• IMPLEMENTATION OF INTERNATIONAL ACCOUNTING AND AUDITING STANDARDS

IMPLEMENTATION OF INTERNATIONAL ACCOUNTING AND
AUDITING STANDARDS
Lessons Learned from the World Bank’s Accounting and Auditing ROSC Program
September 2004
John Hegarty
Frédéric Gielen
Ana Cristina Hirata Barros
 CONTENTS
Executive Summary ......................................................................................................................... i
I. Introduction and Background .................................................................................................. 1
II. Impediments to the Successful Implementation of International Standards ........................... 2
a. Misunderstandings as to the nature of international standards ........................................ 2
b. Lack of appropriate mechanisms for granting national authority to international
standards .......................................................................................................................... 4
c. Inconsistencies between international standards and the legal framework ..................... 5
d. Lack of appropriate linkages between general-purpose financial reporting and
regulatory reporting ......................................................................................................... 6
e. Inappropriate scope of application of international standards ......................................... 7
f. Non-observability of compliance..................................................................................... 9
g. Areas for improvement in the standards themselves ..................................................... 10
h. Mismatch between accounting and auditing requirements and market demands.......... 11
i. Mismatch between accounting and auditing requirements and the capacity to
comply............................................................................................................................ 11
j. Mismatch between accounting and auditing requirements and domestic
enforcement capacity ............................................................................................. 12
k. The special role of the international audit firm networks .............................................. 13
III. The Need for International Consensus on a Comprehensive Framework of Principles
for the Regulation of Accounting and Auditing ........................................................................... 15
APPENDIX
Overview of the Accounting and Auditing ROSC Program……………………………………..16
 ACRONYMS
A&A Accounting and Auditing
EU European Union
FoF Forum of Firms
FSAP Financial Sector Assessment Program
IAASB International Auditing and Assurance Standards Board
IAIS International Association of Insurance Supervisors
IAS International Accounting Standards
IASB International Accounting Standards Board
IASC International Accounting Standards Committee
IFAC International Federation of Accountants
IFRS International Financial Reporting Standards
IMF International Monetary Fund
IOSCO International Organization of Securities Commissions
ISA International Standards on Auditing
ROSC Report on the Observance of Standards and Codes
 IMPLEMENTATION OF INTERNATIONAL ACCOUNTING AND
AUDITING STANDARDS
Lessons Learned from the World Bank’s Accounting and Auditing ROSC Program
John Hegarty ∗
Frédéric Gielen ∗∗
Ana Cristina Hirata Barros ***
EXECUTIVE SUMMARY
This paper addresses challenges to the successful implementation of international
accounting and auditing standards which have been observed by the World Bank
when carrying out the Report on the Observance of Standards and Codes (ROSC)
accounting and auditing assessments. ∗∗∗∗ It describes the ROSC program, outlines the
methodological approach followed, identifies problems common across several
jurisdictions, and makes suggestions for initiatives that could enhance the implementation
of international standards. At present, the ROSC accounting and auditing assessments are
undertaken in client countries of the World Bank. The results presented herein therefore
do not purport to be reflective of the issues in developed market economies. It is arguably
the case that before the recent accounting scandals in Europe and the United States, these
issues were regarded, not least outside Europe and the United States, as unique to
developing markets; after the accounting scandals, these issues are regarded as major
causes of those financial scandals.
A full and balanced combination of capacity and institutionalized incentives for the
rigorous application of international accounting and auditing standards incentives
(both positive and deterrent) is the key to successful implementation of these
standards. The ROSC results show that governments have primarily concentrated on
adopting legislation mandating or allowing the use of international standards, and the
∗
John Hegarty is Manager, Financial Management, for the Europe and Central Asia Region and chairs
the Private Sector Committee of the Financial Management Board of the World Bank.
∗∗
Frederic Gielen is a Senior Financial Management Specialist responsible for the ROSC—
Accounting and Auditing program in the Europe and Central Asia Region and is a member of the
Private Sector Committee of the Financial Management Board of the World Bank.
