"Setting a Global Standard: The Case Convergence for AccountingSir David Tweedie, Chairman, International Accounting Standards Board, and Thomas R. Seidenstein, Director of Operations, IASC Foundation I. THE LOGIC OF INTERNATIONAL ACCOUNTING STANDARDS Over the past decade the rapid integration of capital markets has underscored the desirability of developing a single set of high quality international accounting standards. The growing acceptance of internationalstandards has provided momentum for the work of the International Accounting Standards Board (IASB) and has raised the possibility that international standards could serve as one of the foundations of modern capital markets. The Asian financial crisis and, more recently, the financial scandals in the United States and elsewhere during recent years have underscored the fact that good financial reporting is essential to the effective functioning of capital markets and the productive allocation of economic resources. The failures at Enron, WorldCom, and Parmalat demonstrate the potential costs of reporting failures, not only to particular companies but also to the economy as a whole. Markets punish uncertainty, and any sustained investor concern regarding the quality of financial reporting and corporate governance will be an impediment to economic growth, job creation, and personal wealth. The prospect of rigorous, improved and uniform reporting practices raises hope that the risk of future scandals could be reduced. The growing consensus around the benefits of International Financial Reporting Standards (IFRSs) reflects trends in an increasingly integrating global economy. ' At the end of 1990 the market capitalization of equity 1 International standards, as developed by the IASB and its predecessor IASC, are known as IFRSs or International Accounting Standards (lASs). lAS is the nomenclature used to denote standards set by IASC prior to 2001. The IASB has adopted the new terminology of International Financial Reporting Standards, or IFRSs, to describe standards wholly developed by the IASB. IFRSs is also used to describe the cumulative set of lASs andNorthwesternJournal of InternationalLaw & Business 25:589 (2005) shares of domesticcompanies on the world's stock exchanges totaled $8.8 2trillion. At the end of 2003, the world's market capitalizationof equity shares of domestic companies on the world'sexchanges had grown to $31.8 trillion. The developmentof and innovation in capital markets have offered companies access to cheapercapital, and investors have gained new opportunities for diversification. As capital markets play an increasinglycentral role in today's modem economies, policy-makers are confronted with the question of how to assure thecontinued effective functioning of these markets and, in particular, how to develop asound financial reporting infrastructure. Recent experience suggests that such a reportinginfrastructure must be built on four pillars: 1.Accountingstandards that are consistent, comprehensive, and based on clear principles to enable financial reports to reflect underlying economic reality; 2. Effective corporategovernance practices and strong internal controls; 3. Auditingpractices that give confidence to the outside world that an entityis faithfully reflecting its financial position and economicperformance; and 4. An enforcementor oversight mechanism that ensures that the principles as laid outby the accounting and auditing standards arefollowed. This article focuses on the firstof these four "pillars." The accounting profession and accounting standard-setters are facing a changing marketplaceand are emerging from a tumultuous period. The advent of financial engineeringand other new transactions has raised questions regarding the relevance of traditional accounting practices.At the same time, disparate national solutions to accounting's problems are not sufficient for an increasingly globalized market. The simple fact is that markets are integrating without regard to borders. To seek new investors and to reduce their cost of capital, companies are listing on major international exchanges outside their home jurisdiction. According to statistics from the World Federation of Stock Exchanges,the value of trading in foreign companies accounted for 9.75% of all tradingon the major stock exchanges in 2002, an increase from 4.69% IFRSs. IASs, modified bythe IASB, retain the prefix IAS. 2 World Federation of Exchanges, 2003 Statistics on Worldwide Capitalization of Domestic Equity Markets,available at http://www.world-exchanges.org/publications/ EQUITY 104.pdf (last visited Feb. 27, 2005) [hereinafter 2003 Statistics]. 