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The introduction ofInternational AccountingStandards in Europe:Implications for internationalconvergenceKatherine Schipper aa Financial Accounting Standards BoardPublished online: 12 Apr 2011.

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The Introduction of InternationalAccounting Standards inEurope: Implications forInternational Convergence

KATHERINE SCHIPPER

Financial Accounting Standards Board

ABSTRACT This paper describes several implementation effects associated with themandated adoption of international financial reporting standards promulgated by the Inter-national Accounting Standards Board in the European Union, including a possibleincreased demand for detailed implementation guidance and for a single European secu-rities regulator. The paper also discusses the mandated adoption as a research settingfor considering the relative influences of standards versus incentives as determinants offinancial reporting outcomes, and describes two standard setting challenges that maybecome more pronounced as a result of the mandated adoption.

1. Introduction

At a joint meeting in September 2002, the International Accounting Standards

Board (IASB) and the Financial Accounting Standards Board (FASB) agreed

to work together to develop high quality, fully compatible financial reporting

standards that could be used for domestic and cross-border reporting; this coop-

erative effort is sometimes described as international convergence of US gener-

ally accepted accounting principles (US GAAP) and IFRS financial reporting

standards.1 The IASBFASB convergence effort involves two kinds of projects.

The first type includes short-term projects that are intended to remove many of

the numerous individual differences between International Financial Reporting

Standards (IFRS, which include International Accounting Standards (IAS)

issued by the predecessor body to the IASB) and US GAAP. Examples of

European Accounting Review, Vol. 14, No. 1, 101126, 2005

Correspondence Address: Katherine Schipper, Financial Accounting Standards Board, 401 Merritt 7,

PO Box 5116, Norwalk, CT 06856-5116, USA. E-mail: kschipper@fasb.org

0963-8180 Print=1468-4497 Online=05=01010126 # 2005 European Accounting AssociationDOI: 10.1080/0963818042000338013Published by Routledge Journals, Taylor & Francis Group Ltd on behalf of the EAA.

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current and proposed short-term convergence efforts involve the accounting

treatments of nonmonetary exchanges, discontinued operations, income taxes

and interim reporting. The second type of convergence project involves longer

term joint IASBFASB projects and coordinated projects that are intended to

provide major pieces of improved accounting guidance. Examples of the latter

include the joint projects on revenue recognition and purchase method pro-

cedures and the coordinated project on share-based payments. The goal of the

IASBFASB convergence efforts is to make US GAAP and IFRS financial

reporting standards as nearly as possible the same across jurisdictions while

also improving the overall quality of those standards.

The convergence activities of the IASB and the FASB will of necessity be

directly and indirectly affected by regulatory changes and shifts in economic con-

ditions throughout the world. The purpose of this paper is to identify some pos-

sible implications for international convergence of a particularly significant

regulatory change, namely, the mandated adoption of IFRS by listed enterprises

in the European Union beginning in 2005.2 This change will increase the

number of enterprises that apply IFRS to prepare their consolidated reports

from several hundred to several thousand, and will require the use of IFRS by

enterprises that vary considerably in size, ownership structure, capital structure,

political jurisdiction and financial reporting sophistication. The purpose of this

discussion paper is to explore several implications of this major shift in financial

reporting requirements for the overall international convergence of financial

reporting standards and practices.3

This discussion is organized into six sections. Section 2 discusses how two

kinds of implementation effects associated with the adoption of IFRS in

Europe could affect the FASBs and IASBs convergence activities. The

implementation effects stem from the significant increase in the number of

firms that will be applying IFRS and, perhaps more importantly, from the fact

that new IFRS users will likely be different, in terms of size, ownership structure,

capital structure and financial reporting sophistication, from current IFRS users.

Section 3 discusses the 2005 European adoption of IFRS as a research setting for

considering questions related to the relative importance of standards versus incen-

tives in determining financial reporting outcomes. Sections 4 and 5 discuss two

pervasive, fundamental and difficult financial reporting issues that I believe

will become more pressing and (perhaps) even more difficult as convergence

efforts continue after 2005. Convergence to an improved set of reporting stan-

dards will in my view require resolution of those issues (and many other issues

not considered in this discussion). Section 6 offers some concluding comments.

2. Implementation Effects Associated with the Mandated Adoption

of IFRS in Europe

I am not aware of an authoritative source that identifies the number of European

Union business enterprises that are currently preparing their financial reports

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using IFRS, and that summarizes the characteristics of those enterprises that

might be related to the ease (or difficulty) of applying IFRS, such as size, juris-

diction, ownership and capital structure. However, that number, and the variation

in enterprise characteristics such as size, is sure to increase greatly in 2005.4 This

section discusses two possible implications of that increase and draws some infer-

ences about potential effects on international convergence efforts. Specifically,

I consider the implications of two predictions: that the adoption of IFRS in the

European Union will create a substantially increased demand for implementation

guidance (Section 2.1) and that IFRS adoption will increase the demand for the

creation of a single European accounting enforcement body (Section 2.2).

2.1. The Demand for Implementation Guidance

In their current form, some IFRS are both shorter and less detailed than their US

GAAP counterparts. Some have pointed to this difference as desirable, character-

izing US GAAP as overly detailed and rules-based and IFRS as preferable

because they are principles-based. Some commentators point to the substantial

amount of implementation guidance provided in US GAAP, both in appendices

to the standards themselves and in subsequent guidance such as consensuses of

the Emerging Issues Task Force (EITF), as a source of unnecessary complexity

and burdensome detail.

IFRS do not lack implementation guidance, either in the standards themselves

or in nonauthoritative implementation guides. For example, the recently issued

IFRS 2, Share-based Payment, contains 44 paragraphs of application guidance

(in Appendix B) and the nonauthoritative Guidance on Implementing IFRS 2,

Share-based Payment, contains 13 examples plus an example of disclosures. In

addition, to respond to requests for authoritative implementation guidance for

IFRS, the IASB created the International Financial Reporting Interpretations

Committee (IFRIC) which replaced the predecessor Standing Interpretations

Committee (SIC). The IFRIC is similar in structure to the EITF: both groups

are composed of volunteers (the EITF currently has 13 voting members and

the IASBs website currently lists 12 members of the IFRIC); their non-voting

chairs are IASB (in the case of the IFRIC) or FASB (in the case of the EITF)

staff members; they are charged with addressing, on a timely basis, implemen-

tation issues when undesirable or conflicting practices have developed; consensus

is reached if no more than three voting members present at the meeting object;

representatives of other groups (e.g. IOSCO and the European Commission at

the IFRIC and the SEC at the EITF) are permitted to observe and speak but

not to vote. The due process requirements of the IFRIC and the EITF are

similar in that promulgations of both are subject to ratification by the IASB

(for IFRIC Interpretations) and the FASB (for EITF Consensuses). However,

the IFRICs due process differs from that of the EITF, in that the IFRICs draft

Interpretations must be exposed for a comment period and redeliberated, while

the EITF is not required to expose a draft consensus for comment.5

Introduction of International Accounting Standards in Europe 103

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My view is that the demand for detailed implementation guidance for applying

IFRS will increase dramatically after 2005. That is, as the number of enterprises

applying IFRS increases and those enterprises become more heterogeneous in

terms of jurisdiction, size, capital structure, ownership structure and degree of

accounting sophistication, the number of application questions will also increase.

