Accounting Policies International Financial Reporting Standards Adoption and Effects - Literature review Example

Accounting policies IFRS adoption and effects Introduction The adoption of International Financial Reporting Standards (IRFS) represents a process that began in 2001 to harmonise accounting in the European Union that then spread as a global initiative (Roberts et al, 2008). IFRS is a set of international accounting standards regarding how particular transaction types and other accounting events are reported in company financial statements (Roberts et al, 2008). The guidelines are provided by the International Accounting Standards Board that issues specifications regarding how accountants are to report and maintain accounts (Epstein and Jermakowicz, 2008). The driving rationale behind the creation and adoption of IFRS represented the reduction of potential confusion in individual country accounting reporting procedures that made cross border investing as well as analysis of companies difficult (Epstein and Jermakowicz, 2008). This brief look at IFRS was undertaken to provide some background information that will be useful in this analysis of its adoption in the UK and China. In adopting IFRS, what are the factors which shaped it in China and the UK? In 2002 the EU made it mandatory for all member states to use IFRS for listed companies beginning in 2005 (Jermakowicz and Gornik-Tomaszewski, 2006). The uniformity of accounting standards represented by IFRS was crafted to create an easier platform for investors (inside and outside of the EU) to analyse the financial statements of companies and draw comparisons (Jermakowicz and Gornik-Tomaszewski, 2006). It provides a common accounting framework for international investors along with the fact that the UK (London) is the second largest financial centre globally after Wall Street in the United States (Jermakowicz and Gornik-Tomaszewski, 2006; Engelen and Grote, 2009). The above stock exchange aspect and EU member state adoption represent the application of economic network theory that states additions to a network benefit the entity joining as well as the other members in the network and can drive change regarding policy (Lafour, 2005). There is also the net political value of IFRS that consists of the overall gain in creditability that the EU benefits from by harmonising accounting practices in order to increase transparency within the trade bloc (Ramanna and Sletten, 2009). In terms of factors that helped to shape the IFRS in the UK, Horton et al (2008) advise that the adoption of IFRS has the potential in many cases to decrease information costs, increase liquidity, heighten efficiency and foster more balanced competition in markets. In terms of the adoption of IFRS in the UK, the following represents the exchanges affected (Deloitte, 2015): London Stock Exchange – Regulated Market London Stock Exchange London International Financial Futures and Option Exchange London Metal Exchange ICAP Securities & Derivatives Exchange ICE Futures Europe NYSE Euronext London In terms of companies that are not listed the UK permits them, with the exception of charities (that must use UK GAAP), to use either UK GAAP or IFRS (Deloitte, 2015). The above adoption of IFRS that applies to listed companies was done in order to comply with the EU directive on IFRS as well as to provide a common financial statement reporting system that is uniform among member states (PriceWaterhouseCoopers, 2005). The ability of companies that are not listed to use either UK GAAP or IRFS was done in order to minimise potential increased accounting costs for non-listed companies in terms of compliance (PriceWaterhouseCoopers, 2005). A look at factors that helped to shape the adoption of IFRS in China, its admission to the World Trade Orgainisation (WTO) was one integral part (Buthe and Mattli, 2011). This is done to create a sound and easily understood financial reporting system to help further the country’s economic development (Walter, 2008). In terms of China’s push to advance its footing in global markets, the Chinese Ministry of Finance, that oversees China’s accounting policies, sought to increase investor confidence in financial information provided by companies (Walter, 2008). Regarding the effects of accounting policies and IFRS adoption in the UK, a study by Nobes and Kvaal (2010) found that despite the EU shift to IFRS, there is still the British UK GAAP version that was in place prior to the EU IFRS mandate which is in use by companies that are not listed. The study by Nobes and Kvaal (2010) found that in the UK the treatment of actuarial gains and losses (AGL) along with other comprehensive revenues was still widespread in the UK among listed companies which differs from the IFRS principles based treatment. This is an example of UK GAAP principles. In broad terms, the costs associated with shifting varied accounting changes and principles over to IFRS represents a costly restating of past reports that many companies resist making (Nobes and Kvaal, 2010). This has had the effect of