Socio-Economic Review Advance Access originally published online on March 9, 2007
Socio-Economic Review 2007 5(3):437-465; doi:10.1093/ser/mwl028
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New governance modes for Germany's financial reporting system: another retreat of the nation state?
Department of Accounting and Control, University of Bremen, Germany
Correspondence: phvolmer{at}uni-bremen.de
This paper inquires into the recent changes of accounting regulation in Germany. To track these changes systematically, we develop a general framework for comparing accounting regimes. Within this framework, we find privatization tendencies in accounting governance which go along with international convergence. A closer analysis also shows that the observable privatization processes do not imply a retreat of the state. Quite the contrary, the public sector has increased its interventions—albeit partly on a supranational level. Many reforms do not originate from ‘exogenous’ European legislation and are due to developments in the systemic accounting environment. Looking at the socio-economic context of financial reporting, we identify and discuss possible driving forces such as demographic developments, fraudulent conduct of reporting entities or the globalization of capital markets, which are the intrinsic forces causing the functional convergence towards a new system of accountancy.
Key Words: Governance • socio-economics • financial markets • Germany • capitalist systems • accounting
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1. Introduction |
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 TOPNotes 1. Introduction 2. Accounting: the policy...3. Two decades of...4. Withering influence of...5. SummaryReferences |
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Western states are changing. The traditionally alleged territorial monopoly of regulation ascribed to the nation state is withering under the pressures of growing interdependence and liberalization (Zürn et al., 2004). Observations of privatization as a response to the challenges of economic globalization are often shared among political scientists (e.g. Feigenbaum et al., 1999). Since the late 1970s, nation states have been privatizing facilities involved in resource extraction, telecommunication and transportation as well as public utilities; they have increasingly collaborated in public–private partnerships for the provision of schooling, health, urban development and welfare (Marsh and Rhodes, 1992). At the same time many states have decreased the tax burden on corporate income or made their labour markets more flexible. Demographic changes have necessitated reforms of public pension systems and health care provision (Barr, 2002), which, in the end, could bring about an increased relevance of capital markets.
This paper inquires into the current dynamics of Germany's financial reporting and disclosure regime and tracks its privatization and internationalization processes in particular. These transformations are considered in the broader context of changes which also occurred in the overall national business system. While the financial system has been discussed in various contexts (Weinstein and Yafeh, 1998; Rajan and Zingales, 2003; Lütz, 2002; Lütz, 2005), the disclosure regime has not yet been a focus of attention. It is, however, an important field of research, as it is highly complementary to financial, corporate governance and national business systems. In this context, we examine the major shifts in the disclosure and accompanying enforcement regimes and discuss possible drivers of these changes by contrasting today's governance mode with the settings in the post-war period of strong state involvement in the economy. Sometimes, this period has been characterized as the ‘golden age’ of interventionist nation states (Hobsbawm, 1995; Leibfried and Zürn, 2005). If the state has given up regulatory competencies in favour of private solutions to a significant extent, it might be appropriate to speak of privatization, which again is usually an indicator of the transformation of political systems towards more liberal solutions.
In this paper, we only consider the disclosure requirements and the respective enforcement mechanisms for listed firms. The reason is straightforward: major changes have only taken place for these entities. This also allows us to focus on the framework for the accounts of the economic entities (group accounts), which are considered to be the relevant information for capital markets. Governments have a long-standing tradition of intervening in how this information is to be provided, but they do so with features that have differed across nation states. These differences seem to wither away. This may be due to tensions between the national regulatory might and pressures for change, which can ideally be investigated in this context as capital markets are the champions of globalization.
The remainder of the paper is organized as follows: Chapter 2 provides a brief introduction to the policy field and the regulatory elements of disclosure regulation and the respective enforcement. It provides a typology of possible governance modes applicable in these fields and argues that particular modes of governance are rooted in particular types of business systems. Chapter 3 confronts these theoretical concepts with the developments in Germany's disclosure and enforcement regime. Here, the ‘golden age’ will be used as a starting point, and the emergence of particular governance modes will be traced. We evaluate the significance of the observed changes in Chapter 4. We will first assess the changes in the mix of public and private as well as national and international elements, then address possible drivers of change, and finally inquire into convergence patterns. Chapter 5 provides a summary and conclusion.
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2. Accounting: the policy issues |
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TOPNotes1. Introduction2. Accounting: the policy...3. Two decades of...4. Withering influence of...5. SummaryReferences |
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2.1 Corporate disclosures and accounting enforcement as a policy field
In the context of this paper, we understand disclosure as the dissemination of company-related information to a wider and non-specified audience. This is done through different channels, with different purposes and arrangements. Accounting—being a key feature of disclosure—comprises the process through which financial information on business transactions is recorded, verified and disseminated to wider audiences, mostly other businesses, investors, governments or employees. The results of the accounting process that are presented to the capital markets are financial reports.
Financial reports are commonly perceived as the major source of information for equity markets (e.g. Scott, 2003, pp. 135–164). As disclosures are intended to abate information asymmetries, they can be considered as a correlative to (capital) market participation (Merkt, 2001). A nation state's disclosure regime ‘encompasses all legally recognized information claims that a system of corporate governance or a financial system furnishes financial contracting parties with’ (Wüstemann, 2003, p. 717). Hence, the disclosure regime is likely to be complementary to the ‘variety’ of capitalism existent in a particular nation state, going hand in hand with specific legal, financial and corporate governance systems (Ball, 2001). In short, high-quality disclosures are particularly needed in such systems that strongly rely on market mechanisms, and they are not of such relevance in systems broadly relying on ‘institutional’, i.e. non-market, solutions. This implies that changes in the business systems may also necessitate changes in disclosure regulation, a topic that will be addressed in detail later in this paper.
Disclosure regulation cannot be considered isolated from the enforcement system (Ball, 2001). The information and control rights provided by the system can only be put to work if they can be enforced effectively. Additionally, enforcement can substitute—at least to some degree—for weak legal rules and low investor protection: this relates to courts that can judge on principles like fairness, even in situations when legal rules or standards are missing (Hay et al., 1996; Hay and Shleifer, 1998; La Porta et al., 1998). Therefore, we focus in our analysis on both: disclosure rules and the organization of accounting enforcement.
