Mintz & Morris
Ch. 8
International Financial Reporting:
Ethics and Corporate Governance
Considerations
Ethics Reflection
• Cultural values/differences in auditing
• Secrecy (China) vs. transparency (U.S.)
• Chinese government is major stockholder in most
“public” companies
• Can foreign investors trust the financial reports
produced by accountants in China and audited by BigFour CPA firms?
• Movement towards adopting one set of international
accounting standards – International Financial
Reporting Standards (IFRS)
• Principles-based vs. rules-based standards
• International ethics and corporate governance
Influence of Culture on International
Financial Reporting
• Uncertainty avoidance, individualism, and power
distance
• Cultural Values > Accounting Values > Application
of Financial Reporting Standards
• Accounting values: professionalism, uniformity,
conservatism, and secrecy
• Higher levels of conservatism linked with
countries with higher uncertainty avoidance and
lower individualism
• Higher levels of secrecy linked with countries with
higher uncertainty avoidance and power distance,
and lower individualism
Restoring the Public Trust: An
International Perspective
• Enron, WorldCom, Royal Dutch Shell (UK-Netherlands), Parmalat
(Italy), and Satyam (India)
– Lack of internal controls, ineffective internal audits, and inattentive
boards of directors all share blame for these frauds
• International Federation of Accountants (IFAC) is the global
organization for the accountancy profession dedicated to serving
the public interest
– Rebuilding Public Confidence in Financial Reporting: An International
Perspective
• International Ethics Standards Board of Accountants (IESBA) along
with the International Accounting Education Standards Board
(IAESB) establish guidelines for 167 members and associates in 127
countries worldwide
– Authoritative pronouncements
• Support for ethics education for future accountants
International Financial Reporting
Environment
• Movement to establish one set of accounting
standards for over 40 years
• “Secret reserves” designed to conceal true
financial position
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Can give sense of financial stability
Smoothing net income
Generally only known to management
Make information in financial statements false
Cause lost of trust and confidence of shareholders and
outsiders
– Cover up inefficiency and fraud
Harmonization of Standards
• Philosophy when IAS first set in 1973
– Members of IASC use “best efforts” to bring
standards closer by eliminating obviously
unacceptable standards such as secret reserves
– Major problem early on was lack of enforcement
mechanism for the international accounting
standards (IAS) set by the IASC
Comparability of Financial Statements
• Comparability of financial statements project in 1990s
– Make accounting standards worldwide more similar
– 10 revised IAS’s in 1995
• International Organization of Securities Commissions
(IOSC) membership to regulatory agencies around the
world
– Members from over 100 different countries, that regulate
more than 90 percent of the world's securities markets
– No specific enforcement powers
• Falls on regulatory agencies in each country
The IASC-U.S. Comparison Project
• Report on the Similarities and Differences
between IASC Standards and U.S. GAAP (1996)
• Accomplishments:
– Agreement on comprehensive set of core
standards
– If standards acceptable, recommend endorsement
of IASC standards
– SEC may use IASC standards for foreign private
issuers
Convergence of Standards
• IASC was restructured into the International
Accounting Standards Board (IASB) in 2001.
