Adoption of Ifrs

Adoption of IFRS: its benefits and impacts on firms and countries around the world

The IASB was established in 2001 and since has assumed the responsibility of the standard setting from its predecessor body, the International Accounting Standards Committee (IASC), and began issuing International Financial Reporting Standards (IFRS). IFRS has recently been dominating the regulatory changes in accounting for listed companies around the world. Through the years, over 100 countries have adopted IFRS reporting, some of which include Australia, the European Union, India, Japan, South Africa, Russia and most recently Canada.

In addition, the U. S. Securities and Exchange Commission (SEC) are working towards the final element of a work plan to incorporate IFRS into the U. S. financial reporting jurisdiction. In November 2007, the SEC voted to allow foreign issuers that report in IFRS to file their financial statements with the SEC without reconciling to U. S. generally accepted accounting standards (GAAP). Accounting standard setters anticipate that the use of IFRS will improve the comparability of financial statements, improve reporting transparency, and increase the quality of financial reporting which in turn will lead to greater investor confidence.

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From an economic perspective, some believe that it’s challenging to perceive that such expectations will be achieved as a result of converting to IFRS. However according to proponents of IFRS, publicly traded companies believe that applying these principles will allow for a single set of high-quality accounting standards as this will contribute to better functioning of the capital markets.

In the following paper I will discuss the reasons why firms around the globe have adopted IFRS in relation to the financial reporting and disclosure quality, comparability across firms and countries, and the costs and benefits associated with reporting improvements. Most countries are in favor of adopting IFRS, from the viewpoint that IFRS standards are more capital market oriented, which in turn provides higher quality information that will benefit constituencies of financial statement users as supposed to local GAAP.

If this statement is true, one way to validate it is through recommendations by empirical studies that suggest firms engaging in IFRS implementations should see an increase in market liquidity followed by a decrease in the firm’s value of cost of capital. Leuz and Wysocki, have provided some evidence in relation to the effects of reporting quality on market liquidity. They indicate the issue regarding information asymmetry, where investors who possess less knowledge of a firm’s reporting structure or policies, are concerned about trading with the better informed investors.

They indicate how these non-informed investors are to lower the price at which they are willing to buy, to protect themselves from losses incurred from trading with better-informed investors. Hence investors that possess less information about a stock are less likely to trade. These effects of adverse selection and information asymmetry reduce the liquidity of the securities market. Therefore, IASB strongly encourages essential financial disclosure. This will alleviate the adverse selection problem and will result in increased market liquidity by leveling the playing field among all market participants.

In addition, other studies have shown that improvements in financial reporting and disclosure can affect the cost of capital in a variety of ways. Some of which include, investors that require a higher return from less liquid securities and lower estimation risk as this makes it easier for the investor to estimate a firm’s future cash flow. This in turn, will improve risk sharing in the economy by making investors aware of certain securities or by making them more willing to hold them. Hence reducing the cost of capital.

As important as it can be for firms to disclose essential information to investors, other firms can also benefit from these disclosures for the purpose of decision-making and will help reduce the agency problem existing between shareholders and management. For example, “disclosure on operating performance and governance arrangement provides useful benchmarks that help outside investors to evaluate other firms managerial efficiency or potential agency conflicts and, in doing so, lower the costs of monitoring”.

In addition, the information environment has improved as firms switch over to IFRS, which has also contributed to the increase in higher quality financial reporting. According to Mary E. Barth firms that voluntarily adopted IFRS generally seek lower earning management, lower cost of capital, and more value relevant of earnings. All of which interpret evidence of higher accounting quality. Barth indicates that the accounting quality could be mproved by removing other accounting methods that are not reflective of a firm’s performance and which are used by managers to manage earnings. As part of his testing, he compared firm’s earnings management between those firms reporting under IFRS and firms reporting according to their local GAAP. As a result of his study, it was indicated that after firms had adopted IFRS, they had larger volatility swings in net income, increased ratio of variance in cash flows, higher correlation of accruals and cash flows, small positive net income, and increased occurrence of larger losses.

Opponents argue that a single set of internationally accepted high-quality financial reporting standards may not be appropriate for certain firms as they are exposed to different cultural, political, and legal differences this might continue to impose major obstacles in the progress toward the harmonization of standards. These differences however may not provide for any greater value relevance and reliability. For example, a study conducted by Ball indicates that pension accounting may be subject to earnings management in countries that have less developed pension systems.

Another empirical study indicates that managers can take advantage of and use different assumptions to manipulate financial statements. Proponents of IFRS argue that using common accounting standards across countries will make it more cost-efficient for investors to identify earnings management. When accounting standards are uniform and relevant disclosure is provided, investors are more likely to understand the different assumptions used by management to calculate such pension accounting, which will limit the chances of management to engage in earnings management.

The second important factor as to why countries have chosen to adopt IFRS is mainly because of its increase in accounting comparability across firms. The advantage of a global movement towards IFRS reporting makes it easier for investors and stakeholders to compare different firms and the relevant information to help them assess the company objectives. Comparative reporting will enable users of financial statements in identifying which firms are more or less profitable.