2.2 An analytical framework for accounting governance
Market, community and state governance
Every public policy field requires institutional or market arrangements to be chosen that allow the particular policy goals to be achieved. The key question is: Should one rely on markets, the self-regulation capabilities of society, or on a certain mode of state intervention (see e.g. Mayntz, 1988, p. 285; in an accountancy framework, Watrin, 2001, pp. 58–93)? Research on ‘governance’ examines these questions and, by the use of the term governance, the existence of networks that combine public and private actors is emphasized (Benz, 2004). According to Héritier (2002, p. 3), ‘governance implies that private actors are involved in decision making in order to provide common goods and that non-hierarchical means of guidance are employed ... Where there is governance, private actors may have independently engaged in self-regulation, or a regulatory task may have been delegated to them by a public authority, or they may be regulating jointly with a public actor.’ The concepts of both government and governance include the state and additional structural elements. The concept of governance is broad enough to fit for very different arrangements, in which there is a role for the state, as well as for society and markets. Their particular roles and predominance are discussed in the next sections.
In their seminal work on the analysis of governance in different policy fields, Streeck and Schmitter (1985) distinguish between (at least) three major bases of social order—market, with its guiding principle of dispersed competition, the state with hierarchical control, and community with spontaneous solidarity.1 In the ideal market solution, entrepreneurs seek to maximize their profit in exchange for a good or service provided to their customers on a transactional basis. The ideal state mode of organization is bureaucratic in principle—allocational decisions are made hierarchically depending on who is in power. In the community ideal, finally, leaders of societal groups seek esteem, while their followers cherish the sense of belonging to the group as such (Streeck and Schmitter, 1985, pp. 5–6). Although each of the three principles is said to have its own integrity and tendency towards reproduction, contemporary social order is in fact a continuous struggle of the three for ‘the allegiance of specific groups, for the control of scarce resources, for the incorporation of new issues, for the definition or rules regulating [behaviour], and so forth’ (Cummins et al., 1994, p. 7).
While Schuppert (1990, p. 229) argues that the variety of different governance modes is much broader than the ‘state’, ‘community’ and ‘market’ archetypes suggest, we take the view that finer typologies belong to peculiar policy fields and that almost all finer classifications of governance modes can be subsumed under Streeck and Schmitter's categories. However, the basic framework always needs adaptation to the particular policy field to which it is applied. Hence, we need to specify governance modes that can be applied in the interrelated areas of disclosure and enforcement.
Application in accounting: a framework for inquiring into the governance of disclosure and enforcement
As Puxty et al. (1987) note in their early application of Streeck and Schmitter's framework to accounting governance, the identified modes do not appear in their pure forms but rather in differently balanced combinations. First and foremost, disclosure and enforcement are based in all jurisdictions on legal stipulations, mostly in the form of company and securities law. However, legal stipulations are not sufficient for providing detailed technical rules on how to prepare financial reports. Such necessary specifications can be performed by different actors that are associated with (or rooted in) the three governance modes:
- In a state approach, specifications are made by state agencies, courts and, to a lesser extent, bodies under public law, e.g. bourses or chambers.
- In a communitarian approach, specifications are made by official (private) standard setters, by unofficial/factual standard setters or in (academic) literature.
- In a market approach, specifications are made by private contracts or arrangements.2
- In a state approach, enforcement is enacted by state agencies, courts (which are important for the evolvement of litigation risk to appear) and bodies under public law.
- In a communitarian approach, enforcement will be exercised through institutions that are necessitated by company law such as (supervisory) boards and their committees and the mandatory audit. While these institutions are stipulated by law, they do not belong to the state sector as only private actors are involved.
- In a market approach, enforcement is due to private contracts or arrangements, such as audits.
Table 1 provides a summary of possible arrangements in disclosure and enforcement. Note that the line items represent possible components of a system that are unlikely to be found exclusively. A real life configuration will rather be made up of a combination of these components, both in disclosure and enforcement. Altogether, this offers a comprehensive analytical framework for inquiries into accounting governance, and it will be used in the following to contrast the different governance modes and hence to capture the effect of the recent transformations.
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2.3 Embeddedness issues and predictions of change
Accounting is highly embedded into the national business systems. It is therefore likely that there are specific differences depending on the national systems into which accounting is embedded. The differences found among Western economies are being discussed extensively in various contexts (Esping-Andersen, 1990; Whitley, 1999; Manow, 2001; Yamazura and Streeck, 2003; Crouch, 2005). There are two different approaches to trying to explain this variation.
The first approach, often used in accounting literature, is of an analytical nature. Single (exogenous) variables are regarded as being causal for the appearance of different types of advanced capitalistic systems. In one strand of research, the legal system or tradition is the main explanatory variable (see e.g. La Porta et al., 1997). Classifications based on this factor divide economies either according to the big legal families into ‘Anglos-Saxon’ and ‘Continental-European’ countries or according to the degree of investor protection (which is assumed to be high in Anglo-Saxon and low in Continental-European models) into ‘insider’ and ‘outsider’ systems. In another strand of research, the type of the financial system is supposed to be causal for the type of corporate governance and the business system, for example. Here, ‘bank-based’ and ‘market-based’ systems are distinguished (see e.g. Leuz and Wüstemann, 2004). However, all three classifications lead to (almost) the same clusters of countries.
The second approach is synthetic, and a higher number of variables is considered. Additionally, complementarities are assumed to exist between these variables which lead to consistency of the whole system. Hence, only a small number of business systems will turn out to be workable and stable configurations. A prominent example (but not the only one) is the Varieties of Capitalism approach by Hall and Soskice (2001). They classify countries according to two basic economic archetypes: ‘liberal market economies’ and ‘coordinated market economies’. It also holds for the synthetic models that the country clusters are almost the same as in the analytical approaches. Anglo-Saxon, ‘outsider’ finance systems are likely to be ‘liberal market economies’, while Continental-European, ‘insider’ finance systems with their strong reliance on non-market institutions can be supposed to be ‘coordinated market economies’.
