The current trend in the accounting practice has indicated drastic changes in the level of reporting requirements from the regulating accounting bodies. This trend has been facilitated by the need of the international and national corporations to embrace the aspect of transparency and responsibility to the users of the financial statements being released to them for decision making. Due to the dynamic nature of accounting practice, International Financial reporting standards (IFRS) which regulate the reporting standards in Europe plus several other foreign countries, and the Generally Accepted Accounting Principles (GAAP) which mainly regulate the reporting standards in the US and its allies have been very aggressive in the recent times in addressing the gaps left open by the complexity of the accounting practice, the most notable one being the enforcement of corporations to make disclosures related to corporate social responsibility as well as adaptation of fair value costing method.
The impact of the regulations on the reporting standards has been the production of comprehensive and evidence-based financial statements that not only give diverse information to the users of financial statements but also enhance uniformity in the application of accounting models from all the participating corporations. The United Nations (2008, p.69) claims that the encouragement of preparers to use IFRS has contributed to the issuance of more transparent financial statements and that the step-by-step adoption is creating an enabling atmosphere for smooth transition not in the UK but also in other areas of adoption. However, despite all the hypes about the authenticity of IFRS, its impact on the integrity of financial reporting, more so in the UK has been a subject of major debate in recent years. This issue of integrity comes at a time when the world is waiting for the convergence of IFRS and GAAP, as well as the adaptability of the IFRS around the world. The critics of the IFRS have been vocal in pointing out its limitations which include; subjectivity due to the use of fair value approach of cost, use of rule-based approach rather than principle-based approach (e.g. principle of prudence features significantly in this debate), convergence with US GAAP which is viewed as rigid, the complexity of financial statement, excessive disclosures with little value addition, and understandability by common users and volatility of the IFRS (Beattie, Fearnley and Hines, 2008).
Although the latest developments of criticism are based on the aftermath of the financial crisis that has hit the world in the last two years, it is also viewed that the problem of integrity in the UK financial reporting emerged way before the financial crisis. The issue of integrity is a sensitive one, especially when considering the implication of misrepresented financial statements to the decision-makers who rely on such statements. This paper will discuss the implications of the IFRS in the integrity of financial reporting and whether these IFRS undermine the UK’s financial reporting integrity.
The application of IFRS
IFRS regulations have been regarded as the strongest financial reporting regulatory body across the globe especially evidenced by the consistency shown in financial reporting in Europe when it has been fully adopted. Indeed, there is a proposal for mandatory adoption of IFRS all over the world including in the US where the GAAP has for a long time been credited for creating in-depth reporting, frequent filing, and detailed governance of disclosures. For instance, the US is gearing itself towards adopting the IFRS to replace the GAAP before the projected mandatory adoption in 2011, as the two major regulatory bodies International Accounting Standards Board (IASB) and Financial Accounting Standards Boards (FASB) heighten discussions on the convergence of the rules. Moreover, following the adoption by major players like Australia, Previts (2007, p42) views the universal adoption of IFRS as a positive sign of the support it is gaining and an opportunity to issue confidence that there is quality financial reporting which enables the preparers and other stakeholders gain the attendant advantage. The above developments give indications that the IFRS is highly recognized and that they possess better reporting standards than the other reporting standards.
The adoption of IFRS across the world has been an ongoing process, for instance, Australia adopted and the whole of Europe switched in the mid-2000s while other countries like Hong Kong and South Africa have modified their standards to conform to IFRS requirements. However, according to Transnational Auditors Committee (2007), consistency in adoption has been the major issue despite the timeline for mandatory adaptation. The UK has however fully adopted the use of IFRS in place of the former UK GAAP. The issue of consistency has also been highlighted by Gowthorpe (2006, p. 23) who claim that the IFRS have faced issues related to language, culture, and political competition, leading to complexity in understanding, inconsistency in the application by practitioners, and enforceability problems. The enforcement of adoption to the European preparers was to ensure that there was accuracy and viability of the information for various decision making and to eliminate the instances of governance and ethical flaws that may undermine the investors’ confidence and the company’s value (Chorafas, 2007, p. 255).