3id.The Casefor Accounting Convergence 25:589 (2005) 4in 1995. A robust financial reporting system must cope with this new reality. Regardless of the quality and resources put into the development of existing national accounting standards, thelogic of international standards is plain to see and a broad range of interests will share the benefits. On the broadest level, the removal of barriers for capital flows and the provision of better information for cross-border investment should make the allocation of capital more efficient. This should enhance economic performance, reducemarket risk and provide welfare gains. More specifically, a common financial language, applied consistently, will enable investors to compare the financial resultsof companies operating in different jurisdictions more easily. The removal of a major investment risk-the concern that the nuances of different national accounting regimes have not been fully understood-should open new opportunities fordiversification and improved investment returns. For multinational companies, the acceptance of international standards should cut this cost of complying with various national regimes. Subsidiary companies of multinationalsmust now comply with different national standards in each jurisdiction and then the parent companymust consolidate these different national accounts into a single statement according to its home country's requirements. This process is extremely costly and inherently wasteful of scarce resources. For auditors, a single set of accounting standards should enable international audit firms to standardize training and better assure the quality of their work on a global basis. An international approach for accounting should also permit international capital to flow more freely, enabling audit firms and their clients to develop consistent global practices for accounting problems and thus further enhancing consistency. Finally, for regulators, the confusion associated with needing to understand various reporting regimes would be reduced. II. MAKING THE OBJECTIVE A REALITY The effort to develop international accounting standards is not a new one, but the establishment of the reconstituted IASB in 2001 did mark a turning point. In 1973, the International Accounting Standards Committee (IASC) was formed to begin work on the establishment of an international 5set of standards. As a representative part-time body, the IASC made significant progress toward the objective of creating a comprehensive set of standards that could be accepted by national securities regulators. In 1998, 4 1d. ' For a timeline and brief history of the IASC, the IASB's predecessor, see the International Accounting Standards Bd., History at http://www.iasb.org/about/history.asp (last visited Mar. 30, 2005).Northwestern Journal of International Law & Business 25:589 (2005) the IASC completed a core set of standards in an effort to get such an 6 endorsement from securities regulators. In 2000, the International Organization of Securities Regulators (IOSCO), on behalf of the securities regulatory community, welcomed the progress made by the IASC but could not provide an unconditional endorsement of the standards for the purposes of cross-border offerings and listings. IOSCO identified a number of areas that needed improvement and where existing options in the standards reduced comparability. The weaknesses identified reflectedregulatory concerns, particularly in some of the major marketplaces, regarding both the quality of the standards and the 7 standard-setting process. The effort to create a single set of widely accepted international accounting standards received amajor boost with the reconstitution of the IASC and the subsequent creation of the IASB. The new IASB has become an organization with both the resources to address the concerns of regulators and other market participants ina timely manner and the framework to facilitate the participation of national standard-setters throughout the world . At the heart of the IASB's efforts is the concept of convergence. In the context of the IASB, convergence carries a specificmeaning. The IASB's goal is to identify the best in standards around the world and build a body of accounting standards that constitute the "highest common 9denominator" of financial reporting. For the IASB, convergence must improve both existing financial reporting and consistency across borders. This is not convergencefor convergence's sake. Since the IASB's establishment in 2001, the effort to establish IFRSs as the international basis of accounting has accelerated. Many countries have agreed to adopt IFRSs for publicly traded companies by either January 1, 2005 or January 1, 2007.10The European Union has adopted a regulation that requires publicly traded companies to apply IFRSs, which have been 6 International Accounting StandardsCommittee, Board Meeting Highlights, IASC UPDATE, Dec. 1998, at 1. 7 For the view of the IOSCO, see International Organizationof Securities Regulators, Resolution of the President's Committee on IASC Standards, available at http://www.iosco.org/resolutions/pdf/ IOSCORES 19.pdf (May 2000). 8 For moreon the restructuring of the IASC and the establishment of the IASB,see Ruder et. al., Creation of World Wide Accounting Standards: Convergence and Independence, 25 Nw. J. INT'L L. & Bus. 513 (2005). 9 The objectives of the IASC Foundation and IASB are laid out in the IASC Foundation Constitution. INTERNATIONAL ACCOUNTING STANDARDS COMMITTEE, IASC FOUNDATION CONSTITUTION 5 (2002). 