a case study
Differences in accounting standards hit a globalized economy in four ways: they make it difficult to compare results in one country or region with those in another; make it impossible to establish a level playing field for all companies;
lead to confusion and significantly more work for compliance reasons; and com- plicate the task of regulators who need to solve the home–host problem in pru- dential supervision.7
The subject of this section is that of the challenges presented because of the first and second of these problems. For this case study, based on a 2004 experience, assume that Bank Alpha is an international financial institution of European ori- gin with extensive operations in the United States. As a US company listed on the New York Stock Exchange (NYSE), Bank Alpha is confronted with significant differences which arise in its accounts between US GAAP and rules regarding financial statements in its home country.
● The bank must make a detailed reconciliation of home country and host country reporting on shareholders’ equity and net profit, editing figures to fit US GAAP rules.
● At the same time, financial statements under home country rules are pre- pared in order to meet local regulatory requirements, and in compliance with national banking law.
Some of the differences between accounting systems turn on their head practices the credit institution has classically followed. For instance, in contrast to com- mercial balance sheet required in Bank Alpha’s home country, a financial state- ment drawn up according to US GAAP does not serve to prudently measure distributable profit. Moreover, based on home country commercial code, the accounting system prevents:
● Income from being reported before gains have actually been realized, or
● The risk of losses has been either averted or properly measured.
Let’s now introduce another variable. In contrast to the accounting norms based on commercial law, financial statements drawn up according to IFRS are geared mainly towards providing information considered relevant for investors. As such, like US GAAP, they are designed to give a true and fair view of the entity’s:
● Assets
● Liabilities
● Profitability, and
● Overall financial situation.
While this is indeed serving investor interests and provides for creditor protec- tion, those accountants of Bank Alpha who were not exposed to US GAAP found it to be an alien culture to them. It is, they said to the CEO, a different sort of reporting not necessarily focused on recognition and measurement rules for pur- poses other than transparency.
Another argument advanced by the bank’s home country accountants has been that with investor-oriented financial statements, a true and fair view of an entity’s actual financial situation requires a more extensive application of mar- ket valuation. A direct after-effect has been that of abandoning the bank’s histor- ical cost as a value ceiling, which home country accountants held in esteem.
The CEO of Bank Alpha answered this argument by saying that while the prin- ciple of market valuation is not contained in the commercial law of most
European countries, it has become the guiding concept of modern finance, as well as a notion underpinning globalization. The CEO added that under his watch the credit institution has become a global bank and from his viewpoint:
● Either the commercial law will have to change, or
● It will become irrelevant within the globalized economy to which his country is a major exporter.
The CEO also impressed upon his accountants the need to be flexible and adaptable to the new rules, underlining the fact that in a short timeframe they would have to apply IFRS, which while different from US GAAP, follows similar guidelines.
Prudently, the CEO required a simulation study involving the old and new accounting systems. For comparative purposes, Bank Alpha’s financial figures have been restated for the past two years, to conform to the presentation to be used in the near future. This made evident changes in method of presentation, including the reclassification of:
● Money market paper issued as debt, and
● Money market paper held as trading portfolioassets.
A particularly important test was that of a merger which intervened in the pre- ceding years, recorded under the pooling of interests method of accounting.
Under this method, a single uniform set of accounting policies was adopted and applied retrospectively for the restatement of comparative information.
Integrating the operations of the two predecessor banks, included a good deal of:
● Streamlining activities
● Consolidating banking premises, and
● Eliminating duplicate information technology infrastructure.
It has been a board decision that the introduction of IFRS provides an excellent opportunity to reduce the differences characterizing systems and procedures of the merged banks, by establishing institution-wide accounting policies that are in accordance with the new rules. Nevertheless, even after the effort to base the integrative work on the common accounting standard, there were still issues that required the application of judgment, and the making of estimates in preparing the financial statement.
Many of the judgments made in applying new accounting principles depended on an assumption, which management believed to be correct, that the bank must maintain sufficient liquidity to hold positions or investments until a particular
trading strategy matures. This meant that the institution did not need to realize positions at unfavourable prices in order to fund immediate cash requirements.
A blue ribbon task force was set up to cope with this problem, in view of the fact that increasingly regulatory authorities want to see a clear definition of hypothe- ses made by reporting entities that affect accounting practices. Along this refer- ence, for example, IFRS requires that a reporting entity discloses all significant accounting policies and practices – including the general principles and method for applying them to transactions, events, and conditions arising in its business.
In the case of financial instruments, such disclosure includes criteria for:
● Identifying financial assets as available for sale, and
● Designating, on initial recognition, financial assets or financial liabilities at fair value through profit and loss.
In the case of Bank Alpha, both bullet points identify an experience which it had already had with financial reporting under US GAAP. This was a totally differ- ent experience from the one followed over a long stretch of time under the home country’s accounting system, briefly described in the preceding paragraphs.
Other different practices in disclosure concerned whether purchases and sales for financial assets are accounted for at trade date or at settlement date; when an allowance is used to reduce the carrying amount of impaired financial assets; cri- teria for determining when the carrying amount of impaired financial assets is directly reduced; whether an impairment loss has occurred; amounts charged to the allowance account against the carrying amount of impaired financial assets;
and also, the policy for determining when loans are no longer past due.
In its different host country operations, Bank Alpha also found that differences between jurisdictions exist in regard to regulatory rules impacting other aspects of financial reporting. A practical example is that of allowances and provisions for credit losses. Commercial banks typically have an extensive loans portfolio exposed to credit risk.
● These loans are initially recorded at cost, that is the net amount of pro- ceeds lent.
● Then, they are held at amortized cost, reduced for credit reserves. With this, differences between jurisdictions become apparent.
There is also the general principle that results of all credit-related activities would be adversely affected by any deterioration in the state of the economy, or
economies in which an institution operates, because of the impact economic conditions have on creditworthiness. Global economic and political conditions can also impact on operating results and financial position by affecting:
● The demand for banking products and services, and
● The credit quality of new borrowers and counterparties.
Similarly, any continued prolonged weakness in international securities markets impacts upon a bank’s business revenues through its effect on its clients’ invest- ment activity and the value of their invested assets. A downturn, for example, would reduce revenues from wealth management business. As far as the man- agement of Bank Alpha is concerned, the bank’s policies in this regard apply world-wide. But the law of the land varies by country of operations, and this has implications in terms of financial reporting.