Generally Accepted Accounting Principles (GAAP) as such is used worldwide but it is moderated according to the needs of the respective countries' accounting regulations. However, in 2005, most of the UK listed companies were required to adopt International Financial Reporting Standards (IFRS) in their consolidated accounts.
The UK and Europe were at the forefront in the introduction of IFRS. IFRS was implemented simultaneously across Europe as a common language for business and financial reporting. (http://www.icaew.com/index.cfm/route/103912/icaew_ga/en/Home/Press_and_policy/22_November_2005__Eric_Anstee__The_economic_impact_of_IFRS_Transitional_and_longer_term_effects, Accessed 12 August 2010).
Comparability is one of the most important factors in the implementation of IFRS along with higher standards of accounting. IFRS enables comparability of the firms' financial reports and along with an increase in transparency and reduction in information asymmetry and hence increasing the liquidity of the firms' by increasing investments (Chen, H., Tang, Q., Jiang Y. and Lin, Z. 2010) and making the markets competitive and efficient.
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Financial report provides investors with an insight to the firm's financial health and performance. Access to accurate information can be achieved with higher standards of accounting which help the investor to make an informed decision about their investment in the firm.
IFRS is regarded as a move-forward towards the fair valuation of assets and liabilities. The backers of IFRS argue that it is the best form of accounting which not only enables comparability and reduction in information asymmetry but also increases transparency (Horton, J., Serafeim, G., and Serafeim, I. 2009). But the critics of IFRS argue that the fair value orientation of IFRS will create volatility for the financial reporting due to manipulations by the mangers (Ball, R. 2006).
Impact of adoption of the IFRS on firms' finances varies from country to country. IFRS imposes very stringent disclosure requirements on firms which are intended at improving the visibility of the firm's liabilities, disclosure of pension-related obligation, executive remuneration by disclosing stock option in the accounts (http://www.qfinance.com/accountancy-checklists/international-financial-reporting-standards-ifrs-the-basics, Accessed 12 August 2010). IFRS has set standards for the way the firms account for their fixed assets by setting standards for the estimations of fair value of assets. Mergers and acquisition strategies are also affected considerably by the adoption of IFRS.
Financial reports pertaining to a firm can be used by different users for their own need. With the implementation of IFRS, information asymmetry would be reduced and hence communication between the firm and the users of its financial reports is made effective and smooth. Effective communication leads to lower agency cost. Firms that have implemented IFRS benefit from higher degree of comparability, reduced transaction costs and greater investment from international investors. Investors are greatly benefited from the implementation of IFRS which help them make informed decisions and predictions of the future financial performance of the firm and gives quality accounting practices and transparency (Iatridis, G. 2010). IFRS tends to reduce earnings manipulation and enhance stock market efficiency.
UK is recognised as having a highly regarded accounting standard in the Europe which is very much similar to the IFRS (Iatridis, G. 2010). As such, the UK provided a very distinctive implementation framework unlike other EU countries and as a result, the investors were able to segregate various accounting alteration in a single time frame which helped in eliminating the possibility of any clutter from IFRS disclosures. (Horton, J. and Serafeim, G. 2008).
The study aims at investigating the impact of IFRS on firm's listed in the UK stock exchange by analyzing the financial reports and identifying new information disclosed and whether or not they have any impact of the stock prices of the firm. And to determine if the new standards are more comparable and transparent and if they reflect the true future potential of the firm. Financial and investment ratios are done to calculate the financial performance of the company based on the information collected. The study is conducted on two companies Rio Tinto Plc and Anglo American Plc for the year 2004 and 2005. Accounting information for the year financial year 2004 are available under UK GAAP and IFRS standards and relate this information to the stock market prices of the shares to determine which set of ratios reflect on the market valuation.
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Communication of information regarding the financial performance and financial health of the firm to its potential users is an art of accounting. In determining what information is important and relevant for the users of these financial statements lays the actual art (Elliott B and Elliott J, 2007). The extent to which the firm's resources have grown or declined can be determined from the financial reports which measure the firm's performance during the previous year. This information also helps investors to evaluate the firm's performance to make any informed decision regarding investments and expected return. The investors can use various forecasting methods to determine the future performance of the firm.
