The EU's Adoption of IFRS

Student No. 09175515 INTRODUCTION The harmonization of accounting standards across countries has been engendered by the globalization of politics and markets. In the past 20-30 years the growth in international trade fostered by increased Foreign Direct Investment flow of capital and development of technology has led to multinational firms establishing presence across the world.

This has led to these firms being listed in foreign stock exchanges; this has fuelled the desire to have common international standards that could be understood easily and followed across nations. The European Union (EU) could be said to be in the forefront in the process of harmonizing accounting practices of its member countries. The enactment of the 4th and 7th Accounting Directives (1978, 1983) by the EU and the obligatory implementation of its provisions into law by member countries demonstrate a clear attempt by the EU to create accounting practices which is transparent and comparable across member countries.

The 4th Directive was aimed at harmonizing the national laws on the accounting regulations of companies. Besides aspects affecting format and valuation, main features of the 4th directive include the requirement to prepare annual accounts which provide a true and fair view (TFV) of the company’s assets, liabilities, financial position and profit or loss as well as substantial requirements on information which has to be provided by means of notes (Art. 43, Fourth Directive).

The Seventh Directive on consolidated accounts determines the identification of groups, scope of groups accounts and obligation to prepare, audit and publish group financial statements as well as consolidation-related methods Germany and the United Kingdom provide examples of the two primary accounting philosophies worldwide-the Anglo-Saxon and Continental models (Mueller, Gernon, and Meek, 1991). Anglo-Saxon models historically focuses on equity holders, permitted discretion in preparation of financial statements as long as the resulting tatement provides a true and fair view (TFV) of financial conditions, and decoupled tax and financial reporting. Continental model focuses on debt holders, codified reporting requirements and a strong link between financial and tax reporting (Joos and Lang 1994). Given these accounting philosophies, the implementation of the 4th and 7th Directives into national laws brought changes to the accounting practice of EU members to differing significance.

Although the objective of the 4th and 7th Accounting Directive was to establish comparability and equivalence of financial statements, it failed to achieve this because of the incorporation of considerable number of options which balanced controversial aspects on formats and recognition as well as valuation which were then implemented by the different member states (Thorell and Whittington, 1994: 220).

Another shortcoming of the Accounting Directives to achieve its objective was the different implementation and interpretation of the true and fair view (TFV) principle that has resulted in the possibility that financial statements may provide a TFV in the perception of one country, whereas the principle is essentially violated in another country. In September 2002, the EU by its Regulation (EC) No. 606/2002 took a major step in the harmonization of accounting practice by mandating that all companies listed in regulated markets adopt the International Financial Reporting Standards (IFRS) in preparing consolidated financial statements for year beginning on or after January 1, 2005. The International Accounting Standards Board (IASB) is a privately financed independent body whose predecessor was the International Accounting Standards Committee (IASC). The adoption of IFRS by the EU marked one of the most important developments in the effort to harmonize accounting standards.

The advent of the European Capital Market, introduction of the Euro, increased foreign direct investments (FDI) inflows over the years with a comparative rise in the globalization of markets, the development of high quality accounting standards that are comparable among EU members and of higher transparency and quality meeting the information requirements of investors cannot be overemphasized. The EU main objective in adopting IFRS was therefore, the recognition of a single set of standards that would lead to cross border listing.

As the US Stock Exchange grew, in size (number of companies listed in the market) and liquidity, the influence of the US generally accepted accounting principle (US GAAP) grew. This meant that for European companies wanting to be listed in this market they had to by the regulation of the market reconcile their local financial statement to that of the Securities and Exchange Commission (SEC)-this the regulatory body in charge of the US stock exchange. This process has become very expensive but for most European companies the benefits far outweighs the cost.

To match the growing influence of the US GAAP, the EU supported and co-operated with IASB that culminated in the regulation to adopt IFRS. This development will provide European companies with the opportunity to participate on the international capital markets without competitive disadvantage with respect to financial reporting as well as improve the attractiveness and soundness of the European capital markets in addition to not losing influence over international developments.

Crucial to establishing the authority of the board and of the EU backing for IFRS was the agreement in 1995 between the board and the International Organization of Securities Commission (IOSCO) to work on a core standards programme whereby accounts prepared in accordance with IFRS can be used in cross-border stock market offerings and listings as an alternative to national standards. This agreement led to the recommendation by IOSCO that the world’s securities regulators permit foreign issuers to use IFRS for cross-border offerings (IOSCO, 2000).

One of the motives for the EU adoption of an international accepted accounting standard i. e. IFRS is the development of comparable high quality international set of standards by the standard setters IASB. These quality set of standards are meant to lead to higher quality financial reports which in turn would create markets with high liquidity (Leuz and Verrecchia, 2000) and firms with lower cost of capital (Daske, 2006). The adoption of IFRS however, does not guarantee that the quality of accounting report would high (Ball 2006).

Soderstrom and Sun (2007) state that the quality of financial accounting report is hinged on three factors: 1) the quality of the standards, 2) a county’s legal and political system, and 3) financial reporting incentives. It is generally agreed that companies that voluntary adopted IFRS/IAS prior to the mandatory adoption had motives to develop high quality accounting reports. This companies mostly in code law countries benefited from an offering of a lower cost of equity capital (Daske et al 2007; Kim and Shi, 2007), improving analyst forecast accuracy (Ashbaugh and Pincus 2001), allowing forf a more efficient allocation of savings orldwide(Street et al, 1999), improving comparability and transparency of financial reporting, reducing information assymetry between insiders and outside minority shareholders (Leuz and Verrechia 2000; Leuz 2003) and making it relatively easy to cross list in the well developed international capital market e. g. NYSE, NASDAQ or LSE. The assertion that the quality of financial report by companies voluntary adopting IFRS/IAS against local GAAP were supported by reports from Barth et al. (2008); Van Tendeloo and Vanstraelen (2005); Hung and Subramanya (2007); Christensen et al. (2005) and Ball et al; 2003; Sodestrom and Sun, (2007).

For mandatory adoption of IFRS, discussion continues on the effects of the standard on the quality of financial reports pre and post adoption of IFRS. Using various metrics of earnings management i. e. variance of the change in net income, the ratio of the variance of the change in net income to the variance of the change in cash flow, the correlation between accruals and cash flow, the frequency of small positive net income and timely loss recognition some have argued that accounting quality decreased after the adoption of IFRS. Paananen (2008); Barth et al; (2008), Paananen and Lin (2008).

However, other researches have argued that financial reporting quality vis-a-vis pre adoption of IFRS improved. Horton et al. (2008); Landsman et al. (2009); Chen et al. (2009). Findings on the effects of IFRS on accounting quality are not conclusive. Notwithstanding this, maintain the quality of IFRS standard hence accounting report is hinged on an efficient legal/judicial system and the quality of legal enforcement is imperative. The mandatory adoption of IFRS by European companies has shown a positive effect on the capital market with investors expecting increases in quality of information and decrease in information asymmetry.

CONCLUSION The adoption of IFRS as a common standard for EU companies is one of the major event in the convergence of accounting standards. It is expected that cross border listing of firms will increase and also the rendition of comparable high quality financial reports will result. Although, agreement with regards to the quality of accounting report from the adoption of IFRS is not conclusive. It is important to note that without an efficient legal/judicial system to enforce the standards the motive of adopting a common standard and hence the convergence effort will not be realized.