Prospering in the European Community: state aids and financial reporting.

In the first article of this two-pan series "Prospering in the European Community.- three EC initiatives to ensure it, " Financial Executive, September/October 1990), Richard D. W Mead discussed three EC initiatives to assist cross-border transactions. In this, the second of the two articles, Mr. Mead deals with two emerging issues of relevance to financial executives whose companies are seeking to take advantage of the new opportunities presented by the single European market.- state aids and the harmonization of financial reporting.

STATE AIDS IN THE EUROPEAN CO

With the single-market program gathering steam, the DirectoratesGeneral of the European Commission are being encouraged to apply their newly found muscle as the Commission develops its role as policy maker and watchdog for the 12 member states. Competition policy, clearly of importance to the Commission and the business community, is one of the areas to which the Commission has directed its attention. Earlier this year, the Commission gained member-state acceptance of its Community-wide merger control regulations.

These new regulations, now in effect, give the Competition Directorate-General wide powers to investigate the competitive effects of significant proposed mergers involving companies with operations in two or more member states. ber states. Depending upon the outcome of current discussions between' the Commission and the U.S. government over the question of jurisdiction, the Commission may take an interest in any merge involving companies based outside the Community but which have interests inside the Community.

One aspect of competition policy that has not received much attention outside the Commission is the impact of financial incentive provided by member states on the Community's competition policy and on successful competition within the single-market

During the 1980s, and in particular the last few years, there has been significant restructuring of industry in the European Community, much of it long overdue. Non-EC companies are playing their part in this process to protect-and hopefully to enhance their market positions. Japanese companies have shown growing interest in the Community and, like other non-EC companies, are being attracted to one location rather than another in large part by financial considerations.

It has even been suggested that much of the current Japanese expansion in the Community is financed by the Community's own funds or those of its member states. This suggests a certain irony not lost on member-state companies now facing increased competition from the Japanese from within their own borders. Nor is the message lost on U.S. companies seeking to expand in the Community, especially at a time when every bit of financial assistance is doubly appreciated.

EC surveys in state aids

The Commission has published two surveys of state aids in the EC, one covering the period 1981 to 1986, the other covering 1987 to 1988. The surveys distinguish two categories of state aids: specific and general. Specific aids favor certain undertakings or the production of certain goods, while general aids are applied uniformly across the country's whole economy. Fiscal policies and social security systems are two examples of general aids.

The Commission believes that the effect of most general aids on competition is likely to be diluted, counterbalanced, or neutralized by exchange-rate movements (as long as the Community has no single currency), and has stated that it does not seek to harmonize 12 very different economic and social frameworks through its competition policy. However, it believes that specific aids have a direct and immediate effect on competition, as they are intended to achieve certain objectives in a selective and discriminatory way.

Control over state aids

Companies considering expansion in the EC should be aware that investment and restructuring deals that take advantage of specific state aids may be in for active scrutiny by the Commission, depending on their size and significance. This year there have already been several cases in which the Commission has sought-and won-repayment of state aids in significant restructuring deals. In June, for example, the Commission required British Aerospace to repay 4,44 million in illegal subsidies received when it bought the public-sector Rover Group in 1988. According to the Commission, the subsidies arose because the U.K. government granted British Aerospace a delay in paying the purchase price of S,150 million and helped buy out the remaining private shareholders in Rover.

Indeed, some thought the Commission might have gone further and claimed that British Aerospace paid substantially less than the true market value of Rover. Even without considering the forgiveness of substantial debt that Rover owed the U.K. government, 150 million pounds hardly seemed a generous price to pay for a company that made 64 pounds million in 1989. But the U.K. government wanted to see the Rover Group purchased by a British group, and British Aerospace wanted to negotiate a good deal for its shareholders. Now the company is being penalized.

In another case, the Commission has opened a formal inquiry into allegedly illegal state aid paid by a local authority in Britain to Toyota for building a 4,700 million car plant in the locality. The inquiry will focus on complaints that the land site was sold to Toyota at substantially less than market value.

While the Rover and Toyota cases both arose in Britain, the Commission is actively pursuing similar cases in other countries. The Commission's message to governments and companies alike is that it wants to be fully informed of such deals in advance so that it can judge the effects on competition. A company being offered a state aid package should confirm with the member state concerned that the Commission will have no problem with the package. As a safeguard, the contract for the package should provide for the possibility that the package may be rejected by the Commission in due course. A company that is acquiring a company that has received substantial state aid also needs to check that the contract considers the risk of repayment of the state aid by order of the Commission.

