ACC 305 Accounting Theory
Introduction
The globalization of economic activity has an increased demand for higher quality of accounting standards to enable investors to understand the financial statements and make comparison the financial information of companies from different countries. According to Nobes and Parker 2004 p.77, ‘harmonization’ is defined as ‘a process of increasing the compatibility of accounting practices by setting bounds to their degree of variation. ‘Standardization’ of accounting is expressed as a term that ‘appears to imply the imposition of a more rigid and narrow set of rules. Accurate and consistent information is essential to help investors use financial statements to invest in companies from diverse countries and make investment decision (Deegan, 2009). Extra costs in form of lost potential capital or investment opportunities will be incurred if investors are unable to obtain sufficient and transparent view financial statements on their selected companies (Beier, 2008). According to Healy and Palepu, 2001, an efficient capital market can be achieved by regulators, standard settlers, auditors and information intermediaries. The credible accounting reporting may assist them to make the correct choice. As the capital markets are becoming global, global standards have emerged for institutions to enforce adherence to standards and provide information needs across the world. International Financial Reporting Standards (IFRS) is widely adopted by more than 100 countries for preparing financial statements. The primary objective of IASB is to develop and promote ‘a single set of high quality and principle-based financial reporting standards’ that are used throughout the world’s capital market (IASCF, 2006). The advantages and disadvantages of such a widespread IFRS adoption, the underlying theories of accounting, and some real life events pertaining to the practice of accounting standards are discussed below.
The globalization of economic activity has an increased demand for higher quality of accounting standards to enable investors to understand the financial statements and make comparison the financial information of companies from different countries. According to Nobes and Parker 2004 p.77, ‘harmonization’ is defined as ‘a process of increasing the compatibility of accounting practices by setting bounds to their degree of variation. ‘Standardization’ of accounting is expressed as a term that ‘appears to imply the imposition of a more rigid and narrow set of rules. Accurate and consistent information is essential to help investors use financial statements to invest in companies from diverse countries and make investment decision (Deegan, 2009). Extra costs in form of lost potential capital or investment opportunities will be incurred if investors are unable to obtain sufficient and transparent view financial statements on their selected companies (Beier, 2008). According to Healy and Palepu, 2001, an efficient capital market can be achieved by regulators, standard settlers, auditors and information intermediaries. The credible accounting reporting may assist them to make the correct choice. As the capital markets are becoming global, global standards have emerged for institutions to enforce adherence to standards and provide information needs across the world. International Financial Reporting Standards (IFRS) is widely adopted by more than 100 countries for preparing financial statements. The primary objective of IASB is to develop and promote ‘a single set of high quality and principle-based financial reporting standards’ that are used throughout the world’s capital market (IASCF, 2006). The advantages and disadvantages of such a widespread IFRS adoption, the underlying theories of accounting, and some real life events pertaining to the practice of accounting standards are discussed below.
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Discussion
Some theories favor the adoption of IFRS. Others possess the anti-IFRS perspective. Firstly, the widespread implementation of IFRS committed to providing more accurate and timely financial information to improve financial reporting quality (Ball, 2006). Hence, it allows investors to receive informative reporting. Besides, the change in accounting and reporting under IFRS enhances comparability among listed companies and improves financial transparency (Ball, 2006). Without standardization of accounting, the different accounting standards in various countries may be viewed as a barrier to cross-border on the understandability and interpretation of financial information. Therefore, standardization will enable investors to understand the financial reporting standards from different countries. Moreover, improved transparency reduces agency costs between managers and shareholders as timelier loss recognition provides incentives for managers to undertake more positive-NPV investment hence enhance corporate governance (Ball 2001; Ball and Shivakumar 2005). The efficiency of contracting between lenders and firms can be increased with an improved transparency promised by IFRS as lenders may identify debt covenants violation of firms rapidly with the timelier loss recognition of loss in the financial statements (Ball 2001; Ball and Shivakumar 2005). Hence it can minimize the loss of outstanding debt. There will also be cost-savings in the accounting-standard function rather than duplicate financial process from different countries to understand and interpret financial statements. For example, accounting firms from different countries can avoid double work when interpret different countries’ financial reporting standards, which in turn would save costs of using a single reporting standard. Next, IFRS make it easier for companies to implement cross-border acquisitions, which may encourage increased takeover premium for potential investors (Bradley, Desai & Kim, 1988). Therefore, it is expected that the impact of adopting IFRS on firms should lead to greater standardization and consistency in international accounting. Interestingly, the US has not yet adopted IFRS and resulted in foreign-based companies in the US have to prepare financial statements in accordance to IFRS and another set American Generally Accepted Accounting Principles (GAAP). For many countries, some of the cons outweigh the pros of adopting IFRS and the US in a significant example delayed the conversion to IFRS.
