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The application of International Financial Reporting Standards (IFRS) to the consolidated financial statements of listed companies in the European Union, which became compulsory from 1st January 2005, has raised a number of concerns in terms of the effects of the new accounting standards on reported accounting figures. This study examines how the transition to IFRSs and, more specifically, IAS 32, IAS 39 and IFRS 4 affected the balance sheet values of total assets and equity of banks in the United Kingdom (UK) and France.
The research pursues three main objectives. Firstly, the impacts of IFRS in general on asset and equity value of UK and French banks are revealed. Secondly, the study specifically focuses on how requirements of IAS 32, IAS 39 and IFRS 4 affect banks' total assets and shareholder's equity. Finally, the research provides comparison about those impacts between UK and France.
By employing a 'document analysis' research method, the study obtains results showing that the application of IFRS and more particularly IAS 32, IAS 39 and IFRS 4 makes reported total assets and equity of banks in UK and France more unpredictable, which is consistent with the contemporary literature. Nonetheless, the research also reveals that the conventional view of stockholder-oriented capital market being more affected by IFRS than shareholder-oriented capital market is not confirmed by this study.
The obtainable empirical evidences provide new insights into the impacts of the transition to IFRS from domestic Generally Accepted Accounting Principles (GAAP) on financial statements of the banking sector and help to understand the differences between shareholder-oriented and stakeholder-oriented accounting systems.
Keywords: International Financial Reporting Standards (IFRS); Generally Accepted Accounting Principles (GAAP); European Union (EU), banking sector, The United Kingdom (UK), France, IAS 32, IAS 39, IFRS 4
Chapter 1. INTRODUCTION
Motivation of the study
From 1st January 2005, all listed companies in the EU were required to adopt IFRS in preparing their consolidated financial statements. This is one of the biggest events in the development of financial reporting and will make IFRS the most widely accepted accounting standard in the world. All 2004 financial statements reported under national GAAPs have to be restated according to IFRS to provide comparative figures. Companies are also required to publish reconciliation statements explaining how the transition to IFRS from domestic GAAP affected their financial reports. Therefore, the first time adoption period of the international accounting standards is an exceptional and unique moment of huge changes that offers an attractive opportunity for research. Aware of this interest, the research has chosen to study the impact of transition to IFRS on banks' balance sheet in the UK and France, and more especially we focused on the effects of IAS 32, IAS 39 and IFRS 4 on banks' total assets and equity.
Objectives, methods and results of the study
According to Hung and Subramanyam (2004), 'the IAS adoption is expected to have a particularly profound effect on the financial statements of companies in stakeholder-oriented countries because IAS are heavily influenced by the shareholder oriented Anglo-Saxon accounting model while local standards in many European countries have a greater contracting orientation and are driven by considerations of tax book conformity'. Therefore, the enforcement of IFRS in Europe, and in stakeholder-oriented or Continental European capital market in particular, may introduce deep changes in the accounting practices. Practitioners may arguably expect that companies from 'Continental European' model make higher adjustments in accordance with IFRS than their partners from 'Anglo-Saxon' model. This study will examine this ascertain by researching France and UK as two representatives of Continental European model and Anglo-Saxon model respectively.
The further objective of the study is exploring how banking sector is influenced by IAS 32, IAS 39 and IFRS 4. In the process of implementing IFRS, fair value accounting which is mostly covered in the three standards has been the object of an intense dispute among regulators, practitioners and scholars. During the credit crunch, the question of whether fair value accounting has contributed to the acceleration of the global crisis has been raised by a lot of concerned people, especially in the financial sector which banks are a representative. When fair value accounting is used, all banks must report their trading assets and long-term assets at market value. Thus, any movement of security prices will be shown immediately on the balance sheet, which in turn causes investors' reaction. These responses will be reflected again in the stock prices and a same round continues to happen. This issue is especially dangerous under the financial crisis when banks are incapable to control value of their assets. Therefore, the study will come back to the transition moment to investigate if banks' total assets and shareholder equity is volatile as a consequence of the first time application of IAS 32, IAS 39 and IFRS 4.
