The IFRS Adoption Index: A Tool for the Measurement of Accounting Harmonisation

The IFRS Adoption Index: A Tool for the Measurement of Accounting Harmonisation David Procházka Department of Financial Accounting and Auditing University of Economics, Prague Nam. W. Churchilla 4, 13067 Prague 3 CZECH REPUBLIC prochazd@vse.cz http://webhosting.vse.cz/prochazd Abstract: - The worldwide harmonisation of accounting represented implementation of the International Financial Reporting Standards responds to demand of capital markets for high-quality, comparable and useful accounting information. The benefits of accounting harmonisation are well known. The research evidence an increased usefulness of financial statements prepared in accordance with IFRS in each adopting country. However, the successful adoption of IFRS brings a huge challenge to all sorts of empirical research focusing on the role of IFRS adoption on certain economic variables. When analysing effect of the IFRS on country-bycountry level, the researchers have to control somehow for the fact that IFRS are spread almost over all around the world. Except for some cases, all important world economies have already adopted the IFRS, which are required or allowed for the use by listed companies and even by non-listed companies in certain jurisdictions. To make valid comparison among countries, a sophisticated model evaluating different level of the IFRS adoption has to be developed. The aim of paper is to show some theoretical approaches to solving this newly arising important research issue. Key-Words: - Accounting harmonisation; IFRS; Adoption of IFRS; Harmonisation de jure; Harmonisation de facto; IFRS Adoption Index 1 Introduction The existence of significant differences among national accounting systems causes an information asymmetry of local investors at expense of foreign ones, which do not possess detailed knowledge of local environment. To lower costs relating to obtaining information for decision-making, investors had been pushing regulators by the demand for a single set of accounting standards. The benefits of accounting harmonisation are well known and they served as the main driver for the introduction of International Financial Reporting Standards and their adoption in many countries. The worldwide harmonisation of financial reporting through the IFRS is an accounting response to the integration of world capital markets. For example, the European Union joined this process in 2002, when Regulation (EC) 1606/2002 on International Accounting Standards was approved because of accounting harmonisation efforts within the EU. A development similar to one within the EU can be seen in other parts of world. 2 Problem Formulation The author of this paper is a member of a research team, which is currently exploring whether there is any economical interdependence among migration, foreign direct investments and the IFRS adoption (Procházka & Procházková Ilinitchi, 2011) with a special attention to migration to the EU countries. In case of the European Union, there arises a problem how to measure the IFRS adoption. Pursuant Regulation (EC) 1606/2002, all companies listed on the EU stock exchanges have to prepare their consolidation financial statements in compliance with the IFRS starting from 2005. The cardinal challenge to all sorts of empirical research focusing on the role of IFRS adoption on FDI development is that the IFRS are spread almost over all around the world. Except for some cases, all important world economies have already adopted the IFRS. The paper concentrates on a narrow aspect of accounting research methodology, which is not address by current research at all. An empirical evaluation of intentional and unintentional economic effects stemming from the IFRS adoption across countries is challenged by the fact that IFRS are used almost at all important economies. Therefore, it is difficult or even expelled to find a representative sample of non-adopting countries to check the effects of IFRS in adopting countries. The prob- ISBN: 978-1-61804-124-1 372

lem is usually resolved by comparing the situation in a given country before and after IFRS adoption. However, this enable to make a longitudinal data analysis (for a restricted time-period) only, but the cross-sectional comparison across countries cannot be done. The aim of this paper is to offer potential solutions to a problem how to measure the level of IFRS adoption in a particular adopting country in comparison with other adopting countries. 