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Why did the UK change their accounting standards from UK GAAP to IFRS, and its effect on UK companies
The gathering pace of globalisation is evident in numerous areas, such as the expansion of the European Union; the implementation of the Euro as the single currency in many member states, and ever increasing levels of global trade (Aisbitt, 2005). As such, the breaking down of international barriers and advances in communication technologies have enabled any businesses to gain competitive advantage by accessing low cost labour and other sources of skilled labour from outside their domestic economies. In addition, the opening up of capital markets has made it possible for investors to make investments in companies and projects around the world. Lehman (2005) argues that this globalisation of operations and markets has led to increased levels of political and social pressure on regulators to increase the levels of transparency in their financial reporting standards, as well as making them easier for global users to interpret. This is what ultimately led to the decision by the UK, as part of the wider European Union, to adopt International Financial Reporting Standards instead of their own, diverse national standards. Aisbitt (2005) argues that this trend towards harmonisation has also included a drive towards convergence onto the highest possible set of standards. As such, the UK’s Accounting Standards Board, previously responsible for setting UK GAAP, has been strongly focused on working with the International Accounting Standards Board, and its counterparts in other nations, to develop a more coherent global set of accounting standards.
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However, Aisbitt (2006) argues that the approval of the European Union Regulation which required all listed companies in the EU to present their annual reports according to IFRS was only another step in a wider global move towards convergence. Aisbitt (2006) argues that this move was partly driven by the need to move towards principles based accounting, after scandals such as Enron showed how dangerous it was to continue using narrow rule based regulations. However, the actual move had started in the 1990s, when the International Organization of Securities Commissions began moving towards a global set of standards for listing on recognised stock exchanges. Part of these standards required that companies present their accounts in an accepted and well recognised format to assist international stock market users. Further momentum behind this change was driven by the Norwalk agreement, which was agreed by the US Financial Accounting Standards Board and the International Accounting Standards Board in 2002. Such agreements created a growing trend towards the use of IFRS, and Aisbitt (2006) reported that by 2005 over 100 countries either allowed or required their companies to use IFRS when preparing financial statements.
The ultimate data for all listed companies in the EU to switch to International Financial Reporting Standards was set as being the 1st January 2005; however companies whose financial year began after this time only needed use IFRS for the financial year which started in 2005. There has been a significant debate over the impact of introduction of IFRS, with Walton (2004) claiming that IAS 39 would create significant issues for some companies and KPMG (2005) claiming that many companies and analysts were unprepared for the change. In addition, some people, most notably Jacques Chirac in 2003, complained that the excessive use of market values encouraged by IFRS would make the European economies more volatility. However, since the international standards were introduced across the EU in 2005, there has been little evidence of these issues having significant impacts. Perhaps one of the most significant impacts was that the method for calculating the year-end balance changed, meaning that some companies had to restructure their finances to ensure that they still fulfilled some of their loan covenants after the switch (Ormrod and Taylor, 2004).
However, given that the majority of the literature around IFRS prior to the harmonisation tended to focus on the need for convergence (Flower, 1997) and the extent to which companies complied with IFRS (Sucher and Alexander, 2002), it is clear that there was insufficient attention paid to the extent to which companies would have to adjust to cope with the new regulations. Indeed, prior to 2005, the literature contained very few examples of how companies had managed to change their accounting processes in order to make the transition to IFRS, with HÈ•tten (2005) being one of the few examples of a detailed study of such processes. As such, the professional firms (KPMG, 2005) and trade journals (Accountancy, 2003) actually represent better sources than the academic journals on the impact. Indeed, it is somewhat telling that Ormrod and Taylor’s (2004) study into the extent to which the increased use of market values in the financial statements, and the potential impact this may have on volatility, was published in a trade journal, rather than an academic journal. Although this is arguably a natural consequence of the fact that changes in accounting standards have more of a cosmetic effect on company performance, and thus are not as relevant to academic study as factors which affect a company’s actual performance.