***
Ana Cristina Hirata Barros is a Policy Analyst working primarily on the ROSC—Accounting and
Auditing program in the Europe and Central Asia Region.
∗∗∗∗
This Paper is based on a presentation at the Conference on “Challenges associated with the
Implementation of International Accounting & Auditing Standards” held on October 15, 2004, at the
Financial Stability Forum in Basel, Switzerland and on a presentation at the Conference on
“Practical Implementation Challenges of IFRS” held on October 26, 2004 at the United Nations
Conference on Trade and Development in Geneva, Switzerland. The findings, interpretations, and
conclusions expressed herein are those of the authors, and do not necessarily reflect the views of
The World Bank and its affiliated organizations, or those of the Executive Directors of The World
Bank or the governments they represent.
i
private sector has sought to increase the competence of individuals and firms to apply
international standards. However, governments, for the most part, have not addressed the
need to put in place proper incentives to ensure that this competence is actually applied in
practice. The ROSC results and recent accounting scandals in developed economies
demonstrate that legal requirements and competence alone are not enough – the
commitment to deploy such competence is also essential. Market forces provide certain
positive incentives to comply with high standards, but experience in both developed and
developing economies suggest that countervailing disincentives operate to discourage
such compliance. More emphasis should be placed on the deterrent incentives of robust
monitoring and enforcement regimes to achieve a full and balanced combination of
capacity and incentives.
Effective accounting and auditing regulation is required to underpin such
institutionalized incentives, but international accounting and auditing standards
themselves do not set out requirements as to how such effective regulation should be
exercised. Guidance is not provided on how to “import” international standards into
national legislative and regulatory systems, on the design and operation of appropriate
regulatory frameworks, or on the interfaces with other regulatory instruments and
institutions (such as those for banking and securities regulation) which could contribute
to the monitoring and enforcement of international standards. As currently drafted,
international accounting and auditing standards implicitly assume the existence of legal,
institutional and policy conditions (“preconditions”) which are often undeveloped or
absent in many countries. The structure of national economies, and the role played by
high-quality external financial reporting, shape the extent to which these “preconditions”
present themselves, and efforts to promote the implementation of international standards
need to have regard to these specificities.
International standards are not necessarily appropriate to govern all financial
reporting obligations, this being especially the case with International Accounting
Standards (IAS) / International Financial Reporting Standards (IFRS). There is an
urgent need for the International Accounting Standards Board to specify the
circumstances in which the use of “full” IAS/IFRS is appropriate, and to develop
different standards that would meet the needs applicable to the users of financial
statements of other entities, particularly small and medium-sized enterprises (SMEs).
Many stakeholders continue to have misunderstandings with respect to the very nature of
international standards, which complicates efforts to plan, define and measure progress
towards successful implementation.
Lack of human and financial resources is a significant impediment to the
implementation of international standards. Mobilizing the necessary resources on a
sustainable, long-term basis is a major challenge.
Mechanisms for public oversight of the audit function, including the setting of
auditing standards and the assurance of audit quality, are almost entirely absent in
ii
the countries assessed to date. 1 Models recently introduced in more developed
jurisdictions may not always be applicable in situations where the relative importance of
the various stakeholder groups is different, and national regulators do not always have
easy access to emerging international best practice and consensus.
There are inherent limitations to the extent of reliance that can be placed on the
international audit firm networks and their individual national member firms to
compensate for weaknesses in domestic regulatory regimes. Given the governance
and management arrangements of the networks, and the fact that the networks themselves
are not regulated (only their member firms are, at a national level), the main determinant
of audit quality is the strength of the relevant domestic regulatory regimes, rather than
network membership.
