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The adoption of International Accounting Standards in the European UnionGeoffrey Whittington aa International Accounting Standards Board, London, UK

Online Publication Date: 01 January 2005

To cite this Article Whittington, Geoffrey(2005)'The adoption of International Accounting Standards in the European Union',EuropeanAccounting Review,14:1,127 153To link to this Article: DOI: 10.1080/0963818042000338022URL: http://dx.doi.org/10.1080/0963818042000338022

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The Adoption of InternationalAccounting Standards in theEuropean Union

GEOFFREY WHITTINGTON1

International Accounting Standards Board, London, UK

ABSTRACT This paper discusses the IASBs process of developing accounting standardsfor adoption by listed companies within the European Union. Issues addressed include thestructure of the IASB, its role as a global standard setter and its programme. Particularattention is given to two topics that are both controversial and important, accounting forfinancial instruments and reporting financial performance.

1. History and Background

In 2000, as part of its Financial Services Action Plan, the European Commission

announced its intention to require International Accounting Standards for use in

the group accounts of all companies listed on stock exchanges within the

European Union (EU) from January 2005. This proposal was formally approved

in July 2003. Member states were given discretion to apply this requirement to

a wider group of companies and their accounts. This Regulation not only

applies to full members of the EU but also to members of the European Economic

Area (such as Norway). This gave further impetus to the adoption of International

Accounting Standards within Europe. These standards had already been adopted

by many large internationally listed companies in countries such as Germany2

and Switzerland, which permitted international standards as an alternative to

local standards, and several of the transition economies of Eastern Europe,

which did not have established local standards, were either adopting or permitting

the use of international standards. Notably, Russia intends to require the use of

international accounting standards by its listed companies from 1 January 2004.

European Accounting Review, Vol. 14, No. 1, 127153, 2005

Correspondence Address: Geoffrey Whittington, International Accounting Standards Board, 1st

Floor, 3D Cannon Street, London EC4M 6XH, UK. E-mail: gwhittington@iasb.org.uk

0963-8180 Print=1468-4497 Online=05=01012727# 2005 European Accounting AssociationDOI: 10.1080/0963818042000338022Published by Routledge Journals, Taylor & Francis Group Ltd on behalf of the EAA.

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The adoption of International Accounting Standards by the EU was,

however, only one further step in a long process of developing international

standards. Earlier in 2000, IOSCO, the international organisation of securities

regulators, had recommended that its members allow multinational issuers to

use International Accounting Standards Committee (IASC) standards in cross-

border offerings and listings. This was the culmination of many years of work

by the International Accounting Standards Committee (IASC), from its foun-

dation in 1973, and particularly in the period of its programme to achieve a com-

plete set of core standards (1995 onwards) which was specifically directed

towards achieving the IOSCO approval. As a result of this approval, International

Accounting Standards are now fully accepted for overseas registrants by most of

the worlds stock exchanges, the notable exception being those of the USA where

the Securities and Exchange Commission (SEC) allows overseas registrants to

present accounts prepared on international standards but requires that the

results be reconciled to those that would be reported under US generally accepted

accounting principles (US GAAP).

In addition to the use of International Financial Reporting Standards (IFRS) by

listed companies, many countries adopt international standards for unlisted com-

panies or model their domestic standards on international standards. This practice

is becoming more widespread. For example, the Australian government has

decided to adopt international standards for the statutory accounts of all domestic

companies from 2005 onwards, and New Zealand has indicated that it will

follow, in 2007. A recent survey (Street, 2003) of 59 countries shows that 56

have either adopted, intend to converge with, or intend to adopt IFRS.3 A

wider survey, by Deloitte and Touche (2003) suggests that more than 90 countries

will either require or permit IFRS for listed companies by 2005.4

2. The Demand for International Accounting Standards

A notable feature of the development of IFRS is that they are the product of one

independent, private-sector body, and have arisen in response to demand, from

capital markets not as a result of specific political initiatives by governments.

It has only been in the more recent stages that governments have offered

active support (e.g. in the EU and Australia) and even then, this has arguably

been because international standards had already become important in practice,

so that governments were forced to take a position in relation to them. In the

early stages of the development of international standards, the IASC was

formed by a group of professional accountants and sponsored mainly by their

professional bodies.

The motivation for the creation of the IASC was the need for a common inter-

national language of accounting to serve capital markets which had become

increasingly international, a trend which has continued since. A common set of

accounting standards increases the comparability of companies based in different

countries but traded in the same market. An additional benefit for trans-national

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companies and their auditors is that the preparation of group accounts, consoli-

dating the accounts of companies based in different countries is made easier

and more informative. Finally, there was a benefit to those countries that did

not have an established set of national accounting standards. The adoption of

international standards in such countries provided a ready-made set of standards

which would meet the needs of domestic companies (or at least the larger ones)

and have credibility in international capital markets.

The evidence of this demand is the growth and success of the IASC between

1973 and 2000, after which it was replaced by the International Accounting

Standards Board (IASB). This provides an interesting example for those who

argue that accounting standards should be left to competition in the marketplace

(e.g. Watts and Zimmerman, 1986). The IASC, as a response to demand, was a

product of the marketplace, and, because of this, the IASC had no powers of its

own to enforce adoption of its standards. It therefore had to rely on persuading

individual companies (in those jurisdictions that allow choice) or national regu-

lators that it provided a superior solution to the alternatives that were available

(such as national GAAP).

The adoption of international standards by the EU is a good example of the

nature of the demand. There was no existing single set of accounting standards

within the EU: rather there was a variety of national standards of varying

degrees of completeness, sophistication and authority, reflecting different

national traditions and institutional arrangements. There are currently 15

countries in the EU, 3 in the Economic Area, and 10 more countries scheduled

to join in 2004, a total of 28 countries, so that, without common accounting stan-

dards, there could be 28 different national methods of accounting, in addition to

the use of IFRS and of US GAAP which is permitted by some EU countries. In

order to achieve a single market within the European Community and Economic

Area, there was an obvious need for a shared set of accounting standards to

provide comparable information to the capital market. One possibility would

have been to adopt an established set of national standards, the most likely

candidate being US GAAP. However, this would have tied accounting in the

EU to standards designed to meet the needs of a particular economy: in the

case of US GAAP an economy that was not even a member of the EU. In

these circumstances, the European Commission was faced with a choice either

of creating its own accounting standards, through a new European Accounting

Standards Committee, or of adopting international standards. The latter offered

two obvious advantages. First, a complete set of international standards was

already available, whereas a new set of European standards would have taken sig-

nificant time and effort to develop. Second, international standards had estab-

lished international credibility, confirmed by the IOSCO endorsement, and

would thus provide EU adopters immediate access to international capital

markets. Of course, bodies such as the European Commission are reluctant to

delegate authority completely to independent organisations over which they

have no direct control, so the Commissions acceptance of international standards

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was subject to an approval process, on a standard-by-standard basis, and this

process is currently being tested by the adoption of the first set of standards,

including the controversial standards on financial instruments, IAS 32 and

IAS 39.

3. The New IASB Structure

The IOSCO endorsement of the IASCs standards, in 2000, not only marked the

culmination of nearly three decades of work by the IASC but it also indicated a

significant change in future expectations of international standards. The Board of

the IASC therefore decided to re-constitute it as a smaller committee (the IASB)

with mostly full-time members and with a much larger technical staff.