Since its first adoption in 2003, IFRS has enhanced changes in the reporting requirements of financial statements in the adopting nations and companies, which have influenced the reliability of the financial statements. These changes include the adoption of the use of fair value in reporting especially for assets and liabilities, replacing the standard IAS 22 that required goodwill to be amortized over its useful economic life with IFRS 5 which requires goodwill to be recognized in fair value and subjected to annual impairments or as per the occurrence of contingent events and enforcing extra disclosure of information relevant for the assessment of the extent of risks to financial statements
IFRS are Marjory rule-based which means they deviate from the principle-based approach adopted by the defunct UK GAAP (Beattie, Fearnley and Hines, 2008). In addition, due to the impending uniformity of adoption, audit integrity is influenced through the engagement of accredited IFRS experts, enforcement of quality control of audit, providing support tools for use by clients, and integration of IFRS in audit methodology. However, the implementation approaches adopted by the countries that currently use IFRS and especially European countries have presented divergence of implications on the integrity and the strength to enforce transparency. For instance, creating congruence between transparency and governance has been a major headache, with western European countries like Greece and Holland showing failure in both while Eastern European countries showing great transparency but poor governance.
Indeed, according to Steffee (2009), some European corporations have been very notorious for hiding losses thus leading to the major losses being incurred by the stakeholders who use the information presented by these firms. However, the failure of integrity in financial reporting may not be only deliberately caused, but also may result from poor planning of the adopting preparers (International Accounting Standards Board, 2009, p. 146). To enhance the reliability and relevance of the financial statements especially on the first adoption of I FRS, the FASB absolved the first time adopters from hedging accounting to “their opening IFRS balance sheet for a net position that does not qualify as a hedged item under IAS 39” (International Accounting Standards Committee Foundation and International Accounting Standards Board, 2007, p. 93).
Issues related to undermining the UK’s financial reporting integrity
Fair value accounting
The application of the fair value approach of costing has been subjected to a lot of debate since the adoption of IFRS started. While the global changes in the accounting practice call for the measurement of items at arm’s length, historical costs still remain relevant especially in relation to non-current assets which do not change in economic value as they are not for resale. In addition, these assets are subject to wear and tear, and therefore valuing them at the current market value will result in providing false or misleading information of the true worth of the asset. Indeed, Beattie, Fearnley, and Hines (2008) concur by indicating that fair value accounting leads to the subjectivity of valuation which results in the production of unreliable and confusing reports thus undermining the integrity of the information contained in the accounting statements. Although these authors may be right from their point of view, fair value has seemed to be favorable especially when applied to financial assets.
According to Gowthorpe (2006, p. 127), fair value may be expressed as the amount that an asset could fetch in the market or a liability could be offset between parties with perfect knowledge of the value of such assets and liabilities at arm’s length. One benefit of fair value reporting is that it gives the current value of the business which will be important to the investors as they evaluate the risks and returns of the business (Gee, 2006, p. 409). This means that the true value as per the current worth is reported thus increasing the integrity. However, the worst could come up in the cases of economic crisis especially where the value of all items go down, and specifically where the firm had inflated its value to acquire loans leading to default and liquidity problems to the lender. Indeed, the collapse of the major banks during the recent credit crunch can be a testimony of the disaster that can be caused by fair value reporting.
Rule-based approach vs. principles-based approach
Whether the standards are rule-based or principle-based will have an effect on the reliability and the integrity of the financial information. According to Beattie, Fearnley, and Hines (2008), the IFRS claim that the IFRS is rule-based rather than principles-based and therefore they tend to undermine the concept of true and fair view (prudence principle) thus leading to a decline in the quality of financial reporting. Moreover, according to Witsiepe (2008, p. 112) adoption of the IFRS for the first time poses problems to the preparers due to the rules that they have to comply with, including preparing a comparative balance sheet for the period prior to adoption and revaluation and reclassification of the existing non-current assets to fair value as well as preparing a movement schedule of the asset. However, Godfrey and Chalmers (2007, p. 11) view that the issue of rule-based is connected to the proposed convergence between IASB and FASB, with the main component of conflict being the valuation in IFRS 3 (Business Combinations) which the UK ASB feels that it will not improve the reporting standard in the UK. One element that describes the difference in basis is the presentation of the statements whereby, while the US GAAP has a definite rule on the format of presenting information in the financial statements, IFRS is more flexible on the format of presenting such information.
Accounting practice is a subject of judgment, putting in mind that it should reflect the economic realities otherwise misleading information will be presented to the users. However, since rules are appropriate especially in complex and large economies like the UK in order to enforce ethics in reporting, a set balance between principles and rules is important. From a liberal perspective, despite it being principle-based, IFRS has guidelines that allow it to enforce compliance; otherwise, an exclusive principles-based approach may erode integrity due to compromised enforcement powers.
