Capitalization of Major Markets and the Progress of Adoption of the International Accounting Standards

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1 Capitalization of Major Markets and the Progress of Adoption of the International Accounting Standards Lana S. Nino, CPA, MSBA, Whittier College, Whittier, California ABSTRACT The international effort toward adopting the International Accounting Standards (IAS) has taken a fast turn, with European companies starting to report based on the new in Many countries that are aligned with Europe have followed suit including Australia, New Zealand, and Hong Kong. Countries that are considered major markets as defined by the World Federation of Exchanges (WFE) based on their market size such as European markets, Canada, and Japan benefit from adopting IAS. The adoption opens up their markets to international companies desiring to list their stock on major exchanges. The US, currently the biggest single major market, has taken a cautious and a slower track to the adoption of IAS. This paper explores the effect of the US approach on its dominance in world markets. INTRODUCTION Deloitte and Touche summarized the adoption of the International Financial Reporting Standards (IFRS) by countries around the world in January of Of the 132 reporting countries, 68 have adopted the new. More than 21 countries have permitted reporting under the new, 35 countries have not permitted their use, and 8 countries are selectively adopting only sections of them. Essentially 89 out of 132 have either adopted or permitted IFRS for their domestically listed companies, but how does that compare to the size of these markets in dollars? Many of these adopting countries have a small market size, and a few countries constitute the larger percentage of the overall market. The larger the market size, the more impact the adoption of the has on the overall movement toward adoption and the more influence that country will have in guiding the development of the. Domestic Major Markets Capitalization and Adoption Status Table 1 (Market Sizes - WFE, 2006, in Millions of US Dollars) Major Markets December-06 Status of Adoption NYSE $ 15,421,167.9 Not Permitted Tokyo $ 4,614,068.8 Not Permitted Nasdaq and Amex. $ 3,865,003.6 Not Permitted London $ 3,794,310.3 Adopting Euronext $ 3,708,150.1 Adopting Deutsche Börse $ 1,637,609.8 Adopting Other European Ex. 1 $ 2,241,487.6 Adopting TSX Group (Canada) $ 1,700,708.1 Swiss Exchange $ 1,212,308.4 Adopting Spanish Exchanges (BME) $ 1,322,915.3 Adopting Hong Kong $ 1,714,953.3 Permitted Borsa Italiana $ 1,026,504.2 Adopting Australian (Inc. New Zealand) $ 820,133.8 Adopting Adopted & Permitted $ 17,798, % Not Permitted $ 25,600, % Total Third World Markets 2 $ 7,235, % (See Table 5 for varying status) Total Markets (WFE, 2006) $50,635, % 1

2 As can be seen in the Table 1 below, the total market capitalization for the domestic markets as reported by the WFE, as of December 2006 (WFE, 2006), was $50,635,248.1 million. Only 36% of national markets in dollars have either adopted or permitted the use of IFRS. The adopted status means that all companies in a selected market have to file using IFRS, and the permitted status means that companies may file using the country s national GAAP or IFRS. The major markets adopting are Europe, Australia, and Hong Kong. Many more of these major markets such as Japan and Canada are on a quick path to adopt or permit the use of IFRS. The United States has been proactive in converging Generally Accepted Accounting Principles (GAAP) with the IAS, but no time table for adoption has been announced. Below is a table listing the major markets, its capitalization and status of adoption. Change in US Domination in the Major Markets The US market comprises 38% of the total domestic market capitalization as of December, Europe, Australia and Hong Kong, the major adopting countries, have only 36% of the total market in December of The US market is certainly the dominating power and still can dictate the direction of the, but it is significantly affected by the rapid change of adoption surrounding it. Also the US is losing some of its influential power due to its declining percentage of world markets. In 2004, the US held 44% of the total market (WFE, 2004). With the spread of capitalism, there were significant increases in market sizes in non-us markets, causing a decline of the US percentage to 38% of the total market. The 6% decline is a rapid change occurring in two years. US, Europe, and other Change in Capitalization Percentage Table 2 (Market Sizes - WFE, 2004, 2006, in Millions of US Dollar) Countries 2004 Market Capitalization 2006 Market Capitalization % of Total 2004 % of Total 2006 United States $16,323, $19,286, % 38% Europe $10,344, $14,943, % 30% Other $10,443, $16,405, % 32% $37,112, $50,635, % 100% This significant decline indicates that more listings and growth of publicly traded companies have occurred in markets other than the US market. Certainly the complexity of the accounting rules and new Sarbane Oxley regulations didn t help the new listings in the US