The new framework is described by Figure 1. The model is based, in some

important respects, on that of the USAs Financial Accounting Standards

Board (FASB). A governing body, the Board of Trustees, raises the funds from

a wide variety of sources (including corporates, audit firms and market regula-

tors) and appoints the members of the standard-setting body (IASB), the Advi-

sory Council (SAC) and the Interpretations Committee (IFRIC). It also

monitors the IASBs compliance with its constitution. The IASB sets the stan-

dards independently, but within the broad objectives laid down in its constitution,

and according to a due process of exposure and consultation.

The 14 members are (with two exceptions) full-time and are selected for their

skills and knowledge, not as representatives of any group or constituency. Board

members (other than the two part-time members) are required to resign from their

previous employment, with no commitment to re-employment when their term

on the Board has ended, thus ensuring their independence from their former

employers. The Trustees, in making appointments, are required by the

Figure 1. The new IASB structure. Note: The thick lines represent the Trustees power ofappointment. The thinner lines represent flows of advice, feedback and information.

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constitution to ensure that the membership of the Board has a broad geographical

spread and maintains a balance between former auditors, preparers and users of

accounts. Decisions of the Board are made by a simple majority of eight of the 14

members, in order to avoid the possibility of a blocking minority being able to

force untidy compromises. The composition of the Board is designed to

achieve independent, rational decisions based on an evaluation of the issues,

arguments and facts which emerge from the due process of consultation and

exposure and guided by the Boards conceptual framework.

The IASB is assisted by regular (at present, every four months) meetings with

its Advisory Council (the SAC, whose members also are appointed by the Trus-

tees), which has approximately 50 members from a wide range of nationalities

and backgrounds. The IASB must consult the SAC before adding an item to its

agenda, and the SAC also offers comment on the ongoing work of the IASB.

The IASB also holds regular meetings with the liaison group of national stan-

dards setters, to discuss its programme and, particularly, current and prospective

joint projects. An annual meeting has also been instituted with all national stan-

dard setters, in order to widen the IASBs worldwide contacts and avoid the

possibility that the other standard setters would be discouraged from participating

in the IASBs due process by the apparently privileged position of the liaison

group. The IASB has also instituted a series of regional and national meetings

and visits by Board members and staff, in order to develop contacts with the

wider international community.

The liaison group of national standard setters is listed in Table 1. These are

all from countries that have had a long-standing involvement in the work of

IASC and have well-established standard-setting bodies. Five of these countries

(Australia, Canada, New Zealand, the UK and the USA) were members of the

former G4 1 group of standard setters (disbanded in January 2001), whichformed a technically active sub-set of the membership of the former IASC

(and included the IASC itself). The G4 1 issued a number of important jointposition papers on emerging problems in financial reporting. The liaison relation-

ship is a means of maintaining the active participation of this group in the IASBs

work. The other three special liaison relationships (France, Germany and Japan)

are with standard setters in major economies that are committed to the

international convergence of accounting standards. A liaison member of the

IASB is assigned to maintaining communication and coordination between

Table 1. Composition of the IASB

IASB membersChairman 11 full time and 2 part timeLiaison withFrance USA JapanGermany Canada Australia and New ZealandUK

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the IASB and the respective liaison standard setter. It is intended that the liaison

standard setters will work jointly with the IASB on specific projects, and several

such projects have been established.

In addition to the process of setting standards, the IASB issues interpretations,

developed by the International Financial Accounting Interpretation Committee

(IFRIC). IFRIC members are appointed by the Trustees and its interpretations

are approved by the IASB. These interpretations are intended to fill important

gaps in current accounting standards, not to provide detailed application guidance

which could be obtained by thorough consideration of the existing standards and

the conceptual framework.

This system is intended to enable the IASB to produce a set of high quality

accounting standards (to be known in the future as International Financial

Reporting Standards, IFRSs) suitable for use by international capital markets,

and serving as a model for convergence between different systems of national

standards. In order to achieve this, the IASB will need to persuade those with

regulatory and enforcement powers to approve the use of international standards:

the IASB has no direct powers of its own. The IOSCO endorsement was an

important step in this respect, but IOSCO merely recommends international stan-

dards to its members; it does not require that they be adopted. The US SEC is a

leading member of IOSCO and its requirement that the use of international stan-

dards on US markets should be accompanied by a reconciliation to US GAAP is a

major obstacle to the progress of the IASB. For this reason, the current conver-

gence programme with the FASB, which is intended to reduce the number of

items requiring reconciliation, is extremely important. However, the USA is

not the only geographical area in which the IASB may face obstacles. All

countries, or regulators, in adopting international accounting standards, are

likely to retain some veto or option to avoid applying aspects of IFRSs that

they find to be inappropriate. If such powers are exercised widely, they could jeo-

pardise the possibility of achieving true international comparability. A test case

in this respect may be the European Commissions forthcoming decisions on the

approval of IAS 32 and 39 on financial instruments. At present, the Commission

has approved all of the other standards inherited by the IASB from its predecessor

body, but these two have encountered strong opposition in Europe, particularly

from the banks, and their approval has been deferred, pending the issue of the

final amendments to IAS 32 and 39 in March 2004.5

4. Objectives of the IASBs Programme

The IASB has three broad objectives underlying its work: improvement, conver-

gence and leadership. All three objectives are involved in every aspect of the pro-

gramme, but the balance varies. By improvement the IASB means specifically

the improvement of existing standards, which are those which it inherited from

the IASC and formally adopted at its first meeting in April 2001. The IASB

also inherited an obligation to IOSCO to consider a detailed list of possible

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improvements that IOSCO had identified as part of its endorsement review. This

list was circulated to national standard setters, for comment and additional sug-

gestions, and the IASB considered these proposals and exposed its provisional

conclusions for comment. It made final revisions to the relevant standards in

December 2003, to enable them to be used by EU companies that are adopting

IFRS in 2005, thus completing the first stage of the improvements programme.

However, improvement will continue to be an important element in the

IASBs future programme, not least in relation to IAS 39.

Convergence means reducing international differences in accounting stan-

dards by selecting the best practice currently available, or, if none is available,

by developing new standards in partnership with national standard setters. The

convergence process applies to all national regimes and is intended to lead to

the adoption of the best practice currently available. There is no assumption

that the best solution is that of a particular regime, such as IASB standards or

US GAAP. For example, the current proposal for a convergence project on

accounting for pension costs will consider adopting the UKs FRS 17 approach

of reporting actuarial gains and losses immediately, rather than smoothing

them through the corridor approach which is currently used by both the

IASB and FASB standards. Equally, IASB projects are often conducted jointly

with individual national standard setters or groups of national standard setters,

and are discussed at regular meetings with standard setters. This ensures that

different national approaches are given proper consideration. Nevertheless, the

USA is the worlds largest economy and, in the FASB, has the worlds most pro-

lific and well-resourced national standard setter. It is therefore not surprising that

a significant degree of convergence involves the USA and this is, of course,

particularly in the interests of those EU companies that are listed in the USA

and whose reconciliations to US GAAP, required by the SEC, will be made

simpler by convergence between IASB and FASB standards. To aid their conver-

gence process, the IASB and FASB have, as a result of the Norwalk Agreement

(October 2002), instituted a joint short-term convergence project, looking at

items that can be converged relatively easily, without re-issuing entire standards.

