Aoccounting Standards

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The introduction of
International Accounting
Standards in Europe:
Implications for international
convergence
Katherine Schipper
Financial Accounting Standards Board

Published online: 12 Apr 2011.
To cite this article: Katherine Schipper (2005) The introduction of International

Accounting Standards in Europe: Implications for international convergence, European
Accounting Review, 14:1, 101-126, DOI: 10.1080/0963818042000338013
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European Accounting Review, Vol. 14, No. 1, 101 126, 2005
The Introduction of International

Accounting Standards in
Europe: Implications for
International Convergence
KATHERINE SCHIPPER
Financial Accounting Standards Board
ABSTRACT This paper describes several implementation effects associated with the
mandated adoption of international financial reporting standards promulgated by the International Accounting Standards Board in the European Union, including a possible
increased demand for detailed implementation guidance and for a single European securities regulator. The paper also discusses the mandated adoption as a research setting
for considering the relative influences of standards versus incentives as determinants of
financial reporting outcomes, and describes two standard setting challenges that may
become more pronounced as a result of the mandated adoption.
1.
Introduction
At a joint meeting in September 2002, the International Accounting Standards

Board (IASB) and the Financial Accounting Standards Board (FASB) agreed
to work together to develop high quality, fully compatible financial reporting
standards that could be used for domestic and cross-border reporting; this cooperative effort is sometimes described as international convergence of US generally accepted accounting principles (US GAAP) and IFRS financial reporting
standards.1 The IASB FASB convergence effort involves two kinds of projects.
The first type includes short-term projects that are intended to remove many of
the numerous individual differences between International Financial Reporting
Standards (IFRS, which include International Accounting Standards (IAS)
issued by the predecessor body to the IASB) and US GAAP. Examples of
Correspondence Address: Katherine Schipper, Financial Accounting Standards Board, 401 Merritt 7,
PO Box 5116, Norwalk, CT 06856-5116, USA. E-mail: kschipper@fasb.org
0963-8180 Print=1468-4497 Online=05=01010126 # 2005 European Accounting Association
DOI: 10.1080/0963818042000338013
Published by Routledge Journals, Taylor & Francis Group Ltd on behalf of the EAA.
102
K. Schipper
current and proposed short-term convergence efforts involve the accounting

treatments of nonmonetary exchanges, discontinued operations, income taxes
and interim reporting. The second type of convergence project involves longer
term joint IASB FASB projects and coordinated projects that are intended to
provide major pieces of improved accounting guidance. Examples of the latter
include the joint projects on revenue recognition and purchase method procedures and the coordinated project on share-based payments. The goal of the
IASB FASB convergence efforts is to make US GAAP and IFRS financial
reporting standards as nearly as possible the same across jurisdictions while
also improving the overall quality of those standards.
The convergence activities of the IASB and the FASB will of necessity be
directly and indirectly affected by regulatory changes and shifts in economic conditions throughout the world. The purpose of this paper is to identify some possible implications for international convergence of a particularly significant
regulatory change, namely, the mandated adoption of IFRS by listed enterprises
in the European Union beginning in 2005.2 This change will increase the
number of enterprises that apply IFRS to prepare their consolidated reports
from several hundred to several thousand, and will require the use of IFRS by
enterprises that vary considerably in size, ownership structure, capital structure,
political jurisdiction and financial reporting sophistication. The purpose of this
discussion paper is to explore several implications of this major shift in financial
reporting requirements for the overall international convergence of financial
reporting standards and practices.3
This discussion is organized into six sections. Section 2 discusses how two
kinds of implementation effects associated with the adoption of IFRS in
Europe could affect the FASBs and IASBs convergence activities. The
implementation effects stem from the significant increase in the number of
firms that will be applying IFRS and, perhaps more importantly, from the fact
that new IFRS users will likely be different, in terms of size, ownership structure,
capital structure and financial reporting sophistication, from current IFRS users.
Section 3 discusses the 2005 European adoption of IFRS as a research setting for
considering questions related to the relative importance of standards versus incentives in determining financial reporting outcomes. Sections 4 and 5 discuss two
pervasive, fundamental and difficult financial reporting issues that I believe
will become more pressing and (perhaps) even more difficult as convergence
efforts continue after 2005. Convergence to an improved set of reporting standards will in my view require resolution of those issues (and many other issues
not considered in this discussion). Section 6 offers some concluding comments.
2.
Implementation Effects Associated with the Mandated Adoption

of IFRS in Europe
I am not aware of an authoritative source that identifies the number of European

Union business enterprises that are currently preparing their financial reports
Introduction of International Accounting Standards in Europe
103
using IFRS, and that summarizes the characteristics of those enterprises that
might be related to the ease (or difficulty) of applying IFRS, such as size, jurisdiction, ownership and capital structure. However, that number, and the variation
in enterprise characteristics such as size, is sure to increase greatly in 2005.4 This
section discusses two possible implications of that increase and draws some inferences about potential effects on international convergence efforts. Specifically,
I consider the implications of two predictions: that the adoption of IFRS in the
European Union will create a substantially increased demand for implementation
guidance (Section 2.1) and that IFRS adoption will increase the demand for the
creation of a single European accounting enforcement body (Section 2.2).
2.1. The Demand for Implementation Guidance

In their current form, some IFRS are both shorter and less detailed than their US
GAAP counterparts. Some have pointed to this difference as desirable, characterizing US GAAP as overly detailed and rules-based and IFRS as preferable
because they are principles-based. Some commentators point to the substantial
amount of implementation guidance provided in US GAAP, both in appendices
to the standards themselves and in subsequent guidance such as consensuses of
the Emerging Issues Task Force (EITF), as a source of unnecessary complexity
and burdensome detail.
IFRS do not lack implementation guidance, either in the standards themselves
or in nonauthoritative implementation guides. For example, the recently issued
IFRS 2, Share-based Payment, contains 44 paragraphs of application guidance
(in Appendix B) and the nonauthoritative Guidance on Implementing IFRS 2,
Share-based Payment, contains 13 examples plus an example of disclosures. In
addition, to respond to requests for authoritative implementation guidance for
IFRS, the IASB created the International Financial Reporting Interpretations
Committee (IFRIC) which replaced the predecessor Standing Interpretations
Committee (SIC). The IFRIC is similar in structure to the EITF: both groups
are composed of volunteers (the EITF currently has 13 voting members and
the IASBs website currently lists 12 members of the IFRIC); their non-voting
chairs are IASB (in the case of the IFRIC) or FASB (in the case of the EITF)
staff members; they are charged with addressing, on a timely basis, implementation issues when undesirable or conflicting practices have developed; consensus
is reached if no more than three voting members present at the meeting object;
representatives of other groups (e.g. IOSCO and the European Commission at
the IFRIC and the SEC at the EITF) are permitted to observe and speak but
not to vote. The due process requirements of the IFRIC and the EITF are
similar in that promulgations of both are subject to ratification by the IASB
(for IFRIC Interpretations) and the FASB (for EITF Consensuses). However,
the IFRICs due process differs from that of the EITF, in that the IFRICs draft
Interpretations must be exposed for a comment period and redeliberated, while
the EITF is not required to expose a draft consensus for comment.5
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K. Schipper
My view is that the demand for detailed implementation guidance for applying
IFRS will increase dramatically after 2005. That is, as the number of enterprises
applying IFRS increases and those enterprises become more heterogeneous in
terms of jurisdiction, size, capital structure, ownership structure and degree of
accounting sophistication, the number of application questions will also increase.
On the one hand, if the IASB responds to that demand by providing additional
detailed implementation guidance, dealing with implementation questions will
absorb an increasing portion of the IASBs resources, leaving less time for
other activities, including convergence projects. On the other hand, if the
IASB declines to provide that guidance, I do not predict that the demand will
dissipate; rather, I predict that preparers and auditors applying IFRS in European
jurisdictions after 2005 will turn to other sources of guidance, including,
for example, EITF pronouncements or perhaps their own, jurisdictionspecific GAAP.
I believe there are at least three implications for international convergence of
an increased demand for implementation guidance for IFRS. First, if the IASB
declines to respond to demands for detailed implementation guidance, preparers
will look elsewhere. If they turn to the EITFs consensuses and other forms of
detailed guidance provided in US GAAP, the result will be a sort of convergence,
in the sense that IFRS users relying on EITF consensuses for answers to application questions will not create overt conflicts between IFRS and US GAAP
implementation guidance. However, that form of convergence is not the result
of cooperative behavior and joint decision making but rather the result of preparers and auditors seeking guidance from a credible, non-IASB source. Alternatively, if preparers turn to jurisdiction-specific GAAP (or jurisdiction-specific
practices) the result will be diminished comparability and diminished convergence. I believe that decisions about where to look for detailed implementation
guidance (in the absence of guidance from the IASB) will depend on, among
other things, the incentives faced by preparers and auditors and the characteristics
of jurisdiction-specific GAAP and practices for example, their level of detail.
Second, if the IASB responds to demands for additional guidance, I believe
that one implication is that coordination of the FASB and IASB in the development of standards will not be sufficient for international convergence; the
implementation activities of the IFRIC and the EITF will also have to be coordinated (and perhaps some of their activities merged) if true convergence is to be
maintained. That is, even if the IASB and the FASB are able to issue identical
standards, financial reports will not be comparable and financial reporting will
not be converged, if the implementation guidance for applying those standards
is not the same in all jurisdictions that use IFRS and US GAAP. Specifically,
if the EITF and the IFRIC go their separate ways, differences in reporting
will increase over time, thereby undercutting convergence efforts of the IASB
and FASB.
On the other hand, attempts to coordinate the efforts of the EITF and IFRIC
will also impose costs. Some of these costs (e.g. certain logistical costs and the
105
cost of developing convergence procedures) might be expected to decline with

