[By Nandika Buddhipala]
Introduction
The origination of financial reporting can be closely connected to the requirement to collect and record data which evolved into a stage where the capacity of the human brain was not sufficient to accommodate and memorize the evolving volume of data and transactions. Interestingly the existence of record keeping can be traced back to even five thousand years before the invention of double entry bookkeeping in the 14th century by Italian mathematician Fra Luca Bartolomeo de Pacioli where such evidence can be unraveled during 3,500 to 3,000 BC among Sumerians lived in southern Mesopotamia. Astonishingly, the first recorded name in the human history supposed to be an accountant in the name of “Kushim” rather than a poet, prophet or a warrior.
The long history of financial reporting in the form of accounting and bookkeeping signifies the evolution of socio-economic backdrop and certain prerequisites for the emergence of financial reporting such as formation of private property and property rights, employment of wealth in the form of capital, creation of credit, emergence of money as the common denominator for exchange and the development of commerce up to the level of interchanging of goods on a widespread level, etc.
Historical perspective
The traditional accounting history perspective emphasizes the fact that accounting and financial reporting is required for rational decision-making purposes and such information requirements for rational decision making demands the development and evolution of accounting and financial reporting under demand response theory. However, it is worthwhile to mention the fact that the alternative view is that the accounting information is produced not only in response to the rational demand but also for social and political reasons. It is also understood that the accounting and financial reporting has been a progressive and relative process rather than a static one where the subject matter has been constantly changing and evolving.
Theoretical framework
Financial reporting and disclosure framework has been closely connected to the concepts and theoretical background with Agency Theory, Information Asymmetry, Decision Usefulness Theory and Stakeholder Theory, etc. The most of these concepts and theoretical framework emphasizes on separation of ownership from the management where the management is responsible for the operation of the organization while having responsibility of informing all the stakeholders regarding the progress and the performance of the business entity itself. Therefore, financial reporting emerged as a one of the key important element in the modern business world where various important aspects in financial reporting evolved such as independency, transparency, informativeness, usefulness, creditworthiness, decision supportiveness, relevance, comparability and consciousness, etc to name few of them. The expectation gap between the prepares and the users of the financial reporting over a period of long time has become one of the reasons for constant evolution and dynamism of the subject.
The harmonization of financial reporting
The world is still diverse and various institutions, constituencies and practices are greatly influenced by different social, legal, political and economic factors so as financial reporting. However, world trade even with temporary cyclical ups and downs has been moving towards significant integration with ever increasing cross broader transactions. We have witnessed various cross border IPOs, share buybacks, M&A, multiple listing of business entities in various stock exchanges and emergence of institutional investors with different risk appetites having keen interests in emerging and frontier markets, etc. Therefore, such cross border activities demands harmonization of financial reporting across the borders. The comparability of financial information for rational economic decision making purposes for investor community having diverse investments in different jurisdictions has become a compelling demand in the last century. The harmonization of financial reporting across the world not only attracted the attention of the users, significant amount of work has been put in place towards this direction in the recent past.
Empirical research findings
There has been accounting research work in the recent past to understand the impact brings into capital markets through financial reporting harmonization. It is imperative to find measures or parameters of evidences regarding the impact to capital markets through harmonization of financial reporting. In the accounting research arena direct impact on capital market characteristics such as liquidity, cost of capital, bid-ask spread and improvement in foreign equity and debt participation through financial reporting are measured. Further, indirect impact on capital markets such as informativeness of earning announcements and analysts’ forecast accuracy, etc also identified. Further, some researchers suggest that quantitative features of the capital market such as impact on number of issuers and composition of market segments, etc also should be considered even though there are limited number of research available in that space.
In one of the research it was unraveled that the information content on earning announcements observed an improvement through the reduction in reporting time lags, increase in investments by foreign participants and improvement in accuracy of forecasts of the analyst during post adoption of IFRS compared to pre adoption.
Beuselinck, Khurana, Van der Meulen, (2009) concluded that as a result of adoption of IFRS there was an improvement in disclosures of new information about a firm which reduced the surprise element of the disclosed information. One of the important findings of this study is that since research was conducted among 2,071 firms within 14 EU countries the strong and transparent enforcement mechanism was prevalent in those markets, therefore, the findings of this study may not be applicable for countries with less enforcement mechanisms.
In another research study Cai and Wong (2010) however, focused on G8 countries supported the belief that capital markets improved the level of integration post adoption of the IFRS in comparison to pre-adoption period. The one of the main revelation was that the adoption of IFRS tends to reduce diversity in accounting practices which helps to facilitate efficient movement of capital.
However, in another study on the effect of adopting IFRS on integration of Gulf Countries capital markets, Alnodel, A. (2014) found that the adoption of the IFRS has no significant influence on the integration of the capital markets. It was further observed that the capital markets do not have any long term relationship among each other. Interestingly results of this study contradicted the wildly held view that adopting IFRS improves capital markets integration. It is important to note that this study stressed on other institutional elements which affect the influence of the accounting standards on capital markets integration. It may important to understand the religious influences on the legal framework as well.
In a study conducted in global space consisting 5,045 firms within 22 countries, Drake, Myers, & Yao (2010), it was found that the mandatory adoption of IFRS results in increased market liquidity reflected in share turnover, market depth and bid-ask spreads was attributable to the improvement in comparability of accounting information rather than quality effectof the accounting.