Whichever classification is chosen, it turns out that the models remained stable over decades. This may be due to their peculiar institutional advantages (Hall and Soskice, 2001). However, developments in the 1990s challenged these stable models. It is often supposed that, in particular, the process of economic globalization necessitated a shift towards an arm's length financing style typical of ‘liberal market economies’ with regard to large (internationally significant) companies (Hall and Soskice, 2001, pp. 60–62; Leuz and Wüstemann, 2004). When there is strong reliance on (equity) markets, ‘liberal market economies’ have comparative advantages. This pattern of change may thus lead to a convergence of the varieties of capitalism, which means that different political and economic systems adjust to imitate the one ‘best-suited’ model (Strange, 1996). Currently, this implies a convergence towards the ‘Anglo-Saxon’ model. As disclosures and enforcement are crucial for the functioning of capital markets, changes in the national business systems should also entail consequences in disclosure and enforcement: a move towards an Anglo-Saxon ‘liberal market economy’ should also go hand in hand with building matching coordination patterns. For Germany, this would lead to an increasing use of societal self-regulation capabilities and private or market solutions should be observable. Such changes in accounting would thus be evidence for a change in the overall business system.
In the next section we address the question of whether there has been a substantial shift of governance modes in the policy field of financial accounting in Germany. We start our analysis with the actors involved in the standard setting process, turning subsequently to actors in enforcement processes, before we evaluate the changes in a subsequent chapter.
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3. Two decades of change in financial accounting |
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3.1. Disclosure stipulation
Disclosure stipulation in Germany's financial reporting system is commonly associated with state intervention. Parliament rule setting was a long-standing tradition, having survived two world wars and several economic crises. The relevant law was put forward by the respective ministries (bureaucracy) and had to be approved by the parliament. Interpretation of the law was under the competency of the courts. With the revised corporation law (Aktiennovelle), mandatory disclosure of a balance sheet and a profit-and-loss account where first introduced in 1884. Subsequently, numerous disclosure requirements were included, mainly in the commercial code, but also in corporation law and securities laws. Mandatory disclosure of group accounts was introduced comparatively late with the 1965 corporation law.
One of the features of (traditional) German accounting is its interconnection with taxation since the 1920s. Tax laws still play a role, but only for company (not group or consolidated) accounts. Financial reports technically represent the basis for determining taxable income. Although initially the causation went from company to tax accounts, the high practical relevance of taxation had the effect that tax jurisdiction became de facto a relevant source of accounting rules, which for a long time did not differ substantially between company and group accounts. This inverse regulatory hierarchy has been strengthened by the low relevance of accounting information for decision-making purposes in the German ‘insider’ economy.
In general, the government used to play a predominant role in standard setting and accounting regulation became increasingly codified over time. Nonetheless, there was private actors involvement. The relevant commercial code (HGB) by no means contains all-embracing provisions and state agencies never played any relevant role in defining disclosure rules. The relevant law determines that financial reports have to be rendered according to German Generally Accepted Accounting Principles (Grundsätze ordnungsgemäßer Buchführung, hereafter: German GAAP). German GAAP consist of inputs from different sources that are neither clearly defined nor published as an anthology. In common understanding, GAAP are jurisprudence and comprise regular practice, academic input and professional opinion. The latter especially exerts significant influence on financial reporting in practice (see Marten et al., 2003). It is important to point to the ultimate competency of courts in interpretations of law and assertion of ‘good business practice’ (that is in determining GAAP) by their legislation. While no official standards setter existed, the Institute of Auditors (Institut der Wirtschaftsprüfer, IdW) pronounced standard for proper auditing, which, in turn, were also informative for balance sheet preparers and relevant in court decisions (Schruff, 2006).
In the 1980s, the legislator initiated reforms that focused on listed companies and securities trading. In different regulatory waves the attempt was made to produce an improved legal platform for investors, especially with the financial markets development acts (Finanzmarktförderungsgesetze, FFG). An important component of these legislative actions was the 1994 law on securities trade (Wertpapierhandelsgesetz, WpHG) that introduced additional disclosure rules for listed companies. In the context of insider trading, ad-hoc publicity was defined as a mandatory component of disclosure. This, however, was already European legislation being transposed into German law.
The law on securities trade is only one example of how legal rules in disclosure changed significantly due to European harmonization. The early Treaty of Rome (‘Treaty Establishing the European Community’) from 1957 already established ‘a formal reason for the harmonization of accounting systems across Europe’ (Haller, 2002). These pronouncements had no impact on the national legislators in accounting, as major steps towards an Europeanized accounting law were only taken in 1978 and 1983 when the 4th and 7th European Council Directives were passed. Germany enacted the directives in 1985.3 This transposition caused a sudden shift of many stipulations from GAAP or specific company laws to the commercial code, and its paragraphs concerning financial reporting increased significantly. As Council Directives have to be transposed into each member state's law, the national parliament's power to set accounting law at its sole discretion was curtailed, but most contentious issues in European accounting could still be decided by national parliaments as the directives contained much scope for choice. The EU demonstrated that it does intervene in national governance processes in the case of unsatisfactory transposition: in this context Germany was ordered by the European Court of Justice in 1998 to mend its transposition of disclosure requirements for public companies. In the court's opinion, Germany had failed to transpose stipulations of the aforementioned directives to define appropriate sanctions for companies that are reluctant to obey the respective disclosure obligations. The reason for the Commission's complaint was the fact that only less than 10% of the affected companies complied with the disclosure obligations.4 However, even though the scope of the national parliament on setting accounting rules might have been diminished through European legislation, formulating accounting rules still remained a duty of state institutions (EC institutions in cooperation with the national parliament) and not of any private actors. In 1998, this setting changed in two respects in Germany.
With the supervision and transparency act of 1998 (Gesetz zur Kontrolle und Transparenz im Unternehmensbereich, KonTraG), an amendment to the commercial code was put forward as a reaction to a number of corporate scandals in Germany, and its most striking feature was that it assigned the Federal Ministry of Justice to accredit a privately organized standard setting institution. In the same year, a contract was signed between the Ministry of Justice and the newly founded private standard setter, the German Accounting Standards Committee (GASC). Its board (GASB), staffed with academics as well as users and preparers of financial reports, was authorized (1) to develop recommendations for group accounting, (2) to advise the Ministry of Justice in accounting legislation projects and (3) to represent the Federal Republic of Germany on international standardization committees (see 
342 HGB). In the standardization contract, the Ministry of Justice committed itself to involve the board in all legislation projects concerned with accounting. The major task of the GASB was to develop accounting standards (for consolidated financial statements) independently. However, these standards did not represent official accounting rules until the Federal Ministry of Justice reviewed and published them.
