In the following article, Christopher Nobes suggests that there are several reasons for the differences in accounting systems throughout the world. Read the article and write a two page report on the following: (1) Identify two reasons for differences in accounting systems around the world, according to Nobes. (2) State your own opinion about what the author is saying. (3) Write a prediction of the future: Think ahead ten years from now. Prepare a classification of accounting systems that you think will exist then. What factors motivate your particular classification? The article first examines the existing modelling literature, which contains a large number of suggested reasons for international differences in accounting. After examining terminological problems, a preliminary parsimonious model is developed to explain the initial split of accounting systems into two classes. The term ‘accounting system’ is used here to mean the financial reporting practices used by an enterprise. A country might exhibit the use of several such systems in any one year or over time. Consequently, it should be systems and not countries that are classified. The model proposes a two-way classification using two variables: the strengths of equity markets and the degree of cultural dominance. Implications for classifiers and rule-makers are suggested.Key words: Classification; International accounting.INTRODUCTION AND PREVIOUS MODELLINGMany reasons have been suggested in the literature for international differences in financial reporting. Some authors state that they are merely listing plausible reasons; few provide precise hypotheses or tests of them, as noted by Meek and Saudagaran (1990). Wallace and Gernon (1991) complain about the lack of theory in international comparative accounting. This article seeks to address this.The literature (e.g., Choi and Mueller, 1992, ch. 2; Radebaugh and Gray, 1993, ch. 3; Belkaoui, 1995, ch. 2; Nobes and Parker, 1995, ch. 1) offers a large number of possible reasons for international differences (see Table 1) but no general theory linking the factors. Schweikart (1985) and Harrison and McKinnon (1986) provide some elements of a general theory, without specifying which factors are major explanatory variables for accounting practices. Two somewhat similar theoretical models of the reasons for accounting differences are those of Gray (1988) and of Doupnik and Salter (1995; hereafter DS). Gray suggests a model based on cultural factors, as examined later. DS provide a synthesis of previous discussions, leading to a framework, which is simplified here as in Figure 1 so that an alternative can be proposed later. One difficulty emerging from Figure 1 is that four of DS’s ten variables (see Table 2) are cultural (based on Gray) and six are institutional, but culture is seen as giving rise to the institutions. This suggests the possibility of double counting. A related difficulty with DS is that there is no attempt to connect their six institutional factors to see whether they might cause each other. In particular, it is suggested later that four of the six (taxation, inflation, level of education and stage of economic development) are not necessary. DS thus have provided a mix of theories, not a general theory.A number of terminological issues are raised by studying this literature. These need to be addressed before attempting to develop a general model.SOME TERMINOLOGICAL ISSUESOne of the problems of identifying reasons for differences, and perhaps then classifying accounting systems, is a lack of clarity about what is being examined or classified. This article discusses accounting practices, using ‘accounting’ to mean published financial reporting. In some jurisdictions, the rules of financial reporting may be identical, or very similar, to the practices, but sometimes a company may depart from rules or may have to make choices in the absence of rules. The Price Waterhouse data, used by many researchers, seem to contain a mix of de facto and de jure aspects ‘in a perplexing way’ (Rahman et al., 1996).Another difficulty concerns the word ‘system’ (Roberts, 1995). DS use it to cover such things as regulatory agencies. Others (e.g., Nair and Frank, 1980) have concentrated on a corpus of accounting rules or practices. This article follows the latter route, that is, an ‘accounting system’ is a set of practices used in a published annual report. Although this is a narrow definition, these practices will reflect the wider context in which they operate.Another issue is whether to separate disclosure from measurement practices. Nair and Frank (1980) show that this can be important. Nobes (1983) looks at measurement practices only. DS acknowledge the distinction but add the categories together. It seems appropriate to include the presence or absence of certain key disclosures (e.g., earnings per share, cash flow statements) as elements of a system, and this is discussed later.A further issue is to determine whose accounting practices are being examined. The Price Waterhouse data seem, in practice, to have reported on companies audited by Price Waterhouse (see Nobes, 1981). DS (p. 198) specify the measurement and disclosure practices of ‘companies’, which is vague, particularly for disclosure practices. Nobes (1983, p. 5) chose the measurement practices of ‘public companies’, which the context suggests meant those with securities which are traded publicly.A