partial compliance as opposed to wholesale compliance in terms of EU IFRS. Interestingly, paragraph 11 of the EU IFRS policy permits companies to ignore pre IFRS policy choices in terms of transition, thus the above reluctance on the part of some UK companies is within the spirit of the new regulations (Nobes and Kvaal, 2010). A key underpinning of Chinese foreign investment inflows represents joint venture agreements where the Chinese partner retains operational control (Gong et al, 2007). The first step in shifting to IFRS entailed the adoption of the International Accounting Standards Board (IASB) (formerly known as the International Accounting Standards Committee when China started the process) (Ding and Su, 2008). This represented converting and updating the Chinese accounting system from PRC GAAP (the People’s Republic of China Generally Accepted Accounting Principles) to a more Western standard (Ding and Su, 2008; Walter, 2008). The American Accounting Association (1965, pp 206-207) advises that “Accounting theory is defined as a cohesive set of conceptual, hypothetical and pragmatic proposition explaining and guiding the accountant's actions in identifying, measuring and communicating economic information to users of the financial statement”. This links to the development of a country as Wolk et al (2008) advise that accounting theory is connected to this because it provides for stating basic assumptions, definitions, concepts and principles on how value is arrived at and derived. In terms of theoretical reasons concerning what helped to shape the adoption of IFRS in China, Ramanna and Sletten (2009) refer to the economic theory of networks. China’s acceptance into the WTO and its development of the country’s economy meant that it needed its accounting standards to be compatible with the sphere of countries adopting IFRS in order for it to help drive investment and its stock market (Ding and Su, 2008). Another theoretical aspect that China considered in adopting IFRS is a political value (Peng and Bewley, 2010). By this, it is meant that by adopting IFRS China put itself in the position of being able to lobby for or against future modifications (Peng and Bewley, 2010). As a country seeking to become a global economic leader, having a say in future accounting policies is a critical factor. It needs to be remembered that the IFRS represented a change implemented by the IASB in Europe (Peng and Bewley, 2010). Whilst IFRS does not see itself in that light, it is important that member countries be involved politically concerning new policies and direction in order for IFRS to be a truly global accounting standard. With regard to adaptation, China utilised the principles-based approach and then translated these into the country’s own code under the Chinese Accounting Standards System (Taub, 2006). The Chinese principles-based accounting code embraces fair value principles that are in sync with global IFRS practice (Peng and Smith, 2010). The Ministry of Finance for the People’s Republic of China issued the Accounting Standards for Business Enterprises (ASBE) that represents the incorporation of IFRS (Deloitte, 2006). Whilst the new ASBE is significantly in line with IFRS, there are some key differences: Table 1 - Differences Between ASBE and IFRS (Deloitte, 2006, pp. 3-4) The Chinese Accounting Standards (CAS) also have technical differences from IFRS that represent aspects such as (Deloitte, 2006): The double entry that is solely done for the yuan, with transactions using foreign currencies converted into yuan using the official rather than prevailing rate. In terms of private accounting firms, the historical cost approach is utilised rather than fair value. This is largely due to the fact that it is difficult to obtain accurate prices. CAS standards require considerably more information on areas such as the identity of business partners and transaction fairness, both of which are not deemed important IFRS requirements. Another factor is that standards under CAS are not enforced with the same regour as IFRS. This means that there are broader reporting latitudes that could be taken. This means eliminating a system of laxity in financial principle utilisation under CAS that is difficult to change and also has implications concerning past reports and the differences that occur under IFRS that can result in discrepancies. The above sampling of key aspects represents an indication of a large number of areas that required amending standards regarding the adoption of IFRS in China. Degree that IFRS adoption is suitable for all enterprises in both countries that includes a comparison and contrast. The prior discussion on the factors that shape IFRS adoption in the UK and China found that in the case of the former, the past enforcement of UK GAAP provided a sound basis to move forward concerning IFRS. This is because prior financial reports had consistency regarding their being created within the rules where UK GAAP had similarities to IFRS. As a result, of the above, the layers of adoption differ in terms of these two