What aids are available?

Given these precautions, it still makes sense to include state aids in the overall consideration of a proposed investment in the EC. A detailed list of the state aids available can be obtained from the Commission.

According to the "Second Survey on State Aids in the European Community," the EC as a whole spent ecu 82 billion (US $107 billion) on state aids in 1987 to 1988. By industrial sector, ecu 34 billion was spent on manufacturing, ecu 25 billion on railways and transport, ecu 13 billion on coal, and ecu 10 billion on agriculture and fisheries.

As Table 1 at left shows, West Germany provided the largest total amount of state aid. But Italy provided more aid to manufacturing (ecu 9.6 billion versus West Germany's ecu 7.6 billion) and more total aid as a percentage of gross domestic product (3.1 percent versus West Germany's 2.5 percent). Of the Big Four member states, the U.K. spent a modest sum of ecu 6.6 billion. However, the survey does not take into account the differences in corporate tax structures and rates, which might explain in part the preference of the japanese for the U.K. as their prime investment base in the EC.

The "Second Survey" also analyzes state aids by their primary objectives. Many state aids have horizontal objectives such as R&D, small- and medium-sized enterprises (SMEs), trade and export, the environment, or energy conservation. Other state aids are primarily intended to encourage investment in particular industrial sectors. And still others are designed to stimulate the economy of particular regions. As Table 2 at right shows, horizontal objectives and regional objectives each accounted for about 40 percent of state aids in the EC as a whole, with industrial sector objectives receiving the balance of 20 percent. But these totals mask very different allocations at the member-state level.

West Germany, for example, devoted 60 percent of its state aids to help particular regions, while France devoted only 9 percent to this objective. And within the category of horizontal objectives, West Germany devoted half of its state aids to R&D, while France heavily favored trade and export. It is also noteworthy that France devoted far more of its state aids to help particular industrial sectors than did any other Big Four country.

The Big Four also differed in the wa the provided state aids

Cash grants were preferred by the U.K., whereas West Germany went in for tax reductions. France favored equity participation, soft loans, and guarantees; Italy limited itself almost entirely to cash grants and tax reductions. This pattern may be expected to change as a result of the Commission's inquiries.

National versus Community interests

The "Second Survey" expresses the belief that "greater efforts should be made to increase transparency in the field of state aids and that the results be used as a basis to adapting state aid policy." Transparency is achieved when everyone knows what everyone else is doing-a pious hope, given the increasing competition among member states for investment in their countries.

However, the survey also links the successful attainment of a single market with Community control of national aid policies, since when left alone member states can only take account of their own national interests. " Thus, while member states may find it difficult to resist calls for help from national champions and industries coming under pressure, the Commission will resist any state aids that are inconsistent with the goal of a single market, with the goal of cohesion (which permits aid for the promotion of the peripheral and poorer regions of the Community), and with the Community's and the member states' obligations under GATT.

Two main conclusions can be drawn from the "Second Survey." One is that different member states provide very different amounts of state aids, do it for different purposes, and do it in different ways. The other is that state aids will continue in some form as an important means for member states to encourage investment. However, the Commission is scrutinizing state aids much more closely to ensure their consistency with its policies for competition and regional development. So the message is: shop now, while supplies last-and look before you leap.

FINANCIAL REPORTING IN THE EC

The harmonization of financial reporting currently being pursued by the Commission is an important part of the process of making EC-based companies as well ordered as are their counterparts in the U.S.

EC directives lay down the law and procedures to be adopted by member states relating to company structures, mergers and acquisitions, and disclosure and transparency. The requirements for disclosure and transparency in financial reporting are found mainly in the Fourth and Seventh Directives

Since the adoption of the Fourth Directive in 1978, further regulations and directives have been adopted or proposed to improve disclosure and transparency. These measures include safeguards for the protection of shareholders and creditors through annual reporting requirements, special requirements for small- and medium-sized enterprises aimed at reducing their administrative burden and audit costs, and common standards of professional qualifications for external auditors.

