Accounting Standards and Legal Capital in EU Law

This paper examines the interaction between accounting standards and legal capital in the European Union legal framework. More in particular, it attempts to compare on a parallel basis the distributional and behavioural function of both concepts and to address whether the current legal status quo in the European Union fulfills these functions. First, this paper makes a short reference to the various accounting families which are encountered today, with a strong emphasis on the distinction between Anglo-American and Continental systems. Then, it describes the EU accounting regulation and the introduction of IFRS in domestic legislation. Further, it discusses the concept of legal capital as it has been established in European jurisdictions and it points to the relevance of the Continental accounting standards. It is argued that both are characterized by paternalism, contrasting with Anglo-American standards and American distributional methods, which are outlined by contractariansm. The final argument is that the combination of legal capital rules and Anglo-American standards, like the IFRS, neither achieves the protective role prescribed to the former, nor guarantees the aims of the latter.

Continental systems are more stakeholder-oriented, since debt financing prevails. Debt-financed systems can also be sub-divided into institutionally and governmentally financed; 14 this explains why creditors and governments are considered to be the two most important stakeholders with interests in financial reporting.
The divergence in the financing models around the world has deep roots and can be characterized as path-dependent. Fear and Kobrak state that the differences between American and German accounting and financing models trace their origins to the different degree of the involvement of equity investors and governments in the ownership of railroads in the 19 th century, which were the most attractive investment of that period. 15 Further, when accounting rules were standardized during the Interbellum, legal and government professionals monopolized this process in Germany, while in the US only accountants undertook this task. 16 Thus, the leading representatives of each system adopted a different pattern of standardization, driven either by the markets or the state. 17 This path-dependence proves that legal tradition influences accounting practice and standardization.
Many scholars suggest that the differences between common law and civil law have a crucial impact on accounting standards. 18 Nobes observes a correlation between financing models and legal environments. Professional self-regulation, private enforcement and litigation prevail in common law countries. 19 Codification, governmental regulation and public disclosure and enforcement are the main features of the civil law jurisdictions. Thus, common law appears to be more adaptive to market practice, while civil law is more centralized and doctrinal. The same can be said about Anglo-American and Continental accounting rules. Although a relationship of co-existence between accounting systems and legal rules is observable, we should be cautious about inferring causality. Dutch GAAP (both DCC and DAS), which are equity-oriented despite the civil law background of the Netherlands, show that financing practice may be more relevant than legal origins. 20 The main scope of Anglo-American systems is the information of equity investors, while the main scope of Continental systems is both the information and the protection of stakeholders. 21 The first are called 'neutral' and aim for the presentation of the 'true and fair value' (hereinafter TFV) of accounts, offering more discretion to the preparers. 22 On the other hand, Continental systems are 'prudent' in order to protect stakeholders by being biased in their favour. 23 They tend to report assets more conservatively by valuating assets at the 'lowest of cost or market rule' and by allowing the recognition of unrealized losses but not of unrealized profits. 24 This conservative treatment enables the creation of reserves, called 'hidden', that can be used in a future period when they become realized, even if the company has losses. 25 In reality, Utrecht Law Review | Volume 12 | Issue 1, 2016 they undervalue assets in order to reduce the risk of overvaluation and they transfer this value to future accounts. 26 Continental accounting attracts a lot of criticism and is viewed as non-transparent and as a source of agency problems. 27 Indeed, hidden reserves and conservative bias are not very helpful for informational purposes; nevertheless, they have a central function in creditor protection, because they play a central role in dividend restrictions. 28 Contrary to the above, neutral accounting allows for revaluations. However, this can be done only to the extent that they are justified by a reverse recognition in the previous accounts, achieving transparency and covering valuation risk. 29 Here, the recognition of unrealized profits is generally accepted, although there are exceptions, since their scope is to depict the value which is relevant for equity investors. In practical terms, Continental systems are more restrictive in good years, but they can become more permissive in bad ones, through the use of hidden reserves. 30 The restrictive outcome is driven by two factors: the undervaluation of assets and the link with taxation, which gives management an incentive to report lower profits. Hellman presents practical paradigms on how a prudent system can generate more profits than conservatively adjusted IFRS. 31 An example commonly referred to in the literature is that of Daimler-Benz AG, which reported profits under German GAAP, but losses under US GAAP, when listed on the New York Stock Exchange in 1993; this accounting divergence had negative implications after its merger with Chrysler. 32 Such outcomes have given Continental standards a poor reputation among Anglo-American scholars.
This sub-section examined the distinction between Anglo-American and Continental accounting standards and their distinct mechanisms. Moreover, the former are usually encountered in common law jurisdictions and the latter in civil law jurisdictions.

