Every nation’s accounting standards and practices result from a complex interaction of economic, historical, institutional, and cultural factors. Diversity among nations is to be expected. The factors that influence national accounting development also help explain the accounting diversity among nations.
The following eight factors have a significant influence on accounting development. The first seven are economic, sociohistorical, and/or institutional in nature, and they have occupied most of the attention of accounting writers. The relationship between culture (the eighth item) and accounting development ends the discussion in this section.
- Sources of Finance. In countries with strong equity markets, such as the United States and the United Kingdom, accounting profits measure how well management is running the company. Accounting is designed to help investors assess future cash flows and the associated risks, and to value the firm. Disclosures are extensive to meet the requirements of widespread public share ownership. By contrast, in creditbased systems, where banks are the dominant source of finance, accounting focuses on creditor protection through conservative earnings measures to minimize dividend payouts and retain sufficient funds for the protection of lenders. Because financial institutions have direct access to any information they want, extensive public disclosures are not considered necessary. Japan and Switzerland are examples.
- Legal System. The legal system determines how individuals and institutions interact. The Western world has two basic orientations: code (or civil) law and common (or case) law. Code law derives mainly from Roman law and the Code Napoléon.2 In code law countries, laws are an all-embracing set of requirements and procedures. Codification of accounting standards and procedures is natural and appropriate. Thus, in code law countries, accounting rules are incorporated into national laws and tend to be highly prescriptive and procedural.3 By contrast, common law develops on a case-by-case basis with no attempt to cover all cases in an all-encompassing code. Statute law exists, of course, but it tends to be less detailed and more flexible than in a code law system. This encourages experimentation and permits the exercise of judgment.4 Common law derives from English case law. In most common law countries, accounting rules are established by private sector professional organizations. This allows them to be mo e adaptive and innovative. Except for broad statutory requirements, most accounting rules are not incorporated directly into statute law.5 Code law accounting tends to focus on legal form, whereas common law accounting tends to focus on economic substance. For example, leases are normally not capitalized under code law. In contrast, under common law leases are capitalized when they are, in substance, the purchase of property. Exhibit 2-1 lists code and common law countries.
- Taxation In many countries, tax legislation effectively determines accounting standards because companies must record revenues and expenses in their accounts to claim them for tax purposes. In other words, financial and tax accounting are the same. This is the case, for example, in Germany and Sweden. In other countries, such as the Netherlands, financial and tax accounting are separate: Taxable profits are essentially financial accounting profits adjusted for differences with the tax laws. Of course, even where financial and tax accounting are separate, tax legislation may occasionally require the application of certain accounting principles. Last in, first out (LIFO) inventory valuation in the United States is an example.
- Political and Economic Ties Accounting ideas and technologies are transferred through conquest, commerce, and similar forces. Double-entry bookkeeping, which originated in Italy in the 1400s, gradually spread across Europe along with other ideas of the Renaissance. British colonialism exported accountants and accounting concepts throughout the empire. German occupation during World War II led France to adopt its Plan Comptable (see Chapter 3). The United States imposed U.S.-style accounting regulatory regimes on Japan after World War II. Many developing economies use an accounting system that was developed elsewhere, either because it was imposed on them (e.g., India) or by their own choice (e.g., countries of Eastern Europe that modeled their accounting systems after European Union [EU] regulations). As discussed more generally in Chapter 8, economic integration through the growth of international trade and capital flows is a powerful motivator for the convergence of accounting standards in countries ar und the world.
- Inflation Inflation distorts historical cost accounting by understating asset values and related expenses, and overstating income. Countries with high inflation often require that companies incorporate price changes into the accounts. For example, Mexico applies general price-level accounting when its cumulative three-year inflation rate equals or exceeds 28 percent (an annual average compounded rate of 8 percent).6 In the late 1970s, in response to unusually high rates of inflation, both the United States and the United Kingdom experimented with reporting the effects of changing prices.
- Level of Economic Development This factor affects the types of business transactions conducted in an economy and determines which ones are most prevalent. The type of transactions, in turn, determines the accounting issues that are faced. For example, stock-based executive compensation or asset securitization makes little sense in economies with underdeveloped capital markets. Today, many industrial economies are becoming service economies. Accounting issues relevant in manufacturing, such as valuing fixed assets and recording depreciation, are becoming less important. New accounting challenges, such as valuing intangibles and human resources, are emerging.