On the one hand, if the IASB responds to that demand by providing additional

detailed implementation guidance, dealing with implementation questions will

absorb an increasing portion of the IASBs resources, leaving less time for

other activities, including convergence projects. On the other hand, if the

IASB declines to provide that guidance, I do not predict that the demand will

dissipate; rather, I predict that preparers and auditors applying IFRS in European

jurisdictions after 2005 will turn to other sources of guidance, including,

for example, EITF pronouncements or perhaps their own, jurisdiction-

specific GAAP.

I believe there are at least three implications for international convergence of

an increased demand for implementation guidance for IFRS. First, if the IASB

declines to respond to demands for detailed implementation guidance, preparers

will look elsewhere. If they turn to the EITFs consensuses and other forms of

detailed guidance provided in US GAAP, the result will be a sort of convergence,

in the sense that IFRS users relying on EITF consensuses for answers to appli-

cation questions will not create overt conflicts between IFRS and US GAAP

implementation guidance. However, that form of convergence is not the result

of cooperative behavior and joint decision making but rather the result of pre-

parers and auditors seeking guidance from a credible, non-IASB source. Alterna-

tively, if preparers turn to jurisdiction-specific GAAP (or jurisdiction-specific

practices) the result will be diminished comparability and diminished conver-

gence. I believe that decisions about where to look for detailed implementation

guidance (in the absence of guidance from the IASB) will depend on, among

other things, the incentives faced by preparers and auditors and the characteristics

of jurisdiction-specific GAAP and practices for example, their level of detail.

Second, if the IASB responds to demands for additional guidance, I believe

that one implication is that coordination of the FASB and IASB in the develop-

ment of standards will not be sufficient for international convergence; the

implementation activities of the IFRIC and the EITF will also have to be coordi-

nated (and perhaps some of their activities merged) if true convergence is to be

maintained. That is, even if the IASB and the FASB are able to issue identical

standards, financial reports will not be comparable and financial reporting will

not be converged, if the implementation guidance for applying those standards

is not the same in all jurisdictions that use IFRS and US GAAP. Specifically,

if the EITF and the IFRIC go their separate ways, differences in reporting

will increase over time, thereby undercutting convergence efforts of the IASB

and FASB.

On the other hand, attempts to coordinate the efforts of the EITF and IFRIC

will also impose costs. Some of these costs (e.g. certain logistical costs and the

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cost of developing convergence procedures) might be expected to decline with

experience. However, other coordination costs cannot, in my view, be expected

to decline with time. For example, coordination costs that derive from the due

process procedures of the two bodies will be ongoing. Both bodies must obtain

clearance from their respective boards; the IFRIC exposes its draft Interpretations

for comment and redeliberates the issues based on those comments while the

EITF (sometimes) does not. If the IFRIC were to change its conclusions based

on those redeliberations, the EITF would similarly have to reconsider its (prob-

ably tentative) consensus, in the interests of maintaining converged implemen-

tation guidance. Other ongoing costs involve the acquisition of jurisdiction-

specific knowledge. That is, to the extent that analysis of the issues brought to

one implementation body requires jurisdiction-specific knowledge, the other

implementation body will have to take time to develop that knowledge. There-

fore, another cost of coordination is the need for one of the bodies to become

educated on jurisdiction-specific issues that it considers only because they

have been brought to the attention of the other body.

Finally, an IASB decision to respond fully and completely to increased

demands for detailed implementation guidance, coupled with a formal link and

coordination between the EITF and the IFRIC, could have two effects on the

IASB itself and IFRS. First, as previously noted, time and effort devoted to

implementation activities will by definition reduce the amount of time and

effort that can be spent on short-term convergence projects and major joint

projects involving the IASB and national standard setters such as the FASB.

Second, the provision of answers to constituents detailed implementation

questions could well erode the extent to which IFRS will be viewed as prin-

ciples-based, in the sense of eschewing details and explicit direction for applying

the standards. That, of course, could also be viewed as a form of convergence

with US GAAP but not, in the eyes of some, a desirable form.

In summary, one key convergence issue to be resolved between the FASB and

the IASB involves both the amount of implementation guidance to be provided

when US GAAP and IFRS have been converged at the standards level and the

mechanisms for providing that guidance. In terms of determining the appropriate

amount of implementation guidance, I predict that the IASB will face increasing

requests for authoritative answers to detailed implementation questions as the

number of IFRS users, and their heterogeneity, increases after 2005. Declining

to respond to those requests, perhaps on the grounds that IFRS are intended to

provide principles that require the application of professional judgment, has

the potential to lead to either noncomparability in IFRS reporting (as preparers

and auditors make potentially idiosyncratic judgments) or to the use of authori-

tative guidance from another financial reporting regime, such as US GAAP.

However, responding to those requests will of necessity take away from resources

that could otherwise be devoted to convergence efforts and, potentially, undercut

the basic premise that IFRS are to be principles-based. Finally, I believe that in

order to achieve and sustain true convergence between US GAAP and IFRS it

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will be necessary to develop a converged mechanism for providing detailed

implementation guidance that supports converged standards. That is, I believe

convergence will be impaired to the extent that IFRS and US GAAP do not

provide comparable implementation guidance, even if the standards issued by

the IASB and the FASB are similar or even identical. However, coordinating

the efforts of the EITF and the IFRIC carries its own potentially significant costs.

2.2. Effects on Accounting Enforcement in the European Union

The quality of financial reporting is crucially dependent on vigorous enforcement

that is separate from the financial reporting standard setting function.6 Starting in

2005, the European Union will have a single financial reporting standard setter,

but securities regulation in Europe is at the present time jurisdiction-specific and

subject to considerable cross-jurisdictional variation. For example, a 2001 study

by the Federation des Experts Comptables Europeens (FEE) reports that at least

five different approaches to regulation of financial reporting exist in Europe,

including enforcement by stock exchanges, by a regulator of stock exchanges,

by a separate review panel (the only example provided being the UKs Financial

Reporting Review Panel), by a separate governmental body and, finally, no insti-

tutional oversight of financial reports (FEE, 2001, table 1 and related discussion).

There are efforts underway to increase the cross-jurisdictional consistency of

securities regulation and financial reporting enforcement in the European

Union but this is not the same as creating a single enforcement body. For

example, the Committee of European Securities Regulators (CESR) was created

to improve coordination, specifically, to provide a mechanism for European

regulators to discuss and compare experiences, with the goal of convergence

(or harmonization) in regulatory practices.7 Similarly, anticipating the mandated

adoption of IFRS in 2005, combined with the continuation of jurisdiction-specific

enforcement, FEE has proposed that a body described as the European Enforce-

ment Coordination (EEC) mechanism be established to create a comparable

financial reporting enforcement environment for the application of IFRS (FEE,

2003). The EEC mechanism would not have the ability to override a financial

reporting enforcement decision taken by a national body. Rather it would work

to achieve some degree of similarity in sanctions across jurisdictions (by, for

example, inquiring about the reasons for specific enforcement decisions and

participating in enforcement decisions that involve cross-border listings or that

seem inconsistent across jurisdictions). The EEC body would also seek con-

sultation and coordination from national bodies, and report to CESR on the

extent to which CESRs enforcement principles are being applied by individual

enforcement bodies.

Notwithstanding the apparent views of FEE and CESR that accounting enfor-

cement will continue to be jurisdiction-specific after 2005, I predict that the

mandated use of IFRS will increase the demand for a single European Union

securities regulator with inspection and enforcement authority over financial

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reporting, similar to the role and responsibilities of the Securities and Exchange

Commission in the USA. My prediction is based on the view that users of finan-

cial statements ostensibly prepared using IFRS will want significant assurances

that IFRS have been comprehensively and rigorously applied in ways that

produce comparable financial information, regardless of the reporting entitys

jurisdiction. Direct inspection of reports filed with a single European securities

regulator who can compel its registrants to provide detailed information to

support the judgments and estimates made in applying IFRS would provide a

key element of that assurance, and reliance on a single securities regulator

would reduce coordination costs.8 However, I do not wish to minimize the diffi-

culties involved. Given widely varying legal environments and significant cul-

tural differences among jurisdictions where IFRS will be used, developing a

single European securities regulator would require ceding important national

decision rights.9 That change carries its own costs, and has broad implications

for securities regulation beyond financial reporting.

I believe that the pace of international convergence in financial reporting stan-

dards will be affected by how IFRS implementations are viewed by investors

after 2005 and that financial reporting enforcement will play a significant role

in shaping those perceptions. Effective enforcement that increases the quality

and comparability of financial reports prepared using IFRS will in my view

hasten the convergence process, while a perception either of uneven enforcement

or of enforcement that is relatively lax overall will in my view impair the conver-

gence process. To the extent that creating a single European securities regulator

with expansive inspection and enforcement powers is viewed by users of finan-

cial reports as an efficient means to achieve increases in reporting quality under

IFRS, I predict that such a regulator will be demanded. On the other hand, exist-

ing legal and cultural differences among European Union jurisdictions present

formidable obstacles to the creation of a single pan-European securities regulator.

3. The 2005 European Union Implementation of IFRS as a Setting for

Studying the Relative Influences of Standards versus Incentives on

Financial Reporting Outcomes

A wealth of previous research10 on earnings management has documented that

financial reporting outcomes are determined partly by incentives and partly by

the requirements of accounting standards. The premise of much earnings mana-

gement research is that accounting standards either require or permit enough

judgment on the part of preparers so that the reported numbers are materially

affected both by what is required by the standard and by the incentives of pre-

parers to shape their judgments to achieve some desired financial reporting

outcome. The exact nature of the relation between incentives and standards in

determining the characteristics of reported numbers is, however, not well under-

stood. I believe that the 2005 European Union implementation of IFRS will

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provide a useful research setting for probing this relation further. The rest of this

section provides the basis for this belief.

Several key research design issues confronting researchers who wish to

provide evidence on the relative influences of standards versus incentives in

determining the characteristics of reported numbers are explored by Holthausen

(2003) in his discussion of Ball et al. (2003). Ball et al. argue that the four East

Asian jurisdictions they study have high quality accounting standards but pre-

parers in those jurisdictions face strong institutionally grounded incentives to

make implementation decisions that result in low quality reported numbers.

They interpret their results as indicating that incentives appear to dominate

accounting standards as a determinant of financial reporting in the jurisdictions

they study (Ball et al., 2003, p. 258).11

Holthausens discussion advocates research like that undertaken by Ball et al.,

stating, there is little doubt that determining the marginal effects of accounting

standards, incentives, ownership structure, institutional features of the capital

markets and enforcement on the quality of financial reporting is an interesting

and important issue (Holthausen, 2003, p. 273). Much of Holthausens discussion

considers the characteristics of Ball et al.s research setting and research design in

terms of the research questions implied by this statement. My comments adapt

Holthausens discussion to the setting provided by the 2005 European Union

implementation of IFRS. Specifically, I discuss several characteristics of a favor-

able research setting for investigations which attempt to separate the effects of stan-

dards from those of incentives, and compare those characteristics to the setting

offered by the 2005 European Union implementation of IFRS.

3.1. Standards of High Uniform Quality for All Observations in the Sample

In tests of the relative influence of standards versus incentives, it is necessary to

hold either the incentives or the standards constant and, to achieve maximum

power, the standards and the incentives should act in opposite directions. One

of Holthausens comments on Ball et al. is that the financial reporting standards

used in the four sample jurisdictions might be of uncertain quality overall, or

subject to changes in quality over the sample period, or subject to differences

in quality across the four jurisdictions. In the case of the European Union adop-

tion of IFRS, however, the standards are of high quality (as evidenced by the

IASCs Improvements Project and IOSCOs endorsement); they will not shift

dramatically over time during 20052006, and they will be uniform among the

European Union countries.

3.2. Appropriate and Accurate Measures of Reporting Outcomes

Tests which focus on cross-jurisdictional differences in reporting outcomes such

as earnings quality or value relevance require outcome measures that have

construct validity and that can be measured with reasonable accuracy across

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jurisdictions with differences in incentives or standards. Ball et al.s main results

rely on stock returns as the measure of economic income and test for the timeli-

ness and conservatism of earnings in reflecting the information that is already in

returns (following Basus (1997) approach). Holthausen questions both the use of

timeliness and conservatism to define and measure reporting quality (that is, he

questions the construct validity of the measures) and the reliance on stock

returns to measure economic income (that is, he questions the accuracy of the

measures). With respect to the former, Holthausen questions whether conserva-

tism in particular (i.e. asymmetrically earlier loss recognition) is in fact an indi-

cator of reporting quality. With respect to the latter, Holthausen points to

evidence provided by Morck et al. (2000) of significant variation in some of

the properties of stock returns that matter for tests like those of Ball et al.

Holthausens comments suggest (at least) the following research design possibi-

lities. For tests that use returns data, results in Morck et al. (2000) suggest that some

of the stock markets in the European Union (France, Germany, Portugal, the UK and

possibly Ireland) appear to have favorable characteristics, at least in terms of provid-

ing returns that can be reasonably assumed to capture economic income. In addition,

Morck et al.s results also suggest considerable variation among European Union

jurisdictions in these characteristics, so it may be possible to calibrate the ability

of returns to capture economic income across political jurisdictions.12

Second, recent research suggests that accounting-based indicators associated

by researchers and analysts with earnings quality have construct validity as indi-

cators of reporting outcomes, in the sense that these accounting-based indicators

capture earnings attributes that matter to investors.13 Accounting-based indi-

cators such as earnings persistence and accruals quality as defined by Dechow

and Dichev (2002) can be calculated without reference to stock returns. To the

extent these indicators can be readily calculated for European Union firms

using IFRS, it may be possible to reduce significantly the reliance on price-

based and returns-based tests for some analyses.

3.3. Sufficient Samples of Homogeneous Observations

Ideally, analyses of differences in reporting outcomes as a function of jurisdiction-

specific differences in incentives or standards will avoid pooling observations

across jurisdictions where factors affecting reporting outcomes may differ. In

addition, unless standards and incentives are at least approximately stable over

time, it is not appropriate to combine firm-year observations from different

years. Ball et al.s sample contains 2,726 firm-year observations pooled across

198496 and four jurisdictions: Hong Kong, Malaysia, Singapore and Thailand.

Holthausen (2003, pp. 276277) challenges the assumption of homogeneity

implied by pooling.

In terms of richness of data, the European Union offers 15 countries (joined by

10 more in May 2004), including wealthy countries with significant numbers of

listed firms and less-wealthy countries with relatively few listed firms. Morck

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et al. (2000) provide data, as of 1995, on the number of listed firms in (among

other jurisdictions) many of the current European Union jurisdictions. The

number of listed firms ranges from considerable (1,628, 1,232 and 982 in the

UK, Germany and France, respectively) to modest (70, 100 and 104 in Ireland,

the Netherlands and Finland, respectively). However, Sweden, Belgium, Italy

and Greece all have between 200 and 300 listed firms. Thus, the European

Union offers hope of sufficient sample sizes of listed firms to avoid pooling of

firm observations across jurisdictions.14

3.4. Within a Single Financial Reporting Regime, Considerable Variation

in Incentives

Tests of the relative power of standards versus incentives can either hold stan-

dards constant and vary incentives, or hold incentives constant and vary stan-

dards. The European Union adoption of IFRS in 2005 offers some elements

of both research designs. As a research setting, the European Union also offers

considerable differences in financial reporting incentives. I discuss each of

these three elements in the remainder of this subsection.

3.4.1. Hold standards constant across jurisdictions where incentives vary

Ball et al. posit that incentives are the same (i.e. to make judgments that lead to

low quality reporting outcomes) in all four of their sample East Asian jurisdic-

tions. A more powerful design, however, might be achieved if standards were

held constant and the direction and strength of incentives were allowed to

vary. I believe that the European Union in 2005 has the potential to offer just

such a setting. All jurisdictions will adopt the same standards but the institutional

arrangements giving rise to financial reporting incentives differ, in some cases

dramatically, across jurisdictions. For example, as previously discussed in

Section 2.2, financial reporting enforcement mechanisms differ considerably

across the European Union, and these differences are expected to continue past

2005. Also, research (discussed in Section 3.4.3) has documented significant

differences among European Union firms in key characteristics, such as owner-

ship structure, that have been shown to be associated with reporting incentives.

3.4.2. Hold incentives constant and allow standards to vary

Settings with this characteristic require either free choice between (or among)

financial reporting regimes within a single political jurisdiction or a shift in finan-

cial reporting regimes within a political jurisdiction. Leuz (2003) analysis of

German New Market firms choice between international standards (IAS) and

US GAAP in 1999 and 2000 is an example of the former. The 2005 adoption

of IFRS provides the latter setting; that is, it may be possible to assume, for

some jurisdictions such as the UK and France, that reporting incentives are

stable over time. Then the adoption of IFRS allows for tests of incentives

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interacting with two distinct standards regimes, the pre-2005 period when IFRS

were not permitted and the post-2005 period when IFRS will be required.

3.4.3. Evidence that ownership structure and other factors associated with

reporting incentives differ across European Union jurisdictions

Ownership structure. Previous research (e.g. Warfield et al., 1995; Fan and

Wong, 2002; Francis et al., 2005) predicts and finds that ownership structure

affects reporting outcomes. The available evidence on ownership structures

around the world indicates marked jurisdiction-specific differences in these struc-

tures. For the purposes of this discussion, key data are provided by La Porta et al.

(1999), who analyze the ultimate ownership of large and mid-size listed firms in

27 wealthy countries, including the USA and several European jurisdictions.

They identify four types of ultimate owners: families/individuals; publiclyheld financial institutions such as banks; publicly held nonfinancial institutions;

states. They define ultimate owners as holding direct and indirect voting rights

that exceed 20%. Indirect voting rights can be achieved by cross-holdings of

shares and by pyramids (a pyramid is a chain of entities each of which has hold-

ings in the next entity of the chain; if A owns 43% of B and B owns 25% of C then

A controls C by virtue of a pyramid).

La Porta et al.s results indicate that European Union firms offer significant

variation in ownership structures. For example, 50% of German sample firms

and 60% of French sample firms are widely held, as compared to 5% of Austrian

and Belgian firms, 35% of Spanish firms and 20% of Italian firms. In addition, the

following percentages of sample firms are state controlled: Germany, Spain and

France (20%), Belgium (30%), Italy (40%) and Austria (83%).15 In contrast,

La Porta et al. report that about 80% of US firms are widely held and none is

state controlled; variation in ownership structure is relatively small in the USA

compared to Europe.

As noted by La Porta et al., their focus on a small sample of the largest firms in

each jurisdiction is likely to produce results that do not represent each economy

as a whole because the likelihood of dispersed ownership should be greatest for

the largest firms. When they turn their attention to smaller firms (valuations near

$500 million), they find, as predicted, more concentrated ownership. In the USA,

these sample firms are 90% widely owned and 10% family controlled. However,

in France, Austria, Spain and Italy none of the smaller sample firms is widely

owned and in Germany and Belgium the percentages are 10% and 20% widely

owned, respectively. Again, the evidence supports the view that the European

Union provides significant variation in ownership structures, a characteristic

shown by previous research to be associated with financial reporting incentives.

Other factors. Direct evidence on jurisdiction-specific differences in report-

ing incentives and reporting outcomes is provided by Leuz et al. (2003).

Although their focus is on earnings management, several of their results have

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implications for research questions related to standards versus incentives as

determinants of reporting outcomes. For example, they document marked

jurisdiction-specific differences across the European Union firms in their

sample in firm size and capital intensity; the former measure has been found to

be associated with accruals quality by, for example, Dechow and Dichev

(2002) and the latter is likely to be associated with accruals quality as well, to

the extent it captures the same accounting fundamentals as plant, property and

equipment. Like La Porta et al., Leuz et al. also report jurisdiction-specific

differences in ownership concentration.

To summarize, the required adoption of IFRS by (most) European Union listed

firms in 2005 offers a rich research setting for tests of the relative importance of

standards versus incentives in determining financial reporting outcomes. A large

number of firms that vary considerably in factors previously shown to be associ-

ated with financial reporting outcomes will be subject to a single, high quality

financial reporting standards regime as of 2005, offering the possibility of both

over-time comparisons and cross-jurisdictional comparisons. Using the European

Union as a setting may allow researchers to overcome some design difficulties in

previous research which has examined the determinants of cross-jurisdictional

differences in reporting outcomes.

So far this discussion has considered several implications of the 2005 manda-

tory adoption of IFRS by listed enterprises in the European Union. The next two

sections describe two fundamental, pervasive and difficult standard setting issues

that I predict must be addressed and resolved if convergence between IFRS and

US GAAP is to succeed.

4. Defining the Boundaries of the Reporting Entity, for Purposes

of Consolidation

Both IFRS and US GAAP define the boundaries of the reporting entity, in part, by

means of consolidation requirements.16 Those boundaries determine what assets

and liabilities are shown together on a single balance sheet (and, by implication

what results of activities are shown together on a single income statement). Com-

pleteness requires that all the assets and obligations that are under the stewardship

of a single management group and a single governing board be displayed together

so that users of financial statements can discern all the productive capacity

(assets) and obligations (liabilities) that will determine the returns generated by

the enterprises activities. In particular, the residual claimants (shareholders)

want to have complete information on all the assets under the stewardship of

the governing board they elect and all the obligations that will receive payments

ahead of them.

I believe that consolidation policy presents a significant challenge to conver-

gence between IFRS and US GAAP, for two reasons. First, distinctive ownership

arrangements among European Union firms, relative to US firms, will in my view

place pressure on consolidation policy generally. Second, there is some evidence

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that the IASB intends to develop qualitative standards for consolidation policy,

while recent FASB guidance has been viewed by many as heavily quantitative.

I develop both of these views in the subsections below.

4.1. Distinctive Ownership Arrangements among European Union Firms

European Union firms, relative to US firms, are distinguished by the presence of

complex ownership structures that provide for indirect control. La Porta et al.

(1999) provide several illustrative charts (by their definition, control is achieved

at 20% voting power). For example, Figure 1 (figure 6 of their paper) describes

Allianz Holding, a large German firm.

This chart shows the major shareholders of Allianz, with the shareholdings

below each name (in italics). Allianzs major shareholders are Munchener

Ruckversicherung with 25%, Dresdner Bank, Deutsche Bank and Bayerische

Hypotheken und Wechsel Bank with 10% each, and the Fink family and

Bayerische Vereinsbank with 5% each. The chart also shows Allianzs holdings

in each of its major shareholders, and the cross-shareholding of Dresdner Bank

in Muncherner Ruckversicherung. Thus, Allianz also holds 25% of Munchener

Ruckversicherung, 22.5% of Dresdner Bank, 5% of Deutsche Bank and 22.6%

of Bayerische Hypotheken und Wechsel Bank; and Dresdner Bank owns 9.99%

of Munchener Ruckversicherung. One might conclude (applying the 20% owner-

ship criterion of La Porta et al.) that Allianz controls its controlling shareholder

and controls two other firms that in turn hold significant stakes in Allianz.

This discussion is not intended to imply that Allianz is representative of the

ownership structures of German firms, or that such complex ownership structures

are not found elsewhere. Rather, the discussion is intended to illustrate two

points. The first is that some financial economists view control as existing at

far lower ownership thresholds than are implied by the conventional majority-

ownership criterion commonly associated with US GAAP and IFRS reporting

standards. The second is that discerning control based on a quantitative analysis

of ownership interests is complex whenever there are pyramids and cross-

holdings.

I believe these two points are of concern for international convergence activi-

ties after 2005 because of the distinctive ownership characteristics of European

Union firms, relative to, in particular, US firms and because of the quantitative

approach that has historically been taken in the USA to defining consolidation

policy. As reported by La Porta et al. (1999, table II), and applying a 20% indirect

Figure 1 Ownership of Allianz Holding. Taken from La Porta et al. (1999), Figure 6.

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ownership threshold to define control, about 80% of US firms in their large-firm

sample are widely held (no controlling shareholder) and the remaining 20% are

family (or individual) controlled.17 However, European firms exhibit very differ-

ent ownership structures. Perhaps of most significance for consolidation policy,

about 20% of La Porta et al.s Spanish sample firms, about 30% of the Belgian

sample firms, about 15% of the German and Italian sample firms and about 5%

of the French sample firms are controlled by other firms. The percentages of

the smaller sample firms controlled by other listed firms are 50% in Spain,

10% in Belgium and Italy, 20% in France and 30% in Germany.

4.2. Qualitative versus Quantitative Approaches to Setting Standard for

Consolidation Policy

Both international financial reporting standards (International Accounting Standard

(IAS) 27, Consolidated Financial Statements and Accounting for Investments in

Subsidiaries) and US GAAP (Accounting Research Bulletin (ARB) 51, Consoli-

dated Financial Statements, and SFAS 94, Consolidation of All Majority-owned

Subsidiaries), approach the task of defining the boundaries of the reporting

entity by requiring consolidation when one entity controls another. IAS 27, para-

graph 6, defines control as the power to govern the financial and operating policies

of an enterprise so as to obtain benefits from its activities.18 ARB 51 and SFAS 94

do not define control explicitly and instead refer to a controlling financial interest

as the basis for consolidation. As a practical matter, under both international stan-

dards and US GAAP, the determination of whether one entity should consolidate

another is often made by a quantitative analysis of voting interests, as opposed to

the qualitative application of a definition of control, using professional judgment.

Specifically, holding more than half the voting interest is in many cases viewed as

both necessary and sufficient for consolidation.

However, it is also well known that a majority-voting-interest criterion for con-

solidation is not effective in all circumstances. Those circumstances include, but

are not limited to, the following: (1) latent control, which exists when a party

holds an instrument (such as an option to buy shares or a convertible instrument)

whose exercise or conversion provides that party with majority ownership; (2)

straw man control, which exists when the total voting power of an entity plus

its related parties is a majority of the votes; and (3) effective control, which

exists when a party has a significant minority of the total vote and no other orga-

nized group has a substantial ownership position (particularly when the minority

owned by a single party is a majority of the votes usually cast). Finally, some

entities, defined as variable interest entities in US GAAP, and characterized as

special purpose entities (SPEs) in international standards, are designed so an

analysis of equity ownership or voting interests is not effective in determining

whether one entity should consolidate another.19

In my view, the IASB and FASB have recently taken rather different

approaches to dealing with situations in which analysis of majority voting

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interest an inherently quantitative analysis is not effective in determining if

one entity should consolidate another. Specifically, the IASB appears to me to be

moving toward a standard that would require a qualitative analysis. In its project

on Consolidation (including SPEs), intended to supersede IAS 27 and SIC 12, the

IASBs tentative decisions would replace the indicators of IAS 27 with a defi-

nition of control that rests on three criteria:

the ability to set strategic direction and to direct operating and financing

policy and strategy (Power Criterion); the ability to access benefits

(Benefit Criterion); the ability to use such power so as to increase,

protect or maintain the amount of those benefits (the Link).20

The application of professional judgment to these control criteria would, at least

in principle, accommodate majority voting interest, latent control, straw man

control and effective control. Special accommodation would, however, have to

be made for entities (such as certain SPEs and variable interest entities) where,

by design, there is no ability to determine policy.

In contrast, attempts by the FASB to promulgate a standard on consolidation

policy that is based on applying a qualitative definition of control using pro-

fessional judgment have not so far been successful. The FASB offered the follow-

ing definition of control in a 1999 Exposure Draft, which was itself a revision of a

1995 Exposure Draft:

the ability of an entity to direct the policies and management that guide the

ongoing activities of another entity so as to increase its benefits and limit its

losses from that other entitys activities . . . [C]ontrol involves decision-making ability that is not shared with others.

(paragraph 6a of the 1999 Proposed Statement of Financial Accounting

Standards, Consolidated Financial Statements: Purpose and Policy)

That Exposure Draft received little support from the FASBs constituents and did

not result in a standard. The most recent US consolidation guidance, Interpret-

ation 46R, requires both qualitative and quantitative assessments but is inherently

based on a numerical threshold which requires consolidation of a variable interest

entity based on the ownership of instruments that convey a majority of the varia-

bility of outcomes of the activities of the entity.

As IFRS are implemented in Europe, I predict that financial reporting issues

related to consolidation policy for entities that may be subject to indirect

control (as discussed in Section 4.1) and entities where the analysis of ownership

of equity instruments is not effective for determining whether one entity should

consolidate another will become increasingly important, and that standard setters

will face demands to enhance, significantly, the authoritative guidance for con-

solidation policy. That is, I predict that standard setters will have to define

the reporting entity more clearly than is currently the case to deal with IFRS

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implementations. The implications for convergence arise because the consolida-

tion standards in US GAAP are largely quantitative, while the IASBs tentative

decisions in its consolidations project point toward a standard based on qualitat-

ive judgment, not on quantitative analysis.

The convergence challenge to the IASB and the FASB is to devise an approach

to consolidation policy that addresses several concerns. The first is the (likely)

presence of indirect effective control among many enterprises that will begin

applying IFRS in 2005 that is, control at less than majority ownership achieved

through pyramids and cross-holdings. Clearly, a standard that, like much of US

practice, is based on counting up direct ownership of voting interests will not

be effective in discerning indirect effective control. I believe these ownership

structures will place pressure on the IFRS consolidation standard. Those press-

ures might push the IASB toward a more qualitative standard than the existing

IAS 27, one that is similar in spirit to the 1999 FASB Exposure Draft. If so,

the IASB and FASB will have to consider how best to reconcile and converge

a qualitative approach with the prevailing US approach, which is relatively

more quantitative.

Second, an effective converged standard would also have to lay out consolida-

tion criteria for entities where, by design, analysis of the voting (equity) interest is

not effective in determining if one entity should consolidate another. The FASBs

approach, in Interpretation 46R, is detailed, rigorous and, in some cases, heavily

quantitative. Such an approach is difficult to reconcile with the qualitative criteria

that are the result of the IASBs tentative decisions, as of March 2004. The

IASBs deliberations, however, have considered only entities where analysis of

voting control is effective for determining consolidation policy; they have yet

to reconsider the SIC 12 guidance.

Third, a converged standard should be effective in discerning control in situ-

ations when control is disguised and able to be applied consistently to achieve

comparability of results. Some believe that those criteria are inherently in con-

flict. That is, some believe that a qualitative standard that requires the use of

professional judgment to apply a qualitative definition of control to facts and

circumstances is the most likely to result in consolidation policies and practices

that achieve completeness when control is disguised. Others contend that a quali-

tative, judgment-based standard cannot result in comparable outcomes, thereby

defeating much of the purpose of having a consolidation standard.

5. The Use of Fair Value as a Measurement Attribute

The required adoption of IFRS in the European Union in 2005 will result in many

more enterprises reporting fair value measures. In particular, the revised IAS 39,

Financial Instruments: Recognition and Measurement requires the use of a fair

value measurement attribute for many derivatives (including certain embedded

derivatives), all trading securities and available-for-sale securities, and several

other categories of financial instruments (paragraph 13 of IAS 39). The expanded

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use of fair value measurements that will occur in 2005 has led to well-publicized

concerns among, for example, some European banks. In this discussion, I con-

sider two implications of the expanded use of fair values: the financial reporting

implication of possible shifts in behavior (for example, among banks) associated

with the application of IFRS; and the implication for convergence of concerns

about expanded use of fair value measurements.

5.1. Possible Changes in Behavior Because of the Expanded Use

of Fair Values

Knowledgeable observers, such as the European Central Bank, conjecture that

bank business decisions and risk management practices could be affected by

the required adoption of IFRS, because IAS 39s required use of fair values for

many financial instruments will both increase the volatility of reported results

and tie those results more closely to existing risk positions and external economic

conditions (European Central Bank, 2004). An example of the latter is required

remeasurement at fair value of trading securities and available-for-sale securities;

the fair value measure will tie reported results to changes in fair values (prices) of

those securities.

One way to reduce volatility of reported results is by hedging, for example, of

credit risk or interest rate risk. Increases in the demand for effective hedges will,

in my view, have implications for financial reporting and disclosure generally, in

part because of the substantial (and in some cases, increasing) concentration of

counterparty risks. As noted, for example, by Alan Greenspan, Chairman of

the US Federal Reserve, in the case of US dollar interest rate options and

credit default swaps, a single dealer accounts for approximately one-third of

the global market and a handful of dealers account for about two-thirds of the

market (Greenspan, 2003).

While the existing disclosure requirements allow users of financial reports to

discern the volume of derivatives activity, the challenge in the face of potential

increased demand for hedging instruments is to achieve increased transparency of

information about where the counterparty risk resides, and how that risk is shift-

ing as the demand for hedging instruments grows. This will not be easy; annual

reports of large banks are already voluminous and densely packed with charts,

tables and figures that illustrate risk-related activities. The standard setting chal-

lenge is to arrive at mandated disclosures that provide knowledgeable users of

financial reports with a clear picture of the reporting enterprises risk exposures

and how those risk exposures (and concentrations) are shifting over time in

response to changes in hedging behavior.

5.2. Reliability of Reported Fair Value Measurements

I believe that a key element of international convergence of financial reporting

standards and their implementation is the use of fair value as a measurement

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attribute in a way that is comparable and consistent across IFRS and US GAAP.

Both recent IFRS (especially IAS 39) and US GAAP have increasingly required

fair value measurements, with the intent of enhancing the relevance of reported

numbers. A key issue for convergence is whether fair value measurements can be

accepted as having sufficient reliability.

I define reliability in terms of the FASBs conceptual framework, as a combi-

nation of verifiability and representational faithfulness. Verifiability refers to

consensus among various independent measurers and representational faithful-

ness refers to a close correspondence between the measurement and the item it

purports to measure. I think there is confusion and disagreement among accoun-

tants as how to apply these concepts to fair value measurements. I identify four

possible sources of confusion and disagreement by explaining four characteristics

of fair value measures.

First, in order to be representationally faithful, a fair value measurement does

not require the existence of a market. That is, although fair value definitions refer

to exchange transactions (sales of assets and settlements of obligations) this does

not mean that the items being valued must be exchanged in organized markets in

order for fair value measurements to capture the notion of an exchange. More

specifically, fair value definitions refer to a hypothetical current exchange

between willing parties and are intended to capture the notion of an amount

that would be acceptable to two informed and willing parties to an arms

length transaction. In order to represent an amount at which two willing parties

would view an exchange as fair to both, a fair value measure need not be

vouchable to an independent confirmatory source of the measure such as an

observed price.

Second, because it is based on the notion of a hypothetical current exchange, a

fair value measure takes account of currently available information about the dis-

persion of possible outcomes. That is, a fair value measurement is not intended to

capture the most-likely ultimate settlement amount, because that is not the

amount at which a current transaction between informed and willing parties

would occur. For example, suppose an arrangement has only two possible settle-

ment outcomes: it will settle for 0 with probability 0.80 and for 100 with prob-

ability 0.20. The most likely outcome is clearly 0, but a current transaction

would take account of the dispersion of possible outcomes and would likely

occur at an amount that is close to 20.

Third, volatility in fair value measures does not mean the measures are unreli-

able. The initial fair value measurement of the arrangement described in the pre-

vious paragraph is approximately 20. The fair value will change, as it is revised in

light of new information as the settlement date approaches. Those revisions do

not make the fair value measurement unreliable, either in the sense of verifiability

or in the sense of representational faithfulness. That is, at each measurement date,

verifiability is assessed by the agreement among independent measurers, all using

the same information, and representational faithfulness is assessed by the extent

to which the measurement captures the amount at which willing and informed

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parties would currently transact. Changes in the fair value measurement do not

represent corrections of errors in initial measurement; rather, they represent

new measurements in light of new information. In this example, at the settlement

date, the arrangement would be settled for either 0 or 100 and a reliable fair value

measurement would approach the actual settlement amount as more information

about the outcome arrives.

Fourth, the fair value measure of a performance obligation, by definition, con-

tains the profit that an entity will earn if it undertakes the performance itself.

The inclusion of this margin on performance does not make the fair value

measure an unfaithful (i.e. defective) representation of the performance obli-

gation. On the contrary, its inclusion increases the representational faithfulness

of the measure. This characteristic can be illustrated with a warranty, a form of

performance obligation. Suppose an enterprise estimates that it can either hire

a reliable servicer of its warranties for products sold this period for 700, or

perform the warranty services itself for 650. The fair value measure of the war-

ranty performance obligation is 700 and this amount contains the profit margin

(7002 650 or 50) on performing warranty services. Measuring the warranty obli-gation at 650, the enterprises cost, causes current period income to reflect the 50

profit margin on performing warranty services, even though the performance

obligation still exists and the enterprise has not earned the margin. Measuring

the warranty obligation at 700 defers profit recognition until the obligation is

extinguished, presumably for 650.

5.3. Assessing the Reliability of Fair Value Measurements

For the purposes of this discussion, I distinguish between absolute and compara-

tive reliability. The former captures the absolute verifiability and representational

faithfulness of a measure and the latter captures those characteristics of one

measure as benchmarked against those characteristics of another measure.

Given an appropriate reliability metric, it should be possible to compare the

reliability of inherently unlike financial estimates. Thus, for example, one

might ask what is the comparative reliability of the fair value measurement of

impaired assets relative to the reliability of estimated asset service lives.

I know of no objective empirical measure of either verifiability or represen-

tational faithfulness, so I do not suggest that an empirical analysis of reliability

can be done. However, it is instructive to consider a qualitative assessment of

relative and absolute reliability and to consider what problems arise in obtaining

reliable fair value measures. The reason for the latter is that understanding the

source of unreliability what causes reported numbers to be unreliable

shows the way to making changes that will increase reliability. In the remainder

of this section, I identify and discuss five causes of unreliable fair value measures.

One difficulty in developing reliable fair value measures is a lack of organized

and liquid markets for many assets and obligations. Although the USA contains

organized markets for many financial instruments and for many types of used

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physical assets, there are still far fewer reference markets than there are items to

be measured at fair value, and no markets at all for many intangible assets and

performance obligations (obtaining market prices for performance obligations

would essentially require organized markets for many kinds of services). I specu-

late that some European Union jurisdictions have fewer and less liquid markets

for financial instruments and physical assets than does the USA, thereby exacer-

bating this aspect of the fair value measurement problem for enterprises that will

apply IFRS beginning in 2005.

When prices of identical or similar items cannot be found, fair values are based

on measurement tools and models. In such situations, fair values can be unreli-

able because of intrinsic error in either the measurement tool or the input to

the tool. Fair value measurements may be derived from models that, by defi-

nition, contain simplifying assumptions that introduce measurement error and

that require inputs (such as income or cash flow forecasts) that are themselves

subject to measurement error. This contributor to unreliable fair value measures

can be addressed by developing better measurement tools and better means for

obtaining inputs to those tools. Researchers in economics, statistics, finance

and accounting can and do make contributions in this area.

Regardless of whether fair value measurements are based on external (to the

reporting entity) prices or on measurement methods and models, there is pressure

on information systems to capture the necessary price information or other data.

Therefore, one source of unreliable fair value measures is information systems

that do not capture the necessary data. It is possible, for example, that prices

of similar or even (nearly) identical items exist but that an enterprises infor-

mation system is focused on internal (to the firm) data and not the necessary

external, market-based data. Similarly, it is possible that research has identified

the inputs to be used in a valuation approach, but some enterprises information

systems are not set up to capture those inputs. Financial reporting relies on many

measures which (in effect) use arithmetic to allocate firm-specific transaction

amounts,21 so existing information systems are set up to capture those transac-

tion amounts. Developing fair value measures places new demands on infor-

mation systems, because these measures require extensive use of data on

transactions outside the reporting entity transactions in which the reporting

entity does not participate. One of the costs associated with the increasing use

of fair value measurements is the cost of creating new information systems

that capture market data.

Two other potential sources of unreliable fair value measures are of direct

interest to accounting researchers and accounting educators. Those two sources

are intentional bias in inputs or judgements and lack of expertise. With regard

to the first, ample research on earnings management and fraudulent financial

reporting exists to demonstrate that management can, and sometimes does, pur-

posefully introduce bias into reported measures. This source of measurement

error is associated with perverse incentives, weak internal controls, failed govern-

ance and oversight and other causes that are not directly under the control of

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accounting standard setters. However, to the extent that reported fair value

numbers are unreliable because of management-induced bias, the solution lies

with changing the elements of the reporting environment (such as perverse

reporting incentives and weak enforcement) that make it attractive and feasible

to introduce bias.

With regard to lack of expertise as a source of unreliable fair value measure-

ments, I am not aware of research which documents the amount of inadvertent

noncompliance generally, and reporting of unreliable fair values in particular,

because of a lack of expertise among accountants.22 However, regardless of

its pervasiveness, this source of unreliability offers a challenge to accounting

education and accounting educators.

My experience with teaching financial reporting, coupled with continuing con-

versations with accounting educators and reviews of accounting textbooks and

other teaching materials, indicates that financial reporting is often taught as

complex calculations that allocate transaction amounts, and not as measurement

or valuation. For example, a textbook example or homework exercise provides

the transaction amounts paid by an enterprise and requires the student to apply

accounting reasoning and relevant accounting guidance to arrive at journal

entries that allocate the (given) transaction amounts. Fair value measurements,

however, require a different way of thinking and a different set of skills.

I believe it would be inappropriate for accounting education to cede fair value

measurement to valuation professionals and I do not believe that doing so

will necessarily enhance the reliability of fair value measurements in financial

reports. Rather, I believe that the accounting profession will benefit if accounting

education is shifted to provide students with skills and content knowledge that

will equip them to deal with fair value measurements as accounting professionals,

and that this approach has a better chance of improving the reliability of fair value

measurements in the long run.

6. Conclusions

This discussion has laid out several implications of the 2005 mandated adoption

of IFRS by European Union firms for the international convergence efforts of the

IASB and the FASB. Some of these implications follow from the fact that, begin-

ning in 2005, a large number of listed enterprises, exhibiting significant hetero-

geneity in size, capital structure, ownership structure and accounting

sophistication, will be applying international standards for the first time. I

predict, for example, that the demand for detailed application guidance will

increase substantially, as will the demand for uniform financial reporting enfor-

cement throughout the European Union. A comprehensive response by the IASB

to the (predicted) increased demand for detailed guidance has the potential to

divert resources from major convergence efforts, thereby slowing the pace of

international convergence. In addition, if convergence in accounting practice is

to be substantive and sustained, the IASBs implementation efforts will also

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have to be coordinated with those of the FASB, with possibly significant incre-

mental coordination costs. If the IASB declines to provide detailed implemen-

tation guidance for IFRS, I predict that preparers and auditors will turn

elsewhere, perhaps to US GAAP or perhaps to jurisdiction-specific European

GAAP, for that guidance. Similarly, a drive for comparable reporting will also

increase the demand for a single European enforcement body for financial

reporting. However, the development of such a body would have to overcome

significant existing legal and cultural differences among European Union juris-

dictions, and would also have broad implications for securities regulation,

beyond financial reporting.

I also describe how the adoption of IFRS by European Union firms in 2005 pro-

vides a potentially rich research setting for examining questions related to the

determinants of financial reporting outcomes. For example, because significant

jurisdiction-specific differences in incentives facing preparers will continue to

exist, the adoption of IFRS offers the opportunity to revisit questions pertaining

to the relative importance of standards versus incentives in determining financial

reporting outcomes. Based on previous research, I identify, in particular, owner-

ship structure as a key element in the incentives that affect financial reporting

choices; research in accounting and finance has shown considerable differences

in ownership structures among European Union jurisdictions.

Finally, I describe how the mandatory adoption of IFRS as of 2005 in Europe,

coupled with the IASBs commitment to international convergence with the

FASB, will place additional pressure on two fundamental and pervasive reporting

issues: defining the reporting entity for purposes of consolidation and developing

reliable fair value measures. With regard to the former, US consolidation stan-

dards and practice are based largely on quantitative analyses, while the IASBs

current (as of April 2004) project indicates a tentative preference for a qualitative

approach; convergence will require a reconciliation between these distinct and

potentially conflicting approaches to consolidation policy. With respect to the

latter, I conjecture that the adoption of IFRS (in particular, IAS 39s many fair

value measurement requirements) may shift the behavior of managers who

wish to reduce or avoid the volatility of reported results that tends to accompany

fair value measurements. For example, they may seek additional effective hedges

and, if so, this will have implications for financial reporting and disclosure gen-

erally. I also note that the increased use of fair value measurements in both IFRS

and US GAAP has implications for both research (because fair values require sig-

nificant management estimates and judgments) and accounting education

(because fair value measurements require a different sort of expertise than that

often emphasized in traditional accounting education).

Acknowledgements

The views expressed in this paper are the authors own, and do not represent posi-

tions of the Financial Accounting Standards Board. Positions of the Financial

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Accounting Standards Board are arrived at only after extensive due process and

deliberation. Jennifer Francis, Begona Giner and William Rees are thanked for

helpful comments.

Notes

1This agreement can be found at the FASBs website (www.fasb.org). For convenience, this dis-

cussion refers to IASB and FASB activities to converge IFRS and US GAAP as international

convergence.2Member states of the European Union are permitted to decide whether the requirement will

apply to nonlisted enterprises and to provide an exemption, until 2007, for enterprises that

are listed in both the European Union and in another non-European Union jurisdiction (such

as the USA) and that are following another internationally recognized set of accounting stan-

dards (such as US GAAP). As a practical matter, therefore, the application of IFRS by

certain European enterprises that are listed in the USA and that report using US GAAP will

be delayed.3This discussion is not intended to provide an exhaustive enumeration of the financial

reporting implications of the 2005 European IFRS adoption; my focus is necessarily selec-

tive. In addition, I do not touch on the numerous auditing implications of the 2005

adoption.4At various times in the past, the International Accounting Standards Committee (IASC), prede-

cessor to the IASB, listed on its website companies referring to their use of IAS. As of early

1998, for example, over 400 companies were listed; of these approximately 182 could be ident-

ified as European. At the current time, IASplus, a website maintained by Deloitte, provides a list

that summarizes, by country, the use of IFRS for reporting by domestic listed companies in their

consolidated reports (www.iasplus.com/country). This list indicates whether IFRS is per-

mitted, not permitted or required for domestic listed companies. For example, the list shows

that IFRS are currently permitted for Belgian or German listed companies but will be required

in 2005, and that IFRS are not currently permitted for French, UK or Irish listed companies but

will be required in 2005.5Additional details about the due process procedures and rules of the FASB and EITF can be

found at the FASBs website (www.fasb.org); additional details about the due process

procedures and rules of the IASB and the IFRIC can be found at the IASBs website

(www.iasb.org.uk).6The importance of maintaining a distinction between standard setting and enforcement has been

emphasized by, for example, the Financial Accounting Standards Committee of the American

Accounting Association (1999, p. 451) and the Federation des Experts Comptables Europeens

(2003). Neither the FASB nor the IASB has any enforcement powers.7CESR Standard No 1, Financial Information Enforcement of Standards of Financial Infor-

mation, lays out certain governing principles, and clarifies that the intent is convergence or

harmonization of practices, not the creation of a pan-European securities regulator. Within

Standard No. 1, Principle 20, Coordination in Enforcement, states that in order to promote

harmonization of enforcement practices, both ex ante and ex post coordination of enforcement

decisions on the application of IFRS will take place. The explanatory material to the Principle

clarifies that Decisions of national enforcers reflect the judgment of the enforcer on the

compliance of the financial information with the reporting framework. Exchange of information

among enforcers prior to the decision . . . is limited by technical feasibility, time and confiden-

tiality constraints. The entire Standard is available at the website of the Committee of

European Securities Regulators (www.cesr-eu.org).8Another key element of that assurance, not considered in this discussion, is high quality audits

performed using a common set of auditing standards.

Introduction of International Accounting Standards in Europe 123

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9In terms of legal differences, research has documented substantial differences in legal

approaches to investor and creditor protection across jurisdictions, including several European

Union jurisdictions; see, for example, La Porta et al. (1998). In terms of cultural differences,

Licht (2003) draws on psychology research dealing with cultural orientations and cognitive

styles to describe difficulties in adopting corporate governance approaches imported from

other jurisdictions.10Because this discussion paper is not intended to be a review of the literature, I reference specific

published and unpublished papers only as illustrative examples. I make no attempt to be

inclusive of all papers on a given topic or to summarize the findings of the papers used as

examples.11Ball et al. draw three inferences that are likely to be of interest to those who examine the costs

and benefits of the 2005 European Union implementation of IFRS. First, jurisdiction-specific

characterizations of accounting should include both the formal standards and the institutional

influences on preparers decisions. Second, attempts to increase financial reporting quality

will reap greater improvements from changing incentives than from mandating (presumably

higher quality) accounting rules. Third, jurisdiction-specific patterns of incentives limit the

extent to which comparability can be achieved by imposing a common set of accounting

standards.12Morck et al.s analyses are based on 1995 data from Datastream. They use stock return synchro-

nicity (the extent to which stock prices move up or down together) as an inverse indicator of the

extent to which firm-specific information is capitalized into stock prices. Absent the capitaliza-

tion of firm-specific information, stock returns will not capture economic income. Given the

substantial economic and regulatory changes in the world since 1995, it is possible that an

updated study would reach different conclusions.13See, for example, Schipper and Vincents (2003) discussion of alternative approaches to defin-

ing and measuring earnings quality and Francis et al. (2004) for evidence that both earnings per-

sistence and measures of accruals quality developed by Dechow and Dichev (2002) capture

aspects of earnings quality that are rationally priced by investors.14More recent data (as of 2002) on the number of listed firms on exchanges belonging to the

World Federation of Exchanges (WFE) are available in the WFE Annual Statistical Report

2002. These data indicate that the number of listed firms is, in general, increasing on many

exchanges. The report is available at: http://www.world-exchanges.org/WFE/home15The financial reporting incentives associated with concentrated ownership should vary depend-

ing on the nature of the ultimate owner. As noted by La Porta et al. (1999, p. 476), State control

. . . is a form of concentrated ownership in which the State uses firms to pursue political objec-

tives, while the public pays for the losses. In contrast, family/individual control or control byanother business enterprise would not offer this incentive or opportunity.

16Another element of that definition, not considered in this discussion, derives from criteria for

asset derecognition and liability extinguishment when should an asset or liability be

removed from a reporting entitys balance sheet?17For example, Bill Gates is identified as the controlling shareholder of Microsoft with (at the time

of the study) just under 24% ownership.18More specifically, IAS 27, paragraph 12 states that control exists when one entity has a majority

of voting power, the ability to appoint or remove a majority of the governing board, the power to

cast the majority of votes at meetings of the governing board, or the power to govern the finan-

cial and operating policies of the enterprise under a statute or agreement.19The accounting for such entities under US GAAP is governed by FASB Interpretation 46R,

Consolidation of Variable Interest Entities, An Interpretation of ARB No. 51, revised December

2003. The IASBs guidance is found in Interpretation 12 of the Standing Interpretations

Committee (SIC), Consolidation Special Purpose Entities.20This information is taken from the IASBs project summary, revised as of 1 March 2004;

available at: www.iasb.org.uk

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21For example, depreciation allocates the transaction amount associated with acquisition of a

fixed asset to accounting periods during the assets service life.22An independent investigation of alleged faulty accounting at The Federal Home Loa