Of the proposals for future directives, the proposed Ninth Directive is of most interest to U.S. companies because it would significantly increase a parent company's responsibility for its subsidiary companies in order to protect minority shareholders and creditors. The directive is expected to contain provisions on the disclosure of shareholdings and of the vertical and horizontal relationships between entities. At this point, no one can predict when it will come into effect.

Variations in standards

EC directives set minimum laws to be adopted by member states and allow governments to set the national law above these minima. Thus, considerable variation in accounting standards exists from country to country. In some countries, such as Spain, Germany, and to a lesser extent France, accounting standards and taxation are closely related. In other countries, such as the U.K. and the Netherlands, the objective is to provide an accurate picture of the entity's financial position and results of operations, for the benefit of an efficient capital market and third parties.

These variations cause the following difficulties, among others: 1-1 When bankers operating under the new pan-European banking system face requests for financing from companies outside their own country, they may have to base their credit assessments on statements drawn under unfamiliar accounting standards.

* Companies find it difficult to make a reasonably accurate analysis of a competitor's financial position based on available information.

* Assessing a company being considered for acquisition may prove difficult even if current financial statements are available-and often they aren't. Steps toward harmonization In addition to the large increase in cross-border business activity taking place in the EC, several developments are tending to encourage the harmonization of accounting standards within the Community. First, on the worldwide level, the International Accounting Standards Committee (IASC) has recently published a framework for the preparation and presentation of financial statements. IASC aims to use the framework to review its existing and proposed standards and eliminate the alternative accounting treatments it presently permits. IASC wants the framework to provide guidelines for national standard-setting bodies, but does not go so far as to suggest that national standards conform to IASC standards. The framework does not yet have universal acceptance, but at least it's a start.

Against this background, the European Commission called the standard-setting bodies of EC member states to a meeting in Brussels earlier this year. Much of the discussion focused on comparability of financial reporting, and particularly on the issues identified in a 1989 study by the Federation of European Accountants titled "European Survey of Published Financial Statements in the Context of the

Fourth EC Directive."

Interestingly, most of those attending the conference felt no need to eliminate the options available under the Fourth Directive. Any such move would be premature, they believed, until all companies operating in the EC have had a chance to apply the Fourth Directive to their financial statements. And in view of the varying degrees of timeliness and accessibility of financial statements in the Community, the Commission recognized that there is no point in achieving harmonization so long as financial statements are not readily accessible to those who want to see them.

But it was the first time that the standard-setting bodies of the EC member states had ever met formally to discuss harmonization. They agreed to form a new consultative body comprising themselves and other interested parties (employers and trade unions) and to let the Commission provide the chairman and secretariat of the new body.

The conference also faced the issue of worldwide comparability of financial statements. The Commission wants to play an active role in the development of worldwide accounting standards and has accepted IASC's offer to participate on its consultative committee, on various IASC steering committees, and as an observer on the IASC board, though it will complement EC member states within IASC rather than supplant them. The strength of the Franco-German axis was seen in the Commission's view that IASC should not be dominated by the U.S. or the U.K.

Over the last year, the Commission has made much of the concept of reciprocity or equivalence at the worldwide level. At the conference, the Commission confirmed that its objective is to achieve worldwide reciprocity based on mutual recognition through a minimum harmonization of accounting standards.

Specifically, the Commission proposes that mutual recognition of listing particulars for quotations on stock exchanges and of prospectuses for issues of securities-which now exists within the EC-should be available worldwide through the mutual recognition of reporting requirements and national accounting standards. The concept of reciprocity through mutual recognition of national accounting standards is of major importance to EC companies that trade their shares around the world 24 hours a day.

To this end, the Commission intends to explore the possibility of using worldwide accounting, standards as the bridge between sets of continental standardsEuropean and American, for example-in the event that any two countries are unable to achieve reciprocity. It's up to you now In these two articles, we have identified several areas of relevance to financial executives concerning their companies' operations in the European Community. Significant developments are arising in each area in part from the single-market program and in part from the Commission's desire to establish conformity of standards for companies in the Community in the context of its policy regarding competition.

Other important areas, such as the impact of the single-market program on information systems, also need to be addressed. Clearly, financial executives, who need to ensure that their European Community operations are as well organized as their U.S. operations and are therefore well placed to respond to the challenges and opportunities of the single market, have plenty to keep them busy.