The SEC helped in the selection of such items by providing details of where the

major quantitative differences requiring reconciliation have occurred. The objec-

tive is, as always, to converge to the best solution, so that both FASB and IASB

will make changes in their existing standards as a result of this project. It is

intended to continue this process until the need for detailed reconciliation

between IFRS and US GAAP is removed. In the longer term, the two boards

will coordinate their agendas and exchange information in order to prevent

future divergence as new standards are developed and to promote future conver-

gence on issues of principle.

Leadership, in the IASB context, means developing new accounting stan-

dards to deal with problems not yet addressed adequately by the international

standard-setting community. The IASB should lead the world in partnership

with other standard setters, in developing new initiatives and solutions, for

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problems where there is no national standard with which it is appropriate to con-

verge. An example of a current project in which there is a strong leadership

element is that on share-based payments, particularly with respect to employee

stock options. The FASB developed a pioneering standard on share-based

payment (SFAS 123) which could be regarded as leading the rest of the world,

but it was prevented by domestic political pressure from taking the decisive

step of requiring employee stock options to be expensed. The IASB intends to

take this step in its new standard on share-based payment (due for publication

in March 2004). The IASB, as an international standard setter, has the advantage

of being less susceptible to the level playing field argument, that stringent

national standards may disadvantage domestic companies relative to those over-

seas, which have less stringent regimes. However, because international stan-

dards are not followed in the largest economy in the world, the USA, this

advantage is not as strong as it will be if international standards are converged

with US standards. European companies listed in the USA are particularly

sensitive to this issue. This demonstrates the importance of the convergence

programme between the IASB and the FASB.

Apart from the share-based payments project, the IASB is dealing with explicit

leadership issues in its current projects on reporting financial performance

(intended to replace the current profit and loss account with a new comprehensive

income statement format) and on insurance (intended to provide a new,

more informative, method of accounting for insurance contracts, to replace the

wide range of current national practices which are largely based on regulatory

requirements). It is perhaps not surprising that both of these projects have

encountered strong opposition from preparers of accounts and have therefore

progressed more slowly than was originally planned. Leadership is also involved

in the current project (with FASB) on revenue recognition, and other aspects of

the conceptual framework that are also likely to enter the agenda, as well as a pro-

spective new project (with the UK ASB) on accounting for leases.

5. Targets for 2005

The IASB has set itself a target list of standards to be published by the end of

March 2004, to be available for implementation by EU companies from

1 January 2005. These are listed in Table 2. After these are implemented, it is

intended that there be a period of calm for one year (to 1 January 2006),

during which no additional standards will need to be applied, although new stan-

dards may be published and made available for early adoption, at the preparers

discretion.

The new standard on first-time adoption of accounting standards (IFRS 1),

which was published in June 2003, is designed particularly to assist companies

implementing international standards for the first time and is therefore particu-

larly relevant to (although not solely applicable to) those EU listed companies

that will be required to adopt IASB standards in 2005. The standard provides

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some exemptions from requirements for retrospective application of international

standards in the opening balance sheet (which will be the first comparative

balance sheet dated 1 January 2004 or later). It also makes it clear that, where

retrospective application is required, this should be done on the basis of

current international standards, rather than those applicable at the time of the

original transaction.

The general improvements project, initiated by IOSCOs list of suggested

improvements, has led to revisions of 13 standards, issued in December 2003.

The changes are small, rather than structural, but there are important changes,

such as the elimination of the option to use LIFO as a method of recording

stocks. They reflect the suggestions of national standard setters, as well as

IOSCO. The other arm of the improvements project relates to the financial instru-

ments (IAS 32 and IAS 39). This is the most controversial, and in many respects

the most challenging, of the 2005 targets, and it is discussed in more detail in the

next section of this paper. In order to assist preparers in the implementation of a

complex new pair of standards, the revised IAS 32 and most of the revised IAS 39

were issued in December 2003, but the controversial new section of IAS 39

on macro hedging is being held back until March 2004 to enable the maximum

consultation with the banking industry.

The share-based payments standard will deal with all payments for goods and

services that are made in the form of the purchasers equity, whether in the form

of shares, options on shares, or cash payments indexed on shares. The general

principle is to expense the consumption of such items through the profit and

loss account. In the case of employees and provision of similar services, it is

assumed that the value of the services is impossible to measure direct, so that,

as a proxy, the value of the consideration granted (shares or options, less any

cash payment received for them) measured at grant date, should be used as a

proxy. In the case of goods and services the value of these should be measured

direct at the time of delivery, unless the presumption that direct measurement

is possible can be rebutted. The default measurement in this case is to value

the equity-based consideration at the time of delivery of the goods or services.

When, in the case of employee payments, there are non-market-based vesting

Table 2. IASB targets for 2005 implementation

Standards Latest publication date

First-time adoption Already published, June 2003Improvements general December 2003IAS 32/39 improvements March 2004Share-based payments March 2004Business combinations 1 March 2004Insurance 1 March 2004Accounting for discontinued

operations (short-term convergence FASB)March 2004

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conditions for services and performance whose achievement is uncertain at grant

date, it is now proposed to deal with these conditions by truing up the expense to

the number of shares or options actually vesting. The original proposal was to

rely on a grant date expectation of the amounts that would vest, but truing up

was seen to be a more objective and practical method. It also has the advantage

of converging with the treatment in the current FASB standard. The FASB is

monitoring the IASBs project and it is hoped that the FASB also will soon

require the expensing of employee stock options. This would remove the objec-

tion that the IASB might otherwise face, particularly from EU companies listing

in the USA, that companies reporting on IFRS are required to expense employee

stock options whereas their US counterparts have the choice of not doing so, thus

recording higher earnings numbers.

The business combinations project will produce a standard that is, in many

aspects, convergent with the FASB standard (SFAS 141) issued in 2001. The

IASB proposal, like the FASB standard, abolishes the distinction between

mergers and acquisitions, treating all business combinations as acquisitions. It

therefore precludes the use of pooling of interests accounting. The choice, at

the margin, between the pooling of interest and acquisition methods had

created serious problems of comparability between entities that chose different

methods. In applying acquisition accounting, the standard requires that all the

assets and liabilities of the acquired entity should be recorded at fair value,

including goodwill and those intangible assets (such as in-process research and

development) and contingent assets and liabilities that can be measured reliably,

although they were not previously recognised in the accounts of the acquired

entity. Subsequent to the business combination, goodwill is no longer to be amor-

tised but is, instead, to be subject to an annual impairment test (previously, unless

the expected life of the goodwill exceeded 20 years, impairment testing was

carried out only when there was an indicator of impairment). The impairment

test to be applied is a single step test based on that in the existing international

standard, IAS 36, rather than the more complex two-stage test devised by the

FASB. Thus, the standard is not fully convergent with the US standard, although

both standards share the essential characteristics of abandoning pooling of inter-

est accounting and, within acquisition accounting, replacing amortisation of

goodwill by an impairment test.

