Critical Analysis of IFRS Essay
Detailed Analysis of IFRS
The IFRS are accounting standards, rules and principles that were introduced by an independent organization in the United Kingdom, known as the International Accountants Standards Board. The institution puts forward that the standards would better serve public companies worldwide than the local standards in the country due to the aspect of comparability, transparency and economic growth. There are several countries that have adopted the IFRS over the recent years. The transition to IFRS for the companies in these countries has considerable costs. There are technical and training costs that are incurred that may cause several companies to be cautious in implementing these changes. However, the benefits are numerous and worth it.
The adoption of IFRS enables comparability and harmonization. Harmonization should not be confused with standardization. They both have different meanings. Standardization refers to the agreement by several parties on several technical or accounting standards. It is the process of elimination of the existent accounting alternatives when it comes to financial reporting. Harmonization on the other hand has a certain degree of flexibility although it reduces the options of accounting alternatives. It is important for the accounting practices in different countries to be harmonized especially when it comes to the multinational companies that invest in different countries.
Adoption of IFRS assists a country in several ways. First of all it increases the amount of foreign investment that a country receives from external investors. Uniform accounting standards reduces the information asymmetry between different countries. Host country investors already have certain informational advantages over the foreign investors. They are more aware of the economic opportunities in the country and can anticipate the future direction in terms of government policies. They also have better access to information than the foreign investors.
Different accounting reporting standards put the foreign investors at a higher information disadvantage. The foreign users need time to be trained to understand the host country’s GAAP. The training and time spent represent transaction costs that reduce the cash flows to the investors and cause them to require a higher rate of return from the investment (Young and Guenther, 2003). The pressure on the foreign investor to comply with the rules and regulations in the host country may delay the finalization of a deal between the local company and the foreign investors (Dikova, Sahib and Witteloostuijn, 2010)
The adoption of IFRS by different countries therefore increases the level of foreign investment by reducing the information asymmetry (Gordon and Bovenberg, 1996). Where there are anomalies in the company’s accounting information, it may signify the opportunity to make abnormal profits or it may signal to the foreign investor that the company is in some financial trouble.
The multinationals also incur fewer costs in terms of audit fees and information technology costs causing the company to have more financial resources to invest in the company. If a multinational company has several subsidiaries in different companies it has to get auditors who are able to understand and assess the application of the financial standards in the different countries. Currently, the audit companies which are used frequently by the multinational companies are the big four comprising of Delloite, PWC, Ernst & Young and KPMG. These companies have the required expertise and staffing in the different countries.
If IFRS was to be adopted, it would increase the number of audit companies participating in auditing multinationals. The increased competition would reduce the audit costs. Compilation of the financial statements of the different subsidiaries would also be less time consuming and not require a lot of staff and expertise. International standards make the accounting work easier. The reduction in these costs reflects in the financial statements and the company will record higher profits.
There would be increased economic growth in the developing countries. Recently developed countries have been outsourcing cheaper labour in developing countries where there are high unemployment rates. With harmonization of the accounting standards, the companies would even be more open to outsourcing professionals in the accounting departments. This would increase the foreign investments in these countries creating more employment opportunities leading to higher economic growth.
There is the principal agency problem in companies where the investors have to trust that the senior management is taking care of the business well. Foreign investors may be uncomfortable with the application of the accounting standards in the host countries. They may feel that they have to appoint more directors from the countries that have adopted IFRS to work in the host country. The senior management of the company will therefore comprise of different foreign professionals. These positions could have been given to qualified experts in the host country. In general, the reluctance to adopt the IFRS leads to lesser foreign investment and lost employment opportunities.
There will be increased competition among the companies in the different countries leading to innovation. The foreign companies are armed with the capability of comparing the financial statements of different companies in different countries with the adoption of IFRS. The companies that have experienced increased capital flows and trading activities will realise that as more and more countries adopt IFRS, there will be increased competition for foreign investments. These companies have to perform better. They have to be innovative in the market place in terms of the customer service, product quality and differentiation in the products they offer in the market place. Higher profits signify attractive financial statements to the investors.
The adoption of IFRS also reduces the cost of equity. The investors have access to accounting information of the company lowering the risk of acquiring the asset. When there is harmonization of accounting standards the investors understand the accounting statements more. They are able to perceive the risk of the investment appropriately. Where local accounting standards are used, the complexity makes the investments seem riskier. The investors may have an issue with relying on the regulatory oversight body in the country and the company’s auditors and accountants.
