EAA Financial Reporting Standards Committee

EAA Financial Reporting Standards Committee Sir David Tweedie Chairman IASB 30 Cannon Street London EC4M 6XH UK Address for correspondence: Professo...
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EAA Financial Reporting Standards Committee

Sir David Tweedie Chairman IASB 30 Cannon Street London EC4M 6XH UK

Address for correspondence: Professor Lisa Evans Department of Account and Finance University of Stirling Stirling FK9 4LA UK 30 novembre 2007

IASB Exposure Draft IASB Exposure Draft IFRS for Small and Medium-sized Entities Dear Sir David, On behalf of the EAA Financial Reporting Standards Committee I am sending you this comment on the above quoted Exposure Draft. Principal authors of the comment are Professor Lisa Evans (University of Stirling) and Professor Roberto di Pietra (University of Siena) If you would like any clarification of our comments, please do not hesitate to contact me or the principal author Professor Lisa Evans ([email protected]). Yours sincerely

Prof. Dr. Günther Gebhardt Chair EAA FRSC Email: [email protected] Phone: +49-69-79828498 / FAX: +49-69-79823618

PLACE DE BROUCKÈRE-PLEIN 31, 1000 BRUSSELS, BELGIUM Tel: +32-2-226.66.60 - Fax: +32-2-512.19.29 Website http://www.eaa-online.org

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Comment on the IASB Exposure Draft IFRS for Small and Medium-sized Entities Roberto Di Pietra, Lisa Evans, Jérôme Chevy, Maurizio Cisi, Brigitte Eierle and Robin Jarvis1 on behalf of the European Accounting Association’s Financial Reporting Standards Committee2

1. Introduction and background International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs) have been developed principally for the financial reporting requirements of large and listed enterprises. The IASB previously considered, in principle, full IFRSs as suitable for all entities, but recognised at the same time the different user needs and cost consideration for Small and Mediumsized Enterprises (SMEs) (IASB, 2004, pp. 14-5). Differential reporting, distinguishing between requirements of and for different enterprises (by type or size) already exists in many jurisdictions. The IASB was concerned that regulation of SMEs, if left under the control of other regulators, might not be consistent with the IASB’s Framework or with IFRSs. Partly motivated by this concern the IASB voted in 2003 to extend its focus also to SMEs and set up an advisory panel for SMEs (ibid., Pacter, 2004). In June 2004 the IASB issued the Discussion Paper ‘Preliminary Views on Accounting Standards for Small and Medium-sized Entities’. This invited comments on the central question of whether the IASB should develop separate standards for SMEs, and on further issues and questions arising from this. The European Accounting Association’s Financial Reporting Standards Committee (EAA FRSC) was among the 117 organisations and individuals who commented on this Discussion Paper. Its comment was based on a comprehensive review of prior literature on reporting for SMEs.3 The IASB set up a subcommittee of the Board which made recommendations based on a review of the responses to the Discussion Paper. It concluded that there was a demand for SME standards and that the Board should therefore develop an Exposure Draft. Eligibility to use IASB standards for SMEs should be decided by national jurisdictions (IASB, 2005b). Further, the composition of the Advisory Group was to be reviewed, with (further) representatives of SME financial statement users, preparers, and credit analysts to be added (IASCF, 2004). The project now focused on ‘non-publicly accountable entities’ (NPAEs) (IASCF, 2005). The Framework was to be applicable to all entities – recognition and measurement simplifications were only considered where user needs and cost-benefit considerations are consistent with it. In early 2005 the IASB issued a press release (IASB, 2005a) and a staff questionnaire (IASB, 2005b). This questionnaire dealt with possible amendments to recognition and measurement principles in IFRSs for use in the standard(s) for SMEs and was sent to respondents to the 1

The authors’ affiliations are as follows: Roberto Di Pietra: University of Siena; Lisa Evans: University of Stirling; Jérôme Chevy: Conseil National de la Comptabilité; Maurizio Cisi: University of Turin; Brigitte Eierle: University of Regensburg; Robin Jarvis: ACCA. The opinions in this document reflect the opinions of the authors and not necessarily those of the EAA membership. 2 The members of the EAA FRSC are: Günther Gebhardt, Johann Wolfgang Goethe-Universität Frankfurt (chair); Graeme Dean, University of Sydney; Roberto DiPietra, University of Siena; Lisa Evans, University of Stirling; Martin Hoogendorn, Erasmus University Rotterdam and Ernst & Young; Jan Marton, Göteborg University; Araceli Mora, University of Valencia; Ken Peasnell, Lancaster University; Frank Thinggaard, Aalborg University; Alfred Wagenhofer, University of Graz. 3 The comment letter is available at www.iasb.org/Archive+Information/Archive+IASB+Project++Comment+Letters.htm (comment letter number CL 72). The literature review was published in Evans, L. et al. (2005) ‘Problems and Opportunities of an International Financial Reporting Standards for Small and Medium-sized Entities. The EAA FRSC’s Comment on the IASB Discussion Paper’, Accounting in Europe, 2, pp. 23-45.