markets. Listed below in Table 3 is the change in market sizes in major markets; it is evident that significant increases in market sizes have occurred in the European markets. Although it is too soon to correlate the adoption of the international to the increase in the European market sizes, it is clear that new stock listings are finding the European market more attractive than the US. The adoption of the international accounting will certainly accelerate this trend. The US s Status on IAS The United States has taken a cautious, but proactive approach of dealing with the IFRS. They have agreed to participate with the International Accounting Standards Board (IASB) in the development of the and to converge IFRS with GAAP. But the US has not talked about full adoption or partial adoption of the domestically. Also, the US has to consider the wave of foreign filers adopting IFRS. Presently, the US has over 13,000 companies reporting on its exchanges, of which 1200 are foreign. Some of these foreign companies reconcile their national GAAP to US GAAP using form 20-F, and the remainder use US GAAP. A large percentage of companies using US GAAP are Canadian and European companies. Over 350 European companies will be converting to IFRS in 2005, and now they will be required to reconcile to US GAAP (Deloitte, 2005). In April of 2005, the Securities Exchange Commission (SEC) announced that in 2009 or sooner they will permit foreign filers on the US stock exchanges to use IFRS without reconciling to GAAP, if certain conditions are met (Brackney, Witmer, 2005). These conditions are related to the narrowing of the differences between IFRS and 2

3 GAAP. The SEC has made a huge step in the IASB direction by agreeing to use the IASB methodology in developing accounting. The IASB has been developing accounting at the conceptual level and without integrating complex details as included in GAAP. The SEC has agreed to converge with the IASB at this high level, focusing on the major points rather than the detail. Yet, the SEC has not indicated at which point it will adopt even one standard of IFRS. In addition, details not agreed upon by the SEC and the IASB can be problematic, so even after the convergence of the at the conceptual level, financial statements prepared with the two sets of (IASB and GAAP) can lead to different results. Currently the US has several joint projects with the IASB. These projects are focused on narrowing the main differences in between the US and the international in the major accounting areas. After 2002 and the signing of the Norwalk agreement where FASB and IASB agreed to the convergence of the, a lot of effort took place and continues to take place to narrow the differences. This effort includes semi-annual meetings, joint staffing of all major projects evaluating the, inventory-logging of all differences with a plan to eliminate them, and coordination of activities of interpretative bodies. There is no deadline on the effort, and it is not possible at this time to estimate a timeline (Deloitte, 2005). The United States is the market giant with 38% of all national markets. It has invested over a century in a sophisticated, highly developed GAAP. The US has a strong regulatory system: the SEC. It also has a strong private body to perform the auditing function. This effort has afforded the US significant gains in market capitalization. This is illuminated by the increase of domestic market capitalization in the North America market from 36.7% in 1990 to 51.4% in 2002 (WFE, 2002). The US will not jeopardize its lead in the market place by rushing adoption. Therefore, the US has taken a very careful approach toward convergence. Yet, The US is under significant pressure to accelerate the convergence of the. The major US exchanges, namely the NASDAQ and NYSE, have urged the SEC and FASB for quicker adoption. These exchanges face major upcoming competition from the European exchanges. In addition, the current GAAP has been under attack due to major financial scandals revealed in the last five years. Some professionals claim that certain within IFRS are of higher quality than GAAP. Yet, the SEC s staff has expressed significant concerns about the results produced from applying selected international. These major areas of differences have to be resolved. Also, the SEC is not just waiting for a complete set of, but demanding that the be interpreted and complied with. Compliance requires a regulatory body as strong as the SEC in all reporting countries (SEC, 2000). Currently, the US is in a strong position to influence the direction of the ; it is also in a strong position to refuse IFRS adoption until certain requirements are met. However, if Europe succeeds in adoption of IFRS in the next few years, if institutional investors start backing European and Asian companies due to strong reliance on IFRS, and if foreign companies leave the American exchanges to reduce compliance requirements, this will weaken the US position. Overall Development of the Standards The development of the has been a lengthy and tedious process for all countries involved. The