The proposed insurance standard is the first phase of the much more ambitious

project to lead the improvement and convergence of insurance accounting glob-

ally. It was clear that this project could not be completed within the 2005 dead-

line, but first-time adopters of international standards, particularly those in the

EU, required guidance immediately. The phase 1 standard is intended to

provide it. It is permissive, in so far as insurance contracts can be accounted

for as they are at present, under a variety of national GAAPs and regulatory

regimes, with limited exceptions, such as the use of catastrophe provisions

(which the IASB sees as a profit smoothing device inconsistent with its concep-

tual framework). There are also constraints on the new accounting practices that

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can be adopted (e.g. it is not permitted to change to a method that anticipates

future investment margins, thus front-end loading profit recognition). In order

to allow present practices to continue, the IASB has had to suspend its hierarchy

for choosing accounting policies (contained in IAS 1) in the case of insurance

contracts. Despite this considerable concession, the insurance industry has

been critical of the interim standard. The main reason is that it relates to insurance

contracts rather than insurance companies. Thus, the financial instruments stan-

dards (IAS 32 and IAS 39) apply to all of the financial investments of insurance

companies and to liabilities for items, such as investment contracts, that do not

contain a large enough insurance element to be classified as insurance contacts.

This creates a potential mismatch in valuation, particularly between liabilities for

insurance contacts, which will typically be measured at amortised cost under

existing industry practices, and the financial investment held to back those liabil-

ities which will, unless held to maturity, be measured at fair value under IAS 39.

This would lead to volatility in the net assets of insurance businesses, as fair

values of assets fluctuate with markets whereas the liabilities held are at

a stable, cost-based amount. Many in the industry regard this as artificial

(a result of accounting methods rather than economic realities) and undesirable

(volatility possibly eliciting an adverse response from the markets). At the

time of writing (December 2003) the IASB is still discussing whether there are

any steps that can and should be taken to alleviate this difficulty, without requir-

ing material, and possibly temporary, systems changes for those entities that

are affected.

The short-term convergence project with the FASB has already been referred

to. The project is short term in the sense that it is concerned with changing the

detail rather than the structure of the standard, in order to reduce the need for

reconciliation. The first output of this project outcome is the new guidance on

asset disposals and discontinued operations, exposed in ED4, July 2003, which

will result in a new standard by March 2004, but the work will continue until sub-

stantial convergence is achieved and the reconciliation to US GAAP is minimised

(and preferably eliminated), an objective which is in the interests of EU compa-

nies that list in the USA.

6. Financial Instruments, IAS 32 and IAS 39

The IASB inherited two standards on financial instruments from its predecessor

body, the IASC. These were IAS 32, which dealt primarily with disclosure, and

IAS 39, which dealt with accounting methods. The IASC had started its project

on financial instruments, jointly with Canadian Institute of Chartered Accoun-

tants (CICA) in 1988. Two exposure drafts were issued (E40 in September

1991 and E48 in January 1994). In view of the critical responses to E48, the

IASC decided to divide the project into phases, starting with disclosure and pres-

entation, which were dealt with in IAS 32 Financial Instruments: Disclosure and

Presentation (March 1995). The more controversial issues of recognition,

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measurement and hedge accounting were deferred to the second phase. In March

1997, the IASC jointly with CICA published a Discussion Paper, Accounting for

Financial Assets and Financial Liabilities, which attempted to deal comprehen-

sively with accounting for financial instruments and suggested that fair value was

the most relevant basis for their measurement. This aroused considerable contro-

versy and opposition, and it became clear that it would not be possible to issue a

standard based on comprehensive fair value of financial instruments in time to be

included, before the end of 1998, in the core standards to be considered by

IOSCO. The need to complete the core standards for IOSCO, together with the

urgency of improving accounting for financial instruments, persuaded the

IASC to develop what is described as an interim standard, IAS 39, based on

a mixed-attribute measurement model (combining elements of fair value, histori-

cal cost and hedge accounting). This was preceded by an exposure draft (E62)

issued in June 1998 and IAS 39 was approved in December 1998 (with

subsequent revisions in October 2000).

At the time when IAS 39 was issued, the USAs FASB was the only national

standard setter to have addressed accounting for financial instruments in a com-

prehensive manner and this also used a mixed attribute model, so naturally, the

IASCs standards reflected the FASBs work (particularly SFAS 133 on deriva-

tives and hedge accounting). Subsequently, the IASB sought to improve IAS 32

and IAS 39, to simplify application and remove inconsistencies but, because of

the 2005 target, not to revisit the fundamental concepts of the standards. This

gave the opportunity for critics, particularly the banks, to attack not only the pro-

posed improvements but also the original standards. The issue is of particular

interest in the EU because the controversy has raised the possibility that the

EU may not endorse an important IASB standard. We discuss below, first, the

technical issue, and, second, the political dimension.

6.1. The Technical Issue

IAS 32 and 39 raise a number of difficult technical issues, several of which were

revisited in the IASBs exposure draft (June 2002) suggesting improvements. For

example, the classifications in IAS 32 raise the difficult problem of distinguishing

debt from equity (an issue that requires deeper analysis in IASBs future

improvements of the conceptual framework) and IAS 39 deals with the criteria

for derecognition of financial instruments. However, the centre of the recent con-

troversy has been an issue not revisited in the original improvements proposals,

hedge accounting, and, in particular, macro hedging.

The need for hedge accounting arises mainly because IAS 39 is a mixed-

measurement standard. Traditionally, historical cost has been the basis of

accounting, and this has applied to financial instruments. In recent years, there

has been an enormous growth in the volume of financial derivatives and the

markets in which they are traded. A report by the Bank for International Settle-

ments (2003) records that, in June 2003, the market value of over-the-counter

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derivatives was $7.9 trillion. These instruments often have very low or even (in

the case, for example, of some swaps) zero historical cost, yet their current values

are highly sensitive to the underlying variable (such as interest rates or exchange

rates) and may be very high. Thus, it is important to measure derivatives at

current value, which, in the IASBs standard, IAS 39, takes the form of fair

value. Current values alone do not capture the full economic implications of

derivatives, because of the volatility of their values, and the IASB plans, as a

post 2005 project, to revise IAS 32 on financial instrument disclosures, to

include more disclosures relating to financial risk. This project has been devel-

oped jointly with the Basel Committee Group of banking supervisors.

At the other extreme from derivatives are financial assets that are held to

maturity, and financial liabilities not held for trading. Preparers of accounts

argue that the revaluation of such items before maturity does not yield useful

information (because any changes in value will not be realised) and that revalua-

tion is often unreliable and costly. IAS 39 accepts these arguments by allowing

such items to be accounted for at amortised cost. Loans and receivables held

by the preparer entity can also be carried at cost. Financial instruments held

for trading, on the other hand, are valued at fair value, and changes in value

are reported in the profit and loss account. Financial assets may also be desig-

nated as available for sale, in which case they are valued at fair value, but

changes in fair value are accounted for in equity until they are realised, at

which point they are recycled to the profit and loss account.

The subsequent amendments to IAS 39 (December 2003) introduced the fair

value option whereby any financial asset or liability may be measured at fair

value with changes in fair value passing through the profit and loss account, pro-

vided that it is designated as such on initial recognition. The object of this con-

cession was to ease some of the difficulties raised by commentators on IAS 39.

