IFRS adoption and its effects on accounting numbers: some considerations about the IASB s Framework

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1 IFRS adoption and its effects on accounting numbers: some considerations about the IASB s Framework IRINA-DOINA PĂŞCAN, RAMONA NEAG Financial Accounting Department Petru Maior University Nicolae Iorga Street, No. 1, Tirgu Mures, Mures ROMANIA pascanirina@yahoo.com, ramonaneag@yahoo.com Abstract: It is well known that the evolution and development of accounting has followed the road from practice to theory. The practical experience was one that shaped accounting theory and methods. In the context of financialisation and economic globalization, entities faced the necessity to present financial statements in a language that could be understood by cross-border stakeholders. The international financial reporting standards (IFRS) were issued to meet these demands and they are being used worldwide. Great number of empirical research has highlighted the impact of the adoption of IFRS on accounting numbers in different national jurisdictions. IASB s Conceptual Framework for Financial Reporting, the theoretical foundation of IFRS, must be followed by all countries and by all entities that have adopted the IFRSs. Under these conditions, our objective is to offer insights into the effects that IASB s Framework has on accounting numbers. Our paper is focused mainly on fair value measurement and on the changes in IASB s Framework published in September Key-Words: IFRS, IASB s Conceptual Framework for Financial Reporting 2010, accounting information, fair value, comprehensive income, users of financial reports 1 Issuance and widespread of international financial reporting standards (IFRS) The International Accounting Standards Committee (IASC) was the first attempt to set accounting standards internationally. The IASC was formed in 1973 through an agreement among professional accountancy bodies from the main developed countries (Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom and Ireland, and the United States of America). Its main motivation was to promote the international harmonization of accounting standards, to lessen the differences in accounting practices among countries [1]. During , IASC has issued the first thirteen international accounting standards (IAS). In 1987, the revision of standards was initiated, with the aim of reducing the number of allowed options. This process was ended in 1993 with the adoption of ten revised standards. In 1995, IASC and IOSCO (International Organization of Securities Commissions) have pointed out the necessity to issue a set of forty basic standards [2], process completed in In March 2001, IASC was restructured and the International Accounting Standards Board (IASB) was established. Since 2001, the standards issued by IASB are named International Financial Reporting Standards (IFRS). Aiming to achieve accounting convergence, the IASB has revised the standards in order to eliminate accounting alternatives, redundancies and conflicts arising in their content. Initially, the adoption of international standards was achieved timidly. In countries where the IASC s associate member bodies were located, standard setters sometimes sanctioned the use of its standards. Several Asian countries and Hong Kong began patterning some of their standards on IAS. The New Zealand standard setter adopted IAS 2, on inventories, verbatim as the country s standard [1]. In time, more multinationals from US, Canada, Japan, South Africa, Europe (Switzerland, Germany), begin attending to the international standards. In June 2000, the European Commission announced that listed companies in the EU should be required to adopt IAS in their consolidated statements by Nowadays, the IFRSs are being used worldwide. A study published by Deloitte shows that for 174 jurisdictions for domestic listed companies, IFRSs are not permitted in 27 jurisdictions, permitted in 25 jurisdictions and ISBN:

2 required (for all or for some) in 101 jurisdictions. In case of unlisted companies, IFRSs are not permitted in 35 jurisdictions, permitted for all or some in 42 jurisdictions and IFRSs required (for all or for some) in 60 jurisdictions [3]. The IFRSs have emerged in response to the need for transparency, quality and comparability of the information contained in the financial statements prepared by entities worldwide. It is well known that regulation of accounting affects the quality and quantity of financial disclosures, which in turn have welfare and policy implications in the presence of externalities [4]. The adoption of IFRS in different national jurisdictions is a complex process with important implications on the entities that prepare their financial statements under IFRS, on the quality of financial reports and on the perception of this information by different stakeholders. Every country that has adopted the IFRSs must also follow the Conceptual Framework for Financial Reporting issued by IASB (IFRS Framework), as a theoretical foundation of all the other specific accounting standards. The IFRS Framework describes the basic concepts that underlie the preparation and presentation of financial statements for external users [5] and addresses, among other things, the measurement of the elements from which financial statements are constructed. The measurement bases impose significant limitations on the scope of a balance sheet and an income statement i. It is necessary to remember that the financial accounting data are organized on these measurement assumptions and values are not in any sense absolute, but relative to a framework change the framework and the values will change too [6]. The most relevant example about how the change of accounting regulation (including the conceptual framework) causes the change of accounting numbers is the one of the company Daimler-Benz. In Daimler-Benz, Europe s largest company, announced a New York listing. Its reconciliation for 1993 showed that its consolidated profit of DM0.6 billion under German GAAP converted to a loss of DM1.8 billion under U.S. GAAP... [1]. IFRS Framework states the objective of general purpose financial reporting (by reference to the primary users), wherefrom certain qualitative characteristics of useful financial information emerge; these qualitative characteristics are related to the elements from which financial statements are constructed and to the measurement bases. The measurement bases presented in IFRS Framework (historical cost, current cost, net realisable value and present value) rely heavily on fair value. Measurement debates are mostly presented in terms of historical cost versus fair value. Some researchers argue that the recent changes in IFRS Framework align well with the committees working agenda to incorporate Fair Value Accounting (FVA) in the IFRS [7]. 