experience. However, other coordination costs cannot, in my view, be expected
to decline with time. For example, coordination costs that derive from the due
process procedures of the two bodies will be ongoing. Both bodies must obtain
clearance from their respective boards; the IFRIC exposes its draft Interpretations
for comment and redeliberates the issues based on those comments while the
EITF (sometimes) does not. If the IFRIC were to change its conclusions based
on those redeliberations, the EITF would similarly have to reconsider its (probably tentative) consensus, in the interests of maintaining converged implementation guidance. Other ongoing costs involve the acquisition of jurisdictionspecific knowledge. That is, to the extent that analysis of the issues brought to
one implementation body requires jurisdiction-specific knowledge, the other
implementation body will have to take time to develop that knowledge. Therefore, another cost of coordination is the need for one of the bodies to become
educated on jurisdiction-specific issues that it considers only because they
have been brought to the attention of the other body.
Finally, an IASB decision to respond fully and completely to increased
demands for detailed implementation guidance, coupled with a formal link and
coordination between the EITF and the IFRIC, could have two effects on the
IASB itself and IFRS. First, as previously noted, time and effort devoted to
implementation activities will by definition reduce the amount of time and
effort that can be spent on short-term convergence projects and major joint
projects involving the IASB and national standard setters such as the FASB.
Second, the provision of answers to constituents detailed implementation
questions could well erode the extent to which IFRS will be viewed as principles-based, in the sense of eschewing details and explicit direction for applying
the standards. That, of course, could also be viewed as a form of convergence
with US GAAP but not, in the eyes of some, a desirable form.
In summary, one key convergence issue to be resolved between the FASB and
the IASB involves both the amount of implementation guidance to be provided
when US GAAP and IFRS have been converged at the standards level and the
mechanisms for providing that guidance. In terms of determining the appropriate
amount of implementation guidance, I predict that the IASB will face increasing
requests for authoritative answers to detailed implementation questions as the
number of IFRS users, and their heterogeneity, increases after 2005. Declining
to respond to those requests, perhaps on the grounds that IFRS are intended to
provide principles that require the application of professional judgment, has
the potential to lead to either noncomparability in IFRS reporting (as preparers
and auditors make potentially idiosyncratic judgments) or to the use of authoritative guidance from another financial reporting regime, such as US GAAP.
However, responding to those requests will of necessity take away from resources
that could otherwise be devoted to convergence efforts and, potentially, undercut
the basic premise that IFRS are to be principles-based. Finally, I believe that in
order to achieve and sustain true convergence between US GAAP and IFRS it
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K. Schipper
will be necessary to develop a converged mechanism for providing detailed

implementation guidance that supports converged standards. That is, I believe
convergence will be impaired to the extent that IFRS and US GAAP do not
provide comparable implementation guidance, even if the standards issued by
the IASB and the FASB are similar or even identical. However, coordinating
the efforts of the EITF and the IFRIC carries its own potentially significant costs.
2.2. Effects on Accounting Enforcement in the European Union

The quality of financial reporting is crucially dependent on vigorous enforcement
that is separate from the financial reporting standard setting function.6 Starting in
2005, the European Union will have a single financial reporting standard setter,
but securities regulation in Europe is at the present time jurisdiction-specific and
subject to considerable cross-jurisdictional variation. For example, a 2001 study
by the Federation des Experts Comptables Europeens (FEE) reports that at least
five different approaches to regulation of financial reporting exist in Europe,
including enforcement by stock exchanges, by a regulator of stock exchanges,
by a separate review panel (the only example provided being the UKs Financial
Reporting Review Panel), by a separate governmental body and, finally, no institutional oversight of financial reports (FEE, 2001, table 1 and related discussion).
There are efforts underway to increase the cross-jurisdictional consistency of
securities regulation and financial reporting enforcement in the European
Union but this is not the same as creating a single enforcement body. For
example, the Committee of European Securities Regulators (CESR) was created
to improve coordination, specifically, to provide a mechanism for European
regulators to discuss and compare experiences, with the goal of convergence
(or harmonization) in regulatory practices.7 Similarly, anticipating the mandated
adoption of IFRS in 2005, combined with the continuation of jurisdiction-specific
enforcement, FEE has proposed that a body described as the European Enforcement Coordination (EEC) mechanism be established to create a comparable
financial reporting enforcement environment for the application of IFRS (FEE,
2003). The EEC mechanism would not have the ability to override a financial
reporting enforcement decision taken by a national body. Rather it would work
to achieve some degree of similarity in sanctions across jurisdictions (by, for
example, inquiring about the reasons for specific enforcement decisions and
participating in enforcement decisions that involve cross-border listings or that
seem inconsistent across jurisdictions). The EEC body would also seek consultation and coordination from national bodies, and report to CESR on the
extent to which CESRs enforcement principles are being applied by individual
enforcement bodies.
Notwithstanding the apparent views of FEE and CESR that accounting enforcement will continue to be jurisdiction-specific after 2005, I predict that the
mandated use of IFRS will increase the demand for a single European Union
securities regulator with inspection and enforcement authority over financial
107
reporting, similar to the role and responsibilities of the Securities and Exchange
Commission in the USA. My prediction is based on the view that users of financial statements ostensibly prepared using IFRS will want significant assurances
that IFRS have been comprehensively and rigorously applied in ways that
produce comparable financial information, regardless of the reporting entitys
jurisdiction. Direct inspection of reports filed with a single European securities
regulator who can compel its registrants to provide detailed information to
support the judgments and estimates made in applying IFRS would provide a
key element of that assurance, and reliance on a single securities regulator
would reduce coordination costs.8 However, I do not wish to minimize the difficulties involved. Given widely varying legal environments and significant cultural differences among jurisdictions where IFRS will be used, developing a
single European securities regulator would require ceding important national
decision rights.9 That change carries its own costs, and has broad implications
for securities regulation beyond financial reporting.
I believe that the pace of international convergence in financial reporting standards will be affected by how IFRS implementations are viewed by investors
after 2005 and that financial reporting enforcement will play a significant role
in shaping those perceptions. Effective enforcement that increases the quality
and comparability of financial reports prepared using IFRS will in my view
hasten the convergence process, while a perception either of uneven enforcement
or of enforcement that is relatively lax overall will in my view impair the convergence process. To the extent that creating a single European securities regulator
with expansive inspection and enforcement powers is viewed by users of financial reports as an efficient means to achieve increases in reporting quality under
IFRS, I predict that such a regulator will be demanded. On the other hand, existing legal and cultural differences among European Union jurisdictions present
formidable obstacles to the creation of a single pan-European securities regulator.
3.
The 2005 European Union Implementation of IFRS as a Setting for

