Free movement of capital, the evaluation of cross-border mergers and joint ventures, and international credit assessment all depend on information being prepared in one country and understood in others. One of the most frequent needs for cross-border information non-US groups raising capital in the US always ends with the same outcome: preparation of information under US rules.
Despite its claim to be the most comprehensive system of rules in the world, many people do not see US rules as the right basis of international consensus. The plain fact is that US accounting rules are more affected by the US tax system than is often admitted.
Within the European Union, the programme of harmonisation has not resulted in comparable bottom-line profits. In addition to differences caused by tax regimes, a company reports different profits in different countries due to accounting choices. Four inter-related factors lie behind these differences: legal systems; business structures and raising capital; tax systems; and the strength of the accounting profession.
Legal systems can be traced back to historical events often conquest or revolution. The UK common law system has its roots in the Norman conquest, with judicial decisions gradually laying down a foundation of rules based on precedent. The ability of the courts to evolve our law through new decisions remains. One consequence is that rules set down by parliament tend to be a framework only. Similar systems are found in countries of the Commonwealth.
The legal systems of France and Germany, and consequently many of the countries they have ruled over the years, have their roots in Justinians 6th Century Roman legal system. This tends towards more rules written in legal commercial codes, with the courts looking back to the original meaning of the law. In France, the system is overlaid with Napoleans centralisation of information, frequent state intervention and detailed mandatory charts of accounts adopted from the Germans during times of occupation this century.
In Germany itself, the federal constitution is a model of detail and precision. The experience of economic collapse between the two world wars has left a legacy of super-prudence. The models for business structures and capital raising are linked to the scale of historical international trade. It is not surprising that modern accounting traces its roots to renaissance Italy, where international trade (and the need to account for it) were booming.
As British and Dutch trade grew, capital was raised directly from investors. The result was the establishing of large joint-stock companies, the development of the Amsterdam and London stock exchanges as the largest in Europe and the need for managers to account to the owners. Naturally, the same ideas went with British and Dutch settlers to the new world.
By comparison, France and Germany exhibit a much greater number and variety of small businesses that look to large banks for their main finance. While UK banks generally limit their involvement to lending, German banks, such as Deutsche and Commerzbank, often invest through strategic shareholdings, with a consequent greater degree of involvement at a managerial level than their UK counterparts.
The stock exchanges of Paris, Frankfurt, Milan and Madrid have, to date, listed a far smaller number of companies than London. While London investors have a tendency to short-termism, German investors take a longer-term view. Where stock exchanges developed, there was a consequence both for tax collection and the accounting profession. It is a fact that in the UK not a single company set up under the 1844 Joint Stock Act remains in existence today.
The high failure rate of the first companies meant that a large proportion of Victorian accountants were involved in insolvency. As companies began to be taxed, such accounts as were produced were for absentee investors. Tax collectors therefore based their assessment on separate statements of taxable profit. This led to the development of separate disciplines in large accounting professions of audit and taxation.
Taken together with law containing only a basic framework of rules, it also encouraged the profession to develop and evolve detailed mandatory accounting rules based on commercial logic.
In contrast, countries where there is a more direct involvement of owners in management and a more detailed system of written law have developed annual accounts for the purpose of taxation and central statistics. Accounting professions have been much smaller, tax and audit are a single discipline and there are few mandatory accounting rules outside the law. Rules are more difficult to change and consequently change very little.
Against this historic and commercial diversity come those who would narrow the differences. The European Union attempted the feat through a programme of legal harmonisation starting in the mid-1970s to the late-1980s.
A common directive begins: Whereas annual accounts must give a true and fair view . . . whereas to this end a mandatory layout must be prescribed. The directive, which was approved by the Commission in 1978 in nine official languages, gives directions to each member state to pass national laws. There are a series of problems with this process.
First, the directive is a melting pot of concepts. For example, true and fair view was a UK idea which means different things to different countries. Second, options were negotiated to gain agreement that inevitably allow some countries to avoid change. Third, translation from the original German draft to nine official languages may not preserve original meanings. Fourth, progress through national parliaments is subject to national processes by the government of the day, which colours the law that emerges. And finally, once the law is enacted, it is read and interpreted in a national context in response to national custom and practice.
To its credit, the European experience can be counted a success in terms of formats of accounts and their availability to the public. When it comes to comparing bottom-line profit, the procedure has not worked at all.
A project conducted by Touche Ross in 1989 showed that when the same set of transactions was given to accountants in different countries, application of rules most likely to be used produced very different profit numbers. A further exercise showed that, by flexing accounting rules within available boundaries, there was a range of possible profits. It was not surprising that the UK could generate the highest profit and Germany the lowest. (See Figure 1).
While the conclusions of this study confirmed many suppositions, there have been some surprises in recent years. When Daimler-Benz agreed to reconcile its 1993 profit to US rules, it was naturally assumed that it would be higher than profit under German rules. In fact the reverse was true. Profit of DM615 million under German rules became a loss of DM1,839 million under US rules.
The major factor that had not been appreciated until then was the extent to which Daimler-Benz had squirreled away profit into hidden reserves in the good years and used it to mask losses in bad years.
Other causes of bottom-line differences are numerous: depreciation can be avoided (UK) or accelerated (Germany); goodwill can be charged to profit (most countries) or eliminated without touching profits (UK); profit on contracts can be spread over the contract (UK) or deferred until completion (Germany); and so the list goes on.
The lesson of the European experience is clear: legal harmonisation does not make profits comparable.
But before we put any great effort into trying to make them the same, we might ask whether they should be the same or even need to be the same. A group may well be happy with the status quo, arranging for management accounts that avoid differences, national statutory accounts that exploit the most advantageous tax strategy and consolidated accounts prepared in the most lenient environment (probably the UK).
The prime limiting factor for Europe is that companies in different countries respond primarily to economic and fiscal pressures that occur on a national basis and not a Europe-wide basis. Investment analysts have developed tools that enable them to do their job. They are perhaps more concerned with comparisons of companies within a country than across boundaries. Cross-border mergers and joint ventures, although needing information, do not occur with sufficient regularity to drive harmonisation.
Some users of information are very happy with the competitive advantage that comes both from accounting differences and financial culture. German banks are an example. Their presence on many of their customers management boards gives access to management information without worrying about the limited information available to outsiders. This makes it more difficult for foreign banks to break into the German corporate lending market.
There is, however, one area where there is a need to produce comparable regular information. That is the raising of capital in other countries where the need to restate information becomes a costly and regular annoyance. It is this area where the International Accounting Standards Committee can achieve most. Unlike the European legal process, the force for change exists at a commercial level, and on an international basis.
Signpost
Accounting
The Module this week has sections examining harmonisation and accounting standards. It continues in Parts 12 and 13, covering asset reporting and takeover accounting. Earlier sections appeared in Parts 2,4,5 and 10 and included sections on a general introduction to the subject, an explanation of the role of accounting in control systems, budgeting, costing, concept of costing quality, return on capital employed, current value accounting, the financial analysis of banks and the case for an international accounting system.
Summary
Different legal systems, capital raising mechanisms, and tax systems are among the explanations for European Union failure to harmonise the reporting of profits. Attempts like EU directives to narrow the differences have been frustrated by concepts which mean different things to different people, the need to give concessions to countries to secure agreement, loss of meaning in translation, and national interpretation in response to national custom and practice. The use of hidden reserves, different approaches to depreciation and goodwill, and the timing of profit on long-term contracts are among the causes of bottom line variations.
