Abstract
A decade ago, the near-simultaneous adoption of International Financial Reporting Standards (IFRS) in over 100 countries could fairly have been described as a brave new world in financial reporting. Any systems innovation, and especially an innovation of such importance and magnitude, thrusts those involved (companies, users, and accountants) into the unknown. There was good reason to expect success, based largely on widespread enthusiasm for international standards and, behind that, recognition of the strong forces of globalization. Nevertheless, there were risks involved and there was limited a priori evidence to guide the decision-makers. A decade later, this is still the case. Globalization remains a potent economic and political force, and drives the demand for globalization in accounting. Nevertheless, most political and commercial activity remains local, so adoption of uniform rules does not by itself lead to uniform reporting behavior around the world. For many of the claimed benefits of IFRS adoption to be realized, uniform implementation would have to occur in a wide range of countries, which seems unlikely and requires more than simply creating regulatory enforcement mechanisms. Some evidence of actual outcomes from IFRS adoption has come to light, but, as will be argued below, by and large the evidence to date is not very useful. The IASB’s (International Accounting Standards Board) valuation-centric Conceptual Framework leads it to pay little or no heed to the use of accounting information in contracting, despite the lip service recent amendments pay to even the narrower notion of stewardship. So IFRS adoption is an innovation of historical proportions whose worldwide effects remain somewhat uncertain. The essay concludes with comments on the status of China and the US.
1. Introduction
The widespread adoption of International Financial Reporting Standards (IFRS) a decade ago constitutes a truly historical innovation in financial reporting. All innovations are at least to some degree leaps of faith, and can only be based on prior expectations gleaned from evidence and from reasoning, so their outcomes never are completely as anticipated. In the case of IFRS, prior expectations were high. There were clear reasons and prior evidence of a substantial political and economic demand for accounting globalization, so expectations were very high at the outset, probably too high. There were some equally clear reasons and prior evidence to be cautious, and to expect limits to globalization in actual financial reporting practice, as distinct from standards, though these reservations were seldom expressed in the public commentary.
Against this background, the Institute of Chartered Accountants in England and Wales (ICAEW) commissioned the 2015 PD Leake Lecture which forms the basis of this essay, the objective being to provide a 10-year retrospective on the big bang events of 2005. In that sense, it provides a retrospective on the 2005 PD Leake Lecture published in this journal (Ball Citation2006). While the essay makes several observations on what can (and, perhaps more importantly, cannot) be learned from the research evidence, it is not a literature survey, of which there have been several already (e.g. Negash Citation2009, Brüggemann et al. Citation2013, Mohammadrezaei et al. Citation2013, European Commission Citation2014, Citation2015, ICAEW Citation2014, De George et al. Citation2015, Kaaya Citation2015). Instead, the essay attempts to provide a perspective for assessing the outcomes from IFRS adoption, both present and future.
2. Then and now: summarizing the perspectives in 2005 and 2015
The perspective in 2005 was that IFRS were generally perceived to be high-quality standards, whatever that may be, but that they were incomplete. Ten years later, they remain viewed as of high quality and they are substantially more complete. There already was widespread adoption of IFRS in 2005, and that remains the case today. In the meantime, exactly what adoption means in various regimes has been clarified to a large degree by a systematic review of adopters that was conducted by the International Accounting Standards Board (IASB) and a more nuanced review by Nobes (Citation2006, Citation2013), described below. There remain a handful of holdout countries, most notably the US, but the overall record of formal adoption by jurisdictions is impressive indeed.
A priori, there were many conjectured benefits from IFRS adoption, including more efficient cross-border transacting, enhanced informativeness of financial reports (increased transparency), greater inter-company comparability of financial data, better asset prices (efficiency), lower cost of capital, and balance sheets that facilitate more efficient contracting between companies and lenders. Whether these benefits have in fact materialized is difficult to say. For reasons discussed below, there is limited evidence to go on, and many of the studies are flawed or have been misconstrued.
At the outset, there also were many concerns. One concern was that what constitutes adoption might vary considerably across regimes, which might carve out or modify particular standards to accommodate domestic economic, political, or legal issues, but this has not transpired to a significant degree. Formal adoption has been remarkably uniform.
Whether the newly adopted standards would actually be implemented uniformly was a concern, and remains so. While globalization is a potent force, it has its limits. Political and economic forces are what create the incentives of the actors who determine what actually transpires in financial reporting (managers, auditors, boards, regulators, courts, analysts, press, educators) to push for implementation of adopted rules; the same forces determine – over a very long period – the complex institutional structure within which they act. But politics and commerce are in large and varying degrees local (Ball Citation1995, Citation2006), as distinct from global, leading to incentives and institutional structures that are likely to differ across IFRS adopting countries and to implementation that is likely to differ also as a consequence. Formal adoption of uniform rules by jurisdictions does not by itself lead to uniform reporting behavior. For many of the claimed benefits of IFRS adoption to be realized, consistent implementation across regimes would have to occur, and in view of the formidable variation in local economic and political influences on financial reporting practice by companies, that seems highly unlikely.
One benefit of widespread adoption has been that in some quarters (notably, Europe) adoption has been associated with increased attention being given to governmental regulatory enforcement mechanisms. However, this has not occurred to the same degree on a worldwide basis. Even then, in countries that established or strengthened regulatory enforcement mechanisms that is no guarantee of actual implementation in practice.
Another set of concerns a decade ago arose from the substantial shift to fair value accounting that IFRS adoption brought to many countries for the first time. The major concerns were the subjectivity inherent when fair value estimates are not based on market prices, and the liquidity assumptions implicit even when they are. The concern was highlighted as follows (Ball Citation2006): Fair value accounting has not yet been tested by a major financial crisis, when lenders in particular could discover that ‘fair value’ means ‘fair weather value’. The test came soon afterward, with good but mixed results. In the meantime, some unanticipated concerns have arisen about the effect of fair value accounting in contracting contexts (debt, compensation, supply, licensing, etc.), and some early evidence has supported those concerns.
Finally, there were concerns that the Conceptual Framework project could yet cause IASB/Financial Accounting Standards Board (FASB) some grief (it has already) and there were some longer term concerns (which have not changed substantially). The latter include the effect on the IFRS brand name of permitting its use by regimes without a strong interest in implementation and with low financial reporting quality, and the composition of IASB governance in the long term.
The 2005 perspective was summarized as only time will tell. While in the meantime we have some garnered more evidence to go on, in 2015 it still is early days.
3. IFRS generally are viewed as high-quality standards
The general perception in 2005 was that IFRS were high-quality standards, whatever that may be, but that they were incomplete. Ten years later, they remain viewed as being of high quality, and they are substantially more complete. Completion of several new standards (notably, on revenue recognition, leases, and financial instruments) has dragged on longer than initially envisaged, in large part due to the accounting issues thrown up during the Global Financial Crisis and to the complicated politics arising from the convergence project between the IASB and the US standard setting body, the FASB. While it has taken longer than expected to get there, few commentators would now view the topic area coverage of IFRS as incomplete.
Despite the almost universal agreement that the IASB has produced a set of standards that deserve the sobriquet high quality, it is not entirely clear what that means, or even that different commentators use it to describe the same properties of the standards. From various conversations, I have concluded that the four main properties of IFRS that underlie this general assessment are:
The IFRS standards were developed largely outside of governmental bodies and were not designed primarily to meet political criteria or to correspond with tax accounting rules;
The standards are largely designed to make financial statements reflect the economic substance – rather than the legal form – of a company’s financial affairs;
Greater use is made of fair value accounting as distinct from historical cost, potentially making IFRS balance sheets and earnings more informative and recording economic gains and losses in a more timely fashion; and
The standards are designed to curtail managers’ discretion to manipulate provisions in ways that were considered valid under many of the adopting countries’ prior rules, for example, with the objective of smoothing reported earnings or hiding losses.
These properties are not independent. One commonly heard way of summarizing them is to say that IFRS are designed to increase financial reporting transparency, which can be interpreted loosely as providing more complete and accurate information about the company’s financial affairs. Expectations of increased transparency led to considerable optimism for the future of financial reporting under IFRS, and the optimism was fueled by widespread formal adoption of IFRS around the world.