Indeed, as discussed above, Ormrod and Taylor (2004) argue that one of the major changes of the switch to IFRS is that the resultant changes in the balance sheet figures will actually be on contractual obligations, rather than on earning or valuations. This is based on the fact that the need to mark assets to market value, and the need to better account for items such as goodwill, may mean that companies will violate loan covenants which require them to maintain certain asset to debt ratios or other accounting based measures. As such, Ormrod and Taylor (2004) argue that many companies may need to increase certain factors on their balance sheet, such as the provision made for deferred tax if buildings are revalued, something which could then have an impact on the net asset value and various accounting. In order to avoid such anomalies, where the change in regulations caused an insignificant effect but this was magnified due to contractual obligations or other accounting factors, the Committee of European Stock Exchange Regulators argued that companies should explain how the transition has affected their reports (CESR, 2003), This recommendation was so persuasive that it was made a mandatory condition of listing on the London Stock Exchange. Whilst this will have helped analysts and investors to use the financial accounts to carry out an impartial, ongoing analysis of any affected company, it will also have increased the burden for the company in question, who may have to create two sets of accounts and then compare the two to fulfil this requirement.
Another significant impact was that the latest IFRS, IFRS 3, required a much stronger level of transparency for companies making acquisitions (Stevenson and McPhee, 2005). Under UK GAAP, whenever a company acquired another the amount paid over and above the net asset value was simply termed ‘goodwill’ and amortised evenly over a period of around 20 years. This enabled companies to easily predict the effects on earnings, as well as to be quite elusive about the actual source of value obtained from acquisitions. However, under IFRS 3, businesses will need to be more specific and transparent around the nature of any acquired intangible assets. In addition, rather than amortising for goodwill on a straight line basis, businesses are required to assess their goodwill at least once a year, and amortise it to its current fair value. This allows shareholders and investors to better understand what value has actually been obtained from an acquisition, and how an acquisition has performed each year (Stevenson and McPhee, 2005). Viner (2006) argues that this will have significant impact on media businesses, where large amounts of goodwill are typically associated with each transaction. As such, whilst these companies took contingent and varied approaches to accounting for goodwill under GAAP, they were forced to make significant changes under IFRS, which imposed sizeable accounting burdens (Viner, 2006).
One of the few academic journals which is of interest in determining the impact of the switch to IFRS on UK companies is that of Tarca (2004). This study is based on determining the extent to which listed companies from the UK, France, Germany, Japan and Australia chose to use international standards when declaring their results when they had the choice. As this study was conducted in the run up to the UK, France and Germany’s mandatory switch to IFRS, it provides useful information regarding the extent to which companies voluntarily used IFRS before they were forced to use it. The study also differentiated between the choice to use the United States’ GAAP, as a widely accepted standard, or the IFRS. This study revealed that the companies which were most likely to use an international accounting standard, either supplementary to or in place of their domestic standard, tended to be large, with revenue from many nations, and were listed on more than on stock exchange. This implies that the difficulties associated with switching to IFRS were more likely to affect larger firms, and hence these firms opted to make a voluntary switch earlier in order to become accustomed to the new standards, and the accounting differences they represent (Tarca, 2004).
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However, according to Shearer (2005), there is another reason for this choice; that being that IFRS is almost entirely intended to support global capital markets. As such, their sole aim is to allow investors to make informed decisions based on access to complex and comparable accounting data incorporating a universal fair value measurement. This leads to another main impact on UK companies: the need to report the majority of assets and liabilities at ‘fair value’ as defined by the IASB. This naturally requires companies to make more detailed disclosures and undertake significant amounts of data gathering. However, Shearer (2005) argues that, out of the nearly two million companies in the UK, IFRS would probably be appropriate for less than five thousand, as these are the only ones which depend on international capital markets. In addition, Shearer (2005) argues that the IASB’s demand for international accounting convergence is primarily based on driving a convergence with the US GAAP, and fails to incorporate the standards of other countries. As such, smaller companies will tend to struggle with the switch to a more complicated standard which does not value their existing methods. It is worth noting that this is purely an opinion piece; and that it is written by a partner at Grant Thornton, the accounting firm, who originally supported this switch. As such, it may not be entirely factually accurate or reliable.