effort has required significant support from government agencies, as well as accounting bodies. Several political and economic factors have influenced the development of the body of. Sir David Tweedie, Chairman of IASB, listed the requirements for a strong financial reporting structure as follows: Consistent and comprehensive accounting Effective corporate governance practices Auditing organization to report on entities economic performance and financial position, in order to lend confidence to the outside world Enforcement regulatory bodies to insure that the accounting and auditing principles are followed In addition to the points above, the presupposition behind consistent and comprehensive is years and years of financial reporting experience and analysis of results using the set of, which is currently non-existent with IFRS. Furthermore, although the US GAAP has displayed weaknesses in certain areas, it certainly has been put to the test with over 13,000 filers using it at the end of Despite the remarkable efforts the IASB has made in the development of the, it will take decades for the US and other parts of the world to have confidence in the consistent application of the. Europe s Status on IAS Europe, Australia, and Hong Kong were the first major markets to adopt the international. Australia and Hong Kong have been under the British influence for decades. Although Australia has its own accounting standard board, most of the have been adopted from UK. Now the Australian Accounting Standard Board (AASB) is moving toward IFRS adoption and following the same timing calendar as Europe (Hay, 2004). In 3

4 Europe there are 25 versions of national GAAP used (Euroweek, 2004). Europe has three major objectives in its strong desire to move to IAS: 1) to further advance trade within its European Union in order to create more efficient markets, 2) to facilitate cross-border capital-raising for its European companies, and 3) to open its markets to international companies filing under IFRS. Europe yearns to grow its capital market to the US level and is envious of the US domination of the capital markets. In the last two years, it has been succeeding; The European Market Capitalization has grown significantly in the last two years between 2004 and 2006 (See Table 3). Change in Size in Major Markets Capitalization in 2004 and 2006 Table 3 (Market Sizes WFE 2004, 2006, in Millions of US Dollars) Major Markets Market Capitalization 2004 Market Capitalization 2006 % Change NYSE Group $12,707, $15,421, % Tokyo Stock Exchange $3,557, $4,614, % Nasdaq Stock Market $3,616, $3,865, % London Stock Exchange $2,815, $3,794, % Euronext $2,441, $3,708, % Deutsche Börse $1,194, $1,637, % Other European $1,333, $2,241, % TSX Group (Canada) $1,177, $1,700, % SWX Swiss Exchange $829, $1,212, % BME Spansih Exchanges $940, $1,322, % Hong Kong Exchanges $861, $1,714, % Borsa Italiana $789, $1,026, % Australia and New Zealand $820, $1,140, % Generally, all international companies covet the opportunity to list on the American exchanges and have access to the enormous capital funding available. However, the big exchanges in Europe, such as the London and the Euronext exchange have been marketing their exchanges to Asian-based companies, as cheaper and as less regulated than the American exchanges. Now, the quick adoption of the IAS will certainly make the European exchanges more attractive to the world and to companies who previously have thought twice about listing in Europe. With Europe taking the leap of faith in the new, its capital markets are given a boost, and its overall economy is greatly enhanced. Many European versions of national GAAP, although extensive, were founded on a conceptual basis. The accounting rules govern based on the spirit and not the letter of the law (Buchanan, 2003). The US GAAP is complex and has evolved over time due to the litigious nature of the country. In the US, the private sector, such as FASB, is responsible for producing accounting principles and interpretations, and the government role in setting is limited. In Europe, however, the government is more involved in setting accounting and tax. Since Europe does not have a detailed, convoluted GAAP to depart from, the transition to IFRS will be easier. Besides, IFRS is closer to the European GAAP than US GAAP, because it was also developed at a conceptual level 4

