THE ROLE OF NATIONAL ACCOUNTING STANDARDS IN EUROPEAN UNION COUNTRIES Croatian position and perspectives

Ivana DRAŽIĆ LUTILSKY M.Sc. Graduate School of Economics and Business University of Zagreb E-mail address: [email protected]

Hrvoje PERČEVIĆ M.Sc. Graduate School of Economics and Business University of Zagreb E-mail address: [email protected]

Abstract In order to achieve a high level of harmonization in accounting systems of members in the European Union, International Financial Reporting Standards (IFRS) has been developed. The main purpose of IFRS is to ensure the compatible financial reporting of companies which are listed on the regulated markets. Therefore, IFRS must be applied by the listed companies for external financial reporting. The main problem which occurs is the problem of Small and Medium Enterprises (SME) and their external reporting. The main issue is: should SME apply IFRS or it is more convenient to develop special standards only for SME. In all EU countries there are national accounting standards developed for SME. These standards are prepared according to IFRS and IAS and they must be applied by SME for external reporting. In Croatia, the problem of SME and their reporting is still open. This article is dealing with the problem of SME’s reporting in Croatia.

Keywords: national accounting standards, IFRS, SME’s, FRC, acquis communautaire Introduction

The main aim of this paper is to determine whether is more acceptable for Croatia to develop national accounting standards for SME’s and unlisted companies or to use IFRS for SME’s and unlisted companies as well as for the listed companies. The old Croatian Accounting Act1 prescribes the application of IFRS for external reporting for all companies (not only for those listed on regulated markets). The proposal of new Accounting Act, which is now adopted and in use from January 01, 2006, has included all Directives, Regulations, Decisions, Recommendations, Interpretative Communications and Commission Comments. According to the new Accounting law, Croatian accounting and accounting standards board (His role was to interpret and translate IAS, not to create National Accounting standards for SME’S) stop existing and his role should take Financial Reporting Council. That body will be established by Croatian Government. The meaning of Financial Reporting Council (FRC) is in interpreting and applying IFRS in Croatia in accordance with Stabilization and Association Agreement Pact and acquis communautaire2. The basic functions of FRC should be the interpretation of IFRS and their practical application in Croatian companies, but also eventually to try and develop some National Accounting Standards for SME's and unlisted companies. This is all part of acquis communautaire. In regards, Croatia has to enhance institutional framework for consistent applying and interpreting IFRS. [1: Source: www.mei.hr; „National Stabilization and Association Agreement Pact“(official site of Ministry for European integrations) visited on 20 of November 2005.] With this assumption we would also like to determine the meaning of FRC on small and medium enterprises.