4. Potential benefits of IFRS adoption
There were numerous expected benefits of IFRS adoption that were espoused by commentators of all stripes, including accounting firms, standard setters, politicians, administrators, the press, managers, analysts, and academics. Most of the expected benefits involve the efficiency of markets. As noted earlier, the benefits of any systems innovation when it is undertaken are expectations, not known facts.
Asset markets. Many of the potential benefits of IFRS were thought to lie in the equity and debt markets. Increased financial statement transparency promises higher information quality and reduced information risk to shareholders, and also to lenders. The benefits could occur by the direct channel of providing more information in the financial statements, or indirectly by reducing the cost or increasing the credibility of information supplied through other channels. For example, standardization of accounting rules could reduce the cost of analysts’ research. Uniform accounting rules also could increase comparability across firms in different countries, and reduce the cost of creating standardized international financial databases. From a social welfare perspective, the anticipated outcome would be better public information and hence more accurate valuation in the equity and debt markets (i.e. better prices).
Cost of capital to public corporations. A related and widely touted potential benefit of IFRS adoption was a reduction in the cost of capital to public companies. The reasoning here was that if more information becomes available to investors, their investments will be perceived to be less risky, and as a consequence investors will require a lower return from investing. From a social welfare perspective, the anticipated outcome would be increased wealth, due to increased valuation of existing capital and increased capital creation.
Corporate governance. IFRS adoption was expected to improve corporate governance via several channels. Providing managers with information that is timelier and more accurate could improve decision-making. Rendering managers’ actions and their consequences more transparent could enhance monitoring by boards, investors, analysts, rating agencies, press, etc. Facilitating cross-border mergers, both actual and threatened, could increase the competition to manage the firm. In many adopting jurisdictions’ prior domestic rules, there were no impairment standards comparable to IAS 36 and IAS 38, so timelier loss recognition was expected. This could lead managers to face the music and fix bad decisions earlier; furthermore, the prospect of timelier loss recognition could incent them to undertake fewer pet projects, trophy acquisitions and ill-considered investments in the first place.Footnote1 From a social welfare perspective, the anticipated outcome from all these channels would be a more efficient market for corporate control and hence more efficient operating, investment and financing decisions.
Markets generally. IFRS adoption was expected to reduce the cost of cross-border contracting with suppliers, labour, customers, lenders, investors, etc., and hence to expand the quantity of international transacting in all of the markets in which public corporations participate. From a social welfare perspective, the anticipated outcome would be increased efficiency of markets generally.
All things considered, the perceived benefits of widespread IFRS adoption in 2005 were substantial, being spread across numerous markets and countries, and as a result the event was associated with great enthusiasm.
A decade later, it is still too early to identify the extent and character of the actual benefits that have been obtained. I will argue below that demonstrating the magnitude or for that matter the existence of these benefits is elusive, despite several optimistic attempts to do so. It is not even clear who the ultimate beneficiaries of IFRS adoption would be, or where the benefits could be observed by researchers.
5. Widespread formal adoption by jurisdictions
By 2005 there already was widespread formal adoption by jurisdictions of IFRS for public companies, and that remains the case. In the meantime, exactly what adoption means in various jurisdictions has been clarified to a large degree by a systematic review of 140 countries that was conducted by the IASB, which is summarized in .Footnote2 The analysis covers approximately 70% of all countries worldwide in terms of numbers, including most countries of substantial size. Salient statistics include:
116 of the 140 reviewed countries (83%) require essentially all public companies to report using IFRS. They are listed in .
Not surprisingly, the highest frequency of adoption (98%) is in Europe.
The 116 adopting countries cover 58% of the world’s GDP.
An additional 12 countries permit but do not require public companies to report under IFRS. Four other countries either are in process of adopting or substantially converging to IFRS, or require IFRS for financial institutions only. These are listed in .
Only 8 of the 140 countries (6%) have retained domestic standards for public companies. They also are listed in .
The four most populous countries (China, India, Indonesia, and the US) to date have not adopted IFRS. This also is the case for the three largest economies (China, Japan, and the US).
While China has not formally adopted IFRS, it has signed memoranda with the IASB in 2005 and again in 2015, endorsing convergence. China’s case is discussed further in Section 12.
The US has retained US GAAP, at least for the foreseeable future and perhaps indefinitely. Nevertheless, the US Securities and Exchange Commission (SEC) permits nearly 500 foreign companies with securities that are traded in the US to report under IFRS without requiring a Section 20-F reconciliation to US GAAP.Footnote3 In terms of both the number and the aggregate capitalization of the firms involved, this makes the US one of the world’s largest IFRS adopters. Some conjectures on future US decisions on IFRS for domestic companies are offered in Section 13.
Table 1. Status of IFRS adoptiona.
Table 2. The 116/140 countries that require IFRSa.
Table 3. The 24 jurisdictions that have not adopted IFRSa.
Thus, while there remain a handful of holdout countries, most notably China and the US, the overall record of formal adoption is impressive indeed.
6. Forces against uniformity in reporting practice
Even complete global IFRS adoption by jurisdictions would not in itself imply uniformity in how companies around the world actually report. This section explores the limits to globalization and two major two sources of slippage between formal adoption and reporting practice: uneven adoption of IFRS as issued by the IASB; and uneven implementation of the adopted standards. The simple fact that most economic and political forces remain local rather than global lead one to expect considerable slippage: that is, to expect substantial variation across jurisdictions at the coal face, in actual reporting.Footnote4
Why is this an important issue? It is important because mere adoption of IFRS is considerably less costly than building, maintaining, and operating the complex institutional structure required for adoption to translate into practice. For example, consider the gold standard of complete comparability, the hypothetical property of financial reporting that two otherwise identical companies reporting in different jurisdictions would report identical financial statements. Achieving this ideal is by no means guaranteed by formal adoption alone: it requires adoption of identical versions of IFRS and their consistent implementation across jurisdictions.
6.1. Limits to globalization
By way of background, it is helpful to reflect on why increased convergence in accounting standards has occurred, and why it has occurred in present times. The underlying force behind increased globalization in accounting is increased globalization of the markets in which financial statement information is used (capital, product, supply, labor, corporate control), and increased globalization of the political forces that also influence financial reporting. Increased cross-border transacting in all markets increases the demand for convergence in accounting language and reporting standards.Footnote5 In parallel, political processes have become more trans-national, most notably in Europe.
However, despite substantially increased globalization over recent decades, the world still is in many ways more local than global. This is the case for important variables such as the roles of various stakeholders in the economy and in politics; the contexts in which financial statement information is used; and the complex web of institutions (legal, professional, corporate, educational, etc.) that interact with and complement financial reporting standards in determining actual reporting practice. The conclusion is that local forces will continue to exert an influence on actual financial reporting practice, and that the degree of influence could be considerable in many countries and circumstances. The fundamental limit to uniform IFRS adoption and implementation therefore is that – despite their increased global character – the incentives of parties influencing financial reporting practice (managers, auditors, regulators, courts, boards, block shareholders, politicians, analysts, rating agencies, press, etc.) remain primarily local. There are limits to globalization.
It is worth noting that the European perspective on this issue is atypical. During the past five or six decades, the European Union (EU) and its precursor bodies has converged member countries’ markets and governments to a substantially greater degree than has occurred elsewhere. But as recent events have demonstrated, even within Europe local considerations – across countries and even across regions within countries – have demonstrated the limits to the notion of uniform standards.
It perhaps is no coincidence that so far domestic standards have been retained by the world’s four most populous countries (China, India, Indonesia, and the US), and its three largest economies (China, Japan, and the US). These countries presumably encounter larger than average domestic political and economic forces.
Against this background, I now explore the largest constraints on uniform financial reporting practice: uneven adoption of IFRS as issued by the IASB; and uneven implementation of the adopted standards.