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Discussion Paper, to members of the Working Group on standards for SMEs and to the Standards Advisory Council. By December 2006 a number of issues/standards had been identified (by working group, staff questionnaire, round table discussions) which could be simplified for SMEs. On February 15th 2007 the IASB issued an Exposure Draft (ED) of a proposed IFRS for Small and Medium-sized Entities (pages 255). Together with this draft two other documents were published: The Basis for Conclusions on the Exposure Draft IFRS for Small and Medium-sized Entities (BC) (pages 49), and the Draft Implementation Guidance IFRS for Small and Medium-sized Entities. Illustrative Financial Statements and Disclosure Checklist (pages 81). The deadline for comments on the ED is November 30, 2007. The EAA FRSC is continuing its activity in this area with a new comment letter on the recently issued IASB documents. As with the previous comment letter the objective is to collate and bring to the IASB’s (and EFRAG’s) attention academic research which may be relevant to IASB proposals, and to point out research needs for adequate resolution of standard setting issues. Our comment is structured as follows. Section 2 briefly revisits the key issues arising from our previous literature review and considers to what extent these have been addressed or resolved by the ED and associated documents. In Section 3 we provide a summary of the key findings from the literature reviewed and published during the period 2004-2007. In Section 4 we comment on issues relevant to the ED and the IASB’s SME project. 2. Key issues arising from the previous comment letter In response to the publication of the Discussion Paper in June 2004 we prepared a survey of literature on SMEs in order to address some of the issues and questions proposed in that document. Our key findings were: • Within the EU, SMEs have considerable economic significance; these entities are subject to reporting regimes which provide differing degrees of exemptions. • SME financial statement user groups and their needs differ from the users and user needs of large, public-interest enterprises. There are also significant differences between user groups of the smallest versus the larger SMEs. • Findings regarding the costs and benefits of reporting by SMEs are inconsistent, even within the same regulatory framework. There is a considerable gap in existing research literature on the users and user needs of SMEs, and in particular the actual views and needs of owner-managers. Moves for differential reporting are instead usually driven by other groups, including academics and practitioners. • Arguments for differential reporting frequently refer to undue burdens and disproportionate costs as well as a perceived lack of relevance of statutory accounts to the main user groups. • The main arguments against differential reporting are a demand for universality, the need for comparability, reliability, and the perception that statutory financial statements satisfy some information needs and provide some protection to stakeholders without access to inside information. • The IASB Framework’s objective and concepts of financial reporting appear biased towards large entities with public accountability. However, for SME reporting, objectives, strategies and accountability relationships differ. Thus the objectives and concepts underlying IFRSs may not be suitable for SMEs. A different conceptual framework may be required. • The advantages of IFRS implementation cited in the literature are usually considered less convincing in the context of SMEs. Costs are perceived to exceed benefits. Larger SMEs are more favourably disposed towards IFRSs. • An effective mechanism is required to ensure compliance, consistent application and enforcement of SME standards.

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We recommended that • The IASB should develop a separate set of financial reporting standards for SMEs, but that a three tier system may be required. • Further research was needed to determine to what extent the needs of owner-managers and other users of SME accounts differ internationally and between larger versus the smallest SMEs. • To satisfy cost-benefit considerations, modification not only of disclosure, but also of the recognition or measurement principles in IFRSs might be required. Therefore the standards for SMEs should not be based on the concepts and principles in the IASB Framework and existing standards. Instead, suitable concepts for an international reporting framework for SMEs should be developed on the basis of further research. • Since neither size nor legal form seemed suitable indicators for the companies which should apply the IFRS for SMEs, and since this issue touched on regulatory issues outside the IASB’s authority, we recommended that guidance and criteria should be suggested by the IASB, but EU input would be required to achieve convergence of regulation. Since the publication of the Discussion Paper, the IASB took steps (round tables, staff questionnaire, field tests) to address the research gap on SME users, user needs and cost/benefit issues. However, as had been the case previously, the debate appears again dominated by the accounting profession, regulators and academics, rather than users and preparers of SME financial statements (see also Schiebel, 2007). There are currently a number of independent research projects on SME reporting in progress, but not yet published. This research is likely to be highly relevant to the IASB project. It might be advisable, therefore, not to push for completion of the SME project until this research can be duly considered by the IASB. The ED now focuses on entities which do not have public accountability and publish general purpose financial statements for external users. It does not use quantified size criteria. The Board considers IFRS for SMEs suitable for micro-entities (BC45-50), but does not intend such financial statements as information source for owner-managers nor for the determination of taxable income or distributable income. Who should use the standard should be decided by national authorities and standard setters. Thus the ED and BC appear not to fully reflect the variety of exemptions from full GAAP already existing in many jurisdictions, nor user needs. The ED treats SMEs as a homogeneous group for which it proposes the same accounting rules with the same exemptions, assuming a common group of users, characterized by the same needs. However, for the largest number of SMEs (particularly the smaller and micro entities) the EDs 200+ pages and extensive requirements and rules may not provide an appropriate cost-benefit balance. Further, the continental European accounting traditions of prudence and of a close link between financial reporting and taxation are part of many SMEs’ economic reality. Have the likely economic consequences of the ED’s adoption for such entities been fully explored? Finally, the ED addresses disclosure and presentation, but also recognition and measurement rules. However, its reference points were the Framework and existing IFRSs – in other words, the Board rejected a ‘fresh start’ approach because this might have resulted in different objectives of financial statements, different qualitative characteristics, different definitions and different measurement and recognition concepts: ‘The Board concluded that a ‘fresh start’ approach would be costly and time-consuming and ultimately futile’ (BC68). However, whether the Framework is really a suitable basis for standards for non-publicly accountable firms was one of the most controversial questions in the debate surrounding the Discussion Paper, and it is questionable whether the Board’s above concerns justify its adoption without considering (or commissioning) further research on its conceptual implications for SMEs. This seems in particular important given the current revision of the Framework itself.

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3. Survey of literature on SMEs published since the Discussion Paper Our Comment on the ED is subject to the caveat that, while we have drawn on literature from a number of jurisdictions and language areas, including Italy, Germany, the UK and France, we have, mainly due to linguistic and resource limitations, not been able to access literature from all EU member states or countries represented by the European Accounting Association. A further limitation of this review is the fact that research on financial reporting for SMEs is currently ongoing, and therefore not yet published. While our comment is largely based on empirical research, we do not exclude normative or theory-based papers. Also, empirical papers are not necessarily comparable, because their scope, definitions of SMEs and research quality may differ. Quality also differs for normative papers, which range from high quality theoretical analyses supported by academic literature to statements of authors’ opinions. We limit our use of the latter, however, we do include a small number of non-research references (for example for France, where to our knowledge no empirical work has yet been published but where the journal Option Finance published a special issue on IFRSs in which different groups of constituents voiced their concern). Advantages of an IFRS for SMEs4 The external information flows from SMEs in general are incomplete and fragmentary (Cesaroni and Paoloni, 2006). Small businesses are typically much more informationally opaque than large corporations (Berger and Frame, 2007) and lack a clear strategy for communicating with external stakeholders (Cesaroni and Paoloni, 2006) also because they often do not have audited financial statements to yield credible financial information. According to Berger and Frame (2007, as cited in Cisi, 2007), the lack of credible information available to potential providers of funds may be one of the reason why small entities have historically faced significant difficulties in accessing funding for creditworthy projects. (However, the use of financial statements in bank lending decisions varies, nationally and internationally. Singh and Gray (2006) cite inconsistent findings in older (mainly 1980s) literature on the relevant importance of financial statements for making lending decisions.) The use of IAS/IFRSs creates a harmonised global reporting environment (Superti Furga, 2005). The improved information quality of IFRS has been demonstrated inter alia by Daske and Gebhardt (2006), who found that expert users (‘reputed accounting scholars’) rate the disclosure and information quality of IFRS financial statements of Austrian, German and Swiss firms significantly higher, in particular in comparison to local GAAP. An empirical analysis on the impact of the application of IAS/IFRS on main financial figures of Italian listed companies (Cisi, 2006) indicates that the application of international accounting standards has brought a positive contribution in terms of international comparability and in terms of reliability. An increasing number of SMEs also operates internationally. Cisi (2007) for example shows that this applies to a large number of a sample of unlisted Italian SMEs. These companies are characterised by high gearing and a high level of profitability (compared to listed companies in the same sectors). The research demonstrates that, for the SMEs examined, the application of IAS/IFRS could be an opportunity to better demonstrate results and to improve reliability of financial information in an international context and improve international comparability. Empirical studies also provide evidence that many SMEs in Germany (especially larger ones) have international business activities. Most important are: foreign suppliers, foreign customers and foreign subsidiaries (von Keitz and KPMG, 2006; DRSC et al., 2007). However, few of these German SMEs rate the importance of international comparability of financial statements very highly (DRSC et al., 2007). German evidence suggests also that so far only a minority of SMEs already applies full IFRS (Jahnke et al, 2007; Kajüter et al., 2007; von Keitz and KPMG, 2006; Oehler, 2005). Those SMEs that already apply IFRS are mainly either subsidiaries of parent companies that already provide IFRS financial statements or subsidiaries of foreign parents (Jahnke et al, 2007; von Keitz and KPMG, 2006; Oehler, 2005). DRSC et al. (2007) found that German 4