Accounting conservatism
One of the greatest risks in financial reporting is the overvaluation of assets, i.e. setting a book value higher than the market value. 33 The importance of the concept of market value has been emphasized by the 'Efficient Markets Hypothesis'; 34 however, both of these concepts have received criticism from the literature, especially after the outbreak of the economic crisis of 2008. 35 For this reason, the reporting of past events should be reliable. 36 Reliability can be achieved through 'conservatism' or 'informational asymmetry' in the reporting of profits and losses. Conservatism is divided into 'unconditional' or 'balance sheet' or 'ex ante' conservatism and 'conditional' or 'earnings' or 'ex post' conservatism. 37 Unconditional conservatism focuses on the institutionally-driven procedure of valuating assets and liabilities, which is independent from the timeliness of reporting good and bad news. 38 It will be explained below that this is what happens in prudent systems. On the other hand, conditional conservatism means that there is an asymmetry in the timeliness and a higher degree of verification for reporting bad news rather than good news. 39 It becomes apparent that conservatism is biased; the desirable outcome is the reduction of agency conflicts. The rationale behind conditional conservatism is that managers have incentives to be biased towards revealing good news, because this will reflect a better image concerning their performance. By requiring a stricter degree of verification, conditional conservatism improves the quality of information required for contracting. 40 This is relevant for everybody who has claims against the company, thus both shareholders and creditors. 41 Another function of conservatism is to prevent the exploitation of creditors by making distributions to other claimants, such as equity-holders. 42 This outcome is achieved by decreasing corporate income and assets, through unconditional conservatism. The latter function resembles the restrictive function that legal capital rules have on distribution policy. 43 According to Basu, efficiency in contracting is achieved through the informational character of news-dependent conservatism, unconditional conservatism can only contribute to the behavioural restrictions in distributions and not to informational efficiency. 44 However, according to Watts, the distributional function of conservatism can also assist in contracting efficiency. 45 From the above, we can deduce that unconditional conservatism mostly has a distributional function, while conditional conservatism mostly has an informational one. Indeed, the result of unconditional conservatism is not a lower valuation of assets and earnings, because through hidden reserves and earnings management the value not recognized in present accounts is transferred to future ones. 46 The concept that is affected by unconditional conservatism is the difference between assets and liability, which is equity. If the capital maintenance rules are applied, smaller equity is generated and, consequently, lower dividends are distributed. Thus, unconditional conservatism has a particular legal interest, especially for creditors.
There is a conflation between unconditional conservatism and prudence, or Vorsicht in German. 47 This is because many of the mechanisms used in Continental accounting are unconditionally conservative. García Lara and Mora have observed that Continental accounting systems are more unconditionally conservative than common law systems, while conditional conservatism appears more often in common law systems. 48 Besides, it has been noted that unconditional and conditional conservatism are negatively connected. 49 This means that firms that have adopted unconditional conservatism are more unlikely to adopt conditional conservative methods. Also, conditional conservatism has a higher quality of reporting while unconditional conservatism has a lower one, since conditional conservatism focuses on the timeliness of information. 50 This is connected to the fact that unconditional conservatism allows earnings management, i.e. the mitigation of income fluctuation from one year to another through hidden reserves, as happens with Continental standards. 51 On the contrary, conditional conservatism and income smoothing are negatively related and weakly connected. 52 From this it can be concluded that prudent systems concentrate on the distributional rather that the informational role of reporting, since they are non-transparent. The analogous mechanism employed by neutral systems usually influences the verification of news and not the balance sheet; thus they have solely an informational function.

Summary
This section presented the classification of international accounting families and the types of accounting conservatism. In a simplified scheme, Continental standards appear in civil law jurisdictions and they are Utrecht Law Review | Volume 12 | Issue 1, 2016 more conservative and debt-focused, while Anglo-American standards are associated with the common law, they are more neutral and they better serve the informational needs of equity investors. As will be examined below, this distinction has become less clear recently, after the transplantation of Anglo-American standards into Continental jurisdictions.

The accounting regime in the EU/EEA
This section will consider the regulation of financial reporting by EU Law. It will focus on the efforts for accounting harmonization and homogeneity through the introduction of IFRS for certain accounts. It will argue that the landscape of accounting standards in the EU and EEA is still heterogeneous, although in capital markets a relative convergence has been reached.

Introduction
Since accounting cannot be separated from company law, EU company law harmonization has not ignored financial reporting. Accounting rules may have effects on corporate disclosure and accountability, capital maintenance, transparency, public trading or restructuring. They form an integral part of the regulatory nexus surrounding business corporations; thus, harmonization in accounting rules is a precondition for harmonizing the whole body of company law. Since financial reporting should serve the needs of capital providers, attempting to harmonize this field contrasts with the heterogeneity of capital sources in the EU. 53 Thus, the harmonization effort has led to an accounting regime that is mostly a product of transplantation, rather than origination; IFRS are exogenous to many European markets, compared to the local standards which were developed according to the particularities of Continental economies. While the scope of harmonization is market integration, there is the risk of giving birth to a legal regime that does not reflect the needs of the real economy.
The primary EU accounting law statutes are two directives and a regulation. First, Directive 2013/34/EU regulates the preparation of the annual financial statements and consolidated financial statements of limited liability companies. 54 This Directive replaced the Fourth Council Directive, which regulated the preparation of annual accounts by limited liability companies and the Seventh Council Directive governing the consolidated accounts of groups of companies. 55 Besides, the Eighth Council Directive 56 sets minimum standards for the accounting profession. Lastly, the IAS Regulation (a statute which is relevant for the EEA) introduced the application of IFRS for groups of companies with at least one listed member; until then this practice was exercised voluntarily by many companies. 57 Additionally, the Regulation enables national legislators to extend the application of IFRS to accounts governed by domestic law, an option that had been adopted by 21 Member States and the 3 EEA States.