Accounting harmonization process

Before going further into the accounting harmonization (or better yet the new used word and process is convergence), it is important to consider whether the target is harmonization or standardization. Both terms are used rather loosely in accounting theory and practice. So, harmonization is a movement of increasing compatibility of accounting practise by setting limits on how much they can vary. Standardization, on the other hand, means a rigid and narrow set of rules. Harmonization is much more open and flexible, while standardization doesn’t recognize national differences and it is therefore harder to implement. Accounting harmonization can be considered to be a waste of money and time if there is no benefit and usage for the accounting user groups of information’s. Therefore one of the main objectives of accounting harmonization is to give benefit to the user. 1 It could be used, also, Accounting Law. 2The acquis includes all primary legislation (treaties), secondary legislation (Regulations, Directives, Decisions, Recommendations, etc.) and case law (judgments of the European Court of Justice and European Court of First Instance). Hence, since EU rules are constantly changing (new Directives are enacted, Regulations are amended, judgments are handed down), the acquis is not a static document, but one that is in constant evolution. Some of the benefits, associated with harmonization, are as follows: 1. Cost and money saving to multinational companies; 2. Comparability and comprehensiveness of multinational financial reports and accounting information; 3. Widespread high quality accounting standards and practices will be consistent with local, economic, legal and social conditions; 4. Enhancing common financial reporting “language” so that financial statement will give the same information’s and 5. Facilitating more meaningful comparisons of the financial performance and financial positions and improving the quality of financial reporting. [2: Chairas, Ira Yuta, Wirawan E. D. Radianto: “Accounting harmonization in ASEAN“2002. www.lexusnexus.com] Accounting harmonization helps in different ways to different user groups. Those groups are: management, multinational enterprises (MNE’s), governments, trade unions, employees, investors, bankers and lenders, general public, accountants and auditors. The disadvantages of accounting harmonization would be subversion of various national accounting practices away from the optimal ones for domestic purposes. So, in some case diversity may be well justified. For example, in the company law, tax regulation, sources of finance, business custom, accounting culture, etc. The deterrent perspective is perhaps more common, in light of the corporate scandals that have taken place over the past few years: Enron, Worldcom, Tyco, Parmalat, Ahold… etc. From this perspective, high quality financial reporting, through harmonization, works to avert such scandals, which have enormous economic and social costs. High quality financial reporting and harmonization contributes to promote private sector growth and reducing volatility, through: (a) Strengthening countries’ financial architecture and reducing the risk of financial market crises, together with their associated negative economic impacts; (b) Contributing to foreign direct and portfolio investment; (c) Helping to mobilize domestic savings; (d) Facilitating the access of smaller-scale corporate borrowers to credit from the formal financial sector by lowering the barrier of high information and borrowing costs; (e) Allowing investors to evaluate corporate prospects and make informed investment and voting decisions, resulting in a lower cost of capital and a better allocation of resources; and (f) Facilitating integration into global financial and capital markets. [3: “Implementation of International Accounting and Auditing Standards” Lessons Learned from the World Bank’s Accounting and Auditing, ROSC Program, September 2004. www.worldbank.hr;] High quality financial reporting may also contribute to improving the assessment and collection of taxes on corporate profits. Countries currently have fundamentally different approaches to the relationship between accounting and taxation. At one extreme (total independence), income determination for accounting purposes is completely separate from income determination for tax purposes. At the other extreme (total dependence), either financial statements are prepared in accordance with tax rules, or income determination for tax purposes is determined by the choices made in financial statements. The greater the level of dependency is the greater is the importance of high-quality financial statements for the assessment and collection of taxes on corporate profits. [4: “Implementation of International Accounting and Auditing Standards” Lessons Learned from the World Bank’s Accounting and Auditing, ROSC Program, September 2004. www.worldbank.hr;] So, the old approach was ‘harmonisation’ and the new one is “convergence”. Convergence is a process in achieving quality of standard and the objective is to reach one common high quality answer. The main objective is to develop a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information and to co-operate with national accounting standard setters to achieve this convergence. Everyone seems to agree that a single set of standards is a good idea, and that national standard setters should participate in the process. Outcomes of convergence would be:  Improved economic decision making  Better pricing of capital  More efficient allocation of resources  Increased world-wide investment;  Reduced preparation costs; and  Enhanced regulatory interface. Naturally all the desired outcomes focus on the results that should be expected from better information: • If investors make better decisions, capital will be more fairly priced in relation to risks, and will therefore be more efficiently allocated among competing investment opportunities; • Reducing the risk of relying on bad information, or uncertainty about information quality, should help reduce the tendency of investors to bias their choices towards domestic entities. Capital will flow to the best opportunities no matter where they are (assuming away other sources of risk or restrictions like political uncertainty or domestic content requirements) • For preparers the most obvious immediate payoff is simplified administration – financial reporting systems common throughout the world with no additional local add-ons. But lower cost of capital is longer term goal. • Also benefits regulators who now have common language from which to build regulatory requirements. Not just securities markets, also banking and insurance. [5: “IFRS’s—an overview” Tricia O’Malley, IASB Board Member, World Bank Advanced Program in Accounting and Auditing Regulation Module 14, 6 December 2005; www.worldbank.hr;]

Accounting structure in the EU and in the “future” EU members In all EU countries there are national accounting standards developed for SME's and unlisted companies. These standards are prepared in accordance to IFRS and IAS and they must be applied by SME's and unlisted companies for external reporting. Listed companies, from 1 January 2005, have to use IFRS for financial reporting. In Croatia, the problem of SME's or unlisted companies and their reporting is still open. There are two types of National accounting setters: ones that bring National accounting standards in accordance with IAS/IFRS and the other that bring completely independent standards for their companies. National Standard Setters that bring independent standards are: Australia and New Zealand, Japan, Canada, United Kingdom, France, United States and Germany. [5: Ibidem.] All of the 25 EU Members have National Accounting standards and Company Law, Some countries have Accounting Act (or Law) but some countries are regulating accounting issue through Company Law. Important information is that after changing to capitalism and becoming countries in transition, the new EU 10 Member State all started with implementation of National Accounting Standards in accordance with Directives and IFRS or IAS. Croatia still didn’t recognize the existing issues and problems in appliance of 2.500 pages IFRS within the small and medium enterprises.

