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 in the process for determining the rules. If I may adapt a phrase, I hold it to be self evident that countries are created equal and entitled to participate in the process of setting international accounting standards. Practicability means that not all nations can literally sit around the table at which the decisions are made; but the major economies should be at the table with some representation of the others and the opportunity for others to have their views taken into account.
IASC has the objective of fulfilling this role. It was formed in 1972 by agreement among the professional bodies of 9 leading countries in accounting, including JICPA. Today, through an association agreement with the International Federation of Accountants (IFAC), it has 143 members from 103 different countries. Standards are decided by an international board with 13 country members, currently 3 co-opted members, and some observer members who participate in the debate but do not vote. Japan has been a member of the Board continuously since it began operations in 1973 and Eiichi Shiratori represented Japan with great distinction, being the first Japanese Chairman of the Board from the beginning of 1993 until the middle of 1995. IASC develops its standards in accordance with a full due process which includes publication of preliminary documents and exposure drafts for public comment. Twelve members of the Board - 75% of the voting members - must vote in favour of a Standard for it to be approved.
The Agreement with IOSCO
For several years now, IASC has been working with the International Organization of Securities Commissions (IOSCO), the regulators of the securities markets. The Ministry of Finance represents Japan on IOSCO and the SEC represents the United States. IOSCO has a project to improve the working of the international capital markets by facilitating cross border offerings and listings. This IOSCO endeavour has three parts: first, establishment of rules for non-financial disclosures in an international prospectus, so that a common prospectus can be used for offerings in different countries; secondly agreement on a set of international accounting standards which can be used to prepare one set of accounts to satisfy listing rules in different countries; and thirdly agreement on international auditing standards.
IASC made an agreement with IOSCO in 1995 to work to complete a core set of accounting standards which could be used for cross border listings. When the agreement was made, IASC already had a number of standards which were acceptable to IOSCO, but under the agreement, IASC undertook to carry out 12 major projects, establishing new standards or revising existing standards to eliminate options or make them more comprehensive. Out of the 12 projects, we have now completed 11.
The final standard on the work programme agreed with IOSCO is on Financial Instruments. The project covers accounting for many of the assets that are important for banks, including bank advances, as well as measurement of derivatives together with associated issues in hedge accounting. In Japan, I need not emphasise the very great importance of these issues for accounting generally and for bank accounting in particular. We agreed an exposure draft for the standard on Financial Instruments last April and we have scheduled an extra Board meeting in December of this year in the hope that this will enable us to finalise the standard this year and thereby complete the major projects in the programme agreed with IOSCO.
Under the agreement, IOSCO have said that they will consider endorsing our standards when we have completed the work programme: our standards can become the means for IOSCO to meet the second objective in its programme to facilitate cross border listings. Also of great importance is the statement made by the SEC in the United States in April 1996. The SEC said that it would consider accepting our standards for use in cross border listings in the United States once we had completed the core set of standards, achieving good quality - particularly transparency and comparability - with standards rigorously applied and interpreted. We believe that our establishment of our Standing Interpretations Committee (SIC) during 1997 will have helped to meet the requirements of the SEC as well as IOSCO generally.
The Recognition of IASC's Standards
We hope that completion of the core set of standards will lead to acceptance of IASC's Standards for cross border listings in all countries of the world but, of course, many of those countries accept our standards already. They have been accepted by the London Stock Exchange for over 20 years, and are accepted in one way or another by almost all other European exchanges, as well as many leading exchanges in Asia and other parts of the world. But our standards are currently not accepted in three leading countries: Canada, the United States and, I am sorry to say to this audience, Japan. Frankly, our immediate objective is to obtain acceptance of our standards for cross border listings in these 3 countries. Although we admire the progress which has been made in bringing Japanese accounting closer to international accounting standards, we find it disappointing and difficult to understand that our standards have not yet been accepted more generally for use in Japan. We believe that our standards are more comprehensive and that they provide more transparency for investors than Japanese standards, and also than other accounting systems which have already been accepted in Japan, including those of companies in Hong Kong and Switzerland, which are based on international accounting standards.
IASC has been making exciting progress in obtaining acceptance for its standards in other ways. The European Commission issued a policy statement in 1995, saying that it looked to IASC to achieve the accounting harmonisation which was desired for the purposes of Europe's single market. It said that only IASC was in a position to achieve the harmonisation that was needed in a reasonable time scale. France, Germany and Italy have introduced new laws, providing a way for national companies to use international accounting standards to satisfy regulatory requirements in their home countries, as well as overseas. Companies in these countries will be among the first in the world to be able to use one set of group accounts for all their regulatory purposes, if international accounting standards are accepted by regulatory authorities in the United States and Canada and Japan.