However, it is worth noting that the ICAEW argued strongly in favour of continuing to allow unlisted companies in the UK to use GAAP if they wished (Accountancy, 2006). This argument again acknowledges that IFRS are intended to be used in global capital markets by listed companies. Indeed, this argument could be seen as one of the key reasons why unlisted UK companies can still choose whether to use IFRS or UK GAAP for their accounts, and only listed companies are forced to use IFRS. As a part of this switch, the requirements of UK GAAP were aligned with those of IFRS, with some disclosure reductions, implying that there are still impacts on unlisted businesses, but these are less significant that the impacts on listed businesses. Accountancy (2003) provides more detail on some of the minor impacts on listed businesses, by analysing the GAAP requirements which would not be permitted under IFRS. Some of these include accounting for post balance sheet events and government grants, and engaging in foreign currency translation. In addition, accounting for pension costs, research and development and deferred tax, which were optional under UK GAAP, are not permitted under IFRS.
The switch to IFRS also had a significant impact on the ASB in the UK, whose traditional role was placed under threat by the move to IFRS, which are determined by the IASB. As such, the ASB was forced to balance its traditional role of creating accounting standards which are applicable to the UK context, whilst also looking to make UK GAAP more compatible with IFRS (Wilson, 2002). Wilson’s (2002) reporting on the ASB’s publication of eight new exposure drafts, and its stated intention to produce more in the future, tended to indicate that the ASB was unwilling to accept these impacts and take a backseat to the IASB, as many of these drafts focused on addressing UK only issues. However, Wilson (2002) raised questions over whether these new standards were actually useful for British businesses, many of which would need to abandon them when the transition to IFRS occurred, or whether they were simply a political attempt to maintain the ASB’s importance. This implies that, not only did businesses have to cope with the actual switch to IFRS, but they also needed to cope with the political manoeuvring and debate in the build up to the switch.
Aisbitt (2005) focuses on a somewhat more unorthodox impact of the switch on businesses: the fact that the teaching methods for new financial accountants in the UK are now split between GAAP and IFRS compatible training. Not only does this have an impact on businesses involved in accountancy training, but it can also make it harder for companies to find accountants who have been trained in the specific accounting methods they wish to use, particularly listed companies which need to produce both sets of accounts to illustrate the differences between them. Fortunately, accountancy education was fairly quick to respond to these demands, with new accounting training courses emerging which drew on both IFRS and UK GAAP, and helped trainee accountants to understand the difference. Comparing modern accounting training to previous accounting courses indicates that one of the main impacts has come in the International Accounting area, which has seen a significant increase in importance over the last ten years, based on Laidler and Pallett’s (1998) coverage of the subject. As such, businesses which specialised in international accounting training have seen a surge in interest in the subject, and thus have seen significant beneficial impacts to their bottom line (Aisbitt, 2005).
Management accountants have also seen a significant rise in the importance given to IFRS and both US and UK GAAP. In particular, Financial Analysis (2007) specifically draws the attention to students of the Chartered Institute of Management Accounting, CIMA, to the importance of the convergence between US GAAP and IFRS, and the changes implies versus UK GAAP. This is arguably more of a reactive piece of advice, and is based on the fact that the majority of CIMA students tended to be unaware of the extent of this convergence and its impact on management accounting. As such, Financial Analysis (2007) argue that both students and businesses needed to be aware of the implications of the Norwalk agreement, and the likely future developments in IFRS and US GAAP in order to better react to them.
In conclusion, the decision of the UK, as part of the EU, to move towards IFRS was intended to drive global accounting convergence, and improve the working of European and global capital markets. It has meant that UK businesses have had to adjust to several new accounting methods and implications, most notably the impact of fair value on items such as goodwill and contractual obligations. Whilst unlisted businesses have not experienced as significant an impact as their listed counterparts, the changes to UK GAAP to accommodate the shift will also have had some impacts on them. As such, given the lack of any general academic studies of the shift, or clear patterns of impact, it seems that the majority of changes and impacts will depend on individual company circumstances and strategies.
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