6.2. Uneven adoption
One concern at the outset (Ball Citation2006) was that countries would adopt different versions of IFRS, to the point where the notion of the standards being truly international could be questioned. For example, countries or regions could carve out particular standards or parts of standards that are domestically unacceptable economically or politically, simply by adopting their own version of IFRS. Alternatively, countries could modify particular standards by changing those provisions in the standards that were found to be unacceptable. A case in point is IFRS as Adopted by the EU, which differ in several respects from IFRS as Issued by the IASB. The most prominent difference is the EU’s modification of IAS 39 on financial instruments to soften the impact of that standard on financial institutions’ balance sheets during the Global Financial Crisis. Even differences in commercial concepts, language and institutions can lead to variation in how IFRS as Issued by the IASB translate into local standards.
This concern has proven to be largely if not entirely ill-founded. Setting aside enforcement for the moment, a remarkable feature of the formal adoption by more than 100 jurisdictions to date has been the degree of its uniformity. Nevertheless, the IASB survey quoted in section five does appear to paint a somewhat optimistic picture. The Nobes (Citation2006, Citation2013) survey details a more nuanced reality, revealing variation across jurisdictions in the exact version of IFRS formally adopted, in the translation of IFRS into national languages and concepts, in selection by companies from among the optional treatments afforded by IFRS, in enforcement, and in accounting methods choices made when the standard offers alternatives. How important these differences are in terms of affecting the financial numbers that firms report in practice – and their comparability across jurisdictions – is another matter.
Even if different versions of IFRS have been adopted, the variance in standards across jurisdictions is considerably lower after 2005 than previously. Increased globalization of accounting standards is a fact. At the same time, jurisdictional differences in standards have persisted. National political and economic forces also are strong (Ball Citation1995, Citation2006), and it would be fanciful to assume they are not.
6.3. Uneven implementation
Actual implementation of the formally adopted standards is another matter entirely. There are valid reasons to expect cross-jurisdictional differences in implementation to exist and perhaps to be substantial. First, financial reporting involves a considerable degree of estimation and judgment, particularly so under IFRS. Second, the complex market, political and general institutional forces that come to bear on how corporate managers report to the public remain largely local, and differ substantially among countries. Third, actual implementation is not guaranteed by establishing regulatory enforcement mechanisms, and requires all of the forces that affect how managers report to be aligned. I discuss each in turn.
6.3.1. The role of estimation and discretion
All accounting accruals involve some degree of judgment about future cash flows. As some accounting scandals have revealed, even counting cash (Parmalat) and operating cash flow (Enron) can be manipulated, but it is in the accruals adjustments to cash flow where the role of judgment primarily applies. All working capital accruals (such as unearned revenues, bad debt allowances, income tax expense and inventory valuation adjustments) involve estimates of future outcomes. Longer-cycle accruals such as asset impairment charges, loss provisions, health care and pension costs and liabilities, deferred tax valuation adjustments, and bank loan loss provisions involve estimates of outcomes at more distant future dates. Consequently, there is much leeway in practice in how all accounting standards are implemented.
This is especially the case with IFRS, for several reasons. The IASB has designed IFRS standards that – especially relative to US GAAP – outline broad principles rather than detailed rules, and hence provide more latitude in implementation. Whether this is deliberately designed to provide the IASB’s wide range of constituents a wide range of choices in implementation is another matter, but whatever the motive it does provide greater discretion.
In addition, Nobes (Citation2013, ) identifies 31 choices among alternative accounting methods that are offered in IFRS. For example, IAS 16 and IAS 38 provide a choice between reporting certain long-lived assets at cost or at fair value. While the choices typically are constrained (e.g. they cannot be changed frequently), they provide an additional layer of discretion to managers. Nobes (Citation2013, section 5.2) surveys evidence indicating that the choices made vary along national lines, further testament to the thesis that economic and political forces remain local as well as global.
IFRS also make considerable use of fair value accounting, which books assets and liabilities at amounts that are conceived via hypothetical transactions. Fair values are accounting accruals, not actual arm’s length market transactions, allowing implementation differences. Even for short-cycle items such as financial instruments, only a minority of the IFRS adopting countries possess deep financial markets. Consequently, the reliability of fair values in many jurisdictions is affected by thin trading, illiquidity, wide spreads, subjective mark to model estimates and even government-administered prices. The jurisdictions in which this is the greatest problem tend to have the weakest enforcement institutions (audit profession, legal protections, regulation, boards, analysts, press, etc.) and greatest political involvement.
For longer-cycle items such as property, plant, and equipment, exercising the option to fair value builds an entirely different level of judgment into the financials. Fair-valuing long-cycle assets involves forecasting cash flows over substantial horizons, an exercise that requires judgment and provides managers with discretion over the private information they reveal. Similarly, asset impairment charges are long-cycle accruals and they play a more prominent role in IFRS than in many adopting countries’ prior domestic standards. Because these accruals utilize manager and auditor judgment, they are subject to local political and economic influence.
The conclusion is that rules alone do not determine actual reporting practice. Estimation and discretion are required. This point appears to have been under-appreciated when expectations of cross-regime comparability were formed around the time of IFRS adoption.
6.3.2. Local politics, economics, and institutions
Without pointing fingers at specific countries, it should be clear that the list of formal adopters in includes regimes where there is little incentive for high reporting quality in practice (e.g. for low earnings management, timely loss recognition, high transparency) and even little tolerance of it. Does anyone really believe that implementation will be of equal standard in all of the countries? Many of the countries counted among the 116 adopters simply do not have the infrastructure to enforce actual implementation, even if they wanted to. Many will not want to, due to domestic political and economic factors.
6.3.3. Evidence on incentives versus standards
In addition to the above a priori reasoning, there now is considerable evidence that differences in IFRS implementation do in fact matter. Ball et al. (Citation2000b, Citation2003) report financial reporting quality measures in China and four East Asian countries that are more consistent with the domestic incentives of those influencing actual reporting practice than they are with the countries’ adopted accounting standards, including IAS (the precursor to IFRS). This is described as the primacy of incentives over standards. Following in this tradition, Daske et al. (Citation2008) observe benefits to investors (increased market liquidity and Tobin’s q, reduced cost of capital) from IFRS adoption only in countries with strong legal enforcement mechanisms and where firms have incentives to be transparent. The presumption underlying these capital market measures is that they reflect the quality of information available to investors. Daske et al. (Citation2013) distinguish between firms with high and low reporting quality incentives, which they classify as serious and label voluntary IFRS adoptions. They report that the former are associated with market liquidity and cost of capital benefits, but the latter are not. From a study of German IFRS adopting firms, Christensen et al. (Citation2015) conclude that when higher quality accounting standards are mandated, accounting quality improvements are only observed in firms with incentives to comply. Cascino and Gassen (Citation2015) study the effect of IFRS adoption on compliance and comparability among German and Italian firms. They conclude that incentives (measured at the firm, region, and country levels) affect compliance and that only firms with high compliance measures experience substantial increases in comparability.
6.3.4. Implementation and regulatory enforcement mechanisms
The literature surveyed in the previous section underscores the importance of incentives in the implementation of international standards. The emerging consensus is that changes in rules have little effect on financial reporting quality without incentives of preparers to actually implement them. How are incentives affected by the establishment of governmental (regulatory) enforcement mechanisms?
Here too there is evidence. Christensen et al. (Citation2013) use liquidity in the market for companies’ shares to measure the quality of information available to investors. They observe liquidity increases around IFRS adoption only within the EU. Within the EU, liquidity increases occur only in the five countries with substantial concurrent improvements in regulatory enforcement. Benefits were greatest for companies whose prior domestic standards differed most from IFRS, provided they operated in a strong regulatory jurisdiction.
An unexpected benefit of IFRS adoption in Europe has been increased attention being given to enforcement mechanisms. But even within the EU, at the time of IFRS adoption its member states declined to establish a supra-national body to scrutinize financial reporting, and instead asked the Committee of Securities Regulators to develop common enforcement standards for the separate national bodies.
Enforcement by regulators is but a subset of enforcement mechanisms generally, which include internal and external auditing, as well as monitoring by boards, security analysts, whistle-blowers, private parties on the other side of irregular transactions, short sellers, the plaintiffs bar, and the press. For example, accounting fraud in the US typically comes to light through mechanisms other than the SEC (Dyck et al. Citation2010). The quality and independence of these mechanisms varies across jurisdictions. Many factors can cause them to differ, including a corrupt or ineffective or underfunded policing body, unsympathetic or ineffectual legal systems, and explicit or implicit political pressures or mandates to take it easy on poor quality reporting. These factors are likely to vary considerably across the 116 IFRS adopting countries – another reason for uniform adoption to not translate into uniform reporting practice.