Studying the Relative Influences of Standards versus Incentives on
Financial Reporting Outcomes
A wealth of previous research10 on earnings management has documented that

financial reporting outcomes are determined partly by incentives and partly by
the requirements of accounting standards. The premise of much earnings management research is that accounting standards either require or permit enough
judgment on the part of preparers so that the reported numbers are materially
affected both by what is required by the standard and by the incentives of preparers to shape their judgments to achieve some desired financial reporting
outcome. The exact nature of the relation between incentives and standards in
determining the characteristics of reported numbers is, however, not well understood. I believe that the 2005 European Union implementation of IFRS will
108
K. Schipper
provide a useful research setting for probing this relation further. The rest of this
section provides the basis for this belief.
Several key research design issues confronting researchers who wish to
provide evidence on the relative influences of standards versus incentives in
determining the characteristics of reported numbers are explored by Holthausen
(2003) in his discussion of Ball et al. (2003). Ball et al. argue that the four East
Asian jurisdictions they study have high quality accounting standards but preparers in those jurisdictions face strong institutionally grounded incentives to
make implementation decisions that result in low quality reported numbers.
They interpret their results as indicating that incentives appear to dominate
accounting standards as a determinant of financial reporting in the jurisdictions
they study (Ball et al., 2003, p. 258).11
Holthausens discussion advocates research like that undertaken by Ball et al.,
stating, there is little doubt that determining the marginal effects of accounting
standards, incentives, ownership structure, institutional features of the capital
markets and enforcement on the quality of financial reporting is an interesting
and important issue (Holthausen, 2003, p. 273). Much of Holthausens discussion
considers the characteristics of Ball et al.s research setting and research design in
terms of the research questions implied by this statement. My comments adapt
Holthausens discussion to the setting provided by the 2005 European Union
implementation of IFRS. Specifically, I discuss several characteristics of a favorable research setting for investigations which attempt to separate the effects of standards from those of incentives, and compare those characteristics to the setting
offered by the 2005 European Union implementation of IFRS.
3.1. Standards of High Uniform Quality for All Observations in the Sample
In tests of the relative influence of standards versus incentives, it is necessary to
hold either the incentives or the standards constant and, to achieve maximum
power, the standards and the incentives should act in opposite directions. One
of Holthausens comments on Ball et al. is that the financial reporting standards
used in the four sample jurisdictions might be of uncertain quality overall, or
subject to changes in quality over the sample period, or subject to differences
in quality across the four jurisdictions. In the case of the European Union adoption of IFRS, however, the standards are of high quality (as evidenced by the
IASCs Improvements Project and IOSCOs endorsement); they will not shift
dramatically over time during 2005 2006, and they will be uniform among the
European Union countries.
3.2. Appropriate and Accurate Measures of Reporting Outcomes
Tests which focus on cross-jurisdictional differences in reporting outcomes such
as earnings quality or value relevance require outcome measures that have
construct validity and that can be measured with reasonable accuracy across
109
jurisdictions with differences in incentives or standards. Ball et al.s main results

rely on stock returns as the measure of economic income and test for the timeliness and conservatism of earnings in reflecting the information that is already in
returns (following Basus (1997) approach). Holthausen questions both the use of
timeliness and conservatism to define and measure reporting quality (that is, he
questions the construct validity of the measures) and the reliance on stock
returns to measure economic income (that is, he questions the accuracy of the
measures). With respect to the former, Holthausen questions whether conservatism in particular (i.e. asymmetrically earlier loss recognition) is in fact an indicator of reporting quality. With respect to the latter, Holthausen points to
evidence provided by Morck et al. (2000) of significant variation in some of
the properties of stock returns that matter for tests like those of Ball et al.
Holthausens comments suggest (at least) the following research design possibilities. For tests that use returns data, results in Morck et al. (2000) suggest that some
of the stock markets in the European Union (France, Germany, Portugal, the UK and
possibly Ireland) appear to have favorable characteristics, at least in terms of providing returns that can be reasonably assumed to capture economic income. In addition,
Morck et al.s results also suggest considerable variation among European Union
jurisdictions in these characteristics, so it may be possible to calibrate the ability
of returns to capture economic income across political jurisdictions.12
Second, recent research suggests that accounting-based indicators associated
by researchers and analysts with earnings quality have construct validity as indicators of reporting outcomes, in the sense that these accounting-based indicators
capture earnings attributes that matter to investors.13 Accounting-based indicators such as earnings persistence and accruals quality as defined by Dechow
and Dichev (2002) can be calculated without reference to stock returns. To the
extent these indicators can be readily calculated for European Union firms
using IFRS, it may be possible to reduce significantly the reliance on pricebased and returns-based tests for some analyses.
3.3. Sufficient Samples of Homogeneous Observations
Ideally, analyses of differences in reporting outcomes as a function of jurisdictionspecific differences in incentives or standards will avoid pooling observations
across jurisdictions where factors affecting reporting outcomes may differ. In
addition, unless standards and incentives are at least approximately stable over
time, it is not appropriate to combine firm-year observations from different
years. Ball et al.s sample contains 2,726 firm-year observations pooled across
1984 96 and four jurisdictions: Hong Kong, Malaysia, Singapore and Thailand.
Holthausen (2003, pp. 276 277) challenges the assumption of homogeneity
implied by pooling.
In terms of richness of data, the European Union offers 15 countries (joined by
10 more in May 2004), including wealthy countries with significant numbers of
listed firms and less-wealthy countries with relatively few listed firms. Morck
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K. Schipper
et al. (2000) provide data, as of 1995, on the number of listed firms in (among
other jurisdictions) many of the current European Union jurisdictions. The
number of listed firms ranges from considerable (1,628, 1,232 and 982 in the
UK, Germany and France, respectively) to modest (70, 100 and 104 in Ireland,
the Netherlands and Finland, respectively). However, Sweden, Belgium, Italy
and Greece all have between 200 and 300 listed firms. Thus, the European
Union offers hope of sufficient sample sizes of listed firms to avoid pooling of
firm observations across jurisdictions.14
3.4. Within a Single Financial Reporting Regime, Considerable Variation

