Earnings Reported under IFRS, Tesco and the Concept of Prudence - Case Study Example

Finance and Accounting Table of Contents Table of Contents 2 Introduction 3 Issues related to IFRS 4 Re-introduction of prudence by the IASB 7 Conclusion 8 Reference List 9 Introduction Companies operating worldwide have rapidly adopted International Financial Reporting (IFRS) for improving its quality of financial reporting. IFRS consists of a set of standards that have the ability to enhance the quality of financial reporting and motivate the accountants to maintain transparency and accuracy in preparing financial statements for a business entity. However, the quality of accounting does not only depend on implementation of IFRS, rather it is dependent on overall performance of the business entity, which includes political and legal system of country. It is observed that adoption of IFRS takes into account the changes related to the system, which is brought in order to make the presentation of the financial statements accurate (Bhattacharjee and Islam, 2009). The accounting system has close proximity with that of the laws and regulations followed by the country. With the change in rules and regulation, the accounting system has to encounter modifications that are not quickly adaptable for the companies those who are following IFRS. Thus, they have to encounter difficulties in adopting the changes (Bhattacharjee and Islam, 2009). The issue related to adoption of IFRS are detailed in the report along with the respective solution of reintroduction of prudence by International Accounting Standards Board (IASB). It argues regarding inconsistency in quality of financial reporting that is encountered by the companies worldwide. Hence, the report is prepared for elaborating the issues to the members of the medium sized organisation and whether it is wise enough to adopt IFRS when it has failed to provide positive result in case of Tesco Plc. Issues related to IFRS Literatures have provided many evidences related to the good effects of adoption of IFRS at firm-level as well as country level. It has brought economic consequences such as efficient capital allocation, cost of capital and international capital mobility. However, it has brought huge challenges to the firms regarding its financial reporting. Accounting theory elaborates that financial reporting reduces asymmetry in managing information by disclosing timely and relevant information. Nonetheless, due to variations in economic efficiency and accounting quality across countries, implementation of IFRS has been challenged. Existing literature also gives emphasis on the fact that the accounting quality of IFRS could be improved voluntarily so as to avoid asymmetry of information between the shareholders and managers of the company. Barth et al (2008) have stated that there is higher level of variance in changes of net income, cash flows and correlation between cash flows and accruals, which is inconvenient for financial reporting. They had executed a research among international firms, which adopts IFRS and had stated that these firms exhibit lower level of earnings management. They also recognised that there is timely loss recognition and compared the same with that of the firms that adopt Generally Accepted Accounting principle (GAAP). Extending their discussion regarding the issues of IFRS, Daske et al (2007 cited in Barth et al., 2008), exclaimed that the capital market respond moderately to the voluntary adoption of IFRS. This is due to the lack of transparency in the preparation of the financial statements of the companies. The shareholders cannot rely on the reporting of the company when the accounting standards are questioned. IFRS does not have the ability to forecast accurate earnings of a company and thus cannot depict an accurate value for the investors (O’Connell and Sullivan, 2008; Nobes, 2006). Adoption of IFRS in Bangladesh has brought in a numbers of issues, which can be improved for successful implementation of the accounting standards. Lack of transparency between the managers and shareholders through the financial statements should be concentrated upon in order to avoid agency problem. Vulnerability of the small investors is undoubtedly a major problem in the stock market of Bangladesh. The adoption of IFRS has brought confidence in the investors but the lack of expertise in developing the accountings statements could not do so (Rahaman and Lawrence, 2001). IFRS employs fair value for measuring most of the elements of financial statements. The use of this accounting system can bring a number of subjectivity and volatility in the financial statements. This affects the shareholders as they take investment decisions based on these statements. In maintaining a fair value system, hard work and appropriate knowledge is compulsory without which the valuation process will not be successful. Hence, implementation of IFRS is not relevant if proper accounting system is considered (Niskanen, Kinnunen and Kasanen, 2000; Bushman and Smith, 2001). The major impendence that is encountered by the companies, who have adopted IFRS, in America and Europe, relates to different aspects of accounting rather than only technical part. According to Rong-Ruey Duh (2006) the challenges includes continuous amendments taking place in IFRS rules and regulations, timely analysis of standards, expertise knowledge of users, regulators, auditors and preparers of financial statements. Though IFRS has ability to facilitate any cross-border comparison, increase efficiency