|Divya Raman is currently a third-year law student at the University of Minnesota Law School and is a staff member on the Journal of Global Trade and a technical editor for Constitutional Commentary. Divya also was the winner of the school’s Maynard Pirsig Moot Court Competition and is now a summer associate at a firm in Minneapolis.
The effects of the Enron scandal on American corporate governance standards have been well examined and documented.1 Slightly less well explored, however, are the international scandals such as Parmalat and Ahold, and their effects.2 Following these infamous events, there was a decrease in investor confidence in corporations, and a subsequent withdrawal from American and international stock markets.3 In order to remedy this effect, one of the global approaches has been to try to increase investor confidence by enacting more stringent financial disclosure requirements for corporations.4
The trend has been for each country to enact certain financial reporting standards for all companies, domestic and international, listed on local stock markets. The United States addressed financial disclosure standards for companies listed on the American capital market through the Sarbanes-Oxley Act of 2002 (SOX).5 The European Union (EU) composed directives to govern companies listed on the EU capital markets.6 The EU has also enacted a regulation that requires that companies listed on member state capital markets follow a uniform set of financial reporting standards.7 The companies were required to comply with the International Financial Reporting Standards (IFRS) by January, 2005.8 This requirement, described as the “biggest change to financial reporting in 25 years,” affects approximately 7,000 companies who fall within its purview.9
Australia, Russia, and several countries in the Middle East and Africa have also decided to make the IFRS mandatory for companies listed on their national exchanges, evidencing the global trend and positive attitude towards adopting an international financial reporting system.10 In fact, experts had predicted that nearly 100 countries would comply with the IFRS at the beginning of 2005.11
The IFRS have been described as the EU’s collective accounting principles, and although most European chief financial officers would prefer that the IFRS have a more global application, this description of the IFRS helps illustrate their influential nature.12 Like accounting principles, the IFRS affect more than the accounting standards that companies have to follow, and are structured like the language of business reporting.13 Adapting to a new accounting standard can thus be likened to acquiring a new language. The business effects of the IFRS extend to a company’s personnel, processes, and information systems, in addition to its numbers.14
There can be great variance in accounting procedures, and a change in accounting standards may greatly alter the figures that appear on financial disclosure statements to potential and current investors.15 The subsequent effects to investor confidence and perception of such an alteration can be substantial.16 The implications of this change to the financial statements will depend on the extent to which the local national accounting principles under which the company was previously operating differ from the relevant accounting policies in the IFRS.17
Effect of the IFRS on company financial statements:
As with the acquisition of a new language, it will be necessary to address the issue of company financial statements using similar terms to represent different concepts. For example, one of the key areas in which there has been a reportedly stark change is under the field of “net income,” a field that has great influence on potential and current investors.18 Although the underlying calculations of future profitability and the capital worth of the company do not change in fact, there can be variance in the published numbers and the differences can be alarming.19 To control the effects of the change, companies are advised to be aware of the changing perception of their business performance, and to adapt their accounting policies, procedures and personnel to compensate for the change in investor perspective.20
Despite the expense and risk that companies face in making the change to a new set of accounting and financial reporting standards, there still seems to be a positive attitude towards the new standards.21 This seeming discrepancy can be explained in terms of the future benefits to these companies in the event of increased investor and lender confidence, and the ability to “benchmark themselves against their peers worldwide.”22 Globally uniform accounting standards will thus lead to uniform financial disclosures, and will have an impact upon investors and multi-national companies (MNCs).