The GASB was not the only private standard setter to gain importance for German (group) accounting. Also in 1998, the capital raising facilitation act (Kapitalaufnahmeerleichterungsgesetz, KapAEG) was adopted and brought further significant changes. With this amendment, listed (parent) companies were allowed to publish their consolidated financial statements following recognized international accounting standards, in practice either International Financial Reporting Standards (IFRS)5 or US-GAAP. The act was supposed to enhance the ability of German firms to access foreign capital markets (especially in the USA), because the widely used reconciliation statements had proven costly for preparers and puzzling for users. As US-GAAP statements of US firms were accepted in Germany prior to this, the legislator saw its act as abolishing the discrimination of domestic companies. Moreover, the act was intended to strengthen the German capital market by introducing investor-oriented financial reports. Retrospectively, the first intention can be considered less important, as only a small number of firms used the new opportunity for listings in the USA. The second reason was more relevant: large listed groups had repeatedly and with increasing emphasis expressed their concerns that German accounting rules were not informative enough for investors (e.g. Thiele and Tschesche, 1997; Schildbach, 2002). In fact, a large number of companies used the opportunity that they had lobbied for (Born, 2002) and applied IFRS or US-GAAP after the KapAEG was passed.
Both IFRS and US-GAAP are developed by private standard setters. The Financial Accounting Standards Board (FASB) is the relevant standard setter for the United States accounting rules (US-GAAP), and the International Accounting Standards Board develops the IFRS. As standards for group accounting totally eluded the German authorities’ influence,6 private standard setting reached its climax during the period of this legislation's validity. However, the KapAEG was intended to be an interim solution from the beginning as the legislator had determined 2004 as the expiration date of this regulation. In 2000, the European Commission had put forward a requirement for listed companies domiciled in the European Union to publish consolidated financial statements in accordance with International Accounting Standards (Commission of the European Communities 2000 and 2001; for a conceptual discussion, see Flower, 1997). Consequently, in 2002, both the European Parliament and Council decided that ‘[f]or each financial year starting on or after 1 January 2005, companies governed by the law of a Member State shall prepare their consolidated accounts in conformity with the International Accounting Standards adopted ... if, at their balance sheet date, their securities are admitted to trading on a regulated market of any Member State.’7 In contrast to the accounting directives, this regulation did not have to be transformed into national law as EU regulations are directly relevant for all constituents in the member states (see Hix, 2005). Nonetheless, its contents were taken over into the commercial code in 2004 with an accounting law reform act (Bilanzrechtsreformgesetz, BilReG) that expanded the mandatory application to firms that are in the listing process.
In our context, the consequences of the exclusive reference to IFRS must be evaluated carefully however. Every standard passes through a required comitology process (see Dehousse, 2003), known in an accounting context as ‘endorsement’ (Ruder et al., 2005; Schaub, 2005). Any IFRS has to be approved by the Accounting Regulatory Committee (ARC) which consists of representatives of the member states' responsible ministries. This public sector committee is consulted by the European Financial Reporting Advisory Group (EFRAG), a private organization of users and preparers of accounting standards that also participates in the IASB's deliberations to safeguard European interests. The endorsement process implies an analysis of (1) whether the standard under consideration does not conflict with the ‘true and fair view’ principle as defined in the EC Directives and (2) whether the accounting standards are in the European public interest. The endorsement process is by no means ineffective, as the endorsement of IAS 39 (‘Financial Instruments: Recognition and Measurement’) proved (Ruder et al., 2005). This very standard was endorsed only ‘with the exception of certain of its provisions on the use of the fair value option and certain of its provisions relating to hedge accounting’ [Official Journal of the European Union (L 363/3), 9 December 2004]. Therefore, IAS 39 never became effective in its initial form. As a consequence, the private standard setter may feel obliged to react to the objections of the legislator concerning unendorsed standards or other pronouncements. Moreover, once endorsed, the standards of the board immediately lose their character as pronouncements of a private standard setter by becoming community law (Küting and Ranker, 2004).
Next to the officially recognized private standard setters, new private actors appeared in the area of private disclosure stipulation. One of the most prominent is Deutsche Börse AG, since 1993 operator of the Frankfurt Stock Exchange (Frankfurter Wertpapierbörse). The fact that the largest German bourse is now operated by a private company might have some implications for the policy and governance of the bourse itself. There is some evidence that the private operator is not just performing its operational duties but increasingly interferes in setting rules for the bourse's constituents. Examples include the fact that the Deutsche Börse AG, not the bourse, issues the guidelines for the regulated unofficial market (see 89 of the Exchange Rules for the Frankfurt Stock Exchange). Recently, with the Entry Standard, the Deutsche Börse AG created a new segment in the unofficial (‘open’) market. Furthermore, admission for Xetra Funds, a trading segment for fund shares and fund-managed securities, depends on approval of the Deutsche Börse AG's management [see section 2 (1) of the Conditions for Participation in Xetra Fund]. This sort of regulation also applies to the participation in the ‘Quality Segment for Structured Products’, where specific certificates and warrants are traded [see section 1 (1) of the Conditions for Participation]. The listing requirements in the now defunct Neuer Markt, a special segment for young firms modelled after the NASDAQ, were also set by the Deutsche Börse AG. Here, the application of either IFRS or US-GAAP in consolidated accounts was demanded in addition to legally required disclosures.
