UNIVERSITY OF HULL

Advanced Financial Reporting and Theory 26325 Module Leader: Pat Mould
11/29/2011

Transparency never harms anybody, if that body dont have anything to hide We no longer live in a world of trust me. Innumerable scandals such as Enron, Mahindra Satyam, Kmart, Lehman Brothers and others have eroded investors trust in financial reporting. How can investors accurately recognize the information they are receiving unless it is communicated in a straightforward and uniform style. International Financial Reporting Standards (IFRS) are developing momentum and recognition worldwide with both opportunities and challenges. IFRS has emerged as the global accounting standards in an era of booming globalization regardless of the debates concerning the benefits and the challenges of IFRS. Over 100 countries have adopted, have convergence plans with or accept the use of IFRS (Sacho & Oberholster, 2008). IFRS is principles-based that breaks from GAAPs rules-based approach. Rather than strict compliance with comprehensive rules and bright-line tests, companies and their auditors focus more on the economic substance of a transaction. IFRS supporters consider that an emphasis on principles would help avoid manipulation of financial statements and further lead to greater transparency. A principles-based approach depends on judgement rather than adherence to complete set of rules. Argued upon, stated that a principles-based approach makes it is more difficult to manipulate financial statements. Complex rules with limited justification make it harder for financial statement users to recognize the economic realities behind the numbers whereas principles based approach with broad disclosures that necessitate companies to file the process that led to a significant accounting treatment and describe why its judgment is reliable with underlying principles. The principle of financial reporting is to represent as sincere image as possible of the financial position of a company or organisation and that the financial statements should hold information that is as unbiased and reliable as possible. According to proponents of IFRS, for the preparation of consolidated financial statements, publicly traded companies must apply a single set of high quality accounting standards in order to contribute to better functioning capital markets (Quigley, 2007). IFRS have transformed the financial statements presentation manner and the criteria by which financial services organisations prospects and performance are valued by investors, analysts and customers. The change to IFRS has offered a potential catalyst for the growth of enhanced management information systems that can improve the foundation for decision making and also help satisfy stakeholder demands for more useful disclosure. IFRS gives better insight into risks that are not clear in local GAAP financial statements (PWC, 2006). In a survey of 187 fund managers across Europe undertaken by PWC showed that investors stated that IFRS is posing a true impact on the way they perceive companies and accordingly on their investment decisions. They also felt positive on greater transparency and comparability that IFRS offers.

High quality financial reporting are a force for economic progress and is of critical significance to depositors and their protectors, the prudential regulators, to creditors and to suppliers in general. One of the main reasons of the implementation of IFRS,

as pointed out by Armstrong et al. (2006), was the achievement of capital market integration. IFRS is a booster for economic modernization, linking industrialized nations with market growth globally. It can make an immense contribution to economic growth by building liquidity and transparency around the world. Most private companies are now eligible for IFRS for both small and medium sized entities (SMEs). For SMEs, IFRS reduces topics that mainly are not significant for private companies, simplifies the decision making process, streamlines procedures and minimises the amount of required disclosures. Whereas for few private companies, IFRS offers great flexibility to select accounting policies and make other choices that may have a positive impact on their financial results. IFRS holds the potential to facilitate cross border comparability and enhance transparency in reporting standards, allowing stakeholders to recognize the financial results of entities globally. Furthermore, adoption of IFRS could reduce information costs, thereby increasing the liquidity, competitor competition and market efficiency (Ball 2006). Corporations might even profit by dropping information asymmetry, in order to make more organised investment decisions, and consequently lowering their cost of capital (Choi and Meek, 2005). Besides, reducing international differences in accounting standards to some extent help eliminating barriers to cross-border acquisitions and diversities, this in theory means that investors would be rewarded with healthier takeover premiums. A dramatic example of existence of differences between accounting rules of different countries was provided by Enron which could also be related to the normative theory. According to Unerman and ODwyer (2004) many accounting regulators claimed that the accounting practices that enabled Enron to cover its enormous liabilities by keeping them off their US balance sheet would have been ineffective in UK. This unveiled the differences between UK and US accounting regulations approach and further argued that under UK accounting regulations these liabilities would not have been treated as off balance sheet, thus creating major differences in Enrons balance sheet under US and UK accounting practices. It appears, that firms which adopt IFRSs would tend to display lower potential for earnings management (Leuz and Verrecchia, 2000; Ashbaugh, 2001). Low subjectivity would result in fewer opportunities to influence reported earnings and/or mislead investors. Thus, countries such as the UK, with stronger investor protection mechanisms, the costs of IFRS adoption would more likely to be lower as the level of earnings management is lower because the managers are less prone to manipulate the reported accounting figures (Nenova, 2003; Dyck and Zingales, 2004). In contrast, countries with weak investor protection mechanism, the scale for earnings management would ought to be more and the quality of financial reporting poorer, implying that the costs of adopting IFRSs would be higher (Ali and Hwang, 2000; Hung, 2001). In addition, Latridis (2010) points out that IFRS also help investors in making informed financial decisions and predictions of firms future financial performance. Thus, IFRS would tend to develop stock market efficiency and reduce earnings manipulation, while they would also positively impact on firms stock returns and stock related financial performance measures (Kasznik, 1999; Leuz, 2003). Investors