Effect of the IFRS on investors:
New information technologies have made obsolete most of the previous restrictions national boundaries placed on capital market investors.23 “Information is the lifeblood of the capital market” and the consequent effectiveness of the global capital market will depend thus on the availability of such information to investors.24 Company financial reports are part of this informational structure.25 Therefore, the accounting standards, in accordance with which these financial statements are prepared, and which in effect regulate the extent and nature of financial disclosures, actually help investors make informed decisions about their capital investments.26
Uniform financial disclosures help investors directly compare companies that originate from and are located in different nations.27 Investors need only understand one set of accounting principles to evaluate the figures in all of the companies’ financial disclosure statements.28 Additionally, investors will not be misled by similarly titled financial statement terms that in fact represent different data.29
However, a recent survey from KPMG has indicated that some company financial officers are concerned about the possible negative consequences of the mandated changes on investor confidence and understanding.30 In order to avoid a “knee-jerk reaction on the stock market,” companies will not only have to ensure that the key performance indicators are accurately communicated, but also that recipients of the information are able to understand them.31 Therefore, these company officials suggest that for the beneficial effects of the IFRS to manifest themselves, investors will have to learn the new language as well.32
The survey also highlights the effect of the change in company reporting on new investors.33 The volatility of the required figures and the initial lack of historical comparisons will make it difficult for new investors to properly evaluate the continued progress of a company.34 To ensure that new investors are not discouraged from exploring new investment possibilities, companies will have to start reporting to the market regularly.35
Effect of the IFRS on
Multi-national companies will be able to use uniform financial disclosure and accounting requirements to standardize their financial practices across the parent and subsidiary companies.36 This internal uniformity will lead to more effective communication and will align the interests of all the units, thereby fostering better group decision-making.37 Additionally, the uniform standards will also make internal financial transactions easier to report and manage.38
Labeled as the process of “communicating effectively to the market in a new business language,” the change to compliance with IFRS will be a challenge for any companies who have no experience in this linguistic area.39 These companies will need to review their annual reports, reexamine their information management systems, and adapt these tools to ensure that their audience understands the information accurately.40
Effect of the IFRS on unlisted companies in the EU:
Analysts predict that there will also be external pressure from suppliers, financial providers and banks on unlisted companies to comply with the IFRS, since the IFRS help these service entities compare companies against listed companies based on standard criteria.41 Companies are also expected to face indirect pressure through the job market, since talented financial professionals will want to gain experience and exposure to a growing body of standards, and will thus gravitate toward companies who have adopted these standards.42 Additionally, public companies are also willing to pay professionals who understand the IFRS a premium rate, in order to ensure that their first and only shot at compliance is successful.43 Therefore, the demand and compensation for these individuals will be higher and unlisted companies will have to be able to match what listed companies offer in order to retain and attract them.
Larger, unlisted companies have a special interest in making the decision to comply with the IFRS early on, thereby avoiding the problem of having a paucity of historical financial data when they go public.44 Additionally, given that making the change requires a great investment of money and resources, smaller companies will have to work at allocating funds toward compliance.45 However, the IFRS is still a relatively new body of regulations, and the standards might change early on.46 Unlisted companies who await the final rulings on the contentious issues may be able to conserve funds by not having to rework any procedures and policies to reflect these early changes.47
Corporate scandals that were based on director and accountant misbehavior led to a drop in investor confidence in these entities. The events thus demonstrated the need for proper governance of companies in the interest of protecting investors. However, in capital markets that allow the listing of foreign issuers, government standards that aim at protecting national investors extend beyond the regulation of national companies. The extraterritorial effects of these regulations proves the fact that globalization is a growing phenomenon that affects nations and their citizens.
Particularly in the United States, “[g]lobalization is making the lives of all Americans interdependent with and inseparable from the rest of the world. Communications, commerce, violence, and diseases care little for political boundaries or social divides. So too, then should our concern for the rule of law.”48 It is within this larger movement towards a global economy that global accounting standards are found. As the national boundaries blur for capital market investors, the need for the easy flow of information heightens. To satisfy this need, organizations in the U.S., such as the Financial Accounting Standards Board and the Securities and Exchange Commission, are working with international organizations, such as the International Accounting Standards Board, to develop a global financial reporting standard.
The EU has taken a step towards its ultimate goal of uniformity by making a body of financial reporting standards mandatory on all companies within the Union. This body, the IFRS, made an entry into the daily operations of companies in January 2005 and will facilitate the flow of information for investors in capital market in EU Member States. The next step in the process is to adapt these standards to reflect U.S. accounting principles, in order to develop a truly international standard.
Financial analysts have stressed the importance of directors, accountants, and investors alike to learn the new language of the IFRS in order to fully benefit from the standards. However, lawyers must also be included on this list, since the regulations that are set out in the IFRS, along with the U.S. accounting principles, are the base upon which the convergent, global standard is being built.