• Many countries have adopted international
standards
• Norwalk agreement (memo of understanding)
FASB and IASB embarked on partnership to improve
and converge U.S. GAAP and international
standards
• Mandatory IFRS adoption in EU (2005)
• Study shows accounting quality is generally
improved after adoption of IFRS
Examples of Convergence
• Borrowing costs on constructed asset: US method
of capitalization adopted rather than IFRS
alternatives treatment with expensing an
acceptable option
• Change in accounting policy/principle: IFRS
method of determining cumulative effect of
change on prior years and adjusting asset value
adopted rather than US method of treating it as a
separate item in income statement
Condorsement
• 2008 U.S. business community not supportive of
move to IFRS adoption
– High cost to converge GAAP and IFRS
– High costs to educate and train
– Questions whether IFRS as good as/better than GAAP
• Condorsement is plan B
– 3 Convergence phases
– Final endorsement phase
• Without SEC making a definitive decision,
companies and investors remain in accounting
limbo
Audit, Corporate Governance and
Ethics Considerations
• Auditors charged with determining if IFRS has
been properly implemented
– Common set of auditing standards adds assurance of
meeting that goal
• ISAs similar to U.S. GAAS standards
• Two-tier versus unitary board of directors
• True and fair view versus present fairly
– True and fair view override
– IFRS adopts true and fair view while U.S. adopts
present fairly
IFRS for small and medium-sized
entities
• SMEs have no public accountability (IFRS definition)
and general purpose financial statements
• More than 95% of the companies in the world are
eligible to use IFRS for SMEs
• Reasons to adopt IFRS for SMEs:
– Improved access to capital
– Principles for recognizing & measuring assets, liabilities,
income, and expenses simplified
– Irrelevant topics omitted
– Number of required disclosures significantly reduced
• Standards separate from full IFRS so can be adopted
without adopting all of IFRS
Examples of Differences between IFRS
and IFRS for SMEs
• Property, plant & equipment: costs or
revaluation method for IFRS; costs only for
SMEs
• Goodwill: reviewed for impairment and not
capitalized for IFRS; amortized and tested for
impairment for SMEs
• R&D: research costs expensed as incurred;
development costs capitalized & amortized for
IFRS; all costs expensed for SMEs
Principles vs. Rule-Based Standards
• Rules-Based (U.S. GAAP)
– Provide a vehicle for circumventing the intention of the standard (“bright-line” rules)
• Ex: Accounting for leases
– Financial reporting can be seen as act of compliance rather than act of communication
• Principles-Based
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May present enforcement difficulties
Provide little guidance/structure for exercising professional judgment
Result can be significant loss of comparability among reporting entities
Increased likelihood of retrospective disagreements on accounting treatments
• May result in more litigation
• Objective-Oriented Standards (SEC)
– Explicitly charge management with responsibility for capturing within the company’s
financial reports economic substance of transactions and events
– Auditors responsible for reporting whether management has fulfilled that responsibility
– May require less use of judgment
– May better facilitate consistency and compliance with intent of the standards
Standards Characteristics
• SEC recommends more consistently developed
standards on principles-based or objectives-oriented
approaches with the following characteristics:
– Based on improved/consistently applied conceptual
framework
– Clearly state accounting objective of standard
– Sufficient detail and structure of standard for consistent
application
– Minimize exceptions
– Avoid use of percentage tests (bright-line)
• Ethical considerations play important role in ultimate
standard selected with principles-based approach
because of the greater need for judgment
Earnings Management Concerns
• Mergenthaler study
– Positive association between rules-based characteristics and cost of
managing earnings
– SEC study supports Mergenthaler’s contention
• Jeanjean and Stolowy examined effect of IFRS conversions and
found that, overall, earnings quality was not improved by adopting
IFRS
• Another study suggests managers utilize discretion in principlesbased standards to better convey information to investors
• Subjectivity in IFRS and use of management discretion for quality
reporting
• SEC’s proposed change to a more principles-based system may
expose firms to greater litigation risk
Examples of Rules-Based versus
Principles-Based Standards
• Accounting for Leases
– Principles-based• Emphasizing economic substance over legal form
• If substance of transaction is effectively to transfer
ownership to the lessee, then it’s capitalized
• Drawback: Could lead to a lack of comparability
– Rules-based• Form over substance
• If any 4 lease criteria are met, then must be capitalized
• Drawback: Relies on implementation guidance which can be
manipulated
• IAS applies principles-based accounting for leases
Examples Continued:
• Valuation and Recording of Property, Plant and
Equipment
– Principles-based
• Generic and considerably ambiguous
• Drawback: lack of precise guidelines could create
inconsistencies across organizations
» Fair value estimates
» Cost or revaluation method can be used
– Rules-based
• Bright-line guidelines
Examples Continued:
• Impairment of long-lived assets
– U.S. GAAP
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Recognition of loss: carrying amount > undiscounted cash flows
Measurement of loss: carrying amount less FV
No reversal of impairment
Depreciation: lower of carrying amount or FV
– IFRS
• Recognition of loss: carrying amount > recoverable amount
• Measurement of loss: carrying amount less recoverable amount
• Increases in recoverable amount recognized up to carrying amount
as adjustment for depreciation
• Depreciation: lower of carrying amount or recoverable amount as
adjustment for depreciation
Problem with provisions and reserves
• Provision relates to liability that doesn’t exist at the reporting date
(e.g., contingencies), whereas an allowance reflects the decline in
value of an existing asset
– (1) No legal reserves in the U.S.