related point is that all the researchers look at classifications of countries by their accounting environments or systems. Roberts (1995) highlighted this problem, noting that a country could have more than one system, for example, one system for companies with publicly traded securities, and another for small private companies. Similarly, some large public companies may adopt very different practices from what is ‘normal’ for most large companies in the country. This is becoming especially obvious in continental Europe, with the use of U.S. rules or International Accounting Standards (IAS) by some very large companies. Therefore, it may be useful to refer to a country’s ‘dominant accounting system’, which might be defined as that used by enterprises encompassing the majority of the country’s economic activity. Hereafter, references to a country’s ‘system’ should be taken to mean its dominant system.In some countries, the law requires or commercial pressures dictate that a large number of companies use the same system. For example, in the U.K., most provisions of the Companies Act 1985 and of accounting standards apply to all companies. In other countries, a particular accounting system might be legally or commercially imposed on a small minority of companies, as in the U.S. where ‘generally accepted accounting principles’ are legally imposed on only that small proportion of companies registered with the Securities and Exchange Commission. In both these rather different cases, there is still dearly a dominant system as defined above.Nevertheless, as there can be more than one system in a country it would be more useful to specify accounting systems, and then to note that particular companies in particular countries at particular dates are using them. Of course, for labelling purposes, it might be useful to refer, for example, to the system used in 1998 by U.S. public companies. With labels, it will then be possible to identify separate influences on, and to show separate places in the classification for, for example, ‘normal’ German public companies in 1998, compared to the group accounts of such companies as Daimler-Benz, Deutsche Bank and Bayer in 1998.Also, a country’s accounting system may change dramatically over time, for example, as a result of economic or political revolutions (c.f. China, Russia, Poland, etc.). Less dramatically, accounting in a country can change quite significantly as a result of new laws (e.g., Spain from the late 1980s as a consequence of EC Directives).Lastly, companies in two countries (e.g., the U.K. and Ireland) can use extremely similar accounting practices (i.e., perhaps the same ‘system’). In a similar manner to the characteristics of human individuals, the detailed elements of a company’s accounting practices can differ so much that the number of different sets of practices is effectively infinite. Nevertheless, it is useful for some purposes to recognize that humans all belong to the same species. The individual members of the species are all different but have certain features in common. By analogy, a certain degree of variation among company practices may be allowed without having to abandon the idea that the companies are all using the same system.AN INITIAL STATEMENT OF A GENERAL MODELThe proposal here, which will be explained more fully later, is that the major reason for international differences in financial reporting is different purposes for that reporting.Financing SystemsIn particular, at a country level, it is suggested that the financing system is relevant in determining the purpose of financial reporting. Zysman (1983) distinguishes between three types of financing system: (a) capital market based, in which prices are established in competitive markets; (b) credit-based system: governmental, in which resources are administered by the government; and (c) credit-based system: financial institutions, in which banks and other financial institutions are dominant.Zysman suggested that the U.K. and the U.S.A. have a type (a) system; France and Japan a type (b) system; and Germany a type (c) system. According to Zysman, in all systems companies rely considerably on their own profits for capital but their external sources of funds differ. Where external long-term finance is important, securities are the main source in the capital market system. In such countries, there is a wide range of capital instruments and of financial institutions, and the latter have an arm’s-length relationship with companies. Investors change their holdings through the secondary securities markets, which are large. In credit-based systems, the capital market is smaller, so companies are more reliant on whoever grants credit. This usually means banks, whether under the influence of governments or not. Cable (1985) examined the importance of banks in the German economic system. In this system, investors will find it more difficult to adjust their holdings, so they may be more interested in long-run control of the management.For the purposes of this article, a development of the Zysman classification is proposed, as in Table 3. For this, the concept of ‘insider’ and ‘outsider’ financiers needs to be developed. This idea of insiders and outsiders, which has its roots in the finance literature, has been used before for accounting purposes (e.g., see Nobes, 1988, p. 31), and to discuss contrasting corporate governance systems (e.g., Franks