10 Deloitte, the IASPlus home page, News About International Financial Reporting, at http://www.iasplus.com (last visited Feb. 27, 2005). For a full listing of the countries, refer to Appendix 1, infra.The Casefor Accounting Convergence 25:589 (2005) approved in an E.U. endorsement P rocess, for their consolidated accounts beginning in January of this year. It is expected that in addition to the more than seven thousand publicly traded companies in Europe, tens of thousands of unlisted companies will choose to adopt IFRSs, depending upon various national rules. The momentum towards adopting international standards has not been limited to the European Union, and acceptance of the IASB has extended to six continents and is growing. For example, Australia, Hong Kong, and South Africa have followed the European Union's lead in requiring the use of IFRSs in 2005.12 A Deloitte & Touche study indicates that more than ninety countries either require or permit the use ofIFRSs for publicly 2005.13 inbeginningcompaniestradedMany African and Asian countries, such as China and many countries of South-East Asia, have a policy of pursuing convergence of national standards with IFRSs. Similarly, among Latin American countries, Costa Rica, the Dominican Republic, Panama, and Venezuela have adopted 4IFRSs, and Peru has a formal policy of convergence. Mexico has established a new body with the specific mandate of convergence, and intensive discussions about the acceptance of IFRSs in Brazil are taking 15 place.1 The European Union formalized the regulation for adoption of IFRSs on July 19, 2002. Counsel Regulation 1606/2002 of 19 July 2002 on the Application of International Accounting Standards, 2002 O.J. (L 243) 1, 1-4. The European Union has now endorsed all forty extant IFRSs with the exception of seventeen paragraphs of IAS 39. For further information on the E.U. endorsement process, refer to the Website of the Internal Market Directorate of the EuropeanCommission at http://europa.eu.int/comininternal-market/ accounting/ias-en.htm(last visited Mar. 5, 2005). 12ForAustralia, see the decisionsof the AustralianFinancial ReportingCouncil, Bulletin of the Financial Reporting Council, at http://www.frc.gov.au/content/bulletins.asp (July 3, 2002 and Apr. 2004). In South Africa, the South African Institute of Chartered Accountants, the body responsiblefor the setting of accounting standards, incorporated all extant IFRSs for use in South Africa after January 1, 2005.South African Institute of Chartered Accountants, Contents-Volume 1 Periods Commencing After 1 January 2005,at http://www.saica.co.za/documents/ContentVolumelAfter-to-IJanuary2005.pdf(Jan. 1, 2005). For Hong Kong, see Press Release, Hong Kong Institute of Certified Public Accountants (Dec. 9, 2004), available at http://www.hkicpa.org.hk/corporaterelations/ media/pressrelease/041209e.pdf. 13IASPlusHome Page,supra note 10. 14Id. 15See ConsejoMexicano para la Investigaci6n y Desarrollo de Normas de Informaci6n Financiera [Mexican Council on the Investigation and Development of Rules on Financial Information], Mision y Objetivos [Mission and Objectives], available at http://www.cinif.org.mx (last visited Feb. 27, 2005).NorthwesternJournal of International Law & Business25:589 (2005) III. AN EVOLVING U.S. ATTITUDE TO INTERNATIONAL STANDARDS In and ofitself, the adoption of IFRSs in more than ninety countries is a significant step forward. However, any effort to develop a set of internationalaccounting standards without U.S. participation and acceptance would beincomplete and fail to achieve the full benefits that a common global reporting language couldoffer. U.S. capital markets are the deepest and most liquid, accounting for 46% of the world's market capitalization in 2003. In comparison, the combined market capitalization of exchanges in the European Union, including the recent accession end of 2003.17 world's total at theonly 25.3% of thecomprisedcountries,Whilethe Financial Accounting Standards Board (FASB) and the United States Securities and Exchange Commission (SEC) had participated in and supported the former IASC's work, their participation has not translated into the acceptance of international standards for cross-border listings on the U.S. markets. Because of concerns regarding comparability, the SEC has required the reconciliation of foreign accounts to U.S. GAAP 18in the United States. This remains a lingering source of frustration for non-U.S. companies seeking access to U.S. markets and a barrier for U.S. investors hoping to diversify portfolios with non-U.S. securities. While the FASB and the SEC have a long history of direct involvement in international activities, broader U.S. interest in international accounting standards is a relatively recent occurrence. In the FASB, the United States had a full-time professional and highly skilled standard-setter that had developed special expertise, backed by significant resources for the 19task of standard-setting. At the same time, U.S. market regulators and participants could point to the fact that U.S. GAAP represented the most comprehensive and highest quality set of standards in the world. Some pointedto the depth and the liquidity of U.S. capital markets as testaments 2 0to the strength of the U.S.financial reporting model. Despite the cost of 16 2003 Statistics, supranote 2. 