Emerging pains

By Lawrence Richter Quinn
Illustration: Nicholas Wilton

The numbers from the new market countries are hard to trust. International standard setters must tackle this problem or there may be financial catastrophe

Imagine that you are looking at a financial statement from a company based in one of the emerging market countries of Asia or Africa. Given that a number of international bodies are working to establish international accounting standards (IAS), should you trust the numbers from it as much as you would trust the numbers from a company based in North America? The answer, of course, is no. This is because it appears that, despite the best efforts of a number of groups ranging from the World Bank to the International Federation of Accountants (IFAC), emerging markets are being left behind in the push to establish global accounting standards. Today there is no effective date on the calendar when institutional and individual investors will know they can trust the financial numbers of companies in countries in places as far ranging as Uganda, Bolivia and Thailand. And there is no reason to believe such a date will be established any time soon. The lack of any date for emerging market countries stands in stark contrast with the example of the European union, which is requiring that publicly held companies be in compliance with IAS by 2005.

This is obviously a cause for concern because the cost of failing to establish IAS in Africa, the Americas, Asia and Eastern Europe will be extraordinarily high. Without that date for emerging market countries, investors can expect continued impediments to the flow of international capital and an erosion of the full potential of bilateral and other trade agreements.  More chillingly, it raises the specter of new regional financial meltdowns such as the one that hit Asia some years ago or, more recently, Argentina.

Everyone stands to lose from the failure to include emerging market countries in a robust international accounting system: investors and consumers around the globe; multilateral agencies such as the World Bank and the International Monetary Fund; individual countries lending around the world; and, ultimately, all who believe complete transparency in financial numbers is crucial if future fiascos ranging from Enron to Parmalat are to be avoided.

"It's one thing to have international standards, it's another thing to apply them," says Edward Waitzer, chairman of Stikeman Elliott and currently advising the Chilean Securities and Insurance Com- mission.

John Hegarty, the World Bank's manager of financial management for the Europe and Central Asia regions and chairman of its financial sector committee, agrees. "A lot of countries in what have

traditionally been called emerging markets want to have an international solution to their accounting needs because they don't have the people or resources to develop standards in their own countries. Now, though, they're realizing that IAS 'off the bookshelf' only meets the needs of the largest companies based in their countries. Standards still need to be developed for small and medium-sized companies — that is, the vast majority of companies  — and that is tying up resources and people in countries that have more pressing needs."

How are emerging market countries being left behind? Because the infrastructure needed to put them in place, applied uniformly and transparently from country to country, isn't being built.

"Convergence will not be realized until [international] standards are rigorously interpreted and applied," Lynn E. Turner, former chief accountant at the US Securities and Exchange Commission, now director of the Center for Quality Financial Reporting at Colorado State University, noted a few years ago. "This means settling for nothing less than compliance. The bottom line is compliance matters."

The list of impediments to compliance is enormous. Says Colin Fleming, project manager at the group in charge of writing international standards, London-based International Accounting Standards Board (IASB): "In emerging market countries there's a three- or four-prong stool. The first is accounting standards; the second is a trained, knowledgeable and independent auditing and accounting staff; the third is a strong, independent, impartial regulator; and the last is that you have to have a noncorrupt government system."

Worldwide education in IAS is just beginning. In October 2003, New York-based IFAC announced a major education initiative for accountants around the world, releasing six International Education Standards. While not specifically geared to teaching IAS, they will help increase the overall professionalism of accountants worldwide. Individual IFAC member countries must decide when and how to adopt the initiatives.

Meanwhile, the IASB has jumped on the bandwagon, hiring its first director of education in August 2003. For both the IFAC and the IASB, it will take some time for these educational efforts to take root.

 "You can have the best accounting standards but if you do not understand what the accounting standards mean, it doesn't make any difference," says Fleming. "It's like having the best-designed building. If you don't have people who understand the architectural plans, they're going to be of limited use to you. You can have superb accounting standards but if you don't have people who understand how to translate the rules into a journal entry, then you've stumbled at the beginning."