To strengthen the regulatory arrangements essential for the successful
implementation of international standards, countries should give greater attention
to regulatory preconditions. The relevant international organizations should work
together to develop a consensus on a comprehensive framework of principles for the
regulation of accounting and auditing, and to support the adoption of such a
framework by the competent national authorities. Special efforts should be made to
strengthen and leverage the linkages between the various standards and codes that affect
the implementation of international accounting and auditing standards (these include
those related to the supervision of banking, securities markets and insurance, as well as
corporate governance) and to fill any gaps that remain. Such principles should explicitly
consider the regulatory implications of the diversity of financial systems and market
structures across countries.
The World Bank stands ready to continue working with country authorities,
standard-setters, regulators, private sector stakeholders, and the relevant
international organizations (particularly those represented in the Monitoring
Group) to address the issues identified in this paper.
1
While the ROSC reports generally recommend the adoption of International Standards on Auditing
(ISAs) because this is a more effective means of improving auditing standards in a given country than
the alternative of re-writing the existing suite of national standards, the ROSC reports recognize that
some international standards still need to be revised. The World Bank is contributing to that work,
including as a member of the International Auditing and Assurance Standards Board (IAASB)
Consultative Advisory Group. In the meantime, the ROSC reports recommend that countries take the
ISAs as the foundations for national standards and supplement them with additional requirements that
are believed to be appropriate for the domestic market.
iii
 I. INTRODUCTION AND BACKGROUND
1. High quality financial reporting contributes to promoting 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; 2 (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.
2. Financial reporting is also a building block of a market-based monitoring of
companies, which allows shareholders and the public at large to assess management
performance, thus influencing its behavior.
3. High quality financial reporting also contributes to strengthening the financial
discipline of Government Business Enterprises (GBEs). 3 The relative lack of capital-
market related pressures on GBEs means that the shareholding Ministers need to rely on
administrative monitoring procedures to hold GBE boards accountable. The general
adoption of International Accounting Standards (IAS)/International Financial Reporting
Standards (IFRS) by GBEs enhances shareholding Ministers’ and the public’s ability to
assess the extent to which a GBE is creating or eroding value.
4. 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, the greater the importance of high-
quality financial statements for the assessment and collection of taxes on corporate
profits.
5. As an institution committed to the fight against poverty, the World Bank
undertakes a number of activities to support the development and implementation of
international accounting and auditing standards, as it recognizes the contribution that
2
This can be achieved by shifting gradually from collateral-based lending decisions to lending decisions
which are based on the financial performance of the prospective borrower.
3
Government Business Enterprises are defined within International Public Sector Accounting
Standards, issued by the Public Sector Committee of the International Federation of Accountants
(IFAC). This term generally includes State-Owned Enterprises (SOEs).
1
high-quality financial reporting can make to development. These activities include
financial support to the relevant international standard-setting organizations; diagnostic
work to benchmark countries’ financial reporting standards and practices against
international standards; policy advice and financial assistance to support the enhancement
of these standards and practices; and participation in international discussions and
initiatives aimed at strengthening the regulatory environment, both nationally and
globally, in which international standards are applied.
6. This paper provides an overview of the main program of Bank diagnostic work in
the field of private sector financial reporting: the Reports on the Observance of Standards
and Codes (ROSC) accounting and auditing assessment. It summarizes some of the main
findings of the 38 assessments that have been carried out to date, with specific reference
to the challenges to the successful implementation of international accounting and
auditing standards. Attention is drawn to the need for international consensus on a
comprehensive framework of principles for the regulation of accounting and auditing that
also addresses issues of implementation, which is not covered by existing international
accounting and auditing standards. The paper concludes by raising a number of other
issues to be discussed and resolved going forward, if countries are to receive the support
they need to successfully implement international standards and reap their full benefits.
II. IMPEDIMENTS TO THE SUCCESSFUL IMPLEMENTATION OF
INTERNATIONAL STANDARDS
7. The common themes that emerge from the ROSC findings shed light on the
impediments to successful implementation of international standards, even in countries
that are positively committed to the process. Some of these obstacles are inherent to the
standards themselves, but most are not. Hence, this points to the need for greater focus by
policymakers—both national and international—on creating the conditions and
instruments for successful implementation. The sections that follow describe the most
common categories of obstacles encountered.