For example, where there is a natural hedge between an asset and a liability,

the complications of hedge accounting can be avoided by carrying both items

at fair value and passing the offsetting gains and losses through the profit and

loss account. Also, the problem of separating out and fair valuing an embedded

derivative could be avoided by carrying the whole instrument, including the

embedded derivative, at fair value. Equally, the balance sheet mismatch,

whereby volatility in equity is created because assets recorded at fair value

(because they do not satisfy the requirements of the held to maturity category)

are financed by liabilities recorded at cost (a particular problem in the case of

some insurance liabilities) might be avoided if the liabilities, like the matching

assets, could be recorded at fair value. However, despite its good intentions,

this concession has proved to be controversial, particularly in relation to carrying

an entitys own debt (including its own credit risk) at fair value. This issue has

raised particular concern amongst banking regulators. At the time of writing,

the possibility of amending the fair value option is still under discussion.

Thus, IAS 39 has a mixed measurement model because it is considered essen-

tial to value some financial instruments (notably derivatives) at fair value, but

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other items may be carried at cost, in deference to the views of preparers of

accounts (including banks). Such a system contains the possibility of a measure-

ment mismatch between assets and associated liabilities, and to alleviate this, IAS

39 allows hedge accounting.

Two types of hedge accounting are permitted under IAS 39, fair value and cash

flow hedge accounting. Fair value hedge accounting reflects the case where a

financial instrument is used to hedge the effects of a particular risk factor on

the value of another item currently held, so that it is expected that the value of

the instrument will change inversely with that of the hedged item, in response

to the risk factor, the two value changes offsetting one another. In such a case,

IAS 39 allows the hedged item, which will usually be valued at cost (there

would be no need for hedge accounting, because the offset would be reported

directly, if the hedged item were measured at fair value), to be revalued to the

extent that the revaluation reflects the hedged risk. The changes in value of

both the hedged item and hedging instrument are reported in the profit and loss

account, where they offset one another. Cash flow hedge accounting, on the

other hand, relates to the hedging of future cash flows (such as floating rate inter-

est payments or forecast purchases of inventory) which, by definition, have not

yet occurred and (unlike the hedged item in a fair value hedge) are not yet

recorded in the accounts. Thus, the technique of cash flow hedge accounting is

different: rather than the value of the hedged item being adjusted, the changes

in the value of the hedging instrument are excluded from the profit and loss

account, being recorded direct in equity, before being recycled to the profit

and loss account when the hedged item (the cash flow) affects the income

statement.

Hedge accounting is an exceptional concession intended to deal with a specific

problem, and it can involve either deferring the income statement recognition of

losses (in the case of a cash flow hedge) or advancing the income statement rec-

ognition of gains (in the case of a fair value hedge). It is therefore allowed only

under specific conditions. These are that the hedging instrument, the hedged risk

factor and the hedged item be specifically designated as such at the inception of

the hedge, that the hedge is expected to be highly effective, that the effectiveness

can subsequently be tested, and that the hedge is highly effective. These con-

ditions are built upon the idea of a one to one hedge of specific items, and

this has created difficulties for the banking industry, which does its hedging on

a portfolio basis and would therefore prefer to be allowed to do what is known

as macro hedge accounting. This does not fit naturally into the IAS 39 designation

and effectiveness testing rules and the IASB has worked hard with the banks to

develop an approach which is consistent with these rules but meets at least some

of the needs of the banks.

Macro hedging, as done by the banks, consists of hedging the net position on a

portfolio of assets and liabilities. The example commonly quoted is an interest

rate swap which is designed to fix the interest margin on borrowings and lend-

ings. A bank will typically hold a portfolio of fixed-rate financial instruments as

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assets and will also have fixed rate borrowings. It will collect these into separate

portfolios based on common expected maturity or repricing dates and hedge the

net amounts by entering into an interest rate swap to convert the fixed interest rate

on the next exposure into a variable rate. As described here, this is a cash flow

hedge, to protect against future interest rate fluctuations, but it can equally

well be described as a fair value hedge, designed to protect the fair value of

the net portfolio against the effects of changing interest rates. A critical feature

of this arrangement is that the net portfolio is hedged, rather than individual

items. This makes a great deal of sense from the banks perspective, because

there is a natural hedge between the values of assets and liabilities (or the interest

rates on them, if we take the cash flow perspective) so that it is the risk rep-

resented by the net amount that needs managing by hedging. However, this

does not fit easily with the IAS 39 approach to hedge accounting (or that of

US GAAP) by reference to specific items rather than net amounts.

The implementation guidance to IAS 39 did describe (in paragraph 121) a

means whereby financial institutions could achieve cash flow hedge accounting

for a portfolio, but some banks did not find this attractive, partly because cash

flow hedge accounting can lead to volatility in equity because gains and losses

on hedging instruments are held there prior to recycling. They therefore asked

the IASB to develop a form of fair value hedge accounting suitable for appli-

cation to portfolios of financial instruments such as are held by banks. The

outcome, developed by the IASB assisted by a working party of bank represen-

tatives, is the proposed macro hedge accounting amendment to IAS 39, which is

due to be finalised by March 2004.

The new macro hedge accounting proposals preserve the principle that specific

items must be identified as a hedge (as did the paragraph 121 method of portfolio

cash flow hedge accounting). Thus, items equivalent in amount to the net position

need to be designated as a hedge. The critical problem is to identify these items:

do we take the top slice, the bottom slice or a proportion of each of the assets in

the portfolio (where, as in common, the net position is an asset position) as being

the hedged item? The IASB, after considerable deliberation, decided to take a

proportion of each item as the hedged item, whereas majority opinion in the

banking industry appeared to prefer the top slice. The reason for this being

important is that, because of the uncertainty of payment date, the relevant

assets may not mature on the date expected. Thus, the total may exceed or fall

short of the expected amount. This affects the effectiveness testing of the

hedge. The proportionate approach allows for ineffectiveness when prepayments

cause the actual hedge to be either an over or an under hedging, whereas the top

slice approach allows for ineffectiveness only when prepayments cause under-

hedging. The majority view on the IASB is that the proportionate approach

gives a result that is consistent with that which would be obtained from the

micro approach, embedded in IAS 39, of relating hedge accounting to specific

items. The supporters of a top slice approach argue that, if the amount arising in

a portfolio on a specific maturity date actually exceeds the expected amount, this

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should not give rise to hedge ineffectiveness, because there are sufficient (or more

than sufficient) net assets to offset against the hedging instrument. The central

point at issue is really that the micro principles embedded in IAS 39 do not

translate naturally into a macro hedge accounting system, and the IASB has

had to decide how far it can stretch those principles to accommodate macro

hedge accounting without abandoning them completely.