Investors are restricted to the information available from these financial reports. Hence the quality of information being provided is important for the investors. As investors provide companies with the much needed capital for their economic survival it is important to provide them with the right information. In some cases the managers might not be willing to provide the relevant information. Governments must work along with the regulators in ensuring that investor rights are protected by consistently work towards the improvement of accounting principles and also work towards the global solution for improving comparability and reducing information asymmetry which in turn will lower the cost of capital. (www.deloitte.com, Accessed 12 August 2010).
Regulation of accounting started with the introduction of companies act in 1844. There are various factors that have influenced the accounting standards throughout this period. Some of the individual factors that have influenced the accounting standards setting in the UK are legal system, investors, taxation, inflation, accidents and culture (Day R G 2000).
Socio-economic factor together with individual events have lead to the rise of UK regulations (Day R G 2000). Government actions through regulations coupled with professional action by accounting bodies have help make accounting regulations in the UK.
Accounting information can be manipulated by the providers of this information that's the managers of the firm's in order to hide their inefficiency who along with the accountant give out misinformation about the financial performance of the firm.
The 1960s were a low period for accounting professionals in the UK with large internationally recognised UK-based companies were acquired of providing false information in their financial reports.
One of the two scandals that brought forwards these practices was GEC/AEI affair in 1968. General Electric Corporation (GEC) in the year 1967 attempted to takeover Associated Electrical Industries (AEI). To ward off approach from GEC the directors of AEI forecasted a profit of £10 million and recommended the board not to accept the GEC proposal. The auditors of the AEI accounts argued that the reports were prepared in compliance with the existing guidelines for annual report and were reasonably fair. After GEC succeed in taking over AEI in the new accounts prepared by the new AEI board, they showed a loss of around £4.5million as opposed to showing a profit of £10 million (Day R G 2000). The accounts were prepared from the same set of information which the AEI directors had used to show such huge profit forecasts except for a few changes. This huge error was mainly due to the judgements made by the accounts and previous AEI directors (Elliott B and Elliott J, 2007).
This created awareness among the investor and the press about how accounting can be used as a tool for generating latitude for the company and galvanised both groups in calling for setting up of standards in the reporting of financial statements.
Institute of Chartered Accountants in England and Wales (ICAEW) formed the Accounting Standards Steering Committee (ASSC) in 1970 (Day R G, 2000) was given the responsibility of improving the standards of accounting by reducing the differences in accounting practices through the development of a wide consensus for the proposed standards from the practitioners and directors of firm's by encouraging firm's to disclose their accounting methods they have adopted. The draft prepared by ASSC was adopted my all the accounting bodies calling it Statement of Standard Accounting Practice (SSAP). In the year 1991 Accounting Standards Committee (ASC) was replace by Accounting Standards Board on the recommendation of Dearing Report which was give the responsibility of creating standards for financial reporting (Elliott B and Elliott J, 2007).
2.2 Accounting Harmonization
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Global deregulation of national capital markets as accelerated the process of integration of capital markets worldwide creating a whole pool of investment. Thus firms and investors are no longer restricted by borders for seeking investments and investing. This situation brings to the forefront the issues of accounting practices with the increasing multinational nature of companies which raises doubts about the appropriateness and competence of the accounting guidelines which might end up turning to be costly for both the firms and investors. To deal with this problem, accounting professionals from all over the world formed the International Accounting Standards Committee (IASC) in 1973 to facilitate harmonizing the international accounting practices (Emenyonu, N. E. and Gray, S. J. 1996). But in reality, IASC standards were often too flexible to achieve harmony, which reduced the buoyancy about the international harmonization or reduction in international accounting diversity. This was the case in countries like Japan and Germany where the accounting organizations did not have any important role in setting a unique process. However, the progress or retreat of achieving harmonization was not the sole responsibility of IASC. Nonetheless, IASC is the only organization responsible for promoting accounting harmonization on a worldwide basis.