The problems are further exacerbated by the fact that many emerging market countries have neither an independent securities regulator nor a legal framework for pursuing violators of securities law. In addition, many local professional accounting associations are just getting launched or have been up and running for a very short time.

The bottom line is that the problem of how to enforce international standards looks difficult to solve at the moment. European securities regulators are struggling as they prepare for the implementation of the EU's accounting regulation, which requires that all EU-listed companies prepare consolidated financial statements and be in compliance with IAS by 2005. Outside the EU (and those countries hoping to join it), the International Organization of Securities Commissions (IOSCO) is taking a leadership role on enforcement. The SEC (an IOSCO member) has made enforcement a major concern since global capitals started discussing international standards.

On a more positive note, the Madrid-based IOSCO has begun to look at enforcement issues but has issued no recommendations so far. Meanwhile, it is clear emerging market accounting associations — and, by extension, their governments — do not have the wherewithal to step in.

"The [accounting societies] in emerging economies have very small staffs; they focus more on education and training and practice development than they do enforcement," says Paul Pacter, head of the IASB's project on small to medium-sized businesses, a director of the International Financial Reporting Standards global office, and managing director with Deloitte Touche Tohmatsu in Hong Kong. "But that's the nature of emerging economies: they have bigger fish to fry than the enforcement of accounting standards."

All of these issues are well known to those concerned about accounting and auditing in emerging markets. The issue that no one wants to talk about — or at least is not doing it publicly — is who will finance the necessary education and enforcement infrastructure needed.

In the developed world, how to fund the Financial Accounting Standards Board in the US and the IASB in London have been debated in public; how to finance similar efforts in emerging markets has not. (One exception: the EU has been funding education efforts in countries such as the Czech Republic, which is about to join the EU.)

These issues aside, emerging markets — how to bring them into the new IAS regime — have been a topic of conversation ever since IASB's predecessor, the International Accounting Standards Committee (IASC), was created 30 years ago.

In fact, the IASB spent time pondering the issue of whether emerging markets should have their own international accounting system. Their answer? No, the IASB should not discriminate. Most companies, unlisted or listed, in emerging markets are small to medium-sized businesses. The IASB reasons that these smaller businesses deserve a separate accounting treatment, whether they are in developed or emerging markets. And that is what the IASB is doing: developing separate standards for small to mid-sized businesses, rejecting emerging markets as a different issue rather than a separate body of standards solely for emerging market countries.

So in 1998 the IASB decided to look at small to mid-sized businesses. As a result of that process, it decided to put emerging market issues aside for the moment.

"Naturally in the emerging markets most of the accounting entities are going to be small," explains Pacter. "Most of the emerging economies will not have a stock exchange, so small companies are unlisted. Along the way the IASC never quite decided if it wanted to focus on small companies and issues separate to them, or whether they were going to focus on specific issues in emerging economies such as agriculture. So the IASC's emerging markets project never really got off the ground."

Now that the IASB is focusing only on small to medium-sized businesses, "that will be pretty critical for emerging market countries," says Ian Mackintosh, the World Bank's manager of financial management for South Asia. "They're looking at a simplified version of the standards. That will give emerging market countries a better chance of complying with the standards."

But he adds, "You can't allow small to medium-sized businesses to report in an entirely different set of standards; there has got to be some commonality. The question is, how can you simplify without losing that essential comparability?"

Unfortunately, the IASB has no firm deadline for releasing these standards. "Dealing with emerging market issues is simply not at the top of the list of priorities for the IASB," Hegarty says. "They will admit that their top priority is developing

financial reporting standards for listed [companies], not the small to medium-sized unlisted companies you have in emerging markets. They want to make sure there's a smooth transition for listed companies, and that's where the attention is now."

While the IASB works on its new set of standards for small to medium-sized businesses, others are stepping in to help. One of the most impressive efforts is to increase education about IAS and other accounting and auditing issues. That initiative is being lead by IFAC. Its new International Education Standards cover topics such as Entry Requirements to a Program of Professional Accounting Education (IES1); Professional Skills (IES3); Professional Val- ues, Ethics and Attitudes (IES4); Practical Experience Requirements (IES5); and Assessment of Professional Capabilities and Competence (IES6).