in transparent reporting of the financials, reduce asymmetry in information communication and simultaneously increase competition, efficiency and liquidity, its success has been questioned due to several obstacles such as proper reporting of the profit and earning of a company. This statement is supported by the result of a survey conducted by McEnroe and Sullivan (2011). They stated that the individual investors in the United States (US) were satisfied with the local accounting models and does not desire to invest in such companies, which adopt IFRS. Winney et al (2010) have also portrayed the fact that the small business operating in the US, did not shift from GAAP to IFRS as they did not felt the necessary (Ndubizu and Sanchez, 2006; Daske et al, 2008; Easton and Harris, 1991). Larson and Street (2004) have suggested that the quality of financial reporting is evaluated through a number of factors, which are related to institutional environments and its elements. They have also executed a research for examining the challenges that are involved in implementation of IFRS in the emerging economies. Hail, Leuz and Wysocki, (2009) have highlighted the unique features of markets in the United States in order to understand the affect of IFRS adoption on quality of reporting and compare it with that of US accounting standards. The study ensured that the IFRS has brought in serious challenges related to capital market effects and increased the cost of switching from GAAP to IFRS. It is observed that Tesco Plc has overstated its profit to about £ 250 million through irregularities in revenue recognition in half years earnings result (Lovell, 2014; The Guardian, 2014a). This overstatement not only knocked down the share price of the company but also questioned regarding the effectiveness of adopting IFRS as the accounting principle (Ashbaugh and Pincus, 2001). There was severe consequence for the company when it has to suspend four senior executives as they have misrepresented the revenue recognition and the profit was inflated by an amount of £ 250 million (The Guardian, 2014b) Following the number of issues that are encountered by companies, which have adopted IFRS, several amendments are made by International Accounting Standard Board (IASB). The amendment, which is highlighted in this case, is related to the re-introduction of prudence in the conceptual framework of IASB. Re-introduction of prudence by the IASB IASB have felt the need of re-introducing prudence in the global standard of the conceptual framework after a lot of pressure that was exerted by the companies for committing a number of frauds and misrepresentation of financial statements. The revised framework is expected to publish during 2015 although the board is not very confident regarding the decision (Crump, 2014). According to Association of Chartered Certified Accountants (ACCA), prudence is inserted in the existing IFRS by employing a number of methods. It is mainly concerned with the guidance relating with recognition of liabilities and assets. Thus, it will be wrong not to address and explain the concept of prudence in the IASB framework. This contributes towards the accountability of the financial statements that are prepared by the accountants. Here, accountability refers to the need that should be promoted in order to safe guard the investment of the investors and help them in taking credit decisions (Deloitte, 2014). ACCA have also recognized the need of introducing principles related to the areas, which deal with disclosure and de-recognition and units of accounts. This are viewed as the only gaps that are present within the conceptual framework of IASB. In this way, the framework can make effort in improving the presentation of profit and earning in the financial statement and enhance reliability on the IFRS system. The prudence will deliver coherent meaning of liability, which is brought together by constructive liabilities and economic compulsion. It will also provide a clear view of asset recognition and profit and loss and other income accrued by the company (International Financial Reporting Standards (IFRS), 2008; Deloitte, 2014). Conclusion IFRS has brought considerable changes in accounting system prevalent worldwide. It has helped the accounting systems in the companies to reduce its cost of capital and increase its profit. However, there are serious issues too related with the implementation of IFRS. For example, Tesco overstated its profit and breached the accounting principles that they were employing. This overstatement has raised a debate among the members, which was quite obvious after encountering such a disastrous situation in Tesco. Thus, concern of the chairman regarding adoption of IFRS as the accounting standard for the company is relevant. However, IASB has promised to deliver its best effort to bring prudence in the reporting of financial data. Reference List Ashbaugh, H. and Pincus, M., 2001. Domestic accounting standards, International accounting standards, and the predictability of earnings. Journal of Accounting Research, 39, pp. 417-434. Barth, M. E., Landsman W. R., Lang, M. 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The Guardian, 2014b. £2bn wiped off Tescos value as profit overstating scandal sends shares sliding – as it happened. [online] Available at: [Accessed 3 November 2014]. Winney, K., Marshall, D., Bender, B. and Swiger, J., 2011. Accounting Globalization: Roadblocks to IFRS Adoption in the United States. Global Review of Accounting and Finance, pp.167 – 178. Read More