could even profit as it may lead to better informed valuation of equity markets decreasing the risk of adverse selection for the less informed investors. However, scope for reporting ambiguity would increase, based in part on IFRSS reliance on the judgement practised by individual company managers to report on the financial position and also due to the underlying basic assumptions of IFRS and how it identify various forms of transactions. Thus, this would result in significant height of uncertainty for the investor in the uniformity, objectivity and transparency present in the organisations financial disclosure. The introduction of IFRS represents a fundamental shift in financial reporting. The need to educate stakeholders, generate the necessary awareness and managing the required changes would consume reasonable management commitment and time to acquire a successful transition. Furthermore, with increased transparency and other benefits above provide an influential argument for IFRS adoption, with such a transition, the compliance costs linked should not be neglected. The incremental cost of shifting from domestic GAAP to IFRS may have been significant for some firms under this mandatory setting (ICAEW 2007). Previous researches claim that voluntarily adopted IFRS firms are more likely to be larger and hence are able to benefit from economies of scale. In addition to these direct costs, other indirect costs could also be incurred making investors worse off. To ease this burden, IFRS 1 allows a first-time adopter to set an assets transition-date fair value as its deemed cost instead of applying IFRS retrospectively. Value perceptions vary as IFRS closes the gap between companies internal reporting and what they account to in the public. In the research carried out by PWC almost three-quarters reported that the changes to IFRS has lead to some impact on their vision of the value of the individual companies they invest in because of relatively easy financial information and greater transparency. Because of improved transparency, managers act better in the interest of shareholders (Ball 2005). Thus, international investors favour the financial information of the company to be reported according to the IFRS. Transparency facilitates creditors, investors and market participants to assess the financial state of an entity. However, aiding investors make better decisions; transparency builds confidence in the fairness of the markets. Also, its important to corporate governance as it enables board of directors to assess managements effectiveness and to take corrective action on time, when needed, to address decline in the companys financial state. Therefore, it is vital for all companies to present an understandable, reliable and comprehensive representation of their financial performance to better accountability and smaller risk of expropriation of investors wealth by the managers. Better transparency improves economic decisions made by managers in the economy. Improved decision making quality, thus results in lower monitoring costs. The general public will better examine public sector institutions, creditors will better monitor borrowers, shareholders and employees will better monitor corporate

management and depositors would be able to monitor banks. Hence, wrong decisions would not go unquestioned. Transparency and fair value accounting improve the quality of decision making in the public sector, and therefore would aid efficient policy by enhancing public sectors understanding of how policymakers could respond to future crisis. In low quality reporting organization, managers set to meet objectives such as decreasing the volatility of their own compensation, payouts to other stakeholders and avoiding recognition of losses. In contrast, high quality organisations are highly unpredictable, more volatile and informative. This argument is strengthened by IFRSs emphasis on fair value accounting. This aims to incorporate more timely information on losses on securities, economic gains, derivatives and other financial statement transactions, and to incorporate more timely information on current economic losses on long term tangible and intangible assets. IFRS assure to present earnings more informative and as a result, paradoxically extra volatile and harder to forecast. The accounting standards led to extreme volatility by relying too much on unreliable market information which caused the financial crisis. Thus, accounting standards should provide not just transparency, but stability too. According to Hans Hoogervorst (IASB Chairman), transparency is a vital precondition of stability. The crisis occurred due to enormous threats were allowed to build up on and off balance sheet without being noticed. Stability is meant to collapse in the end with inappropriate transparency about risks. Stability is not the same as transparency, but without transparency there can be no durable stability. Consequently, by increasing transparency, accounting standards can contribute to stability. With regards to financial instruments, IASB had an important reason continue using international accounting standards as they assisted stability by eliminating artificial noise in the income statement and the balance sheet. For instance, basic loan features which are dealt with on a contractual yield basis are esteemed at amortized costs deeming to provide more relevant information in volatile market conditions. Due to the credit crisis investors globally had lost faith which the financial industry faced. In such times, markets usually turn suspicious and tend to overreact. Hence, lack of transparency leads directly to lack of stability. This is why IFRS should be fully committed to transparency as letting things happen and cleaning later is more costly than preventing a crisis through full risk transparency. IFRS aims to strengthen its worldwide sense of ownership by enabling the quality of the standards first class, the need of awareness of the challenges on implementation of standards by the standard setters and the existence of a healthy sense of accountability.

For several years, accounting professionals, financial analysts, investors and regulators across countries have called for intensified efforts to harmonize accounting standards. With increasing growth of global markets, several companies are seeking listings in various countries; as a result, investors demand highly comparable accounting standards in order to neglect confusion. A common set of accounting principles could save resources in creating multiple financial reports and thus would save time. The prime challenge for investors is the time essential to assess and understand the adjustments introduced by the new accounting standards. Business in todays generation is complex, thus the need for an accounting framework which brings economic stability and transparency to complex transactions is vital. It positively helps investors around the world that all nations move to a single, unique set of high quality international standards rather than a different accounting framework in each country. Thus a number of considerations are required to be evaluated in making such a transition.

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