Based on banks' reconciliation statements and 'Notes to the account', the research design allows us to directly compare total assets and equity prepared under UK GAAP and French GAAP at the end of 2004 with those under IFRS at 1st January 2005, because listed companies adopting international accounting standards are required to restate their prior-year results under IFRS during the adoption year. However, detailed information about the impact of IAS 32, IAS 39 and IFRS 4 on assets and equity is unavailable in some French banks. While we can obtain all necessary details from financial reports of UK banks, there are only one and three French banks providing information about the effects of three standards on total asset and shareholder's equity respectively. The lack of information makes the analysis more difficult in obtaining generalisable results to compare between two countries.
The empirical investigation encompasses three basis steps of analyses. First, the study documents the magnitude of changes in total assets and equity caused by the transition from local GAAP to IFRS. Second, researcher explores the proportion of change originated from IAS 32, IAS 39 and IFRS 4 requirements in total changes due to IFRS in both UK and France. The research also identifies which items are affected the most by three standards and explain reasons. Finally, the comparison between UK and French results is presented.
The results of the research can be summarised as follows. The first time application of IFRS made reported balance sheet total and equity more volatile. While total assets of banks in both UK and France increased by more than 10%, the trend of equity's adjustments was different between two countries: equity of French banks went up, whereas that of UK went down. In terms of the effects of the implementation of IAS 32, IAS 39 and IFRS 4, the rise in total assets of UK banks almost doubled as much as the rise of French banks. This increase can be explained by IFRS requirements in offsetting between financial assets and financial liabilities, insurance, classification and measurement of financial instruments and derivatives and hedge accounting. The adoption of the three standards also led to potentially greater volatility of equity. Shareholder's equity in UK banks reduced by 8%, whereas the figure slightly increased by 2% in France.
The findings contribute to the growing literature in terms of the impact of IFRS on financial statements. They demonstrate that accounting figures become more volatile because of the transition to IFRS from local GAAP. Nevertheless, the results also prove that the conventional view about Continental European accounting model being more influenced by IFRS than Anglo-Saxon model is not correct in case of the impact of three specific standards on specific sector in this study.
Structure of the research
The remainder of the study is organised into five further chapters and a brief summary of the contents of each chapter is as follows.
Chapter two provides information about background of the study, with the aims to help better understanding about process of IFRS adoption in EU as well as differences between IFRS and national GAAP, especially focuses on UK GAAP and French GAAP. Reasons of selecting IAS 32, IAS 39 and IFRS 4 for researching are also explained in this chapter.
Chapter three presents the research issues to be studied, by reference to existing research and pertinent professional documents. This chapter discusses a review of the literature which attempts to capture the impact of the transition to IFRS on accounting figures and financial reporting quality.
Chapter four discusses details of sample selection, data collection methods and research methodology applied in the study. By employing 'document analysis' method which takes full advantages of published documents, the study explores the nature and size of the effects of IAS 32, IAS 39 and IFRS 4 on total assets and shareholder's equity of banks in UK and France.
Chapter five provides empirical evidence based on banks' data about the impact of IAS 32, IAS 39 and IFRS 4 on balance sheet's items. Explanations about adjustments in accordance with IFRS requirements are also presented in this chapter.
Finally chapter six forms the concluding remarks, limitations of the study and suggestions for future research.
Chapter 2. BACKGROUND FOR THE STUDY
The aim of this chapter is to briefly provide information about motivation of the research. Firstly, the study will discuss about incentives to harmonise accounting rules and the process of IFRS adoption in EU. After that the differences between IFRSs and national GAAPs (UK GAAP and French GAAP) will be explored, and the explanation of why IAS 32, IAS 39 and IFRS 4 being chosen to research in this study comes then.