For a general discussion on the complexity of differential reporting see Eierle (2005).

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SMEs surveyed appeared somewhat reserved with regard to possible implementation of an IFRS for SMEs. In the UK IFRS for SMEs is likely not to be well received as a standard for small entities vis-à-vis medium entities because the UK already has the Financial Reporting Standard for Small Entities (FRSSE) (Sian and Roberts, 2007). It is a popular standard with estimates suggesting a 80% up take which implies that it meets the needs of small entities and users of their financial statements (see also Reid and Smith, 2007). This can be contrasted to the desire of developing countries who do not have any alternative to the full IFRS and who would welcome the opportunity to adopt IFRS for SMEs (Sian and Roberts, 2007) (see also below). Definition of NPAE/scope of the project Questions and concern arise from the definition of ‘NPAE’ by the IASB (Haller et al., 2007; Liberos, 2007). It is questionable whether entities that are of major economic significance in their home country should be permitted to apply IFRSs for SMEs (Haller et al, 2007). (This is however not a question for the IASB, but will rest with national regulatory authorities and standard setters.) The IASB uses a very broad definition, which makes it difficult to develop a standard suitable for the heterogeneous group of entities. Though the IASB used entities with 50 employees as guideline and explicitly states that the ED-IFRS for SMEs is suitable for micro-entities, the content of the ED seems to suggest that the IASB’s focus was on larger SMEs (with more external users or stronger international orientation). The ED suggests that the financial reporting user needs for SMEs are similar or identical to those of bigger SMEs (cf BC 46). However, it has been questioned whether IFRSs for SMEs can be suitable for micro entities (Roubaud, 2007). Sian and Roberts (2007:78) argue that ‘[t]he current draft IASB SME standard appears to be too complex for micro-entities’. These may be better served by local systems of rules considering small entities in their specific economic context (Di Pietra, 2005). This is supported by survey evidence from Italy and Poland, where respondents favoured a standard to be produced locally so that it could be compliant with local tax rules (Sian and Roberts, 2006). Other authors argue that the IASB should not ignore the needs of micro-entities. This is because, while in the EU national jurisdictions and the Commission may provide a suitable differential framework, this may not be the case in developing economies. Singh and Gray (2006) note that developing economies frequently have large SME sectors and that therefore an IFRS for SMEs would have important implications. In fact, small and micro-enterprises are probably even more common in developing and transitional economies than in developed economies, although the majority of prior literature on such entities focuses on the latter (Sian and Roberts, 2006). For example, in Hungary (and other transitional economies – cf. Jaruga and Fijałkowska, 2004, with regard to Poland) large-scale privatisation has given rise to a large number of SMEs and microenterprises, for which national accounting regulation often provides insufficiently (Borbely and Evans, 2006). However, the recognition and measurement simplifications of the ED-IFRS for SMEs are generally considered as very minor (Haller et al., 2007; Küting, 2007) and do not adequately take into account the specific business models and activities of SMEs as well as their shareholder and governance structures (Haller at el, 2007a; see also Küting, K. 2007). Since SMEs are defined as being not publicly accountable, the quantity and quality of the required disclosure items should also be reconsidered, since extensive disclosure might be associated with competitive disadvantages and an invasion of privacy (Haller et al 2007). The EU Commission also appears to feel that the ED does not go far enough in simplifying the life of European SMEs and has identified a number of other measures. According to Commissioner McCreevy (2007): ‘We have repeatedly emphasised that accounting for SMEs must be simple and reflect the nature of the business of small companies. The feedback we have received from Member 6