True and fair value versus prudence
A most fundamental characteristic of Directive 2013/34/EU is that it enables wide discretion for the Member States to preserve their own accounting philosophy, prudence or TFV principle. 58  in Article 2(3) of the Directive, has a central importance and implies a retreat of prudence, and the situation has not changed after Directive 2013/34/EU. 59 Nevertheless, it has to coexist with prudence, according to Article 31(1)(c). The view extracted from the case of Tomberger (Case C-234/94) is a predominance of the TFV principle; 60 if a subsidiary's accounts comply with the TFV principle, it is not contrary to the prudence principle to include these accounts in the balance sheet of the parent company. However, EU linguistic politics are not helpful. All the linguistic versions of the Directive, apart from the English one, contain the words 'in any event/case' in the section on prudence. 61 This is explained by the impact of Roman law in all European languages apart from English, as well as by the translation procedures in European organs. 62 This means that there is no clear balance and that the Member States enjoy wide discretion in the application of the same concepts. 63

IFRS in the EU/EEA
The IAS Regulation is much more radical than the Directives. It introduces the mandatory application of IFRS for the consolidated accounts of publicly traded companies, as they have been adopted by the European Commission pursuant to the (procedure of the) IAS Regulation. The mandatory application of IFRS for consolidated accounts of listed companies is justified by the fact that although there is a substantial divergence among the economic and financial systems of EEA States, there is a relative convergence of their capital markets. 64 IFRS are equity-focused accounting standards set by the International Accounting Standards Board (IASB), an international independent standard-setting body. Together with the US and UK GAAP, they are the most characteristic Anglo-American standards. 65 IFRS have a clear informational role in the context of capital markets and provide for informational comparability among different companies, something which is impossible if they are subject to different accounting regimes. 66 This is crucial for consolidated accounts, which treat a group of companies as a 'single accounting entity'. 67 Consolidated accounts are helpful in determining someone's investment strategy, while individual accounts can also be used for distributional and regulatory purposes, such as taxation. 68 Consequently, by mandating IFRS only for consolidated accounts, the Regulation draws a new dichotomy; now, accounting systems are not only determined by the financing systems they serve, but also by the type of accounts they bind. Even though the IAS Regulation introduces an Anglo-American transplant into Continental Europe, there is a homophony in favour of its provisions, because it regulates an environment that requires equity-oriented information.
The standards used in individual accounts are still determined by national legislators; this is the cardinal compromise reached by the Regulation. 69 For individual accounts, EEA States enjoy discretion. They can require, permit or prohibit IFRS. Additionally, their implementation can vary according to the following factors: (i) whether IFRS apply to individual or consolidated accounts, (ii) whether the covered companies are listed or non-listed, (iii) whether such an option applies to all firms or firms of certain industries, such as credit institutions, (iv) whether IFRS apply to some companies according to their size, and (v) whether accounts are used for distributional or only for informational purposes. The effects of requiring or permitting the use of IFRS on individual accounts are Utrecht Law Review | Volume 12 | Issue 1, 2016 very important from a legal point of view. Firstly, wherever IFRS are adopted, individual accounts have to be separated from taxation, because they are incompatible. 70 Analogously, the influences that IFRS may have on national GAAP, as in the case of Germany, have led to a similar outcome. 71 Secondly, individual accounts continue to determine dividend distributions under IFRS, altering the whole discussion about legal capital, since assets, liabilities and equity are now calculated by a different method. In practical terms, under IFRS, assets can be valued higher and unrealized profits can be distributed, circumventing the restrictive nature of capital maintenance rules. Thirdly, accounting standards may influence contractual obligations between the company and third parties, such as debt covenants, if they are accounting-based. 72 An additional point of interest is auditors' liability; auditors traditionally have a 'watchdog' function over managers, resulting in a natural inclination towards conservative accounting. 73 Since Continental accounting is always conservative, the introduction of less conservative standards, without voluntary adjustments, is likely to create confusion and malfunctions.
A final remark should be made about the possible efficiency of adopting IFRS. As Ball et al. and Van Tanderloo and Vanstraelen have empirically observed, high quality standards are a pre-requisite for high quality reporting, but do not themselves guarantee such an outcome if the incentives of preparers are problematic. 74 Thus, IFRS may not work that well in economies characterised by close links between companies and stakeholders, because in those economies there is no demand for a high quality of reporting, due to this proximity. 75 In the EU context, the different degrees of enforcement effectiveness among the Member States play a central role, which also has an impact on the quality of the information produced. 76 Additionally, in those cases where IFRS are not mandated, but just permitted, the element of comparability is reduced. Further, companies bound by such a regime may decide to adopt IFRS not in order to enhance quality, but with the intention of increasing distributions. And in the same way, the mandatory application of IFRS in an economy with weak institutional features may not augment comparability, because it may not be easy to distinguish the genuine from the malign incentives. The long list of issues arising from the IAS Regulation shows the various legal implications of this statute. 77