Various commodity prices, interest rates, currency swaps and exchange values have become internationally linked with the effort from the jurisdictions from all over the world increasingly supporting harmonization of accounting practices and national policies (Bisgay, L. and Jayson, S. 1989). International harmonization in accounting standards means a widely acceptable and recognized accounting system that will improve financial statements comparability and provide appropriateness to the circumstances without any constraints by the local accounting regulations (McLeay, S. et al. 1999). International harmonization in accounting standards means a widely acceptable and recognized accounting system that will improve financial statements comparability and provide appropriateness to the circumstances without any constraints by the local accounting regulations. According to Tay and Parker (1990), 'Harmonization' is the practice of relating a movement away from total diversity 'towards a state of harmony which may include total uniformity' whereas 'Standardisation' involves the process of 'total uniformity' (Tay, J. and Parker, R. 1990). The differences of the two terms would be in respect of their application to accounting parameters. 'Harmonization' involves coordination or harmony for a more flexible and comprehensive approach whereas 'Standardisation' requires a more disciplined approach which should result in a state of uniformity.
2.3 Introduction to IFRS
Firms have recognised the need for set of internationally accepted accounting principles. As more and more firms are becoming multinational a need for common language for business which is accepted globally aids not only in the preparation of the financial reports but also helps compare and analysing information from these reports for the entities. (PWC, 2008)
Established in 1973 IASB was given the responsibility for matters involving preparation and implementation of accounting standards which can be used internationally. IASB along with its own prepared standards also adopted all of the International Accounting Standards (IAS) principles which were collectively called as IFRS.
Each new standard is draft and discussed in public which allows for the scrutiny of the standard. This method helps in reducing the number of different accounting treatments and thus helps in the process of harmonization (Elliott B and Elliott J 2007).
Financial Reporting Standards (FRS) 1 state that firms adopting IFRS for the first time are required to prepare their financial statements according to the IFRS guidelines. The firms are also required state their comparative figures also under IFRS. (PWC 2008)
2.3.1 Principal differences between UK GAAP and IFRS
IFRS has brought about significant changes to policies regarding of reporting of groups financial statements and presentations. The set of changes are listed below:-
IAS 10: Dividends (www.production.investis.com, accessed 12 August 2010)
Dividends are generally paid to the shareholders after the balance sheet had been prepared.
Principles under UK GAAP for reporting for financial report required the dividends to be recognised in the profit and loss statement for the related period for which it has occurred.
IFRS standards require dividends to be recognised as liability which is to be deducted from the equity for the corresponding period for which the accounts are prepared. This is to be approved by the firm's board during the general body meeting.
Hence the dividend payment which are to be made for the year ending 31 December 2005 which have not been approved by the board after the balance sheet is prepared, has to be deducted from the equity for the year ending 31 December 2006. (www.production.investis.com, accessed 12 August 2010)
IAS 12: Income taxes (www.production.investis.com, accessed 12 August 2010)
Deferred tax is treated similarly to approaches under balance sheets. Under this approach appropriate tax rate is applied to the differences raising form carrying forwards value of the assets and liabilities and their tax.
In contrast, UK GAAP considers timing differences rising in the profit and loss statement. This has no impact on the changes to the consolidated group accounts.
Transition to IFRS results in a few adjustments to be made in the financial statements related to the deferred taxes, lease incentives, pension funds and shares based bonus payments. The pension deficit has also been reclassified from deferred tax assets to liabilities. (www.production.investis.com, accessed 12 August 2010)
IAS 17: Leases (www.production.investis.com, accessed 12 August 2010)
Operating lease incentives were stated under the profit and loss account until the rent review brings under the UK GAAP.