Since accounting standards also affect all other aspect of a business, corporate lawyers will have to be aware of the changes and be able to aid a client through the transition. Lawyers will thus have to learn this new language with their clients so that an effective mode of communication is preserved. Additionally, as the standards change to incorporate U.S. accounting principles, lawyers will have to be aware of the changes and how they affect the clients. In this manner, the “rule of law” can adapt to the global economy, and set the scene for standard international practices.
1. See, e.g., Lynne L. Dallas, A Preliminary Inquiry into the Responsibility of Corporations and their Officers and Directors for Corporate Climate: The Psychology of Enron’s Demise, 35 Rutgers L.J. 1 (2003); Charles M. Elson & Christopher J. Gyves, The Enron Failure and Corporate Governance Reform, 38 Wake Forest L. Rev. 855 (2003); Kathleen F. Brickey, From Enron to Worldcom and Beyond: Life and Crime after Sarbanes-Oxley, 81 Wash. U. L.Q. 357 (2003).
2. John R. Schmertz & Mike Meier, EU and U.S. Agree on Auditor Oversight Measures, 10 Int’l L. Update 62 (2004).
3. Estelle M. Sohne, The Impact of Post-Enron Information Disclosure Requirements Imposed Under U.S. Law on Foreign Investors, 42 Columb. J. Transnat’l L. 217, 217 (2003).
4. Brent Longnecker, Sarbanes-Oxley: Financial Friend or Foe?, 121 Banking L.J. 606, 606 (2004).
5. Sohne, supra note 3, at 217.
6. Cleary, Gottlieb, Steen & Hamilton Memorandum, The E.U. Transparency Directive – Financial Reporting – Implications for E.U. Issuers and Non-E.U. Issuers, 1428 PLI/Corp 989, 991 (2004).
7. The member states of the European Union are Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, the United Kingdom, Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia.
8. Stephen Zeff, US Accounting Principles Confronts the IASB: Roles of the SEC and the European Commission, 28 N.C. J. Int’l L. & Com. Reg. 879 (2003); Europe and IFRS, supra note 9, at 4. There is also a limited exception for companies who currently follow other international standards, such as the U.S. accounting principles through the Sarbanes-Oxley Act, or companies that have only issued debt, and not equities or securities, on another member state’s regulated market, to delay compliance with the IFRS till 2007. Europe and IFRS, supra note 9, at 6.
9. PricewaterhouseCoopers, Europe and IFRS - Your Questions Answered, 2 (2002) [hereinafter Europe and IFRS].
10. Europe and IFRS, supra note 9, at 6.
11. Robert Bruce & Rod Newing, The Search for Common Ground, ft.com, Sept. 28, 2004.
12. Neil supra at 52; Europe and IFRS, supra note 9, at 13.
13. PricewaterhouseCoopers, Making the Change to IFRS: How Will it Impact Your Business? 7 (2002) [hereinafter Making the Change].
15. Making the Change, supra note 13, at 1 (recently, one company prepared its first financial statement according to International Financial Reporting Standards (IFRS) and was shocked to see that its return on investment appeared to have fallen from 16 percent to 3 percent. Suddenly, it became clear to this company that the change to IFRS was about much more than number-crunching.).
16. Morgan Witzel, The Importance of Guidance from the Top, ft.com, Sept. 28, 2004.
17. Europe and IFRS, supra note 9, at 12.
18. Making the Change, supra note 13, at 1.
19. See supra note 15 and accompanying text.
20. Making the Change, supra note 13, at 1.
21. Europe and IFRS, supra note 9, at 13 (reporting that 71 percent of those using IFRS are positive about the benefits of the transition to their business).
22. Making the Change, supra note 13, at 3.
24. Sam DiPiazza & Bob Eccles, Building Public Trust (2002).
25. Making the Change, supra note 13, at 3.
26. Bruce, supra note 11.
27. Making the Change, supra note 13, at 3.
30. Bruce, supra note 11.
38. Making the Change, supra note 13, at 4.
41. Kim Thomas, The Benefits of Staying Ahead of the Curve, ft.com, Sept. 28, 2004.
48. Robert J. Grey, Jr., Lending Justice a Hand: Hope Across the Globe is Rooted in the Rule of Law, 90 ABA Journal 8 (2004).