countries. In order to understand this, an official document prepared by the IFRS (2015a) was utilised so that various areas could be compared. In terms of the extent of IFRS application in the UK, all domestic companies that trade on public markets have switched to IFRS as of 2015 (IFRS, 2015b). This is not the case in China. As of 2015 companies whose securities trade on the Stock Exchange of Hong Kong can select either IFRS Standards, Chinese Accounting Standards (ASBE) or Hong Kong Financial Reporting Standards (HKFRS) (IFRS, 2015c). For companies whose securities trade in mainland China, they only utilise the Chinese Accounting Standards for Business Enterprises (ASBEs) (IFRS, 2015c). The translation of IFRS standards in China was handled by the Chinese Ministry of Finance along with China’s Accounting Standards Committee in conjunction with the IFRS Foundation (IFRS, 2015c). This differs from the UK that adopted IFRS Standards as set forth by the EU that were issued by the IASB with limited modifications (IFRS, 2015b). In order to understand the siutability of IFRS for all enterprises in the UK, a comparative regarding IFRS and UK GAAP provides a basis for understanding: Table 2 - Comparing and Contrasting UK GAAP and IFRS (Ernst & Young, 2011) The above are highlighted areas that have been used to illustrate that the differences between UK GAAP and IFRS are minimal and the suitability of IFRS for all companies in the UK. In terms of assessing the suitability of IFRS for all companies in China, the analysis is more complex. This is because the Chinese Accounting Standards on the mainland uses three formats (IFRS, 2015c). These represent the ASBE that stands for Accounting Standards for Business Enterprises, ASSBE that represents Accounting Standards for Small Business Enterprises, and ASFE that stands for Accounting Standards for Financial Enterprises (China Briefing, 2013). In order to understand the complexities of adopting IFRS to suit listed Chinese companies, it means understanding they were developed under a socialist regime where accounting was used to determine the assets available to a company as opposed to being for profit and loss under the Western accounting sense (China Briefing, 2013). Another difference is that Chinese accounting standards under the socialist regime did not include the debts held by a company (China Briefing, 2013). The new accounting standards that were devised in cooperation with the IFRS Foundation and the Chinese Accounting Standards has resulted in a system that is approximately 90 percent regarding compliance with IFRS (2015c). However, the different accounting standards as described above means that this applies only in the case of ASBE (Accounting Standards for Business Enterprises) for listed companies (China Briefing, 2013). As the changes needed to adapt the other two Chinese accounting standards (ASSBE - Accounting Standards for Small Business Enterprises, and ASFE - Accounting Standards for Financial Enterprises) would be costly as well as time-consuming for non-listed companies, the suitability of IFRS for all types of Chinese enterprises is low. In adopting IFRS, which country is more successful and why. In China, the purpose was to bring listed companies into compliance with IFRS in order to increase conformity with the rest of the world and the WTO. It also needs to be explained that business interests and policy under its market economy is controlled by the state. The Chinese five year plans set goals and objectives regarding what the state wants to achieve for the economy which determines the emphasis or lack of emphasis for varied business sectors (Naughton, 2005). As a result, success is based on what the government is seeking to achieve. There has not been any appreciable increase regarding inward bound Chinese FDI since the adoption of IFRS. Part of this is due to the fact that most of the joint venture arrangements in automotive and other industries had been in place prior to 2007 (Hudson, 2015). Another important factor is that the new five year plans of the government seek to develop domestic companies and sectors that do not require foreign joint venture investment. In terms of the UK, the adoption of IFRS was designed to increase cross border investments throughout the EU (IFRS, 2015b). In a study conducted by Henock and Oktay (2015) they could not find any evidence to support that there were increased investments after the adoption of IFRS in the UK or the EU. In a look at the benefits of IFRS, it was found that it has and is providing consistency regarding offering investors information in a framework they can more easily understand concerning looking and evaluating different companies in varied EU countries (Henock and Oktay, 2015). It also aids in reducing accounting costs for multinationals that operate in different countries (Henock and Oktay, 2015). This has also been found to be the case in China (Hudson, 2015). The history of adoption in these countries that considers political, economic and institutional factors and how these have affected