Under IFRS the rule IAS 17 these benefits from lease are stated over the period of the lease. Hence, reductions in the reporting profits which in turn increase the liabilities of the group. (www.production.investis.com, accessed 12 August 2010)
IAS 19: Employee pension benefit scheme (www.production.investis.com, accessed 12 August 2010)
IFRS 19 retirement benefits rule in UK GAAP for benefit scheme for group accounting states that the group should state net deficit arising out of the defines benefit scheme in the balance sheets. (www.production.investis.com, accessed 12 August 2010)
IAS 19 also required the group to continue stating net deficit in its balance sheet. But under IAS 19 bid value is used in measuring the assets instead of using the mid-market value method used in FRS17. This gives rise to a different set of net deficit and profit and loss accounting values. Unlike the UK GAAP method where the deferred taxes were removed from the pension scheme, under IFRS it us shown separately within the non-current assets. (www.production.investis.com, accesses 12 August 2010)
IAS 38: Intangible assets (www.production.investis.com, accessed 12 August 2010)
All software and website development costs were classified as tangible fixed assets under the UK GAAP.IAS 38 requires all such costs to be classified under intangible assets whenever these costs are not a part of the associated hardware. Certain items of plant, property and equipment are also to be reclassified as intangible assets. Group's income statements are effected by such reclassification. (www.production.investis.com, accessed 12 August 2010)
IAS 39: Financial instruments (www.production.investis.com, accessed 12 August 2010)
Forward contracts and interest rate hedging are stated at their initial value and later re-measured to fair value at date for the balance sheet. These changes in value are stated in the income statement of the period which it has raised under the IAS 39 rules. If it is not possible to make a fair value adjustment for a particular date then it cannot be stated as it does not meet the IAS criteria. (www.production.investis.com, accessed 12 August 2010)
IFRS 2: Share based payments (www.production.investis.com, accessed 12 August 2010)
IFRS 2 requires that the fair value for all the share-based payments to be stated in the profit and loss accounting during the vesting period of the award. But under the UK GAAP these charges are fixed based on the difference between the market price of the share at the awards date and exercise value which is calculated to be zero. IFRS 2 calculates these chargers based on the Monte Carlo Pricing Method. (www.production.investis.com, accessed 12 August 2010)
IFRS 3: Business combinations (www.production.investis.com, accessed 12 August 2010)
Goodwill is stated on the balance sheet of the group's accounts for the year end October 2002. Retrospectively, deciding not to state them under IFRS 3. Resulting in the value of goodwill to be fixed at 1st October 2004 under UK GAAP deeming it as cost and which will no longer be amortised. Subjected to annual impairment review which might indicate the value may not be recoverable. If not adjustment are identified then the value of goodwill be fixed during the transition period. (www.production.investis.com, accessed 12 August 2010)
IAS 7: Cash flow statements (www.production.investis.com, accessed 12 August 2010)
IFRS regulations classify cash flows into three different types of activities namely operating, investing and financing. But under UK GAAP regulations these heading are different and are reclassifies within the cash flow other than this there is no major changes. (www.production.investis.com, accessed 12 August 2010)
2.4 Ratio Analysis
Analysing the financial statements would helpful with the usage of ratios. By relating ratios to the financial statement analysis, it will determine the success, failure or progress of a business. The most important tool of financial statement analysis is to identify the key financial and non-financial data and then the process of relating with each other and also verifying the external factors of the company, which is termed as Ratio Analysis. (Pendlebury, M. and Groves, R. 2001). Ratios facilitate the business to identify varying financial trends and compare performance and measure of success among other businesses from the similar industry. The advantage of analyzing ratios is to identify irregularities and abnormalities which are useful to ascertain the financial standings of the company for the present as well as the future. Ratios describe the relationship between each and every financial data available in the financial summary of the company (Elliott, B. and Elliott, J. 1993). These ratios will help in providing information for the annual review and performance reports.
A clearer definition can be stated as
"A full understanding of the precise implications of a given ratio is possible only if it is accompanied by a clear definition of its constituent parts. The user must be able to judge the accuracy and reliability of the underlying business operations before the reliability of the ratio can be assessed. In addition, the definitions of ratios may vary from source to source as concepts and terminology is not universally defined." (Elliott, B. and Elliott, J. 1993).