Adoption of IFRS in EU
The EU's attempt in creating an integrated single market for financial services typified by the introduction of the euro has put pressures on harmonisation process of accounting rules. Prior to this effort, each EU member state applied its own generally accepted accounting principles (GAAP) which best reflect practices and situations of each country. National accounting systems are surprisingly diverse. Research suggests that this is because of cultural differences, differences in legal and financial, and taxation systems. Each of these reasons for differences in accounting regulations is considered in turn.
Culture has an impact on the way accounting standards are set and enforced in the community as well as on measurement &disclosure aspects of accounting. Gray (1988) characterised that Anglo countries which include UK, US, Australia would rank relatively low on the accounting values of conservatism and secrecy. Tsakumis (2007) suggested that national culture does play an important role in accountant's disclosure judgement. A high uncertainty avoidance country tends to disclose accounting information to those who are closely involved in company's business activities rather than to wide public to avoid conflict and competition.
There are two major law systems in the world which are civil law and common law (David and Brierley, 1985). Common law uses limited amount of statue law and mainly deals with problems case by case. Preceding case will be basis for following cases and greatly depends on court's judgements. So in common law countries, accounting is mainly principle approached and is guided more detail in each circumstance. Countries use common law system are mainly English speaking countries such as UK, US, Australia, Canada. Civil law, in contrast, relies heavily on statutory law and detailed rules, so accounting standards are set by government and accounting practices are specified in law. Governments use accounting as a tool to control other issue such as tax. France, German, Italy are examples of civil law countries (Nobes, 1998)
Corporate finance- Debt or equity
Provider of finance will determine the main users of accounting information. In other word, they decide the features and nature of accounting information in demand (Nobes, 1998). Countries with dominant fund providers are outside equity market will demand for information which is future- oriented. They are more favour of relevance so prefer the use of fair value accounting. By contrast, countries with dominant fund providers are inside credit market (banks, government) will require information showing the repayment ability or operating profit. Instead of relevance, they more focus on reliability and historical cost accounting.
The diversification of accounting standards in different member states will lead to various disadvantages for European companies such as cost of preparing consolidated financial statements, difficulties in gaining access to foreign capital market or lack of comparability between financial reports. Thus, convergence will help analysts and investors to compare firms across borders in a better way as well as develop an integrated financial market that can effectively compete with US for highly-mobiled international capital. But it also implies that EU member states will lose their independence in making local accounting standards that suit local economic conditions (Renders and Gaeremynck 2007) or if they start adjusting something from IFRS, its main strength as a common standard will be slowly lost.
The process of harmonising accounting rules was initially pursued within the EU by the enactment of the Fourth Directive (1978) and Seventh Directive (1983), commonly known as the accounting directives. However, those directives were not an appropriate mechanism to achieve accounting harmonisation because they compromised between various practices among different member states which results in little comparability in financial reporting among EU countries. In June 2000, the European Commission issued a new directive requiring that all listed companies in the member states to adopt IFRSs from 2005 onwards. In July 2002, the European Parliament and the Council passed the IAS regulation. This requirement affected approximately listed 7,000 firms while the required adoption date is 1st January 2007 for firms trading securities in the US and basing their financial statements on the US GAAP, and firms trading debt securities other than equity securities.
Comparison between GAAPs and IFRSs
According to Jermakowicz and Gornik Tomaszewski (2006), the process of IFRS adoption is costly, complex and troublesome for European firms because national GAAPs are more or less different from IFRSs. The purpose of this section is to provide a brief understanding about the differences between the two accounting systems this study focuses on- UK GAAP, French GAAP and IFRS. It is generally accepted that differences between national GAAPs and IFRS have existed in a lot of aspects. However, within the scope of this study, we will specifically concentrate on variations which significantly impact on assets and liabilities of banking industry such as requirement on measurement and disclosure of fair value.