the adoption of IFRS The EU determined that it would adopt IFRS as it needed a common accounting standard for its member countries in order to help provide a basis for easier company financial comparisons (IFRS, 2015c). As a result, the UK adoption of IFRS was due to a larger political stage where the EU determined it needed to have a common accounting standard for companies in order to spur increased cross border and foreign investment that would be aided by a common framework investors could understand and compare on a country to country and company to company basis as opposed to different accounting rules and policies (IFRS, 2015b). The political factors in terms of China were similar regarding seeking to utilise an accounting framework to aid in easing investment in its domestic companies (IFRS, 2015c). China’s application and acceptance to the WTO represented a series of political moves the country undertook in order to become more easily accessible to foreign investment as well as apply network theory to expand its reach and influence on the world stage (Hudson, 2015). From an economic standpoint, the UK’s position as the second largest financial centre after Wall Street in the United States represented an important factor in terms of IFRS (IFRS, 2015b). As a trading bloc, the EU does business with every region internationally, thus the ease of investment represents a boost to trade as well as development. China’s economic situation is also similar to its market economy sought to attract FDI to aid in the growth and capabilities of its domestic companies and industries (Hudson, 2015). A more recognisable accounting standard represented an important part of this process (Hudson, 2015). From an institutional framework, the EU has sought, since its inception, to ease and eliminate barriers in cross broader and international investment regarding its member countries (Posner and Veron, 2010). The EU’s institutional framework represents the Accounting Standards Board (ASB) that is the equivalent of the IASB (International Accounting Standards Board) (Posner and Veron, 2010). In the instance of China, the accounting foundation was based on the socialist system that underwent reform into PRC GAAP, a principles-based system. The adoption of IFRS required a collaboration by the Chinese Ministry of Finance, the IFRS Foundation and China Accounting Standards Committee (CASC) (Forsberg and Ojala, 2014). The adoption of IFRS in China represented convergence as opposed to adoption as the above institutions developed the Chinese Accounting Standards for Business Enterprises (ASBE) (Forsberg and Ojala, 2014). This resulted in a new accounting regime in the country that differed from the modifications made in the UK that were modest as opposed to representing a new accounting standards approach. Why China used convergence rather than full adaption. Chinese accounting standards under the principles-based PRC GAAP represented a system that was devised in a socialist country before it converted to a market economy. In February of 2006, the Chinese Ministry of Finance issued thirty-eight new Accounting Standards for Business Enterprises (ASBE) that is considered the new Chinese accounting standard (Rutledge et al, 2015). The above has been explained as it provides insight regarding China's convergence as opposed to the adoption of IFRS. In terms of clarity, convergence represents moving toward uniformly or as a union rather than taking on or adopting a system that represents alignment in order to replace or modify what had already been used for certain areas (Peng and Bewley, 2010). China’s convergence represents the understanding that its unique cultural environment, customs, and history was better suited to implementing IFRS by taking its precepts and applying them as opposed to adopting standards that represented a Western background that offered many differences (Forsberg and Ojala, 2014). One aspect of the significant difference between IFRS and CAS is shown under double entry where under CAS it is done solely using the yuan, with foreign currency transactions converted using the official as opposed to prevailing rate (Rutledge et al, 2015). Other aspects of CAS that differ considerably from IFRS are the identity of business partners as well as the fairness of transactions, and the lack of attention in making allowances for bad debt (Rutledge et al, 2015). Decades of accounting practices in China meant that in order to take on a new accounting approach, convergence offered a means to achieve higher compliance as opposed to the wholesale change represented by adoption (Forsberg and Ojala, 2014). The effect of IFRS on the stock market in both countries as well as the effect on investors. In terms of the effect of IFRS on the stock market in the UK, research uncovered that the cost of equity capital reduced after IFRS was implemented (Samarasekera et al, 2012). In terms of equity financing, since the implementation of IFRS in the UK disclosure quality in financial statements has risen and has been effective regarding securing