The complexity of IFRS financial statements
The claim of undermined integrity by Beattie, Fearnley, and Hines (2008) has been based on the view that the financial statements prepared under IFRS are complex, counter-intuitive, and too detailed to be understood by the users especially the analysts and investors. The primary purpose of financial reporting is to communicate the information in financial statements to the various users of such information for their independent decision-making processes. These authors claim that the statements are too complex and technical to be misunderstood not only by the shareholders and the investors but also by the financial analysts, directors, and audit partners. This complexity becomes the source of eroding the integrity of financial reporting as the users may not be in a position to question the information they can not even comprehend. Another element of the IFRS that was disputed by the authors was the failure of being consistent such that they keep changing thus making the users fail to understand them. Indeed, since their first adoption, there have been changes in almost every subsequent year to date, for instance, there were changes in share-based payments, business combinations, insurance contracts, and non-current assets disclosure in 2004; financial instruments disclosure changes in 2005; and operating segments changes in 2007.
However, the supporters of IFRS have claimed that they are not as complex as they are alleged to be. For instance, Gill (2007) views that while US GAAP comprises over 2000 pages of regulations, IFRS has fewer than 2000 pages making them simpler to the users. Although this does not preclude IFRS from claims of integrity, the important route would be to simplify the rules and the principles so that all the users can understand.
One of the major transformations of standards under IFRS is the requirement of enhanced disclosures especially in relation to financial (e.g. financial instruments and retirement benefits disclosures) and non-financial issues such as environmental and social reporting. According to Beattie, Fearnley, and Hines (2008), these mandated disclosures have lengthened the size of financial statements with little value addition. Moreover, they claim that most of the added disclosures are meaningless and burdensome to the users of the financial statements and since most of the users don’t have the time to read the voluminous notes/disclosures, they (disclosures) may be used as a gateway to misrepresent information thus undermining the integrity of reporting.
Although the arguments may have some weight, the truth is that the business environment is rapidly changing and the decision-makers require having as much information as possible to make informed decisions. For instance, Gowthorpe (2006, p.386) views that different disclosures relating to environmental impact, employees reports, effects of changing prices, and financial instruments will effectively benefit the analysts. When all this information is disclosed, the users will be in a better position to understand the company. However, strictness in enforcing disclosures puts the preparers on their toes to ensure they provide reliable information thus boosting the integrity of reporting. For example, retirement disclosures will help employees understand the reliability of the firm in terms of employment, environmental and social disclosures will help the shareholders, investors, and the government understand the environmental risks associated with the company as well as the impact the company/preparers poses to the environment and the society in which it operates. Such environmental risk disclosures are important as they aid the regulatory authorities to determine the level of regulations they are to enforce towards the minimization of the environmental hazards exposure to the society. These disclosures enhance the improvement of social welfare and thus lead to the support of the integrity of financial reporting.
The trend in the accounting environment is influencing adjustments in the mode of financial reporting due to the increasing demand for information by the users for decision making. Moreover, the integrity of the information provided to the users is becoming a question of discussion around the world, with calls for comprehensive standards to regulate financial reporting taking the center stage. In the UK, the adoption of the IFRS since they were established was meant to eliminate the limitations of the previous GAAP standards. However, some critics have been hasty to denounce the application of the IFRS citing undermining of UK’s financial reporting integrity as a call of concern with their claims being backed by complexity and the application of fair value accounting. To some extent, the integrity of the financial reporting may be compromised by the use of fair value especially in unstable economic situations where they may present information that compromises the true and fair view principle. In addition, the complexity of the financial statements especially following the increase in the number of disclosures reduces the understandability of the statements and maybe a source of eroded transparency thus undermining the financial reporting integrity.
Despite the limitations, IRFS has shown improvement in the transparency in financial reporting especially considering that the requirements for enhanced disclosure provide a wide variety of information to the users of the financial statements for informed decision making. Despite being described as subjective, fair value accounting is a better measure of accounting items in the contemporary business environment putting in mind that it gives the investors and other stakeholders the true current worth/value of the company as reflected in the arm’s length. The proposals for mandatory globalization of the IFRS have received approval from all over the world including the US and Canada with the implication that IFRS tends to be more realistic to the changing global economic and accounting environment which requires a flexible and principle-based approach in financial reporting. Whether the IFRS undermines the integrity of financial reporting or not will depend on the depth of reporting and the consistent to which it is adopted in support of the regulatory frameworks in the respective adopting economies.
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