In term of the limitations of IFRS, companies will find that the cost to conversion of IFRS is significant as they do not have as many resources to implement the new standards and bear the training of accounting staff and management (Jermakowicz & Gornik-Tomaszewki, 2006). For example, training programs for accounting staff across a company is necessary to enable them adopt an entirely different system of accounting standards. The implementation of IFRS by a country involves local economic and political influence from managers, auditors, court regulators and other parties. Hence, the international differences on financial reporting quality and practice are inevitable, despite IFRS or no IFRS (Soderstrom & Sun 2007). Therefore, uniform accounting standards may not be achieved due to factors such as legal and political systems, which in turn affect the earning quality of firms. For example, EU Commission has modified the IAS 39 (financial instrument) when adopting IFRS as they argued that aspects of IAS 39 would have negative economic impact on their banks. This was mainly due to most of the banks in EU was owed by the government. According to Gary 1988, it is essential to identify the mechanism by which at the society level are linked to accounting values at the subcultural level, which are likely to have a direct impact on the development of accounting systems in practice. For example, in United Kingdom, where the levels of uncertainty avoidance is relatively low, more individualistic and Masculine due to the high competitiveness and corporate governance and self-regulation system in U.K.. While the level of professionalism is high and the preference for conservatism and secrecy are low hence it tends to have a higher degree of disclosure in accounting practices. It is argued that differences between countries in terms of their culture may impede the movement towards international harmonization of accounting standards. Besides, different religious belief would have impact on accounting practices, which transcend national boundaries (Hamid, Craig & Clarke, 1993). They point out the notions of stewardship in Western accounting practices are irrelevant to the Islamic faith as resources are deemed as be held in belief of god rather than providers of debt and equity capital. There is prohibition of interest on debt. For example, Western accounting standards consider accounting issues related to time value of money would be irrelevant within Islamic tradition. Hence, we cannot expect there is more uniformity in accounting practices without international consistency in the implementation of IFRS.
In real life corporate accounting scandals occur under both ruled-based or the principles-based IFRS. Enron case, one of the largest corporate scandals in the last 10 years, has eroded investors’ confidence in U.S. GAAP used as this accounting fraud took place on such a scale even while detailed rules under U.S (Dembinski, Lager, Cornford, & Bonvin 2006). GAAP had been followed. Enron used special purpose entities to hide its debt off its balance sheet and trigger bankruptcy. This implied that the problem under U.S. GAAP is fundamental and the financial intermediaries did not act in the best interest of investors by ignoring the misleading financial statements. The Sarbanes-Oxley Act (SOA) of 2002 has emerged followed by the Enron scandal, enjoined the U.S. Financial Accounting Standards Board to accord the validity of IFRS and principles-based accounting standards, which indicates the importance of fairness in financial reporting (Cunningham, 2006). Next, the collapse of HIH Insurance took place by using principles-based standards, it relates to a series of transactions where the true and fair financial position of HIH was hidden from its shareholders (HIH’s operating profit was significantly overstated). Inadequate corporate governance, regulation and auditing and poor management decisions have been attributed to the cause of the corporate scandal (Buttimore, Flood, Zhou & Peursem 2007). Overall, tighten accounting standards and corporate governance regulations should be established to mitigate accounting scandals and where the reinforcement of IASB’s role for the convergence of accounting standards is critical to prevent a repeat of the accounting failures.
Some theories favor the adoption of IFRS. Others possess the anti-IFRS perspective. Firstly, the widespread implementation of IFRS committed to providing more accurate and timely financial information to improve financial reporting quality (Ball, 2006). Hence, it allows investors to receive informative reporting. Besides, the change in accounting and reporting under IFRS enhances comparability among listed companies and improves financial transparency (Ball, 2006). Without standardization of accounting, the different accounting standards in various countries may be viewed as a barrier to cross-border on the understandability and interpretation of financial information. Therefore, standardization will enable investors to understand the financial reporting standards from different countries. Moreover, improved transparency reduces agency costs between managers and shareholders as timelier loss recognition provides incentives for managers to undertake more positive-NPV investment hence enhance corporate governance (Ball 2001; Ball and Shivakumar 2005). The efficiency of contracting between lenders and firms can be increased with an improved transparency promised by IFRS as lenders may identify debt covenants violation of firms rapidly with the timelier loss recognition of loss in the financial statements (Ball 2001; Ball and Shivakumar 2005). Hence it can minimize the loss of outstanding debt. There will also be cost-savings in the accounting-standard function rather than duplicate financial process from different countries to understand and interpret financial statements. For example, accounting firms from different countries can avoid double work when interpret different countries’ financial reporting standards, which in turn would save costs of using a single reporting standard. Next, IFRS make it easier for companies to implement cross-border acquisitions, which may encourage increased takeover premium for potential investors (Bradley, Desai & Kim, 1988). Therefore, it is expected that the impact of adopting IFRS on firms should lead to greater standardization and consistency in international accounting. Interestingly, the US has not yet adopted IFRS and resulted in foreign-based companies in the US have to prepare financial statements in accordance to IFRS and another set American Generally Accepted Accounting Principles (GAAP). For many countries, some of the cons outweigh the pros of adopting IFRS and the US in a significant example delayed the conversion to IFRS.