2 Changes in IASB s Conceptual Framework for Financial Reporting 2010 in the context of global financial crisis The Framework for the Preparation and Presentation of Financial Statements was issued in 1989 by the IASC and adopted by the IASB in In September 2010 a new Framework was approved by IASB: the Conceptual Framework for Financial Reporting 2010 (IFRS Framework). The main changes in IFRS Framework are related to the identity of users and the qualitative characteristics of useful financial information. First, regarding the identity of users, IFRS Framework locates investors at the centre of the reporting process; the definition for users includes existing and potential investors, lenders and other creditors (IFRS Framework, paragraph OB 2). In the previous framework, the primary users of general purpose financial reporting were present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies and the public (IASC Framework 1989, paragraph 9). IASB motivates this change stating that investors, lenders and other creditors have the most critical and immediate need for the information in financial reports (IFRS Framework, paragraph BC 1.16). Second, IFRS Framework replaces the term reliability with the term faithful representation as a qualitative characteristic of useful financial information. Zhang and Andrew (2008) argue that the complete removal of the term reliability was a significant decision because this change in terminology eliminated the possibility of a trade-off between relevance and reliability this trade-off has been frequently invoked as a reason for not using fair value measurements, which are perceived as often being relevant but unreliable. Accordingly, this reframing of the qualitative characteristics of financial information laid the conceptual foundation for fair value accounting to dominate approaches to measurement within accounting practice [8]. The development of international accounting standards has been driven largely by the need to ISBN:

3 accommodate global capital markets [8]. Following the global financial crisis, the faith in the financial markets has been questioned. In the research literature, the changes in IFRS Framework were critically analyzed in the context of financial crisis, some authors suggesting that IFRS Framework works to reinforce the interests of financial capital [8]. For example, the orientation towards investors as a primary user of financial reports is as symbol of the success of financialisation, wherein financial markets became a proxy for the public interest [8]. Financialisation is defined in the research literature as the increasing dominance of financial markets, financial motives, and financial institutions in the operation of domestic and international economies. This shift has brought about an overriding effect of financial interests over real economy [7]. Representatives of the Financial Crisis Advisory Group (FCAG) ii underline the importance of accounting regulation in times of financial crisis. Accounting was not a root cause of the financial crisis, but it has an important role to play in its resolution, said Hans Hoogervorst, Co-Chairman of the FCAG. Harvey Goldschmid, Co-Chairman of the FCAG also pointed out that improved financial reporting will help restore the confidence of financial market participants and thereby serve as a catalyst for increased financial stability and sound economic growth. The independence and integrity of the standard-setting process, including wide consultation, is critical to developing high quality, broadly accepted accounting standards responsive to the issues highlighted by the crisis [9]. The emphasis on faithful representation instead of reliability in IFRS Framework can be seen as a measure designed to increase the confidence in financial markets, because faithful representation enables fair value measurement. 3 Fair value accounting and its implications in financial reporting process The international financial reporting standards allocate much "space" for the measurement and disclosure of fair value. Why? One possible answer is formulated in the objective of general purpose financial reporting, relative to providing financial information about the reporting entity that is useful to present and potential investors, lenders and other creditors in making decisions about providing resources to the entity (IFRS Framework, paragraph OB 2). Moreover, general purpose financial reports provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting entity (IFRS Framework, paragraph OB 7). We consider that fair value measurement for certain assets and liabilities provide useful financial information for estimating the value of an entity, because, in this way, the carrying amount of an entity is close to its market value. Provisions related to fair value measurement and disclosure were presented in different accounting standards, so that the requirements regarding fair value were dispersed and, in many cases, did not clearly expressed the objective of fair value measurement or disclosure. In order to eliminate this deficiency, in May 2011, IASB has issued IFRS 13 Fair value measurement, a new standard that replaces the existing provisions about fair value measurement