in Incentives
Tests of the relative power of standards versus incentives can either hold standards constant and vary incentives, or hold incentives constant and vary standards. The European Union adoption of IFRS in 2005 offers some elements
of both research designs. As a research setting, the European Union also offers
considerable differences in financial reporting incentives. I discuss each of
these three elements in the remainder of this subsection.
3.4.1. Hold standards constant across jurisdictions where incentives vary
Ball et al. posit that incentives are the same (i.e. to make judgments that lead to
low quality reporting outcomes) in all four of their sample East Asian jurisdictions. A more powerful design, however, might be achieved if standards were
held constant and the direction and strength of incentives were allowed to
vary. I believe that the European Union in 2005 has the potential to offer just
such a setting. All jurisdictions will adopt the same standards but the institutional
arrangements giving rise to financial reporting incentives differ, in some cases
dramatically, across jurisdictions. For example, as previously discussed in
Section 2.2, financial reporting enforcement mechanisms differ considerably
across the European Union, and these differences are expected to continue past
2005. Also, research (discussed in Section 3.4.3) has documented significant
differences among European Union firms in key characteristics, such as ownership structure, that have been shown to be associated with reporting incentives.
3.4.2. Hold incentives constant and allow standards to vary
Settings with this characteristic require either free choice between (or among)
financial reporting regimes within a single political jurisdiction or a shift in financial reporting regimes within a political jurisdiction. Leuz (2003) analysis of
German New Market firms choice between international standards (IAS) and
US GAAP in 1999 and 2000 is an example of the former. The 2005 adoption
of IFRS provides the latter setting; that is, it may be possible to assume, for
some jurisdictions such as the UK and France, that reporting incentives are
stable over time. Then the adoption of IFRS allows for tests of incentives
111
interacting with two distinct standards regimes, the pre-2005 period when IFRS
were not permitted and the post-2005 period when IFRS will be required.
3.4.3. Evidence that ownership structure and other factors associated with
reporting incentives differ across European Union jurisdictions
Ownership structure. Previous research (e.g. Warfield et al., 1995; Fan and
Wong, 2002; Francis et al., 2005) predicts and finds that ownership structure
affects reporting outcomes. The available evidence on ownership structures
around the world indicates marked jurisdiction-specific differences in these structures. For the purposes of this discussion, key data are provided by La Porta et al.
(1999), who analyze the ultimate ownership of large and mid-size listed firms in
27 wealthy countries, including the USA and several European jurisdictions.
They identify four types of ultimate owners: families/individuals; publicly
held financial institutions such as banks; publicly held nonfinancial institutions;
states. They define ultimate owners as holding direct and indirect voting rights
that exceed 20%. Indirect voting rights can be achieved by cross-holdings of
shares and by pyramids (a pyramid is a chain of entities each of which has holdings in the next entity of the chain; if A owns 43% of B and B owns 25% of C then
A controls C by virtue of a pyramid).
La Porta et al.s results indicate that European Union firms offer significant
variation in ownership structures. For example, 50% of German sample firms
and 60% of French sample firms are widely held, as compared to 5% of Austrian
and Belgian firms, 35% of Spanish firms and 20% of Italian firms. In addition, the
following percentages of sample firms are state controlled: Germany, Spain and
France (20%), Belgium (30%), Italy (40%) and Austria (83%).15 In contrast,
La Porta et al. report that about 80% of US firms are widely held and none is
state controlled; variation in ownership structure is relatively small in the USA
compared to Europe.
As noted by La Porta et al., their focus on a small sample of the largest firms in
each jurisdiction is likely to produce results that do not represent each economy
as a whole because the likelihood of dispersed ownership should be greatest for
the largest firms. When they turn their attention to smaller firms (valuations near
$500 million), they find, as predicted, more concentrated ownership. In the USA,
these sample firms are 90% widely owned and 10% family controlled. However,
in France, Austria, Spain and Italy none of the smaller sample firms is widely
owned and in Germany and Belgium the percentages are 10% and 20% widely
owned, respectively. Again, the evidence supports the view that the European
Union provides significant variation in ownership structures, a characteristic
shown by previous research to be associated with financial reporting incentives.
Other factors. Direct evidence on jurisdiction-specific differences in reporting incentives and reporting outcomes is provided by Leuz et al. (2003).
Although their focus is on earnings management, several of their results have
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implications for research questions related to standards versus incentives as

determinants of reporting outcomes. For example, they document marked
jurisdiction-specific differences across the European Union firms in their
sample in firm size and capital intensity; the former measure has been found to
be associated with accruals quality by, for example, Dechow and Dichev
(2002) and the latter is likely to be associated with accruals quality as well, to
the extent it captures the same accounting fundamentals as plant, property and
equipment. Like La Porta et al., Leuz et al. also report jurisdiction-specific
differences in ownership concentration.
To summarize, the required adoption of IFRS by (most) European Union listed
firms in 2005 offers a rich research setting for tests of the relative importance of
standards versus incentives in determining financial reporting outcomes. A large
number of firms that vary considerably in factors previously shown to be associated with financial reporting outcomes will be subject to a single, high quality
financial reporting standards regime as of 2005, offering the possibility of both
over-time comparisons and cross-jurisdictional comparisons. Using the European
Union as a setting may allow researchers to overcome some design difficulties in
previous research which has examined the determinants of cross-jurisdictional
differences in reporting outcomes.
So far this discussion has considered several implications of the 2005 mandatory adoption of IFRS by listed enterprises in the European Union. The next two
sections describe two fundamental, pervasive and difficult standard setting issues
that I predict must be addressed and resolved if convergence between IFRS and
US GAAP is to succeed.
4.
Defining the Boundaries of the Reporting Entity, for Purposes

of Consolidation
Both IFRS and US GAAP define the boundaries of the reporting entity, in part, by
means of consolidation requirements.16 Those boundaries determine what assets
and liabilities are shown together on a single balance sheet (and, by implication
what results of activities are shown together on a single income statement). Completeness requires that all the assets and obligations that are under the stewardship
of a single management group and a single governing board be displayed together
so that users of financial statements can discern all the productive capacity
(assets) and obligations (liabilities) that will determine the returns generated by
the enterprises activities. In particular, the residual claimants (shareholders)
want to have complete information on all the assets under the stewardship of
the governing board they elect and all the obligations that will receive payments
ahead of them.
I believe that consolidation policy presents a significant challenge to convergence between IFRS and US GAAP, for two reasons. First, distinctive ownership
arrangements among European Union firms, relative to US firms, will in my view
place pressure on consolidation policy generally. Second, there is some evidence
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that the IASB intends to develop qualitative standards for consolidation policy,
while recent FASB guidance has been viewed by many as heavily quantitative.
I develop both of these views in the subsections below.
4.1. Distinctive Ownership Arrangements among European Union Firms

European Union firms, relative to US firms, are distinguished by the presence of
complex ownership structures that provide for indirect control. La Porta et al.
(1999) provide several illustrative charts (by their definition, control is achieved
at 20% voting power). For example, Figure 1 (figure 6 of their paper) describes
Allianz Holding, a large German firm.
This chart shows the major shareholders of Allianz, with the shareholdings
below each name (in italics). Allianzs major shareholders are Munchener
Ruckversicherung with 25%, Dresdner Bank, Deutsche Bank and Bayerische
Hypotheken und Wechsel Bank with 10% each, and the Fink family and
Bayerische Vereinsbank with 5% each. The chart also shows Allianzs holdings
in each of its major shareholders, and the cross-shareholding of Dresdner Bank
in Muncherner Ruckversicherung. Thus, Allianz also holds 25% of Munchener
Ruckversicherung, 22.5% of Dresdner Bank, 5% of Deutsche Bank and 22.6%
of Bayerische Hypotheken und Wechsel Bank; and Dresdner Bank owns 9.99%
of Munchener Ruckversicherung. One might conclude (applying the 20% ownership criterion of La Porta et al.) that Allianz controls its controlling shareholder
and controls two other firms that in turn hold significant stakes in Allianz.
This discussion is not intended to imply that Allianz is representative of the
ownership structures of German firms, or that such complex ownership structures
are not found elsewhere. Rather, the discussion is intended to illustrate two
points. The first is that some financial economists view control as existing at
far lower ownership thresholds than are implied by the conventional majorityownership criterion commonly associated with US GAAP and IFRS reporting
standards. The second is that discerning control based on a quantitative analysis
of ownership interests is complex whenever there are pyramids and crossholdings.
I believe these two points are of concern for international convergence activities after 2005 because of the distinctive ownership characteristics of European
Union firms, relative to, in particular, US firms and because of the quantitative
approach that has historically been taken in the USA to defining consolidation
policy. As reported by La Porta et al. (1999, table II), and applying a 20% indirect
Figure 1 Ownership of Allianz Holding. Taken from La Porta et al. (1999), Figure 6.
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ownership threshold to define control, about 80% of US firms in their large-firm

sample are widely held (no controlling shareholder) and the remaining 20% are
family (or individual) controlled.17 However, European firms exhibit very different ownership structures. Perhaps of most significance for consolidation policy,
about 20% of La Porta et al.s Spanish sample firms, about 30% of the Belgian
sample firms, about 15% of the German and Italian sample firms and about 5%
of the French sample firms are controlled by other firms. The percentages of
the smaller sample firms controlled by other listed firms are 50% in Spain,
10% in Belgium and Italy, 20% in France and 30% in Germany.
4.2. Qualitative versus Quantitative Approaches to Setting Standard for