Misunderstandings as to the nature of international standards
8. Fundamental to the implementation of international accounting and auditing
standards is a clear understanding of what these standards are, what they require, and
what it means to adopt them. Failing this, countries are unable to set concrete
implementation targets or to measure progress in reaching those targets. The ROSC
findings suggest that clarity of understanding is not universal, which helps to explain the
sometimes significant gaps between prior self-assessments of compliance⎯such as those
published by the International Accounting Standards Board (IASB) and International
Federation of Accountants (IFAC)⎯and the ROSC results. 4 The concept of adopting
4
For example, the International Accounting Standards Board’s (IASB) “2004 International Financial
Reporting Standards” states—based on information provided to the IASB by Deloitte Touche
Tohmatsu (2004)—that there are 92 countries around the world that either permit or require the use of
IAS/IFRS by at least some (if not all) domestically listed companies by 2007. The ROSC results
2
international accounting standards has been interpreted in various ways by transition
countries, which may hamper rigorous and uniform application of IAS. 5 The ROSC
results show, however, that the adoption of International Standards on Auditing (ISA) has
been less contentious. Many transition economies have taken the ISAs as the foundations
for national standards and supplemented them with additional requirements, believed to
be appropriate to their domestic market. Still, some countries have adopted only selected
standards or adopted ISA in force as of a particular date in the past, with no account taken
of changes since then. These misunderstandings give countries, and various stakeholder
groups within them, a false understanding of the actual standards gap and the true
implementation challenges they face.
Illustrations 6
Accounting Standards:
Country ABC claims that IFRS are required for all listed companies. The ROSC report shows that
the law mandates the use of a translation of international accounting standards, as effective in
1999. In a number of economically significant enterprises, the differences between the then-
applicable international standards and “full IAS/IFRS” had an adverse impact on the quality and
transparency of financial statements.
Country XYZ claims that all consolidated financial statements must be prepared in conformity
with IFRS. The ROSC report showed that Country XYZ has adopted IAS 27, Consolidated
Financial Statements and Accounting for Investments in Subsidiaries, but failed to incorporate the
body of international standards that together form IFRS. The authorities did not recognize that
IAS 27 is merely one of the standards that are required when preparing consolidated financial
statements. Other international accounting standards such as IAS 1, Presentation of Financial
Statements, IAS 39, Financial Instruments: Recognition and Measurement, are equally important.
Auditing Standards:
Country ABC claims that ISA are required for all statutory audits. However, paramount standards
such as ISA501, Audit Evidence—Additional Considerations for Specific Items (which covers
auditing segment information), and ISA550, Related Parties, have not been adopted domestically.
suggest that the actual number of countries that either permit or require the use of full IAS/IFRS is
much lower.
5
Some interpretations of this concept include: the adoption of “Western” book-keeping methods; one-
off transformations of financial statements prepared in accordance with local standards; the
development of local standards “based on” IAS/IFRS; the adoption of IAS/IFRS in force as of a
particular date in the past, with no account taken of changes since then; and the adoption of a subset of
IAS/IFRS (e.g., excluding interpretations, which are not endorsed and hence not effective).
6
Illustrative examples are based on actual findings described in published ROSC reports, which are
available at www.worldbank.org/ifa/rosc_aa.html.
3
Lack of appropriate mechanisms for granting national authority to international
standards
9. To be effective in a national setting, international standards require the force of
law or other regulatory backing. If not, compliance becomes a matter of non-transparent
discretion on the part of preparers and auditors of financial statements, outside the
constraints of any regulatory framework. In such cases, the standards should more
properly be considered “offshore” rather than “international.” There is currently no
international consensus on what mechanisms should be used to provide regulatory
backing, and different countries have adopted different approaches, many of which fail to
achieve their stated objective. Countries are also bound by their constitutional and
administrative law, which can limit significantly their ability to impart domestic legal
force to international standards issued by non-official private sector organizations.