17 id. 18 See Form 20-F, Items 17(c) and 18(b), 17 C.F.R. § 249.220f (2005). 19 For more information see Financial Accounting Standards Board, Facts About FASB at http://www.fasb.org/facts (last visited Feb. 21, 2005). 20 SECstaff and officials have emphasizedthis point on several occasions.See Global Markets, NationalRegulation, andCooperation:Hearing on US.-EU FinancialRegulations Before the House Comm. on FinancialServices, 108th Cong. (2004) (statement of Ethiopis Tafara, Director, Office of International Affairs, U.S. Sec. Exch. Comm.), available at http://www.sec.gov/news/testimony/ts051304et.htm; see also Are Current Financial Accounting Standards Protecting Investors?:Hearing Before the House Subcomm. on Commerce, Trade and Consumer Protection, 107th Cong. (2002)(statement of Robert K. Herdman, Chief Accountant, U.S. Sec. Exch. Comm.), availableat http://www.sec.gov/news/testimony/021402tsrkh.htm.The Case for Accounting Convergence 25:589 (2005) reconciliation and compliance with U.S. listing rules, 462 companies from 53 countries were listed on the New York Stock Exchange at the end of 2 2001, the year that the IASB was established. ' OnJanuary 20, 2005, the 22number had fallen slightly to 460 companies from 47 countries. Because of the significant international presence in U.S. markets,it would hardly be surprising if a widespread belief existed, particularly in the United States itself, that U.S. GAAP was becoming the de facto international set of standards. However, a combination of factors has led to what is now a focused effort aimed at convergence of U.S. GAAP and IFRSs. As mentioned above, there had always been pressure on the SEC to relax or remove the reconciliation requirement for non-U.S. companies, but market forces and events provided additional incentive for the United States to participatein 23 process. internationaltheThe IASB is an international body insulated from national political pressures, committed to a rigorous due process, and established with a similarstructure as the FASB. Its creation gave encouragement to the SEC and the FASB to see the IASB as a viable and credible partner, consistent with the one that the FASB had advocated in its vision statement for 24 international standard-setting. Upon formation of the IASB, then SEC Chairman Arthur Levitt commented: Strong and resilient capital markets cannot function without highquality information. Efficient capital allocation depends on accurate, timely and comparable financial reporting. The [IASB] Board members who have been appointed today carry an enormous burden. It is up to them, working in cooperationwith our Financial Accounting Standards Board and other accounting standards setters, to create global accounting standards that will support effectively the imperatives of a global 21 N.Y. STOCK EXCHANGE, 2001 Statistics, available at http://www.nyse.com/pdfs/ 01 forlist030113.pdf(Jan. 13, 2003). 22 N.Y. STOCK EXCHANGE, 2004 Statistics, available at http://www.nyse.com/pdfs/ updatedforlist_041228.pdf (Dec. 29, 2004). 23 The Senate Committee on Banking, Housing, and Urban Development held a series of hearings after the collapse of Enron, which among other things explored international accounting and the possibilities for convergence. As part of these hearings,Paul Volcker, Chairman of the IASC Foundation, David Ruder and John Biggs, Trustees of theIASC Foundation, and David Tweedie, Chairman of the IASB, were called to testify. See Accounting Reform and Investor Protection Issues Raise by Enron and Other Public Companies:Hearings Before the Senate Comm. on Banking, Housing, and Urban Development, 107th Cong. (2002) (testimony of Paul Volcker, Chairman of the International Accounting Standards Committee Foundation, David Ruder and John Biggs, Trusteesof the International Accounting Standards Committee Foundation, and Sir David Tweedie, Chairmanof the International Accounting Standards Board). 24 IASPlus Home Page, supra note 10.Northwestern Journal of International Law & Business 25:589 (2005) 25 marketplace. The initial work program of the IASB also laid the groundwork for a serious initiative to eliminate the differences in international accounting standards that caused reconciliations with U.S. GAAP to be necessary. The platform of revised international standards resulting from the initial work program raised confidence in the United States about the quality of IFRSs, while reducing the scope of differences between U.S. GAAP and IFRSs. The IASB's initial work program addressed many of the concerns raised by members of IOSCO, including the SEC. The Improvements Program, the bulk of the IASB's initial work, amended and eliminated options in fourteen International Accounting Standards (IASs) inherited from the 26 