Consolidation Policy
Both international financial reporting standards (International Accounting Standard
(IAS) 27, Consolidated Financial Statements and Accounting for Investments in
Subsidiaries) and US GAAP (Accounting Research Bulletin (ARB) 51, Consolidated Financial Statements, and SFAS 94, Consolidation of All Majority-owned
Subsidiaries), approach the task of defining the boundaries of the reporting
entity by requiring consolidation when one entity controls another. IAS 27, paragraph 6, defines control as the power to govern the financial and operating policies
of an enterprise so as to obtain benefits from its activities.18 ARB 51 and SFAS 94
do not define control explicitly and instead refer to a controlling financial interest
as the basis for consolidation. As a practical matter, under both international standards and US GAAP, the determination of whether one entity should consolidate
another is often made by a quantitative analysis of voting interests, as opposed to
the qualitative application of a definition of control, using professional judgment.
Specifically, holding more than half the voting interest is in many cases viewed as
both necessary and sufficient for consolidation.
However, it is also well known that a majority-voting-interest criterion for consolidation is not effective in all circumstances. Those circumstances include, but
are not limited to, the following: (1) latent control, which exists when a party
holds an instrument (such as an option to buy shares or a convertible instrument)
whose exercise or conversion provides that party with majority ownership; (2)
straw man control, which exists when the total voting power of an entity plus
its related parties is a majority of the votes; and (3) effective control, which
exists when a party has a significant minority of the total vote and no other organized group has a substantial ownership position (particularly when the minority
owned by a single party is a majority of the votes usually cast). Finally, some
entities, defined as variable interest entities in US GAAP, and characterized as
special purpose entities (SPEs) in international standards, are designed so an
analysis of equity ownership or voting interests is not effective in determining
whether one entity should consolidate another.19
In my view, the IASB and FASB have recently taken rather different
approaches to dealing with situations in which analysis of majority voting
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interest an inherently quantitative analysis is not effective in determining if

one entity should consolidate another. Specifically, the IASB appears to me to be
moving toward a standard that would require a qualitative analysis. In its project
on Consolidation (including SPEs), intended to supersede IAS 27 and SIC 12, the
IASBs tentative decisions would replace the indicators of IAS 27 with a definition of control that rests on three criteria:
the ability to set strategic direction and to direct operating and financing
policy and strategy (Power Criterion); the ability to access benefits
(Benefit Criterion); the ability to use such power so as to increase,
protect or maintain the amount of those benefits (the Link).20
The application of professional judgment to these control criteria would, at least
in principle, accommodate majority voting interest, latent control, straw man
control and effective control. Special accommodation would, however, have to
be made for entities (such as certain SPEs and variable interest entities) where,
by design, there is no ability to determine policy.
In contrast, attempts by the FASB to promulgate a standard on consolidation
policy that is based on applying a qualitative definition of control using professional judgment have not so far been successful. The FASB offered the following definition of control in a 1999 Exposure Draft, which was itself a revision of a
1995 Exposure Draft:
the ability of an entity to direct the policies and management that guide the
ongoing activities of another entity so as to increase its benefits and limit its
losses from that other entitys activities . . . [C]ontrol involves decisionmaking ability that is not shared with others.
(paragraph 6a of the 1999 Proposed Statement of Financial Accounting
Standards, Consolidated Financial Statements: Purpose and Policy)
That Exposure Draft received little support from the FASBs constituents and did
not result in a standard. The most recent US consolidation guidance, Interpretation 46R, requires both qualitative and quantitative assessments but is inherently
based on a numerical threshold which requires consolidation of a variable interest
entity based on the ownership of instruments that convey a majority of the variability of outcomes of the activities of the entity.
As IFRS are implemented in Europe, I predict that financial reporting issues
related to consolidation policy for entities that may be subject to indirect
control (as discussed in Section 4.1) and entities where the analysis of ownership
of equity instruments is not effective for determining whether one entity should
consolidate another will become increasingly important, and that standard setters
will face demands to enhance, significantly, the authoritative guidance for consolidation policy. That is, I predict that standard setters will have to define
the reporting entity more clearly than is currently the case to deal with IFRS
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implementations. The implications for convergence arise because the consolidation standards in US GAAP are largely quantitative, while the IASBs tentative
decisions in its consolidations project point toward a standard based on qualitative judgment, not on quantitative analysis.
The convergence challenge to the IASB and the FASB is to devise an approach
to consolidation policy that addresses several concerns. The first is the (likely)
presence of indirect effective control among many enterprises that will begin
applying IFRS in 2005 that is, control at less than majority ownership achieved
through pyramids and cross-holdings. Clearly, a standard that, like much of US
practice, is based on counting up direct ownership of voting interests will not
be effective in discerning indirect effective control. I believe these ownership
structures will place pressure on the IFRS consolidation standard. Those pressures might push the IASB toward a more qualitative standard than the existing
IAS 27, one that is similar in spirit to the 1999 FASB Exposure Draft. If so,
the IASB and FASB will have to consider how best to reconcile and converge
a qualitative approach with the prevailing US approach, which is relatively
more quantitative.
Second, an effective converged standard would also have to lay out consolidation criteria for entities where, by design, analysis of the voting (equity) interest is
not effective in determining if one entity should consolidate another. The FASBs
approach, in Interpretation 46R, is detailed, rigorous and, in some cases, heavily
quantitative. Such an approach is difficult to reconcile with the qualitative criteria
that are the result of the IASBs tentative decisions, as of March 2004. The
IASBs deliberations, however, have considered only entities where analysis of
voting control is effective for determining consolidation policy; they have yet
to reconsider the SIC 12 guidance.
Third, a converged standard should be effective in discerning control in situations when control is disguised and able to be applied consistently to achieve
comparability of results. Some believe that those criteria are inherently in conflict. That is, some believe that a qualitative standard that requires the use of
professional judgment to apply a qualitative definition of control to facts and
circumstances is the most likely to result in consolidation policies and practices
that achieve completeness when control is disguised. Others contend that a qualitative, judgment-based standard cannot result in comparable outcomes, thereby
defeating much of the purpose of having a consolidation standard.
5.
The Use of Fair Value as a Measurement Attribute
The required adoption of IFRS in the European Union in 2005 will result in many
more enterprises reporting fair value measures. In particular, the revised IAS 39,
Financial Instruments: Recognition and Measurement requires the use of a fair
value measurement attribute for many derivatives (including certain embedded
derivatives), all trading securities and available-for-sale securities, and several
other categories of financial instruments (paragraph 13 of IAS 39). The expanded
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use of fair value measurements that will occur in 2005 has led to well-publicized
concerns among, for example, some European banks. In this discussion, I consider two implications of the expanded use of fair values: the financial reporting
implication of possible shifts in behavior (for example, among banks) associated
with the application of IFRS; and the implication for convergence of concerns
about expanded use of fair value measurements.
5.1. Possible Changes in Behavior Because of the Expanded Use