As stock market operators earn their money with the prosperity of their respective bourses, they have a natural self-interest in enhancing listing quality. It is difficult to judge to what extent the Deutsche Börse AG has until now influenced or demanded reforms in the listing rules of the Frankfurt Stock Exchange, but there is a clear evidence that privately set disclosure requirements have increased in recent years. Issuers on the Frankfurt Stock Exchange now have the choice between listing in the Prime Standard or the General Standard. In the latter, disclosure requirements are less demanding and accord with minimum legal requirements. Listing in the Prime Standard, in contrast, requires among other prerequisites quarterly reports in German as well as English, application of international accounting standards (IFRS or US-GAAP) and ad hoc disclosures that go beyond legal requisites. Only firms listed in the Prime Standard are eligible for the important indices such as DAX, which are calculated and published by Deutsche Börse AG. Firms are therefore effectively forced to follow the Prime Standard's rules.
3.2 Enforcement regulation
Similar to disclosure, enforcement is regulated using multiple legal sources. Although sanctions for non-compliance of the respective disclosure rules can be found in criminal law, the field is mainly covered by corporation law and in particular the commercial code. The annual audit is Germany's main enforcement mechanism, having become mandatory for public corporations in the early 1930s (Streissle, 2001). Since 1961 the German public accountants act (Wirtschaftsprüferordnung, WPO) exists, which defines how the auditing profession is to be governed (see Schruff, 2006).
While professional bodies do not significantly interfere in the development of disclosure rules, bodies under private and public law are an integral part of enforcement. Every auditor is obliged to be a member of the Chamber of Auditors (Wirtschaftsprüferkammer, WPK), a professional organization governed by public law, founded in 1961. Organizations under public law differ from private ones in various respects: They are set up by stipulation of law and staffed with members coming from the field that they govern. Being equipped with quasi-governmental powers, this arrangement is supposed to combine the advantage of self-administration with the force of the public sector. Although they are therefore situated somewhere between societal and state governance, we understand these institutions rather as being part of the latter because their emergence does not go back to societal initiatives. The WPK is assigned by law to regulate the accreditation of public accountants, supervise the profession and to operate a system of quality controls. The chamber is also responsible for pronouncing auditing standards (see Marten et al., 2003; WPO 57). Here, the chamber is authorized and obliged to define binding rules with a legal character.
Although the Chamber of Auditors is assigned by law to pronounce auditing standards, it has delegated this responsibility to the Institute of Auditors (IdW). This private organization with voluntary membership has published a wide range of pronouncements that interpret the relevant law and are intended to fill gaps in (legal) auditing and accounting regulation (Born, 2002, p. 483). In 1998 the institute, being a member of the International Federation of Accountants (IFAC), adopted the latter's International Standards on Auditing (ISA). However, instead of fully taking over the international standards, the IdW decided to draft ISA-based auditing standards (IdW AuS) in German that still embody German auditing legislation and practice (see Brinkmann and Spieß, 2006; Ruhnke, 2006). These pronouncements represent a technical expression of opinion and therefore neither constitute legal requirements nor are enforcement mechanisms as such. Despite this, they effectively bind auditors as their application is considered to be a part of the principles of proper auditing (see Marten et al., 2003). Departure from these rules is accepted only in exceptional cases and bears risks of litigation.
The auditor oversight act of December 2004 (Abschlussprüferaufsichtsgesetz, APAG) established the Auditor Oversight Commission (Abschlussprüferaufsichtskommission, APAK), which took up its work in January 2005. It is designed as an organization sui generis under legal supervision of the Ministry of Economic Affairs, with its volunteering members selected directly by the Ministry. As the Chamber of Auditors traditionally exercises professional oversight, the new board merely enhances the public sector's influence on auditing oversight by supervising the chamber's operations and intervening in its decisions if necessary (Böcking and Dutzi, 2006). In case of conflict, the board may impose its ruling on the chamber.
EU legislation had no major impact on the developments in auditing. The 8th Council Directive (84/253/EEC) contained—unlike its counterparts in disclosure—comparatively few novelties. Transposed into German law in 1985, it dealt to a large extent with professional qualification and admission, a field that was already comparatively sophisticated in Germany due to the highly challenging admission exams (Coenenberg et al., 1999). Also the new 8th Directive (2006/43/EC) does not bring many significant changes: in the context of corporate fraud and international harmonization, most of the new provisions have already been transformed into German legislation. Still, some changes are to be incorporated into German law, such as the disclosure of auditing fees (e.g. Lanfermann, 2005). The directive's stipulation to set up an organization to exercise auditor oversight had become redundant with the auditor oversight act. The 8th Directive as amended in 2006 also expresses the intention to adopt IFAC's International Auditing Standards. With the EU attempting to endorse the international standards fully, it takes away the IdW's current privilege of transposition including national peculiarities. In future, the institute's authority to pronounce its IdW AuS is limited to issues that have been left unconsidered by the ISA (2006/43/EG, Art. 26, 3). Furthermore, the EU intends to implement a comitology procedure for ISA (2006/43/EG, Art. 26, 1–2) comparable to the IFRS endorsement process (Lanfermann, 2005).
The aforementioned supervision and transparency act of 1998 (KonTraG) not only amended disclosure stipulations. It also interfered with enforcement by expanding the responsibilities of auditors, directors and members of the supervisory board. Here, liability for all mentioned parties was extended and the setup and audit of internal risk control systems became mandatory. Another recent development is the introduction of additional external control. Oversight agencies complement the enforcement role of auditing. While auditors are individual agents, appointed by and paid for by the audited firm, agencies exercise an abstract and general enforcement role in regard to the individual financial reports. They choose whose accounting will undergo deeper scrutiny to achieve an overall functioning of the system. The concept of state agencies as the responsible bureaucracy for enforcement in accounting is relatively new in Germany and has come up with the move towards capital market oriented disclosure regulation. The Federal Oversight Commission for Financial Services (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) was set up in 2002 and pools the responsibilities of formally separate bodies engaged in the oversight of banks, insurance companies and the trade of securities. Nevertheless, the BaFin intervened only occasionally in accounting contexts (see Schüler, 2004).8 Since 2005, with the passing of the financial statement monitoring act (Bilanzkontrollgesetz, BilKoG), the commission is part of a two-tier screening system with a private sector organization as its main operational arm. The Financial Reporting Enforcement Panel (Deutsche Prüfstelle für Rechnungslegung, DPR) was established and took up its operations in July 2005. The panel, which is known in the German financial press as the ‘accounting police’ (Bilanzpolizei), extends the enforcement procedure by implementing a second stage of random checks beyond the statutory audit (Hommelhoff and Mattheus, 2004). Also, the panel examines reports in cases of suspicion. The private organization has developed its power mainly because it is backed by public authority. In the case of a finding, the usual procedure is to demand correction of the respective statement. Only if this is not fulfilled will the oversight commission BaFin intervene with the public sector's means of law enforcement.