States, the European Parliament and stakeholders is that the current IASB draft is not simple enough to be applicable for the bulk of SMEs in the EU. At this stage, therefore, I do not intend to propose that the IASB draft be endorsed for application in the EU’. The Commission’s latest publications address further simplifications of accounting rules (COM 2007, Par. 394) with the aim of a reduction of the administrative burden for SMEs. The first measure is to exempt micro entities from the application of the accounting directives. In addition, the Commission proposed to exempt small entities from the requirement to publish their accounts and to make it possible for certain medium-sized entities to use exemptions currently available only for small entities (ibid.). In contrast to the IASB, the EU uses quantitative criteria to identify companies eligible for differential reporting exemptions. Botosan et al.5 (2006:192) agree with the notion that ‘calls for separate private company GAAP should be framed within the legal and institutional environment of each country. If public and private companies are subject to the same financial reporting requirements, as in many IASB countries, then the need for separate private company GAAP might be justified within an appropriate cost-benefit framework’. However, this does not apply in the US, where private companies need not comply with public company GAAP. They argue that ‘if there is demand for separate private company GAAP, then market forces, rather than standard setters, may be better at meeting the differential information needs of various private company stakeholders. The Committee does not see a persuasive argument for standard setters to create a separate private company GAAP in the US’ (ibid., 188). However, the same may not apply in countries where IFRSs have been adopted as a or the main form of GAAP. Many of these jurisdiction will face a major challenge in deciding which types of entities should be subject to an IFRS for SMEs (Singh and Gray, 2006). This may lead to a revision of the current systems of differential reporting in some countries, which in turn, in some jurisdictions (e.g. Australia or India) could lead to increased regulation for some types of SMEs which are currently subject to wide exemptions (ibid.). Also, in the UK, the Financial Reporting Standard for Smaller Entities (FRSSE) differs considerably from the ED in terms of its target catchment group and in that the ED is significantly more complex (McDowell, 2007). Users and user needs: which Framework for SMEs? According to the Basis of Conclusion, the ED was developed by ‘(a) extracting the fundamental concepts from the Framework and the principles and related mandatory guidance from IFRSs (including Interpretations), and (b) considering the modifications that are appropriate in light of user needs and cost-benefit considerations’ (BC66). The BC’s arguments appear to contain a contradiction in that, while it acknowledges that the circumstances and user needs of SMEs can differ from those of publicly accountable entities (BC21), it later argues that the above approach nevertheless would be appropriate because ‘the needs of users of financial statements of SMEs are similar in many ways to the needs of users of financial statements of publicly accountable entities’ (BC67). The suggestion that the financial reporting user needs of SMEs may be similar to those of larger/public companies may be supported by survey evidence from the US, which suggests that ‘private company users find public company GAAP financial statements to have significant 5

On behalf of the American Accounting Association’s Financial Accounting Standards Committee.

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decision usefulness, and to be cost-benefit effective’ (Botosan et al., 2006: 192). In addition, Botosan et al. (2006:180) argue, with reference to the US, that ‘external users of small business financial statements do not perceive their needs to be substantially different from decision makers who deal with larger companies. Accordingly, arguments based on differential user needs may not be sufficient to justify separate private company GAAP’. However, the assumptions upon which the IFRS’ financial statement model is developed are strongly related to the Anglo-Saxon economic context. It has been suggested that in economic contexts in which different enterprise models are developed and where user needs are different, the IFRS Framework may not the most appropriate to satisfy those user needs (Di Pietra, 2005; Lionzo, 2005). Therefore some authors call for a different conceptual approach. For example, Paoloni (2006) argues that the principles of the Framework should be tailored to better meet the characteristics of SMEs. In particular, the Framework could be simplified and some elements omitted with the aim of defining a new ‘corporate communication model’, formed on the accrual and going concern basis and on the qualitative characteristics of comparability, materiality, reliability, understandability and relevance. In accordance with the information needs of stakeholders, simplifications should be considered with respect to all types of evaluation problems that are not in accordance with the typical SMEs’ activities. Campedelli (2006) suggested that a separate set of accounting standards for SMEs should focus on information needs of specific users of SME financial statements. It should be characterized by a matrix of principles descending from IAS/IFRS fundamental principles, properly simplified in the light of specific users needs and considering the costs/benefits of information. Financial statement users are a heterogeneous group with differing information requirements (Ballwieser, 2006; Kirsch and Meth, 2007; DRSC et al., 2007). This is stressed in much of the literature reviewed; for example, Paoloni (2007) suggests a taxonomy based on size and the firm’s market (national versus international). She suggests that large family businesses and small family businesses operating in an international market would benefit from the IFRS for SMEs, but that for small family businesses operating nationally the costs would outweigh the benefits, and compliance problems would be likely. She suggests that national GAAP with (additional) exemptions would be a better solution for these types of companies. It might also be useful to distinguish SMEs’ on the basis of attitude towards external disclosure, on the administrative and accountancy competences, on the number of external stakeholders and their information needs (Paoloni, 2006). Empirical studies from Germany show that the main purposes of financial statements of SMEs are: basis for taxation; providing information for banks, determining dividend payments, providing information for investors, providing information for management (Oehler, 2005; Bundesverband der Deutschen Industrie e.V. and Ernst and Young, 2005; DRSC et al., 2007) – in other words, many purposes explicitly excluded by the IASB’s ED. Providing information for customers, suppliers, employees or potential investors is, by contrast, for most SMEs of minor importance (Oehler, 2005; Bundesverband der Deutschen Industrie e.V. and Ernst and Young, 2005; Kajüter et al 2007; DRSC et al., 2007). (The types of transactions and financial statements items frequently occurring in German SMEs as opposed to those more rarely occurring are listed in DRSC et al., 2007).) The suitability of IFRS for SMEs for individual company accounts, the link between financial statements and taxation, and accounting and national legal systems are also perceived as controversial in France (e.g. Brouzes and Quéré, 2007). Kirsch and Meth (2007) conclude that because user groups and their information requirements differ among SMEs, a more focused approach is necessary for the development of an IFRS for SMEs. They argue that smaller SMEs are usually managed by their owners and that for these smaller entities bank financing is of major importance – this is also supported by empirical 8

