The Implications of International Financial Reporting Standards in the United Kingdom - Research Proposal Example

Introduction “The way capitalism was founded was based on the private’s industry goal of maximizing earnings to accumulated greater individual wealth among the owners of the equity in corporations” (Madura, 1992). The capital and money markets are administer by the investment banking industry which allows stock exchanges and over the counter markets to allow investors and companies to connect in a business transaction to purchase equity in private and public companies to gain partial ownership of the enterprises. The history of the European investment banking industry dates back to the 1700’s when London was the major city for investment banking activity. The United States after it was founded in the late part of the 18th century attracted a lot of European entrepreneurs and investors which later enjoyed a great surplus of a diversified workforce that contributed to the creation of the richest nation in the world. The United States which took the lead in the 20th century to build the best and most sophisticated financial system with a self regulated accounting practice based on generally accepted accounting principles (GAAP) gained early experience in this emerging industry and obtain the greatest market share of equity selling volume in the world. The rise financial rise of Europe after the 1999 creation of a common monetary unit, the Euro, among member European nations solidified the investment banking industry at the turn of the 21st century. In 2005 the European Union adopted the financial framework called the International Financial Reporting Standards (IFRS) become the first body of nation to adopt the new system whose mission is to become the world standard for international accounting practices worldwide. Executive Summary The decisions made by investment bankers depend on the information that is readily available to them in the marketplace. Financial information, particularly the financial statements of a company are essential tools used by investment bankers in the decision making process. In the United States companies abide by the generally accepted accounting principles, while in Europe companies abide by the international financial reporting standards. The utilization of each of these frameworks affects the information contained within them. This report studies the effect the different financial frame works has on the information contained within the financial statements prepared under the different systems. The report includes an analysis of financial statements of actual companies in the same industries operating on different sides of the hemisphere. Problem Statement The investment banking practices in Europe and the United States do not follow the same procedures and regulations due to the GAAP and IFRS frameworks utilized in each continental region are different. The fact that investment banking operates differently affects company and capital investor’s world wide. For example if a US based company wishes to sell its share in a European stock exchange such as the London Stock Exchange the company has to prepared a set of financial statements based on IFRS standards to qualify to sell in the European stock market. Such discrepancies along with many other aspects of the game create inequality among financial markets that influence the behavior of its participants. The creation of the IFRS in 2005 and its subsequent adoption in the European market was a step in the right direction since it created a set of standards that can unify economic activity across nation including investment banking activity. The problem is that activities such as investment banking require people to fully understand the implication of the changes. Investors accustomed to the GAAP based standards of the US market might be turned off by the new IFRS standards which will be perceived as inferior standards that may distort reality since they are new standards which have not gone through the rigorous process GAAP based standards have gone for many decades of experience and constant improvements on the financial accounting framework. The discrepancies between the two systems must be further studies to determine how much different two sets of financial report are utilizing the different frameworks and what are the specific areas which are different between both systems. Research Objectives The main objective of the research is to determine the implication of IFRS in the UK in the research investment banking sector and how they affect the participants in the industry in comparison with the American investment banking industry. The main reason of the differences is that the United States operates following general accounting principles standards, while the European Union works based on the new financial reporting international standards. The report analysis both systems in order to determine if the discrepancies are material and if they are affecting cross-border investment banking activity. The report examines the progress of IFRS and its future implication for economies world wide. “The two target markets: United States and Europe must recognize the need to have systems that assimilate other standards forces tougher regulation on the international boards to integrate in order to allow comparability and more business opportunities such as the $150 billion initial public offering Chinese market over the next five years” (Luu, 2007). The report tries to provide a through analysis on the subject utilizing various research methods and establishes two research proposals in order to continue the research on the topic. It appears that industry