The State-level choices
EEA States have the option to extend IFRS application to individual accounts of listed companies and to all accounts of non-listed companies. For all of these accounts, national legislators can permit, require or prohibit the application of IFRS. Until 2013, 12 EEA States required the use of IFRS for the individual accounts of listed companies, 12 permitted their adoption and 7 prohibited this. 78 Additionally, some states that permit IFRS may require them for certain types of companies. If IFRS' application is extended to individual accounts, then distributions are made according to IFRS and not national GAAP. Thus, there is a small group of states that still consider that their national GAAP can better serve the interests of creditors and other stakeholders (Austria, Belgium, France, Germany, Hungary, Spain and Sweden). As shown by a study of the German KPMG, the decision of those states can be justified by the fact that their national GAAP are substantially divergent from the IFRS. 79  high-quality standards in markets affected by major financial scandals. 83 However, what seems paradoxical for these countries is their dependence on debt financing and the divergence of their national GAAP compared to IFRS. 84 The same applies to the Eastern European states, although many of them already had equity-friendly standards before the IAS Regulation. In other cases, such as in Greece, the wide introduction of IFRS has led to the eventual reform of the domestic GAAP. 85 There is another group of states that leave the decision about the adoption of certain standards to the companies themselves. A first group consists of Western and Northern European countries with strong equity markets, some of which traditionally have equity-driven standards. A second one is comprised of some Eastern European states and Portugal, which decided to implement an intermediate position between the two extreme ones. As was already discussed, this option offers flexibility, but also creates deficiencies in comparability and the opportunity for manipulation. Companies with discretion in applying IFRS can use standards that better fit their particular characteristics, in this way manipulating the interests of third parties. However, as was explained before, in many jurisdictions, such as the UK or the Netherlands, the differences between IFRS and local GAAP are not substantial; 86 thus the above-described flexibility is narrow in practice. Consequently, this intermediate option has many behavioural implications in those cases where national GAAP and IFRS are relatively distant. Thus, it should be noted that the wider the divergence between local GAAP and IFRS, the more important this discussion becomes. The decision to adopt IFRS is not an easy one to make; since the vast majority of Continental jurisdictions had a different accounting tradition to IFRS, the transition between the old and the new regime may not be simple. Yet, economies evolve and change; thus, the swift change from national GAAP to IFRS may reflect new market needs. In any case, an analysis of the economic teleology of adopting IFRS is beyond the scope of this paper.

Some final thoughts about the IAS Regulation
The IAS Regulation creates a bifurcated regime. Firstly, IFRS are made mandatory for consolidated accounts of listed companies, thereby compelling the harmonization of standards in this field. This intrusion is not unjustified, because it follows the informational needs of capital markets and the practice of the voluntary adoption of high-quality equity-focus standards by European firms prior to the enactment of the Regulation. 87 The success of the first stage is mirrored by the fact that all the 31 EEA States somehow allow or require the adoption of IFRS for the consolidated accounts of non-listed companies. The second point more controversially concerns what happens (a) with the individual accounts that impact distributions or taxation and (b) whether IFRS can be extended to non-listed firms. Both of these decisions lie at the discretion of national legislators and regulators. As noted above, there is a small group of states that rigidly reject any further application of IFRS. A second group of states require the adoption of IFRS for certain companies, while a third group permit them for certain or all companies. The stance of the first group seems rather conservative; however, it represents a devotion to another accounting philosophy that may better reflect the needs of local markets. The dangers of the decision of the first group are linked with the decision of the second group; mandatory IFRS application may or may not suit the characteristics of local economies. The third option is less paternalistic and more contractarian; companies can choose the standards they consider to be better. Here, the needs of outside parties are dealt with by the companies themselves and they are not centrally regulated.
Lastly, it was explained that IFRS are equity-focused and work well in capital markets. Nevertheless, they may prove burdensome for non-listed firms, since they are very complex. At the IASB level, there is a special form of IFRS which are especially designed for small and medium-sized enterprises (IFRS for SMEs are compatible with the existing legal regime. 88 Until now, no state has adopted IFRS for SMEs, although four have adopted standards based thereon and some have indicated that they intend to adopt them, while others express concerns as to the compatibility of IFRS for SMEs with the IAS Regulation. Since IFRS for SMEs are especially designed for small and medium-sized companies with more concentrated ownership, they may seem preferable for non-listed companies compared to the normal IFRS, which are designed for bigger entities and are rather complex for smaller ones, although the image in the literature is not yet clear. 89

Summary
The accounting regime in the EU cannot be characterized as being fully harmonized. This outcome derives from the existence of two conflicting accounting philosophies among the Member States, which has affected the wording of European statutes. The most substantial effort for harmonization comes with the introduction of IFRS, which has created a 'two-standard' system: some firms are using IFRS while others are using their national GAAP. 90 In the following sections it will be explored whether IFRS, as equity-focused standards, or Continental GAAP, as debt-focused standards, can better serve the scope of capital maintenance rules in order to protect creditors.

Legal capital and accounting rules in EU law
This section will give a brief synopsis of the discussion surrounding legal capital rules in EU Law. It will not compare the situation with alternative systems of creditor protection, but it will try to examine the reasons for adopting mandatory creditor protection instead of a voluntary system. Finally, it will test the interaction of legal capital rules with the accounting ones.

Limited liability and the protection of creditors
The fundamental function of limited liability is that shareholders are not liable against creditors with their own property for corporate debts. 91 Thus, limited liability is a mechanism of risk mitigation to protect shareholders against creditors. 92 Its concept is complemented by that of separate personality; 93 a separate group of assets, belonging to the company and not the shareholders, is created. The major risk for corporate creditors is that the assets of the company will somehow return to the shareholders, leaving nothing with the company in order to satisfy their claims. 94 All jurisdictions provide for rules that aim to prevent shareholders from obtaining a value that should be given to creditors. 95 However, there are different patterns in order to achieve this; the two conflicting models are the contractarian, which is voluntary, and the paternalistic, which is mandatory. 96 EU and EEA jurisdictions, bound by the Second Council Directive, 97 have adopted the mechanism of legal capital, which includes a variety of mandatory rules that impose restrictions on shareholders concerning Utrecht Law Review | Volume 12 | Issue 1, 2016 distributions. 98 Part of this complex and broad concept is the narrower dividend distribution regulation, which restricts the most direct way of transferring value to shareholders: via a dividend distribution. 99 The mechanism employed by the Directive is a twofold test: one is assets-based and the other is profitsbased. 100 Distributions cannot be higher than the difference between assets and liabilities plus share capital and undistributable reserves, as defined by national law. Also, distributions cannot be higher than the net profits of the company for the given financial year, plus any potential reserves from previous years, which are the hidden reserves. The most important concepts of this mechanism are the share capital and the undistributable reserves. These form the so-called 'cushion' of equity or legal capital. 101 This cushion is not to be given to the shareholders because it exists in order to pay creditors. 102 From this, we can derive that legal capital only exists for the interest of the creditors. In a hypothetical world where companies would not have creditors, there would be no need for capital maintenance rules, because they would serve no purpose.
EU Law uses this cushion as a means of mandatory creditor protection. However, the modern trend in the US is to disconnect dividend distribution from specific numerical calculations and to link them with corporate disclosure and the solvency of a firm. 103 Even those American jurisdictions that determine the distributions according to the relationship between assets and liabilities tend to employ much more flexible rules, while they lack the "cushion" function of the legal capital. 104 The restrictive function is here succeeded by private initiative, namely contract, and more precisely debt covenants. In the USA there is normally a test called the equity insolvency test. If it is not followed, directors might be liable. Furthermore, the fraudulent transfer law is applicable. Debt covenants can impose many restrictions on the debtor; one of those is a restriction in dividend distributions. 105 In practice, European and American companies may be subject to dividend restrictions of the same nature but of very different origin. 106