Table 1. Accounting structure in the EU members Country Company Law Accounting Act (or National Accounting Law) Accounting Standards Austria Yes No Yes Belgium Yes No Yes Cyprus Yes Yes Yes Czech Republic Yes Yes Yes Denmark Yes Yes Yes Estonia Yes Yes Yes Finland Yes Yes Yes France Yes No Yes Greece Yes Yes Yes Ireland Yes No Yes Italy Yes No Yes Latvia Yes Yes Yes Lithuania Yes Yes Yes Luxembourg Yes No Yes Hungary Yes Yes Yes Malta Yes No Yes Netherlands Yes No Yes Germany Yes No Yes Poland Yes Yes Yes Portugal Yes Yes Yes Slovakia Yes Yes Yes Slovenia Yes No Yes Spain Yes No Yes Sweden Yes Yes Yes Great Britain Yes No Yes CROATIA Yes Yes No Source: International Accounting Guide 2001 and ROSC report taken from www.worldbank.org; official site visited 20. October 2005.

The “future” EU candidates have some different practice. Only Bulgaria and Moldova have National accounting Standards while all the other countries are still struggling with Accounting Act and IAS/IFRS. In Moldova, National accounting Standards are based on IAS version as of 1996-1997 and Accounting Act is currently redrafted and taking under consideration “Acquis communautaire”. In Bulgaria, Accounting Act is applicable since 1991 and National Accounting Standards are applicable since 2003 and they are very similar to IAS/IFRS (but the listed companies are obligated to use IFRS). Like in Croatia, financial reporting of unlisted companies and SME’s has a strong fiscal “fingerprint”. It means that taxes regulations are dominating over accounting regulations. Such a concept is in Romania, Serbia and Montenegro, Turkey and in BiH. As far as the company law is concerned, there is no state-level company law in BiH. Instead, this matter is covered by entity laws. Until recently, each entity had its own regime for accounting and auditing. Accounting standards were based on outdated translations of International Financial Reporting Standards (IFRS), with important differences in interpretation between the two entities. A state level Framework Accounting and Auditing Act (FAA) was passed in 2004, and enabling legislation passed in each entity more recently. A new state Independent Standards Commission was established to ensure full IFRS and ISA compliance for all companies in BiH with revenue of one million convertible marks (KM) or greater or 50 or more employees. This legislation has not yet been fully implemented - consequently, there are no standards on the state/national level at this stage.

Table 2. Accounting structure in the “future” EU members Country Company Accounting Act (or National Law Accounting Law) Accounting Standards Bosnia and Herzegovina* Yes Yes No Bulgaria Yes No Yes Macedonia Yes Yes No Moldova Yes Yes Yes Romania Yes Yes No Serbia and Montenegro* Yes Yes No Turkey* Yes Yes No Ukraine Yes Yes No CROATIA Yes Yes No

*World Bank has divided it on entities: Serbia, Montenegro and Kosovo. Also BiH on: Republika Srpska (Banja Luka) and the Federation (Sarajevo). Turkey is divided on European part (Istanbul) and Asian Part (Ankara). Source: International Accounting Guide 2001 and ROSC report taken from www.worldbank.org; official site visited 20. October 2005. So, considering the experience of the 25 EU Members for SME’s and unlisted companies and to avoid domination of tax regulations in external reporting, the “future” EU Members (and Croatia) have to try to develop and implement National Accounting Standards.

