not be the case; reserves often are secret.
Fair presentation and substance over form characterize common law accounting described above. It is oriented toward the decision needs of external investors. Financial statements are designed to help investors judge managerial performance and predict future cash flows and profitability. Extensive disclosures provide additional information relevant for these purposes. IFRS are also aimed at fair presentation. IFRS are particularly relevant for companies relying on international capital markets for finance. Fair presentation accounting is found in the United Kingdom, the United States, the Netherlands, and other countries influenced by political and economic ties to them (such as British influence throughout the former British Empire and U.S. influence on Canada, Mexico, and the Philippines). All listed European companies follow fair presentation accounting in their consolidated statements since they now use IFRS. Further, IFRS are the benchmark for standards now being developed in China and Japan
Legal compliance accounting is designed to satisfy government-imposed requirements, such as calculating taxable income or complying with the national government’s macroeconomic plan. The income amount may also be the basis for dividends paid to shareholders and bonuses paid to managers and employees. Conservative measurements ensure that prudent amounts are distributed. Smooth patterns in income from year to year mean that tax, dividend, and bonus payouts are more stable. Legal compliance accounting will probably continue to be used in individual-company financial statements in those code law countries where consolidated statements adopt fair presentation reporting. In this way, consolidated statements can inform investors while individual-company accounts satisfy legal requirements.
We believe that the integration of the world’s capital markets will be the most significant influence shaping accounting development in the future. This development is the reason behind the trend toward fair presentation accounting, at least for consolidated financial statements. It is also the key driver behind the activities of the International Accounting Standards Board and the European Union’s “IFRS 2005” decision, and it is why financial statement analysis is increasingly global in nature.

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