Highlights of IFRS Research
Conversion from U.S. GAAP to IFRS is a heavily discussed topic in the corporate world. Expected benefits of adoption include reporting consistency, enhanced global competition and improved financial reporting transparency. While many countries worldwide have already adopted IFRS, many other countries are closely examining its effects before adoption, not only from an economic perspective but also from a reporting quality position.
COMPARING RESULTS
Researchers Elaine Henry, Stephen Lin and Ya-Wen Yang evaluated the difference between financial results under U.S. GAAP compared to IFRS. Their results show that convergence between U.S. GAAP and IFRS is occurring. Using 2004 to 2006 reconciliation disclosures, the authors found that the calculated difference between shareholders’ equity under U.S. GAAP and under IFRS declined from 2004 to 2006. In addition, the difference between U.S. GAAP and IFRS reported net income during this period also declined but remained significantly different. Pensions and goodwill appeared to be the dominant reconciliation items.
Reconciliation amounts varied by industry and country, raising questions about consistency between region and industry. Additionally, more than 70% of the companies examined in 2004 through 2006 had a higher return on equity under IFRS compared to U.S. GAAP. The 2007 SEC elimination of the IFRS-to-U.S. GAAP reconciliation for non-U.S. companies with securities listed in the United States suggests a need for users of financial statements to be aware of the potential for differences resulting from the two sets of standards.
“The European-U.S. ‘GAAP Gap’: IFRS to U.S. GAAP Form 20-F Reconciliations” was published in the June 2009 issue of Accounting Horizons.
ECONOMIC IMPACT
Researchers Holger Daske, Luzi Hail, Christian Leuz and Rodrigo Verdi examined 3,100 firms in 26 countries mandated to adopt IFRS in “Mandatory IFRS Reporting around the World: Early Evidence on the Economic Consequences.” The study examines the economic effects of IFRS, for both early and mandated adoption.
The authors concluded that a company’s adoption of IFRS creates strong economic benefits in countries with rigid regulation over financial reporting. These benefits include an increase in the stock’s market value, an increase in market liquidity, and a lower cost of capital. Companies with major differences between GAAP and IFRS standards show the greatest benefit when supported by a strong regulatory environment.
Additionally, the researchers found that in firms that adopt early, benefits are not only strong in the year of the change to IFRS, but also in the year that reporting is officially mandated. Results reinforce the view that strong enforcement of reporting standards not only enhances transparency for investors but also increases the market position of adopters.
The paper also investigates possible contributing factors unrelated to IFRS adoption that may have caused these economic benefits to occur. Self-selection appears to be a primary reason; firms voluntarily changing to IFRS had factors unrelated to the accounting standard change that gave them an economic advantage.
The article, appearing in the December 2008 issue of the Journal of Accounting Research, reinforces the economic benefits of voluntary early adoption of IFRS, combined with a strong regulatory environment emphasizing transparency and financial reporting quality.
MANAGEMENT OF EARNINGS
French authors Thomas Jeanjean and Hervé Stolowy examined the effect of IFRS conversion on earnings quality—specifically on management manipulation of earnings to avoid recognition of losses. Their work examined more than 1,100 firms in three countries to determine whether the earnings management appeared to increase or decrease after implementation of IFRS.
The authors measured financial reporting quality as a reduction in earnings management. Earnings management was assessed as the frequency of small profits compared to small losses—an established statistical research design used in similar past studies. Australia, France and the U.K. were selected for examination, as these three countries were unable to adopt IFRS before the mandatory transition date, thus eliminating any early adoption benefits.
Based on the author’s research, earnings management remained consistent in Australia and the U.K. after IFRS adoption. However, in France, earnings management appeared to increase, suggesting that, overall, earnings quality was not improved by adopting IFRS.
The research further discusses the subjectivity of IFRS accounting standards and the necessary use of management discretion for quality reporting. The authors suggest that the efforts of the standard-setting bodies should be focused on enhancing IFRS adoption reporting incentives and strict enforcement as opposed to “harmonizing accounting standards.” They state that “sharing rules is not sufficient in itself to create a common business language.”
“Do Accounting Standards Matter? An Exploratory Analysis of Earnings Management Before and After IFRS Adoption” was published in the November/December 2008 issue of the Journal of Accounting and Public Policy.
FOREIGN INVESTMENT
Will global adoption of IFRS increase the amount of investments in foreign businesses? According to research published in the Journal of Accounting and Public Policy, the effect will be small, largely due to “home bias.”
Prior research reveals that investors perceive a higher risk associated with foreign investments due to numerous factors, including differences in financial accounting standards, uncertainty about financial statement quality, and a lack of familiarity with anticipated future cash flows. Home bias is the idea that shareholders favor domestic over foreign investments, preferring the certainty and familiarity of financial information available from domestic firms. In addition, investors feel they have a greater understanding of domestic financial reporting, which enhances their decision making.
Authors Messod Beneish and Teri Lombardi Yohn examined prior research related to home bias to predict the effect of IFRS adoption on investments in foreign equities by domestic investors. Their work, published in the November/December 2008 issue of the journal, suggests that the geographic proximity of domestic companies causes investors to perceive a “home court” advantage compared to foreign companies—one that will not be reduced even when IFRS adoption standardizes financial reporting.