investors (Samarasekera et al, 2012). In another study, it was found that profits for post-IFRS UK reporting companies increased in contrast to UK GAAP and that net equity was 35 percent lower (Samarasekera et al, 2012). To further investigate the above, it would need to look at the origins of listed firms, meaning those that were not originally UK based. This might explain the rise in profits and reduction in net equity as UK GAAP and IFRS are both principles-based, thus their treatment of these areas is essentially the same. In a study prepared by Hamburg et al (2010), they found the move toward the fair value of assets as well as liabilities represents the explanation for the above changes in terms of company financial statement, but no correlation in terms of stock market impact could be stated in terms of evidence. The difficulty in correlating stock performance impact due to IFRS is based on the fact that since its adoption in the UK in 2002 the period 2008 to 2012 could not be used due to the global financial crisis, and stock performance since 2008 has been skewed by recovery. As a result, stock performance was looked at between 2002 and 2007. The only study that could be found reported a decrease in the underpricing of IPOs (Initial Public Offerings) and a relative increase in IPO proceeds, however, the impact of IFRS on these areas was not correlated in any studies (Hong et al, 2014). Punda (2011) helps to explain the above as well as the increase in net profits and a decrease in net equity. He states that under IFRS “the measurement to ‘… fair value less costs of sale’ or on the disposal of the discontinued operations is shown after tax” (Punda, 2011, p. 29). In terms of the impact of IFRS in China, it first needs to be explained that companies can issue ‘A’ shares that are denominated using the Chinses RMB that usually apply for Chinese investors, or ‘B’ shares that are denominated in Hong Kong or US dollars that apply or are intended for foreign investors (Rutledge et al, 2015). Since convergence, investors have seen earnings reports become more relevant for ‘A’ shares due to a general rise in value (Lee et al, 2013). This was not the case in ‘B’ shares as stock on the Hong Kong exchanges were utilising the Hong Kong Financial Reporting Standards (HKFRS) that is a principles-based GAAP (Rutledge et al, 2015). This meant that the HKFRS was using a version of IAS that had a close relationship to IFRS HKFRS. As brought forth in a prior section, the ABSE Chinese mainland public company reporting standard represented the Chinese Ministry of Finance and IFRS Foundation convergence that applied modified Chinese accounting codes for the use in financial reports (Lee et al, 2013). As a result, the earnings and profits were restated that resulted in a general rise in the value of the mainland companies and a slight gain in stock performance which was not the case for Hong Kong stocks. Conclusion This look into the adoption of IFRS in the UK and China revealed that there are many similarities in terms of economic, and political factors. These represented the need to develop heightened accounting transparency using a common framework (IFRS), and the importance of being in a broad sphere of influence provided by IFRS (political) in order to help guide and shape future accounting developments. The UK’s position, in terms of being a member of the EU and in the region that devised the foundation for IFRS, means that the adoption of this new accounting standard represented a less complex adjustment due to the similarities to UK GAAP. The situation differed considerably in China, even though the economic and political factors were similar in terms of increasing accounting transparency and having a voice in future IFRS developments. China’s conversion to a market economy from its former socialist roots entailed adjusting to a different accounting framework that represented including debts as a part of financial statements. It also meant the development of ASBE (Accounting Standards for Business Enterprises). This represented convergence as opposed to adoption that is a considerable difference in terms of the path taken by China that contrasts with the UK whose UK GAAP was close to IFRS. In comparing and contrasting the two countries. The approaches in terms of convergence (by China) and adoption (by the UK) represented a major difference that defined the paths taken to implementing IFRS. The nuances of convergence meant that the applicability of IFRS to all Chinese enterprises was less encompassing than in the UK due to the similarities of UK GAAP to IFRS. The change to IFRS impacted UK listed companies regarding increasing profits but decreased net equity. It was uncovered that these factors did not result in any measurable change in stock prices as research data for this aspect could not be located. The situation concerning stock market performance in China differed as profits were restated that caused a general increase in the value of mainland Chinese listed firms. 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