In term of the limitations of IFRS, companies will find that the cost to conversion of IFRS is significant as they do not have as many resources to implement the new standards and bear the training of accounting staff and management (Jermakowicz & Gornik-Tomaszewki, 2006). For example, training programs for accounting staff across a company is necessary to enable them adopt an entirely different system of accounting standards. The implementation of IFRS by a country involves local economic and political influence from managers, auditors, court regulators and other parties. Hence, the international differences on financial reporting quality and practice are inevitable, despite IFRS or no IFRS (Soderstrom & Sun 2007). Therefore, uniform accounting standards may not be achieved due to factors such as legal and political systems, which in turn affect the earning quality of firms. For example, EU Commission has modified the IAS 39 (financial instrument) when adopting IFRS as they argued that aspects of IAS 39 would have negative economic impact on their banks. This was mainly due to most of the banks in EU was owed by the government. According to Gary 1988, it is essential to identify the mechanism by which at the society level are linked to accounting values at the subcultural level, which are likely to have a direct impact on the development of accounting systems in practice. For example, in United Kingdom, where the levels of uncertainty avoidance is relatively low, more individualistic and Masculine due to the high competitiveness and corporate governance and self-regulation system in U.K.. While the level of professionalism is high and the preference for conservatism and secrecy are low hence it tends to have a higher degree of disclosure in accounting practices. It is argued that differences between countries in terms of their culture may impede the movement towards international harmonization of accounting standards. Besides, different religious belief would have impact on accounting practices, which transcend national boundaries (Hamid, Craig & Clarke, 1993). They point out the notions of stewardship in Western accounting practices are irrelevant to the Islamic faith as resources are deemed as be held in belief of god rather than providers of debt and equity capital. There is prohibition of interest on debt. For example, Western accounting standards consider accounting issues related to time value of money would be irrelevant within Islamic tradition. Hence, we cannot expect there is more uniformity in accounting practices without international consistency in the implementation of IFRS.
In real life corporate accounting scandals occur under both ruled-based or the principles-based IFRS. Enron case, one of the largest corporate scandals in the last 10 years, has eroded investors’ confidence in U.S. GAAP used as this accounting fraud took place on such a scale even while detailed rules under U.S (Dembinski, Lager, Cornford, & Bonvin 2006). GAAP had been followed. Enron used special purpose entities to hide its debt off its balance sheet and trigger bankruptcy. This implied that the problem under U.S. GAAP is fundamental and the financial intermediaries did not act in the best interest of investors by ignoring the misleading financial statements. The Sarbanes-Oxley Act (SOA) of 2002 has emerged followed by the Enron scandal, enjoined the U.S. Financial Accounting Standards Board to accord the validity of IFRS and principles-based accounting standards, which indicates the importance of fairness in financial reporting (Cunningham, 2006). Next, the collapse of HIH Insurance took place by using principles-based standards, it relates to a series of transactions where the true and fair financial position of HIH was hidden from its shareholders (HIH’s operating profit was significantly overstated). Inadequate corporate governance, regulation and auditing and poor management decisions have been attributed to the cause of the corporate scandal (Buttimore, Flood, Zhou & Peursem 2007). Overall, tighten accounting standards and corporate governance regulations should be established to mitigate accounting scandals and where the reinforcement of IASB’s role for the convergence of accounting standards is critical to prevent a repeat of the accounting failures.
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conclusion
In conclusion, some countries believe that the global standardization of
accounting standards may improve comparability among listed companies and
improve financial transparency; the benefits include such as a lower cost in
accounting-standard function and timeliness of financial information. Despite
various benefits of the adoption of IFRS, the effectiveness of uniform global
standards is yet to be seen. In theory, factors such as culture, legal and
political systems and religion beliefs differences may affect the effectiveness
of the global standards. In practice, a crisis compels regulatory development,
followed by another crisis compels another regulatory improvement. It appears
to develop cyclical manner. For example, The Sarbanes-Oxley Act (SOA) of 2002
emerged followed by the Enron scandal. In my opinion, it is naïve to consider
there is ‘one size fits all’ accounting system, the lack of consistency and
differences in interpretation of IFRS in different countries are obstacles to
accounting convergence. Nevertheless, the IASB and the US standard-setter
(FASB) should continue jointly working to reduce the differences between
international standards and U.S. GAAP and improve the harmonization of
accounting standards.
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