is moving towards a conversion of system that will allow comparability between GAAP and IFRS. The paper tries to determine the current status of the progress in this area and what the future beholds for all the participants of the marketplace. The subject matter has international implications that affect the global economic balance. It is very important for students studying finances to get acquainted with the latest accounting methodologies that are affecting practices internationally. The professionals working in the industry must adapt to the changes and take immediate continued education along with company training to stay on top of their profession. A secondary objective of the project is to determine to what affect can each accounting lead to different decision making due to the accounting framework being utilized. “The research framework utilized in this paper is more based on epistemology. Epistemology is the study of knowledge and justified belief”(Stanford, 2005). In this piece of literature the knowledge utilized by financial professionals is studied in an objective manner between the GAAP and IFRS frameworks. Both systems are analyzed thoroughly in order to gain knowledge about how they work to then use that knowledge to perform a comparison of the systems and its implication for investment bankers making decision based on the financial information provided by the financial statements. In globalize business environment investment bankers it is imperative for these professionals to differentiate and know the implication of the discrepancies among the system in order to make good decision. A secondary research framework that may have been utilized is ontology. “Ontology is the study of the categories of things that exists or may exist in some domain” (Sowa, 2003). This approach is associated with conceptualization of ideas and may follow a philosophical approach that even though utilizes a comparative basis is not well suited for this study since subjectivity is part of conceptualization. The work illustrated in this paper required an objective comparison of two financial systems in order to comprehend the impact of the discrepancies of the users of financial statement particularly investment bankers who are highly depend on the information provided by financial statements as part of their daily routine of work. Literature Review “Investment banking is the financial service function of handling the marketing of a security issue to the public” (Bodie & Kane & Marcus. 2002). The issuance of corporate financial instruments such as common stocks is administer by the investment banker in order to ensure the buyers are in place and the initial or secondary issuance of a firm’s equity or money market instruments are able to raise the capital require by the company. The issuance of new stocks can take place in one of three ways: private placement, through a shelf registration process or in the open market which may take place a stock exchange or in over the counter marketplaces such as NASDAQ. “A shelf registration is a form of registration in which established issuers are allowed to pre-register securities and await favorable market conditions to obtain the best timing to realize the sales of the issuance of stocks” (Teweles & Bradley & Teweles, 1992). A private placement is an internal marketplace created by the investment banker in which a closed circle of investors is invited to make bids to purchase the stock of a company directly before anybody else has a change to purchase the stocks. In such a scenario the investors must be well aware of the financial framework under which the company they are bidding on operates. During the last negotiations and final presentations the company pitches to the investor new information about the finances of the company may be reveal and the investor must know how to interpret the information based on their knowledge of financial frameworkds such as GAAP and IFRS. One of the most popular services which firms contract the assistance of an investment banker is to perform initial public offerings (IPO). “An IPO is an issuance of a common stock for the first time to the general public as a firm starts a conversion process of going from a private corporation to a public corporation” (Jones, 1996). During this initial phase of stock valuation there is a lot of money to be made by institutional and professional investors. “One of the most successful IPO’s ever was the initial public offering of Linux Corporation whose stock rose nearly 700% in its first day of trading during the IPO which started at $30 per stock” (Linux, 2007). The accounting practices of public companies are highly scrutinized and are regulated by Generally Accepted Accounting Principles (GAAP) in the United States and by the International Financial Reporting Standards utilized in Europe. The GAAP guidelines promoted by the United States accounting profession sets standards for the accounting practices performed by professionals in the investment banking industry. The International Financial Reporting Standards does not require specific standards for investment fund activity for public or private companies. The European practice is more flexible and allows for lower costs associated with industries with lower amount of regulations. “GAAP based financial statements do not provide comparative financial statements, while IFRS mandates two years worth of balance sheets, income statements, statements of cash flow and statements of stockholder’s equity” (PWC, 2007). The balance sheet in the asset allocation segment has an item separated for the inclusion of company investments under GAAP. The International Financial Reporting Standards does