6.3.5. Implementation and transparency
A commonly perceived benefit of adopting IFRS standards is increased transparency about the company’s financial affairs. But uneven implementation across regimes raises the question of whether widespread IFRS adoption means that differences in implementation now substitute – at least to some degree – for previous differences in adopted rules.Footnote6 Stated alternatively, to what extent does widespread IFRS adoption sweep real differences in reporting practice under the rug? Can uneven implementation of uniform rules actually reduce transparency and increase user information processing costs, by burying actual reporting differences across regimes at the less transparent level of implementation, as distinct from the more open level of using different standards?
6.4. One policy implication: institutions are complements
The experience to date with widespread IFRS adoption highlights the complexity of the regime-level web of complementary economic, political, legal, and social institutions that affect financial reporting behavior. Institutional complementarity implies that turning one dial at a time tends to have limited effectiveness. In the specific context of IFRS adoption, the evidence indicates that changing the rules is ineffective by itself: more dials need turning before the players involved believe it is in their interests to actually increase reporting quality.
This perspective would seem particularly relevant for the numerical majority of the 116 IFRS adopting regimes listed in that have limited infrastructure. Indulging in the luxury of citing myself (Ball Citation2001, p. 128):
An economically efficient public financial reporting and disclosure system requires the following infrastructure: training an audit profession of adequate numbers, professional ability, and independence from managers to certify reliably the quality of financial statements; separating as far as possible the systems of public financial reporting and corporate income taxation, so that tax objectives do not distort financial information; reforming the structure of corporate ownership and governance to achieve an open-market process with a genuine demand for reliable public information; establishing a system for setting and maintaining high-quality, independent accounting standards; and, perhaps most important of all, establishing an effective, independent legal system for detecting and penalizing fraud, manipulation, and failure to comply with standards of accounting and other disclosure, including provision for private litigation by stockholders and lenders who are adversely affected by deficient financial reporting and disclosure. The scope of these requirements is unavoidably wide, because the accounting infrastructure complements the overall economic, legal, and political infrastructure in all countries.
Put simply, uniform accounting standards do not guarantee uniform reporting practice, because many regimes lack the complementary infrastructure for that to occur.
7. Other concerns about IFRS adoption
Naturally, any substantial systems innovation when it is undertaken comes with concerns which, like the expected benefits, are not known facts at the time, and mostly remain conjectural for some time. It would be unusual if IFRS adoption was an exception, even though public commentators generally expressed few concerns in the lead-up to 2005. With this in mind, the current section attempts to provide a counterbalance to the almost unqualified enthusiasm with which that historic event was received.Footnote7
7.1. One global brand name
A longer-term concern of widespread IFRS adoption arises from allowing countries to use the IFRS label, regardless of how interested they are in high-quality financial reporting and whether they possess the institutional structure to achieve it. One potential effect is dilution of the IFRS brand name. Another is that a uniform IFRS label discards information about reporting quality differences.
This raises the question of why countries with endogenously low financial reporting quality would adopt IFRS in the first place. Some insight is provided by the Spence (Citation1973) signaling model, which holds that a signal needs to come at some cost to be credible. Suppose that all regimes have hitherto only been able to place their own labels on their firms’ financial reporting (i.e. certifying that they meet endogenous domestic standards). Suppose there subsequently arises an opportunity to relabel their firms’ financial reporting as meeting the standards of IFRS, which all regimes view as a signal of high quality. Suppose it is costless to adopt the new label. What regime will decline to adopt it? What low-quality regime will continue to voluntarily attach a low-quality label to their financial reporting?
The question then becomes the extent to which the 116 IFRS adopting regimes have backed up their implicit claim of high quality by incurring costs to actually obtain high quality. Adoption per se is low-cost: it merely requires a legislative or administrative act. In even can be argued to come at a negative cost, since the regime now need not incur the cost of operating its own standard-setting body. Further, low-quality regimes that adopt IFRS need not incur all the costs of actually implementing the new standards. They are more likely to have weak institutions (be without a strong audit profession, independent boards, effective courts, etc.).
These issues are not central in the current debate, but could become important over time.
7.2. Reduced competition in standard setting
Competition among alternative economic systems, including financial reporting systems, is conducive to healthy innovation. History is replete with examples of one system learning from the institutional structure of a competing system, the most famous example in accounting being the near worldwide adoption of the Italian method of double entry bookkeeping. It is worth noting that this is how a variety of code law countries, including most of Continental Europe, came to adopt – in the form of IFRS – a set of standards that are founded on common law notions such as them being developed by a non-government body, high reporting transparency, the role of economic substance over legal form, and separation from tax accounting rules.Footnote8 In my view, adopting uniform worldwide standards invites risky centralization and reduced innovation.
7.3. Conceptual framework
The IASB has put considerable effort into developing a conceptual framework, which it currently describes as follows:Footnote9
The Conceptual Framework describes the objective of, and the concepts for, general purpose financial reporting. It is a practical tool that:
a. assists the IASB to develop Standards that are based on consistent concepts;
b. assists preparers to develop consistent accounting policies when no Standard applies to a particular transaction or event, or when a Standard allows a choice of accounting policy; and
c. assists others to understand and interpret the Standards.
The desirability of a conceptual framework is taken for granted by many. One source of demand for such a framework is discomfort with a case-based approach to standard setting. Another source is those who place a high value on a coherent logical hierarchy of authorities, ranging from abstract premises to detailed rules and practices.
My own view is that conceptual framework is a Hayekian (Citation1988) conceit, a delusion, and a snare. It is a conceit because the world is complex and untidy, and not organized by a small set of ideas like a conceptual framework. So I am comfortable with a process of common law case-based adjudication of issues as they arise, which can appear untidy, and I am skeptical of centralized planning of activities (industries?) like worldwide financial reporting.
Does (say) the worldwide automobile industry need a centralized planning document to design and make vehicles that buyers of different types find useful? Do law, medicine, engineering, and other professions (begging the question of whether accounting still can be described as a profession) have universal conceptual frameworks?
A conceptual framework in accounting also has proven to be a delusion, despite attempts over at least half a century to prove otherwise. As well documented in Zeff (Citation1999), the US experience with conceptual frameworks over a considerable period of time has not been very positive. In the 1960s, the Accounting Principles Board of the American Institute of Certified Public Accountants published a series of Accounting Research Studies that were designed to lay the foundation for such a framework, but they had little impact on its rule-making, or on reporting practice. A similar fate met the 1973 Trueblood Report and the FASB’s six Statements of Financial Accounting Concepts issued from 1978 to 1985. In 2004, the FASB and the IASB commenced a joint project to develop a common conceptual framework, the first phase of which was completed in 2010. Since then, the FASB appears to have lost interest in working on a conceptual framework, and has busied itself in rule-making. The IASB by all accounts remains keen on having one, but as its description of the project cited above shows, by 2015 it has dropped international convergence as an objective of the Framework.Footnote10
Finally, a conceptual framework can prove to be a snare, because it can incent the planner that adopts and – and becomes deeply committed to it – to ignore evidence of its unintentional consequences. No planner’s framework is foolproof. None can anticipate all the future events it will be required to address, and as a consequence solutions that would seem optimal under the circumstances can be blocked due to their inconsistency with the framework.
An important example of the undesirable consequences of imposing such a matrix on rule-making is the role of financial reporting in contracting contexts, including (but by no means limited to) its role in stewardship and more widely in contracting. This issue appears to have caused some tension between the IASB and those commenting on earlier drafts of its framework, and to have led the Board to make several clumsy patches to it. The saga is discussed further in the following two sections.
7.4. Summary of concerns
While I have spent more time discussing the concerns associated with widespread IFRS adoption than on summarizing the expected benefits, that is not because I believe they are in some sense weightier. Rather, it is because the concerns are less obvious and have been given less exposure in the public discourse.