of Fair Values
Knowledgeable observers, such as the European Central Bank, conjecture that
bank business decisions and risk management practices could be affected by
the required adoption of IFRS, because IAS 39s required use of fair values for
many financial instruments will both increase the volatility of reported results
and tie those results more closely to existing risk positions and external economic
conditions (European Central Bank, 2004). An example of the latter is required
remeasurement at fair value of trading securities and available-for-sale securities;
the fair value measure will tie reported results to changes in fair values (prices) of
those securities.
One way to reduce volatility of reported results is by hedging, for example, of
credit risk or interest rate risk. Increases in the demand for effective hedges will,
in my view, have implications for financial reporting and disclosure generally, in
part because of the substantial (and in some cases, increasing) concentration of
counterparty risks. As noted, for example, by Alan Greenspan, Chairman of
the US Federal Reserve, in the case of US dollar interest rate options and
credit default swaps, a single dealer accounts for approximately one-third of
the global market and a handful of dealers account for about two-thirds of the
market (Greenspan, 2003).
While the existing disclosure requirements allow users of financial reports to
discern the volume of derivatives activity, the challenge in the face of potential
increased demand for hedging instruments is to achieve increased transparency of
information about where the counterparty risk resides, and how that risk is shifting as the demand for hedging instruments grows. This will not be easy; annual
reports of large banks are already voluminous and densely packed with charts,
tables and figures that illustrate risk-related activities. The standard setting challenge is to arrive at mandated disclosures that provide knowledgeable users of
financial reports with a clear picture of the reporting enterprises risk exposures
and how those risk exposures (and concentrations) are shifting over time in
response to changes in hedging behavior.
5.2. Reliability of Reported Fair Value Measurements
I believe that a key element of international convergence of financial reporting
standards and their implementation is the use of fair value as a measurement
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attribute in a way that is comparable and consistent across IFRS and US GAAP.
Both recent IFRS (especially IAS 39) and US GAAP have increasingly required
fair value measurements, with the intent of enhancing the relevance of reported
numbers. A key issue for convergence is whether fair value measurements can be
accepted as having sufficient reliability.
I define reliability in terms of the FASBs conceptual framework, as a combination of verifiability and representational faithfulness. Verifiability refers to
consensus among various independent measurers and representational faithfulness refers to a close correspondence between the measurement and the item it
purports to measure. I think there is confusion and disagreement among accountants as how to apply these concepts to fair value measurements. I identify four
possible sources of confusion and disagreement by explaining four characteristics
of fair value measures.
First, in order to be representationally faithful, a fair value measurement does
not require the existence of a market. That is, although fair value definitions refer
to exchange transactions (sales of assets and settlements of obligations) this does
not mean that the items being valued must be exchanged in organized markets in
order for fair value measurements to capture the notion of an exchange. More
specifically, fair value definitions refer to a hypothetical current exchange
between willing parties and are intended to capture the notion of an amount
that would be acceptable to two informed and willing parties to an arms
length transaction. In order to represent an amount at which two willing parties
would view an exchange as fair to both, a fair value measure need not be
vouchable to an independent confirmatory source of the measure such as an
observed price.
Second, because it is based on the notion of a hypothetical current exchange, a
fair value measure takes account of currently available information about the dispersion of possible outcomes. That is, a fair value measurement is not intended to
capture the most-likely ultimate settlement amount, because that is not the
amount at which a current transaction between informed and willing parties
would occur. For example, suppose an arrangement has only two possible settlement outcomes: it will settle for 0 with probability 0.80 and for 100 with probability 0.20. The most likely outcome is clearly 0, but a current transaction
would take account of the dispersion of possible outcomes and would likely
occur at an amount that is close to 20.
Third, volatility in fair value measures does not mean the measures are unreliable. The initial fair value measurement of the arrangement described in the previous paragraph is approximately 20. The fair value will change, as it is revised in
light of new information as the settlement date approaches. Those revisions do
not make the fair value measurement unreliable, either in the sense of verifiability
or in the sense of representational faithfulness. That is, at each measurement date,
verifiability is assessed by the agreement among independent measurers, all using
the same information, and representational faithfulness is assessed by the extent
to which the measurement captures the amount at which willing and informed
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parties would currently transact. Changes in the fair value measurement do not
represent corrections of errors in initial measurement; rather, they represent
new measurements in light of new information. In this example, at the settlement
date, the arrangement would be settled for either 0 or 100 and a reliable fair value
measurement would approach the actual settlement amount as more information
about the outcome arrives.
Fourth, the fair value measure of a performance obligation, by definition, contains the profit that an entity will earn if it undertakes the performance itself.
The inclusion of this margin on performance does not make the fair value
measure an unfaithful (i.e. defective) representation of the performance obligation. On the contrary, its inclusion increases the representational faithfulness
of the measure. This characteristic can be illustrated with a warranty, a form of
performance obligation. Suppose an enterprise estimates that it can either hire
a reliable servicer of its warranties for products sold this period for 700, or
perform the warranty services itself for 650. The fair value measure of the warranty performance obligation is 700 and this amount contains the profit margin
(700 2 650 or 50) on performing warranty services. Measuring the warranty obligation at 650, the enterprises cost, causes current period income to reflect the 50
profit margin on performing warranty services, even though the performance
obligation still exists and the enterprise has not earned the margin. Measuring
the warranty obligation at 700 defers profit recognition until the obligation is
extinguished, presumably for 650.
5.3. Assessing the Reliability of Fair Value Measurements
For the purposes of this discussion, I distinguish between absolute and comparative reliability. The former captures the absolute verifiability and representational
faithfulness of a measure and the latter captures those characteristics of one
measure as benchmarked against those characteristics of another measure.
Given an appropriate reliability metric, it should be possible to compare the
reliability of inherently unlike financial estimates. Thus, for example, one
might ask what is the comparative reliability of the fair value measurement of
impaired assets relative to the reliability of estimated asset service lives.
I know of no objective empirical measure of either verifiability or representational faithfulness, so I do not suggest that an empirical analysis of reliability
can be done. However, it is instructive to consider a qualitative assessment of
relative and absolute reliability and to consider what problems arise in obtaining
reliable fair value measures. The reason for the latter is that understanding the
source of unreliability what causes reported numbers to be unreliable
shows the way to making changes that will increase reliability. In the remainder
of this section, I identify and discuss five causes of unreliable fair value measures.
One difficulty in developing reliable fair value measures is a lack of organized
and liquid markets for many assets and obligations. Although the USA contains
organized markets for many financial instruments and for many types of used
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physical assets, there are still far fewer reference markets than there are items to
be measured at fair value, and no markets at all for many intangible assets and
performance obligations (obtaining market prices for performance obligations
would essentially require organized markets for many kinds of services). I speculate that some European Union jurisdictions have fewer and less liquid markets
for financial instruments and physical assets than does the USA, thereby exacerbating this aspect of the fair value measurement problem for enterprises that will
apply IFRS beginning in 2005.
When prices of identical or similar items cannot be found, fair values are based
on measurement tools and models. In such situations, fair values can be unreliable because of intrinsic error in either the measurement tool or the input to
the tool. Fair value measurements may be derived from models that, by definition, contain simplifying assumptions that introduce measurement error and
that require inputs (such as income or cash flow forecasts) that are themselves
subject to measurement error. This contributor to unreliable fair value measures
can be addressed by developing better measurement tools and better means for
obtaining inputs to those tools. Researchers in economics, statistics, finance
and accounting can and do make contributions in this area.
Regardless of whether fair value measurements are based on external (to the
reporting entity) prices or on measurement methods and models, there is pressure
on information systems to capture the necessary price information or other data.
Therefore, one source of unreliable fair value measures is information systems
that do not capture the necessary data. It is possible, for example, that prices
of similar or even (nearly) identical items exist but that an enterprises information system is focused on internal (to the firm) data and not the necessary
external, market-based data. Similarly, it is possible that research has identified
the inputs to be used in a valuation approach, but some enterprises information
systems are not set up to capture those inputs. Financial reporting relies on many
measures which (in effect) use arithmetic to allocate firm-specific transaction
amounts,21 so existing information systems are set up to capture those transaction amounts. Developing fair value measures places new demands on information systems, because these measures require extensive use of data on
transactions outside the reporting entity transactions in which the reporting
entity does not participate. One of the costs associated with the increasing use
of fair value measurements is the cost of creating new information systems
that capture market data.
Two other potential sources of unreliable fair value measures are of direct
interest to accounting researchers and accounting educators. Those two sources
are intentional bias in inputs or judgements and lack of expertise. With regard
to the first, ample research on earnings management and fraudulent financial
reporting exists to demonstrate that management can, and sometimes does, purposefully introduce bias into reported measures. This source of measurement
error is associated with perverse incentives, weak internal controls, failed governance and oversight and other causes that are not directly under the control of
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accounting standard setters. However, to the extent that reported fair value
numbers are unreliable because of management-induced bias, the solution lies
with changing the elements of the reporting environment (such as perverse
reporting incentives and weak enforcement) that make it attractive and feasible
to introduce bias.
With regard to lack of expertise as a source of unreliable fair value measurements, I am not aware of research which documents the amount of inadvertent
noncompliance generally, and reporting of unreliable fair values in particular,
because of a lack of expertise among accountants.22 However, regardless of
its pervasiveness, this source of unreliability offers a challenge to accounting
education and accounting educators.
My experience with teaching financial reporting, coupled with continuing conversations with accounting educators and reviews of accounting textbooks and
other teaching materials, indicates that financial reporting is often taught as
complex calculations that allocate transaction amounts, and not as measurement
or valuation. For example, a textbook example or homework exercise provides
the transaction amounts paid by an enterprise and requires the student to apply
accounting reasoning and relevant accounting guidance to arrive at journal
entries that allocate the (given) transaction amounts. Fair value measurements,
however, require a different way of thinking and a different set of skills.
I believe it would be inappropriate for accounting education to cede fair value
measurement to valuation professionals and I do not believe that doing so
will necessarily enhance the reliability of fair value measurements in financial
reports. Rather, I believe that the accounting profession will benefit if accounting
education is shifted to provide students with skills and content knowledge that
will equip them to deal with fair value measurements as accounting professionals,
and that this approach has a better chance of improving the reliability of fair value
measurements in the long run.
6.
Conclusions
This discussion has laid out several implications of the 2005 mandated adoption
of IFRS by European Union firms for the international convergence efforts of the
IASB and the FASB. Some of these implications follow from the fact that, beginning in 2005, a large number of listed enterprises, exhibiting significant heterogeneity in size, capital structure, ownership structure and accounting
sophistication, will be applying international standards for the first time. I
predict, for example, that the demand for detailed application guidance will
increase substantially, as will the demand for uniform financial reporting enforcement throughout the European Union. A comprehensive response by the IASB
to the (predicted) increased demand for detailed guidance has the potential to
divert resources from major convergence efforts, thereby slowing the pace of
international convergence. In addition, if convergence in accounting practice is
to be substantive and sustained, the IASBs implementation efforts will also
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have to be coordinated with those of the FASB, with possibly significant incremental coordination costs. If the IASB declines to provide detailed implementation guidance for IFRS, I predict that preparers and auditors will turn
elsewhere, perhaps to US GAAP or perhaps to jurisdiction-specific European
GAAP, for that guidance. Similarly, a drive for comparable reporting will also
increase the demand for a single European enforcement body for financial
reporting. However, the development of such a body would have to overcome
significant existing legal and cultural differences among European Union jurisdictions, and would also have broad implications for securities regulation,
beyond financial reporting.
I also describe how the adoption of IFRS by European Union firms in 2005 provides a potentially rich research setting for examining questions related to the
determinants of financial reporting outcomes. For example, because significant
jurisdiction-specific differences in incentives facing preparers will continue to
exist, the adoption of IFRS offers the opportunity to revisit questions pertaining
to the relative importance of standards versus incentives in determining financial
reporting outcomes. Based on previous research, I identify, in particular, ownership structure as a key element in the incentives that affect financial reporting
choices; research in accounting and finance has shown considerable differences
in ownership structures among European Union jurisdictions.
Finally, I describe how the mandatory adoption of IFRS as of 2005 in Europe,
coupled with the IASBs commitment to international convergence with the
FASB, will place additional pressure on two fundamental and pervasive reporting
issues: defining the reporting entity for purposes of consolidation and developing
reliable fair value measures. With regard to the former, US consolidation standards and practice are based largely on quantitative analyses, while the IASBs
current (as of April 2004) project indicates a tentative preference for a qualitative
approach; convergence will require a reconciliation between these distinct and
potentially conflicting approaches to consolidation policy. With respect to the
latter, I conjecture that the adoption of IFRS (in particular, IAS 39s many fair
value measurement requirements) may shift the behavior of managers who
wish to reduce or avoid the volatility of reported results that tends to accompany
fair value measurements. For example, they may seek additional effective hedges
and, if so, this will have implications for financial reporting and disclosure generally. I also note that the increased use of fair value measurements in both IFRS
and US GAAP has implications for both research (because fair values require significant management estimates and judgments) and accounting education
(because fair value measurements require a different sort of expertise than that
often emphasized in traditional accounting education).
Acknowledgements
The views expressed in this paper are the authors own, and do not represent positions of the Financial Accounting Standards Board. Positions of the Financial
123
Accounting Standards Board are arrived at only after extensive due process and
deliberation. Jennifer Francis, Begona Giner and William Rees are thanked for
helpful comments.
Notes
This agreement can be found at the FASBs website (www.fasb.org). For convenience, this discussion refers to IASB and FASB activities to converge IFRS and US GAAP as international
convergence.
2
Member states of the European Union are permitted to decide whether the requirement will
apply to nonlisted enterprises and to provide an exemption, until 2007, for enterprises that
are listed in both the European Union and in another non-European Union jurisdiction (such
as the USA) and that are following another internationally recognized set of accounting standards (such as US GAAP). As a practical matter, therefore, the application of IFRS by
certain European enterprises that are listed in the USA and that report using US GAAP will
be delayed.
3
This discussion is not intended to provide an exhaustive enumeration of the financial
reporting implications of the 2005 European IFRS adoption; my focus is necessarily selective. In addition, I do not touch on the numerous auditing implications of the 2005
adoption.
4
At various times in the past, the International Accounting Standards Committee (IASC), predecessor to the IASB, listed on its website companies referring to their use of IAS. As of early
1998, for example, over 400 companies were listed; of these approximately 182 could be identified as European. At the current time, IASplus, a website maintained by Deloitte, provides a list
that summarizes, by country, the use of IFRS for reporting by domestic listed companies in their
consolidated reports (www.iasplus.com/country). This list indicates whether IFRS is permitted, not permitted or required for domestic listed companies. For example, the list shows
that IFRS are currently permitted for Belgian or German listed companies but will be required
in 2005, and that IFRS are not currently permitted for French, UK or Irish listed companies but
will be required in 2005.
5
Additional details about the due process procedures and rules of the FASB and EITF can be
found at the FASBs website (www.fasb.org); additional details about the due process
procedures and rules of the IASB and the IFRIC can be found at the IASBs website
(www.iasb.org.uk).
6
The importance of maintaining a distinction between standard setting and enforcement has been
emphasized by, for example, the Financial Accounting Standards Committee of the American
Accounting Association (1999, p. 451) and the Federation des Experts Comptables Europeens
(2003). Neither the FASB nor the IASB has any enforcement powers.
7
CESR Standard No 1, Financial Information Enforcement of Standards of Financial Information, lays out certain governing principles, and clarifies that the intent is convergence or
harmonization of practices, not the creation of a pan-European securities regulator. Within
Standard No. 1, Principle 20, Coordination in Enforcement, states that in order to promote
harmonization of enforcement practices, both ex ante and ex post coordination of enforcement
decisions on the application of IFRS will take place. The explanatory material to the Principle
clarifies that Decisions of national enforcers reflect the judgment of the enforcer on the
compliance of the financial information with the reporting framework. Exchange of information
among enforcers prior to the decision . . . is limited by technical feasibility, time and confidentiality constraints. The entire Standard is available at the website of the Committee of
European Securities Regulators (www.cesr-eu.org).
8
Another key element of that assurance, not considered in this discussion, is high quality audits
performed using a common set of auditing standards.
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K. Schipper
In terms of legal differences, research has documented substantial differences in legal