Firms that are exposed to high or low risk of return as a result, will reduce investors information asymmetries and lower estimation risk. Moreover, the improvement in comparability across firms allows for increased market liquidity and reduces firms cost of capital. Studies have suggested that prior to adopting IFRS, firm’s local GAAP standard which were tailored to the needs of analysts and investors would in theory reduce biased information and build investor confidence.

A study conducted by Tan, Wang and Welter in 2009, indicated that once firms had adopted IFRS, their foreign analysts had increased significantly more for those who had the greatest level of GAAP differences. There have been a number of studies conducted to test whether IFRS adoption does in fact increase comparability. The outcome of these studies is mixed. Bielstein et al. concluded that IFRS adoption, results in greater foreign investment for countries that have strong reliability and comparability.

Other empirical studies claim that cultural, political, and business differences continue to impose significant obstacles in increasing the comparability of accounting information. Lang Maffet and Owens find that accounting comparability does not improve for IFRS adopters relative to a control group of non-adopters. The two conclude that there is little evidence that IFRS adoption increases comparability. Overall, from the research obtained, there is little empirical evidence proven on the effects of reporting comparability than reporting quality.

The third important factor for countries adopting IFRS, are the costs and benefits associated in producing high quality accounting standards and the improvement in comparability across firms. As mentioned previously, the ultimate benefit a firm receives by adopting IFRS reporting is from the increase in market liquidity followed by a lower cost of capital. In order to achieve this high standard, there are costs that a firm is exposed to. Such incurred costs include transitional costs, ongoing costs of compliance to the firms, and enforcement costs relevant to government agencies.

Standish summarizes his findings in relation to cost and benefits of firms moving to IFRS that will tend to see lower transaction costs when preparing financial reports. They will only be reporting against a single set of accounting standards instead of multiple sets. In addition, he makes note of a “positive network externality” that arises through the use of a single set of accounting standards by all constituencies. This will save market participants from requiring additional time and energy of having to learn, apply and understand multiple sets of standards.

Other benefits that result from the transition to IFRS will improve comparability between a firm’s financial statement for investors and shareholders. Thereby, making investment decision’s easier. According to Leuz and Wysocki, there are direct and indirect costs associated with improving reporting. The direct costs include the preparation, validity, and circulation of accounting reports. These costs can vary and increase significantly. In addition, firms will require assistance and hire consultants that have expertise in IFRS reporting.

These specialists help train key personnel in the organizations so that they are able to produce financial statements that are in accordance to IFRS reporting. The costs tend to be more difficult for smaller companies to finance such activities for disclosures and reports, as their profit margins are small. Disclosure costs have characteristics of indirect costs. Whereby a firm can reduce its monopoly power by providing too much detail to the market, as sensitive profitability information is assimilated to its competitors.

Other empirical studies have noted that with these costs and cost-benefit trade-offs that firms are undergoing, it may not be suitable for them to obtain high quality reporting. Rather, encourage firms to provide certain disclosures in which the cost of disclosing such information does not exceed their benefit. Moreover, it is important that the standard setters recognize the net benefits obtained from the high quality reporting and comparability, as they differ across firm industries and countries.

It’s relatively evident why most companies would like to switch over to IFRS due to the number of benefits that are associated with the transition as described above. One would automatically presume that a single set of accounting standards that are used universally by most firms within different countries would deliver comparability, increase reporting transparency, allow for foreign investments, hence increasing market liquidity and low cost of capital. However, there is very little empirical evidence that claim these characteristics as being true after conversion.

Having said that, Ball has noted that IASB has been successful in serving the public by developing comprehensive set of high quality standards that have convinced over 100 countries to adopt these principles for the purposes of financial reporting. There are some advantages of having a single set of accounting standards unified. As such, these standards contain characteristics of a “public good”, for example, the investor can use this information in an annual report without eliminating its usefulness to other investors. In other words, the marginal cost for another investor viewing these annual reports would be zero.

A second advantage of unifying accounting standards and disclosure practices is to reduce management from using their own judgement in financial reporting, by reducing the risk of altering the reports to mislead capital market participants. Moreover, these uniform standards provide protection for auditors against firms. These standards are to also be enforced by auditors, whereby the firm has very little opportunity to shirk, hence reducing information asymmetry and increasing investors and stakeholder’s confidence of the firm. Lastly, unifying these standards will increase accounting comparability across firms.

If each firm or country were to implement different local accounting standards, this can impose high costs for both the firm and its external users, such as investors as this will create negative externalities and will reduce domestic investments which can impact countries' trade volume profitability, where the majority of countries main source of income is driven from. Opponents of IFRS adoption feel that a single set of accounting standards do not benefit all firms and countries. These differences in countries arise from cultural, economic, political and legal systems.

For example, firms may have to respond to political pressures from the government due to balance sheet volatility, as a result of fair valuing. The IASB should review accounting standards as they are released to eliminate the possibility of political pressures on countries that are exposed to such tight regulation. One of the main reasons why countries and firms around the world adopt IFRS is due to the results achieved from reporting quality and disclosure practices. However, IFRS can occasionally produce ineffective reporting quality and disclosure.