3 International convergence of accounting standards 3.1 Literature overview The harmonisation of accounting is defined as a process of increasing the compatibility of accounting practices by setting bounds to their degree of variation (Nobes, 2010). Harmonisation is motivated by investors who seek the best opportunities to invest their scarce economic resources. As financial information of companies domiciled in a particular country are used not only by domestic investors, but also by foreign ones, investors strain to persuade regulators to unify or harmonise the accounting rules in worldwide context. The introduction of a single set of accounting standards is supposed to enhance both understandability and comparability of financial statements across companies and countries. To keep local and attract foreign capital, states have been adopting worldwideaccepted accounting standards such as the IFRS. The successful spread of IFRS can be thus attributed either to the political motives or to the role of economic networks (Ramanna & Sletten, 2009). Accounting research addressed the harmonisation process in many even before the international harmonisation through IFRS. The measurement of comparison among companies and the measurement of level of harmonisation among countries (Archer et al., 1995) are one of the most important. Before any measurement model is developed, it has to be pointed out that two layers of harmonisation should be precisely distinguished. The IFRS enactment by a country is just the first step of the harmonisation process (so-called de jure harmonisation). De jure harmonisation aims at harmonisation of rules, which are applied when preparing financial statements. The first attempt to measure harmonisation of financial reporting practice can be found in van der Tas (1988), who suggested and further refined (van der Tas, 1992) three indices for the measurement of accounting harmonisation and comparability. Herfindahl index (denoted H-index) was customised for the measurement of harmonisation within a particular domestic financial reporting system. The logic of H-index rests on the number of possible options on accounting choices and politics for accounting treatment in a given accounting area. The basic H- index was further developed in order to capture the possibility of existence two or more financial reporting systems within one national jurisdiction (Cindex). After certain modification of C-index, I- index was suggested for the assessment of accounting harmonisation within an international context. Other authors further developed and modified these indices to control for international specifics in a more proper way (Archer et al., 1995). In additional, needed statistical properties of these indices were assessed (Archer et al., 1996; Morris & Parker, 1998). Taplin (2003) completed the development of index model by introducing T-index, which can be considered as a general index respecting both all possible accounting specifics and required statistical characteristics. A comprehensive study focusing on the history and all modifications of the van der Tas s indices were elaborated by Taplin (2004). Index-based methods are used quite extensively by accounting research. Among important works using indices belong those of Emenyonu & Gray (1992); Hermann & Thomas (1995); Emenyonu & Adhikari (1998); Cañibano & Mora (2000) and Aisbitt (2001). There are several limitations of indexbased techniques hindering their utilisation in a scientifically proper way (Ali, 2005). Indices are also defective conceptually, as they perceive the ultimate aim of harmonisation is a complete removal of all alternative methods and their replacement by a single accounting treatment. However, the quest for uniformity does not respect different economic circumstances under which entities operate their business. Statistical models are suggested to replace indices in order to measure accounting harmonisation even if companies are allowed to choose among alternative accounting treatments. First methods used a relatively simple chi-square test (Tay & Parker, 1990), which cannot be although used for small and large samples Ali (2005). Due to limitation of basic statistical models, Archer et al. (1996); McLeay et al. (1999); Rahman et al. (2002) and Jaffar & McLeay (2007) use regressions and other statistical modelling methods. 3.2 Measurement of the IFRS adoption level Accounting literature concentrates mainly on measures applicable for the evaluation of de facto harmonisation. The research on de jure harmonisation ISBN: 978-1-61804-124-1 373

is relatively undervalued. First measure was proposed by Rahman et al. (1996). Among other approaches can be mentioned CIFAR Disclosure Index (CIFAR, 1995); Disclose Index and Methods Index (Ashbaugh & Pincus, 2001) and Accrual Index (Hung, 2001). The most comprehensive measure of de jure harmonisation was introduced by Ding at el. (2005). Their model focuses on the conformity of national accounting principles with IFRS. So-called IFRS Conformity Index refers to 111 accounting items, which were classified into four categories according to their (non)application similarly to Rahman et al. (1996) methodology. Due to difficulty in distinguishing of certain differences, items were finally categorised only by two attributes absence and divergence. The model is further refined in Ding at al. (2007). Despite the IFRS Conformity Index is able to measure harmonisation of national accounting standards with the IFRS in a very precise way, its usage in models assessing the impact of IFRS adoption on certain economic variables are arguable. With the growing usage of the IFRS, the economic costs of different national accounting principles mitigate. The comparison of effects from the IFRS adoption among various countries is not possible, as all (or almost all) countries have already adopted IFRS. For the purposes of statistical modelling, the level of IFRS adoption cannot be measured with reference to the extent, in which local accounting standards conform to IFRS. The solution of