– (2) Revaluation reserves relating to investments shown as cumulative
other comprehensive income if based on market adjustments for AFS
securities
– (3) Reserves caused by foreign currency translation are called
cumulative translation adjustments and they, too, appear in
comprehensive income
– (4) Profit and loss account reserves are reflected in retained earnings
(e.g., appropriations of retained earnings)
• Provision or reserve can be manipulated to manage earnings
• Secret/hidden reserves: net assets and equity will be understated
Global Business Ethics
• Dependent on strong internal controls, effective
corporate governance systems, and a guiding code of
ethics
• CIMA Code of Ethics
– Principles:
• Integrity: straightforward, honest, and truthful
• Objectivity: nothing overriding professional judgment
• Professional competence and due care: ongoing commitment to
professional knowledge and skill
• Confidentiality: don’t disclose professional info unless given
permission
• Professional behavior: comply with relevant laws and regulations;
avoid negative reputation
“Threats and Safeguards”
• Similar to AICPA Conceptual Framework for
Independence
• Threats:
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Self interest threat
Self review threat
Familiarity threat
Intimidation threat
Advocacy threat
• Possible threat? -- assess whether it is significant,
then take action
– Ex: whistleblowing or grievance procedures that exist
internally to deal with resolving possible threats
Handling Ethical Dilemmas: CIMA
• General guidance (similar to decision-making
model presented in chapter 2):
– CIMA key questions : (1) Would I feel
comfortable about my professional peers,
family and friends knowing about the
situation? and (2) How would I feel if I saw
this in a newspaper?
Global Code of Ethics
• IFAC established IESBA to issue high-quality ethical
standards in IFAC Code
• IFAC Code establishes ethical requirements for professional
accountants performing services in the global business
arena
– Member bodies may not apply less stringent standards than in
IFAC Code
– If national laws/regulations prohibit complying with IFAC
provisions, then follow national laws
– Provisions virtually identical to those embodied in the AICPA
Code
– Principles-based code
– Codes must inspire ethical behavior
Global Fraud
• 2012 Global Fraud Survey
– Billing fraud most common
– U.S. experienced greatest number of fraud cases; Latin
America and Caribbean had highest median loss
– 778 cases of occupational fraud in the U.S.
– Lack of internal controls was most common factor for fraud
• Antifraud controls: external audits of financial
statements, codes of conduct, and internal audits
• Global fraud levels and the cost of fraud have dipped
along with a rising tide of insider threats
• More companies are adopting risk mitigation and
compliance measures
Combating Global Business Fraud
• Efforts should include:
– Evaluate the legal and regulatory enforcement environment;
– Motivate management to understand, commit to, and support
anti-fraud and anti-corruption initiatives;
– Assess risks to the company’s business, brand and reputation;
– Maintain compliance in light of the scope and complexity of
global business operations;
– Obtain legal advice when responding to compliance issues or
threats;
– Work with the accountants and auditors to prevent and detect
fraud;
– Educate the workforce about the risks of wrongdoing; and
– Cultivate a company-wide culture of compliance.
