Harmonizing Disclosure of Corporate Finances to Reduce Risks to Investors

International rules for corporate financial disclosure evolved slowly in the 1990s as rapid integration of securities markets made compliance with widely varying national rules both costly and confusing for companies and regulators. By 2006, a limited effort by a small group of international accountants to write disclosure rules for companies that sold stock in more than one country had become an unusual instrument of international governance. No treaty or international agreement provided a framework for financial disclosure rules. Instead, private efforts became public law by means of a slow process of government endorsement.

 

An important date was January 1, 2005, when the European Union (EU) required more than seven thousand public companies headquartered in its twenty-five member countries to follow the financial disclosure rules established by the private International Accounting Standards Board (IASB). Officials of the Bush administration announced that the United States, too, might hand over to the board as early as 2007 financial reporting rule-making for foreign listings. Russia, South Africa, Australia, Taiwan, Hong Kong, and India also had plans to adopt the rules made by the international board. However, the seemingly technical task of harmonizing accounting standards produced difficult political issues from the start, because what financial information was disclosed and how it was disclosed could change markets. Reporting requirements could alter the projects firms chose to undertake, how they compensated employees, how well firms fared against competitors, and how effectively they attracted investors. Traditionally, national financial disclosure rules varied so widely that a substantial profit under one country’s rules could be a substantial loss under another’s.

 

International standards developed gradually over a generation. In 1973, a committee of private-sector accountants from nine countries formed the International Accounting Standards Committee and began issuing proposed international accounting standards. The committee, one of several competing efforts in the 1970s and 1980s, initially skirted thorny political issues by proposing standards that left companies and national regulators wide latitude in interpretation.

 

In the 1990s and early 2000s, rapidly integrating markets and international financial crises increased companies’, stock exchanges’, and national regulators’ interest in more rigorous international disclosure rules. The Asian financial crisis of the mid-1990s created calls for greater corporate transparency, even though corporate reporting flaws were not among its main causes. Accounting scandals in the United States and Europe in 2001– 2004 alerted international investors to hidden risks and highlighted major weaknesses in national disclosure rules.

 

Company executives, stock exchange managers, accountants, investors, and other market participants each had somewhat different reasons for supporting harmonization of corporate financial reporting. Multinational companies, seeking to diversify their shareholder base and lower their cost of capital by listing on stock exchanges outside their home countries, found duplicate reporting not only burdensome but also sometimes embarrassing. Managers of large stock exchanges, seeking to gain listings from foreign companies, found their national reporting rules created a competitive disadvantage. The accounting profession, dominated by five international firms through most of the 1990s, feared that conflicting statements of profits and losses under different national rules could impair accountants’ credibility. Investors, seeking higher returns in foreign markets, found variable results a new source of uncertainty.

 

In order to gain public legitimacy, the harmonization effort started by a small committee of accountants—the IASB—reformed its structure and improved procedural fairness in 2000 and 2001. The board’s new structure emphasized expertise rather than national representation, paralleled that of the U.S. and British accounting standard setters, and was dominated by members from countries with Anglo-American accounting traditions. The reformed board consisted of twelve full-time and two part-time members who served a maximum of two five-year terms and were appointed for their technical expertise as auditors, preparers, and users of financial statements. To coordinate the board’s rule making with that of national standard setters, seven board members were given formal liaison responsibilities with specific countries, the United States, Britain, France, Germany, Japan, Canada, and Australia, giving those countries an elite status. The board also drew on the expertise of a geographically diverse advisory council and interpretations committee. By early 2005, the board had issued forty-one accounting standards, including controversial requirements for expensing of stock options and accounting for derivatives.

 

The board aimed to produce international standards “under principles of transparency, open meetings, and full due process.” Board meetings were open to the public. Agendas of board and committee meetings were posted in advance on the board’s website, and summaries of decisions were posted afterward. Draft standards and interpretations were subject to public notice and comment (usually 120 days for standards and 60 days for interpretations), and sometimes to public hearings. The publication of final standards included a discussion of their rationale, responses to comments, and the board’s dissenting opinions. The board also published an annual report. The board and affiliated organizations, headquartered in London, employed about sixty people, including board members, and had an annual budget of about $18 million, provided through contributions from accounting firms (including $1 million from each of the four largest international firms), corporations, central banks, and international organizations.

 

As in the United States and Britain, a self-perpetuating oversight group, the International Accounting Standards Committee Foundation (IASCF), was intended to provide a buffer from political pressures and assure efficient operation. Its trustees chose board members, appointed the board chair, raised operating funds, and reviewed the board’s constitution and procedures every five years. Its constitution provided that its twenty two-member self-perpetuating “financially knowledgeable” board of trustees be “representative of the world’s capital markets and a diversity of geographical and professional backgrounds.” It called for six representatives from North America, six from Europe, four from the Asia/Pacific region, and others without geographical designation. The foundation’s first chair was Paul Volcker, former head of the United States’ Federal Reserve Board.

 

Informal public and private networks also supported the board’s work.The EU encouraged the creation of a private-sector technical group (the European Financial Reporting Advisory Group, EFRAG) and formed the Committee of European Securities Regulators (CSER), which quickly established guidelines for member states’ enforcement bodies, including independence and authority to monitor and correct accounts. To reduce the chances that each nation would in effect create its own standards through different interpretations, CESR also established a database of nations’ enforcement decisions and urged national regulators to follow precedents as they were established. The International Federation of Accountants (IFAC) proposed a peer review system for periodically and randomly reviewing the accounts of multinational companies and issued a new standardized audit report form to improve the comparability of accounts. In May of 2004 the SEC and CESR announced that they were increasing their collaborative efforts in order to improve communication about regulatory risks between Europe and the United States and to promote convergence in future securities regulation.

 

Enforcement of accounting standards, however, was left to national regulators. The board remained a private membership organizationwith no authority to compel nations or companies to adopt its disclosure rules. The public character of its authority rested solely on the endorsement of its processes and standards first and foremost by national governments and then by complex networks of national politicians, regulators, accounting firms, stock exchanges, companies, investors, and other market participants. Enforcement practices varied widely among nations that represented major markets.

 

In 2006, the development of international corporate financial accounting standards appeared to be sustainable. Standards had improved markedly over time in scope, accuracy, and use. However, it was not yet clear what degree of harmonization the international board would achieve, whether a critical mass of nations and companies would continue to support the board’s efforts, and how well standards would be enforced by national regulators. Standards for financial derivatives, stock options, and other complex instruments remained controversial. Nations’ capacities to administer and enforce international disclosure rules varied widely, raising the possibility that standards would be accepted on paper but ignored in practice. EU companies complained that standards were costly and confusing: “The standards have been criticized by businesses of all sizes for making accounts unreadable and irrelevant,” the Financial Times reported inMarch 2006. In addition, the board’s funding remained uncertain. The “big four” accounting firms continued to provide a third of funding, raising charges of undue influence, while other contributions were ad hoc.

 

Political realities suggested that gradual partial harmonization of standards and practices over a period of years was as much as could be expected. Whether such harmonization would reduce or increase hidden risks to investors remained to be seen.

 

This case study is drawn from Full Disclosure, Fung, Graham and Weil, 2007.