As is the case with expected benefits, a decade later it is still too early to evaluate most of the concerns raised, some of which pertain to long term effects. One concern expressed in Ball (Citation2006) – that countries would adopt substantially different versions of IFRS – has proven to be somewhat over-stated, even if justified to a degree. Another – that countries would enforce and implement IFRS differently – has proven to be well-founded. But it remains early days.
8. Unintended consequence: IFRS and the use of accounting information in contracting
The Law of Unintended Consequences reminds us that purposeful intervention in a complex system normally leads to unanticipated outcomes, both good and bad, however well-intentioned the intervention may be.Footnote11 So it would be surprising if a substantial system intervention like IFRS did not lead to some blind alleys.
A case in point originates in the vexed difference between the value relevance and costly contracting perspectives on financial reporting. It is a fundamental proposition that the optimal accounting system depends on the use made of the information it produces. The proposition is demonstrated by Gjesdal (Citation1981), who compares accounting information in firm valuation and with its use in stewardship, or contracting with managers.
In its Conceptual Framework project, which seeks a unitary perspective on financial reporting, the IASB has struggled to reconcile these competing demands. It initially adopted a valuation-centric approach to financial reporting and consequently treated stewardship as unimportant. Its reasoning was outlined in a Discussion Paper on which comments were solicited (IASB Citation2006, ¶ BC1.40 and BC1.41):
The relationship of an entity’s management and its owners is essentially the same as that of an agent (management) that acts on behalf of a principal (shareholders or other owners). The economic interests of management may not always be the same as those of shareholders. Members of management may have the ability to take advantage of their position in various ways, for example, to enrich themselves unjustifiably (that is, beyond agreed-upon remuneration) at the expense of owners.
Some of the concern about stewardship seems to stem from the potential tension between the interests of management and those of shareholders. The boards acknowledge that those are important issues that standard-setters need to keep in mind. Financial reports generally are useful to those with the responsibility for making decisions about management remuneration and monitoring management’s dealings with an entity’s owners because financial reports include the effects of all transactions engaged in by management on behalf of owners, as well as transactions between the entity and members of its management. But providing information for the specific purpose of helping to decide what constitutes excessive remuneration or unjust enrichment is not the purpose of financial reporting.
This position received substantial negative feedback. In an analysis of the comments received, Accounting Standards Board et al. (Citation2007) noted that 78% of those addressing stewardship stated it should be a separate objective of financial reporting. Respondents stated that the absence of a stewardship objective would weaken shareholder rights, would give excessive emphasis to the secondary market for companies’ shares, as distinct from real decisions within firms, and would have other undesirable effects.
The IASB responded with a revised draft (IASB Citation2015a) using the term stewardship 18 times, but falling short of endorsing it as a distinct reporting objective and incorporating it in a seemingly perfunctory manner. The Board expressed the reasoning behind its current position as follows (IASB Citation2015b, ¶ BC1.10):
For the following reasons, the IASB rejected the idea of identifying the provision of information to help assess management’s stewardship as an additional, and equally prominent, objective of financial reporting:
(a) information about management’s stewardship is part of the information used to make decisions about whether to buy, sell or hold an investment (i.e. resource allocation decisions). … ; and
(b) introducing an additional primary objective of financial reporting could be confusing.
The first-listed reason seems an attempt to finesse the valuation-stewardship divide by defining stewardship as a subset of valuation. This sleight of hand allows the Board to retain a unitary objective of financial reporting, under which the only game in town is valuation.
Taking a valuation perspective on stewardship ignores important dimensions of how accounting information is used in contracting with managers. Contracts between firms and its managers commonly provide accounting-based mechanisms to better align the incentives of managers and owners. Firms commonly contract with managers based on variables such as revenue, net income (before or after special items, discontinued operations, depreciation and amortization, interest, taxes, etc.), rate of return on assets, and rate of return on equity, for example, by paying bonuses if target levels are obtained. This use of accounting information – in contracting with managers – cannot readily be shoe-horned into valuation.
More importantly, the Board’s position ignores important uses of accounting information in a wider range of contexts than contracting with managers. These include debt, supply, royalties, licensing, dealership, and other commercial arrangements. These contractual uses of accounting information do not constitute valuation. For example, debt pricing is a different (though related) matter than debt covenant design. It appears that important uses of financial statements in contracting contexts are difficult to fit into the Board’s valuation-centric world view, so they are pushed to the side.
The second reason given by the IASB for downgrading stewardship (that otherwise it could be confusing) underscores the notion that the world as a complex and untidy place that cannot organized by a small set of ideas in a single document like a Conceptual Framework. It denies the reality that rule-makers sometimes have to balance competing demands on financial reporting that are not reconcilable to a small set of ideas and that might imply that different rules are optimal.
Some insight into these issues comes from the relation between IFRS introduction and the use of accounting information in debt contracting, the topic of the two following sections.
9. IFRS introduction and accounting information in debt contracting
As outlined in Section 3, IFRS introduction is generally believed to have increased financial reporting transparency, meaning that IFRS-compliant financials are more informative about the firms’ financial affairs. Assuming that is so, would that improve financial statements from the perspective of all users?
Here there arises the distinction between transparency and contractibility. Even if IFRS financials are more informative, that does not necessarily make them more useful in contracting. Indeed, in the context of debt contracting, IFRS standards introduce some potential drawbacks.Footnote12 Many of these drawbacks could well apply in other contracting contexts, but the discussion that follows is addressed toward debt contracting alone.
Relative to the prior domestic standards of IFRS-adopting countries, the new standards provide borrowing firms with more discretion over the reported numbers that would be used in accounting-based debt covenants. First, IFRS make considerably more use of fair value accounting measurements. The subjectivity involved in estimating fair values, particularly for longer-cycle assets, impairs contractibility. Second, many IFRS standards provide borrowers with choice among accounting methods, as documented in Nobes (Citation2013). Third, IFRS are principles-based, providing fewer implementation rules and accordingly giving managers wider discretion in implementation.
In addition, fair value accounting incorporates into firms’ earnings a larger number of shocks to firms’ asset values. While this might render balance sheets more informative, the shocks that are incorporated into earnings are transitory.Footnote13 Thus, a gain or loss in value that is incorporated into current-period earnings will not repeat in future earnings. This renders current earnings a poorer predictor of future earnings. For longer-term debt, this reduces the usefulness of earnings as a predictor of future debt service capacity.
IAS 39 (revised in IFRS 9) gives firms the option to fair value certain of their own liabilities. Debt is an agreement to repay principal and interest at the historically contracted rate. The amortized cost method records the present value of that obligation, discounted at the historical contractual rate. Consequently, a balance sheet that records assets at cost less any impairment and liabilities at amortized cost provides an effective mechanism to trigger new rights to lenders when the ratio of assets to liabilities falls. Debt is not an agreement to repay fair value. The effectiveness of a contractual trigger mechanism based on balance sheet leverage is much reduced when debt can be written down to fair value whenever credit quality deteriorates.
One possible response from lenders and borrowers would be to exclude some earnings and balance sheet components from the contractual definitions of earnings and balance sheet quantities, as studied by Li (Citation2010). However, the audited financial statements provided to lenders do not always provide sufficient information to do so. Another possibility would be to contract on the basis of frozen GAAP, which would require keeping parallel sets of records under prior domestic standards. This would lose feasibility over time as newer internal accountants and external auditors are not trained in old methods and old software becomes obsolete. It would require multiple accounts to be kept for companies making multiple debt issuances at different points in time.
For many firms, the more efficient response would be to simply reduce the use of accounting-based covenants such as leverage and interest coverage restrictions, and perhaps substitute non-accounting covenants such as restrictions on new investment, asset sales, and new debt issuance. What is the evidence?
A study of 3037 new debt issuances over 2001–2010 investigated how their contractual terms changed after the 2005 IFRS adoption date. It compared 1362 new issuances in 22 IFRS-adopting countries (the treatment sample) with 1675 new issuances in 21 non-IFRS-adopting countries (the control sample).Footnote14 There was a substantial fall of approximately 50% in accounting covenant use post-adoption. Conversely, there was an increase in non-accounting covenant use. For banks, the reduction in accounting covenant use after IFRS adoption was considerably larger, with the prime suspect being banks’ greater use of fair value accounting for assets and liabilities.