While courts are part of accounting enforcement only in a wider sense, their rulings constitute a serious threat to managers in some legislations, such as the USA. Fraudulent or misleading accounting information may lead to liability claims by investors or criminal prosecution. The governance that courts may provide lies in filling regulatory gaps by case decisions. In the context of the German corporate scandals, a number of cases were brought to the courts and proved first of all that there is little room for liability charges. Only in rare cases, as in the ruling of the Federal Court of Justice of 2000 against EM-TV, have investors been successful in claims founded on misleading financial information. In other cases against the same company, investors failed to prove that they had acquired its shares as a result of misleading ad-hoc information.
The number of liability claims has traditionally been very limited in Germany. Only owners of more then 10% of the stock or a group of owners with equal voting rights were allowed to sue for liability against members of the management board. The above-mentioned supervision and transparency act of 1998 introduced first steps to decrease these barriers. A second reform in 2005 was the corporate integrity and modernization of legal appeals law (Gesetz zur Unternehmensintegrität und Modernisierung des Anfechtungsrechts, UMAG), an amendment of corporation law. It changes an investor's rights in different respects (e.g. Duve and Basak, 2006). First, it facilitates the ability to trigger exceptional audits. Second, it introduces the possibility of individual actions against members of the management if a minimum stake of 1% of stock is owned. This comparatively low barrier allows smaller groups of investors to take legal action against management and increases the risk of board members being held liable for their actions. As a consequence, the number of complaints as regards misleading financial information rose and the legislator introduced the possibility of model law suits (Musterklagen) that are conducted, instead of numerous separate cases on the same issue.
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4. Withering influence of the nation state? Re-balancing accounting governance |
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4.1 Rebalancing the public–private mix
In the ‘golden age’, disclosure and enforcement were designed to fit Germany's Continental-European, insider and ‘coordinated-market economy’ (in the sense of Hall and Soskice, 2001). However, it is also clear that accounting governance was not fully exercised by the state.9 Still, many fields were at least under indirect control of the state. Entities under public law that combine self-regulation with the public sector's authority (examples are the mutual stock exchanges and the WPK) represent this mixed mode best.
The domination of public intervention was most obvious in standard setting, where a comparatively intense state approach was used. Societal components, such as rules on recognition and measurement in auditing standards, existed, but they were rather scarce. German GAAP had to be regarded as being mainly influenced by accounting and taxation jurisdiction. The government also intervened in the field of enforcement by pronouncing laws on auditing and assigning the Chamber of Auditors as an organization under public law that is solely responsible for a large bundle of governance tasks. Enforcement agencies interfering in financial accounting did not exist, however, and disclosure stipulation was again primarily regulated by laws. During the ‘golden age’, stock exchange governance did not have much relevance. Disclosure stipulation was therefore mainly of a legal nature. Hence, it should be obvious that, in the areas examined, Germany cannot be considered a ‘liberal market economy’ in the golden age.
Over the last two decades, accounting policy has significantly altered. Figures 1 and 2 refer to the framework introduced above and give shape to the changed governance modes in accounting. Here, the importance of the respective institutions in disclosure and enforcement are summarized and classified on an ordinal scale according to their respective importance. These figures do not solely illustrate the distribution of influence between the respective actors but also capture the overall intensity of regulation. It can be seen that the role of private actors has increased while the state sector has been withdrawing from the responsibility of fulfilment. However, the public sector still requires that the tasks are exercised in the public interest. For this, new structures had to be implemented such as endorsement mechanisms, oversight structures and a strengthening of enforcement institutions. Overall, an activation and incorporation of the community's self-regulation capabilities is observable.
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First and foremost, the German parliament has lost its monopoly in standard setting for group accounts. However, the nation state's loss of influence does not constitute an outright shift from the state to the private sector in this very field. The public sector retains its jurisdiction in accounting, albeit partly at the European level. While private actors (GASB and IASB) have become involved in standard setting, their rules have to be legitimated by the respective authorities. Thus, the state's interventionist interest is now combined with the flexibility and professionalism of private standard setters. Further private sector involvement appears with the increasing use of listing requirements by the stock exchanges. Today, listed groups have additionally to comply with the rules defined by stock exchanges: as for companies listed in the Prime Standard, the privately set disclosure requirements of the Deutsche Börse AG go further than legal requirements. Next to institutional changes that effect screening processes in enforcement, the legal base of litigation has been reformed in order to strengthen the courts' ability to enforce accounting rules. Changes in enforcement that result in setting up private bodies as in auditing oversight or screening are initiatives of the public sector. Hence, it is beyond doubt that private actors are increasingly influential in formulating disclosure requirements, while, at the same time, the public sector gains on importance in enforcement.
It would thus be wrong to diagnose a complete shift away from state intervention in financial reporting. What has taken place is a significant change of the public–private mix of accounting regulation towards an amplified relative private involvement. This is only possible due to the increased amount of intervention in financial reporting regulation. Although the organizations responsible for standard setting or additional enforcement are privately organized, not a single responsibility has been shifted completely from the public to the private sphere. Rather, the private sector has taken a bigger slice of the growing cake of intervention. Privatization does therefore not mean a ‘race to the bottom’, as the amount and complexity of accounting regulation has risen in Germany during the last decades. However, the rising amount of private participation has to be put into another perspective: it always seems to go hand in hand with the state sector creating structures which allow the fulfilment of public tasks to be guaranteed.
4.2 Rebalancing the national–international mix
While the form of intervention in accounting has changed due to private actors' participation, this is not the whole picture of Germany's new accounting governance. Another dimension of the recently implemented changes is a shift from national to international and supra-national governance forms. Figure 3 illustrates that this dimension is another subject of analysis to be considered when discussing regulatory changes in a governance context.