approaches to investor and creditor protection across jurisdictions, including several European
Union jurisdictions; see, for example, La Porta et al. (1998). In terms of cultural differences,
Licht (2003) draws on psychology research dealing with cultural orientations and cognitive
styles to describe difficulties in adopting corporate governance approaches imported from
other jurisdictions.
10
Because this discussion paper is not intended to be a review of the literature, I reference specific
published and unpublished papers only as illustrative examples. I make no attempt to be
inclusive of all papers on a given topic or to summarize the findings of the papers used as
examples.
11
Ball et al. draw three inferences that are likely to be of interest to those who examine the costs
and benefits of the 2005 European Union implementation of IFRS. First, jurisdiction-specific
characterizations of accounting should include both the formal standards and the institutional
influences on preparers decisions. Second, attempts to increase financial reporting quality
will reap greater improvements from changing incentives than from mandating (presumably
higher quality) accounting rules. Third, jurisdiction-specific patterns of incentives limit the
extent to which comparability can be achieved by imposing a common set of accounting
standards.
12
Morck et al.s analyses are based on 1995 data from Datastream. They use stock return synchronicity (the extent to which stock prices move up or down together) as an inverse indicator of the
extent to which firm-specific information is capitalized into stock prices. Absent the capitalization of firm-specific information, stock returns will not capture economic income. Given the
substantial economic and regulatory changes in the world since 1995, it is possible that an
updated study would reach different conclusions.
13
See, for example, Schipper and Vincents (2003) discussion of alternative approaches to defining and measuring earnings quality and Francis et al. (2004) for evidence that both earnings persistence and measures of accruals quality developed by Dechow and Dichev (2002) capture
aspects of earnings quality that are rationally priced by investors.
14
More recent data (as of 2002) on the number of listed firms on exchanges belonging to the
World Federation of Exchanges (WFE) are available in the WFE Annual Statistical Report
2002. These data indicate that the number of listed firms is, in general, increasing on many
exchanges. The report is available at: http://www.world-exchanges.org/WFE/home
15
The financial reporting incentives associated with concentrated ownership should vary depending on the nature of the ultimate owner. As noted by La Porta et al. (1999, p. 476), State control
. . . is a form of concentrated ownership in which the State uses firms to pursue political objectives, while the public pays for the losses. In contrast, family/individual control or control by
another business enterprise would not offer this incentive or opportunity.
16
Another element of that definition, not considered in this discussion, derives from criteria for
asset derecognition and liability extinguishment when should an asset or liability be
removed from a reporting entitys balance sheet?
17
For example, Bill Gates is identified as the controlling shareholder of Microsoft with (at the time
of the study) just under 24% ownership.
18
More specifically, IAS 27, paragraph 12 states that control exists when one entity has a majority
of voting power, the ability to appoint or remove a majority of the governing board, the power to
cast the majority of votes at meetings of the governing board, or the power to govern the financial and operating policies of the enterprise under a statute or agreement.
19
The accounting for such entities under US GAAP is governed by FASB Interpretation 46R,
Consolidation of Variable Interest Entities, An Interpretation of ARB No. 51, revised December
2003. The IASBs guidance is found in Interpretation 12 of the Standing Interpretations
Committee (SIC), Consolidation Special Purpose Entities.
20
This information is taken from the IASBs project summary, revised as of 1 March 2004;
available at: www.iasb.org.uk
125
21
For example, depreciation allocates the transaction amount associated with acquisition of a
fixed asset to accounting periods during the assets service life.
22
An independent investigation of alleged faulty accounting at The Federal Home Loan Mortgage
Corporation (Freddie Mac) in the USA concluded that the alleged accounting errors resulted in
part from a lack of accounting expertise among the firms accountants. The investigation concluded
that the alleged accounting errors often result[ed] from judgments and decisions by employees
who lacked the expertise to appreciate the significance, gravity of, or rigor required by, the accounting decisions they were making (Baker Botts LLP, report dated 22 July 2003, p. 5).
References
American Accounting Association (1999) Financial Accounting Standards Committee response
to IASC discussion paper, Shaping IASC for the Future, Accounting Horizons, 13,
pp. 443452.
Baker Botts LLP (2003) Report to the Board of Directors of The Federal Home Loan Mortgage
Corporation: Internal Investigation of Certain Accounting Matters December 10, 2002July
21, 2003.
Ball, R., Robin, A. and Wu, J. (2003) Incentives versus standards: properties of accounting income in
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Basu, S. (1997) The conservatism principle and the asymmetric timeliness of earnings, Journal of
Accounting and Economics, 24, pp. 337.
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fee_publication
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The Accounting Review, 78, pp. 967 1010.
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Illinois. Available at: www.federalreserve.gov/boarddocs/speeches/2003
Holthausen, R. (2003) Testing the relative power of accounting standards versus incentives and other
institutional features to influence the outcome of financial reporting in an international setting,
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Political Economy, 106, pp. 11131155.
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European Accounting Review