Another difficult issue that emerged in the context of macro hedge accounting

was that of demand deposits. Banks have substantial demand deposits (customer

accounts that are repayable on demand) that bear no (or a negligible) rate of inter-

est and can therefore be regarded as fixed interest (at a zero rate) liabilities. These

liabilities typically have a short life to redemption, although they often revolve,

the current deposit being replaced by another, as is also the case with trade recei-

vables and payables. The banks often establish a minimum aggregate level of

these items, described as core deposits, that they expect to remain outstanding

for several years and include them in the portfolio to be hedged. This is a sensible

commercial strategy and no problem arises for the IASBs macro hedging system

if the total portfolio sums to a net asset position: in this case the core deposits

merely reduce the amount by which the assets need to be hedged. The problem

arises when the portfolio is in a net liability position. In this case, the core depos-

its will be part of the liabilities that are hedged. Under the IASBs fair value

hedging principles, the item to be hedged must exist and be designated at the

inception of the hedge. If the item is a core deposit that does not exist at inception

(although the core deposit existing at inception is expected to be replaced at the

time that the hedge has effect, by another, similar, deposit), then it does not

qualify for fair value hedge accounting. It could qualify for cash flow hedge

accounting, because this applies to expected future cash flows rather than

present assets or obligations, but the banks prefer fair value hedge accounting.

Another problem in relation to the fair valuing of core deposits is that the IASB

has decided that the demand feature means that the fair value of such deposits is

their nominal amount. This amount does not vary as interest rates vary, so that it

does not seem to be a suitable object for fair value hedge accounting, which

attempts to match changes in the value of the hedging instrument to changes in

the fair value of the hedged item. This difficulty also could be avoided by the

use of cash flow hedge accounting (which focuses on variations in interest pay-

ments rather than on variations in fair values), but the banks do not find this to be

an attractive alternative.

6.2. The Political Dimension

The development of the IASBs macro hedging proposals is, in many ways, a

model of how the IASB should be responsive to the real problems of its constitu-

ents but, at the same time, should not compromise its fundamental principles,

which are essential to achieving consistency and comparability in accounts and

to balancing the interests of preparers and users of accounts.

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IAS 39 was originally issued by the former IASC, which had gone through a

full due process of consultation before implementing it. Moreover, it was one of

the standards in the package approved by IOSCO and it was also effective by the

time that the EU ministers decided, at the Lisbon meeting of 2000, to adopt IASB

standards in 2005. The IASB recognised that IAS 39 needed improvement, par-

ticularly to aid implementation, but it did not anticipate some of the criticisms

that were levelled at it by some European banks, which included the allegation

that the IASB had not followed its due process.

The banking industry had been critical of the original IAS 39 in its submissions

to the IASC. Perhaps these criticisms would have been expressed more forcefully

had the IOSCO and EU endorsements been in existence at the time: it is possible

that many saw international standards as not being relevant to them. However,

several banks within the EU and in Switzerland (as well as Japan) have since

implemented IAS 39 or a standard closely resembling it (such as the FASBs

SFAS 133), without any obvious damage being caused, so the problems

created by IAS 39 should not be insurmountable.

When the banks responded to the Exposure Draft on improvements to IAS 39,

they raised issues (such as macro hedge accounting) that were not addressed in

the draft. The IASB was prepared to address these concerns, as part of its due

process. The banking industry in Europe mounted a campaign outside the

IASBs due process to persuade politicians and other leaders of opinion that it

was being harshly treated and its arguments not heard. This included complaints

to the EU Internal Markets Commissioner Frits Bolkestein, who was responsible

for overseeing the EU adoption of IASB standards. The IASB decided to deal

with both the technical objections to IAS 39 and the allegations of lack of due

process (which it did not accept, but felt must be publicly disproved) by

holding a series of round-table discussions with those who had submitted com-

ments on IAS 39. They were held in public in Brussels and in London and

lasted for a whole week in March 2003. They provided a very useful exchange

of information and, although time-consuming, were worthwhile for a complex

standard such as IAS 39 which had been developed by one board (the IASC)

and was being revised by another (the IASB).

As a result of the round-table discussions, a number of amendments were made

to IAS 32 and IAS 39 (such as the clarification of loan loss provisioning). The

most difficult problem to emerge was that of macro hedging and a working

party, containing IASB members and banking representatives, was set up to

find a technical solution. The result was that the IASB proposed the macro

hedge accounting system described earlier.

Some of the banks, particularly the French banks, were not happy with this

outcome and took political lobbying a stage further. President Chirac of France

wrote a much publicised letter to President Prodi of the EU expressing anxiety

that the IASB standards were not sensitive enough to European interests and

that, in particular, volatility resulting from application of the standards would

be damaging to the European economy. Possibly as a result of this view,

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Ecofin, the committee of EU finance ministers, has resolved to re-examine the EU

framework for approving accounting standards, with a possible view to changing

the role of the European Financial Reporting Advisory Group (EFRAG), the

advisory body. In the meantime, in July 2003 the EU regulatory committee,

ARC, has endorsed all of the IASB standards other than IAS 32 and IAS 39,

on the ground that the latter are still being discussed, and this was formally con-

firmed, in September, by the European Commission.

Thus, accounting has become explicitly a political issue. It is, of course, a

matter for the EU to choose what standards it wishes to adopt, and, in particular,

whether these are independently developed standards designed to command

international respect and application, or whether they are designed to meet

the perceived interests of the EU economy or particular groups within it. The

IASBs role is to develop standards of the former type in order to meet the

needs of global capital markets, not specifically those of the EU, and it must

be seen to be impartial in its dealings and not susceptible to political pressures

from favoured clients. It must certainly work strenuously to follow its due

process and listen to its constituency, as it did in the round-table meetings, but

having listened it must make an independent decision in accordance with its

principles.

The benefit of international accounting standards, set in this manner, is that

their objectivity and transparency should give investors greater confidence in

accounting information, reducing the perceived risks of investment and lowering

the cost of capital. Cross-border investment, in particular, should be encouraged

by removing the barriers to communication that are created by having different

national languages of accounting. These benefits are obviously consistent with

the European Commissions ambition to create a single market within the EU.

They are also consistent with the ambition that the EU capital markets should

play an important future role in the global capital market.

7. Beyond 2005

As stated earlier, the IASB has determined that, following the completion of its

programme for January 2005 application, there will be a period of calm for one

year, during which no new standards will be required to be applied. However,

new standards will continue to be issued, and some may be available for early

application, at the preparers option. The IASBs own programme of developing

new standards seems likely to be as active and full as ever.

Table 3 lists the projects on which the IASB is currently engaged and which

should lead to new standards being issued in the period following March 2004,

with application not required before January 2006. These are divided into two

groups; first completion standards which complement and complete standards

that have been issued recently, and, second, new standards, which break new

ground either by replacing existing standards or creating additional ones.

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The business combinations phase 2 standard is being jointly developed with

the FASB and will address some of the problems of applying acquisition account-

ing, such as accounting for step acquisitions. The second phase of the insurance

project has the ambitious intention of devising a new, internationally acceptable

method of insurance accounting. This is bound to be controversial. The financial

risk disclosure project, as has already been described, will lead to a revision and

extension of IAS 32, and the short-term convergence project with FASB will con-

tinue its work of removing the need for IFRS/US GAAP reconciliation.The second group, the new standards, contains some innovative and controver-

sial projects. The project on reporting financial performance has attracted particu-

lar interest and criticism in the EU countries and is therefore discussed in more

depth in the next section of this paper. The two improvements projects also

aim to achieve international convergence in areas where practice is at present

diverse and unsatisfactory. That on pension costs is likely to prove to be the

most controversial, especially within the EU, where defined benefit pension

plans are important. In the short term, it is hoped, in 2004, to make minimal

amendments to IAS 19 to allow companies that do not use the smoothing mech-

anism to report actuarial gains and losses in the Statement of Changes in Equity.