• Top management should “walk the talk”
Global Bribery
• Corruption is part of some country’s culture so that fraud,
bribery, and kickbacks are a way of doing business
– “grease payments” (U.S.,) “baksheesh” (Middle East), “mordida”
(Latin America), or “ghoos” (India)
– Payment not intended to influence outcome, only timing
• one of the few exceptions from anti-bribery prohibitions of the U.S.
Foreign Corrupt Practices Act (FCPA)
• UK Bribery Act bans facilitating payments
– Act includes a new corporate criminal offense of failure to prevent bribery
– Over ½ of all corruption incidents identified from “tips” when
whistle-blowing hotline is available
– Preventing corruption is fundamentally a matter of corporate
culture
• Assess the way things really happen in the company
UK Bribery Act
• Principles for Adequate Procedures
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Risk assessment
Top level commitment.
Due diligence.
Policies and procedures
Effective implementation
Monitoring & Reporting
• No successful prosecution brought against a company by the
UK’s Serious Fraud Office (SFO) since the Act has been in place
• Potentially wide territorial reach
• SFO defined questionable business practices:
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Abnormal cash payments
Pressure exerted for payments made urgently or ahead of schedule
Payments being made through a third party country
Private meetings with public contractors
Lavish gifts
Agreeing to contracts not favorable to the organization
Unexplained preference for certain contractors
Suspected Illegal Acts
• IESBA issued exposure draft for how to respond to suspected illegal
acts
– Outlines situations where professional accountant would need to blow
the whistle
– Seeks to strike balance between confidentiality and public interest
– When disclosure should occur: suspected illegal act directly or
indirectly affects the employing organizations’ (or clients’) financial
reporting and suspected illegal act relates to subject matter of the
professional services being provided by the professional accountant
– Makes distinction between accountant and auditors responses
• Accountants held to slightly lower standard
– Initial response to draft has been critical
• AICPA says “safe harbor” should be included; made their own formal response
for suspected illegal acts
• Whistleblowing may conflict with ethics requirements contained in
some codes of ethics
Cultural, Legal, and Market Determinants
of Corporate Governance Systems
• Ethical issues exist because of: legal systems,
business practices, and cultural considerations
• Investor protection differs significantly across
countries; higher level of protection in common
law places
• Cultural aspects influence the way investors are
being protected
• Link between ownership concentration, private
benefits of control, corporate governance, and
the legal system is not undisputed
Corporate Governance Systems
• How organizations are run
– Proper corporate governance has accountability and
transparency
• Comply or explain principle: found in Cadbury Code
– Companies have option to follow best practice or explain why
they weren’t appropriate for them
– Formally recognized in EU directive in 2006
– Codes vary from country to country; all address issues such as
role, composition, and effectiveness of the board and its
committees, the remuneration of executive directors, risk
management and internal control, and communication with
shareholders
– 3 reasons this approach is more appropriate than traditional
Comply or Explain Principle
• 3 reasons this approach is more appropriate
than traditional:
• Leaves decisions about appropriateness of company’s
governance arrangements in hands of management
and shareholders
• Encourages companies to follow accepted best practice
but also recognizes that sometimes it may be
appropriate to achieve good governance other ways
• Enables codes to set more demanding standards
Corporate Governance in Germany
• Corporate governance fundamentals come from: provisions of the
German Stock Corporation Act, the German Codetermination Act,
and the German Corporate Governance Code
• Stock corporations have 3 corporate bodies
– Annual general meeting of shareholders, a board of management and
a supervisory board.