findings (KfW Bankengruppe, 2004; Segbers and Siemes, 2005). Therefore, for these entities banks are among the main user groups. Due to owners’ direct involvement in management, major principal agent conflicts are expected between owner managers and creditors (Kirsch and Meth, 2007). Therefore, banks need financial statements mainly for verification purposes. Consequently, banks will be primarily interested in receiving control information via financial statements (Kirsch and Meth, 2007). Banks do however usually not depend on published financial statements since they have the right or power to demand the information they require (cf. also Singh and Gray (2006), above). A similar reasoning applies to somewhat bigger SMEs which will have some external shareholders but who usually also have the rights and power to receive internal information in addition to the financial statements provided. Thus, like banks, these external shareholders are primarily interested in receiving information with feedback value for verification purposes (Kirsch and Meth, 2007). In big SMEs with primarily external shareholders, owners usually do not have access to internal information but are dependent on receiving information with predictive value for making decisions (Kirsch and Meth, 2007). Because of these differing information needs of capital providers Kirsch and Meth recommend to restrict the scope of the IASB project to those SMEs whose capital providers have access to additional internal information and therefore place greater emphasis on the reliability of accounting information (rather than its predictive value) (see also Botosan et al., 2006, below). Kirsch and Meth (2007) are supported by empirical studies on credit decisions by German banks. These show that banks, in addition to externally available financial statements, usually also use internal management accounting information, as for example plan data, for their credit decisions (Freidank and Paetzmann, 2002; Segbers and Siemes, 2005). Moreover, German banks currently still prefer financial statements prepared in accordance with the German Commercial Code to IFRS financial statements (Freidank and Paetzmann, 2002; Oehler, 2006). Banks cite creditor orientation and less volatile accounting data as main advantages of German Commercial Code financial statements in comparison to IFRS financial statements (Oehler, 2006). Correspondingly, SMEs in Germany report that so far they have not been forced by banks to provide IFRS financial statements (Kajüter et al, 2007). While in France there seems to be no strongly perceived need for IFRSs for SMEs, there is a perception that business representatives fear that the banking industry and international groups will pressure them into adopting IFRSs for SMEs (Roubaud, 2007). Finally, Sian and Roberts (2007) found that the perceived usefulness of an IFRS for SMEs may differ significantly between (developed and developing) countries: UK stakeholders were very reluctant to adopt IFRS for SMEs, while Kenyan stakeholders were keen to do so (see above). Costs of implementing IFRSs and IFRSs for SMEs Among the greatest problems of compliance with ‘Big GAAP’ for SMEs is ‘Accounting Standards Overload’ (Singh and Gray, 2006, with reference to AICPA, 1981). Problems are associated with high compliance costs, lack of technical expertise, irrelevance of standards, and competitive disadvantages (Singh and Gray, 2006). Among the costs are also the stigma attached to a qualified audit opinion as a result of non-compliance and the opportunity cost of compliance (since it may prevent SMEs to use resources to develop more relevant information) (ibid.). According to empirical surveys the main disadvantages that SMEs see in switching towards IFRS are: the complexity of the standards, the costs for switching to IFRS, follow-up costs and negative impact on taxation (von Keitz and KPMG, 2006; similar DIHK and PWC, 2005; Oehler, 2005).6 Education 6

Note also that where only one set of accounts is produced which also serves tax purposes, companies are likely to exploit accounting choices and engage in earnings management to reduced taxation. This also applies to SMEs (see Garrod, Ratej Pirkovic and Valentincic (2007) and is unlikely to cease with the adoption of IFRSs (Nobes, 2006). Garrod, Kosa and Valentincic (2007) show, for small private compenies in a transitional economy (Slovenia),

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of employees is regarded as one of the major problems when switching to IFRS (Ull, 2006) and therefore as one of the major cost factors (Bundesverband der Deutschen Industrie e.V. and Ernst and Young, 2005; DIHK and PWC, 2005; Kajüter et al, 2007; Oehler, 2005). This is not surprising since the majority of SMEs report only little knowledge of IFRS (Kajüter et al, 2007; von Keitz and KPMG, 2006; but compare DRSC et al., 2007). The majority of SMEs therefore demands for IFRSs for SMEs less complex accounting rules, reduced disclosure and simplified recognition and measurement rules (Bundesverband der Deutschen Industrie e.V. and Ernst and Young, 2005; similar von Keitz and KPMG, 2006). However, even assuming the IASB’s project would satisfy these demands, not all of the above problems would be eliminated or greatly reduced by the implementation of an IFRS for SMEs. For example, there is concern that the implementation of IFRSs for SMEs will still entail major work for which much planning is needed (Roubaud, 2007) and that IFRSs for SMEs could or should have been simplified more (Liberos, 2007; see also Küting, 2007; see also above). While accounting options such as those available in the ED may in principle provide opportunities for cost savings, they may harm the comparability of financial reporting information and can therefore reduce benefits for users (Köhler, 2007; similar Haller et al, 2007). In order to be able to judge whether a specific option is economically advantageous to an entity it has to evaluate both alternatives. This results in additional costs (Köhler, 2007). A further implication affects accounting practitioners: ‘practitioners with even one mediumsized or large client will now need to keep up with two sets of standards, not one’ (Murphy and Page, 1998: 64, with reference to the UK context, as cited by Reid and Smith, 2007:8). Fair value There is further concern that the IASB has taken the opportunity of the SME project to push its own agenda, notably on issues like ‘fair value’ (Liberos, 2007). In large listed companies, the use of fair value measurement aims to give information about the effective market value to investors in shares continuously traded in active markets. However, the switch from historic cost accounting to fair values affects the information function of the financial statement and poses complexities for quantitative determination, with obvious consequences for financial statement results, particularly when companies operate in volatile markets (Superti Furga, 2005). Thus, according to Jermakowicz et al. (2006), the IASB advocates its fair value approach on the grounds of relevance, but this approach is expected to bring increased volatility in the reported values of assets as well as earnings. In the Italian context, in which the basis of the accounting system is historical cost, the use of fair values to evaluate assets and liabilities seems to be one of the main reasons for SMEs’ reluctance to switch to IFRSs. This leads Paoloni (2006) to suggest that the ED’s most relevant simplification, in addition to the redefinition of the scope of the financial statement, concerns the definition and the use of fair values. Financial instruments meeting specific criteria are measured at amortised cost less impairment7; others are measured at fair value through profit or loss8 (ED 11.7-8). The draft specifies the conditions which have to be met before instruments (receivables, payables or loans) may be measured at amortised cost. The available-for-sale and held-to-maturity classifications in IAS 39 are not available (Cisi, 2007). However, it is arguable whether the ED’s simplifications are perceived as sufficient. Paoloni (2006) argues that SMEs’ shares are not publicly traded, strategies are controlled by owners and the main users of financial statements are finance providers, i.e. mainly banks. As a result, fair value‘incremental influence of economic incentives over prescriptions from accounting standards by financial statement preparers in a code-law setting with high alignment between financial and tax reporting and no agency problems’. 7 E.g. normal trade accounts and receivables and payables, bank loans, investments in non-convertible debt-instruments (ED.11.10). 8 E.g. investments in equity instruments with published price quotations; interest rate swaps, options and forward contracts, investments in convertible debt, etc. (ED.11.11).