The paper is titled “Information Frictions and Investor Home Bias: A Perspective on the Effect of Global IFRS Adoption on the Extent of Equity Home Bias.”
SUMMARY OF PROS AND CONS
A recent independent research study prepared for FASB examines issues surrounding IFRS adoption in the United States. This working paper was provided to the SEC with the Financial Accounting Foundation’s comment letter in February 2009. The authors provide a thorough review of academic research on IFRS adoption, addressing issues and questions brought up by the SEC when it released its IFRS adoption road map and request for comments in 2008.
Areas examined include cost/benefit trade-offs, the effect on capital markets and the economy, financial reporting effects, and political, regulatory and legal implications of IFRS adoption. The paper, “Global Accounting Convergence and the Potential Adoption of IFRS by the United States: An Analysis of Economic and Policy Factors,” also discusses the effects on the standard-setting process itself, including issues with the International Accounting Standards Board.
Authors Luzi Hail, Christian Leuz and Peter Wysocki summarize the potential benefits of adoption as “greater market liquidity, a lower cost of capital and a better allocation of capital.” Financial reporting comparability will also likely be enhanced. Additionally, the research reveals that multinational companies will receive a cost savings as they will no longer have to report under several sets of standards.
On the negative side, studies suggest that a major impact will be the cost of transition to IFRS. According to research, the benefits to U.S. investors may not exceed costs. Additionally, due to U.S. GAAP’s high standards, financial reporting improvements will be minor. Research also suggests that these costs and benefits will vary across firms and will be difficult to trace upon adoption.
The working paper concludes with options the U.S. might want to consider. They include the following scenarios: (1) Retain U.S. GAAP, (2) adopt IFRS but require increased disclosure for U.S. firms, or (3) consider developing an International U.S. GAAP or I-GAAP.
The full text of this report is available at ssrn.com/abstract=1357331.
PREPARING FOR TRANSITION
When a country switches from its domestic GAAP to IFRS, many people and organizations are affected. Getting ready for the transition is a major task. Research by John Goodwin, Barry J. Cooper and Shireenjit Johl evaluated the preparedness of Australian listed firms for IFRS. Specifically, these researchers examined changes in explanations from Australian GAAP to IFRS between the half-year and annual reports in the first year of IFRS adoption.
Switching from Australian GAAP to IFRS required Australian firms to provide new accounting information via the firms’ reporting function. Due to the operational significance of IFRS, firms were expected to consider compliance with IFRS as sufficiently important to be treated as a strategic management issue. If Australian firms and their auditors were prepared for the transition, then no changes to explanations in the annual reports would be anticipated.
Examination of changes to explanations from Australian GAAP to IFRS between the two reporting dates of the first year of IFRS revealed that 33% of firms changed their explanations. The researchers conclude that most of these firms or their auditors were unprepared for IFRS at transition, consistent with observations made in the months preceding IFRS adoption and with most other related studies.
Among changes to explanations, most concerned cash flows, earnings and equity, with most firms revising their initial IFRS earnings or equity by less than 5%, usually downward. The most often adjusted item was income tax. The explanation for this was complexity of the income tax standard and the fact that a tax reconciliation was only prepared at the annual report preparation time.
“How Prepared was Australia for International Financial Reporting Standards? The Case of Listed Firms” appeared in the March 2008 issue of the Australian Accounting Review.
QUALITY OF FINANCIAL STATEMENTS
A study by Christoph Kaserer and Carmen Klinger calls into question the widespread belief that a true and fair view accounting approach provides higher quality financial statements data vis-à-vis a conservative accounting approach. Their research, covering the 10 years ending in 2005, shows that for those German companies that used IFRS or U.S. GAAP, their earnings were more associated with prior-year cash flows than with prior-year accruals. For those companies that followed German GAAP, there was no difference between earnings persistency of accruals and cash flows.
Prior research shows that investors systematically overreact to accrual-based accounting information, which is referred to as the accrual anomaly. Kaserer and Klinger provide empirical evidence that the accrual anomaly, while present in Germany, is associated with companies that report their financial statements under IFRS or U.S. GAAP, and not associated with companies that reported under German GAAP. The researchers offer the explanation that true and fair view accounting, which relies on difficult-to-verify information, may not be suitable to improve accounting information quality in the context of a weak corporate governance system.
The authors show that the economic impact of an accounting system choice, that is, the choice between a conservative and a true and fair view accounting system, will be determined by the corporate governance system under which this accounting framework is implemented. Since true and fair view accounting depends on difficult-to-verify information, the quality of this information depends on management incentives to report reliable information. If the management incentives are poor, for example, due to corporate control or external enforcement mechanisms being lax, a true and fair view accounting system might be poorly applied and, thus, yield less reliable information vis-à-vis a conservative accounting system.
“The Accrual Anomaly Under Different Accounting Standards—Lessons Learned from the German Experiment” appeared in the September-October 2008 issue of the Journal of Business Finance & Accounting.