Path-dependence and regulatory patterns
It is rational to seek the roots of this transatlantic divergence. As in accounting standards, the explanation is path dependence. Historically, legal capital rules were present not only in Europe, but also in the US. 107 However, only in Europe was this concept maintained in its original form, while in the US the rules were gradually abolished. 108 The explanation seems to be the dominance of debt-financing and self-financing among European forms, while the American ones had greater exposure to equity markets. 109 This distinction justifies, in the eyes of European legislators, the recruitment of mandatory, rigid and conservative rules for the prevention of agency costs of the most important constituency; on the other hand, American firms could better achieve economic efficiency through flexible rules. 110 Subsequently, financing features have led European jurisdictions to be more focused on creditors. 111 An analogous explanation has been proposed for the divergence in accounting rules and corporate governance. 112 From this, it can be assumed that Utrecht Law Review | Volume 12 | Issue 1, 2016 distribution reductions through capital maintenance rules are a protectionist tool that reflects the needs of a particular economy.
Consequently, we are inclined to draw a parallel line between prudence and capital maintenance: both systems are strict and restrictive in favour of creditors. Analogously, Anglo-American standards and distribution rules (outside Europe) are more flexible, but can become more conservative through voluntary means. This is a conflict between empowering rules, which are associated with the initiative of private parties leading to wealth creation, and restrictive rules, which are intrusive as regards the voluntary character of private transactions in order to protect a certain goal. 113 Another closely related dichotomy is that of contractarianism and paternalism. A paternalistic corporate law regime reduces corporate initiative with mandatory rules, whereas contractarian rules allocate the power to determine the essence of a contract to the private parties. 114 Under the second model, judges and legislators monitor only the procedure under which such an outcome can be achieved. Continental accounting and EU capital maintenance rules enact a more restrictive and paternalistic pattern, by intervening in the corporate nexus of contracts in order to promote the interests of certain stakeholders. 115 In Europe, legal and accounting rules were designed with the same philosophy in order to achieve the same scope. Common law jurisdictions are governed by more permissive rules, something that benefits incorporators and equity investors. Undoubtedly, the legal and accounting differences are interconnected and they are influenced by the dominant financing models and regulatory patterns in each jurisdiction. Section 5 will later analyze what happens when an accounting transplant is introduced in an environment with an opposite accounting tradition.

The criticism against legal capital rules
Legal and accounting literature divides creditors into two major classes: voluntary, or contractual, and involuntary, or non-contractual, such as tort victims. Voluntary creditors are further divided into sophisticated and unsophisticated, which are trade creditors. Involuntary and unsophisticated voluntary creditors are also called non-adjusting, because they do not have any contractual protection in terms of priority against other creditor claims in the case of insolvency. 116 Sophisticated or adjusted creditors are those that will take private initiatives to protect themselves, not only in the case of insolvency, but also against any kind of agency risks. For adjusting creditors, legal capital is not very helpful, for two reasons. First, legal capital rules do not determine the amount of legal capital that a particular company should have. 117 Apart from minimum capital rules, the amount of legal capital is determined by the contractual will of shareholders. Second, capital maintenance rules are not capital adequacy rules, in the sense that the company does not have to actually hold the amount of legal capital in its hands. 118 Thus, in most cases, legal capital rules do not preserve a sufficient amount for the benefit of non-adjusting creditors, who have no other means of protection. This is why mandatory insurance may be more beneficial for this constituency. On the other hand, legal capital functions as a behavioural rule that restricts the flow of value to the shareholders and reduces agency costs. From this perspective, it can be helpful for contractual creditors, particularly adjusting creditors. 119 Theoretically, these creditors can base their decision to establish a contractual relation on the protection given by legal capital. Nevertheless, they can achieve similar protection contractually. 120 In order to assess whether legal capital rules are efficient, it is advisable to examine whether creditors actually rely on such rules. Easterbrook 122 Leuz et al. empirically support the fact that German and British creditors find statutory restrictions to be sufficient; covenants only have a complementary function in these jurisdictions. 123 Although many legal scholars have observed that the use of debt covenants in Europe is more limited than in the US, they hesitate to establish causality between legal capital rules and this outcome. 124 In a mandatory system, the protective buffer is determined by law and not by the parties; thus, a voluntary determination of the buffer is more adaptable to the will of the parties involved. 125 In a parallel way, mandatory protection is supposed to be generating lower transaction costs, because there is no need for a private agreement. 126 Nevertheless, mandatory protection, being inflexible, can prevent some economically efficient activities compared to contractual protection. 127 Analogously, mandatory protection can be beneficial, both for sophisticated and non-sophisticated creditors, while debt covenants primarily benefit the contracting creditor. This is particularly important for European firms, since trade creditors constitute a very important source of financing. 128 These creditors can free ride in voluntary protection, but still, covenants serve primarily individual and not collective interests. 129 Consequently, a covenant violation may lead to an outcome that benefits only one creditor at the expense of all the others. 130 The use of covenants is not only affected by the existence of mandatory protection, but also by other characteristics of corporate laws. In the US, boards generally have greater discretion compared to European jurisdictions, and consequently it is easier for them to commit themselves in restrictive covenants. 131 Usually, the final decision about dividend distribution in Europe falls on the shareholders. 132 As will be explained in Section 5, corporate governance models, ownership structure and agency conflicts have a crucial impact on dividend policy and practice, which is highly relevant when we compare European with American firms. An additional factor is that many continental jurisdictions may hold creditors liable in case of insolvency if they had a significant impact upon the company. 133 All the above are indicators of the limited use of covenants in Europe and maybe an explanation as to why European jurisdictions have developed mandatory instead of contractual protection mechanisms.
The discussion on legal capital is long and has recently attracted particular focus. There is a significant part of the literature that advocates the abolition of the current regime in favour of a system determined by the solvency of a firm. 134 In a solvency test, creditor protection is achieved by ensuring that after the distribution, the company will still be solvent and the creditors' claims will not be at risk. 135 However, the purpose of this paper is not to assess the optimal nature of a balance sheet-based or a solvency-based regime. Its scope is to understand why and how capital maintenance rules operate and how they interact with the available accounting systems.

The impact of accounting rules on capital maintenance
A balance sheet contains information about a firm's assets, liabilities and equity, which are all accounting concepts. Subsequently, from an accounting perspective, equity is the difference between assets and Utrecht Law Review | Volume 12 | Issue 1, 2016 liabilities. 136 Accounting figures can take two forms of value: real or market value and nominal or book value. 137 Since the real value of an asset or a liability can never be definite (if it is not in cash), the function of accounting rules is to find the most appropriate way of valuing them. Anglo-American and Continental systems differ most in this respect: the first are equity-focused and concentrate on the effort of valuating assets and liabilities at their true and fair value, while debt-focused systems are prudent, or conservative in the same task, because they focus on the needs of creditors. Since dividends can only be distributed from the distributable part of equity, we can understand the significance of accounting rules for the legal procedure of distributing dividends.
It was mentioned that some accounting standards are biased conservatively in the valuation of assets and liabilities, and other are neutral in an attempt to reflect their real value. 138 In the EU context, this distinction is mirrored in the two prevailing accounting philosophies: the TFV principle and prudence. Common law GAAP, Dutch GAAP and IFRS are closer to the former, while Continental GAAP are closer to the latter. After the IAS Regulation, it is possible to apply IFRS to the balance sheet used for distributions if a Member State allows this. Generally, IFRS value assets higher and liabilities lower than Continental GAAP and allow the recognition of unrealized profits. 139 The outcome of such a regime is twofold: first, distributable amounts are higher and, second, it is possible to distribute profits that have not yet been realized. The balance sheet test is also associated with the creation of hidden reserves, which are not permitted under IFRS. 140 On the other hand, IFRS are more discretionary in the valuation of accruals, which are non-cash assets and liabilities. This is why IFRS will not produce high-quality reporting in the absence of high-quality incentives. 141 In practical terms, under IFRS, share capital and undistributable reserves play a lesser role, and a larger flow of dividends to the shareholders will be enacted. The previous section was inconclusive as to whether capital maintenance is more effective than alternative systems; however, if it has a protective function, the issue of whether IFRS offer less effective protection than the traditionally used Continental GAAP should be considered.
Opponents of IFRS point to their informational rather than distributional role, as well as the special focus on publicly traded companies. 142 The second point is important, given the fact that IASB has published a special form for IFRS for SMEs, which have not yet been accepted by any EEA State, apart from the United Kingdom. 143 A second argument is that creditors face an asymmetry in dividend distribution that has to be counterbalanced. A fundamental rule in dividend distributions is that dividends legally paid to the shareholders are never returned. If neutral standards are used instead of prudent ones, then the creditors bear the risk of an overvaluation of assets or an undervaluation of liabilities. 144 This asymmetry against creditors has to be corrected by another asymmetry, which is prudence. This rationale shows why the distribution of unrealized profits is contrary to the rationale of capital maintenance, since the latter attempts to prevent a distribution of profits that have not been valued with certainty. Prudent systems try to provide certain information to creditors in such a way that it cannot be misinterpreted. 145 Even strong opponents of the balance sheet test recognize that the application of IFRS in the balance sheet can prove problematic. 146 A third decisive point is the incompatibility of IFRS with taxation, which may force companies to suffer additional costs; on the other hand, managers have less incentives to manipulate individual accounts in order to have tax benefits, thereby increasing the quality of reporting. 147 A last remark concerns the fact that IFRS can voluntarily become more protective towards creditors; 148 as was mentioned, this can be achieved through news-dependent conservatism. However, this proposition suffers from the same defects as IFRS in general. Conditional conservatism concerns the asymmetry in recognizing bad news against good news and does not serve the distributional purposes of prudence. The philosophy of capital maintenance rules is to restrict dividend distributions, as a means of agency cost reduction. This is why it should be supplemented by behavioural and informational conservatism.

Summary
This section suggested that capital maintenance rules have a behavioural mentality. Accounting standards concentrated on the informational needs of equity holders may weaken this rationale. Thus, if there is any possibility that these rules can become effective, this can be achieved through the use of Continental standards. The following section will assess this proposal by examining the agency conflicts between corporate management, shareholders and creditors and the informational effectiveness of IFRS.

Accounting standards and the incentives of their users
This section will examine the agency costs created by the use of a certain accounting standard, between corporate managers, shareholders and creditors and will apply these findings to the particularities of European corporate governance systems. Also, it will test whether IFRS can work effectively enough in all Continental markets. The conclusion will be, firstly, that conservative accounting is favoured by creditors and should be mandatory when distribution restrictions are also mandatory. Secondly, some European markets have weak institutional features; in such an environment it is possible that IFRS will have no distributional use and will be ineffective in their informational scope. This is why such markets should have prudent rules, at least as a default rule, if not a universal requirement.

Agency conflicts
It was already indicated that financial reporting should be helpful for its primary users, which are the financiers of a firm. 149 It equally has informational and strategic and even pecuniary implications for management. 150 Subsequently, the choice of a certain accounting standard may create three-dimensional agency conflicts: between shareholders, creditors and the management. 151 The most serious agency problems can be created when ownership is separated from control; there is a fear that the management, as an agent, will use corporate resources without taking into account the interests of the shareholders, as principals. 152 Dividend distribution is an area where agency conflicts may arise: shareholders pursue higher dividends, while managers and shareholders prefer to use the same resources for their own goals. 153 It was explained that mandatory legal capital rules are a mechanism aiming for a decrease in those conflicts. Further, the same can be achieved by voluntary debt covenants or conservative accounting rules. 154 Thus, in dividend distribution policies, it is possible to observe an occasional alignment of interests between management and creditors. However, if ownership is not separated from control, as happens in most European companies, then the situation becomes much less desirable for the creditors. 155 Now there is an alignment between shareholders and the management, which makes creditors the potential victims of expropriation, together with minority Utrecht Law Review | Volume 12 | Issue 1, 2016 shareholders and other stakeholders. 156 Consequently, there is a need for mechanisms that decrease these conflicts. From an accounting perspective, conservatism can serve this role, by being downward-prejudiced against the valuation of assets and earnings. 157 The empirical evidence from Europe is that creditors prefer conservative accounting valuations. 158 Similarly, firms with stronger agency conflicts over distributions between shareholders and creditors are more likely to employ conservatism; lower agency and transaction costs will emerge in such an event. 159 However, the corporate governance model of a firm also plays a significant role in the reduction of those conflicts. In a model where shareholders prevail, there is a greater demand for news-dependent, or conditional, conservatism, whereas in stakeholder-centred models, the same information can be obtained though private channels of information. 160 This illustrates why Continental stakeholders may find prudence more relevant than conditional conservatism. This shows that creditors will request dividend restrictions, if they can. Analogous restrictions can be achieved through debt covenants. Thus, in the absence of capital maintenance rules, creditors will agree such covenants with their debtors for their protection. In the same way, if creditors find that a particular accounting standard is not sufficient for them, they will request the use of a more conservative one. The potential adoption of conservative standards will have beneficial effects for the cost of debt. 161 In other words, if a firm uses accounting standards which are not favourable for its potential creditors, this will affect the terms or the final decision about contracting. Further, according to Nikolaev, there is a remarkable demand for conservative accounting even when debt covenants are used. 162 From the perspective of creditors, the use of conservatism is essential. Thus, the real debate is whether conservatism should be imposed on a mandatory basis instead of being contractual.
Continental GAAP are prudent, thus conservative in the valuation of assets and earnings. On the other hand, IFRS are neutral in their valuations; nevertheless, they can be adjusted to become conservative. Generally, a prudent/conservative system will generate lower dividends than a neutral one. In a system of mandatory capital maintenance, there is a possibility that creditors will consider such protection as sufficient. In reality, it is less likely that European firms will adopt debt covenants. 163 If creditors rely on the protection given by legal capital, they will logically prefer that the balance sheet should be calculated conservatively, in order to produce lower dividends. If a firm has the option to choose between conservative and neutral standards, the most desirable choice for creditors is the conservative one. If, however, a firm chooses neutral standards, the creditors are less protected than in a scenario where conservative standards would have been adopted. This evolution will create additional agency costs for the creditors; if they find them dangerously high, they will seek an additional protective mechanism; they may request the use of conservative standards, or they may impose a covenant, or both. Thus, the scope of capital maintenance has failed, since a sufficient solution will not be provided for agency conflicts created and the creditors will be forced to proceed to further action.
The determination of dividends with a certain standard can be seen simply as a policy decision, which favours a certain constituency. 164 Nevertheless, the jurisdictions that have adopted capital maintenance rules and debt-oriented accounting have done so because they took a policy decision to protect creditors. The prevalence of mandatory creditor protection through company law and accounting was not made at random; in those jurisdictions there was a greater demand for debt rather than equity investments. A jurisdiction will decide to favour equity investors more when it is judged that market needs are better served. However, in a market where capital maintenance rules may have a protective function, it will be more effective to tie them to prudent accounting. Therefore, states where businesses continue to have a strong reliance on debt financing have no reason to prefer equity-focused standards. Such a policy decision does not make sense from a distributional angle. In the next sub-section, it will be claimed that the informational contribution will also be limited.

Incentives versus standards
Someone may ask why the EU States, having mostly a conservative accounting tradition, have decided to introduce IFRS, which is an Anglo-American transplant. The reasons are threefold: the better operation of capital markets, the enhancement of accounting quality and the better comparability between different firms. 165 The focus of the IAS Regulation on the harmonization of the consolidated reporting of traded firms seems to serve these purposes. 166 There is a general assumption in the accounting literature that IFRS provide accounting information which is of better quality compared to the various national, non-US, GAAP. 167 Analogously, the mandatory application of IFRS is usually followed by encouraging signals from the capital markets. 168 The idea that IFRS can produce better accounting quality is very important. It is contended that if creditors have accounting information of better quality, even if it is more equity-relevant, this can have an overall positive effect for the formation of their business strategy. 169 Thus, in any case it is vital to understand whether IFRS can produce accounting information which is of better quality. If this statement is true, there is a strong counterargument against the absence of a distributive character of those standards.
It is advocated that high-quality standards cannot produce high-quality information if they are followed by poor incentives on the part of the preparers. Ball et al. have empirically supported this statement by looking into four East Asian markets, three of which have a weak institutional environment. 170 Analogously, Van Tanderloo and Vanstraelen have observed that German firms did not decrease the amount of their earnings management when they switched from the non-transparent German GAAP, where hidden reserves are allowed, to the transparent IFRS. 171 Further, Ball and Shivakumar have argued that UK private companies generally have worse quality reporting than public companies, despite being bound by the same auditing and financial reporting regulations. 172 Thus, institutional features such as capital markets, law enforcement and ownership structure shape the reporting quality. 173 Analogously, low accounting quality can be substituted by alternative, contractual means of protection, or it can be the outcome of insider access to the information of a firm. 174 The above imply that the adoption of IFRS does not automatically lead to better reporting. Daske et al. divide IFRS adopters into 'serious' and 'label' adopters. 175 Serious preparers promise to embrace better incentives; label preparers do not. The adoption of high-quality standards may be attractive in markets with weak institutional characteristics; however, this is not always followed by cheaper financing. 176 As seen in Section 3, most states requiring IFRS for individual accounts of listed firms are Eastern European or Mediterranean countries with a weak institutional background. Even if the mandatory and universal Utrecht Law Review | Volume 12 | Issue 1, 2016 adoption of IFRS reflects a commitment by these states to the promotion of business-friendliness, it is doubted whether this is feasible under the given circumstances.
For those European countries without strong capital markets and institutional characteristics, it would be preferable to concentrate on correcting the malfunctions of their institutional environment and simply to permit serious adopters to apply IFRS, since these are the only firms that can truly benefit from these standards. This is a contractarian approach; the adoption of equity-friendly standards may or may not lead to better economic consequences and it is left to the individual parties to take this risk. If local GAAP are the default rule, then potential IFRS adopters risk being characterized as label adopters if their incentives are not genuine. Continental firms usually reflect a different corporate mentality system than British or American ones and their institutional characteristics may differ from those for which IFRS are designed. 177 A potential mandatory imposition of IFRS thereon can have disastrous effects: creditors do not receive the information and protection they may require and equity investors are not always offered high-quality reporting.
The default rule chosen by a jurisdiction should comply with the common characteristics of local companies. Most Continental markets are less equity-influenced than Anglo-American ones; there, the existence of mandatory restrictions in creditor protection should be accompanied by conservative accounting rules as a starting point, because this combination makes legal capital rules more likely to succeed in their scope. Requiring equity-focused rules makes sense in a market that is dominated by equity financing, where high-quality standards can flourish to the benefit of the dominant capital providers. In markets inclined towards debt financing, the optional application of IFRS seems to be preferable to a mandatory system. In such a case, a potential voluntary adoption of IFRS with an option to expropriate creditors will be received negatively and will prove unsuccessful. Thus, creditors will be protected by a conservative regime, unless companies are willing to seriously commit themselves to a better quality of information that can reduce the costs of capital and agency conflicts and enhance investor confidence.

Summary
This section recommended that mandatory creditor protection can better protect creditors if conservative standards are applied. Additionally, it claimed that the adoption of IFRS will not be effective where agency conflicts and a willingness to expropriate reign. On the contrary, transaction costs will remain high. Thus, if it is suspected that creditors can be easily expropriated, then mandatory IFRS adoption does not seem to be advisable.

Conclusion
This paper asked whether capital maintenance can work effectively with neutral accounting standards. It concluded that if a legal system wants to concentrate on creditors, then it is more meaningful to apply conservative standards. Moreover, the stronger the institutional features of a jurisdiction, the more probable it is that neutral standards will be efficient. However, this conclusion should not be misjudged. It was explained that both capital maintenance and conservative accounting trace their roots to the traditional reliance on creditors for capital. Accounting and legal rules are the offspring of particular factors that may still be present, or may have changed. In the case of the introduction of Anglo-American accounting standards in Continental legal systems, it seems that this evolution is a product of legal transplantation and not origination, a phenomenon that becomes more and more crucial in corporate law systems of Continental jurisdictions. 178 Thus, when the IAS Regulation came into force, it was not clear whether the new accounting regime reflected the true needs of many European markets. As was analyzed, IFRS were introduced in EEA jurisdictions in order to promote the efficiency of capital markets and equity investments, although it is not guaranteed that they can achieve this goal on their own. On the other hand, the impact that the legal capital