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based accounting loses importance and user needs differ (see above), being satisfied by a more limited range of information (Paoloni, 2006). It has also been suggested that providers of credit finance, in particular, may be more focused on information about the ability of an entity to repay its financial debts by means of its ordinary capacity, rather than on unrealized fair value based measurements (Santucci, 2007). On the one hand, the information given by fair value measurement may even be misleading when unrealized gains – for example as a result of revaluation - lead to an increase in equity, without any effect on free cash flows. On the other hand, it is argued (ibid.) that fair value measurement does not provide additional information to a lender whose main interest is in information about entities’ ability to meet debt repayments or the value of the companies’ assets as security in case of liquidation. According to IAS 39, fair value ought to be defined on the ‘presumption that an entity is a going concern without any intention or need to liquidate, to curtail materially the scale of its operations or to undertake a transaction on adverse terms. Fair value is not, therefore, the amount that an entity would receive or pay in a forced transaction, involuntary liquidation or distress sale’. Moreover, fair values rarely derive from market values, but are often calculated in the form of discounted cash flows. The result of this calculation is influenced by the variability of the discount rate used (Santucci, 2007). Botosan et al. (2006) suggest that where this is not addressed by market forces, the IASB should consider providing relief for private companies. However, they express concern that ‘in the absence of a set of guiding principles, the IASB may be vulnerable to the lobbying efforts of private company constituencies’ (ibid:192). With respect to such principles to guide the IASB’s work, Botosan et al. argue that ‘[s]ince theoretical research suggests that information for stewardship purposes should be ‘harder’, the IASB could consider ‘hardness’ of information as one factor in deciding GAAP exceptions’ (ibid.). However, they also argue that where private companies enter into complex transactions, they should also be expected to have or obtain the expertise to account for these. Compliance Cisi’s (2007) empirical findings seem to suggest that Italian SMEs see financial statements as a statutory burden rather than an opportunity to communicate with stakeholders, and that some do not fully comply with legal disclosure requirements. More generally, Botosan et al. (2006:188) claim that ‘evidence suggests that when the cost-benefit calculus is not favorable, market forces lead to deviations from GAAP’. It is unlikely that the move from national GAAP to an IFRS for SMEs would alleviate such compliance problems. In regimes in which the IFRS for SMEs would be more onerous or costly than existing local small company GAAP compliance problems are likely to increase. While the IASB’s Framework refers to ‘… high quality enforceable standards’, it is questionable how standards can be enforced when a growing number of SMEs in Europe are not subject to the statutory audit. 4. The IASB’s Questions, and our Summary and Conclusions The ED raises 11 very specific questions on which it seeks guidance. We suggest below some tentative responses to questions 2, 4 and 9: Question 2: Recognition and measurement simplifications that the board adopted The literature reviewed above does not address the specific questions raised by the board. It does however suggest that the simplifications adopted may not be significant enough to provide sufficient relief for SMEs, in particular smaller ones. It is also argued that they may not sufficiently take into account the type of activities of SMEs and governance and business structures. The 11

suitability of the Framework as the basis for IFRSs for SMEs is again questioned. Most importantly, it is once again suggested that the IASB is progressing with this project without having awaited or obtained sufficient research evidence on SME user needs. Question 4: Whether all accounting policy options in full IFRSs should be available to SMEs Some views expressed in the literature suggest that options may harm the comparability of financial reporting information and therefore can reduce benefits for users. Additional costs may arise in assessing whether a specific option is economically advantageous, as both alternatives have to be examined. Question 9: Adequacy of disclosure Given the fact that SMEs are defined as not publicly accountable, the question has been raised as to whether additional disclosure exemptions might better protect the interests of SMEs (since comprehensive disclosures are perceived as potentially creating a competitive disadvantage). Unfortunately the literature reviewed above does not address most of the issues raised in the IASB’s questions. This is partly because, as noted above, some research on reporting for SMEs and the implications of the IFRS for SMEs is currently still ongoing, but findings are not yet available. There may be a risk, therefore, that the IASB is acting too soon, rather than awaiting further research results which might allow it to better address user needs. In other words, the research gap referred to in our previous comment letter still exists. This has also been stressed by Schiebel (2007), who examined the IASB’s due process with regard to the development of the ED. He points out that while the IASB claims to have created the ED on the basis of the information needs of external users of SME financial statements, neither academic research nor the IASB’s own processes can as yet claim to have identified these information needs. He argues that the IASB’s work is therefore based on a very biased view of these needs. While not providing answers to most of the IASB’s questions, we summarise below issues (partly arising from the literature, partly raised by members of this working group and the EAA FRSC) which we consider to be relevant to the IASB’s SME project: • The ED does not define an adequate basis for modifying full IFRS, i.e. it neither clearly states who the users are nor what the uses of SME financial statements are, nor does it explain how these differ from users and uses of full IFRS financial statements. Such an explanation would be helpful in allowing commentators to judge whether the modifications from full IFRS are justified. • The ED appears to treat SMEs and their financial statement users as homogenous groups. While it claims to be suitable also for micro-entities, its focus appears to be a narrow one. The large majority of (smaller) European SMEs and the information needs of many stakeholders are not addressed. In fact, it may be impossible to take into account in such a standard the worldwide (or even European) user needs of all SMEs. SMEs do not have a dominant user group, as is assumed for listed companies. National (and supra-national) regulators may wish to consider allowing IFRSs for SMEs as an option for companies to apply, rather than a requirement. IFRSs for SMEs cannot be the only benchmark for adequate reporting by all SMEs. A solution might be to let the market (i.e. specific users) decide which set of standards to apply (cf. Dye and Sunder, 2001). • Practical problems may arise for SMEs from a possible conflict between the EU’s and the IASB’s approaches to differential reporting, for example with regard to the EU’s quantitative and the IASB’s qualitative definition of SMEs. • There is a concern that the Framework is not the best basis for developing an IFRS for SMEs. Is there sound evidence to suggest that it is, or are the IASB’s reasons mainly pragmatic?