Key differences between UK GAAP and IFRS
From 2005 onwards, all publicly traded companies in the UK are required to apply IFRS in preparing financial statements while unlisted and individual financial statements are also permitted to use IFRS as a main set of accounting standards. It has been argued that the UK had a noticeable influence over IFRS. For instance, the first chairman of the International Accounting Standards Committee was British and its head office has always been based in London (Nobes and Parker 2002). As a result, IFRS is generally stemmed from Anglo-Saxon accounting model which UK is a representative. Besides, there are other reasons explaining why IFRS tends to follow the Anglo-Saxon accounting principles. First, the defining user group of IFRS is investor. This view is consistent with the Anglo-Saxon approach to corporate governance (Dewing and Russell 2008). Furthermore, as Flower (1997), Nobes and Parker (2006, p.97) comment, the Board 'is heavily dominated by former Anglo-Saxon standard-setters'. However, this has been disputed by Cairns (1997). He argued that the IASB was then led by a French (Georges Barthes), who is definitely from Continental European. Moreover, the secretariat of IASB was headed by a European secretary-general, there were total six out of fourteen IASB board members, who not only were European, but also worked for the European Community.
Flower (1997) opposed Cairns's view by presenting an argument that the representatives of the Continental European countries, in generally, come from the big four accountancy firms which dominate the market of listed companies and have strong Anglo-Saxon origins. Therefore, they tend not to properly stand for their countries' approach to financial reporting. Thus the crucial goal of Anglo-Saxon accounting system and IFRS which provides information about financial results of companies to all concerned stakeholders is similar.
The differences in implementation of IFRS, however, do occur in each country due to differences in social, economic and political backgrounds. Take UK as an example. Looking at micro level, Nobes and Parker (2002), Cairns and Nobes (2002), and Cairns (2003) revealed a lot of differences at the individual standards level between UK GAAP and IFRS as follows:
Fair value. It is generally known that both UK GAAP and IFRS have selected fair value method as the basis for their accounting principles. The adoption of fair value in IFRS is even stricter than UK GAAP when it requires income statement to be responsible for the changes in fair value of items which have not been traded such as derivatives. In other words, IFRS is more concerned for mark-to-market value of assets and liabilities than fair values based on actual market price. Under this requirement, both realised and unrealised adjustments in fair value of items would be included in income statements, which may make companies' earnings and other reported figures more volatile in the first year of transition to IFRS.
LIFO method. UK GAAP does not accept LIFO as a method of measuring inventory, while IFRS allows it
Research and development costs. As required by IAS 39, research costs would have to be written off once incurred and definitely cannot be carried on the balance sheet. Development cost is still allowed to capitalize, which is the same as UK GAAP.
Stock options. IFRS requirements which regard the value of share options distributed to employees as an expense in income statement could have a significant impact on earnings.
Distributable profits. There are a lot of IFRS requirements which affects distributable profits. Once companies move to fair value from historical cost, they cannot discount deferred tax liabilities, have to make higher provisions for deferred tax and include pension deficit in reported income. These requirements will absolutely reduce distributable profits which influence companies' ability to pay dividends (Cairns, 2003).
Derivative contracts. According to IFRS, some derivative contracts will not be classified as hedges as they do not meet the criteria. While UK GAAP allowed postponement of such contracts until the date when transaction took place, IFRS will not permit that kind of deferment. This treatment would affect the income statement even before the transaction actually took place. This is more beneficial for investors regarding obtaining the updated value of the firms, rather than historical costs of such items, particularly if the period of financial instruments was long. Nevertheless, companies would cope with more difficulties in measuring the fair value of all such instruments (Cairns, 2003)
Compared to UK GAAP, IFRS is more advantageous in terms of providing a common financial language (Healy and Palepu 2001, Hope et.al 2005). The common financial reporting standards will help companies more easily to invest across physical boundaries and attract more investors including small investors. Such investors are generally not as easy to analyse financial information as some big financial institutions so they certainly want to explore companies across nations with one common accounting standard. Nevertheless, under IFRS, while fair value requirement conveys more updated value of a firm as compared to historic cost method, it also raises an issue regarding methods used to determine fair value and its reliability. When the market for some financial instruments is not ready, a company has to design a mathematic model to measure their fair values and the question is how the accuracy of that model is assessed and then how to compare the value of the same instruments between different companies (Perry and Nolke, 2006).
Key differences between French accounting standards and IFRS
The implementation of IFRS in Europe leads to a lot of alterations in the Continental European accounting practices (Demaria and Dufour, 2007). The literature has shown that the IFRS adoption is expected to have more profound impact on the financial statements of corporations in stakeholder-oriented countries because IFRSs are heavily influenced by the Anglo-Saxon accounting system while national standards in many European countries are generally perceived as tax driven, creditor oriented, law based, and focused on the distributable profit by preventing companies from presenting unrealized revenues in their income statement (Hung and Subramanyam 2004, Bertoni and Derosa 2005).
It is generally accepted that ownership concentration in France is high and owners are directly involved in companies' management (Nobes 1998). There is therefore less need for financial statements as a means of communication with owners. Moreover, the demand for accounting income is strongly influenced by the payout preferences of various stakeholder groups. Because these stakeholders prefer less volatile earnings, firms in code-law countries such as France, Italy and Germany tend more involved in income smoothing (Ball et al. 2000). Furthermore, La Porta et al. (1998) note that French-style civil-law countries provide the weakest legal protection for creditors and shareholders and the poorest enforcement of legislation; they also note a strong correlation between poor legal protection of investors and high ownership concentration.
According to Nobes and Parker (2002, 2006), there are some major differences between French GAAP and IFRS:
Most continental European countries rely heavily on intermediaries such as banks or financial institutions. Debt financing leads to conservative approach and an emphasis on historical costs (Bertoni and Derosa 2005, Jindrichovska and Mcleay 2005). Thus the implementation of IFRS and more specifically, the introduction of fair value accounting for valuating assets and liabilities, causes a fundamental change from perspectives of accounting practitioners and users (Bertoni and Derosa 2005). Under IFRS, variations in fair value are recognized in the income statement. Under French GAAP, any revaluation surplus is credited directly to equity.
While all gains on foreign currency transactions are recognized immediately, unrealised gains on foreign currency transactions may be deferred according to French requirement
In terms of internally developed intangibles, IFRS requires development costs to be capitalised once certain criteria are met. By contrast, development costs are normally expensed as incurred.
Regarding financial instruments, there is significant difference between these two sets of accounting standards. Under IFRS, derivatives are stated at fair value whereas under French accounting rules, derivatives usually are not presented in the balance sheet other than for the premiums paid and received. In the absence of hedge accounting, only unrealised losses of derivatives are stated in the income statement. Hedge accounting is permitted more frequently than under IFRS.
Banking industry and the importance of IAS 32, IAS 39 and IFRS 4
Banks and financial institutions were significantly affected by the new international accounting standards. One critical factor is that IFRS rely heavily on fair value accounting, as opposed to the concept of historical cost. From the lesson of Millennium Bridge in London, Plantin et.al (2008) explained the danger of fair value application to banks' accounting system. When fair value accounting is used, all banks must report their trading assets and long-term assets at market value. Thus, any movement of security prices will be shown immediately on the balance sheet, which in turn causes investors' reaction. These responses will be reflected again in the stock prices and a new round starts. This issue is especially serious under the financial crisis when banks are incapable to control their asset value, thereby worsening situation (European Central Bank, 2004, p.45).