this issue should be based on scope of entities, which use the IFRS as their accounting system. Therefore, it is necessarily to assess conceptually the scope of companies, which are subject of IFRS reporting. In this context, we can utilise fact that IFRS are adopted in the legal framework of various countries in different ways. For example, Regulation (EC) 1606/2002 obliges companies, which are listed on the EU stock exchanges, to prepare their consolidated financial statements in compliance with the IFRS as adopted by the EU. In addition to this obligation, member states may broaden the scope of entities, which are obliged or allowed to apply the IFRS, which can be utilised when constructing the measure of IFRS adoption level. A greater number of companies, which are allowed or obliged to apply IFRS in their separate and/or consolidated financial statements in a particular country, a higher motivation of foreign investors to put capital in given country can be expected. Furthermore, the attractiveness of economical environment can be increased by a favourable taxation regime. For the purpose of the model development, a favourable taxation regime is such a regime, which is either totally independent on accounting or in case that tax base refers to accounting income income reported in the IFRS financial statements is also relevant for the tax calculation. The proposed model identifies eight possible areas, for which IFRS can be relevant (see Table 1). The measure of IFRS adoption level uses a simple binary variable 1, if the IFRS are required or allowed in a particular area, or 0 if not permitted. The maximum value of the IFRS Adoption Index is 8, if IFRS are required or allowed to be used in all eight areas. If a country is not engaged in accounting harmonisation in any of defined areas, the IFRS Adoption Index reaches value of 0. Insert Table 1 here The construction of the IFRS Adoption Index allows for distinguishing among various jurisdictions according to the extent, at which entities domiciled in particular jurisdictions are obliged or allowed to prepare their financial statements in compliance with the IFRS. Based on criteria outlined in Table 1, each country can be classified under one out of nine categories depending on areas of possible or mandatory IFRS utilisation. Table 2 summarises the calculation of the IFRS Adoption Index for the member states of the EU. Although accounting is the subject of EU-wide regulation under a common regulatory framework, there are considerable differences between Member States in the de jure harmonization of financial reporting. The main reason for existing differences is that the Regulation on application of IAS defines the obligation to use standards in the consolidated financial statements of listed companies only. For all other entities, a choice of accounting standards remains fully in the responsibility of Member States. Each country follows its own motive when establishing its accounting system, especially in terms of separate financial statements, which are used for statutory, taxation and other purposes. It can be assumed that historical and cultural traditions significantly influence the decision whether mandate or permit the application of IFRS beyond the minimal requirements of the Regulation. Insert Table 2 here The lowest level of the IFRS adoption is evidenced in Austria, which has applied the Regulation on IAS just in the most restricted extent and minimum requirements were implemented in national legislation only. Similarly, the scope of companies ISBN: 978-1-61804-124-1 374

applying the IFRS pursuant domestic legal regulatory framework is relatively narrow in France, Hungary and Spain. On the other hand, seven out of 27 Member States of the European Union have qualified for the level 8 of the IFRS Adoption Index, which means that IFRS can be applied effectively by all companies both in their separate and consolidated financial statement. Furthermore, the taxation regime is relatively favourable to implementation of the IFRS. It means that either tax regime is established independently on accounting system or, if tax legislation rests on statutory accounts, the IFRS profits are relevant for the derivation of tax base, too. 4 Conclusion The existence of significant differences among various national accounting systems has been gradually removing by the worldwide implementation of IFRS. The harmonisation of accounting rules and accounting practices is an important research issue. The paper presents a brief review of relevant research evidence, especially on issue addressing the measures of international accounting harmonisations. The main limitation of presented approaches is that they encompass mostly correlation of de facto accounting harmonisation between a pair of countries. The formulation of regression models, which are constructed in order to assess the role on IFRS adoption on explained economic variables, demands a coherent measure of de jure harmonisation. The IFRS Conformity Index, developed by Ding et al. (2005) on data from 2001, measures this harmonisation of rules with respect to absence and divergence of domestic GAAP in comparison with the IFRS. To overcome its unifying assumption of equal extent of the IFRS adoption, the IFRS Adoption Index is