and Mayer, 1992; Kenway, 1994). ‘Outsiders’ are not members of the board of directors and do not have a privileged relationship with the company (e.g., such as that enjoyed by a company’s banker who is also a major shareholder). They include both private individual shareholders and some institutions. For example, insurance companies and unit trusts normally have widely diversified portfolios, so that any particular holding does not constitute a large proportion of a company’s capital. Therefore, such institutions should perhaps be counted as outsiders. By contrast, ‘insiders’ such as governments, banks, families and other companies are all likely to have close, long-term relationships with their investees. This will involve the private provision of timely and frequent accounting information.Both of Zysman’s credit-based systems fall into category I of Table 3. Category II (a credit-based system with a large amount of listed debt with outsider owners) is plausible but uncommon. A possible example is discussed near the end of this subsection. Category III is an equity-based system where most shares are owned by insiders. In Japan, for example, there are large numbers of listed companies and a large equity market capitalisation, but the shares are extensively owned by banks and other companies (Nobes and Parker, 1995, p. 9 and ch. 13).Category IV systems involve important equity markets with large numbers of outsider shareholders. In these systems there will be a demand for public disclosure and for external audit because most providers of finance have no involvement in management and no private access to financial information. This is the classic setting of most of the finance literature (e.g., Jensen and Meckling, 1976; Beaver, 1989). More recently, a connection between more disclosure and lower cost of equity capital has been examined in such a context (Botosan, 1997). Pursuing this line, this article suggests that the key issue for financial reporting is the existence or otherwise of such Category IV financing. Ways of measuring this are proposed below.In a particular country, there may be elements of several of these four systems. For example, small companies are unlikely to be financed by a Category IV system in any country. However, for the moment, let us assume that the economic activity in any country is dominated by one particular financing system. The hypothesis predicting a correlation between the style of corporate financing and the type of accounting system is that the rule-makers for, and the preparers of, financial reports in equity-outsider (Category IV) countries are largely concerned with the outside users. The conceptual frameworks used by the rule-makers of the U.S., the U.K., Australia and the IASC make it clear that this is so. In particular, they state that they are concerned with reporting financial performance and enabling the prediction of future cash flows for relatively sophisticated outside users of financial statements of large companies. By contrast, credit-based countries (mostly Category I) will be more concerned with the protection of creditors and therefore with the prudent calculation of distributable profit. Their financiers (insiders) will not need externally audited, published reports. This difference of purpose will lead to differences in accounting practices. The less common categories (II and III) will be discussed later.Empirical researchers would need to establish relevant measures to distinguish the categories (as done, for example, by La Porta et al., 1997). These might include the number of domestic listed companies in a country (or this deflated by size of population), the equity market capitalization (or this deflated by GDP), and the proportion of shares held by ‘outsiders’. Although the boundary between the types of financing system may sometimes be unclear (as in many of the classifications in social science, languages, law or, even, biology), the contrast between a strong equity-outsider system and other systems should be clear enough, as the Appendix demonstrates for some countries.Financial Reporting SystemsIt is proposed that financial reporting systems should be divided initially into two classes, for the moment labelled as A and B. Class A corresponds to what some have called Anglo-Saxon accounting and Class B to continental European. To assist researchers in measuring a system, some core features of the two systems are suggested in Table 4. For example, systems of Class A will share all, or a large proportion of, the practices shown for that class. Clear examples of actual systems exhibiting all of the features exist.It is proposed that, for developed countries, the extent that a particular country is associated with Class A or Class B accounting is predictable on the basis of its position with respect to financing systems. If the present accounting system was developed in the past, then reference to the past importance of financing systems will be relevant. Strong equity-outsider markets (Category IV) lead to Class A systems; otherwise Class B systems prevail.Even if a particular country is traditionally associated with weak equity markets and therefore Class B accounting, the country might change. For example, China has been changing in the direction of a strong equity-outsider market and Class A accounting (Chow et al., 1995). However, the accounting might remain stuck in the past for legal or other