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• • • • •



There are calls for greater simplification and more exemptions. Given that the ED is considerably more complex than for example the UK’s FRSSE, are the ED’s simplifications sufficient to generate an appropriate cost-benefit balance? There is still uncertainty about the relevance to users of the ED’s fair value rules. Reliability or ‘hardness’ of accounting information may be more important to SME users than its predictive value. In this context, Botosan et al. (2006:192) state that the AAA FRSC ‘is concerned that in the absence of a set of guiding principles, the IASB may be vulnerable to the lobbying of private constituents’. Such a risk may be in particular high if the IASB is not willing to await the guidance which current research on SME reporting may be able to offer. On the other hand, as pointed out by Baskerville and Cordery (2006), SME financial statement users and preparers are unlikely to be used to lobbying at high level. Therefore, unlike many of the IASB’s other constituents, they may be less able to represent their interest. What effect is the current revision of the Framework likely to have? The IASB's board structure does not represent SME constituents – this may have to change if the IASB considers setting standards for SMEs is part of its remit. The IASB refers to ‘high quality, understandable and enforceable standards’ (ED P2). This begs the question of how jurisdictions will enforce the standard (given that many SMEs are exempt from the audit requirement). If the IFRS for SMEs is of greatest relevance to developing economies, are these economies’ needs and circumstances considered? The local institutions are carrying out field tests in a number of developing nations. Their results should be awaited before completion of the SME project. Further research is also required (and should be commissioned by the IASB) after the introduction of the IFRS for SMEs. This might consider inter alia who has adopted the standard, and for what constitutency, how (well) the standard is working with respect to SMEs of different size and in different jurisdictions and what new evidence may emerge on adoption with respect to user needs.

We hope that the above literature review and suggestions may be useful to the IASB’s considerations. References IASB/IASCF IASB (2004) Discussion Paper. Preliminary Views on Accounting standards for Small and Medium-sized Entities (London: IASCF). IASB (2005a) IASB issues staff questionnaire on recognition and measurement principles for small entities, Press Release, 5 April http://www.iasb.org/news/press.asp IASB (2005b) Staff questionnaire on possible recognition and measurement modifications for small and medium-sized entities (SMEs), 5 April http://www.iasb.org/news/press.asp IASB (2007) Basis for Conclusions on Exposure Draft IFRS for Small and Medium-sized Entities (London: IASCF). IASB (2007) Draft Implementation Guidance IFRS for Small and Medium-sized Entities. Illustrative Financial Statements and Disclosure Checklist (London: IASCF). IASB (2007) Exposure Draft of a Proposed IFRS for Small and Medium-sized Entities (London: IASCF). IASB website: http://www.iasb.org IASCF (2004) Small and medium-sized entities, IASB Update, December, pp. 4-5 IASCF (2004) Small and medium-sized entities, IASB Update, December, pp. 4-5 13

IASCF (2005) Accounting standards for non-publicly accountable entities (NPAEs), IASB Update, February, p.1 IASCF (2005) Accounting standards for non-publicly accountable entities (NPAEs), IASB Update, February, p.1

Empirical studies Bundesverband der Deutschen Industrie e.V. and Ernst and Young (2005) Rechnungslegung im Umbruch, Berlin: Industrie-Förderung Gesellschaft mbH, 2005. Cisi, M. (2006) ‘IAS/IFRS standards for small and medium-sized entities: international comparability versus usefulness. An analysis in the Italian context’, Proceedings of the Conference: Emerging Issues in Accounting and Business, EIAC Padova July 2006. Cisi, M. (2007) ‘IFRSs for SMEs in the Italian unlisted companies context’, paper presented at the EIASM Workshop on Accounting and Regulation in Siena (Italy) 20-22 September 2007. Daske, H. and Gebhardt, G. (2006) ‘International Financial Reporting Standards and Experts’ Perceptions of Disclosure Quality’, Abacus, 42 (3/4), 461-98. DIHK and PWC (2005) International Financial Reporting Standards (IFRS) in mittelständischen Unternehmen, Frankfurt am Main: PWC. Eierle, B. (2005) ‘Differential reporting in Germany – a historic analysis’, Accounting, Business & Financial History, 15 (3), 279 -315. Garrod, N., Ratej Pirkovic, S., Valentincic, A. (2007) ‘Political cost (dis)incentives for earnings management in private firms’, Working Paper, available at http://ssrn.com/abstract=969678 Garrod, N., Kosi, U. and Valentincic, A. (2007) ‘Asset write-offs in the absence of agency problems’, Journal of Business Finance & Accounting, forthcoming. Deutsches Rechnungslegungs Standards Committee (DRSC), Haller, A., Eierle, B., Bundesverband der Deutschen Industrie, Deutscher Industrie- und Handelstag (2007) Ergebnisse der Befragung deutscher mittelständischer Unternehmen zum Entwurf eines internationalen Standards zur Bilanzierung von Small and Medium-sized Entities (ED-IFRS for SMEs) – English version available at: http://www.standardsetter.de/drsc/docs/press_releases/071129FinalReport_SME.pdf Jahnke, H.; Wielenberg, S. and Schumacher, H. (2007) ‘Ist die Integration des Rechnungswesens tatsächlich ein Motiv für die Einführung der IFRS in mittelständischen Unternehmen?’, Kapitalmarktorientierte Rechnungslegung, 7-8, 365-376. Jermakowicz, E.K. and Gornik-Tomaszewski, S. (2006) ‘Implementing IFRS from the perspective of EU publicly traded companies’, Journal of International Accounting, Auditing and Taxation, 15, 170–196. Kajüter, P., Barth, D. And Dickmann, T. (2007) ‘Rechnungslegung nach IFRS im deutschen Mittelstand? – Der Standardentwurf ‘IFRS für kleine und mittelgroße Unternehmen’ im Licht empirischer Befunde’, Der Betrieb, (60), 1877-1884. Oehler, R. (2005) Auswirkungen einer IAS/IFRS-Umstellung bei KMU, München: Herbert Utz Verlag. Oehler, R. (2006) ‘Auswirkungen einer IAS/IFRS-Umstellung auf das Kreditrating mittelstaendischer Unternehmen’, Der Betrieb, (3) 113-9. Reid G. C., Smith J. A. (2007), ‘Practitioner views on financial reporting for smaller entities’, unpublished paper. Schiebel, A. (2007) ‘External users of SMEs’ financial statements are different! Wild guess of sound empirical analysis’, unpublished paper, available at http://ssrn.com/abstract=994684 Segbers, K. and Siemes, A. (2005) ‘Mittelständische Unternehmen und ihr Kommunikationsverhalten gegenüber der Bank – Ergebnisse einer empirischen Studie’ (Teil I und II), Finanz Betrieb, (4) and (5) 229-237 and 311-319. Sian, S., and Roberts, C. (2006) Micro-Entity Financial Reporting: Perspectives of Preparers and Users, IFAC, December. 14

Sian, S., and Roberts, C. Micro–Entity Financial Reporting: Perspectives of Preparers and Users in the UK, Kenya, Italy, Poland and Uruguay, IFAC, forthcoming. Ull, T. (2006) IFRS in Mittelständischen Unternehmen, Wiesbaden: Deutscher Universitäts-Verlag, 2006. Von Keitz, I. and KPMG (2006) Rechnungslegung nach IFRS – auch ein Thema für den Mittelstand, 2nd edition, Düsseldorf: KPMG, 2006.