The policy on international accounting harmonisation in Australia is particularly interesting. Australia has a strong national standard setter but, because of pressures from the Australian Stock Exchange and leading businesses, the national standard setter has adopted a special programme of harmonisation. It is reviewing all Australian accounting standards with the objective that compliance with Australian accounting standards will automatically secure compliance with international standards. Australian standards will not be identical to international standards: they may require additional information or they may eliminate certain options which are permitted under international standards, but they will secure compliance.
IASC also attaches great importance to helping developing countries and countries in transition to market economies. For example, we are undertaking particular initiatives to encourage China and Russia to adopt international accounting standards, and we are giving them practical help to that end.
Securing IOSCO's endorsement for the core set of standards, and achieving recognition of international accounting standards for use in cross border listings in all major countries, will be significant landmarks for IASC. But they will not represent accomplishment of our main objective. That objective is to have global accounting standards, creating one set of accounting rules, followed by international and national companies alike. For international companies are compared with national companies.
The most efficient way to form global accounting standards will be through a partnership between IASC and national standard setters. IASC must be a partner in the effort because it has an established set of international standards - the only one of its kind - together with established mechanisms for international representation and an international due process. National standard setters must be partners because they have or can have legal powers and they have resources, expertise and channels of communication, with constituencies in their country. Although global accounting standards might emerge through market forces in other ways over the long term, a partnership between IASC and national standard setters is the best way forward in terms of efficiency and political acceptability.
Here we see a weakness in IASC's present structure. Our members are professional accounting bodies and in most leading economies, these bodies are not the national standard setters. People involved in national standard setting may be appointed to represent their country on the IASC Board, but this does not happen as a result of constitutional requirements. The national standard setters do not regard IASC as their international organisation.
To consider the question of whether some change in IASC's structure is desirable, to provide a basis for a more satisfactory relationship with national standard setters, the Board appointed a Strategy Working Party early in 1997. The Working Party has also been considering how to ensure that IASC operates as efficiently as possible and whether its due process needs any improvement. The Working Party is about to publish a consultative document which proposes formal involvement of national standard setters in IASC affairs. Part of the plan would be to seek agreements with national standard setters that they consider IASC's proposals for standards through national due processes with the aim of attempting, though not guaranteeing, to bring about adoption of the same standards nationally and internationally. I urge people in Japan to contribute to the debate about IASC's structure. We, at IASC, will listen to the debate very carefully before we make up our minds about the best way forward. There are many possibilities. Proposals for the exact nature of membership relationships, the size and functions of different boards and committees within IASC, voting requirements for passing standards and many other things may need to be tested by vigorous debate. I do not want to argue today for any particular resolution of those issues. But I do want to say to you that I believe that national standard setters must be members of IASC and we must have a partnership with them to make progress as rapidly as is desirable towards agreement on global accounting standards. Some structural change is inevitable. If we do not make the necessary changes, the world will pass us by: other institutions will take over the job. Of course, I also think that the strength we derive from our links with professional accounting bodies must be maintained.
Perhaps one other comment on our possible structural reform is called for particularly to address the position in Japan. Japan does not have a national standard setter of the kind, independent of government, found in most other leading economies. You may wonder whether this would mean that Japan could not participate in a new organisation on the standard setting side even though it could continue to do so through its professional body on the other side. Germany has recently formed a new national standard setter of a kind that would enable it to participate in IASC activities. Does Japan need to do the same thing? Japan may feel that there are attractions in its adopting the same path as Germany. This path creates certain institutional strengths which may bring benefits in themselves. A decision to do this would be warmly welcomed by IASC. But I believe that the importance of the Japanese economy is such that Japan must be included in all areas of IASC's work regardless of the details of its domestic arrangements for setting accounting rules.
In this paper, I have argued that accounting standards bring strong economic benefits and that particularly great benefits are to be obtained from internationally harmonised standards, converging towards one set of global accounting standards. Changes in arrangements for national accounting standards have often taken place at times of national economic stress, or in response to cases which threatened to reduce confidence in investment through established capital markets. But nevertheless the actions taken brought economic benefits far beyond solution of the problems which immediately provoked them.
Japan is currently experiencing a time of economic stress. I wonder whether people in Japan will think that this is the ideal time to accept international standards for cross border listings in Japan, whether they will think that acceptance of international standards would provide the clearest possible signal of Japan's determination to be in the mainstream of international accounting developments. I wonder whether people in Japan might think that this is the ideal time to undertake a review of all Japanese accounting rules to incorporate the best of international accounting so that, like Australia, Japan could say that compliance with national standards would produce compliance with international standards without the two sets of standards necessarily being identical. People might think that this would remove inhibitions for international investors in investing in Japanese companies and would enable Japanese companies to obtain their capital on the most favourable possible international terms. People might think that everything possible would then have been done to ensure that accounting was playing its part in the economic recovery which your overseas visitors so warmly wish you to enjoy.