not obligate the companies using their international standards to reveal to the general public investment activity in its annual financial statements. The formatting of the income statement and balance sheet is standardized in the United States, but in Europe there is not set format while the balance sheet under both systems are basically the same. The financial recognition of financial instruments varies between the European and American financial systems. GAAP records a transaction involving a security on the day the trade is made; while IFRS recognizes the financial the financial asset when an entity becomes a party to the contractual provisions of the financial instrument. In terms of financial classification the IFRS have a more in-depth system the values instruments in different ways taking into consideration different variable of different types of financial instruments, thus a better classification of various types of instruments exist. Generally accepted accounting principles value instruments utilizing the fair value method. The implementation of IFRS came at a time when the US based stock exchanges were rapidly expanding their market share through acquisition and mergers. “The New Stock Exchange (NYSE) has the greatest market capitalization with over $11 billion in public equity” (Luu, 2007). The second largest exchange in the world is the over the counter NASDAQ market. The proposed alliance of the London Stock Exchange (LSE), Euronext and Deutsche Boerse (DB) would place the newly merged exchange into the 2nd position in the world in terms of market capitalization value. The European market needs to unite forces to obtain a greater competitive position in the industry and expanding its investment banking activities in hedging, derivatives, stocks and money market instruments to further increase the popularity of the market among native and foreign investors. “In the United State the investment banking industry is downsizing and during the last five years 26.8% of the participants in the investment banking seized to operate in the United States market” (Luu, 2007). “The European investment banking industry in 2008 is taking strides towards a totally deregulated marketplace that will help increase the economic activity in the area and facilitate international investment in the region” (Vault, 2007). Technology has helped the European market accelerate its speed of business. 3G technology is well on its way. The convergence age and the integration of media mediums into a single platform driven by high speed internet access moving the speed of creation of knowledge and accessibility to information a incredible speeds. In the investment banking industry the people working on the deals utilized messaging technology, wireless transfer of information, GPS technology and other technological advances to improve their productivity. The national goals of many nations including the EC are being facilitated by the use of IFRS. “The framework has worked well in the investment banking industry, Canada is the second nation that is well on its way of leaving their Canadian GAP behind and adopting the IFRS guidelines” (Mondaq, 2007). “The Retained Earnings Statement shows the changes in retained earnings during a specific accounting time period” (Weygandt & Kieso & Kimmel, 2001). In the GAAP based AMR Corporation financial statements as illustrated on Appendix C page 21 illustrate at the top of the report losses associated with the loss of value of derivative investments financial instruments. This is shows because GAAP mandates accounting professionals to be disclosed on the face of the statement of stockholders equity. “The statement of stockholders equity of British Airways does on provide information regarding investment activity because according to IFRS an investment fund might not have equity” (Pwc, 2007). The statement of Cash Flows of companies under IFRS in the UK governance show all information related to investment funds without any exceptions. In the United a company is able to hide the bad effects of operating performances based. The consolidation of subsidiaries, investment funds and other investment of the corporation are treated very differently in each of the two financial frameworks. The IFRS defines a subsidiary based on the premise of financial control and may include special purpose entities as part of the same large conglomerate business corporation which provides a better assessment of the capacity, overall expenses, potential revenue streams allow with greater insight into the operation of a company operating in the United Kingdom. “The GAAP includes the information of subsidiaries only if the subsidiary also happens to be an investment fund” (Pwc, 2007). Importance of the Study The study recognizes the impact financial regulation has on the economic system on a nation. Investment banking serves the function of facilitating the equity liquidity that allows companies to easily raise capital for the company’s operating and expansion needs. The effects each regulatory framework in having on the money and capital markets in each of the two target markets is important in order to decipher the if the world is ready for full convergence based on IFRS comparability. Investment banking is directly correlated with the growth in the European region in the last 10 years. Since 2005 Europe took the lead and became the first nation to utilize the newly created International Financial Reporting Standards that rule the accounting discipline and finance practices such as investment banking. The study investigates the topic in order to find the solutions based on the current state of the industry utilizing secondary research and