Normative references, theoritical analyses, literature reviews American Institute of Certified Public Accountants (1981) Tentative Conclusions and Recommendations of the Special Committee on Accounting Standards Overload, AICPA, New York. Ballwieser, W. (2006) IFRS für nicht kapitalmarktorientierte Unternehmen?, Zeitschrift für Internationale Rechnungslegung, 23-30. Baskerville, R. F. and Cordery, C. J. (2006) ‘Small GAAP: a large jump for the IASB’, paper presented at the Conference for Financial Reporting and Business Communication, Cardiff Business School, 6-7 June. Berger A. N., Frame, W. S. (2007) ‘Small Business Credit Scoring Credit Availability. Journal of Small Business Management’, 45(1), 5–22. Botosan, C. A., Ashbaugh-Skaife, H., Beatty, A. L., Davis-Friday, P. Y., Hopkins, P. E., Nelson, K. K., Ramesh, K., Uhl, R. and Venkatachalam, M.: American Accounting Association’s Financial Reporting Standards Committee (2006) ‘Financial accounting and reporting standards for private entities’, Accounting Horizons, 20 (2), 179-194. Borbely, K. and Evans, L. (2006) ‘A matter of principle. Recent developments in Hungarian accounting thought and regulation’, Accounting in Europe, 3, 135-68. Brouzes, J.-M and Quéré, H. (2007) Option Finance, June. Campedelli, B. (2006) ‘Principi contabili internazionali e imprese minori. Una prospettiva europea’, Rivista Italiana di Ragioneria e di Economia Aziendale, marzo-aprile. Cesaroni, F. M., Paoloni, P. (2006) ‘I principi contabili per le piccole e medie imprese’, Rivista piccola impresa/small business, n. 1-2006. Di Pietra, R. (2005) ‘Il progetto di estensione degli IAS/IFRS per la redazione dei bilanci delle PMI’, in L’analisi degli effetti sul bilancio dell’introduzione dei principi contabili internazionali IAS/IFRS, RIREA. Dye, R.A. and Sunder, S. (2001) ‘Why not allow FASB and IASB Standards to compete in the US’, Accounting Horizons, 15 (3), 257-271. Evans, L., Di Pietra, R., Gebhardt, G., Hoogendoorn, M., Marton, J., Mora, A., Thinggård, F., Vehmanen, P., Wagenhofer, A. (2005) ‘Problems and Opportunities of an International Financial Reporting Standard for Small and Medium-Sized Entities. The EAA FRSC’s Comment on the IASB’s Dicussion Paper’, Accounting in Europe, 2, 23-45. Freidank, C.-C. and Paetzmann, K. (2002) ‘Auswahl und Einsatz von Datenmaterial, Analysemethoden sowie externen Beratern zur Vorbereitung von Kreditvergabeentscheidungen’, Der Betrieb, 55 (35) 1785-1789. Haller, A., Beiersdorf, K. and Eierle, B. (2007) ‘ED-IFRS for SMEs – Entwurf eines internationalen Rechnungslegungsstandards für kleine und mittelgroße Unternehmen’, Betriebs-Berater, 62, 540-551. Jaruga, A. and Fijałkowska, J. (2004) ‘Small and medium-sized enterprises in Poland – the case of accounting regulations’, unpublished paper. KfW Bankengruppe (2004) Unternehmensfinanzierung: Noch kein Grund zur Entwarnung, Frankfurt am Main: KfW. Kirsch, H.-J. and Meth, D. (2007) Adressaten einer IFRS-Rechnungslegung für mittelständische Unternehmen, Betriebs-Berater Special, 6, 7-12. 15

Köhler, A. (2007) ‘IFRS-Standardentwurf für den Mittelstand – Ausgangssituation in Europa und Entwicklungsperspektiven’, Betriebs-Berater Special, 6, pp. 2-7. Küting, K. (2007) ‘IFRS-Standardentwurf für den Mittelstand: Der Preis einer Umstellung ist zu hoch’, Betriebs-Berater Special, 6, 1. Liberos, C. (2007) Option Finance, June. Lionzo, A. (2005) Il sistema dei valori di bilancio nella prospettiva dei principi contabili internazionali, Milano: Franco Angeli. McCreevy, C. (2007) ‘Simplification of the business environment for companies’, European Commissioner for Internal Market and Services, Speech/07/527, Lisbon 13 September. McDowell, K. (2007) ‘Overview of Differences’, presentation at ICAS/ASB Discussion Forum: IFRS for SMEs: Useful for the UK?, Edinburgh, 8 March. Murphy, R. and Page, M. (1998) ‘Small, but imperfectly formed’, Accountancy, 121 (1253), 64. Nobes, C. (2006) ‘The survival of international differences under IFRS: towards a research agenda’, Accounting and Business Research, 36 (3), 233-245. Pacter, P. (2004) ‘Will the GAAP widen for SMEs?’ Accountancy, January, 118. Paoloni P. (2006) Il bilancio delle piccole imprese nella prospettiva internazionale, Il progetto IASB International Accounting Standards for SMEs, Torino: Giappichelli. Roubaud, J.F. (2007) Option Finance, June. Santucci, S. (2007) Identification of the actual users of SMEs financial statement and their information needs: influence on the ED IFRS for SMEs’ structure and potential solutions. Document prepared for EFAA Workshop on IFRS for SMEs, Warsaw, May the 30th 2007. Singh, R. and Gray, S.J. (2006) ‘International Financial Reporting Stadards (IFRS) for Small and Medium-Sized Entities (SMEs): Issues and Challenges for National Jurisdictions’, Indian Accounting Review, 10 (2), 1-17. Superti Furga, F. (2005) Il bilancio d’esercizio nel quadro dell’informativa societaria. Economia Aziendale 2000 - n. 3.

Other Communication from the Commission on a Simplified Business Environment for Companies in the Areas of Company Law, Accounting and Auditing (COM, 2007 394).

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