SME’S financial reporting

By the new Croatian Accounting Act, companies that are not listed on stock exchange should choose between appliances of IFRS in whole or should use standards of financial reporting which are defined by the Financial Reporting Council or Board in accordance with IFRS. This part of the Accounting Act brings new challenge for the Croatian accounting professionals. There are two streams among them, one thinks that they should also prepare their financial statements in accordance with IFRS and the other flow thinks that it would be better for SME’s and unlisted companies to prepare their financial statements in accordance with Croatian National Standards. The first stream thinks that there is no need to complicate existed situation with another set of accounting standards, because Croatia is for the last 13 years successfully using IAS/IFRS and it seems unjustified to develop national standards now. The second stream is taking in consideration the difficulties with which SME’s and unlisted companies are dealing. Since, there is a problem with implementation of IFRS in preparing financial statements, accountants are preparing financial statements in accordance with Tax regulations (Corporate Income Tax Law and VAT Law) and at the moment they are dominating over accounting regulation. There are strong connections between the issues of corporate reporting, auditing, corporate governance and the professionalism of accountants. A regulatory structure which recognizes these connections is more likely to be effective than one which does not. The general Financial Reporting Council’s3 (or Board) aim is to promote confidence in corporate reporting and governance. The FRC’s objectives are to promote:  high quality corporate reporting;  high quality auditing;  high quality corporate governance; and  integrity, competence and transparency of the accountancy profession. [6:“Implementation of International Accounting and Auditing Standards” Lessons Learned from the World Bank’s Accounting and Auditing, ROSC Program, September 2004; www.worldbank.hr ; research for the ROSC report made on countries that have Financial Reporting Council or Board] The FRC’s actions are based on certain key principles, which are referred as regulatory philosophy. The most important principle is that a well-informed market is the best regulator. The Financial Reporting Council (or Board) is an example of an integrated regulator. The regulation of accounting and auditing cannot be considered in isolation but need to be seen in the context of the environment in which companies operate and the entire reporting process; and there will be benefits if it can improve the architecture for co-operation between national audit regulators. In different countries FRC has different roles. In some countries, like United Kingdom and Ireland, FRC is a regulator for auditing and accounting. But in some countries it have only regulatory role for the accounting. By the new Croatian Accounting Act and Auditing Act, the accounting regulation and auditing regulation are structured separately. It means that two separates Boards or Councils are in control of those regulations and professionals. The vision that there should be a single set of high quality accounting standards for use in all of the world’s capital markets, for listed companies, is well justified. It is believed that is important of those standards to be set by independent standard setters, following due process and free from political influence. In this regards truly is supported the work of the International Accounting Standards Board (IASB). In developing, as well as in developed nations, small and medium entities (SME’s) play a critical role in national economies. In the European Union, for instance, SME’s represent 99 percent of all enterprises. As SME’s struggle to compete in a global world, they, like larger entities, must be aware of a wide range of international rules and regulations. To help them to meet this need, IFAC focuses both on serving as a resource to this constituency and providing relevant guidance. IFAC is commissioning the development of a guide to International Standards on Auditing designed specifically for SMEs and the

3 In the text it will be used FRC. small and medium accounting practices that serve them. View of the development of this guide is essential to helping SMEs to meet their responsibilities to the public interest. [7: “An Overview of the International Federation of Accountants, International Standards on Auditing, International Education Standards, the IFAC Code of Ethics and Statements of Membership Obligations” By Graham Ward, President, International Federation of Accountants; World Bank Advanced Program in Accounting and Auditing Regulation Module 15;December 20, 2005]