IFAC is regarding the release of the standards as a major step forward for the international accounting and auditing profession: they were two years in development (the project was launched in November 2001). "These standards are crit-ical components of IFAC's overall efforts to provide clear benchmarks to current and potential IFAC member organizations to assist them in ensuring high-quality performance by professional accountants worldwide," IFAC president René Ricol said at the standards' release. Warren Allen, chair of the IFAC education committee said then: "In an environment of ongoing change, it is essential that professional accountants develop and maintain an attitude of learning to learn. IESs are designed to cultivate and reinforce this attitude among accountants so they effectively maintain their professional competence throughout their careers."

Claire Egan, technical manager of the IFAC's education committee, says, "In emerging markets, efforts to build the capacity of the profession, including competence, is a very important issue. The establishment, development and management of a professional body for the account-

ing profession is key to building capacity. Coupled with this is the need to build an appropriate regulatory framework to govern the accounting profession and the professional body, and recognize quality standards, including education standards. Implementation, monitoring and enforcement of international standards can be problematic."

Egan lists these education issues as important to emerging markets: the lack of a basic educational infrastructure, which might allow students to reach the international standards of competence expected of professional accountants, and insufficient local resources — both human intellectual capital and finance — to develop and deliver quality education at a level that would gain international recognition. "This is often problematic in developing and emerging economies," she says.

Egan considers her education committee the international standards setter, setting benchmarks for accounting education around the world. She adds the committee also has a role in acting as a catalyst to bring together the developed and developing nations, as well as nations in transition, and to advance accountancy education programs worldwide.

"The committee's immediate priority has been focused on issuing the standards," Egan says, "and is now turning its attention to considering what additional guidance is necessary to assist member bodies and other interested parties in implementing the requirements of the stan-dards. We expect this to be of key interest to many member bodies, particularly [to] those in developing and emerging markets."

IFAC views itself as working in tandem with the IASB on the education front — the educational complement to what the IASB is doing on the standards-setting front. "Certainly originally the emerging markets were not excluded in discussions as the IASC was formed," says Pacter. "In the late 1970s there was some history where the emerging markets complained about being left out of the IFAC's activ-ities. But then the IFAC broadened its membership to include the accounting profession in the emerging markets," he says. "And it took on a number of global issues: ethics, education, auditing standards. But it did nothing to develop its own accounting standards. Instead it looked to the IASC. In effect IFAC became the sponsor of IASB."

While IFAC has been putting together its education standards, the World Bank and IMF have also found themselves in an educational role, as has the UN. According to Hegarty, there are three reasons why the bank is involved in education about international accounting standards: as a bank, a large part of the money it raises is on the world bond markets. "You want to tell your story to the world markets in a way that they can understand," Hegarty says, "so we simultaneously comply with US GAAP and IAS. As a result, we have a very direct interest in IAS."

Also, the bank prefers that IAS be used when it is lending money for projects implemented by commercial entities. "So we obviously require transparency," he says. "When we are not happy with the degree of transparency provided by local entities we require them to report their financial statements in IAS."

Finally, the bank's official development assistance also lends itself to IAS reporting. "It's roughly only US$50 billion that we're talking about," Hegarty says, "but it's part of the resource transfer that our companies require. Obviously private-sector flows are important and our client countries need to make themselves attractive to the investment environment. The quality of financial reporting is very important."

As a result, post-East Asia crisis, the bank and related agencies launched its Reports on the Observance of Standards and Codes initiative. The bank — and more specifically, the IMF — has recognized 12 areas and associated standards as useful for the operational work for the fund and the bank. Those include: accounting; auditing; anti money laundering and countering the financing of terrorism; banking supervision; corporate governance; data dissemination; fiscal transparency; insolvency and creditor rights; insurance supervision; monetary and financial policy transparency; payments systems; and securities regulation.

Regarding IAS, the bank's de facto and major role has become telling client countries how close they are to complying with international standards. "At the World Bank we have a standards initiative; in 12 different areas we've been promoting the use of international standards and assessing a company's performance against those standards," Hegarty says. "IAS is part of that."

