EU Adoption of International Financial Reporting Standards: Beneficial for Member States?
Have International Financial Reporting Standards (IFRS) been beneficial for investors? Is there any merit to the push for including financial stability as a criterion for endorsement of financial reporting standards? Should accounting policy be a lever for economic policy?
These were a few of the questions I found myself grappling with as I prepared to participate in an international panel in late June, moderated by Valerie Ledure of the European Commission (EC) and involving key industry stakeholders, each with their own burning questions about the IFRS.
The panel was held in Latvia shortly after the issuance of the EC report and related working paper on the International Accounting Standards (IAS) regulation review. The IAS review was part of an overall review of the European Union (EU) financial reporting institutional framework and was effectively an assessment of the efficacy of IFRS adoption across EU member states.
Before sharing my reaction to the report, it may help to provide some background on the IAS regulation.
Objectives of the IAS Regulation Review
Listed companies in the EU have had to report their consolidated accounts under the IFRS since 2005. By and large, adoption of the standards has been welcomed by financial reporting stakeholders, including investors for whom comparable reporting by companies across countries is highly desired. That said, the journey towards and after the adoption of IFRS has not been lacking in challenges, and the following questions have often been posed by different stakeholders:
- Did IFRS requirements exacerbate the global financial crisis when compared to national accounting standards, such as UK or German Generally Accepted Accounting Practice (GAAP)?
- Do the benefits of IFRS adoption outweigh the costs of its implementation?
- Are IFRS reporting outcomes consistent with the legal requirements of EU member states, and of financial statements needing to represent a “true-and-fair” view?
- How effective is the IFRS endorsement process within the EU? Should the criteria be revised to encompass financial stability as an objective?
- Are IFRS standards consistently implemented across different countries?
- Are IFRS standards of a sufficiently high quality?
The EC’s report sheds light on these wide-ranging questions, informed by views from all key stakeholders elicited through a survey conducted in 2014. In addition to eliciting stakeholder perspectives through the 2014 survey, the EC report provides an extensive and balanced literature review around the questions of whether IFRS adoption benefits outweigh the costs and whether IFRS standards contributed to, and exacerbated, the recent global financial crisis.
Preceding Initiative: The Maystadt Report
The EC’s report builds on another cornerstone report by Philippe Maystadt, issued in 2013, which focused on the reform of the European Financial Advisory Group (EFRAG, responsible for providing IFRS endorsement advice to the EC after reviewing the technical suitability of proposed IFRS standards from a European standpoint). The Maystadt report aimed to ensure a coherent and effective articulation of EU-wide perspectives on IFRS standards during the endorsement process, and in so doing strengthening the EU influence when interacting with the International Accounting Standards Board (IASB).
Takeaways on EC’s IAS Regulation Report
There were a whole set of critical issues addressed in the EC report and also at the Latvia conference including: the role of IFRS for small and medium enterprises; definitions of “public good” and “true-and-fair view”; governance of the IFRS Foundation; progress in the implementation of the Maystadt report; headway in the global adoption and consistent application of IFRS standards such as the question of if/when the US would adopt IFRS. Each of these issues warrants several tomes; a few sentences cannot do justice to the variety of perspectives put on the table. Below are just a few of my key takeaways from reading the report and participating at the conference:
- Investors have benefitted from IFRS: In general, it is difficult to quantify the benefits of any reporting regime. The EC report acknowledges that empirical evidence within academic studies have limitations and lack unanimity in their conclusions. Nevertheless, on balance, there is evidence that shows benefits for investors and users of financial statements through the following:
- A higher degree of financial reporting transparency through improved accounting quality and disclosure, more value-relevant reporting, and more accurate market expectations and analyst forecasts
- Greater comparability of financial reporting across countries and industries
- Increased liquidity, cross-border investment, and lower cost of capital
- Financial Stability and Endorsement of IFRS: One issue that has been a subject of debate is whether financial stability should determine whether IFRS standards are endorsed in the EU. Unlike the Maystadt report, the EC report has not recommended the inclusion of financial stability as a criterion of endorsement. The EC report noted that it found that stakeholder respondents were mostly supporting the retention of existing endorsement criteria, where there is no need to evaluate the impact on financial stability of proposed accounting standards.
Why is there a debate around financial stability as an accounting objective? Several regulatory and political authorities have tended to push for the inclusion of financial stability as an endorsement criterion. Their view tends to be coloured by concerns about income statement volatility associated with fair-value measurement. There is also a perception that fair-value measurement led to excessive write-downs and contributed to the erosion of bank capital during the financial crisis. To inform the debate, the EC report reviewed empirical evidence on the role of accounting including fair-value during the financial crisis. The report cites academic evidence which, from my reading (i.e., not all studies come to the same conclusion), tends to dispel the notion that fair-value accounting exacerbated the financial crisis. Similarly, a 2015 Basel Committee publication and 2014 CFA Institute publication, Financial Crisis Insights on Bank Performance Reporting, finds that there was an overstatement of alleged detrimental effects of fair-value accounting during the financial crisis.
Users of financial statements would be concerned if the idea of financial stability excludes reporting economic volatility. Instead, providing fully transparent information, where investors can more effectively distinguish between banks that are taking high risk from those that are not, is consistent with long-term financial stability. Another benefit of transparent financial reporting is that it shifts the financial stability perspective from “crisis cure” to “crisis prevention.” It should not be forgotten that investors play a key role in enforcing market discipline whilst providing debt and equity risk capital to banking institutions and ensuring the capital adequacy of banks, and they require a transparent reporting regime to facilitate their correct pricing of individual bank securities.
Overall, the EC report shows that IFRS standards have been beneficial for EU financial reporting, and anticipates that we’ll see additional benefits from establishment of the proposed EU capital markets union.
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