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To cite this article: Katherine Schipper (2005) The introduction of International

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licensing, systematic supply, or distribution in any form to anyone is expressly

European Accounting Review, Vol. 14, No. 1, 101 126, 2005

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The Introduction of International

At a joint meeting in September 2002, the International Accounting Standards

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current and proposed short-term convergence efforts involve the accounting

Implementation Effects Associated with the Mandated Adoption

I am not aware of an authoritative source that identifies the number of European

Introduction of International Accounting Standards in Europe

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2.1. The Demand for Implementation Guidance

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Introduction of International Accounting Standards in Europe

cost of developing convergence procedures) might be expected to decline with

will be necessary to develop a converged mechanism for providing detailed

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2.2. Effects on Accounting Enforcement in the European Union

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Introduction of International Accounting Standards in Europe

The 2005 European Union Implementation of IFRS as a Setting for

A wealth of previous research10 on earnings management has documented that

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Introduction of International Accounting Standards in Europe

jurisdictions with differences in incentives or standards. Ball et al.s main results

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3.4. Within a Single Financial Reporting Regime, Considerable Variation

Introduction of International Accounting Standards in Europe

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implications for research questions related to standards versus incentives as

Defining the Boundaries of the Reporting Entity, for Purposes

Introduction of International Accounting Standards in Europe

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4.1. Distinctive Ownership Arrangements among European Union Firms

ownership threshold to define control, about 80% of US firms in their large-firm

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4.2. Qualitative versus Quantitative Approaches to Setting Standard for

Introduction of International Accounting Standards in Europe

interest an inherently quantitative analysis is not effective in determining if

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The Use of Fair Value as a Measurement Attribute

Introduction of International Accounting Standards in Europe

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5.1. Possible Changes in Behavior Because of the Expanded Use

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Introduction of International Accounting Standards in Europe

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Introduction of International Accounting Standards in Europe

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Introduction of International Accounting Standards in Europe

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