Accounting Scandal

I should be guilty of dissembling if I were not to refer to the economic difficulties which have affected Japan recently along with several other countries. I assume that these difficulties have come as a shock to people in Japan because of their contrast with the prolonged period of economic success which preceded them. But they show, as history has shown so often, that the enjoyment of steady uninterrupted growth, over the very long term, is beyond the capacity of nations. Every country, no matter how successful, seems bound to experience setbacks. The history of the changing wealth of nations is the subject for a different speech by a different speaker. But accounting has a part to play, an important part, because of its role in making markets work effectively. And this is very much the subject for this speech and this speaker.

The Value of Accounting Standards

Today, the central focus of accounting is surely the measurement of business performance. Over the last 200 years or so, the broad trend of economic development has been towards specialisation, large scale production, enabled by increasing domestic and international trade. Large scale production has depended on the growth of capital markets. Hence, although other purposes remain important, the modern focus of accounting has come to be to serve the capital markets, to make those markets work efficiently. This process is not finished in any country of the world, much less internationally.

I want to emphasise the importance of this purpose of accounting. People who provide capital do so for a return and they wish to have reports of performance to help them decide how much to invest in particular businesses and on what terms. They wish performance to be reported in a manner which helps them to assess future prospects. Investors generally dislike risk. The higher they perceive the risk to be, the higher the return they seek for providing capital to a particular business. Perceived risk comes partly from economic fundamentals: from technologies, from demand factors and from competition. But it also comes from accounting. If accounting information is failing to meet the needs of investors, perhaps because it is perceived by them to be unreliable, the investors will feel more uncertainty in judging economic prospects than is warranted by the economic fundamentals. Investors will require to be compensated by a higher rate of return for the information uncertainty, as much as for more fundamental economic uncertainty. Share prices will be lower than they could be, the cost of capital will be higher; and this is just as surely an economic disadvantage as having to pay higher wages to the workforce. Some worthwhile investment will not take place: economic growth may be significantly depressed.

This role of accounting in contributing to economic growth and prosperity is widely regarded as vital, among governments in the developed world and the developing world alike. The views of agencies which provide investment finance for developing countries and countries in transition to market economies are of particular interest. They believe that the development of effective capital markets, partly through good accounting, is a most important way of promoting growth in the poorer countries of the world. The richest countries have equal need to maintain and improve their accounting. They are not immune to accounting failure and, as business becomes more complex and exposed to a new kind of risks, accounting faces new challenges.

The Need for International Accounting Standards

A British case of the 1960s, in which the results of a business for a particular year were portrayed as a profit by one party and a loss by another party, without breaching such accounting rules as then existed, is often cited as the key trigger for starting the process of setting accounting standards in the UK. In recent years, cases of this kind have been observed at the international level. Daimler Benz reported a profit under German accounting rules but a loss under US accounting rules. The British motor company Rover reported a profit under UK rules and a loss under German. Are not these variations just as damaging for capital markets as similar variability in domestic measurements? The answer is "Yes" and, indeed, there are additional reasons for concern.

Imagine the case of an international business, with operations in many different countries. It is likely to be required to prepare accounts for its operations in each country, in compliance with the rules of that country. It will then have to convert those accounts to conform to the rules of the country in which the holding company is resident, for the preparation of group accounts. If the company has listings on stock exchanges outside its home country, those exchanges or their regulators may require the accounts to be filed under some other basis. The extra cost is enormous: chief financial officers of the largest companies say that it can run to hundreds of millions of yen each year. Heavy costs also fall on investors in trying to compare the results of companies based in different countries and they may just be unable to make such comparisons.

But the biggest cost may be in limiting the effectiveness of the international capital markets. Cross border investment is likely to be inhibited. Investors will no doubt take the trouble to analyse the annual reports and consider investment in some of the largest companies in some of the largest countries. They may invest in these companies, requiring a premium rate of return, that is imposing a premium cost of capital, to compensate them for the costs of the analysis and the uncertainties they feel about the results of using an unfamiliar or deficient accounting system. In many other cases, investment may just not be considered because the costs and uncertainties are too great. So the use of different accounting rules in different countries limits the efficiency of the capital markets in attracting investment funds to the applications where they will earn best returns and therefore has some depressing effect on economic growth in general.

The Role of IASC

The need for international accounting harmonisation should be met by an international accounting organisation. No single country can expect to have its standards used as international standards. Different countries have different but legitimate points of view about the requirements for accounting rules and have a natural right to be represented