IAS 39 'Financial Instruments: Recognition and Measurement' which governs the recognition and valuation of financial instruments is particularly important for banks and financial institutions, whose assets and liabilities consist principally in such instruments. In essence, IAS 39 represents a change from historic cost accounting which the estimation is made in the past by the seller and the buyer to fair value accounting which the estimation is made by the current market (Perry and Nolke, 2006). Under historic cost accounting, financial instruments intended to be held for the long-term were accounted for at cost, whereas under IAS 39 the same instrument would be measured at fair value. If no ready market exists for the instrument then under the fair value rules it would be valued based on an estimation of market value using a mathematical model. Proponents of the fair value approach argue that it introduces greater transparency and comparability to valuations of assets and liabilities thus benefit investors in evaluating true value of firms. Nevertheless, critics argue that fair value accounting leads to more volatility to accounts as short-term price movements in the underlying securities or currencies are directly reflected in the accounts and, there is a lack of consistency in the mathematical models used in valuation between entities.
From the banking industry's perspective, the key motivation is the desire to protect accounts from potential misinterpretation by the financial markets. That is the reason why not all national accounting standard-setters shared the industry's concerns with the UK standard-setter advocating full implementation of IAS 39. Other standard-setters including that of France were extremely against IAS 39. Concern about IAS 39 was so strong in France that the French President, Jacques Chirac, wrote to the EU President arguing that the IFRSs 'were not sensitive enough to European interests' (Whittington, 2005, p.143). After much dispute, IAS 39 was finally accepted in EU subject to two "carve out" which concerned 'full fair value' option and hedge accounting provisions.
IAS 32 'Financial Instruments: Presentation' which specifies how to account for equity capital is another controversial standard (Perry and Nolke, 2006). It classifies the paid-in capital from members or partners in a small or medium company as a financial liability- and not as equity- because the capital is, in principle at least, repayable. Thus, IAS 32 leads to write off a big amount of equity and substantially increase liabilities. In addition, IAS 32 requires that this 'liability' is accounted for at fair value, which in this case is the current market value of the company, based on future earnings expectations by the market. Therefore, the net effect of IAS 32 will not only take away small and medium enterprise's equity capital, but also its considerable protection against hostile takeovers. That is why IAS 32 was strongly objected by European businesses (especially German companies).
In preparing financial statements in 2005, most companies has selected to take advantage of certain transitional provisions stated in IFRS 1 'First-time Adoption of International Financial Reporting Standards' which offer exemption from presenting comparative information or applying IFRSs retrospectively. The most importance of these provisions is the exemption from presenting comparative information in accordance with IAS 32, IAS 39 and IFRS 4 'Insurance Contracts'. Because banks often group the effect of the first application of the two former standards with the latter, this study also explores their combining impact on banks' financial statement in 2005.
Because of the incentives of harmonising accounting rules, EU has passed the regulation which requires all EU listed companies to adopt IFRS from 1st January 2005 onwards. This requirement has significant impact on financial reports of European organisations because national GAAPs are usually different from IFRSs. In the next chapter, we are going to discover how the impact of the first time application of IFRS has been studied by researchers and what results they have achieved.
Chapter 3. LITERATURE REVIEW
The recent transition of European companies to IFRS as discussed above is giving rise to a number of studies attempting to capture its impact. Typically these studies use the 2004 financial statements, which were initially prepared on the basis of national GAAP and then restated under IFRS as comparatives for the 2005 financial statements.
This chapter will provide a review of the literature with the aim of providing a broad and adequate background to the questions that are going to be researched in the subsequent chapters. It intends to support the research with the results and findings of other researchers. The issue of the transition to IFRS will be considered in two specific groups. The first involves research analysing the impact of the EU's transition to IFRS on published accounting figures in different countries as well as different sectors, while the second refers to papers examining the effects on financial reporting quality and key financial ratio.
Impact of IFRS adoption on accounting figures
The initially adoption of IFRS has impacted on financial statements of EU firms which attracts studies attempting to capture this influence. Table 1 presents an overview of prior research on this issue.