providing primary research techniques to provide a research design model to further investigate the subject matter. Research Design The information provided in this report was mainly gathered utilizing secondary research to obtain data to be analyzed by the researcher. The writer of the report blended the data with his business knowledge and personal experience to provide an unbiased analysis into the topic. Secondary research is information gathered from established sources such as books and other written or visual material. The sources utilized to gather information include peer reviewed journals, textbooks, professional databases, financial publications, newspapers and other online sources. Due to time constraints primary research was not utilized in the study. “Primary research is information directly gathered by the investigators utilizing various techniques which allow a more specific targeted study of specific elements of a particular topic” (Kotler, 2006). Even though it was not utilized a model of the types of primary research initiatives that can be performed to provide further insight into the subject provided to be utilized in subsequent investigation into the GAAP / IFRS investment banking dilemma. In order to further investigate the subject two primary research experiments that can be performed to obtain valuable data to better understand and interpret the effects of the differences in financial framework are questionnaires and industry observation to perform quantitative analysis. The first technique involves designing an effective questionnaire with industry specific questions in order to obtain feedback from investment bankers actively practicing in an investment banking firm in the United States and in Europe that handle both domestic and international business affairs. The candidate profile includes professionals with strong business education of at least a bachelor’s degree, five or more years of experience in finance / accounting, started working in the industry prior to 2005 and with an intelligence quotient of a least 120. The questionnaires would be administered to 30 people from a minimum of 10 different companies divided equally between the United States and Europe. Appendix A shows a sample questionnaire on the subject that could be utilized by the researcher in order as a primary research tool to facilitate the gathering of information and data. The second experiment that can help in the investigation is industry observation to perform quantitative analysis on the effect of IFRS in Europe. The data collection involves observing compiling sales industry sales volumes three years prior to International Financial Reporting Standards and three years after its implementation. Analysis would be performed to determine the state of the industry from 2003-2005 in comparison with 2006-2008. A precise schedule of this research activity is provided in the Appendix section of this report. “Correlation statistical technique must be performed to compare the sales activity in Europe each year vs. the industry standard during the six year span of time” (Mann, 1995). The hypothesis of this experiment is that the overall sales volume levels adjusted for inflation have increase each year since its inception in comparison with the industry after the year 2005. Another statistical tool that can create a mathematical model to determine the demand of the industry is a multiple regression analysis. “A multiple regression analysis that builds a probabilistic model that relates a dependent variable Y to more than one independent predictor variable” (Devore, 1995). Data and Analysis The data obtained utilizing secondary research shows many views which depict the GAAP system as a superior system than the newly born IFRS. Its longevity, status and overall effectiveness at providing comparability among the participant of the market are superior and more truth wordy. The IFRS has the potential to gain lot o recognition worldwide. The Canadian market is in the process of switching form Canadian based generally accepted accounting principles to the international financial reporting standards. The experts in financial regulations are working on a system to create a comparability basis between GAAP and IFRS. The advantages of IFRS include lower implementation costs, greater flexibility, potential for greater acceptance worldwide as more and more emerging markets such as the Asian and South American market begin to adopt their practices to international financial reporting standards. The more countries that end up adopting IFRS, the better it will be for the participants of the investment banking game. Greater international business will benefit everyone and will provide a way to increase economic progress in many location worldwide since investment banking serves the function of providing a gateway that allows the private industry to raise capital to create new businesses and expand existing operations. The project under way to create a basis in order to allow comparability between GAAP and IFRS utilizing a convergence method is a great project that will help out the investment banking industry and will help it generate greater levels of revenue from trade activity in new emerging markets. The European Union and the United States are the two biggest players in the industry and will be at the forefront of the revolution to spread investment banking practices globally to improve the ability of emerging markets to raise capital and accelerate private sector activity in other nations. The framework that will allow nations to have similar systems is IFRS. GAAP is too big to disappear and it should help ensure IFRS standards don’t become to soft. The higher standard of the GAAP system raises cost, thus it is preferable a simple system so that nations motivated to adopt the new IFRS framework to allow investors to compare financial data on an even basis with other investment opportunities in developed markets such as the United Kingdom. In order to compare the differences in the financial statements of real corporation operating in the same industry in different markets which obligate each firm to comply with the financial framework area one company operating in the UK and another company with headquarters in the United of America were selected. The two companies selected were Investec and Merrill Lynch. Investec has to comply with IFRS, while Merrill Lynch prepares its financial reports based on GAAP. Investec financial statements for 2007 as illustrated on Appendix C show two year comparisons on all four financial statements as instructed by IFRS. The GAAP financial statements prepared for Merrill Lynch show three or two year comparisons. Showing comparison between years is great enhancement that provides the data to perform variance analysis. In this case the American company had better comparative basis since two of the four financial statements had three years of information. GAAP does not mandate companies to provide more than one year information in its official financial statements; IFRS does which provide added information which does not require the financial analysis to retrieved previous years annual reports to retrieved financial statements. An expert in the matter knows that data has to be comparing over the years, but a novice investor will make decision based on the information provided in the financial statements of the current year, thus IFRS does a better job at ensuring the release of added information for the users of financial statements. The investors decision are superior under as far as having higher quantity of information that allows an investor with analytic abilities and a business mentality to obtain a greater information base in which to base a decision. A numerical extraction of data from the financial statements of the two company will help illustrate the impact of the different standards of the financial statement and the decision making an investment banker would make based on the results. The balance sheet of Merrill Lynch shows 7 items related to investment held by the company. It shows in items 5-12 from top to bottom of the balance sheet in the asset section that company has equities & debentures, mortgages, contractual agreements, commodities and related contracts, municipal and money markets, investments in US government and agencies and corporate debt and preferred stock investments worth a combined $203,848 million. This detailed information about the investment activities of the company is not illustrated in the balance sheet of Investec. A decision maker evaluation the company would know the type of risk associated in the investment activity of the company from the information revealed in the Merrill Lynch financial statement. By knowing the general composition of the company’s portfolio the decision maker is better informed on the actual status of the corporation. Investec may have a high risk portfolio composed of penny stocks and future derivatives, but the typical it is impossible to determine that due to the IFRS framework utilized by Investec which hides this information. Another example of numerical differences due to standards is in the income statement. The Merrill Lynch income statement is created based on GAAP specific format criteria. The income statement illustrates six sources of income in the revenue section at the top of the statement for an overall total income of $28,034 million, while the Investec income statement shows eight items prior to displaying the total income of 1,160 million euros. By providing more detail of revenue activity the IFRS prepared statements provide the decision maker with greater capacity to perform variance analysis on more income related resources to determine if the areas of weak of growth in the income stream of a company. Schedule The primary research experiments are subsequent research projects that provided an extension into this area of research that can contribute to the accumulation of knowledge in the international finance discipline. The experiment involving the creation of a questionnaire guided on questions similar to the template questionnaire provided in the supplements of the paper can take place in the 1st quarter with a deadline of eight weeks after its initiation. Following the collection of data the information is taken to corporate headquarters to prepare an official final report based on the findings to be prepared before the end of the 2nd financial trimester. In order to comply with this deadline the team must follow a specific work path. Appendix D shows a Gantt chart of the timeline for this project and associated work schedule breakdown. The second experiment involves the collection of data based on the observed behavior of the market. The observations that need to be retrieve compromised a six year span that has not expired yet. All the data necessary will be ready by the 4th quarter of 2008, thus the timeline for completion of the project is the 1st trimester of 2009. The statistical analysis will be performed utilizing multiple regression, correlation, probability, and variance analysis among other statistical methods. In order to clearly illustrate the work and specific schedule associated with the timely completion of a project are shown in Appendix E with a Gantt chart of the experiment. Recommendations / Conclusion The investment banking industry has helped the American and European markets raise capital in order to expand the industrial activity in their territories. Governmental institutions also benefit from the industry since they utilize the sale of money market instruments to raise capital for operational activity and infrastructure projects which benefit all the people in the region including the business community. The United States established a framework for financial and accounting information in the 20th century called generally accepted accounting principles that brought reliability, confidence, comparability and assurance that the information among the corporation was legitimate and easy to compare among them since the financial reports were prepared in standard formats. In Europe an international set of standards was adopted by the EU first to serve as a model for the future spread of the framework across other nations in the world. The GAAP will not seize to exist because of IFRS since it is a superior system so the only way for the two systems to coexist is to find a way to convert from one format to another. “A project for convergence between system to be able to read one set of data under one system and have a defined basis to compare the reports creating exact equal value is under way” (Lawrence, 2007). This project will help both markets have more inter-continental business activity and greater foreign investment injections about the participants in each nation. References Annual Report: Investec (2007). Available from < http://investec.investoreports.com/investec_ar_2007/index.htm> [Accessed 29 December 2007]. Annual Report: Merrill Lynch (2006). Available from < http://www.ml.com/annualmeetingmaterials/2006/ar/pdfs/annual_report_2006_complete.pdf> [Accessed 29 December 2007]. Bodie, Z. and Alex K. and Alan J.M. (2002). Investments. Boston: McGraw-Hill Irwin. Devore, J.L. (1995). Probability and Statistics for Engineering and the Sciences (4th ed.). Belmont: Duxbury Press. Jones, J. (1996). Investments: Analysis and Management (5th ed.). New York: John Wiley & Sons. Kotler, P. (2003). Marketing Management (11th ed.). New Jersey: Upper Saddler River. Kpmg.com (2007). Investment Banking. KPMG. Available from [Accessed 25 December 2007]. Lawrence, G. (2007). IFRS: Coming to America. Journal of Accountancy, 203(6). Available from [Accessed December 25, 2007]. Luu, T. (2005). Investment Banking 2005-2010: Competitive Opportunities. Available from http://www.slideshare.net/twain/2020knowhow-investment-banking-20052010 [Accessed 26 December 2007]. Madura, J. (1992). Financial Markets and Institutions (2nd edition). Florida Atlantic University. Saint Paul: West Publishing Company. Mann, P.S. (1995). Statistics for Business and Economics. New York: John Wiley & Sons. Mondaq.com (2007). Banking and Financial. Available from [Accessed 26 December 2007]. Vault.com (2007). European Banking: An Overview. Vault Europe. Available from [Accessed December 26, 2007]. Weygandt, J., and Donald E.K. and Paul D. Kimmel (2002). Accounting Principles (6th ed.). New York: John Wiley & Sons. Pwc.com (2007). Similarities and Differences: A comparison of International Financial Reporting Standards, US GAAP, and Canadian GAAP for Investment Funds. PriceWaterHouseCoopers. Available from [Accessed 25 December 2007]. Sowa, J.S. (2003). Ontology. Available from < http://www.jfsowa.com/ontology> [Accessed 2 January 2008]. Stanford.edu (2005). Epistemology. Available from < http://plato.stanford.edu/entries/epistemology/> [Accessed 2 January 2008]. Teweles R. and Edward, B. and Ted T. (1992). The Stock Market (6th ed.). New York: John Wiley & Sons. Appendix A: Questionnaire International Finances 1. What system do you consider superior? [GAAP or IFRS] 2. Has the complexity of the investment banking game increased since the inception of IFRS? [Yes or No] 3. Is convergence of GAAP / IFRS good for the industry? [ Yes or No] 4. Which system is easier and cheaper to implement in investment banking affairs? [GAAP or IFRS] 5. Which system illustrates higher industry profits? [GAAP or IFRS] 6. Does currency value and foreign exchange positioning affect the amount of business volume? [Yes or No] 7. Is the future of the investment banking industry bright? [Yes o No] 8. Which system is more truth-worthy? [GAAP or IFRS] 9. Do you expect FRIS to continue to spread across the world? [ Yes or No] 10. What is the biggest emerging market for international investment banking activity in the next 10 years? [Name of a country] Appendix B: Merrill Lynch Financial Statements 2006 (Annual Report: Merrill Lynch, 2006) (Annual Report: Merrill Lynch, 2006) (Annual Report: Merrill Lynch, 2006) (Annual Report: Merrill Lynch, 2006) (Annual Report: Merrill Lynch, 2006). Appendix C: Investec Financial Statements 2007 (Annual Report: Investec, 2007) (Annual Report: Investec, 2007) (Annual Report: Investec, 2007) (Annual Report: Investec, 2006) Appendix D: Gantt chart volume of business in UK investment banking industry (2003-2008) Task # Description Person Resp. Start Date End Date 1 2 3 4 5 6 7 8 1 Multiple regression model Stats Team Dec. 1 2008 Dec. 14 x x 2 Correlation Analysis Marketing Team Dec. 15 Dec. 28 x x 3 Probabilistic models Stats Team Dec. 29 Jan. 4 x 4 Variance Analysis Accounting Team Jan. 5 Jan.12 x 5 Summary report of project CEO Jan. 13. 2009 Jan. 27 2009 x X Appendix E: Questionnaire Project Gantt chart Task # Description Start Date End Date 1 2 3 4 5 6 7 8 1 Preparation Questionnaire week 1 week 1 x 2 Selection Companies week 2 week 2 x 3 Selection Participants week 3 week 4 x x 4 Submission IQ test week 5 week 5 x 5 Submission week 6 week 6 x 6 Evaluation data week 7 week 7 x 7 Final Report week 8 week 8 x Read More