The current proposal for a longer term project includes consideration of conver-

gence with the UKs FRS 17 with respect to the reporting of actuarial gains and

losses in the income statement (gains and losses to be reported immediately in

the profit and loss account, thus eliminating the smoothing achieved by the cor-

ridor and amortisation method of the current IAS 19). A particularly sensitive

issue will be the method of presenting these gains and losses, possibly within

the new performance statement format which may be available in time for the

long-term revision of the pension standard. Other issues which may be con-

sidered include the measurement of the return on pension fund assets, the dis-

count rate applied to liabilities, and the identification of the cash flows on

which pensions liabilities are based.

Table 3. Current work for post-2005 application

Completion standardsBusiness combinations, stage 2Insurance, stage 2Financial risk disclosuresShort-term convergence (FASB)

New standardsReporting financial performanceConvergence/improvement:

Pension costs (IAS 19)Government grants (IAS 20)

Consolidations and SPEsRevenue recognition (IAS 18)Extractive industries

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The new standard on consolidations and special purpose entities is intended to

strengthen the IASBs existing guidance on the application of the control prin-

ciple (SIC 12), to make it Enron proof. The next item on the new standards

list, revenue recognition, is an important project addressing a fundamental

issue and may lead to revision of the conceptual framework as well as the

current IAS 18. It is a joint project with the FASB. Finally, it is hoped in

2004, after March but available for retrospective application, to issue a brief stan-

dard on accounting for exploration costs in extractive industries. This will give

interim guidance, pending the results of a longer term project on the topic.

The IASB also has a number of significant projects that are in the research or

early development phase. These are listed in Table 4. Most are being developed

jointly with individual national standard setters who are doing the preliminary

research necessary to define the scope of a project suitable for formal adoption

on the Boards agenda. The least active of these, at present, is that on financial

instruments. The IASB has been preoccupied with the improvements to IAS 32

and IAS 39 but, for the longer term, it is regarded as important to observe the

operation of these standards and to consider whether it might be possible to intro-

duce a new, more satisfactory (from both the conceptual and practical points of

view) method of accounting for financial instruments.

There are also problems and issues not reflected in Table 4 that might be

adopted as projects. Notably, the revision of the conceptual framework, which

underlies all of the standards, is regarded as fundamentally important. Two

aspects of this (revenue recognition and measurement) appear in Tables 3 and

4, but others, such as the definition of equity, also require attention.

Thus, even after the 2005 deadline, the IASB has a full agenda, and the period

of calm is unlikely to see diminished activity by the Board.

8. The Reporting Financial Performance Project

The issue of performance reporting, and particularly the re-formatting of the

income statement, is an urgent one, especially because of the problem of present-

ing the changes in fair values which are becoming increasingly a feature of IFRS

and financial reporting practice generally. It is a very controversial issue amongst

preparers and users of accounts, there being little apparent consensus on the

precise changes that are needed, although there is widespread recognition that

Table 4. Projects in the research and early development stages

Accounting for small and medium enterprises (SMEs)MeasurementLease accountingAccounting for extractive industriesManagement discussion and analysisAccounting for financial instruments

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some changes should be made. It is also an issue that is of particular interest to

academics, much research effort having been devoted to the role of income,

and specific components of income, in determining share prices.

The project on reporting financial performance was initiated by the IASB in

2001, as a joint project with the UKs ASB.6 As its title suggests, the project is

wider than the income statement, covering also the cash flow statement and

the re-structuring of the IASBs statement of changes in equity. However, the

income statement is at the heart of the project and has been the centre of the

debate so far, so the discussion here will concentrate on that.

The central purpose of the project, contained in its original brief, was to

propose a format for a comprehensive income statement. Thus, the project was

concerned with the form of presentation rather than the detailed content of the

income statement, as prescribed by other standards, and was not intended

to change the requirements for recognition or measurement of transactions.

The concept of comprehensive income implies that the project embraces all

income, expenses, gains and losses, including those currently reported in

equity, but excluding transactions between the entity itself and equity holders.

This brief has given rise to difficulties, subsequently, in relation to gains and

losses that IASB standards allow to be held in equity, such as available for

sale financial instruments and derivatives held as cash flow hedges. Under

present standards, such items are recycled from equity to the income statement

when they are realised. Some commentators, such as the Accounting Standards

Board of Japan (ASBJ) have pointed out that a comprehensive income statement

eliminates the possibility of recycling to the income statement, although it can

allow recycling between headings within the statement. In this respect, the

critics argue that it is self-contradictory to attempt to create a comprehensive

income statement that does not change the current recognition requirements

when those requirements allow certain items to be withheld from the income

statement until such time as they are recycled to it.

The main reason for initiating a project to develop a format for a comprehen-

sive income statement was the increasing use of current values (particularly fair

value) in IASB standards. Fair value changes affect not only financial instruments

but also some fixed assets and long-term liabilities (such as, possibly, pension

obligations). Clearly, these changes can be important and require transparent

reporting, and a format is needed to achieve this. The UK had already, in

effect, developed a comprehensive income statement in FRS 3 (1992), but this

was done in two statements, the second of which (the Statement of Total Recog-

nised Gains and Losses) tended to be given less prominence than the income

statement. In 1997, the FASB issued SFAS 130, Reporting Comprehensive

Income, which requires that comprehensive income be disclosed within US

GAAP by adding other comprehensive income (OCI) to items that are reported

in the income statement. In 1999 the G4 1 issued a discussion paper advocatinga single comprehensive income statement, and the ASB subsequently (in 2000)

issued an exposure draft FRED 22 proposing a comprehensive income statement to

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replace FRS 3 in the UK. Meanwhile, the IASC, aware of the likely future increase

in the use of fair values, appointed a steering committee to investigate the topic.

The report of this committee was not published, but it was available to the

newly formed IASB, and one of its proposals was a split of income and expense

items to separate out those amounts that were based on fair value.

The IASBs development of the comprehensive income statement concen-

trated on the format. Preparers of accounts, in particular, are anxious to identify

some concept of earnings which is separated from other gains and losses. Various

rationales for this were examined and found to be too subjective to provide infor-

mation that was comparable across different entities. These include:

1. Operating or core earnings should be identified. The difficulty with this is

that it depends entirely on the entitys business model, which is, in turn, sub-

jective. Identical operations could be classified differently by different entities

simply because of their different business models. This approach has been

favoured by the FASB in its recent explorations of the topic.

2. Recurring earnings should be separated from non-recurring earnings. The

difficulty with this is that few items are totally recurring or non-recurring.

Most have varying degrees of predictive content. Moreover, this predictive

content is difficult to assess.

3. Earnings that are within managements control should be separated from those

that are outside the managements control. The problem here is that external

factors have some impact on most elements of earnings. Equally, manage-

ments decisions are responsible for deciding to which external risks the

entity is exposed.

As an alternative, the IASB proposed to adopt a separation of the element of

each item that is the result of remeasurement (a change in the value at which

an asset or liability is recorded) from that which is the result of initial recognition

or derecognition (typically due to purchase, sale or use of an asset or liability).