- Educational Level Highly sophisticated accounting standards and practices are useless if they are misunderstood and misused. For example, a complex technical report on cost behavior variances is meaningless unless the reader understands cost accounting. Disclosures about the risks of derivative securities are not informative unless they can be read competently. Professional accounting education is difficult to achieve where general educational levels are low. Mexico is a country where this difficulty has been overcome. In other situations, a country must import accounting training or send its citizens elsewhere to get it, something that China is now doing. (Mexico and China are discussed in Chapter 4.) Several of these first seven variables are closely associated. For example, the common law legal systoem originated in Britain and was exported to such countries as Australia, Canada, and the United States. These four countries all have highly developed capital markets that dominate the orientation of their financial reporting. Financial and tax accounting are separate. By contrast, most of continental Europe and Japan have code law legal systems and rely on banks or the government for most of their finance. Thus, their accounting rules generally conform to tax laws. Establishing cause and effect is difficult. The type of legal system may predispose a country toward its system of finance. A common law legal system emphasizes shareholder rights and offers stronger investor protection than a code law system. The outcome is that strong equity markets develop in common law countries and weak ones develop in code law countries.Taxation is an important function of accounting in any country with a corporate income tax. Whether it dominates the orientation of accounting may depend on whether accounting has a major competing purpose, namely, informing outside shareholders. (Tax accounting is not suitable for this purpose.) If common law results in strong equity markets, taxation will not dominate. There will be two sets of accounting rules: one for taxation and another for financial reporting. Tax rules will dominate in code law/credit-based countries, and accounting for taxation and financial reporting will be the same.8 Two basic orientations of accounting have evolved out of these circumstances. One is oriented toward a fair presentation of financial position and results of operations; the other is designed to comply with legal requirements and tax law. The fair presentation versus legal compliance distinction is further discussed at the end of the chapter.
- Culture Culture encompasses the values and attitudes shared by a society. Cultural variables underlie nations’ legal systems and other institutional arrangements. Hofstede identified four national cultural dimensions (or societal values): individualism,uncertainty avoidance,power distance, and masculinity. His analysis is based on data from employees of a large U.S. multinational corporation operating in 40 different countries.9 Briefly, individualism (versus collectivism) is a preference for a loosely knit social fabric over an interdependent, tightly knit fabric (I versus we). Uncertainty avoidance is the degree to which society is uncomfortable with ambiguity and an uncertain future. Power distance is the extent to which hierarchy and an unequal distribution of power in institutions and organizations are accepted. Masculinity (versus femininity) is the extent to which gender roles are differentiated and performance and visible achievement (traditional masculine values) are emphasized over relationships and caring (traditional feminine values). Some scholars now call this achievement orientation.
Drawing on Hofstede’s analysis, Gray proposed a framework linking culture and accounting.He suggests that four accounting value dimensions affect a nation’s financial reporting practices. They are:
- Professionalism vs. statutory control: a preference for the exercise of individual professional judgment and professional self-regulation, as opposed to compliance with prescriptive legal requirements. A preference for independent professional judgment is consistent with a preference for a loosely knit social framework where there is more emphasis on independence, a belief in fair play and as few rules as possible, and where a variety of professional judgments will tend to be more easily tolerated. . . . [P]rofessionalism is more likely to be accepted in a small power-distance society where there is more concern for equal rights, where people at various power levels feel less threatened and more prepared to trust people, and where there is a belief in the need to justify the imposition of laws and codes.
- Uniformity vs. flexibility: a preference for uniformity and consistency over flexibility in reacting to circumstances. A preference for uniformity is consistent with a preference for strong uncertainty avoidance leading to a concern for law and order and rigid codes of behaviour, a need for written rules and regulations, a respect for conformity and the search for ultimate, absolute truths and values. [Uniformity] is also consistent with a preference for collectivism . . . with its tightly knit social framework, a belief in organization and order, and respect for group norms. . . . [U]niformity is more easily facilitated in a large power-distance society in that the imposition of laws and codes of a uniform character are [sic] more likely to be accepted.
- Conservatism vs. optimism: a preference for a cautious approach to measurement to cope with the uncertainty of future events instead of a more optimistic, risktaking approach. A preference for more conservative measures of profits is consistent with strong uncertainty avoidance following from a concern with security and a perceived need to adopt a cautious approach to cope with uncertainty of future events. . . . [A]n emphasis on individual achievement and performance is likely to foster a less conservative approach to measurement.
- Secrecy vs. transparency: a preference for confidentiality and the restriction of business information on a need-to-know basis versus a willingness to disclose information to the public. A preference for secrecy is consistent with strong uncertainty avoidance following from a need to restrict information disclosures so as to avoid conflict and competition and to preserve security. . . . [H]igh powerdistance societies are likely to be characterized by the restriction of information to preserve power inequalities. Secrecy is also consistent with a preference for collectivism . . . with its concern for those closely involved with the firm rather than external parties. . . . [S]ocieties where more emphasis is given to the quality of life, people, and the environment, will tend to be more open especially as regards socially related information.