Table 1 Literature about impact of IFRS adoption on accounting figures
Hung and Subramanyam (2004)
Banque de France (2005)
Soledad Moya and Ester Oliveras (2006)
Chemical pharmaceutical and fashion
Decrease in gearing and liquidity
Ormrod and Taylor (2004)
Significant but mixed
Significant but mixed
Increase the volatility of earnings
No major influence
Committee of European Banking Supervisors (2006)
18 European countries
Differences stemmed mostly from the first application of IAS 39
Callao et al. (2007)
Increase in long-term and total liabilities
A number of researchers such as Jermakowicz (2004), Hung and Subramanyam (2004), Cordazzo (2008), Tsalavoutas (2009) are indicating that the first time application of IFRS has led to an increase in equity or income or both equity and income. Jermakowicz (2004) identifies that the adoption of IFRS by listed companies in Belgium has caused a significant rise in shareholder's equity and decrease in net income. Hung and Subramanyam (2004), while investigating the effects of IASs on financial statements of German firms, find that the adjustment related to financial instruments on average increases equity by 7 million. This is likely due to German GAAP requires lower of cost or market values for financial instruments, while IAS applies fair values. In 2005 annual report of Banque de France, they found that the application of IFRS led to a 12.6 percent increase in balance sheet total of three leading French banking groups, in which the main reason for the increase is the inclusion in the balance sheet of derivatives at fair value. Moreover, this application created a rise of 5.8 percent in three French banks' equity, mainly as a result of adding unrealised gains of available-for-sale financial assets. Moya and Oliveras (2006) conclude that the IFRS effects on German Corporations in chemical pharmaceutical and fashion sectors were important and often they created a significant increase in retained earnings in the first year of adoption of IFRS. This could be explained by the highly conservative philosophy of German accounting rules leading to understatements of assets and overstatements of liabilities. Lopes and Viana (2008) find that, in Portugal, the transition to IFRS has led to less conservative reported profit for publicly traded companies. Cordazzo (2008) concludes higher shareholder's equity and net income under IFRS than under Italian GAAP for Italian companies. Similarly, Tsalavoutas (2009) reports a positive impact on shareholder's equity and net income, negative impact on gearing and liquidity when analysing how IFRS adoption affects Greek listed companies.
By contrast, several authors conclude the opposite results. The change from UK GAAP to IFRS on covenants in debt contracts results in a significant but varied impact both on reported earnings and on balance sheet values. It also causes the increase in volatility of earnings (Ormrod and Taylor 2004). Other researchers find that there was no overall major influence on equity of firms on the first time application of IFRS, but the effect differs for different companies or different sectors (Aisbitt 2006). In the analysis undertaken by Committee of European Banking Supervisors in 2006, the aggregated data from banks' balance sheets in 18 European countries showed that the impact of the standards on regulatory capital is relatively immaterial and the differences stemmed mostly from the first application of IAS 39. In Spain, companies adopting IFRS have experienced an increase in long-term and total liabilities, and a decrease in shareholders' equity (Callao et al. 2007).
The differences between IFRS accounting figures and national GAAP accounting figures can be explained by a lot of reasons. Cairns (2006) suggested that the most major consequences of the change to IFRS in the UK would be the recognition of all derivatives on the balance sheet at fair value, the full recognition of pension deficits, restrictions on the use of hedge accounting and revised accounting for mergers and acquisitions.
According to Renders and Gaeremynck (2007), "IFRS adoption also leads to increased disclosure and reduced accounting choices, resulting in a loss of private benefits for company insidersâ€¦. this loss depends on characteristics of the institutional environment (i.e. the level of investor protection)â€¦.in countries with strong laws or extensive corporate governance codes IFRS is more likely adopted as the loss of private benefits for company insiders is smaller". Under IFRS, more stringent criteria are put for classification of insurance products which may reclassify some insurance products as investment products. As a result, insurance companies have to state financial instruments such as derivatives at fair value rather than historical value allowed under their own GAAP. This would cause earnings distortion which unexpectedly affects financial position of insurance companies (Reuters, 2005a).