Conclusion

Small and medium-sized enterprises and unlisted companies have special requirements which need to be considered. It is necessary for accounting and auditing regulators to be both independent and accountable. The implementation of international standards needs to take into account all of the forces affecting corporate behaviour and all of the layers of the corporate reporting process. The process as a whole needs to contribute to wealth creation. The arguments in favour of international standards convergence (i.e. the benefits to companies and investors of lowering the costs of cross-border transactions) apply equally to monitoring and enforcement activities. Indeed, it could be argued that much of the effort devoted to international standards convergence will be wasteful if there are inconsistent or duplicative national approaches to monitoring and enforcement. Inconsistency will constrain the improvements in investor confidence; duplication will increase costs for both companies and investors. The benefits from co-operation amongst national regulators are already well-understood in the banking, securities and insurance markets. There are well-established international organizations at the global and European levels which make it easier for the national authorities to co-operate and to adopt common approaches. It is reasonable for them to request a consistent regulatory framework in which to operate. A single worldwide regulatory approach or regulatory organization is neither feasible nor desirable because the national differences in the factors affecting the design and intensity of monitoring and enforcement activities (e.g. companies and securities law, the strength of the accounting profession, the extent to which investors are able to exert influence over companies, etc.) are likely to persist for a long time. However, it is more realistic to hope that, over time, there could be agreement on common principles and on co-operation arrangements. International agreement on common principles would make cross-border regulatory co- operation easier and more effective. As yet, however, there are no equivalent organizations for the national audit regulators. Given the recent creation of independent audit regulators in a number of countries, and the likelihood of this number increasing in future, we believe that there would be merit in the establishment of an international mechanism to facilitate exchange of information and the development of common principles which would help to reduce the risk of inconsistency or duplication. [8: “An Overview of the International Federation of Accountants, International Standards on Auditing, International Education Standards, the IFAC Code of Ethics and Statements of Membership Obligations” By Graham Ward, President, International Federation of Accountants; World Bank Advanced Program in Accounting and Auditing Regulation Module 15;December 20, 2005] Harmonization process still hasn’t strike the problem of Small and Medium Enterprises (SME’s) and their external reporting. This means that international accounting standards for SME’s still haven’t been developed, but, it is important to emphasize, the problem of SME’s financial reporting is now under consideration in relevant international accounting associations (such as IFAC). IFAC is dealing with the possibility of development of accounting standards for SME’s. The main issue about SME’s financial reporting is: should SME’s applying IFRS or is more convenient to develop special standards only for SME’s. In all EU countries there are national accounting standards developed for SME’s. These standards are prepared according to IFRS and IAS and they must be applied by SME’s for external reporting. Authors have set two hypotheses for this research paper: First hypothesis is: According to the experience of new Member States (EU 10 and EU 15), should Croatia establish the Financial Reporting Council or Board whose purpose would be the development of national accounting standards for SME’s and unlisted companies. The main aim in this hypothesis is, by using the method of description and comparison on Member States, to determine whether is more acceptable for Croatia to develop national accounting standards for SME’s or to use IFRS for SME’s as well as for the listed companies. By analyzing the accounting structure of the EU members, it is determined that all the members have developed national accounting standards for SME’s. Contrary, the analysis of accounting structure of the future EU members indicates that these countries haven’t developed national accounting standards for SME’s and their financial reporting (with the exception of Bulgaria and Moldova). In Croatia there are two streams regarding SME’s financial reporting. One stream considers that SME’s should prepare their financial statements in accordance with IFRS, while the other thinks that it would be better to develop national accounting standards for SME’s. Therefore, the problem of SME’s financial reporting in Croatia still hasn’t been solved. In accordance to the experience of new Member States (EU 10 and EU 15), Croatia should establish the Financial Reporting Council, or it could be named National Accounting Committee or Board, whose purpose would be the development of National Accounting Standards for SME’s and unlisted companies because that is the practice in all EU Members and even for some “future” EU Members. The second hypothesis is: The meaning of Financial Reporting Council or Board (FRC) in interpreting and applying IFRS in Croatia is in accordance with Stabilization and Association Agreement Pact and acquis communautaire. The main aim in this hypothesis is, to determine the functions of FRC in Croatia. The basic functions of FRC should be the interpretation of IFRS and their practical application in Croatian companies. The new Accounting Law, which is adopted, has included all Directives, Regulations, Decisions, Recommendations, Interpretative Communications and Commission Comments. This is all part of acquis communauitaure. Croatia, also, has to enhance institutional framework for consistent applying and interpreting IFRS. According to the new Accounting law, Croatian accounting and accounting standards board stops existing and his role should take Financial Reporting Council (FRC). That body will be established by Croatian Government. Accordingly, FRC is the body which has the possibility of the development of national accounting standards in Croatia. On the basis of analysis of accounting structure of EU members, it is determined that the FRC’s basic aim is to promote confidence in corporate reporting and governance. The FRC’s objectives are to promote high quality corporate reporting, high quality auditing, high quality corporate governance and integrity, competence and transparency of the accountancy profession. According to the new Accounting Law, FRC in Croatia has the obligation to translate and interpret IFRS for practical appliance. That means, basically, good translation and translation on time. But also to develop and enforce National Accounting Standards, which is regulated by the new Accounting Act and recognized in the practice experience of all EU Members. Currently, IFRS are used by all Croatian companies, not only for those listed on the regulated markets. But, FRC has also the opportunity to develop national accounting standards for SME’s. On the basis of this research, it is the author’s opinion that the main objectives of FRC in Croatia should be the same as in the EU members. The authors believe that Croatian FRC should take the effort to develop national accounting standards for SME’s. These standards would make SME’s financial reporting much easier and more confidential. So, Croatia is trying to follow up the trends which are set up by the acquis communautaire and the enlargement of the European Union.

References

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