included in different standards with a single definition of fair value and an unified framework for fair value measurement and disclosure. IFRS 13 explains how to measure fair value when it is required by other IFRSs. It does not introduce new fair value measurements, nor does it eliminate the practicability exceptions to fair value measurements that currently exist in certain standards [10]. IFRS 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, i.e. an exit price (IFRS 13 Fair value measurement, paragraph IN8). IFRS 13 applies for assets, liabilities and entity's own equity instruments, when another IFRS requires or permits fair value measurements or disclosures about fair value measurements, except for share-based payment transactions within the scope of IFRS 2 Share-based Payment, leasing transactions within the scope of IAS 17 Leases, measurements that have some similarities to fair value but that are not fair value, such as net realisable value in IAS 2 Inventories or value in use in IAS 36 Impairment of Assets. IFRS 13 explains how to determine fair value for financial reporting, and different IFRSs allow or request fair value measurement for assets, liabilities or entity's own equity instruments, in the moment of initial recognition and/or subsequent to initial recognition. In the table below we have summarized the items from the statement of financial position for which international accounting referential requires or allows fair value measurement at the end of each reporting period. ISBN:

4 Table 1 Fair value measurement in the statement of financial position according to the international accounting referential Asset, liability or own equity instrument IAS/ IFRS Fair value measurement requested Property, Plant and Equipment IAS 16; IAS 36 Intangible assets IAS 38; IAS 36 Plan asset IAS 19 Non-monetary IAS 20 grant (for asset and grant) Financial asset IAS 39 Financial IAS 39 liability (certain categories) Investment IAS 40 property Biological asset IAS 41 Goods received IFRS 2 in a share-based payment transaction Non-current IFRS 5 Assets Held for Sale allowed The table above shows that the IFRSs propose extensive use of fair value measurement in the statement of financial position. Considering the period when IFRS 13 was issued, we consider that IASB s response to global financial crisis includes this new fair value guidance. Also, as shown above, the subtle changes in IFRS Framework can be seen, in the context of financial crisis, as measures intended to bring under the spotlight the importance of fair value measurement. Fair value accounting (FVA) collects from the markets the information needed in order to calculate the value of assets and liabilities. Therefore, in FVA, the viability of a free market is of great importance. Accordingly, some authors show that the new IFRS Framework embeds a globalised commitment to financialisation within the practice of accounting, which in turn works to support and sustain the centrality of financial markets in contemporary economies [8]. The research literature is rich in opinions and debates about the advantages and limits of fair value accounting. The fundamental case in favour of fair value accounting seems obvious to most economists: fair value incorporates market information into the financial statements. Incorporating more information in the financial statements by definition makes them more informative, with potential advantages to investors, and other things being equal it makes them more useful for purposes of contracting with lenders, managers and other parties [11]. Moreover, considering the changes in IFRS Framework, it can be noticed that fair value meets the conceptual framework criteria in terms of qualitative characteristics of accounting information better than other measurement bases. In fact, fair values are relevant, can be faithful representations of assets and liabilities, are neutral, timely and comparable [11]. However, still in the context of the new framework, problems with fair value can appear in practice, because of its lack of verifiability. Zhang, Y. (2011) criticizes fair value accounting and explains his point of view referring to the volatility of markets: In the previous historical cost accounting system, share market prices and estimations... were not taken into account of value measurement in the accounting system. Hence the volatility of the share market was virtually isolated having very limited effect on measuring values in other economic sectors. In this sense, FVA, together with the practice of reporting Comprehensive Income, allows this erratic market valuation to be transmitted into the internal evaluation produced by the firm which would significantly influence any economic decisions made upon this valuation information. In the contemporary financialised economic environment this technical feature would distort the price discovery process in the business activities facilitating the volatility of financial markets to permeate the broader economic system [7]. A new measure of performance in the context of fair value measurement: the comprehensive income The wide use of fair value measurement in the international accounting referential has made its mark including on the way financial performance is measured. A new performance measure, the comprehensive income, must be reported according to the international accounting standard no. 1 ISBN:

5 Presentation of financial statements starting with January 1 st, The comprehensive income includes the profit or loss plus other comprehensive income. The components of other comprehensive income are: changes in revaluation surplus, actuarial gains and losses on defined benefit plans, gains and losses arising from translating the financial statements of a foreign operation, gains and losses on remeasuring available-for-sale financial assets and the effective portion of gains and losses on hedging instruments in a cash flow hedge (IAS 1, paragraph 7). In the context of full fair value measurement, the comprehensive income is considered to be the most pertinent indicator to measure the financial performance of an entity [12]. Barlev, B. and Haddad, J. R. (2003) also sustain the importance of comprehensive income reporting and relate the comprehensive income concept with fair value accounting. In their opinion, the fair value accounting (FVA), in contrast to the historical cost accounting (HCA) that hides the real financial position and income, is more value relevant. Moreover, the FVA also provides a complete full disclosure and it is compatible with transparency. Although the advantages of financial statements based on FVA are overwhelming, HCA figures are still needed for various purposes (for example, in case of taxable income). Consequently, a dual system of reporting that incorporates FVA and HCA may evolve. A comprehensive income statement may be an alternative or an addendum to a dual system of reporting [13]. Considering the new IFRS Framework, we believe that comprehensive income is an appropriate measure for performance. Financial reports are destined mainly for investors and lenders, and they need information to assess how effectively and efficiently management has discharged their responsibilities to use the entity's existing resources (IFRS Framework, paragraph OB 4). There are opinions against comprehensive income reporting, arguing that gains and losses that participate to comprehensive income determination are not performance related or are not under the control of the entity. Nevertheless, we consider that management efficiency is related to its capability to juggle with these external factors, so that the entity could obtain economic benefits. Regarding management effectiveness, unrealized gains and losses give information about how the resources are managed. For instance, hedging shows how effectively management works with investors resources and, therefore, should be considered an indicator of performance. The emphasis on fair value and the priority given to investors, as primary users of general purpose financial reports, have generated a shift on the way financial performance is measured. Real operating performance has become less important to users, and a new performance measure, the comprehensive income, expressing the value change of wealth, prevails in financial reporting. 4 Conclusion We build our paper based on the presumption, often proven in empirical research, that accounting numbers presented in financial reports are a consequence of the used accounting referential and, within it, of the conceptual framework. For a long time, researchers testify the impact of the change of the accounting referential on the entity s financial position and performance and on the value relevance of accounting data reported under the new accounting regulation. The adoption of IFRS means more than relocation or change in accounting regulation. The implementation of IFRS requires a new system for performance evaluation. The IFRSs require or allow the wide use of fair value measurement. Under these circumstances, the ability of net income to summarize financial performance was questioned and a new measure for financial performance, the comprehensive income, was gradually introduced into the international standards. Our paper shows that the changes in IFRS Framework, published by IASB in September 2010, in the context of financial crisis, were intended to increase the confidence in financial markets, by means of the emphasize on fair value measurement and on investors, as primary users of general purpose financial reports. References: [1] Zeff, S. A., The Evolution of the IASC into the IASB and the Challenges it Faces, The Accounting Review, Vol. 87, No. 3, 2012, pp [2] Diaconu, P., The adoption of International Accounting Standards - an evolutionary process, Accounting, auditing and expertise, Vol. 1, 2007, pp [3] Deloitte, Use of IFRS by jurisdiction, 2012, available on line at [4] Fields, T. D., Lys, T. Z. and Vincent, L., Empirical research on accounting choice, ISBN:

6 Journal of Accounting and Economics, Vol. 31, 2001, pp [5] Deloitte, Framework, available on line at [6] Walton, P., Aerts, W., Global Financial Accounting and Reporting. Principles and Analysis, Thomson, [7] Zhang, Y., Accounting and Neoliberalism: A critical reading of IASB/FASB s Conceptual Framework for Financial Reporting 2010, Critical Perspectives on Accounting Conference, 2011, pp. 1-22, available on line at 1_0037_paper.pdf. [8] Zhang, Y. and Andrew, J., Financialisation and the Conceptual Framework, Critical Perspective on Accounting, 2013, 10 pages. [9] IASB, Financial Crisis Advisory Group publishes wide-ranging review of standardsetting activities following the global financial crisis, 2009, available on line at [10] KPMG, Unified fair value measurement and disclosure guidance for IFRS, 2011, available on line at ights/articlespublications/in-the- Headlines/Documents/in-the-headlines pdf [11] Kothari, J., Barone, E., Advanced Financial Accounting: An International Approach, Financial Times Press, [12] Dumitrana, M. et al., Comprehensive income Past, present and future, Scientific Annals of the "Alexandru Ioan Cuza" University of Iasi, Economic Sciences Section, 2010, pp [13] Barlev, B., Haddad, J. R., Fair value accounting and the management of the firm, Critical Perspectives on Accounting, Vol. 14, 2003, pp i Since 2007, the titles used in the IFRSs for these financial statements are Statement of financial position and, respectively, Statement of comprehensive income. ii The Financial Crisis Advisory Group (FCAG), a high level group of recognised leaders with broad experience in international financial markets, was formed at the request of the International Accounting Standards Board and the US Financial Accounting Standards Board to consider financial reporting issues arising from the crisis. In July 2009, FCAG published its recommendations related to accounting standard-setting activities, and other changes to the international regulatory environment following the global financial crisis. ISBN: