Financial Reporting Regulation - Assignment Example

Financial Reporting Regulation Introduction One of the major events in the history of accounting is the implementation of IFRS across the European Union from January 2005. European Union faced the prospect of diverse financial reporting regimes across European Union participants when it moved across the markets within Europe. It has become essential to adopt universal financial reporting standards in order to achieve true scale of financial integration (Deloitte, 2012). In June 2002, the EU has adopted a regulation to prepare their financial statements in agreement with IFRS or IAS which is required to be followed by all listed European Union companies in the regulated markets. Companies are open to select their national reporting standards and follow Generally Accepted Accounting Principles (GAAP) for associate and subsidiary companies. The regulation is applicable only on the consolidated accounts. The regulation came into consideration from the year 2005 (PwC, 2005). With an aim to develop common accounting standards in 1973, nine countries including UK formed International Accounting Standards Committee (IASC). Over hundred countries have it’s become members. Countries, especially bigger economies, are bringing in their own perspectives and adapting to this accounting standards. In coming up with common acceptable accounting standards IASC had to deal with accounting conflictions (Accounting Standards Board, 1999). IASC has not been successful in resolving all the conflicts with all member countries as it is nearly an impossible task to fully satisfy more than hundred accounting bodies from across the world. International Financial Reporting Standards (IFRS) or International Accounting Standards (IAS) is applicable to more than 90 countries. In the European Union only the listed companies are required to follow IFRS mandatorily (Accounting Standards Board, 1999). The standards that are issued directly by the International Accounting Standards Board are not those that UK listed companies will follow, but are those that the European Commission has endorsed. Except for some changes in IAS 39 relating to the fair value of financial instruments, IFRS 6 and some of the IFRIC interpretations, European Union has now endorsed IFRS (IFRS, 2012). The EU regulation is only enforceable for listed companies. A member state has an alternative to extend the use of IFRS within their jurisdiction to unlisted companies. Department of Trade and Industry has said that the unlisted companies would still be permitted to adopt IFRS over UK GAAP as there is no mandatory instructions for unlisted companies to move to IFRS (IFRS, 2012). Arguments in favour of financial reporting regulation Mainstream economistic reasoning has also been influential in respect of the issue of how best to regulate financial accounting. Some of the above perspectives have implications for how accounting should be regulated. Perspectives that assume the existence of perfect information clearly would not see the need for further regulation. Under the scenario of perfect and complete markets, a company that accepted all projects with non-negative present values would simply have to announce these present values or cash flows to the market, if we take a slightly less abstract view (although strictly in such reasoning this would automatically happen for markets to be perfect and complete). The value of the company would then equal the present value of these cash flows, which in turn would equal the market price. Under these circumstances one may even question whether annual reports are necessary. Within mainstream economic thinking (that assumes ‘perfect and complete markets’ to maximise well-being and the role of ‘accounting information’ to be confined to serving markets), the answer to this question would be in the negative as it would be to the question ‘is the regulation of accounting necessary in this context?’ The market here provides what is deemed an unambiguous and value free measure of wealth. Even in a broader, more holistic view, the argument might weigh against state and/or quasi-state regulation in this economic sphere where markets were more perfect and complete. In any case, the scenario of perfect and complete markets does not reflect the real world. Markets are not complete and perfect and thus the market does not provide an unambiguous measure. So we can consider the case for state and/or quasi-state regulation within a mainstream economics perspective. Other perspectives hold that the functioning of markets (within an institutional, regulatory framework) is enough to regulate financial accounting adequately. Businesses have an incentive to provide accounting information to the market to raise capital and an interest in being honest and providing good quality information due to the negative impacts of loss of reputation (organisations failing to inform or misleading the capital market will be regarded as ‘lemons’ – and punished). Another way of seeing this is that there are strong incentives for managers to disclose information, e.g. they may need to raise finance in the competitive market and will thus provide relevant information to aid them in this (and reputation has a value here so honesty may pay). In addition there is a market for managers, in so far as the managers themselves would want to inform the market as to how well they are doing and hence enable them to seek other jobs elsewhere. The ‘free market’ camp would thus argue that, even in the real world, we should leave it to the market or what some call ‘market regulation’ (noting that markets themselves always appear to require some form of state regulation in practice). Some argue the market for information is good enough to produce an optimal supply. There are also contracting arguments that have been put forward. Companies could simply have a contract with their suppliers of capital to disclose certain information to them, including having the information audited. Any undisclosed information could then be obtained by private searches and/or payment for additional information that may be required. One point that may be made here too is that regulation beyond the market may displace some of the positives of market functioning. It may problematically, for instance, restrict the accounting methods that may be used (although that may also reflect a poor form of interventionist regulation). Further, users will tend to overstate their desire for disclosure if they do not have to pay for it (although indirectly they may bear costs). The costs will be borne by those supplying the information. The history does indicate that companies will voluntarily disclose at least some information (at least they will disclose some information under other pressures). While those observing practice historically often admits to some evidence of this type of market-induced effect, substantively they point to weak financial accounting here and the case for regulating financial accounting in terms of state and/or state-backed or quasi-state professional regulation, beyond the more liberal approach. The view here is that the market for information is such that without interventionist regulation a sub-optimal amount of information will be produced. And the comparability it facilitates may be less than desirable. The case for likewise regulating notions of broader corporate social responsibility accounting is similar. This being said, contexts vary and a great deal of pressure may be placed on business (e.g. by competitive forces, a strong civil society) without legislation or quasi-law. Under the contracting arguments, the actual cost of enforcing the individual contracts or ‘group contracts’ would be higher than those costs associated with state and/or state-like regulation. Even with these contracts there would be a need for comparability of accounting practices (Clive Owen & Co LLP, 2012, p 8). A number of related arguments for regulation have been suggested, reflecting the assumption of an imperfect markets context, including the following: Left unregulated as envisaged, market forces would ‘lead to an uneven possession of information among investors’. Consequently the regulation would provide an equitable solution. ‘It is only fair that the less informed be protected from the more informed.’ Some have more power than others (over others) in terms of accessing information. Accounting information shares the characteristics of a public good, and therefore suffers the same problems of externalities and free riders. Under these conditions the absence of the regulation envisaged could result in the under provision of information. Managers have incentives not to disclose unfavourable information. Consequently investors would be unable to distinguish good companies from bad ones, resulting in ‘adverse selection’. Further, investors need protection from the fraudulent, which would actually produce misleading information. Due to information asymmetries, the disclosures may not obviously be seen as fraudulent. Arguments against regulation of financial reporting Other managers argue that markets are not so speedy in re-adjusting to changes. If they may keep returning to reasonable positions or an equilibrium (a contestable view for some), people may get hurt in the process given its slow speed. Indeed this may be in ways they can scarcely be compensated for. The ‘balanced’ view on financial accounting discussed above may be taken as implying that regulation to improve transparency should not be universally overly strict, or it might imply the need for a regulation that has limits and that might be set so as to prevent firms competing in the market place in terms of information disclosure, which may drive disclosure towards too much transparency. In an imperfect markets context, a particular level of disclosure or transparency would be optimal for social welfare. A degree of secrecy or confidentiality is required to allow the system to function for the best (e.g. discourage monopolistic practice that might be encouraged through information sharing, create incentives for research and development). A degree of transparency is required to facilitate financing and the better allocation of resources. The regulation envisaged may bring this balanced disclosure about better. Markets functioning without that may lead to ‘beggar-my-neighbour’ disruptive forms of competition in respect of disclosure. Some analysts of the issues have used game theory as a framework and tried to model (appreciating the possibility of audit) external financial accounting disclosures in relation to the incentives of regulators and corporate managers (e.g. incentives to disclose or hide, to be honest or dishonest). From this quasi-descriptive modeling (to which dimensions of uncertainty and the costliness of information can be built in) an attempt is made to see if answers can be found to questions such as: Is rigid regulation better than flexible regulation? Is mandatory disclosure better than a looser more voluntary approach? This framework can enhance appreciation of the character and feasibility of actual and potential regulatory forms, although it is not straightforward to translate this into social welfare implications in an imperfect markets and imperfect societal context. The adoption of IFRS can result in an inadvertent reduction in transparency. Following are the main differences between UK GAAP and IFRS: The Statement of Principles allows use of both historical cost and current value approaches in measuring balance sheet categories. The dual use of historical and current value methods is known as modified historical cost basis. Under historical cost, the carrying values of assets and liabilities are stated at the lower of cost and recoverable amount. This approach is more conservative as compared to IAS approach which uses fair value method. Also the choice of historical or current value method is based on subjective analysis of a company’s management and hence it is open to some manipulation (Accounting Standards Board, 1999, pp. 9-15). Research and development costs - Under IAS 39, research costs can’t be carried on the balance sheet and would have to write them off as incurred. Companies would still be allowed to capitalize development in line with UK GAAP (IFRS, 2012). Fair value - If we look at global level, both UK GAAP and IFRS have adopted fair value method as the foundation of their accounting standards. IFRS takes fair value adoption even higher when it says that income statement will include the changes in the fair value of items that have not been yet traded like derivatives. The emphasis in new accounting standards is on mark-to-market fair value of assets and liabilities rather than on actual market price based fair values. Now both realised and unrealised changes in fair values would be incorporated in income statements. The first year of transition will see high volatility in earnings and balance sheet statements. Though this brings higher volatility, it will also test the management skills in proper presentation and explanation of changes. It may also change the benchmarks of success for managements (Deloitte, 2013, pp. 1-2). Revaluation of Fixed Assets - The UK companies do not hold the option of valuing tangible fixed assets under IFRS as it had previously under FRS 15 (Swift, 2011). Inventory - The ‘last-in first-out’ method is permitted under the UK GAAP for valuation of inventories whereas for IFRS only the ‘weighted average’ and ‘first-in first-out’ methods are permitted and not the ‘last-in first-out’ method for valuation of inventories (PwC, 2011, pp. 14-15). Stock options - Internet and share market last boom in late 1990s led to rapid increase in share options as a way to reward employees. The new requirements to record an expense on income statement for the value of share options granted to employees could have a significant impact on earnings. AstraZeneca said in its pro forma 2004 IFRS numbers that new accounting rules on stock options has made it re-consider the use of stock options in rewarding its employees (PwC, 2008, p 2). Agricultural - UK GAAP allowed companies to use a cost model for biological assets and all agricultural produce. But under IAS companies would have to use mark to market method for valuing such assets. Now companies would have to use market valuation even for assets in far off countries (BDO, 2013). Inclusion of business disposals gains in profits from operations - BAT’s profits for year 2004 increased by £1.3bn after it included gains from disposals to operating profits. Adding disposal gains to operating profits will make it harder for investors and analysts to separate the earnings from continuing businesses (Grant Thornton, 2008, pp. 5-7). Conclusion The International Financial Reporting Standards are being followed by many countries in the European Union and the world. Listed companies in the United Kingdom use IFRS as the foundation of their consolidated accounts. Financial Reporting Standard for Smaller Entities (FRSSE) can be used by companies which are deemed small under the Companies Act. FRSSE is a distillation of UK standards with some exemptions such as consolidated cash flow statements, accounts and fewer disclosure requirements. Unlisted companies in the United Kingdom have a choice for the implementation of IFRS or UK GAAP (ACCA, 2011). The reason why some unlisted companies have adopted IFRS is that their parent companies are listed and it becomes easier for them to implement the same on the basis of accounting across all groups of companies. For large companies with public accountability or without public accountability and for small, publicly accountable entities, the reporting requirement is International Financial Reporting Standards (IFRS). For small companies with no public accountability the reporting requirement is based on Financial Reporting Standard for Smaller Entities (FRSSE). Inspite of differences between IFRS and UK GAAP, IFRS has been implemented successfully throughout United Kingdom (BOD, 2011, p 3). References BDO. 2011. The Future of UK Financial Reporting. [Pdf]. Available at: http://static.bdo.uk.com/assets/documents/2011/10/The_Future_of_UK_Financial_Reporting_-_Implications_for_the_financial_services_sector.pdf. [Accessed on November 04, 2013]. ACCA. 2011. Future of financial reporting in the UK and Ireland. [Pdf]. Available at: http://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/tech-tp-fofr3.pdf. [Accessed on November 04, 2013]. Swift, R. 2011. 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