Although the accountancy profession has played a major role in the development of
international standards, and in their promotion at a national level, the profession itself
does not have sufficient authority to ensure their successful implementation, unless acting
in a regulatory capacity derived from specific legislation.
10. For countries with a tradition of reliance on laws and regulations (rather than
standards) for the fixing of accounting and auditing requirements, specific issues arise.
Rather than giving authority to a continuing process of standard-setting, new statutory
measures are required whenever a new international standard is enacted, or an existing
international standard is amended. Typically, such changes must be gazetted in the
official language of the country. Such an approach can lead to delays in keeping the body
of translated and gazetted IAS/IFRS up-to-date; this approach also entails significant
costs and technical difficulties of carrying out translations. At the same time, preparers
are also faced with difficulties, as they wish to comply both with domestic law and with
current IAS/IFRS, which may not always be perfectly aligned. When such procedures are
combined with an explicit endorsement mechanism to screen individual international
standards for local adoption (as in the European Union), there is the further possibility
that certain IAS/IFRS may not be accepted (either in full or in part). Due attention must
also be given to the political significance of introducing a mechanism that may deprive a
jurisdiction of the ability to have final say over the standards to which it grants legal
authority.
Illustrations
Accounting Standards:
With respect to the European Union, the European Commission publishes in the Official Journal
the translations of the individual “bare” international standards into the applicable languages of
all Member States. However, several issues remain with respect to the translations of IFRS,
which may have an adverse impact on compliance in EU Member States:
Certain information contained in the IASB’s bound volume of IFRS has not been
translated and published in the Official Journal. Such excluded information includes the
4
Appendices to the IAS/IFRS, which contain Application Guidance and Basis for Conclusions,
which may be important to fully understand the application of, and reason for, particular IFRS.
Currently, Exposure Drafts for new IFRS and Draft IFRIC Interpretations are not
translated and published (and, thus, made readily available). In order to make it easier for
interested stakeholders to provide input to the development of new IFRS (including IFRIC
Interpretations), Exposure Drafts and Draft IFRIC Interpretations should be translated, and such
translations published, at the time of release.
Auditing Standards:
In country ABC, it is not clear whether a court would hold a statutory auditor to the duty of care
required by International Standards on Auditing—in cases where statutory audits are required to
be conducted in accordance with ISA—since language requirements in judicial procedures before
courts may require an official translation of ISA in the local language, which has yet to be
published.
11. Substantially all countries that so far have been the subject of A&A ROSC
assessments lay down their accounting and auditing requirements in legislation, which is
applicable to the generality of companies. This differs from the tradition in the United
States, for example, where state company law has usually been silent on issues of
accounting and auditing, and where legal general-purpose financial reporting obligations
are enshrined in federal securities requirements. Although there may be arguments in
favor of instituting a special regime for publicly traded companies (for which IAS/IFRS
are appropriate), care needs to be taken to avoid conflicts and overlaps. Company law is
concerned with the regulation of companies and typically provides for the protection of a
wide range of stakeholders; often, it also covers issues relating to corporate governance.
In contrast, securities law is primarily concerned with the regulation of markets and with
the protection of market participants. The mechanisms used to achieve these different
policy objectives are not always aligned, and can have different impacts on how the role
of accounting and auditing is shaped. Successful implementation of international
standards necessitates due regard for these differences. The case may be made for
requirements going beyond those contained in international standards (e.g., the concept of
ISA-plus, or the addition of country-specific obligations to respond to specific audit
reporting mandates).
Inconsistencies between international standards and the legal framework
12. Also fundamental to the implementation of international accounting and auditing
standards is an unequivocal relationship between the legal framework (e.g., company law
and securities law) and international standards. The ROSC results point to several stress
areas between domestic laws and the standards, which could adversely impact
compliance, as well as monitoring and enforcement efforts.