DRIVERS OF ADOPTION
Wai Fong Chua and Stephen L. Taylor examine the rationale behind the ever-increasing recognition of IFRS. To demonstrate the dramatic change that has occurred over the past 20 years, the article begins with a quote from R.K. Goeltz in a 1991 Accounting Horizons article: “Full harmonization of international accounting standards is probably neither practical nor truly valuable.” This common view from nearly 20 years ago has been turned upside down, with the widely held view today that IFRS will be adopted eventually by virtually every nation.
The IFRS movement is often explained on economic grounds, but the authors question whether economic justifications for IFRS are supported empirically. They offer an alternative explanation that incorporates social and political factors.
Economic rationales typically offered for convergence to IFRS include transparency, quality and comparability. The authors point out, with regard to transparency, that periodic financial statements are just one part of the information set used to evaluate the performance of publicly traded companies. Regarding improved quality, the authors note that empirical evidence indicates that the quality of the financial reporting process has more to do with the manner in which standards are enforced than differences in the standards themselves. On the third item, comparability, the authors are struck by the almost total lack of evidence to support the view that financial reports under different accounting regimes lack comparability.
Chua and Taylor purport that there is lack of support for convergence to a single set of accounting standards, that is, IFRS, at least in the way that supporters of IFRS typically claim. The authors suggest that the driving force behind the IFRS movement is not the economic role of accounting, but rather the political nature of accounting standard setting. They note that the critical impetus at a national level for adopting IFRS has usually been from the government or its agencies.
Standard setting at the national level has been filled with political controversy in recent years. A transfer of the standard-setting process to an entity external to national boundaries could eliminate what people in the regulatory and political arena regard as a “messy” process at the national level.
Chua and Taylor provide evidence that political and social factors have been central to the development and diffusion of IFRS. They suggest that outsourcing the manufacture of accounting standards to a single private agency appears to be a rational, lower-cost option, which reduces economic and political costs for individual countries as long as they retain residual decision rights regarding IFRS adoption.
“The Rise and Rise of IFRS: An Examination of IFRS Diffusion” appeared in the November-December 2008 issue of the Journal of Accounting and Public Policy.
THE CHINESE APPROACH
History is likely to note 2007 as a special time in the development of Chinese accounting and financial reporting standards. In that year, the nation’s new, essentially IFRS-convergent, accounting standards became required for certain companies. China’s path toward IFRS offers an interesting illustration of how globalization received backing from regimes previously regarded as least likely to be interested. Authors Yuan Ding and Xijia Su offer a descriptive analysis of the process leading up to IFRS in China.
China inherited a closed regulatory culture from the former Soviet Union. China began its economic reform from a planned economy to a market-oriented economy in 1978. Subsequent to that year, accounting regulation and practices have significantly evolved from primarily serving macroeconomic planning to providing information for investors and lenders. The authors provide a brief history of accounting standards development in China. Two key events occurred in 1992: The Accounting Standard for Business Entities (similar to a conceptual framework) was issued, and the government announced a plan to issue new accounting standards. By 2001, 16 new accounting standards had been promulgated.
The general trend was for slow but steady convergence of Chinese accounting standards with international standards. However, researchers have questioned the actual effect of changes in accounting standards on financial reports due to weak enforcement. To respond to concerns of other nations regarding whether China’s new accounting standards were actually convergent with IFRS, the Ministry of Finance established a task force whose main job was to persuade the IASB to sign a memorandum endorsing China’s move toward IFRS. This memorandum was signed in November 2005 by a representative of China and IASB Chairman Sir David Tweedie, supporting the view that China’s new accounting standards were substantively convergent with IFRS, with three exceptions. The exceptions regarded related-party transactions, reversal of impairment of depreciable assets, and government subsidies.
To reap the benefits of adoption of new accounting standards, enforcement is likely to play a more critical role than the actual standard setting. Weak corporate governance is a problem that hinders Chinese authorities’ ability to prove to foreign counterparts that Chinese financial reports are consistent with international standards not just in form but also in substance.
“Implementation of IFRS in a Regulated Market” appeared in the Journal of Accounting and Public Policy in the November-December 2008 issue.
Cynthia Bolt-Lee (boltc@citadel.edu) is an associate professor of business at The Citadel School of Business Administration in Charleston, S.C. L. Murphy Smith (lmsmith@tamu.edu) is a professor in the Accounting Department at Texas A&M University.
Editor’s note: This article is part of a series that samples accounting research and distills key findings for busy practitioners and preparers. These summaries explain the implications of a wide range of research and give CPAs the opportunity to apply the results in day-to-day activities. Readers interested in more detail should review the full text of each article to explore the hypothesis, research process, statistical analysis, supporting theories and conclusions.
AICPA RESOURCES
JofA articles
“IFRS: A Preparer’s Point of View,” April 09, page 46
“IFRS: Beyond the Standards,” Feb. 09, page 34
Use journalofaccountancy.com to find past articles. In the search box, click “Open Advanced Search” and then search by title.
CPE
International Versus U.S. Accounting: What in the World is the Difference?, a CPE self-study course (#731667)
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