5 and has not had a chance to become overly complex. Also, European corporate management is accustomed to taking a standard set of laws and applying their own interpretation to produce financial statements. Europe s adoption of the new improves transparency and comparability between all European companies, which will essentially make its markets more efficient. Financial statements from a French company will make sense to German investors and vice versa. At the end of 2005, and after the first year of adoption of IFRS, financial statements from Austria, Belgium, Denmark, France, Germany, Greece, Slovenia, Portugal and others were theoretically comparable. US international companies listed on European exchanges will not be able to ignore the European markets and their regulatory requirements. These companies will be forced to file a second set of statements that complies with IFRS. Companies in countries who opt to list outside of their exchanges will find the European exchanges more attractive than the American markets due to simpler regulations and the absence of a reconciliation requirement US GAAP. Australia and Hong Kong adopting IFRS only enhances Europe s position in the market place. However, the road to the second largest capital market for this segment is not free of obstacles. Europe has not adopted IFRS fully, and it has not committed to adopting IFRS automatically upon issuance. The European accounting regulations go through an endorsement process that entails voting by a 25-member European commission, inviting comments from private groups, as well as translating into all the European languages prior to endorsing new statements (Brice, 2004). At the end of 2004, the European Commission endorsed all IASs, IFRS 1 through 5 and all interpretations in existence at that time, but elected to wait on adopting IAS 39 fully. IAS 39, which deals with recognition and measurement of financial instruments, can have significant impact on financial statements of companies falling under it (Deloitte, 2004). A summary of the challenges of Europe s adoption of IFRS at this point follows: IFRS is not fully completed. New and revised are issued all the time, which makes it impossible for companies to rely on a stable, cohesive set of regulations and apply it accurately. Add to that any accounting software changes that have to be implemented to comply with the new rules. IFRS has not been put to the test; it will take years of reporting and analysis prior to endorsement of the IFRS for the world. Europe will both benefit and suffer from being the first pioneer. The lack of a full set of interpretation of the will allow companies to report differently under the same due to personal interpretation. This will create a paradox for the auditing community as well as the European commission, which is equivalent to the SEC in the US. The institutions and investors participating in the capital markets may get frustrated and lose credibility in the new reporting mechanism once inconsistencies of application of are revealed, which will slow down new investments. Canada and Japan s Status on IAS Canada has announced that it will be adopting IFRS by 2011; this means that all publicly traded Canadian companies will be filing in accordance with IFRS by then. This is a major change considering that for years Canada was harmonizing Canadian GAAP with the US GAAP. In addition, it has allowed foreign companies listing on the Canadian exchange to use IFRS without any reconciliation required to Canadian GAAP (Deloitte, 2005). This step will help the exchanges in Canada in their ability to compete for listings with Europe. Canada is on the forefront of the standardization effort and will exert some influence on the US to adopt. The Canadian markets have historically emulated the US accounting structure. Change in Size in Canada and Japan Market Capitalization in 2004 and 2006 Table 4 (Market Sizes WFE 2004, 2006, in Millions of US Dollars) Major Markets Market Capitalization 2004 Market Capitalization 2006 % Change Tokyo Stock Exchange $3,557, $4,614, % TSX Group (Canada) $1,177, $1,700, % 5

6 Many large Canadian companies list in Canada and on the US exchanges. Canada allows its publicly traded companies listing in the US to prepare financial statements for Canadian purposes in accordance with US GAAP. In addition, the US allows Canadian companies listing in the US to have their statements reviewed by a Canadian regulatory review. This reliance is based on a multi-jurisdictional disclosure system created between the US and Canada more than a decade ago. Yet Canada feels that it is time to get on board of the international wagon which will give Canadian companies access to US and European markets as well. Japan is a very conservative and protective country with a strong stock exchange. Standing alone, it has 9% of total markets listed in Table 1. Japan is in a unique position since its system differs from the Asian Colonial countries such as Singapore and Hong Kong, which have had significant influence from the British Empire (Buchanan, 2003). Japan, although in Asia, has had material US influence that assisted it in developing a strong, capitalistic market structure. Japan has recently been making steps toward a transparent market. In July of 2001, the Japanese government established a new board from the private sector, the Accounting Standard Board of Japan (ASBJ). In November 2004, the ASBJ initiated talks with the IASB on convergence with the new. More recently, Japan has reformed its financial systems to expand investor participation. It has initiated more disclosure and public reporting, allowing for more transparency in its reporting entities. Japan has recently announced that they are on the fast track to IFRS adoption; it recognizes the importance of having access to the international markets and