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Changes in these dimensions are not necessarily interrelated. Accounting history provides numerous examples of alterations in intervention happening only along one of the two axes. A prominent example is the foundation of the US-American Securities and Exchange Commission (SEC), which introduced governmental scrutiny into financial accounting while standard setting remained in the hands of the profession. German accounting governance, however, displays changes that also represent a move towards internationalization.
Until now, the most visible alterations happened in disclosure stipulations: EU law was transformed and became relevant as a parallel source of legislation. However, national initiatives have been fostering internationalization, too. The foundation of the GASB as a standard setter in the Anglo-Saxon style or the permission for listed groups to apply extra-territorial standards have to be mentioned. Only recently has the EU regulation started interfering significantly in enforcement. Nevertheless, in Germany certain international settings were adopted even before this. The foundation of the Auditor Oversight Commission, established before this was required by EU law, follows an international trend that first appeared with the Sarbanes Oxley Act. Something similar happened in the organization of the auditing process: while the EU intends to fully endorse the ISA, the German institute of auditors has already transformed these standards with its IdW AuS. By this, we see another clear shift from the national level of private involvement towards supra-national rule-making. With full endorsement of the original ISA, this shift becomes even more pronounced as the IdW loses its remaining scope for adding its own views.
4.3 Driving forces of transition: some conjectures
While EU harmonization is a major driver for the changes, there are forces beyond this, as not all changes can be traced back to EU initiatives (see Figure 4). While many changes in Germany's accounting system have occurred in the European context, it would be wrong to identify the European integration as the sole—or even most important—driver of change. As witnessed in all areas of accounting, German regulation occasionally changed before the respective relevant EU laws became enacted. Implementing EU rules required further changes and adaptations, but the fundamental governance adjustments had already been implemented at the national level. This points to more fundamental drivers behind the adaptations in the accounting environment.
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Major changes have occurred on the equity markets. Direct barriers to capital movements such as controls of capital flows have been greatly reduced. Foreigners can now articulate their demand for shares. The German legislator did not intend to constrict the chances of German firms being listed on foreign stock exchanges or of attracting foreign investors into the country. For this purpose, indirect barriers such as the cost of collecting information and information asymmetries needed to be dismantled (e.g. Merton, 1987). For individual firms, an international integration of financial accounting lowers the reporting costs of the firm (e.g. Saudagaran and Biddle, 1992). Examples of extra costs arising from separate standards include the mandatory reconciliation of financial reports to US-GAAP or the statement of cash flows, which has not been required in Germany until recently.
Some even see the adoption of international accounting rules as a prerequisite for executing strategies of internationalization or introducing performance-based pay. Radebaugh et al. (1995), for instance, argue that Daimler-Benz's painful move to US accounting happened in order to implement its global business strategy, including the merger with Chrysler Corporation. Additional managerial surveys claim that companies use the international accounting environment (including cross listings) for other operational reasons like stock option plans or advances in reputation in order to boost marketing efforts (Mittoo, 1992; Radebaugh et al., 1995).
Adaptation of internationally comparable rules of enforcement and disclosure further reduce the firm's cost of capital by improving the agency relation between management and investors (e.g. Bancel and Mittoo, 2001). Higher governance standards lower the risk premium for investors. It is therefore in the firm's economic interest to opt for the highest level of enforcement and disclosure when ownership is dispersed. This is increasingly the case in Germany with the dissolution of the so-called Deutschland AG. As long as it is not demonstrated that previously existing governance regulation in Germany is interchangeable with new regulation from other capital markets (e.g. enforcement agencies), it is advisable to introduce elements of other capital markets for signalling purposes. This is especially important as German accounting regulation initially evolved to meet the needs of a structured market or insider economy. Making Germany's capital markets more attractive by establishing comparable rules and procedures is not only in the individual firm's or the investor's interest. There are additional external effects. Vitols (2005) mentions the creation of jobs in financial services, the strengthening of the competitiveness of industry, and the facilitation of high-tech start-ups by easing equity financing.
The governance change is also a result of the regulatory reactions of legislators to relatively recent corporate scandals and fraud. Corporate crises in Germany happened analogously to the cases of accounting fraud in the USA that are commonly associated with names like Enron, Worldcom and Adelphia. In Germany a number of firms, especially the ‘new economy’ firms, failed rather unexpectedly; some of them were involved in serious accounting fraud (Comroad, Flowtex). This led to a certain degree of regulatory pressure, especially as the private ownership of shares by inexperienced investors had become extremely popular, partly due to the emergence of online brokers at about the same time. Regulatory action after widely recognized events is a typical pattern in accounting governance (e.g. Coffee, 2002; in a general context, Owen and Braeutigam, 1979).
Another important change in the economic environment is the increased complexity of business transactions that needs to be accounted for. This is not only true for the field of financial instruments, where accounting dynamics are particularly high. It is questionable whether traditional German GAAP, with jurisdiction as a dominant factor, would be able to keep up with the ever-rising complexity. Finally, Germany's changing demographic structure, which is shifting dramatically towards a disproportionately high percentage of pensioners, can be named as an additional change in the economic environment, which is anticipated in the regulation. It is expected that the present pay-as-you-go system will have to be transformed into a funds-based system (Boersch-Supan and Winter, 2001; Vitols, 2005). This will not only increase the importance of the capital market even further, but will also accelerate dispersed ownership, accentuating the need for investor-oriented accounting regulation.
4.4 Convergence towards the US model as the final stage?
Taking an international perspective on the evidence reported in this paper, it appears that many of the alterations indicate a trend of convergence towards US accounting. Hence, it could be argued that we observe what is sometimes called Delta-convergence (e.g. Knill, 2005, p. 769). The US system indeed shows some distinctive features that the German transition process has picked up. While traditional German accounting was subject to the generally applicable commercial code and corporation law, the US approach of developing a distinct regulation for listed companies was adopted.10 Also, the organization of rule-making became similar: independent full-time standard setters that are not dominated by the auditing profession and that are solely responsible for listed companies' accounting appeared first with the FASB. This board serves as an archetype for the IASB and many national boards such as the GASB. The due process appears especially to be a role model for other standard setters that allow public participation in standard setting, and has been adopted from the Federal Administrative Procedures Act of 1946.