As will be discussed in the following section, there are limits to what can be concluded from early evidence of IFRS adoption effects, but the results described above do provide some food for thought about the IASB/FASB focus on valuation uses of financial reporting at the exclusion of contracting uses.
10. Conservatism, prudence, and conditional conservatism
A related issue is the position of the IASB and FASB on the concepts of conservatism, prudence, and conditional conservatism. Conservatism has long been a well-known attribute of accounting, and the notion that it is linked to the use of accounting information in the debt market goes back at least as far as Gilman (Citation1939). Conditional conservatism refers to timelier financial-statement recognition of losses than gains. An extensive and long-standing literature holds that this asymmetry in accounting is due in large part to the use of financial statement information in debt contracting, and also to its use in firms contracting with managers. The literature includes Leftwich (Citation1983), Watts and Zimmerman (Citation1986), Ball et al. (Citation2000a), Ball (Citation2001), Holthausen and Watts (Citation2001), Ahmed et al. (Citation2002), Watts (Citation2003a,b), Ball and Shivakumar (Citation2005, Citation2006), Beatty et al. (Citation2008), Wittenberg-Moerman (Citation2008), Zhang (Citation2008), and Aier et al. (Citation2014).
Nevertheless, it is fair to say that the IASB and FASB have tried to expunge the term conservatism from their vocabulary and have only reluctantly – after receiving substantial negative feedback – recently embraced the term prudence in its stead. Even then, the new approach involves internal contradictions.
The draft Conceptual Framework states (IASB Citation2015a, p. 2.15): To be a perfectly faithful representation [of economic phenomena], a depiction would have three characteristics. It would be complete, neutral, and free from error. Responding to criticism that an earlier draft did not endorse conservatism, the Board introduced the concept of prudence (conservatism being on the outer as a term), and attempted to reconcile it with its neutrality criterion as follows (IASB Citation2015a, p. 2.18):
Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution when making judgements under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. Equally, the exercise of prudence does not allow for the understatement of assets and income or the overstatement of liabilities and expenses, because such mis-statements can lead to the overstatement of income or the understatement of expenses in future periods.
This attempt to reconcile neutrality and prudence/conservatism is unconvincing. To me at least, the concepts are inconsistent.
The position also is inconsistent with the IASB’s own standard-setting. IAS 36 requires asset impairments to fair value (i.e. downward revaluations), but does not require upward revaluations. Similarly, IAS 38 requires intangible asset impairments, but not revaluations generally. While IAS 16 provides a fair value option for property, plant, and equipment that is symmetric, and IAS 36 allows impairment reversals, there is a distinct asymmetry in these rules that is inconsistent with neutrality and is more consistent with conditional conservatism.
11. Some comments on research and IFRS standard-setting
A particularly pleasing feature of the public discourse surrounding IFRS over past decades has been the extent to which academic research has addressed issues of interest to those involved in standard-setting, and the extent to which those involved in standard-setting have taken note of the research. The advocacy of using current market prices by early scholars such as Chambers (Citation1966) set the stage for the current emphasis on fair value accounting by the IASB and the FASB. More recently, the Boards appear to have begun to digest the implications of research on contracting and stewardship, which seem to have influenced revisions in the Conceptual Framework, if not substantially.
There already is a large and growing academic literature focused on the effects of IFRS adoption, which makes for a natural marriage between standard setting and research. For standard setters, wholesale revision of the accounting standards by any jurisdiction is a leap into the unknown, so subsequent evidence of its consequences – both intended and unintended – is potentially very useful to those responsible for the decision. For researchers, the 2005 adoption event provides a rare quasi-experiment involving a very substantial change in financial reporting in many countries and by a very large number of public firms. So it is not surprising that the event has precipitated a substantial body of research, including some commissioned or surveyed by accounting bodies such as the Association of Chartered Certified Accountants (ACCA) and the ICAEW. In reviewing its decade-earlier decision to adopt IFRS, the European Commission (Citation2014, Citation2015) undertook an extensive and detailed survey of the literature on its effects. So, in the particular context of IFRS, there is considerable evidence of research informing standard setting.
Nevertheless, this section offers some cautionary observations about the use of research in the context of establishing and evaluating IFRS. The observations are not intended to place a damper on this pleasing process, but rather to inject a note of realism into it. The observations concern the limitations in the data used in collecting evidence of effects of IFRS adoption.
11.1. Data limitations
Several characteristics of the available data limit the inferences that can reliably be drawn from them, including:
As noted in Section 2, it still is early days. Only 10 years have passed since the big 2005 adoption event, which gives researchers only 8–9 years of post-IFRS data to study.
One half or more of the post-IFRS data are affected by the Global Financial Crisis and subsequent economic malaise.
Other institutional changes occurred around the time of IFRS adoption, including changes in enforcement. Confounding events make it difficult to identify IFRS effects per se.
Because many countries and firms adopted IFRS essentially simultaneously, it is easy for the researcher to overstate the statistical significance or reliability of estimated effects (i.e. to understate the standard errors).
The short- and long-run effects of innovations can differ, sometimes substantially. One process is diffusion, in which an innovation spreads over time. At the other extreme is correction, in which initial enthusiasm wanes and consequently adoption effects fall over time. Which model applies to IFRS adoption? How representative are initial effects of long-run effects?
Even if substantial in aggregate, many beneficial effects of IFRS adoption are likely to be spread across the adopting economies, and to be small and difficult or impossible to observe in individual firms. Examples include the effects of: standardization of concepts and language; standardized structure of financial statements; and reduced costs of maintaining international databases. Similarly, the costs of training a new generation of accountants and users, akin to the costs of learning a new language, are not easily measurable and likely do not lie in the firm-level data typically studied by researchers.
11.2. Flawed or incomplete theory underlying the tests conducted
An additional limitation of available research is that the theory as to where researchers would see the costs and benefits of IFRS adoption is not well developed. I will illustrate this point in the context of two areas of research: value relevance and cost of capital studies.
11.2.1. Value relevance studies
Ball and Brown (Citation1968) first demonstrated the value relevance of accounting information, in the form of an association between changes in companies’ market values and changes in the earnings numbers produced by the actual financial reporting system in place at the time. But applying a value relevance criterion to evaluate accounting innovations such as IFRS adoption is another matter entirely.Footnote15
An example of applying a value relevance criterion to evaluate IFRS adoption is the Lee et al. (Citation2013) report on China converging its reporting standards to IFRS in 2007. The report was commissioned by the ACCA. It purports to show that convergence increases value relevance, particularly for companies with greater legal, governance, and commercial incentives for high-quality financial reporting. The criterion is justified as follows:
Value-relevance analysis examines the association between the share price of firms and the accounting information they issue, such as book value and earnings. It is inferred here that the higher the association, the more useful the accounting numbers issued by firms are to the valuation decisions of investors, who are an important group of end-users of financial statement information.
The inference is far from clear.Footnote16 The major problem with using correlation with share prices as a benchmark is that it takes share prices as exogenous. A positive result in this study could simply mean that as a result of convergence companies are now booking into their accounts more of the information that investors already bid into share prices. Why would investors care about how closely earnings or book values correlate with share prices, if they already know the prices?
The appropriate welfare-economic criterion for assessing a financial reporting innovation is not whether it leads to a higher association with share prices. Rather, it is are the prices better? That is, do the prices incorporate more information than hitherto and thus provide better signals to investors and firms? In contrast, a simple correlation with prices takes the prices as an exogenous benchmark. I am aware of no studies of IFRS adoption that asks the correct question.
This point is illustrated by the following extreme hypothetical example. Suppose the accounting rules required every public firm to set the book value of equity on its balance sheet equal to the total market value of its equity at the close of trading on the balance date (price times number of shares), and record earnings as change in market value, adjusted for dividend distributions and net capital contributions. These hypothetical rules would receive the highest possible value relevance score: a perfect correlation between book and market, and a perfect correlation between earnings and returns. But the reported accounting numbers would add nothing to what is known already: they simply would duplicate prices, would be economically redundant, and would do nothing to improve prices (see Ball Citation2001, Ball et al. Citation2008). This hypothetical scenario illustrates the general result that value relevance scores are not by themselves informative about the benefits to investors from systems innovations such as IFRS.
