Contribution of IFRS to Rising Transparency for Stakeholders and IDEAs' Effect on Economic Stability - Case Study Example

Critically assess how the use of IFRSs contributes to increased transparency for stakeholders, and the extent to which IFRSs can influence economic stability Contents Contents 2 Transparency & Economic Stability under IFRS 4 Conclusion 9 References 11 Introduction This paper is a critical analysis of the IFRS adoption by the firms and if this has enhanced the transparency in disclosures and influenced economic stability. Globalisation is the integration of businesses and markets of different countries. This provides opportunities to firms to expand their operations and infrastructures and gain economies of scope. All these factors are incentives for firms to go global. However this also poses challenges to the accountant due to differences in accounting standards and disclosures. Over the years the requirement of high-quality and uniform accounting framework has been extolled to foster international business relationship. The countries across the world are adopting IFRS leaving behind their local GAAP realizing the need for unified global reporting standards. The IFRS are the reporting standards which were issued by IASC till 2000 and then by IASC’s successor organization IASB which is a UK-based standard-setting body. IFRS is adopted by more than 100 countries following the efforts made by IASB and FASB for convergence of their respective conceptual frameworks. A topic by topic analysis of IFRS is not given here but empirical results suggesting the impact of IFRS adoption are provided. A subjective analysis by Ray Ball provides the potential advantages and challenges of IFRS to the investors. Empirical studies have suggested improved information environment of the firms following the adoption of IFRS. The adoption of IFRS has also led to increased cross-country equity investments by retail investors across the world. This means that the one of the most important indicator of economic stability i.e. share market performance is improved with increase in trading volumes. The Boards in their convergence of reporting frameworks have limited the use of fair value accounting realizing that the financial markets are not true representative of the fair value of financial instruments and it affects the financial statements of the firms having significant financial instruments held for trading. Transparency & Economic Stability under IFRS Corporate transparency can be defined as the dissemination of firm-related information to the outsiders who have direct and/or indirect financial stake in the firm. It is viewed as an indicator of financial reporting quality. Till now the countries had their own accounting standards but the globalisation has led to the emergence of comparable accounting standards so as to enable the users of financial information be able to assess the firm’s financial health. The concept of transparency is different among countries such as in US the concept is ‘fair presentation’ whereas in UK it is ‘true & fair view’. The financial reporting standards ensure the transparency in financial disclosures. IFRS are the reporting guidelines issued by IASB which is a standard-setting body based in UK. It includes International Accounting Standards (IAS) issued before 2001 by IASC, IFRS issued by IASB after 2001 and interpretations of those standards. IASB develops standards on the basis of clearly stated principles, also known as principles-based standards. This contrasts with the US GAAP which is considered rules-based standards. The adoption of IFRS helps the multinational firms in applying uniform accounting standards for all its subsidiaries. The IFRS is used by around 100 countries and since 2002 the convergence of IFRS and US GAAP is in process. This convergence is expected to bring more transparency in disclosures. The US companies are allowed to prepare financial statements according to IFRS without complying with US GAAP (Nandakumar et al, 2010, p.8). Figure 1 shows the results of survey conducted by AICPA regarded the public opinion to IFRS adoption as follows: Figure 1: Results of Survey on IFRS adoption in US Source: (Rich et al, 2011, p.1246) The Results in figure 1 shows that 50% of the respondent firms wanted to adopt converged IFRS whereas 18% of respondents simply want to switch to IFRS and similar number of respondents declined but kept it as an option. This shows the majority of the US firms favour the IFRS. Ray Ball, without any theoretical foundation or empirical evidence, identifies the advantages of uniformly adopting IFRS: 1. IFRS provides more comprehensive, timely and accurate financial statement information. Keeping in view that the annual reports are the only source of financial statement information, this may lead to a well-informed decision and less risk. 2. Improved financial reporting quality helps small investors to make better informed decisions and compete with professionals. 3. Making the financial statements more standardised by eliminating differences helps the analysts as they don’t have to make changes in financial information for international comparison. 4. This leads to reduced cost of processing the financial information. This also increases market efficiency. 5. Removal of barriers to cross-border business combination increasing the takeover premium (Ball, 2006, p.11). Although Ray Ball cautions that the implementation of IFRS may be uneven. He argues that despite the globalisation, political and economic influences on reporting standards are local. He states the example of accounting accruals as this requires subjective judgement to some extent. This might hinder the uniform adoption of IFRS in all the countries. The uniform financial standards will also reduce the competition among other reporting systems. The political influence of IASB for IFRS adoption in various countries may become highly politicised and bureaucratic. Presently it can motivate countries to adopt the uniform financial reporting standards but cannot demand the enforcement from country’s side (Ball, 2006, p.15-18). These factors can reduce the potential of IFRS in enhancing the increased transparency and financial stability. Another study was conducted on three types of firms- firms that have adopted IFRS compulsorily, firms that have adopted IFRS on voluntary basis and those firms that are yet to adopt IFRS. The study examined if IFRS adoption leads to improved information environment of the firms. The results showed that the information environment of only those firms improved that had voluntarily adopted IFRS. IFRS adoption by non-financial firms is beneficial. It was also found that those firms that report under national GAAP were likely to face deficit in information intermediation in future (Horton, Serafeim & Serafeim, 2010, p.28-29). Slightly contrary to this result, the empirical evidence on European firms since 2005 regarding