The FASB operates under the approval of a strong governmental body interfering in its operations: the public sector, via the Securities and Exchanges Commission, is responsible for the entire regulatory field of accounting and hence for the FASB's standards. The main focus of the Commission is, however, on enforcement, where its activities are wide-ranging and intense (Ford, 2005). With its filing process, a second stage of enforcement appeared in the 1930s that has now been introduced in various forms all over the Western world. Finally, US litigation has to be mentioned, which plays an important role in enforcement. With the current reforms, parallels can also be seen in this field of jurisdiction, even if the class action suits are still not as usual and easy to initiate as in the USA.
One possible explanation for the US dominance in accounting convergence is the fact that investor-oriented accounting has been first and furthest developed in the USA, with regulation dating back to the beginning of the twentieth century (Scott, 2003). In addition, the bargaining power within international organizations cannot be underestimated. The SEC still refuses to accept IFRS reports as a sufficient precondition for entering US exchanges. Only since the IFRS gained importance due to the EU's decision to adopt international rules has the IASB started being a serious partner for its US counterpart. Currently, FASB and IASB are working on the convergence of their standards, which also indicates that there are internationalization tendencies within the USA model as well. A clear signal of their will to converge is the current conceptual framework project, where the boards draft a common charter for standard setting (Crook, 2006).
Although one might assume that US regulation has been an archetype for various reforms in Germany, there is no formal (Delta-) convergence towards this system. In fact, both systems are changing. It can be observed that current developments in disclosure and enforcement are in many cases brought forward by international organizations that comprise European and US members. Next to the IASB, the New York-based International Federation of Accountants has to be mentioned here.
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5. Summary |
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In this paper we have proposed a general framework for analysing changes in the policy fields of disclosure and enforcement regulation and have presented a first application. While this framework would also be applicable for international comparisons, we use it to describe changes for the case of Germany. As a starting point for our inquiry, we selected the ‘golden age’ of the nation and intervention state when the traditional German approach towards accounting regulation was fully developed. This system underwent major changes in recent decades. Private participation in accounting regulation increased significantly and—more importantly—was institutionalized. At the same time supra-national governance gained importance. However, the common perception that the public sector sacrificed competencies in standard setting is true only for a seven-year period after the legislator allowed listed groups to prepare their reports according to foreign accounting standards. Today, privately pronounced standards are subject to serious public sector endorsement procedures. In the area of enforcement, both the public and the private sector gained influence with the adoption of a two-tier process that involves regular spot checks. These are carried out by a newly established panel that is backed up by an authority to intervene as a last resort. The endorsement of the International Standards on Auditing (ISA) has led to an increased state intervention, as the ISA was transposed by the Institute of Auditors, a private sector organization, before. Traditionally, prior to the appearance of ISA, the Institute drafted its own auditing rules and therefore had even greater latitude. In the field of disclosure, finally, one witnesses increased influence of stock market operators as well as the public sector (the EU) insisting on greater adherence to existing rules.
Consequently, even though the state intervention in accounting has increased, the relative stake of private participation caused a shift in the public–private mix in favour of the latter. This is possible due to an overall increased level of regulatory intervention in accounting. These changes correspond to the general move towards the predominantly US- and investor-oriented accounting model that seems to dominate global accounting to an increasing extent. Taking these internationalization tendencies into account, a new governance mode with increased complexity has been established.
A shift towards internationalization and professionalization of authority is evident. Disclosure level stipulations, at least, have been altered by the domestic and foreign capital market demands. Next to the globalized capital markets, a number of drivers can be identified that drove the changes, reaching from very generic ones such as demographic change to genuine accounting issues such as the increased complexity of business transactions that need to be reported. The issue remains, however, whether the emerging accounting regime will eventually replace all national arrangements completely or be provided in parallel to these. The latter seems more plausible considering the idiosyncrasies of the national systems that remain for a large part of commercial arrangements.
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Notes |
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* The authors would like to thank the VolkswagenStiftung for generous funding.
1 In fact, Streeck and Schmitter distinguish a fourth—‘associationist’—basis of social order as a qualitatively different mixture of the previous three. We consider these arrangements as a part of the ‘community’ basis.
2 ‘Good practice’ can be regarded either as communitarian or market governance. Its emergence due to market forces is at least a theoretical option. Here, risk premiums are expected to be higher when unknown or dubious practices are applied (Parker, 1990; Edwards et al., 1997; Leuz and Verrecchia, 2000; Healy and Palepu, 2001; Verrecchia, 2001). As communitarian deliberation empirically is mostly organized by professional organizations, we decided to assign ‘good practice’ to communitarian governance.
3 In Germany, the Fourth, Seventh and Eighth Council Directives were transposed into national law with the Bilanzrichtliniengesetz of 1985. Formally, these Directives refer to Article 54, 3 (g) of the Treaty of Rome. The Fourth Directive of 25 July 1978 (78/660/EEC) relates to the annual accounts of certain types of companies; the Seventh Directive of June 13, 1983 (83/349/EEC) relates to consolidated accounts and the Eighth Directive of April 10, 1984 (84/253/EEC) deals with persons responsible for carrying out the statutory audits of accounting documents.
4 Verdict C-191/95 of the European Court of Justice as of 29 September 1998.
5 IFRS are the standards which have been issued by the IASB, and IAS refers to the standards promulgated by the IASC. The concept of IFRS includes all currently effective IAS and IFRS. Throughout the text we will use the term IFRS for ease of reading.
6 However, there is also a German member in the IASB and the GASB cooperates with the IASB as one of its liaison standard setters.
7 Cited from Regulations (EC) no. 1606/2002 of the European Parliament and of the Council of 19 July 2002.
8 In the process of restructuring banking and insurance oversight, the BaFin was set up in 2002 as an integrated financial supervisory authority (Schüler, 2004, p. 13). One of its responsibilities is overseeing the trade in securities. It is not responsible for the oversight of stock exchanges (see http://www.bafin.de).
9 This is consistent with other findings where, for example, France is supposed to rely much more strongly on etatism than Germany does (Lahusen, 2000).
10 However, the German legislator did not switch to securities regulation that is dominant in the USA.
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