11.2.2. Cost of capital studies
One claimed benefit of IFRS adoption (discussed in Section 5.2) is that investors will require a lower return from investing because firms are now more transparent and investment in them is perceived to be less risky. Equivalently, expected future earnings would sell at a higher price post-IFRS. This story is too simple. The effects of IFRS introduction cannot be analyzed by considering a single firm in isolation.
For example, if all the firms in an industry adopt IFRS and all benefit from higher transparency, the effect is to reduce the industry supply price of capital. Competition among firms in the industry then passes the benefit on to consumers in the form of reduced product prices. Fundamental economics suggests the ultimate beneficiaries may be consumers, not firms or investors, suggesting that researchers studying firms’ capital costs might be looking in the wrong place.
Further, IFRS adoption is a macroeconomic event involving all public firms in more than 100 countries. Increased global transparency means that all firms initially would face a lower supply price of capital, but in response they would be expected to expand investment, increasing the demand for capital and its supply price. This suggests that the expected net effect of IFRS adoption on capital costs might not be large, and would be reflected in the quantity rather than the price of new investment (see García Lara et al. Citation2016).
12. The case of China
China has not formally adopted IFRS, but signed a memorandum with the IASB in November 2005 endorsing convergence of its domestic Accounting Standards for Business Enterprises (ASBE). This memorandum was updated in November 2015, for example, by announcing a joint working group to advance the use of IFRS in the country. Soon after the first agreement, in early 2006 China announced a revision to ASBE that incorporated IFRS.
One might conclude that China is almost an IFRS-adopting jurisdiction. This is the impression one might garner from the IASB’s detailed review, which it summarized by answering its question What is the jurisdiction’s status of adoption? with China has adopted national accounting standards that are substantially converged with IFRS.Footnote17 However, China retained its domestic rules on accounting for related-party transactions, government subsidies and the reversal of impairments of depreciable assets. These are areas of great domestic political and economic significance in China. Especially for politically connected enterprises, the difference between ASBE and IFRS treatments could have substantial effects on their financial statements and on their financial reporting quality. For example, related-party transactions are considerably more common in China than in most western countries, and consequently reported numbers are rendered more malleable by the ability of related parties to vary the terms on which they transact.
Implementation is another problem area. China does not yet possess the institutional structures that are complementary to high-quality accounting standards. For example, in formal terms China has adopted fair value accounting. Implementation of fair value rules is problematic even for short-cycle assets such as marketable securities, because the Chinese government controls the price of many unlisted securities. In general, a combination of political incentives to massage the numbers, weak corporate governance, weak shareholder rights, a compliant press, and inconsistent regulatory enforcement leads one to conclude that China’s substantial convergence exists more in form than in substance.
The case of China illustrates the importance of national political and economic forces. It also highlights the limitations of scoring convergence by counting the number of common standards, as distinct from measuring actual outcomes in the financial statements (Ball et al. Citation2000a).
13. Whither the US?
The US has retained US GAAP for domestic-domiciled firms, at least for the foreseeable future and perhaps indefinitely. Options that have been floated range from retaining the status quo to abandoning GAAP in favour of IFRS, with several intermediate possibilities.Footnote18 The outcome is impossible to predict, so I will confine my remarks to outlining some of the major factors involved in the decision.
(1) The ultimate decision lies with the SEC. The Commission was created by Securities Exchange Act of 1934, and has responsibility for oversight of accounting and auditing for companies with securities publicly traded in US markets.
(2) The SEC conducts an economic analysis of most major initiatives. In its evaluation of the options concerning IFRS, it would be expected to take into account benefits such as those listed in section four above, as well as costs. Hail et al. (Citation2010, Abstract) describe the elements of an IFRS cost/benefit analysis as follows:
Our analysis shows that the decision to adopt IFRS mainly involves a cost-benefit trade-off between (1) recurring, albeit modest, comparability benefits for investors; (2) recurring future cost savings that will largely accrue to multinational companies; and (3) one-time transition costs borne by all firms and the U.S. economy as a whole, including those from adjustments to U.S. institutions.
For example, smaller companies and those without foreign operations are more likely to oppose IFRS, due to positive costs and the absence of perceived benefits.
(3) The SEC decision on IFRS will involve political considerations as well as economic. The Commission and its budgets are products of Federal legislation, requiring it to pay close attention to the political winds. Despite the following (tongue in cheek?) statement on its website, the Commission’s governance structure is subject to substantial political influence:Footnote19
The Securities and Exchange Commission has five Commissioners who are appointed by the President of the United States with the advice and consent of the Senate. Their terms last five years and are staggered so that one Commissioner’s term ends on June 5 of each year. To ensure that the Commission remains non-partisan, no more than three Commissioners may belong to the same political party. The President also designates one of the Commissioners as Chairman, the SEC’s top executive.
The reality is that the political party controlling the White House appoints a majority of the Commissioners, including the chair, and two Commissioners are associated with the other party (e.g. three Democrats and two Republicans). The parties have different views on the role of regulation, so the outcome on IFRS might depend on who is in government at the time the decision is made.
(4) It is hard to imagine the US Government ceding complete sovereignty over accounting standards to a body that is answerable to over 100 countries.
(a) On economic grounds alone, it would seem unwise to comply with an equilibrium arising from all of those countries’ political and economic interests.
(b) On political grounds, and depending on the party in power, there is aversion to ceding authority over the US economy to a foreign organization.
Sovereignty is one of several reasons the FASB (or a reconstituted successor body) most likely will remain in place. Other reasons are discussed below.
(5) It also is hard to imagine the SEC locking itself into the Conceptual Framework, with all the unforeseen consequences that could emerge. That would be a surrender of sovereignty to a document over which it might not be able to exercise substantial influence in future. Because the IASB is beholden to the Framework, the SEC therefore would seem unlikely to fully adopt IFRS as issued by the IASB.
(6) Equally, the SEC seems unlikely to completely retain the complete status quo. It permits foreign companies with securities that are traded in the US to report under IFRS without requiring a Section 20-F reconciliation to US GAAP. But it requires domestic companies to file under US GAAP and, if they also issue IFRS compliant reports (for example, because they issue securities that are traded in other jurisdictions), it requires them provide a reconciliation of IFRS financials to GAAP. US multinationals have complained about the inequity of being required to provide three documents (GAAP, IFRS, and a reconciliation) but their international competitors only being required to file one. At a minimum, the reconciliation requirement would seem likely to be withdrawn.
(7) There are many IFRS-GAAP differences that appear to be unresolvable, despite the considerable effort the two bodies have put into the converging their standards. To date, the problem areas have been leases, financial instruments, insurance contracts, and the Conceptual Framework. This reflects the fact that the FASB and IASB have different political and economic constituencies to answer to. It is a graphic illustration of the general point that politics and economics are not entirely global, and have substantial national characteristics that would be foolish to ignore. Perhaps recognizing this, the FASB has abandoned the convergence project, and neither the FASB nor the IASB continues to use the term. The term implies that at some point the two sets of standards will meet on common ground, which now seems unlikely.Footnote20
(8) It is hard to imagine the SEC regulating the application of a purely principles-based set of accounting standards, without detailed rules. The reasoning underlining this view is outlined in Ball (Citation2009, pp. 310–12) and includes: administrators operate in a world of rules, and regulators generally regulate by creating and enforcing rules; regulating the application of principles involves assessing judgment, and hence comes with a risk of being found wrong, which is anathema to career bureaucrats; and detailed rules provide both financial statement issuers and their auditors with more certainty over regulatory responses to their actions. Again indulging in quoting myself (Ball Citation2009, p. 312):
If the U.S. did attempt a move toward principles-based accounting, for example by allowing domestic companies to report under IFRS, a skeptical prediction is that the SEC would pay only lip service to the change, and this would be fine with the audit firms. Principles-based financial reporting would require companies and their auditors to be both able and willing to make the judgments necessary to apply broad principles in specific circumstances. It also would require SEC staff to be able and willing to evaluate those judgments. A principles-based set of accounting standards such as those embodied in IFRS soon would be supplemented by a flurry of implementation guidelines or rules issued by FASB, the SEC or individual audit firms, the net effect being similar to the current system. Stated differently, the current financial reporting system is an endogenous result of U.S. market and political/regulatory forces, and hence is unlikely to change in substance (as distinct from appearance) unless those forces themselves change.