• Clear separation of duties between management and supervisory
functions; prohibits simultaneous membership on both boards
• Stakeholder capitalism
• Members of Board of Management like peers; share collective
responsibility for all management decisions
• Supervisory board oversees company’s board of management and
appoints its members
– Up to one-half of supervisory board members elected by the
company’s employees
Governance in Germany vs. US
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Germany-system has concentrated ownership and insider control
US- system relies on external participation
Germany- two-tier boards: Management and Supervisory Board
US – unitary system
Germany- Influential stakeholders on the Supervisory Board (includes
employee representation)
Germany- Management Board prepares financial statements
US- Management of the company prepares financial statements
Germany- Fiduciary duties emphasized
US-shareholder interests are emphasized
Germany-Comply-or-explain principle
US- CEO’s must certify compliance
Germany- “true and fair” view
US- “present fairly”
Corporate Governance in China
• State-owned enterprise (SOE) has been undergoing a process of
“corporatization”
– Includes better defined shareholder rights
– Increased efficiency and accountability
• 3 statutory corporate governing bodies:
– Shareholders
– Board of directors
– Board of supervisors
• 2 new statutory corporate positions:
– Chair of the board of directors
– CEO
• Increased disclosures of accounting fraud and corruption at Chinese
companies
– More detailed audits of state-owned enterprises in 2013
Corporate Governance in China
• Traditional model of state-owned and state-managed
enterprises became two-fold: state ownership of
property with management rights in SOEs separated
out
• Slow in company privatization
• Subordinate-superior relationship tends to be polarized
• SOE’s haven’t embraced capitalism
• China's SOEs serve two masters: the Communist Party
and private shareholders
– Party hold trump card because it appoints CEO’s
• Most significant issue: enforcement of the many
provisions that already exist in the law
Governance in China vs. US
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China- reporting practices focus on needs of major shareholders
US- focus on needs of investors
China- two-tier system of oversight
China- Chair must be independent
US-all members of audit committee must be independent
China- fiduciary duties for controlling shareholders
China- no required certification of financial statements
China- comply or explain gaps between existing corporate governance
practices and Corporate code
US- CEO’s must certify compliance with corporate governance
Growing crisis in China involving bad corporate governance
Deadlock between SEC and Chinese government
Main problems of Corporate
Governance in China
• High degree of state ownership of listed companies
resulting in oppression of
• minority shareholders
• Separation of ownership and management control not
clearly defined
• Interference by State in company management issues
• Majority of directors are “inside” or executive directors;
few independent directors lead to insider control
• Lack of transparency and information disclosure
• SOEs suffer from a lack of accountability
• Lax oversight by the China Securities Regulatory
Commission (the "CSRC”).
Corporate Governance in India
• Various committees issue variety of
recommended guidelines
• Kumar Mangalam Birla Committee- suggests
separate section on corporate governance
compliance in annual report
• Many similarities between India and US
Governance in India vs. US
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India- More diverse share of ownership
India- Require 33%-50% directors to be independent
US- A majority required to be independent
India- Independence of directors can be problematic because of influence
of family businesses and blockholder owners
India- Fiduciary duties of directors to act in best interest of company and
shareholders
India- Certification of annual accounts is recommended
India- Annual reports must carry status reports over compliance; external
auditors issue certificate of assessment of compliance
India- comply or explain noncompliance with mandatory requirements
India- Audit committees, min 3 directors, 2/3 independent
US- All independent
India- CEO and CFO of listed companies must (a) certify that the financial
statements are fair and (b) accept responsibility for internal controls
CLSA Corporate Governance Watch
2007 - 2012
• India’s corporate governance
– Score improved 3% from 2007 to 2012
– Ranking remained same
• China’s corporate governance
– Score declined 4% from 2007 to 2012
– Ranking down 2 places
– Low score in enforcement and corporate culture
Concluding Thoughts
• While ethical standards may vary, one truth does
not: Honesty, Integrity, and Trust are the basis for
sound business relationships
• Great examples of company’s ethical
responsibilities in international business:
Starbuck’s Standards of Business Conduct
– UK bribery act contains same language
• Wanting to be an ethical person and doing it are
separate issues
• “Good ethics is good business”