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Chapter 2 Development and Classification Discussion Questions 1. a) Sources of finance. Where capital markets/shareholders are the principal source of finance, accounting focuses on profitability, stewardship, and a fair presentation of results and financial position. There are high levels of disclosure in published financial statements. When banks are the principal source of finance, accounting tends to be conservative and disclosures are usually relatively low (banks have direct access to information). When governments are the principal source of finance, accounting is aimed at the information needs of government agencies such as tax collection, assembling macroeconomic statistics, or compliance with macroeconomic goals. b) Legal system. Accounting in code law countries tends to be highly prescriptive, detailed, and procedural, designed to cover every possible circumstance. Accounting standards are a part of national laws. Accounting in common law countries is more adaptive and innovative and tends to allow more judgment to suit the circumstance. Accounting standards are set in the private sector. c) Taxation. This tends to parallel the legal system. In common law countries (where accounting standards are set by the accounting profession), accounting and taxation are separate. In code law countries (where accounting standards are national laws), accounting and taxation are essentially the same. d) Political and economic ties. Accounting technology and expertise is imported and exported based on the contacts that nations have with each other through commerce, conquest, etc. e) Inflation. Historical cost accounting is the basis for initially recording transactions around the world. Inflation puts stress on the historical cost principle. Where inflation is high, accounting adjusts recorded amounts to reflect price level changes. f) Level of economic development. This factor defines the difficulty and types of the accounting issues that are faced in a nation. Accounting is complex where business transactions are complex (in highly developed economies); it is simpler where transactions are simpler (in less developed countries). g) Education levels. This factor defines the limits of accounting sophistication in a nation. Accounting cannot get very sophisticated where education levels are relatively low (unless the country imports accounting training or its citizens are sent elsewhere for it). 2. The text lists seven environmental circumstances asserted to have direct effects on accounting development. We judgmentally rank the list as follows: a. Sources of finance b. Legal system c. Taxation d. Political and economic ties e. Education levels f. Inflation g. Level of economic development Students may wish to alter this ranking and justify their own. It should also be pointed out that the rankings for certain countries may be quite different. Capital markets as a source of finance are driving accounting development today. This phenomenon is the reason why the European Union decided to abandon its own effort at developing European accounting principles and require IFRS for EU listed companies. It is behind the convergence movement described in Chapter 8. The chapter argues that the fair presentation versus legal compliance classification describes accounting today better than the one based on legal system. This argument is consistent with sources of finance as the driver of accounting development today. Level of economic development exerts only a moderate effect. This is because developing economies tend to import accounting technologies (and training) from developed countries. For example, many countries in emerging market economies are adapting sophisticated Western accounting systems in order to enhance their development efforts. 3. Culture underlies institutional and other arrangements in a nation that directly affect accounting development. Individualism, power distance, and uncertainty avoidance are likely to be the most important influences. Individualism, small power distance, and weak uncertainty avoidance tend to be correlated with and found in common law countries with fair presentation accounting. There is a strong accounting profession, accountants rely on professional judgment, and capital markets are the principal source of finance. Collectivism, large power distance, and strong uncertainty avoidance tend to be correlated with and found in code law countries with legal compliance accounting. The profession is relatively weak - accounting is influenced by law, instead. Accounting is more conservative and prescriptive, and banks and governments are the principal sources of finance. 4. This question is controversial and there is no consensus of opinion at present. However, as noted in the answer to question 3, culture exerts a second-order effect on accounting. It underlies institutional and other arrangements in a nation that directly affect accounting development. We feel that economic and legal factors are more clearly linked to specific features of accounting, whereas cultural variables are linked to broader generalizations about accounting. Thus, we argue that economic and legal factors explain national differences in accounting practice better than culture. 5. Generally speaking, these patterns of accounting development are still valid today, but less so than in 1967. The descriptions of accounting in the chapter for the respective exemplar countries are broadly true. However, note that the Netherlands is really the only country that can be described by the microeconomic pattern. There are also only a few countries that follow the macroeconomic pattern. The independent discipline approach is not as ad hoc as it was in 1967. Most of these countries (in particular, the United Kingdom and United States) now have conceptual frameworks to guide accounting policy formulation. The uniform accounting approach is less relevant as more and more countries privatize their economies. We expect these patterns to break down in the future as financial reporting converges around International Financial Reporting Standards. As discussed in this chapter, the trend is for fair presentation accounting at the consolidated financial statement level. The macroeconomic and the uniform approaches will persist in certain code law countries at the individual company financial statement level (for example, for tax collection purposes). The microeconomic and independent discipline approaches have always been fair presentation oriented. So, they will likely disappear due to convergence, as discussed above. 6. Conservative measurements and secretive disclosures tend to be correlated. At the same time, less emphasis on conservative measurements and transparent disclosures also tend to be correlated. This is largely to due to the principal source of finance in a country. Banks and governments are concerned about the safety net that conservatism affords; and because they tend to have direct access to information, public disclosure is less important. Capital markets demand a fair presentation of financial position and results of operations along with high levels of disclosure 7. Classifications are a way of viewing the world. They abstract from complexity and reveal fundamental characteristics that members of the group have in common and that distinguish the various groups from each other. Classifications provide the basic structure for understanding what is alike and what is different in accounting around the world. By identifying similarities and differences, our understanding of accounting systems is improved. 8. Judgmental classifications rely on knowledge, intuition and experience. Empirically derived classifications apply statistical methods to databases of accounting principles and practices around the world. This chapter discusses Mueller’s four approaches in accounting development (1967), which is essentially a judgmental classification of accounting. The fair presentation versus legal compliance classification and classifications based on legal systems are also judgmental, though largely supported by empirical data. 9. The chapter discusses three major accounting classifications. The first is the one by Mueller (1967): Macroeconomic approach, where accounting practice is designed to enhance macroeconomic goals; Microeconomic approach, where accounting develops from the principles of microeconomics; Independent discipline approach, where accounting develops from business practices based on judgment and trial-and-error; and Uniform approach, where accounting is standardized so it can be used as a tool of administrative control by central government. The second classification is the one based on legal systems, which closely parallels the third classification based on practice systems. Generally speaking, the features of common law accounting (legal system) are those described for fair presentation accounting (practice system). The features of code law accounting (legal system) are those described for legal compliance accounting (practice system). Fair presentation (common law) emphasizes substance over form and is oriented toward the decision needs of external investors. Thus, it is capital markets oriented. Financial statements help investors judge managerial performance and predict future cash flows and profitability. Extensive disclosures provide additional relevant information for these purposes Legal compliance (code law) 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 employees. Conservative measurements ensure that prudent amounts are distributed and smooth income brings stable tax, dividend and bonus payouts. As noted above, fair presentation accounting is associated with common law countries, while legal compliance accounting is associated with code law countries. However, many companies from code law countries now follow International Financial Reporting Standards in their consolidated financial statements. IFRS are based on the principles of fair presentation. 10. The chapter contends that many accounting distinctions at the national level are becoming blurred because of global capital market pressures. An increasing number of companies are listing on multiple stock exchanges. This has pressured accounting policy makers around the world to harmonize (converge) reporting requirements. This has also pressured companies to devise financial reporting practices that satisfy multiple requirements and user groups. At the same time, some code law countries where accounting is aimed at legal compliance have dual reporting. Consolidated financial statements are aimed at fair presentation (IFRS), while individual company financial statements continue to be aimed at legal compliance. 11. Our preference for classifying based on fair presentation versus legal compliance over legal system follows from the answer to question 10. Many companies from code law countries now prepare two sets of financial statements. Consolidated financial statements follow fair presentation principles, while individual company accounts follow legal compliance principles. Listed companies from the European Union now follow International Financial Reporting Standards in their consolidated financial statements. IFRS are based on fair presentation principles. 12. In your authors’ opinion, the prospects for the harmonization of national systems of accounting is low. As the chapter demonstrates, accounting satisfies the information needs of its users and develops in response environmental circumstances. Unless these forces converge, there is little reason to expect accounting to converge. Also, taxation is a fundamental influence on accounting in many countries - it is the reason accounting exists in the first place. Unless governments are willing to relinquish their sovereignty over such matters, national accounting systems cannot be harmonized. At the national level, accounting systems are too entrenched. However, the story is different at the transnational (or international) level for consolidated financial statements. Convergence is occurring here, driven by the globalization of capital markets. Companies now seek capital from around the world and must appeal to the information needs of a worldwide investor group. The type of information these investors seek is similar, regardless of where they reside. This same force drove the European Union requirement for listed companies to comply with International Financial Reporting Standards starting in 2005. This means dual reporting for many companies, especially those from European countries where accounting is legalistic and tax-driven. Local financial statements will be prepared in compliance with local laws and accounting standards, but secondary financial statements will be prepared for the worldwide investor group. Consolidated financial reporting is converging onto fair presentation based on IFRS. Exercises 1. a. The dominant factor influencing accounting development in Taiwan is political and economic ties, namely those with the United States since the 1950s. In 1949, defeated by the Communists, Chiang Kai-shek fled to Taiwan and set up a provisional government there. Taiwan soon began receiving substantial U.S. economic aid to prevent the further spread of Communism. Taiwan is a dynamic capitalist economy and the United States is the country’s largest trading partner. Taiwan is an economic power that is a leading producer of high-technology goods. Services make up more than two-thirds of GDP. Nevertheless, small, family owned businesses are the basis for the economy. Taiwan has a credit-based, rather than capital markets-based financial system. Its (Germanic) code law legal system dates from the years (1895 – 1945) when Taiwan was a Japanese colony. Given the influence of the United States, it can be expected that taxation will not directly impact financial reporting (despite the code law legal system). Additional development factors are a low level of inflation and high education level (literacy rate approaching 100 percent). b. Overall, one would expect accounting to resemble U.S. accounting, emphasizing a fair presentation and full disclosure as opposed to compliance with legal requirements. Accountants can be expected to exercise judgment and not merely follow the rules or the tax laws. c. The above prediction is accurate according to the fifth edition of this textbook (Prentice Hall, 2005) and Ronald Ma, ed., Financial Reporting in the Pacific Asia Region, Singapore: World Scientific Publishing (1997). Accounting in Taiwan is largely based on U.S. accounting. Accounting standard-setting is a private sector activity, modeled after the U.S. Financial Accounting Standards Board. 2. Gambia and India (both former British colonies) have common law legal systems, while Belgium, Czech Republic, Mexico, Senegal (former French colony), and Taiwan have code law legal systems. China’s legal system is not derived from code law, but more closely resembles code law than common law. Gambia and India have fair presentation accounting because of the British colonial influence and Senegal has legal compliance accounting because of French colonial influence. As members of the European Union, both Belgium and the Czech Republic require International Financial Reporting Standards (fair presentation) for consolidated financial statements. China is also basing its reporting standards on IFRS. Because of U.S. influence, Mexico and Taiwan have fair presentation accounting. 3. For each of the three comparative accounting development patterns to be identified, four U.S. examples are listed. (Students were asked to identify two examples each.) a. The macro-economic pattern 1. Accounting for investment tax credits. 2. Disclosure of corporate social responsibility activities. 3. Selected application of accelerated depreciation methods. 4. Disclosure of oil and gas reserves by oil companies. b. The micro-economic pattern 1. Mark to market accounting for financial instruments. 2. Segmental financial reporting according to FASB Statement No. 131. 3. Pension accounting and disclosure of pension liabilities. 4. Industry-specific accounting, e.g., for banks, insurance companies, public utilities, railroads. c. The independent discipline approach 1. The realization principle. 2. Reporting of business income as a residual between realized revenues and recognized expenses for a given period. 3. Classifying assets and liabilities as current and noncurrent on the balance sheet. 4. Foreign exchange translation according to FASB Statement No. 52. 4. The answer to the question depends on the countries and the companies chosen. In general, one would expect students to discuss measurement and disclosure issues. Accounting in common law countries is based on fairness and substance over form, whereas in code law countries it stresses legal compliance, including tax laws. Thus, accounting and tax are separate in the former, but the same in the latter. Specific practices where this distinction is most obvious is in accounting for depreciation, leases, pensions, and deferred income taxes. Accounting in code law countries tends to be more conservative and it is common to see discretionary reserves used to smooth income. Of course, these are broad generalizations. Disclosure involves the amount and type. Generally, higher levels are found in common law countries and lower levels are found in code law countries. It is difficult to generalize about disclosure types. Students ought to compare such issues as disclosure of accounting policies, segment information, contingent liabilities, and social and nonfinancial matters. This exercise also lends itself to a group project where one student takes one company and another student takes the other. The length of the answer will vary depending on how in-depth the instructor wants to be. One reason why the similarities and differences may not conform to expectations is due to the type of company chosen. Large multinational corporations, especially from code law countries, often have different reporting than their domestic counterparts. Their disclosure levels are more extensive and they may not use home GAAP. All EU listed companies must now prepare consolidated statements using IFRS. It is useful to compare the two companies chosen on the basis of size, extent of multinational operations, and international listing status. Also note that the Netherlands has always followed “common law” accounting (i.e., fair presentation) even though it is a code law country. 5. At the time of writing, the 2005 annual report was the most recent one available. The stock exchanges with the most foreign listed companies were New York (452), London (334), Nasdaq (332), Euronext (293), and Luxembourg (206). The attraction of New York, London, and Nasdaq for foreign companies is that these are the major capital markets in the world. Euronext and Luxembourg attract many European companies. The stock exchanges with the highest proportion of foreign to total listed companies were Luxembourg (84%), Bermuda (66%), Mexico (54%), Swiss (29%), and Euronext (23%). As noted, Luxembourg and Euronext attract many European companies. The Swiss Exchange does as well. Bermuda is known as a financial center with easy laws, which may explain its high