Pacter acknowledges some emerging market issues may have been ignored along the way and are only recently being addressed by accounting standards setters. "In emerging markets, certainly extractive industries are of interest and so are agriculture and property development," he says. "But those issues are very relevant in developed countries as well. It's a dilemma for IAS. Should it address small business and development for small companies whether in emerging countries or developed countries? At the moment the IAS has decided to develop a separate body of accounting standards for smaller unlisted companies wherever they're located."

While IFAC, the IASB and others sort through the multitude of issues to bring about true compliance with IAS, investors need to take a cautious approach. On the one hand, it's clear many companies, whether in developed or emerging markets, may say they are in complete compliance with IAS when in fact they are not.

"All the IASC's achievements and its hard-won support from IOSCO, the SEC, the European Commission and national standards-setting bodies are being undermined by poor levels of compliance by companies that purport to comply with IAS and by some poor [or lack of] auditing of IAS financial statements," says British chartered accountant David Cairns in his International Accounting Standards Survey 2000 report.

The problem is no less pronounced in emerging markets. Accountants and auditors agree, sometimes with countries cherry picking a set of global standards that would better reflect their financial position for any given accounting scenario. In one case it might be IAS; in another, US GAAP; in yet another, local GAAP. In other cases local companies may not be educated enough in IAS to know they're reporting incorrectly: what they're doing is unintentional. That speaks to the need of greater education, as IFAC promises, of course.

Finally, the regulators in a particular country may say that they want to comply with IAS or are requiring full compliance when in fact they are changing the rules themselves.

"Accounting standards setters in many countries say they are adopting IAS when they write their national accounting standards and at a high level it's true. But in detail there are many, many differences," says Pacter. "Almost all Asia — Japan, Thailand, Hong Kong, Singapore — you find that none of those countries is in true compliance with international standards," Pacter says. "[Just about] each [one] says it conforms but when you look at the financial details you find many differences, even within the same country. Singapore, Hong Kong, the Philippines and Thailand all say they have adopted IAS in its entirety.

"My point is that no matter which country in Asia says it is modeling itself after IAS, there's not one country that can say honestly its national standards are identical to IAS," Pacter says.

There are significant problems elsewhere as well. Consider Africa. One expert claims many African companies are unwilling to prepare financial statements in accordance with GAAP because it made them more vulnerable to taxation; they are not convinced that by having credible accounting they can challenge an overall aggressive tax command.

Everyone agrees stakeholders are moving in the right direction in addressing emerging market IAS concerns — certainly, the educational efforts of IFAC and the World Bank, among others, are a major first step in the right direction. Certainly, the good intentions are there. "Some developing countries went so far as to change the law," says Fleming. "Some have imbedded the text of IAS in their corporate law but without trained accountants or infrastructure to support them you don't have the knowledge. They don't have the bricks and mortar that helps build the building."

Other challenges remain tremendous. Among them: should each country develop its own "IAS light" or should the IASB develop its own "IASB light?" asks Pacter.

Robust enforcement remains a crying need, Hegarty says. "Until enforcement works itself out, many of the benefits of international standards won't accrue," he notes. "What matters in enforcement is a robust regime for enforcement and a degree of independence, capacity and resources. Frankly, if the environment isn't conducive it isn't going to happen."

The frustration for accounting and auditing professionals is that the international accounting and auditing environment that everyone would like to see is so slow in coming. "The biggest challenge is that people want to get there very fast. I don't think we can get there as quickly as they want," says Fleming. "I've sat in meetings and you listen to [accounting and auditing professionals] and they have the best intentions in the world. But the wherewithal isn't there, and they don't realize that the time to build up the expertise is phenomenal."

He adds: "We can write the standards in plain English and prepare the necessary implementation and educational materials but unless there is a corresponding investment by others in the infrastructure, even with the best rules in the world they're not going to get there any time soon."

Ultimately — at least for the moment — the investment environment in many developing markets remains on hold.

Lawrence Richter Quinn is a freelance writer based in Washington, DC