For the purpose of review for the research on the effects of IFRS on stock markets, we consider the ratio analysis. These ratios quantify the company's efficiency and reliability to the investors. The ratios include profitability ratios, efficiency ratios, liquidity ratios, financial gearing ratios and investment ratios. Here, we consider the key eight ratios which are relevant to the mining and extraction industry.
Return on Capital Employed (ROCE) is termed as the ratio which determines the profitability and efficiency of the firm's accounts (www.investopedia.com, accessed on 25 August 2010). In accounting term, this ratio focuses on the competence with which the capital employed has been utilized. This ratio is the primary measure of profitability for the company. Here, the capital employed in considered as the total assets of the firm, which when measured intends to show the efficiency with which all the resources of the firm are well utilized by the managers. (Pendlebury, M. and Groves, R. 2001)
The Gross profit margin provides how much profit the business creates on its cost of sales. It is the relationship between gross profit and sales revenue. Cost of sales or Cost of Goods Sold includes all purchases, costs of conversion and other inventory costs. It is termed as the total of contribution to the business, after paying for direct fixed and variable unit costs. (www.investorwords.com. accessed on 25 August 2010)
The Net profit margin is defined as the profits earned through the sales or revenue generated during the accounting period. Just as similar to the Gross profit margin, this varies from various types of businesses as well as industry. When both are calculated and compared, one can gain the standings of the company's non-direct and non-productive costs such as marketing, administration and finance costs. Net Profit Margin has a great influence on the market returns. It indicates that the higher the company's Net Profit Margin, higher would be the company's abnormal return and the market adjusted return which can be evaluated through the firm's stock. (Martani, D., Mulyono, Khairurizka R., 2009)
Return on shareholder's funds (ROSF) is commonly used ratio by industry investors which is helpful in measuring the profit for the period which is available to the owner's stake in a business. This is the ratio of the percentage between the net profit and shareholder's funds which includes the share capital and the reserves (Powell, P. 1988). It determines the profitability of the firm in terms of the capital provided by the owners of the firm i.e. the shareholders of the firm. It focuses on the attention of the profit earned on behalf of the firm's shareholders, by relating the profits to the total amount of shareholder's funds employed in the company (Pendlebury, M. and Groves, R. 2001).
Current Ratio, also known as 'liquidity ratio' or 'cash asset ratio' is a short term measure of a company's liquidity position and provides the measure of the company's ability to meet short term obligations such as debt and other short term payables with its short term assets like cash, inventory and other short term payables. (www.investopedia.com accessed on 25 August 2010). Current ratio compares current assets with current liabilities.
Gearing Ratio is the ratio between the long term liabilities of the company with its capital employed by the firm. This interpretation of this ratio is that it needs to in equilibrium, like the shareholder funds being larger than the long term liabilities. Gearing is the measure of leverage of the company, that is higher the leverage of the company, higher the risk involved in the company. Such a company is more exposed to downturns in the business cycle as it would find difficulty in servicing its debt regardless of its low sales turnover. Gearing ratio is also known as debt to equity ratio. (http://www.investopedia.com/terms/g/gearingratio.asp, 25 August 2010). Gearing ratio is considered the most important for analyzing the financial factors of the company. As per IFRS principles set in the debt covenant, it is stated that in case of equity capital, the company does not have to repay the contributed capital or pay the returns on the capital, whereas in case of debt, it is the obligation to repay the original capital as well as to pay a return on capital. (http://www.business-standard.com/india/news/gearing-ratio-should-be-basedmarket-valuesdebt-equity/09/12/386406/, 25 August 2010). According to the article in Business Standard by Bhattacharya, M.K., Gearing ratio is to be calculated on the market value of debt and equity. As mentioned above, it helps in identifying the leverage in the company and also provides information on what state of risk is involved in the company. Hence the financial standing of the company can be evaluated with the help of the market value of equity and debt rather than its book value.