with IFRS, and its companies can certainly choose between listing in the United States and the European markets. Third World Countries Status on IAS Throughout Asia, there exist more than 20 different governing bodies of accounting. These countries include Russia, India, Indonesia, Singapore, Philippines, Thailand, and the various territories within China. In South America, there are several sets of GAAP that exist in Argentina, Brazil, Chile, and Venezuela (Business Credit 2004). The domestic GAAP in these countries has been greatly influenced by the local revenue and taxation rules. An alternative way of viewing the different domestic GAAP is by understanding the underlying economies and legislation of these countries, which may clarify why a certain accounting principle may be appropriate. For example, in countries with strong patent laws, it may make sense to capitalize research and development, while in countries without them, expensing research and development is more justifiable. Additionally, in countries with low inflationary rates, the use of the historical cost principle in the financial statements is valid, but in countries with a high inflationary rate, indexing the statements for inflation is more appropriate. In summary, each country s GAAP may have emerged based on its economic and political condition. The biggest challenge in this segment is that the auditing bodies are weak and application of the may be inconsistent. Also, comparability between financial statements for companies in this segment may be questionable. The markets in third world countries comprise 14% of the total domestic capital markets, and it has over 20 countries within it. This sector is growing rapidly since in 2004 it only constituted 11% of world markets. Table 5 lists Third World countries included in the world federation of exchanges and Deloitte and Touche reported their current status of adoption for these countries as of January Many of these countries such as Singapore, India, Philippines, and Sri Lanka, have a national GAAP that is almost identical to IFRS (Deloitte, 2005), yet these countries have not claimed adoption. Instead, they have included the within their national GAAP, allowing them to keep local provisions that may contradict the. The primary reason for the rush to cut and paste the is the lack of something better. Several of these countries lack a highly organized standard setting body similar to the Financial Accounting Standard Board (FASB) in the US. They also lack an independent legislative process that is free from governmental influence. This feature is necessary for the success of IFRS implementation. Certain other countries have been approving part of IFRS within their national GAAP without fully adopting the full IFRS set of. Therefore, these countries status of adoption varies (Table 5) from full requirement of adoption, to permission to use, or to cutting and pasting a large part of the within their national GAAP Developing countries, although in need of a consistent set of rules for their companies to follow, resist complying with all the disclosures required by IFRS. In addition, these emerging countries often have taxation requirements that may conflict with the ; therefore, they have been selective in the pieces they embrace from IFRS. In Africa, some companies have been unwilling to prepare financial statements in accordance with IFRS because it makes them vulnerable to taxation, and they are not confident that the new accounting rules will help them overcome an aggressive tax system (Quinn, 2003). The entanglement of the accounting rules, the revenue collection rules, and the historical government involvement in standard setting will slow full adoption of the. Yet, emerging countries will benefit a great deal from relying on the international effort to set. Suddenly, a South African company listing on the London exchange becomes an attractive investment for US institutions, and 6

7 a French telecommunication company can acquire an Indian Company without regard to material accounting differences, theoretically. With the increase of globalization and trade with Third World countries, this segment will attain the most benefit from the IFRS, and not just for publicly traded companies, but also for the private sector, since many US and European companies have established trade relations with firms in emerging countries for outsourced labor and manufacturing. Few emerging countries that do not have domestic exchanges and thus are not included in Table1 percentages have adopted IFRS fully. The most notable one is Russia (Yakushin, 2004). Other countries adopting include Zambia, Kenya, Panama, and Peru. However, It is one thing to have international, and it is another thing to apply them, says Edward Waitzer, the advisor of the Chilean Securities and Insurance Commissions. Emerging countries need an infrastructure in place, with auditing organizations to attest to internally prepared financial reports, and enforcement agencies to detect and penalize non-compliance (Quinn 2004). Third World Countries Status of Adoption Table 5 (Deloitte, 2005) Americas Country Formal Status Progress made toward adoption Argentina Not Permitted Not Permitted Peru Required Required Mexico Adopted some not existing in Mexican Standards Chile Brazil Venezuela Required Required Africa -Middle East Turkey Permitted Permitted Iran Not mentioned in study Israel Not Permitted Not Permitted South Africa Required Required Asia Pacific Malaysia Sri Lanka Permitted Adopted most Indonesia Korea Permitted India Adopted most Philippine Required Domestic listers Adopted word-for-word most China Required - certain listers Singapore Adopted word-for-word most Thailand Adopted most Taiwan Required - certain listers 7