proposed. The logic of the IFRS Adoption Index stems from the fact that the pattern of de jure harmonisation differs substantially among countries. In some jurisdictions, only consolidated financial statements of listed companies have to be prepared in compliance with IFRS. Other states broaden the scope of IFRS reporting and they permit the application of IFRS even in separate financial statements on unlisted companies. The IFRS Adoption Index provides a platform for differentiating among countries in those econometric models, which deal with the assessment of influence of the IFRS on macroeconomic variables. However, there exist several limitations of the Index. Firstly, there are numerous fields, for which IFRS financial statements can be found useful. The Index contains eight fundamental fields, which can be modified or extended in some instances. Secondly, binary values 1 and 0 express whether IFRS are adopted or not in a particular field of financial reporting, but without any further elaboration of specifics in each country. Certain research designs may require further refinement of the level of adoption. Distinguishing between mandatory and voluntary application of IFRS can be crucial e.g. in research evaluating the comparability of financial statements. However, the extension of number of categories regarding the level of IFRS adoption from two categories (i.e. required/allowed, not permitted) to three (i.e. obligatory application, voluntary application, not permitted) triggers a conceptual problem how to sum up the results from each field. It is possible to denote the obligatory application of IFRS by mark 2, voluntary application by 1 and not permitted application by 0. Yet, it can be hardly assumed that obligatory application is twice better than the voluntary application of IFRS. Thirdly, the IFRS Adoption Index implicitly assumes that all fields of the IFRS adoption are equally important for the users of financial statements. This presumption enables to sum up the partial results from each field together and the IFRS Adoption Index can be thus reformulated as a percentage of fields, in which the IFRS can be actually applied, in relation to all areas of possible IFRS utilisation. The assumption, that users of financial statements perceive all areas of possible application of the IFRS as equal, helps in overcoming the conceptual shortcomings of ordinal measurement scales (Stevens, 1946). Yet, the assumption is not realistic. Further research should therefore deal with the quantification of weights to be assigned to each of defined areas of the IFRS application. The calculation of coefficients are expected to rest on the users perception of relative importance of each field, in which a particular country may require, permit or prohibit the application of IFRS for the preparation of consolidated and/or separate financial statements. Acknowledgement This paper is an output of a research project Adoption of the IFRS and Its Influence on the Mobility of Labour and Capital" supported by the Internal Science Foundation of the University of Economics, Prague (registration number F1/4/2011). References: [1] Aisbitt, S. (2001). Measurement of Harmony of Financial Reporting Within and Between Countries. The Case of the Nordic Countries. European Accounting Review, 10(1), pp. 51-71. ISBN: 978-1-61804-124-1 375

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Table 1: The areas of IFRS application for the calculation of IFRS Adoption Index No. Areas of the IFRS adoption IFRS required IFRS not or permitted permitted I Consolidated financial statements of a consolidating listed company 1 0 II Separate financial statements of a consolidating listed company 1 0 III Consolidated financial statements of a consolidating unlisted company 1 0 IV Separate financial statements of a consolidating unlisted company 1 0 V Separate financial statements of a consolidated unlisted company 1 0 VI Separate financial statements of a non-consolidated unlisted company 1 0 VII Financial statements of entities in certain industries 1 0 VIII Taxation 1 0 Source: Author Table 2: The IFRS Adoption Index for the EU countries EU Member State I II III IV V VI VII VIII Index Austria 1 0 0 0 0 0 0 0 1 Belgium 1 0 1 0 0 0 1 0 3 Bulgaria 1 1 1 1 1 1 1 0 7 Cyprus 1 1 1 1 1 1 1 1 8 Czech Republic 1 1 1 1 1 0 0 0 5 Denmark 1 1 1 1 1 1 1 1 8 Estonia 1 1 1 1 1 1 1 1 8 Finland 1 1 1 1 1 1 1 0 7 France 1 0 1 0 0 0 0 0 2 Germany 1 0 1 0 0 0 1 1 4 Greece 1 1 1 1 1 1 1 0 7 Hungary 1 0 1 0 0 0 0 0 2 Republic of Ireland 1 1 1 1 1 1 1 1 8 Italy 1 1 1 1 0 0 1 1 6 Latvia 1 1 1 0 0 0 1 0 4 Lithuania 1 1 1 1 1 1 1 0 7 Luxembourg 1 1 1 1 1 1 1 1 8 Malta 1 1 1 1 1 1 1 1 8 Netherlands 1 1 1 1 1 1 1 1 8 Poland 1 1 1 1 1 0 0 1 6 Portugal 1 1 1 1 1 0 0 0 5 Romania 1 1 0 0 1 0 0 0 3 Slovakia 1 1 1 0 0 0 1 1 5 Slovenia 1 1 1 1 1 1 1 0 7 Spain 1 0 1 0 0 0 0 0 2 Sweden 1 0 1 0 0 0 1 0 3 United Kingdom 1 1 1 1 1 0 0 1 6 Source: Author based on Deloitte and PwC data 1 1 The calculation uses data about the regulatory framework published by Deloitte and PricewaterhouseCoopers as at the end of 2011. The respective url are as follows: http://www.iasplus.com/en/resources/use-of-ifrs http://www.pwc.com/en_us/us/issues/ifrs-reporting/assets/ifrs_country_adoption.pdf ISBN: 978-1-61804-124-1 377