5
 Illustrations
Accounting Standards:
In country ABC, company law does not authorize a company to account for the amount of the
correction of an error retrospectively. IAS/IFRS require retrospective accounting so that the
correction of an error is excluded from the determination of profit or loss for the period in which
the error is discovered. Such inconsistencies result in difficulties for preparers and auditors, who
may find themselves unable to comply with both domestic law and international standards.
Auditing Standards:
In country ABC, company law does not authorize a statutory auditor to disclaim his or her
opinion. This conflicts with ISA, which requires an auditor to disclaim an opinion when the
possible effect of a limitation on scope is so material and pervasive that the auditor has not been
able to obtain sufficient appropriate audit evidence.
Lack of appropriate linkages between general-purpose financial reporting and
regulatory reporting
13. IAS/IFRS are standards for the preparation of general-purpose financial
statements, aimed at meeting the needs of a wide range of users, but predicated on the
assumption that placing primary emphasis on the needs of shareholders will result in
measurement, recognition and disclosure requirements that also meet the needs of other
users. However, significant other users of financial statements need not necessarily share
this view, and where they have the power and authority to do so, frequently impose
different special-purpose financial reporting obligations designed to meet their specific
needs (e.g., reporting for taxation purposes, or reporting for prudential and supervisory
purposes). Not all countries successfully manage this interface between general-purpose
and regulatory reporting, and it is common to encounter cases where rules designed for
the latter (e.g., on loan loss provisioning in the banking sector, or on the timing of income
recognition) have an impact on the former, when a single set of financial statements is
intended or required to meet both objectives. Hence, the requirements of regulatory
reporting may conflict with those of IAS/IFRS, thereby precluding successful
implementation. Companies may have the option of voluntarily preparing additional
financial statements in which full compliance with IAS/IFRS can be achieved, but this
has negative cost implications and also raises uncertainties among users as to which are
the “real” figures. In addition, financial statements prepared and audited on a voluntary
basis typically fall outside the scope of domestic regulatory regimes, thereby often
reducing the reliance users can place on them. Progress is possible when the difference
between general-purpose and special-purpose/regulatory reporting is understood, and
when—instead of inserting special-purpose requirements in the rules governing general-
purpose reporting—countries acknowledge the existence of parallel systems, and seek to
minimize differences between them. This minimizes the incremental costs of multiple
6
reporting and also leverages the enforcement role of regulatory bodies with respect to
general purpose financial reporting.
Illustrations
Accounting Standards:
In country ABC, banks are required to present their financial statements in conformity with
national accounting regulations and IAS/IFRS. In practice, most banks purport to prepare their
consolidated financial statements in conformity with IAS/IFRS, since these are required by
foreign shareholders, correspondent banks, and credit-rating agencies. The national bank has
issued a number of regulations relating to the determination of loan losses, which require banks to
calculate impairment in the unsecured portion of loans and receivables on the basis of a
provisioning matrix that specifies a range of fixed provisioning rates for the number of days a
loan has been classified as nonperforming (for example, 0 percent if less than 30 days, 1 percent
if 30-90 days, etc.). In preparing their IAS/IFRS financial statements, banks apply the national
bank regulations, which may not always be appropriate to calculate the recoverable amount of
originated loans and receivables under IAS 39, Financial Instruments: Recognition and
Measurement. IAS 39 requires impairment or loan losses to be calculated as the difference
between the asset’s carrying amount and the present value of expected future cash flows,
discounted at the financial instrument’s original effective interest rate, which may differ
significantly from the impairment or loan losses determined in conformity with the national bank
regulations. The national bank does not accept the co-existence of two different reported net
incomes, i.e., the net income determined in conformity with national bank regulations for
purposes of prudential supervision, and net income determined in conformity with “full
IAS/IFRS” for general-purpose financial statements.