It was found that that there was an increase in stock trading activity in the Frankfurt Stock Exchange after the mandatory adoption of the IFRS. This research, Brüggemann, U. (2011), was conducted with 4,869 firms from 31 countries across the world. It was further concluded that adoption of IFRS promotes more foreign investments in equity. Unfortunately, this study did not analyze other factors that can influence foreign investments.
Another study conducted by Chen & Tsang (2015, July) with 1,181 firms from 50 countries established that firms mandatorily adopted IFRS have a higher likelihood to cross list as well as a large increase in cross-listing target countries compared to firms which do not adopt IFRS. It was further found that firms from countries mandatorily adopted IFRS are likely to cross list their stocks in countries which mandate IFRS adoption and also has high capital markets liquidity.
There was an interesting revelation in a study Hong, Hung, & Lobo (2014) where it was found that significant statistical and economical reductions in under-pricing of IPOs among countries which mandatorily adopted IFRS together with high increase in the funds raised in foreign markets as result of reduced information asymmetry through higher comparability of financial reports. It was further analyzed that such relationships were strong for firms in countries with high creditability in accounting changes implementation.
A study concluded with 4,399 firms from 23 countries Yu, G. (2010) observed that harmonization of accounting standards results in reducing information asymmetry promoting cross-border investment activities emanating from reduction in information processing costs for public financial statements and reduction of private information barriers. This study further supports that IFRS adoption results in more M&A activities often associated with high premium on takeover.
It was established that increase in economic growth and international capital markets has been possible through the elimination of trade barriers in raising of capital across international markets by research conducted in Bangladesh, Qurashi & Islam (2014). They found that the elimination of preparation of multiple financial statements cater to various stock exchanges through IFRS adoption facilitated the firms to get into capital markets across the borders. This developing country experience in IFRS adoption has been further confirmed by Tyrall, Woodward, & Rakhimbekova, (2007) in Kazakhstan even though benefits experienced slow.
It was established that the cross border M&A activities supposed to be higher in countries with higher similarity in accounting standards and increasing volume of M&A activities usually driven by strong IFRS implementation enforcement in target countries in an examination conducted in 32 countries covering the period from 1998 to 2004, Francis, Huang, & Khurana, (2015).
In a study, Florou, & Pope (2012), consists of 10,852 firms from 45 countries covering the period from 2003 to 2006 found that adoption of IFRS influences the resource allocation of institutional investors. However, they established that such relationship exists when there is strict application of laws and with lower level of corruption only.
A review conducted between 2000 and 2013, Lourenço, & Branco (2015), revealed that in general adoption of IFRS results in improving accounting quality, increasing ability of predicting by market analysts, improving comparability and better use of accounting information. However, it was established that country and company factors has a major role on such relationship. They concluded that management incentives and institutional factors would influence financial reporting; therefore, such factors can be regarded as important pre-requisites in creating common business language.
In an examination, Bae, Tan, & Welker (2008), conducted with 6,888 firms from 49 countries it was found that closeness of various domestic GAAPs to IFRS closely related to likelihood of foreign analysts following such firms and higher ability to provided more accurate forecasts for those companies.
A study, DeFond, Hu, Hung, & Li (2011), surveyed foreign mutual fund investments. They observed that the adoption of IFRS leads to comparability of financial reports only in countries that have credible implementation of the standards. They further, noted that improvements supposed to be strong in firms which use same accounting standard in the same industry. They concluded that adopting IFRS mandatorily in nations having a strong credibility of implementation of standards, experience a higher level of foreign ownership in the mutual funds.
The impact of IFRS adoption on capital markets was evaluated by Procházka, & Pelák, (2015), and observed that the within EU post IFRS adoption results were mixed and therefore, they believed that generalization such as adoption of IFRS would eventually lead to developments and improvements in capital markets were not suitable proposition for EU territory. They stressed that country specific regulation also should be considered.
A study with a 1,084 firms from EU during 1995 to 2006, Li & Shroff (2010), revealed that there was a reduction in cost of capital during the post adoption of IFRS period. It was however found that such reduction in cost of capital only happened in markets with strong legal enforcement mechanism.
Hope et al. (2006) established that countries with a relatively weak investor protection are more likely to adopt IFRS.
The study of Ramanna and Sletten (2009) concluded that strong economies are reluctant to hand the power over standard-setting to independent international authority. Ramanna and Sletten (2014) further found out the degree of IFRS harmonisation of a particular country increases in the perceived value of its IFRS network. High value of the network effects can however result in adopting the accounting rules, which do not suit well to domestic institutions. In fact, some countries adopt IFRS even if it leads to replacement of comparatively superior local standards by IFRS.
Concluding remarks
Even though there are research studies with regard to financial reporting harmonization through IFRS adoption and its impact on capital markets most of such research work brings in empirical evidence of an effect of IFRS adoption in a positive or mixed manner. However, it is important to draw attention to the fact that some of the studies emphasis on positive effect on IFRS adoption subject to a number of factors affecting this effect, particularly company’s characteristics and countries characteristics, etc. Further, it is important to understand that most number of research studies have been on developed countries whereas only fewer research work are on developing countries. The impact on financial reporting harmonization through IFRS adoption on capital markets in developed markets may be different to that of developing markets specifically where strong legal enforcement framework exists in developed markets compared to developing. Furthermore, suitability of IFRS framework to developing markets also questioned in very few research work.
Finally, IFRS framework would complement the socio-economic, political and legal enforcement strengths of a jurisdiction together with strengths ethical and governance framework of business organizations rather than act as a substitute of such factors.
(The author is the Chief Financial Officer of Commercial Bank of Ceylon PLC and a Member of the Institute of Chartered Accountants of Sri Lanka)
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