(9) The distinction between rules-based and principles-based accounting standards is not as simple in practice as is commonly believed. First, rules generally are based on principles. Second, some system is needed to apply broad principles to more specific circumstances, whether it is left entirely to the individual preparers and auditors of financial reports acting separately in each case, or whether a rule emerges for all to follow. Third, rules can be efficient ways of enshrining the experience gained in applying general principles to specific circumstances that repeat across firms and time, without individual preparers and auditors needing to reinvent the wheel each time.Footnote21
(10) The context in which the IASB prefers principles-based accounting standards differs from the US context in material ways. In particular, the IASB is responsible to over 100 different jurisdictions, with their own political and economic agendas, and with different sets of circumstances in which broad principles are applied. The optimal solution for the IASB then would seem less detailed than that of the FASB. This is another reason the SEC almost certainly will need a domestic standard setting body like the FASB to establish detailed rules as they emerge from experience.
(11) A domestic US accounting standards body seems highly likely to be retained. Its form and function could follow several scenarios:
Even if the US fully adopts IFRS as issued by the IASB, a US body would be required to represent US political and economic interests at the IASB, when it is modifying existing standards or creating new standards.
Under the previous scenario, a US body would be required to provide more-detailed rules implementing the IASB’s principle-based standards.
If the US adopts its own version of IFRS, a US body would be needed to review new IFRS standards for political and economic acceptability, recommend whether they be adopted, make any desirable changes, translate them into US terminology, and ultimately endorse them into the accounting principles that are generally accepted in the US.
If the US adopts its own version of IFRS, but IASB decisions were to become substantially inconsistent with US political and economic interests, it could be important to have maintained an active accounting standards body that could quickly take over a full standard-setting role (i.e. as an option that could be exercised if needed).
If the status quo is maintained, with US GAAP and IFRS being developed along co-operative (if not identical) lines, maintaining a domestic body would be a prerequisite. This obviously would be the case if for some reason the US ever decided to completely go it alone and develop US GAAP independently, with minimal interaction with the IASB.
Under all scenarios, a US standard-setting body seems likely to continue for the indefinite future.
14. Conclusions
The adoption of IFRS in over 100 countries a decade ago was a once in a lifetime systems innovation, of great promise and magnitude. There was good reason to expect success, based largely on widespread enthusiasm for international standards and, behind that, recognition of the strong forces of globalization. Nevertheless, there were risks involved and there was limited a priori evidence to guide the decision-makers. A decade later, this is still the case. Globalization remains a potent economic and political force, and drives the demand for globalization in accounting. Nevertheless, most political and commercial activity remains local, so adoption of uniform rules does not by itself lead to uniform reporting behavior around the world. For many of the claimed benefits of IFRS adoption to be realized, uniform implementation would have to occur in a wide range of countries, which seems unlikely and requires more than simply creating regulatory enforcement mechanisms.
Some evidence of actual outcomes from IFRS adoption has come to light but, by and large the evidence to date is not very useful. After a decade of hindsight, IFRS adoption is an innovation of historical proportions whose worldwide effects remain somewhat uncertain.
Acknowledgements
This essay is based on the 2015 PD Leake Lecture delivered at the Institute of Chartered Accountants in England and Wales in London on 14 October 2015, and revisits my 2005 PD Leake Lecture with the benefit of a decade of hindsight. I am extremely grateful to the Institute for their continued interest in the topic and my views on it, and particularly to Robert Hodgkinson, Gillian Knight, Brian Singleton-Green, and Nigel Sleigh-Johnson. The essay has benefited greatly from several discussions with my colleague Hans Christensen, and from the comments of Mark Clatworthy and Edward Lee.
Disclosure statement
No potential conflict of interest was reported by the author.
Notes
1. This argument is developed in Ball et al. (Citation2000a), Ball (Citation2001), and Ball et al. (Citation2003). Subsequent development includes Biddle et al. (Citation2009), Bushman et al. (Citation2011), and García Lara et al. (Citation2016).
2. http://www.ifrs.org/Use-around-the-world/Pages/Analysis-of-the-IFRS-jurisdictional-profiles.aspx, accessed 10 September 2015.
3. Acceptance From Foreign Private Issuers of Financial Statements Prepared in Accordance With International Financial Reporting Standards Without Reconciliation to U.S. GAAP, Securities Act Release No. 33-8879, Exchange Act Release No. 34-57026, December 21, 2007. Available at http://www.sec.gov/rules/final/2007/33-8879.pdf.
4. This subsection summarizes the framework first laid out in Ball (Citation1995) and elaborated in Ball (Citation2001, Citation2006). Subsequent events, both in accounting and more widely in economics and politics generally, have shown the framework to be quite robust.
5. This also helps in explaining why, relative to the prior standards of many adopting countries, IFRS aim at greater transparency in public reporting (the former common law model): the prior insider access model of many countries, with less emphasis on public reporting quality, was inefficient for cross-border transacting.
6. Nobes (Citation2013, section 4.4) makes a related point, referred to as covert options.
7. Many of these concerns were expressed in the previous lecture (Ball Citation2006), to which the reader is referred for more detail.
8. This distinction is discussed in Ball et al. (Citation2000a, Citation2003).
9. http://www.ifrs.org/Current-Projects/IASB-Projects/Conceptual-Framework/Pages/Conceptual-Framework-Summary.aspx, visited 10 September 2015.
10. A joint FASB/IASB News Release on 28 September 2010 stated (emphasis added): the objective of the conceptual framework project is to create a sound foundation for future accounting standards that are principles-based, internally consistent and internationally converged. See http://www.fasb.org/cs/ContentServer?pagename=FASB/FASBContent_C/NewsPage&cid=1176157497474.
11. Brüggemann et al. (Citation2013) use the term in much the same context, the relation between IFRS and contracting. The notion of unintended consequences was first described in Citation1759 by Adam Smith. It achieved widespread attention in Citation1936 as a result of the famous sociologist Robert K. Merton (father of Robert C. Merton, winner of the 1997 Nobel Prize in Economic Sciences).
12. For more details, see Ball et al. (Citation2015).
13. In theory, and assuming no changes in discount rates, shocks to asset prices are completely independent across time (Samuelson Citation1965).
14. Results are from Ball et al. (Citation2015). Similar results are in Brown (Citation2013) and Chen et al. (Citation2015).
15. The role of value relevance studies in evaluating financial reporting generally is debated in Barth et al. (Citation2001) and Holthausen and Watts (Citation2001).
16. There also is reason to doubt that Lee et al. (Citation2013) did, in fact, demonstrate a post-IFRS increase exists in the data. The whole-sample results () indicate no post-IFRS change in the value relevance coefficients at the conventional 5% level of statistical significance. Even then, the significance likely is substantially over-estimated because all company-level observations are assumed to be independent of each other, without adjustment for clustering Petersen (Citation2009). Clustering likely is a larger issue in the individual clusters for which subsequent tables report stronger results.
17. http://www.ifrs.org/Use-around-the-world/Documents/Jurisdiction-profiles/China-IFRS-Profile.pdf. In fairness, the IASB classifies China as using national standards, not IFRS, but its jurisdictional profile is headlined by the cited statement that ASBE are substantially converged to IFRS. This might be correct in terms of a simple count of the number of standards ASBE and IFRS have in common, but it is a misleading index of the comparability of financial statements across jurisdictions.
18. Hail et al. (Citation2010) provide a comprehensive analysis.
19. https://www.sec.gov/about/commissioner.shtml, accessed 8 April 2016.
20. Despite their differences, the two bodies still share a lot in common and still work closely together, but now they apparently recognize that there always will be differences.
21. By way of analogy, lower law courts apply the broad-application decisions of higher courts to more specific circumstances. Their decisions become binding in other specific circumstances that are not materially different.
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