Auditing Standards:
In country ABC, banks are required to prepare statutory financial statements in conformity with
IFRS/IAS and prudential accounting rules, which may differ from “full IAS/IFRS requirements”
(for example, with respect to loan loss provisioning, as illustrated above). Some banks elect to
prepare an additional set of “full IFRS/IAS” financial statements and have them audited in
accordance with ISA. However, these audits of IFRS-based financial statements fall outside the
scope of the quality review system, which was established pursuant to the law on auditing, since
the quality review system does not extend to “contractual” audits. It is unclear whether the users
of IFRS-based financial statements understand this important distinction.
Inappropriate scope of application of international standards
14. Full IAS/IFRS are not appropriate for use by all reporting entities; full IAS/IFRS
should be used unchanged as the standards for public interest entities, and separate
standards should apply to other entities (the “Big GAAP/Little GAAP” 7 distinction).
National standard-setters thereby become setters of “Little GAAP” until the IASB issues
7
Generally Accepted Accounting Principles (GAAP).
7
a separate set of standards suitable for use by such other entities. It will be interesting to
monitor the experience of national standard-setters in the EU, subsequent to the
introduction of IAS/IFRS in 2005, to determine whether a national body limited to setting
“Little GAAP” can continue to attract the human and financial resources necessary to do
its job properly, as well as ensure that national concerns are properly considered in the
IASB’s standard-setting process.
15. Many countries have traditionally applied a single set of accounting requirements
to all companies (or all companies using a specific legal form), irrespective of size.
However, the use of IAS/IFRS as that single set of requirements has frequently led to
unintended negative consequences, hindering successful implementation, as full
IAS/IFRS are not appropriate for small- and medium-sized entities. 8 In such cases, the
necessary capacity for proper application was often not in place, costs of compliance
were disproportionate, and enforcement bodies either did not exist or were unable to cope
with the volume of work required. Over time, the culture of compliance suffers, even
among those companies that should be expected to have the resources to comply. Success
is greater when the application of IAS/IFRS is confined to public interest entities only,
and when limited resources are focused on ensuring compliance by these entities.
16. The situation with respect to auditing standards is more straightforward, given the
international consensus that International Standards on Auditing are suitable for the
conduct of all financial statement audits, subject to the need to improve ISA on particular
issues as discussed above. Instead, the difficulty arises in the determination of the scope
of legal requirements for audit. There are inherent limitations on the ability to perform a
proper audit of many smaller entities because of the ability of owner/managers to
override controls, and many countries have only limited audit capacity. As with
IAS/IFRS, the application of ISA to excessive numbers and/or inappropriate types of
entities almost always leads to problems of general compliance, even on those
engagements where compliance should be possible.
Illustrations
Accounting Standards:
In country ABC, the accountancy law requires that all private sector enterprises present
IAS/IFRS-based financial statements. This requirement significantly increased the accounting-
related expenses with little benefit, generated a significant issue in terms of corporate income tax
assessment and collection, and eventually resulted in pervasive noncompliance with financial
reporting requirements.
Auditing Standards:
In country ABC with a population of approximately 10 million, over 15,000 companies are
subject to annual statutory audit requirements. A significant number of them are family-owned
small- and medium-sized enterprises in which there is little public interest in such a requirement
8
The IASB is currently developing a set of standards applicable to small- and medium-sized enterprises.
8
to be audited. Also, although International Auditing Practice Statement (IAPS) 1005, “The
Special Considerations in the Audit of Small Entities” provides guidance on auditing small
entities, the quality of small entity ISA audits was determined to be low, and significant
compliance gaps with ISA were found.
Non-observability of compliance
17. Third-party users are usually unable to directly determine if a preparer or auditor
has complied with the appropriate standards. 9 Instead, users must rely on a range of
intermediary governance, regulatory and reputational agency bodies (e.g., auditors,
underwriters, analysts), which may not function at the necessary level of quality in some
countries. In such countries, it is effectively impossible for a third party that does not
have special negotiating leverage (e.g., a major lender to the company) to gain any
insight into actual levels of compliance and/or to exercise pressure for improvement,
thereby reducing the incentives for preparers and auditors to comply. Particular problems
of non-observability arise whe