The investors are aware of the challenges that auditors face while dealing with company accountants using aggressive accounting principles. Harmonization of standards causes the investors to weigh the risks well lowering the risk of investment which ultimately leads to lower costs of equity. The investors are more willing to accept lower returns from the host company. Information has been observed to affect the prices of the company’s assets. The company has an opportunity to influence the cost of its capital by providing detailed accounting information to its investors. The companies also have access to a larger pool of capital raising their liquidity and the amount of capital it can raise in the market (Covrig, Defond and Hung, 2007)
In countries that have adopted IFRS, there has been an increase in the trading activities. The lower costs of equity also attract more investors. The adoption of IFRS reduces the occurrence of financial or economic crises. The international standards make the financial statements very transparent minimising the risk of senior management getting involved in manipulation of provisions and creating hidden reserves (Iatridis, 2010).They find it hard to participate in earnings management where they “smoothen” the earnings and hide the company losses in order to present a favourable financial position to the public. In a research study conducted in 2007, the companies that had adopted IFRS exhibited lesser evidence of earnings management and more timely loss recognition (Ball and Shivakumar, 2005)
In companies that have adopted IFRS, there is higher disclosure of information in the financial statements. The high quality of these disclosures was evidenced in a research study that was conducted in various companies spread over three countries which were Germany, Austria and Switzerland (Daske and Gebhardt, 2006). There are companies that wield a considerable influence in the countries they operate in. A declaration of higher profits will lead to changes in their stock prices affecting the trading in the stock exchange. Senior management are aware of this so they try to manipulate profits to increase the stock prices and market perception of the company.
IFRS disclosures however cause the senior management to reveal a lot of information to the investors which reduces the market reaction to the news. If a company records higher profits due to amortization of assets, the investor is aware of what has occurred causing the stock prices to remain stable. Accounting information is analysed by creditors when they are structuring the loan agreements. Financial statements that are not transparent lead the creditors to view the company as very stable therefore reducing the restrictive nature of debt covenants. The use of IFRS is cost-saving since they reduce earnings manipulation and the creditor is able to enter into contracts that reflect the situation on the ground. These restrictive covenants assist greatly as they prevent the company from entering into other business transactions that would lead to insolvency or bankruptcy (Beke, 2011).
The use of FVA has been noted to increase volatility of the company’s earnings. IFRS encourages fair value accounting where the firm’s assets are stated in the financial statements at their fair value. This represents the amount of money the company would get on the sale of the assets in an arms-length transaction. It is the opposite of historical cost accounting where the assets are recorded at the book values. In the section of securities, a company is expected to use quoted prices when they are available. If they are not present, the company has to use certain valuation methods while incorporating all available market information to arrive at the fair value. The IASB advisory panel inform the senior management that there will be times where they will have to make adjustments on an observed market price.
The fair value approach is more transparent as it shows the investors the current values of the company’s financial assets and liabilities (Laux and Leuz, 2009). There have been arguments however refuting the value of fair value accounting. This is especially for assets and liabilities that the company will hold for a long time or to maturity date. Using fair value accounting can lead to economic instability due to the market inefficiencies, investors’ irrational behaviours at times and liquidity bottlenecks.
Fair value accounting leads to the companies being able to violate debt covenants. The bond holders or debt holders usually enter into agreements with the companies which restrict their financial operations in order to protect their financial interests. Fair value accounting enables the companies to increase their leverage in times of economic booms. This causes financial vulnerability in the markets. In the event of a financial crisis it will end up being a severe financial crisis. On the other hand historical accounting forbids increase in asset revaluation. The company is able to utilise the hidden reserves in times of economic depression.
When it comes to the periods of economic depression, the companies operating under fair value accounting are forced to write down the value of their assets. When they choose to sell these assets in the market, they sell them at very low prices. These low prices are relevant since similar companies have to consider these prices when it comes to valuing their own assets. Historical accounting avoids these transactions and revaluations in times of economic depression causing the market to be stable. In the 2008 financial crisis there were several experts who mirrored their concerns on the continued adoption of IFRS by different countries in the world yet the standards were clear on the importance of fair value accounting.
These arguments are extensive however fair value accounting has several advantages in times of either booms or depression. The investors and the public get a true picture of the financial conditions when the asset values are written down. If companies had not written down their assets, sooner or later the extent of the financial crisis would have emerged. The IFRS cause volatility however they are not solely responsible for the financial crisis. They actually act as a messenger or pointer to the investors on the adverse economic situation on the ground. The IFRS data information corresponds more to the stock prices (Harris and Muller, 1999)
There are several studies that have been carried out to assess the relationship between corporate governance and the adoption of IFRS. Corporate governance has been defined as the economic, legal and social aspects expected from companies. Managers are unable to manipulate the books of accounts giving rise to corporate governance. This is important as firms that are governed well have better pay-out ratios, higher profits and less vitality and risk.
Adoption of the IFRS in many countries has various advantages. It will lead to economic stability in different countries due to the increased foreign investment and division of labour. There will be decreased transaction costs such as training, accountancy and audit fees for the foreign investors. IFRS greatly reduces earnings manipulation as it increases the transparency of the financial statements. There are mandatory disclosures in the off-balance sheet items that make it hard for the company accountants to manipulate the profit and asset figures. It also decreases the costs of equity. The investors are able to understand the accounting data of investments clearer reducing the perceived risks of the project. They are more willing to accept lower returns.
Finally, the IFRS encourages fair value accounting which shows the investors the market prices of the company’s assets and liabilities. It acts as a signal in times of economic boom and depression. It also encourages and ensures corporate governance in the company which leads to healthy companies.
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