The objective of separating out remeasurements was that they are objectively a

distinct property, rather than a result of managements subjective judgement

and business model. Also, it was believed that the extent of remeasurement

was relevant information from the perspective of users. Not only does remeasure-

ment facilitate comparison of those entities that remeasure from those that do not,

where there is a choice (as in the designation of financial instruments) but it is

also relevant for predictive purposes. Remeasurement reflects changes in expec-

tations about items that will be realised, as cash flows, subsequently. Such

changes in expectations, by their nature, will tend to be unique, rather than per-

sistent, and predicting them will probably be more difficult, and certainly will

involve a different predictive model, than the prediction of the routine business

transactions of the firm. Thus, the separation of remeasurement is a relatively

objective dis-aggregation which can provide useful information to the analyst.7

Because remeasurement affects, potentially, all items in the income statement,

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it was proposed to use a columnar format to provide the separation. A further

possible advantage of the columnar format is that it avoids the habitual tendency

to ignore items below the line in a vertical format.

The use of the columnar format for the separation of remeasurements, enabled

the comprehensive income statement to have an independent horizontal format,

reflecting the types of broad category, such as operating or financing, that are

familiar features of traditional income statements. However, the IASB, as with

the remeasurement criterion, preferred to define the broad categories in a rigorous

and objective manner, to serve the needs of users, particularly with respect to

comparability. It thus excluded the possibility of preparers taking a through

the eyes of management view by using their own business models to define

items such as core earnings in the horizontal format. The broad categories pro-

posed by the IASB were business profit, financing expense, taxation, and discon-

tinuing items. Business profit was the residual item, in the sense that anything not

falling into the other categories should appear there, and it was divided into three

sub-categories: operating profit, other business income and financial income. The

distinction between operating profit and other business income provides some

room for management judgement as to what is operating, but this was limited

by restricting the other category to include (at the entitys option) such items

as property revaluations and disposal gains and losses, foreign exchange adjust-

ments and goodwill.

The complete format appears, in outline form, in Table 5. A comprehensive

income statement with this type of format was field-tested on a selection of

preparers of accounts and discussed with the user community. There was con-

siderable support for it from users, although some still sought a central earnings

number which fell short of comprehensive income. There was criticism from

many preparers, who saw the format as limiting their capacity to tell it the

way it is, that is, through the eyes of management. It is clear that most preparers

would prefer a system that gave more scope for the expression of their business

models. An obvious problem with the IASBs approach arises in the case of banks

Table 5. Proposed comprehensive income statement format

TOTALIncome beforeremeasurement Remeasurement

BUSINESSOperating otherbusiness financialincome

FINANCINGCOSTSTAXDISCONTINUED

OPERATIONSPROFIT

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and other financial institutions whose business consists of dealing in financial

instruments and managing interest margins. The nature of such a financial

business contradicts the IASBs distinction between business and financial.

Useful and constructive discussions have been held with preparers to explore

possible solutions to this problem, but a satisfactory resolution has not yet

been reached. Another problem that was raised by manufacturing companies

was the extent to which the separation of remeasurement was relevant to

working capital items, such as provisions for bad debts or impairments of inven-

tories. This difficulty again reflects the business model, and further exploration

and discussion are needed.

In view of the various difficulties raised by the field visits, the IASB has

decided, after a review of the project (September 2003) to continue to develop

a comprehensive income statement, but with an open mind and in close consul-

tation with its constituency. This is a leadership project which needs to be done,

but an important aspect of leadership is that others should follow the leader! The

first stage will be to issue a discussion paper, reporting the IASBs thinking to

date, including what it has learned from the field visits, and presenting alternative

views. One possibility might be to issue an exposure draft to amend IAS 1,

Presentation of Accounting Statements, to require (rather than, as at present,

permitting) a statement of gains and losses that are not reported in the income

statement. IAS 1 already requires such items to be reported in a Statement of

Changes in Equity but that statement also includes transactions with owners,

such as new issues of shares. As an alternative, IAS 1 allows a statement like

the UKs Statement of Recognised Gains and Losses (STRGL), although,

unlike the STRGL, it allows for recycling to the income statement where other

IASB standards (such as IAS 39) require it. This would meet the criticism

made by the Japanese standard setter, ASBJ, and others. Consultations are also

taking place with the FASB, which, as indicated earlier, has tended to favour

the business model approach. In the interest of convergence, it is important

that the IASB and the FASB do not diverge on an issue so fundamental as the

format of the income statement.

9. Conclusions

We here draw conclusions about three aspects of the IASBs work towards the

2005 adoption of its standards in Europe, and its wider role as an international

standard setter. These are the technical programme, the political dimension

and the implementation problem.

With regard to the technical programme of developing standards, we have

tried to convey the range and richness of the IASBs programme. This has to

be put into the context of the tight time constraint imposed by the EU target

and the need to consult the constituency (particularly on IAS 32 and IAS 39).

The result has been enormous pressure on the IASB and its staff, and the pro-

gramme has not advanced as quickly as was originally planned, particularly

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with respect to the projects on insurance and reporting financial performance.

However, the IASB will have a workable set of standards ready for implemen-

tation in 2005. Beyond then, it has an equally demanding programme of improve-

ment, convergence and leadership.

With regard to the political dimension, the IASBs relationship with the EU has

gone through a learning process, during which the IASBs constituents within the

EU have tested the effectiveness and limits of political lobbying. The IASB has

tried, within the constraints of its resources and its EU-imposed timetable, to

consult fully with interested parties and to meet reasonable demands.

However, the IASB is determined not to be swayed by sheer political pressure:

once the IASB has completed its due process and determined its standards it is

the European Commissions responsibility to decide whether to endorse the

IASB standards and, if not, what alternative to choose. The IASB is also

engaged in a cooperative convergence programme with the FASB, and another

political dimension of the IASBs work is the attitude of the SEC and those

who control it. The SECs response to the future output of the convergence

project will determine whether accounts prepared in compliance with IASB stan-

dards are eventually accepted on US markets without the requirement for a recon-

ciliation to US GAAP. Such an outcome is in the interests of many European

companies. Finally, the IASB needs to continue to meet the needs, and

command the support, of the many countries outside the EU and the USA

which are committed or intending to commit to the implementation of IASB

standards.

Implementation has not been discussed earlier in this paper because it is

outside the control of the IASB. Nevertheless, it is of critical importance to the

success of international standards that they be effectively and consistently

implemented. If this is not achieved, international standards will not command

respect, however good their intrinsic quality. It is therefore to be welcomed

that the European Commission is working to achieve consistent regulation of

the auditing profession with the EU: the auditors play a critical role in ensuring

effective implementation. The creation of CESR, the Committee of European

Securities Regulators, is particularly to be welcomed, because it offers the pro-

spect that a uniform system for monitoring accounts will be established by the

securities regulators, performing a role similar to that of the UKs Review

Panel. Such a system will produce a powerful incentive for companies listed

on the securities markets to comply thoroughly with international standards.

Of course, the implementation problem, like the other dimensions of the

IASBs work, goes beyond Europe. This is why the Trustees of the IASC Foun-

dation are setting up an educational programme, to increase worldwide under-

standing of the IASB standards. The work of the International Auditing and

Assurance Standards Board is also extremely important by helping to establish

a common international quality of auditing.

In summary, the IASB has a heavy programme of standard setting and has to

work within an overtly political environment, which is perhaps inevitable for an

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international body. It also needs to foster a