8 Numerous other issues exist in emerging markets, such as the lack of a trained independent auditing and accounting staff. The move for worldwide education in IFRS is just beginning. In 2003, the International Federation of Accountants (IFAC) started a major education initiative by compiling the first few educational. Although the will not compensate for actual training effort, they are geared toward increasing professionalism, establishing educational guidelines, and setting values and ethics within the profession internationally. Nevertheless, it will take decades to train an international set of accountants that follow and apply the same IFRS rules consistently. Another challenge in the adoption of IFRS in emerging countries is the size of representative companies in these markets. Most companies in those regions are medium or small companies that are, for the most part, unlisted. The IFRS was developed with publicly traded companies in mind and therefore can be too complex for the smaller size group (Quinn, 2003). It also can have far too many disclosure requirements. Still, small to medium sized companies cannot be allowed to report on a totally different set of despite the lack of published for that sector. So, the IASB will have to accelerate the development of private sector to truly help emerging countries catch the wave of standardization. In summary, the Third World market cannot succeed in adoption and implementation of IFRS without the following steps: The government has to fully support and fund the establishment of an independent legislative body to review, adopt, interpret and publish. Each country has to diligently study its revenue collection and taxation rules to interweave the new without affecting national budgets. IASB has to accelerate and establish a firm deadline for producing appropriate for the private sector. Educational organizations have to put a formal training program in place to train accountants on the new. The regulatory body of each country has to be strengthened, in order to force compliance with the. The International Organization of Securities Commission (IOSCO) will have to discourage partial adoption of the. In conclusion, based on the challenges aforementioned, emerging countries may take the longest to catch up with the world movement toward standardization, despite the waves of fast adoption of IFRS. Summary The recent European adoption of the international accounting has certainly facilitated the unification of these markets and it increased their appeal to international listers. Canada and Japan have announced their intent to adopt in the near future following Europe s footsteps. Also, many third-world countries in the Asia-Pacific Region and Latin America have either adopted part or all of the International Financial Reporting Standards (IFRS). The US is taking a methodical approach to approving the and to the development of interpretations correlated with the. The US is a major force in the international arena in terms of its market size, and it has strong financial reporting infrastructure. However, the US market size domination in world markets is rapidly declining with more than six percentage decrease from 2004 to The recent announcement by Canada and Japan that they are moving toward full adoption in the near future will also put more pressure on the US to accelerate its adoption time table. The US is working hard toward convergence, but convergence is done at the high conceptual level of the. It will take decades to reconcile all the details. By then the US market may lose a significant part of its appeal to new listers and further declines will happen in the US percentage of world markets. In conclusion the US s cautious approach may cost the US a lot of economical dollars. LIMITATION OF THE STUDY AND FUTURE STUDIES This paper has analyzed the adoption status of the international accounting of all countries included in the World Federation of Exchanges reports. The focus was on major markets with a review of markets in third world countries. It is not certain whether the complex and demanding regulatory environment of the US has affected the downward change in US dominance, yet it can be assumed that these factors didn t assist the US. Future research will continue to monitor change in US market capitalization percentage as compared to total world markets in conjunction with IAS adoption. 8

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