New accounting standards changed 12 per cent on average profit of 27 blue chips. ICI, the chemicals company of the UK was the biggest winner in the sample when its earnings expanded 93 per cent to GBP474million, while Telecom Italia's earnings dropped 22 per cent to 1.8billion (Financial Times, 2005c). As reported in Reuters (2005a), under IFRS, Tesco's projected annual profit of £2,000million was reduced by £30million equivalent to 1.5 per cent only. But for some corporations the effect would be much more significant. New accounting regulations would reduce Royal & Sun Alliance net assets by £400m. This is a huge number by any standards and stakeholders of Royal & Sun Alliance have cause for concern.
Impact of IFRS adoption on financial reporting quality
Although the IFRS adoption process is costly, and complex for European companies (Jermakowicz and Gornik-Tomaszewski, 2006), EU member states expect significantly economic benefits from the new standards. The implementation of IFRS would reduce information asymmetry resulting in lower agency costs (Healy and Palepu, 2001) and also lead to lower costs of equity and debt financing (El-Gazzar et al, 1999; Botosan and Plumlee, 2002). Hope et.al (2005) suppose that countries are more likely to adopt IFRS to enhance investor protection, to improve the comparativeness and comprehensiveness of their financial information and to make their capital market easier for foreign investors to access. The effect of the IFRS implementation on financial reporting quality is summarised in table 2.
One of the generally accepted methods to evaluate accounting quality is to test its relevance to market value. Agostino et al. (P2) defined market value relevance as a statistical relationship between financial information and stock prices or returns.
While investigating a sample of more than 400 firms applying IFRS from 1990 to 2004, Barth et al. (2006) find that the accounting quality of IFRS is lower than US GAAP but higher than national GAAPs. Tsalavoutas (2009) concludes that reporting quality of Greek listed firms has improved under the new accounting system, especially for companies with non-'Big 4' auditors. Similarly, Bartov et al. (2005), Hung and Subramanyam (2004) suppose that the value relevance of earnings reported under IAS is greater than under German accounting standards. The value relevance of adjustments from UK GAAP companies in the transition to IFRS is explored by Horton and Serafeim (2006). From data of 85 firms listed on London Stock Exchange, the authors indicate that the adjustment is value-relevant with respect to earnings rather than to shareholders' equity. Recently, Barth et al. (2008) have compared the characteristics of accounting amounts for firms using IAS with those do not and find that the former is exposed with higher accounting quality, less earnings management and greater value relevance of the amounts. In the same way, Swartz and Negash (2006) investigate the impact of IFRS on the Johannesburg Securities Exchange and conclude that accrual information prepared under IFRS is more value-relevant than under national accounting standards.
In contrast, according to Wu et al. (2005), Hu (2002), Lin and Chen (2005), accounting information based on IFRS is no more value-relevant than that based on Chinese GAAP. They explain that this is the result of the lack effective control and monitoring infrastructures rather than the nature of IAS. This conclusion is consistent with research of Ball et al. (2003) regarding financial reporting quality in Hong Kong, Thailand, Singapore and Malaysia which are supposed to apply accounting standards similar to IAS. In Germany, Schiebel (2006) carries out a similar research concerning the value relevance of IFRS and German GAAP. They find that German GAAP is considerably more value relevant than IFRS.
In terms of banking sector, Agostino et al. explore the impact of IFRS adoption on the market valuation of accounting information in the European banking industry. In accordance with their evidence, the application of IFRS has enhanced the information content of both earnings and book value for more transparent banks while less transparent units have not experienced an increase in book value relevance. They also find that Germany and Italy are affected most and UK is influenced least by the IFRS introduction. This is consistent with the generally accepted view that IFRS require more disclosure than local rules in the Continental European countries and that the accounting quality under UK GAAP is quite similar to IFRS (Christensen et al. 2007)
Results from above studies are very mixed, with some presenting that the movement to IFRS enhances value relevance, while others concluding conversely. This maybe depends on different countries with different cultures, politics, and on different points of time.
Table 2 Literature about impact of IFRS adoption on financial reporting quality