reasons of inertia. Nevertheless, in some countries, certain companies might be especially commercially affected. They might adopt Class A accounting by using flexibility in the national rules, by breaking national rules, or by producing two sets of financial statements. Some German examples of these routes can be given. Bayer’s consolidated financial statements (for 1994 onwards) have used non-typical German rules, that are different from those used in its parent’s statements, in order to comply with International Accounting Standards (IAS). Further, officials of the Ministry of Finance have announced that departure from German rules would be ‘tolerated’ for such group accounts. In the case of Deutsche Bank (e.g., for 1995), two full sets of financial statements were produced, under German rules and IAS, respectively.A related issue is that, as noted earlier, there are two aspects of financial reporting which can be separated: measurement and disclosure (e.g., Nair and Frank, 1980). Table 4 contains examples of both aspects. As explained below, the measurement issues seem to be driven by the equity/creditor split, and the disclosure issues by the outsider/insider split. The equity/creditor split leads to different kinds of objectives for financial reporting. As suggested earlier, systems serving equity markets are required to provide relevant information on performance and the assessment of future cash flows in order to help with the making of financial decisions. Systems in a creditor environment are required to calculate prudent and reliable distributable (and taxable) profit. By contrast, the outsider/insider split leads to different amounts of information: where outsiders are important, there is a demand for more published financial reporting.It has been assumed here that equity financing systems are normally those which are associated with large numbers of outsiders, so that Class A systems are an amalgam of equity and outsider features. However, if there were countries (Category II of Table 3) with large markets for listed debt but not for listed equities, then one might expect a financial reporting system with the high disclosures of Class A but the measurement rules of Class B. Perhaps the closest example of a system with Class B measurement rules but high disclosures is the German system for listed companies. Germany does indeed have an unusually large market in listed debt.This way of distinguishing between the forces acting on measurement and those acting on disclosure may help to resolve the difficulties of a cultural explanation as discussed by Baydoun and Willett (1995, pp. 82-8).Category III (equity-insider) financing would not produce Class A accounting because published financial reporting is unimportant. The main financiers may be interested in performance and cash flows but they have access to private ‘management’ information.Colonial InheritanceSome countries are affected by very strong external cultural influences, perhaps due to their small size or underdeveloped state or former colonial status. Such culturally dominated countries are likely to be using an accounting system based on that of the influential country even if this seems inappropriate to their current commercial needs (Hove, 1986).Colonial inheritance (Factor 2 in Table 1) is probably the major explanatory factor for the general system of financial reporting in many countries outside Europe (Briston, 1978). It is easy to predict how accounting will work in Gambia (British) compared to neighbouring Senegal (French). The same general point applies to Singapore (Briston and Foo, 1990) or Australia (Miller, 1994). Colonial inheritance extends of course to legal systems and to other background and cultural factors, not just to direct imports of accounting (Parker, 1989). Allied to this are the effects of substantial investment from another country, which may lead to accountants and accounting migrating together with the capital.Another influence is invasions (Factor 3) which may lead to major influence on accounting, as is the case with Japanese, French, and German accounting. However, when the invader retires, any foreign accounting can be gradually removed if it does not suit the country: Japan closed down its Securities and Exchange Commission when the Americans left, whereas France retained its accounting plan in order to aid reconstruction after World War II (Standish, 1990).WHY OTHER FACTORS MAY BE LESS USEFULIf the above conclusions are accepted (i.e., that a general two-class model of financial reporting systems can be built which rests on only the importance of financing systems and colonial inheritance), then most of the seventeen factors listed in Table 1 seem unnecessary as explanatory independent variables, at least for the initial two-class classification. This section explains why, starting with DS’s factors.TaxPrevious writers (e.g., Nobes, 1983) have not been helpful by listing tax as one of the major causes of accounting differences. These writers have, in effect, suggested that Class A accounting systems are not dominated by tax rules whereas Class B systems are; and therefore, that the tax difference is one of the reasons for the difference in accounting systems. However, the disconnection of tax from accounting in Class A systems may be seen as a result of the existence of a competing purpose for accounting rather than the major cause of international