Earnings per Share (EPS) are considered the most essential component in determining the share price of the company. It is an indicator of the company's profitability where it specifies the portion of the profit allotted to each outstanding share of the common stock (Elliott, B. and Elliott, J. 1993). The profitability of a business depends on the revenue a company can generate, and through the calculation of EPS it is possible to determine the viability of the company. This ratio also allows us to compare various entities' capability to generate income for the company. (http://investing-school.com/definition/earnings-per-share-eps/, 25 August 2010). According to the IAS 33 (1998), for the purpose of a reliable calculation, they defined two EPS figures for disclosure, The Basic EPS and Diluted EPS. Here the Basic EPS is stated to be calculated on the basis of the weighted average of ordinary shares which is currently on issue during the accounting period. Diluted EPS is described to calculate the diluted earnings per share with the weighted average of ordinary shares currently on issue along with the potential ordinary shares.
Price Earnings Ratio (P/E) is the ratio of the company's current share price with comparison to it's per share earnings. This is another indicator of the company's standing in the market which as similar to the EPS. A high P/E ratio implies that investors anticipate much higher earnings in the future as compared to a low P/E ratio. (http://www.investopedia.com/terms/p/price-earningsratio.asp, 25 August 2010).
For an investment to be profitable it is important for it to provide a more than expected returns. If the earnings growth of the company is uniform then the expected return are also uniform for an investment. Hence if the earnings of the company are high, a higher return can be expected. And this is what the investors look for in a company before making a decision about investing into it. Investors see the higher earnings of the company as an indicator of its value which is called as buying earning outlook adopted by the abnormal earnings growth model. (Penman, S. 2007)
The total earnings from an investment, includes earnings with dividends which is called as cum-dividend earnings. Firm value is derived from the expected cum-dividend earnings (Penman, S. 2007). Abnormal earnings growth is the share of cum-dividend earnings higher than the normal earnings. (Penman, S. 2007)
Abnormal Earning Growth t = Cum-dividend Earnings t - Normal Earnings t
Hence investor must be given a reliable and specific data in order to make a decision about investing in a particular company by getting a picture of the company's value and its future earnings.
Analyzing ratios is widely used tool for the purpose of analysing the financial statements. Ratios analysis helps us in comparing the financial performance to the previous years' and also helps in evaluating the strength and weaknesses of the firm.
Ratio Analysis helps a firm with various accounting data relationships, which in turn gives the decision maker an insight into the firm's financial performance. Hence Ratio Analysis is advantageous in the following ways:-
Indicates trends of the business which aids in the purpose of forecasting and preparing budgets for the firm.
The firm can benefit with the ratio analysis for the purpose of comparative study for the previous years and also comparison within the industry.
Evaluates the liquidity, operating efficiency, profitability and solvency of the firm. While assessing the liquidity ratios, it helps us in know the short term financial position of the firm. The turnover ratios aids in evaluating the operating efficiency of the firm and performance of the firm by how it has utilized its resources. To measure the profitability of the business, we use the profitability ratios which help in understanding the actual performance and the earning capacity of the firm. With solvency ratios, it shows the strength in the relationship between the assets and the liabilities.
The limitations of ratio analysis are mentioned as follows:-
Ratio analysis stresses on quantitative information and thus the qualitative aspect is ignored. Hence, with this information, it will not be useful for decision making purposes. The data provided is likely to be few months out of date, thus it gives a misleading indication about the firm's current financial position.
With the absence of a standard technique to analyse the ratios, different firms use different methods. Thus the ratios of one firm cannot be compared with the ratios of another firm.
Also some firms use various accounting methods. For example, for the evaluation of stock, some firms might consider the FIFO (First-In-First-Out) method while some firms might consider the LIFO (Last-In-First-Out) method. So, in such ways, comparison between two firms is impossible.
While comparing performance, we have to consider the changes in price, technology as this affects the cost of production, sales and the valuation of assets.
(http://www.accountingformanagement.com/financial_statement_analysis_accounting_ratios.htm, accessed on 22 August 2010)