IASB's predecessor. At the same time, five of the "improved" standards, IASs 16, 17, 24, 28, and 40 eliminated differences between IFRSs and U.S. 27GAAP. Further differences were removed when the IASB completed a new business combinations standard that banned the pooling method of accounting and eliminated the amortization of goodwill, bringing 28 international practice and U.S. GAAP into line. The IASB also introduced a requirement to expense share-based payments, broadly 29 consistent with one of the options permitted under U.S. GAAP. The FASB has since removed one of its options, aligning its requirement with 30 the international approach. Furthermore, in the aftermath of Enron, the United States became more receptive to non-U.S. approaches to accounting. While the accounting standards are rarely the cause of the reporting failures, and while U.S. GAAP provide a high degree of transparency for investors, Enron and subsequent failures demonstrated the need for improvement. Indeed, concerns were expressed that dependence on overly detailed rules for accounting (rather than principles and auditor judgment) may have 31 hampered the quality of financial reporting. 25 Press Release,Securities Exchange Commission,SEC Chairman ArthurLevitt Congratulates IASC on Selection of New Board Members (Jan. 15, 2001), available at http://www.sec.gov/news/press/2001-17.txt. 26 These standards are 1AS 16,17, 24, 28 and 40. INTERNATIONAL ACCOUNTING STANDARDS BOARD, IMPROVEMENTS TO INTERNATIONAL ACCOUNTING STANDARDS (2003). 27 Id. 28 BUSINESS COMBINATIONS, International Financial Reporting Standard No. 3 (International Accounting Standards Bd. 2004). 29 SHARE-BASEDPAYMENT, InternationalFinancial ReportingStandard No. 2 (International Accounting Standards Bd. 2004). 30 Press Release, Financial AccountingStandards Board, FASB Issues Final Statementon Accounting for Share-based Payment (Dec. 16, 2004), available at http://www.fasb.org/ news/ nr121604 ebc.shtml. 31See Herdman, supra note 20; see also Office of the Chief Accountant and The OfficeTheCasefor Accounting Convergence 25:589 (2005) In this context, the idea of drawing upon the "best of breed" of existing national and internationalstandards offered potential to improve deficiencies identified in the U.S. reporting environment as a result of the financial reportingscandals. At times, national standard-setters, including the FASB, have found it difficult to act alone. Thecase of accounting for stock options (or share-based payments for employee services) is such a case. Constituents often complain that a "tough" standard would put local companies at a competitivedisadvantage relative to companies outside of 32their jurisdiction. Local politicalpressures and policies may work against individual nationalstandard setters. An international standard setting process, independent of political pressures, can establishfinancial reporting standards that would apply to all companiesin all jurisdictions, thus eliminatingperceived disadvantages. IV. THE NORWALK AGREEMENT The coalescenceof these conditions provided the environment in which both the FASB and the IASB could commence work on eliminating differencesbetween U.S. GAAP and IFRSs, and both Boards were willing to act. The appointment of Bob Herz, one ofthe IASB's original members, as the Chairman of the FASB in 2002, sent a message about the importance and relevance of international standards. This set the stage for the FASB and IASB's first joint meeting in September2002.As a result of this meeting, the FASB and the IASB published a joint memorandum of understanding, now known as the NorwalkAgreement. The two Boardsagreed to: a. Undertake a short-termproject aimed at removing a variety of individualdifferences between U.S. GAAP and International Financial Reporting Standards (IFRSs,which include International of Economic Analysis, U.S. Securities & Exchange Comm'n, Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial ReportingSystem of a Principles-Based Accounting System, available at http://www.sec.gov/news/ studies/principlesbasedstand.htm (July 25, 2003). 32 Opponents of mandatorystock option expensing haveoften used this argument asa case against reform of existing practice. See FASB Stock Options Proposal: Before the House Comm. on Financial Services, Subcommitteeon Capital Markets, Insurance and Government SponsoredEnterprises, 108th Cong. (2004) (statement of George Scalise, President, Semiconductor Industry Association); Comment Letterfrom the International Employee Stock Options Coalition tothe Financial Accounting Standards Board (Jan. 30, 2003), at http://www.siia.net/govt/docs/pub/taxletter01 3003.pdf. 33 For informationregarding convergence andjoint IASB-FASB initiatives,see Financial Accounting Standards Board, Short-term InternationalConvergence at http://www.fasb.org/ project/short-term intl convergence.shtml(last visited Feb. 27, 2005) and International Accounting Standards Board, IASB Activities at http://www.iasb.org/current/ iasb.asp?showPageContent=no&xml=16_13_67_23092003.htm(last visited Feb. 27, 2005)."