accounting differences. Lamb et al. (1995) look at this in detail, concluding that:Rules for the determination of the taxable profit of businesses will be important in all countries (assuming that taxation of profit is significant).Without some major competing purpose for accounting for which tax rules are unsuitable, tax rules made by governments will therefore tend to dominate accounting, so that tax practices and accounting practices are the same (as in Class B).In some countries (or for some companies), there is the major competing purpose of supplying financial reports to equity-outsider markets (for which tax rules are unsuitable). In this case, for many accounting topics, there will be two sets of accounting rules (and practices): tax rules and financial reporting rules (as in Class A).Consequently, the tax variable is not needed to explain the difference between Class A and Class B systems. Nevertheless, for those systems where tax and accounting are closely linked (Class B), international differences in tax rules do create international accounting differences. However, these are detailed differences within a class of accounting systems which all share the major feature of being dominated by tax rules, which is one of the distinguishing marks of the class.There is a further important connection here. The equity/credit split in financing, as discussed earlier, coincides with the proposed equity-user/tax-user split: accounting systems designed to serve creditors are systems dominated by tax rules. This is because the calculation of the legally distributable profit (to protect creditors) and the calculation of taxable profit are both issues in which governments are interested. The calculation of legally distributable profit is a different purpose from the calculation of taxable profit but it is not ‘competing’ in the sense of requiring a different set of rules because both calculations benefit from precision in the rules and from the minimization of the use of judgment, which is not the case for the estimation of cash flows.Incidentally, DS follow previous writers and suggest that, ‘In many countries, tax laws effectively determine accounting practice’ (p. 196). However, they then find that tax is not a useful independent variable in explaining accounting differences. It is argued above that tax is not an independent variable for the main classificatory split. DS failed to find even a correlation, probably because they mis-specified the tax variable by using the marginal rate of corporate income taxes. This measure seems inappropriate for several reasons. First, tax rates change dramatically over time, without any obvious effect on accounting (e.g., the top U.S. rate fell from 46 per cent to 34 per cent in 1987; the main rate in the U.K. rose in 1973 from 40 per cent to 52 per cent, and then fell to 33 per cent in 1991). Second, many systems have more than one marginal rate (e.g., in Germany in 1995, 45 per cent for retained profit but 30 per cent for distributed profit; and, in the U.K., 33 per cent for large companies but 25 per cent for small). Third, the tax burden depends greatly on the definition of taxable income not just on the tax rate. More importantly, in countries with a small connection between tax and accounting (typical of Class A), the tax rate will have little effect on accounting; and in countries with a close connection (typical of Class B), the effect of tax on accounting will be in the same direction and probably almost as strong whether the rate is 30 per cent or 50 per cent. For all these reasons, the level of the marginal rate of tax will not help to predict the financial reporting system.Level of EducationDS’s variable here is the percentage of population with tertiary education. It is hard to see how one could explain the major accounting differences on this basis. Can one explain the large accounting differences between, on the one hand, the U.K., the U.S. and the Netherlands (where Class A dominates) and, on the other hand, France, Germany and Italy (where Class B dominates) on the basis of the rather similar levels of tertiary education? Again, can one explain the remarkable similarities between accounting in Malawi, Nigeria and Zimbabwe (Class A countries) and the U.K. (also Class A) on the basis of the rather different levels of tertiary education? Instead there seems to be a connection with the ‘colonial inheritance’ point, as discussed earlier and as taken up again in the ‘level of economic development’ point below. Thus it is not surprising that the education variable did not help DS. Previous suggestions related to this factor (e.g., Radebaugh, 1975) seem, more plausibly, to involve the comparison of developed with less developed countries.Different levels of professional accounting education might be relevant (Shoenthal, 1989), perhaps especially in developing countries (e.g., Parry and Grove, 1990). However, Nobes (1992) casts doubt upon the relevance of this type of factor for classification. To the extent that this is not another issue related to developed versus developing countries, differences in professional education might be covered by Factor 8 in Table 1 (age and size of accountancy profession) and may be a result of accounting differences rather than their cause.Level of Economic DevelopmentIt is suggested that the key issue here is not the influence of the stage of economic development on financial reporting (as chosen by DS). Gernon and Wallace (1995, p. 64) agree that there is ‘no conclusive evidence’ about the relationship. The problem is that, while many African countries with a low level of development have accounting systems rather like the U.K.’s, some have completely different accounting systems rather like that in France. By contrast, the U.K. or the Netherlands have a rather similar level of economic development to that of Germany or Italy but completely different accounting systems.It would seem plausible to argue that, if accounting systems were indigenously created in all countries, then they would develop differently in developed and undeveloped economies. However, it is suggested that this point is largely overridden by the proposition that developing countries are likely to be using an accounting system invented elsewhere. Perhaps the system has been forced on them, or they have borrowed it. Either way, it is usually possible to predict accounting in such countries by looking at the source of the external influences. Therefore, the level of development is not the key predictor for the split between Class A and Class B. Cooke and Wallace (1990) seem to support the distinction between developed and developing countries when it comes to the influence of various environmental factors on accounting.Legal SystemsFor developed Western countries and for many others (e.g., Japan, South America and most of Africa), it is possible to split countries neatly into codified legal systems and common law systems (David and Brierley, 1985). As DS note, this is of great relevance to the regulatory system for accounting. However, there is a high degree of correlation between equity-outsider financing systems and common law countries, and between credit-insider systems and codified law. On the whole, therefore, the same groupings would result from using a legal system variable rather than from using a financing system variable, as DS find. This again suggests the possibility of double counting. The exception of the Netherlands, which raises further doubts about using the legal variable for accounting classification, is explained below.For culturally dominated countries, both the legal and accounting systems are likely to have been imported from the same place, so the correlation between these two variables is unsurprising. Both factors can be explained by the colonial influence factor, so the legal factor is not needed. For other countries, there may be aspects of the common law system which predispose a country towards the creation of strong equity-outsider systems (La Porta et al., 1997), but going that far back in the causal chain is not necessary for the present model. For present purposes, it may be more useful to specify the legal variable as the regulatory system for accounting rather than the more general legal system. The variable would be measured by locating the source of the most detailed accounting regulations. A 0/1 variable would contrast (i) rules made by professional accountants, company directors, independent bodies, stock exchanges and equity market regulators, and (ii) rules made by tax authorities, government ministries (other than those concerned primarily with listed companies) and legal bureaucrats.Once more, it could be argued that this version of the legal variable is not independent but is dependent on the financing variable. In strong equity-outsider systems, commercial pressure gives the strongest power over financial reporting to group (i) because, since the financial reporting for the equity/outsiders uses separate rules from tax rules, there is no need for group (ii) to control them. In particular, many of the disclosures (e.g., consolidated financial reports, cash flow statements, segmental reporting, interim reporting) are not relevant for tax or distribution purposes in most jurisdictions. Financial institutions and large companies are sufficiently powerful to persuade group (ii) to allow financial reporting to respond to commercial needs. In common law countries, the importance of group (i) creates no problems of jurisprudence because non-governmental regulation is commonplace. In the rare case of a codified law country with a strong equity market (e.g., the Netherlands), the regulatory system for financial reporting can still give prominence to group (i) although this creates tensions (Zeff et al., 1992). In all systems, group (ii) retains full control over tax rules.Inflation LevelsAnother factor included by DS is the rate of inflation and, once more, previous writers have not been helpful here. For example, although Nobes (1983) did not include inflation as a key variable, Nobes and Parker (1995, p. 19) suggested that ‘Without reference to this factor, it would not be possible to explain accounting differences in countries severely affected by it’. However, on reflection, the more important issue is illustrated by other points that they make in the same section:’accountants in the English-speaking world have proved remarkably immune to inflation when it comes to taking decisive action’;’in several South American countries, the most obvious feature … is the use of methods of general price-level adjustment’;’the fact that it was governments which responded to inflation in France, Spain, Italy and Greece … is symptomatic of the regulation of accounting in these countries’.In
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