For instance, IFRS can lack in setting descriptive details in its guidelines making it difficult for countries to follow. Some countries find their local GAAP easier to read and understand due to the level of detail and examples provided. These complexities in the rules create havoc for firms that would like to report in IFRS, but find it challenging to exclusively follow these guidelines outlined by the IASB. As a result, this can lead to poor financial reporting quality. Other countries and firms conclude that fewer rules and guidelines will encourage management to produce effective accounting policies that will rompt them to make appropriate judgement calls. Information asymmetry and agency costs play a significant role in relation to disclosure and financial reporting quality. The key motivating factor for any firm is, that more disclosure provided will create a positive signal to investors and hence, will reduce the information asymmetry and agency costs. Companies will see increases in investor confidence while earning high profitability levels. Moreover, firms adopting IFRS, chances are that they are subject to fewer opportunities to part take in earnings management or deceive investors.

Studies have indicated that countries that have adopted IFRS do not all achieve the same degree of benefit. The study implies to those countries which have a weak structure in place for investor protection, will tend to see the most benefits from adopting of IFRS. In the contrary, countries that have a strong structure in place for investor protection will see marginal benefits. The increase in benefits received by a country whether small or large will improve investor protection and provide for more comparable and comprehensive financial reporting.

The cost and benefits of a firm converting to IFRS can be substantial depending on how one views it. The benefit driven through the implementation of IFRS will include lower cost of capital, increases firm value and creates a stable level of investors’ confidence. In addition, as discussed above, the benefits will also increase as a result of better financial reporting quality and cross-country comparability for foreign investors, auditors, and other constituencies. These benefits obtained through the adoption of IFRS are not free. The cost of implementing such an accounting standard can cost firms millions.

There are various types of costs that are incurred in the different processes a firm undergoes. The transition costs can be significant in relation to auditing fees. The cost of auditing work will increase, due to testing and validating accounting data as most of the assumptions used by firms are judgemental. Other costs involve training key personnel to apply applicable standards in practice. Companies tend to have shortages of staff that have ever been exposed to IFRS accounting, this is more apparent in Canada. As a result, these companies struggle as they need to learn and apply these new standards.

Moreover, the cost related to the risk involved of the manipulation of accounting standards, as these standards do not provide strict reporting rules for companies to follow, can impose a huge cost on the firm, if the auditor refuses to provide an unqualified opinion on the firm. Overall, the costs are generally higher during the first couple of phases through the transition. In the long run, costs tend to decline as employees are more aware of the standards and a basic foundation has been developed by IFRS consultants and auditors. At the present moment, IFRS reporting is widely used by many countries across the globe.

Based on the studies gathered above, countries and firms are optimistic about replacing their local GAAP with IFRS accounting standards. By moving towards a universal set of high-quality accounting standards will lead to improving the firm’s performance, by increasing shareholders' wealth through investors’ confidence, and lower the cost of capital hence reducing information asymmetry. In addition, other benefits include comparability across all nations, this will help facilitate a better understanding by investors of accounting information released in public financials.

Comparability will result in an increase of auditors understanding of the types of policies and assumptions companies implement. This will help ensure that companies are not partaking in earnings management. Comparative accounting standards can be most beneficial to analysts. This will enable analysts to predict the firm’s future forecast of cash flows in comparison to the industry average. As mentioned above, the IFRS accounting standards are costly to implement. Studies have made reference to these transition costs as extremely pricy to develop, however, in the long run their costs tend to decline.

This may in fact be true, however, those companies that have incorporated IFRS standards will continue to see new accounting pronouncements issued by the IASB, as they work to improve their guidelines. As a result, firms will continue to spend in areas of training and seeking professional advice on how these new standards will impact their firm.

References

1. Bielstein, 2007. How the IFRS movement will affect financial reporting in the U. S.: Article: KPMG
2. Daske andGebhardt, 2006. Discussion of Daske and Gebhardt, Journal of Accounting Finance and Business Studies.
3. Lang, Maffet, and Owen, 2010. Earnings Movement and Accounting Comparability, the Journal of Accounting Research
4. Leuz and Verrecchia , 2004. Firms' Capital Allocation Choices, Information Quality, and the Cost of Capital
5. Luez and Wysocki, 2008. Economic Consequences of Financial Reporting and Disclosure Regulation, Journal of Accounting Research
6. Mary E. Barth, 2006. Accounting Quality: International Accounting Standards, The Journal of Accounting Research
7. Ray Ball, 2006. International Financial Reporting Standards (IFRS): Pros and Cons for Investors, Journal of Accounting Research
8. Soderstorm and Jialin Sun, 2007. IFRS Adoption and Accounting Quality: A review, The Journal of Accounting Research
9. Standish, 2003. Evaluating National Capacity for Direct Participation in International Accounting Harmonization, Journal of Accounting Research
10. Tang, Wang, and Welkor, 2011. Analyst Following and Forecast Accuracy After Mandated IFRS Adoption. Journal of Accounting Research.
11. William R. Scott, Fifth edition, 2009. Financial Accounting Theory

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