the effect of mandatory IFRS reporting on the stock prices’ ability to reflect information is consistent with disclosures under IFRS. The stock price revealed new firm-specific information in the period in which IFRS was adopted. Moreover IFRS adoption increased the ability of the analysts to incorporate industry related information in the prices (Beuselinck et al, 2010, p.36-37). These studies impress upon an idea that IFRS adoption whether voluntary or compulsory has led to increased transparency and information dissemination. IFRS continue to be adopted by countries. The economic stability of a country is directly related to the stability and efficiency of its stock markets. Evidence collected from a year after the mandatory adoption of IFRS by over100 countries showed that the adopter firms experienced increased market liquidity and decreased cost of capital. The results were better in the case of voluntary adopters. It was also found that the capital market benefits were experienced only in those countries that had enforced IFRS adoption strictly or those that provided these firms with incentives to be transparent. However the results were not fully attributed to the IFRS adoption but the strict enforcement and reporting incentives also played a significant role (Daske et al, 2008, p.1130-1132). The results on the earnings management in UK, Australia and France showed that post IFRS adoption the pervasiveness of earnings management is not affected rather increased in France. This was not fully attributed to the standards alone but management incentives and institutional factors were equally important (Jeanjean & Stolowy, 2008, p.16). A study on the adoption of IFRS on share trading volume in the open markets provides strong evidence suggesting the increased trading volume. This means that the IFRS adoption leads to enhanced cross-border share markets investments by retail investors. This study supports the efforts by IASB and FASB to encourage unified global reporting standards (Brüggemann, 2011, p.25). Another study on European capital markets consequences of IFRS mandatory adoption revealed that there was increased value relevance and information content regarding earnings announcement coupled with decreased cost of equity (Prather-Kinsey, Jermakowicz & Vongphanith, 2008, p.23). The decreased costs of capital means that the investors require lower returns because they consider the investment to be less risky. This translates into lower accounting risks perceived by investors. The occurrence of recent financial crisis was blamed on the requirements of reporting fair value of financial assets by the IFRS and US GAAP. With the sub-prime mortgage crisis, the market values of these financial instruments plummeted and companies especially banks had to record losses on their statements. This meant that the market values were not representatives of fair value. This has resulted in limiting fair value accounting in the new reporting framework therefore depending less on the market pricing of financial instruments (Walton, 2011, pp.1,3). It can be inferred from such changes that IFRS acknowledges the inefficiency of the financial markets and relying too much on market valuations may lead to collapsed financial system. The information content of the annual reports in different countries is affected by institutional factors such as legal system. The countries where the enforcement occurs by codified law and governmental process is important such as Germany, they are known as ‘code-law’ countries. Those countries where the shareholders’ opinions matter and financial markets matter are ‘common-law’ countries. Example is US and UK. The abuse of transparency in national GAAP of code-law countries has been highly prevalent due to legal imposition of techniques such as statutory reserves. However the cases of accounting abuse are also cited in common-law countries. Code-law countries have consistently opposed to the new IFRS framework mainly for the fair value accounting of financial assets. The effect of IFRS adoption on German companies since 2000-2006 suggested a decline in the accounting quality. From the matched sample the authors could not find any improvement in the quality of financial reporting. The accounting quality was driven by change in accounting standards rather than the new adopters in 2005 (Paananen & Lin, 2008, p.25-26). This result does not undermine the studies done by Beuselinck et al (2010) or Prather-Kinsey, Jermakowicz & Vongphanith (2008) because their studies were more focused on the new European IFRS adopters. The economic stability of a country to some extent is determined by the transparency and stability of financial markets, high liquidity and low transaction costs. There is enough empirical evidence that IFRS adoption has led to increased transparency, market liquidity, lower cost of capital, and reduced accounting risks. These factors seem to rectify some of the previous problems reporting frameworks posed. Conclusion This paper analyzed the impact of global IFRS adoption on the transparency and economic stability of a country. An analysis by Ball (2006) provided the advantages and challenges in adopting IFRS. The empirical evidence suggested that the IFRS adoption whether voluntary or compulsory led to improved information environment of the firms. The studies on European firms post mandatory IFRS adoption showed increased reflection of firm-related information in the stock prices. Analysts were also able to incorporate industry related information in the prices. The cross-country equity investment increased substantially. The IFRS adoption by non-financial firms particularly showed improved results. This might be due to debate over the fair valuation requirements of financial instruments. However the valuation of financial instruments on fair value basis has been limited in the new IFRS framework. Germany has debated over the introduction of new IFRS standards which has actually decreased the accounting quality of the German firms. The improved earnings quality and capital market benefits could not be attributed to IFRS adoption alone but the strict enforcement and institutional factors played equally important role. The worldwide acceptance that the uniform accounting standards will lead greater disclosure quality is not based on unfounded notions but on the strong evidence suggesting the usefulness of IFRS. References Ball, R. (2006). International Financial Reporting Standards (IFRS): pros and cons for investors. [Pdf]. Available at: http://www.passmagazine.co.uk/abr/pdf/005-028.pdf. [Accessed on November 23, 2011]. Beuselinck, C. et al. (2010). Mandatory IFRS Reporting and Stock Price Informativeness. [Pdf]. Available at: http://arno.uvt.nl/show.cgi?fid=107197. [Accessed on November 23, 2011]. Brüggemann, U. et al. (2011). How do individual investors react to global IFRS adoption? [Pdf]. 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