Some Views on how IFRSs Increases Transparency and Economic Stability

 

According to information economics, economy is characterized by information asymmetry, in which some parties to business transactions may possess an information advantage over others (Scott, 2005). In order to reduce information asymmetry, financial information fulfill the role to convey fair and faithful information to investors and to record operation results to reflect manager efforts. Thus some specific qualities are required for financial information, like relevance, faithful representation, capability, timeliness, understandability and so on (Kieso, 2009). However, information asymmetry, which creates the demand for information production by firms, also creates a demand for regulation of that information production. This is because of the problem of unanimity – the amount of information that firms would privately produce need not, and in general will not, equal the amount that investors want. As a result, investors may push for regulation to remedy the perceived deficiency (Scott, 2005). We have witnessed lots of regulation coming, and it seems that there is no slowing down in the rate at which new regulations and standards are coming afterward. But there is a fact often ignored by standard setters that regulation has a cost. As recent financial crisis in the global capital markets has undermined the importance and the quality of financial disclosure and the transparency in markets around the world, our attention is attracted back to information asymmetry question and many are searching and analyzing which financial information disclosure rules and standards should be followed (Elliott, 2011). Many agree that one set of financial information standards would be necessary for the market globalization, and IFRSs has the best potential to meet the need. To support this argument is one of the purposes of the text, and the other is to offer reasons for the support by critical assessment. The text would be constructed in five parts, which include the purposes of financial information, the qualities of financial information, why IFRSs would be a need, how IFRSs increases transparency and economic stability, and conclusion.

Part 1 the Purposes of Financial Information

Since in the early eighteen century, a joint stock company had emerged in England, and the transferability of shares led to the development of a stock market. In order to transfer the shares better, investors would try to know the business circumstances more. At the same time, firms would like to communicate its internal business information to the externals so as to get the firms valued correctly and finance less costly. During the process of information demanding and offering, financial information plays a replaceable role. Thus it began a long transition for financial accounting, from pure management purpose to a system to inform relevant information of the firms to internal and external parties for serving their interests. However, in the real world, there is a formally recognized fact that some parties to business transactions may possess an information advantage over others (which is also called information asymmetry), and the information asymmetry hinders the information communication efficiently and makes investment decision costly (Brealey, 2003). There are two major types of information asymmetry called adverse selection and moral hazard. According to the definition by Scott, adverse selection is a kind of information asymmetry in which one or more interest groups to a business transaction may have an information advantage over others, and moral hazard is a kind of information asymmetry in which one or more parties to a business transaction can observe their actions in fulfillment of the transaction but other parties cannot (Scott, 2005). To reduce information asymmetry or control them fulfills the most role of financial information.

Part 2 the Qualities of Financial Information

It is a difficult task for financial information to control information asymmetry. The environment of financial information is both very complex and challenging, because the most useful financial information to inform investors, in which adverse selection can be effectively controlled, need not be the best measure to motivate managers’ performance, in which moral hazard can be effectively controlled. Investors’ interests are be best served by information with reliable and fair value and managers’ interests are best served by information with stable measurement. It is this need for financial reporting to fulfill a dual role of meeting investors’ information needs and the manager compensation needs that creates the fundamental problem of financial information (Castro, 2006).

There are two basic views of reactions to the problem. One is to let market force determine what kinds of and how much information firms should produce. Investors and other financial information users are treated as demanders and managers as supplier, and then let the forces of demand and supply determine the production of information. The second is to turn to regulation on the grounds that information is such a complex commodity that market forces alone fail to adequately control information asymmetry (Scott, 2005).

At the present time, we live in a time of market force and regulation, and we simply do not know which of the above two reactions to the information asymmetry is on the right track. But there are some fundamental qualities for financial information required both by market force and regulation, which includes relevance, faithful representation, comparability, timeliness, understandability (Kieso, 2009). If these qualities are reasonably guaranteed in financial information, a high-quality financial reporting would be available which could convey the internal information to the outsiders and enhance the transparency for investors effectively. Then transparency can speed up the stock price adjusting to the real value and decrease the volatility of the stock price, and further enhance the whole economic stability by increasing every single stock price’s stability accumulatively.

Part 3 Why IFRSs would be a Need

For many years, many nations have relied on their own standard-setting organizations, like Canada has the Accounting Standards Board, and the United States has the Financial Accounting Standards Board (FASB). The standards issued by these organizations are sometimes principles-based, rules-based, tax-oriented, or business-based. In other words, they often differ in concepts and objectives. However, the recent global financial crisis has undermined the importance of financial disclosure and transparency in markets around the world, and many are examining which financial reporting standards and rules should be followed as a result (Elliott, 2011). Since the entire world markets are becoming increasingly intertwined and the capital markets are becoming increasingly integrated, most agree that there is a need for one set of international accounting standards. Starting in 2000, two major standard-setting bodies have emerged as the primary standard-setting bodies in the world, and one is the International Accounting Standards Board (IASB). The IASB issues International Financial Reporting Standards (IFRSs), which is used on most foreign exchanges. IFRSs is presently used in over 115 countries and is rapidly gaining acceptance in other countries as well.

The objectives of IFRSs are 1) to develop a single set of high-quality, understandable, and enforceable global accounting standards that require high-quality, transparent, and comparable information in financial statements and other reporting to help participants in the world’s capital markets and other users to make economic decisions; 2) to improve the use and rigorous application of those standards; and 3) to bring about convergence of national accounting standards and International Accounting Standards with high-quality solutions (Scott, 2005). Based on its wide usage and its universal objectives, it is generally believed that IFRSs has the best potential to provide a common platform on which companies can report and investors can compare financial information, and this argument gets its support in this text.

Part 4 How IFRSs Increases Transparency and Economic Stability, 

Compared with the financial information produced complying with different regulations in different nations, we believe that, by providing financial information based on the only one set of standards, IFRSs will help investors to make their investment decision better by producing financial information with more faithfulness, comparability, timeliness and understandability, and all of these will further decrease information asymmetry and increase transparency and economic stability. Here are the reasons:

  • Transparencyand economic stability are mainly influenced by the qualities of financial information, and the specific relationship between them is described as below:

Relevance – to be relevant, financial information should be helpful for investors to make investment decision better when it has predictive value, confirmatory value, or both. Financial information has predictive value if it helps investors to form their own expectations about the future, and confirmatory value if it helps users to confirm or correct prior expectations (Kieso, 2009). The more the information is relevant, the more the business circumstance would be known, and the more transparency can be guaranteed. Also, the more the firm future expectation is correctly formed, the more the stock price would be stable and the more the accumulated economy would be stable.

Faithful Representation – it means the descriptions match what really existed or happened. Faithful representation is a necessity because most users have neither the expertise nor the time to assess the factual content of the information. To be a faithful representation, information must be complete, neutral, and free of material error. Completeness means that all necessary information should be provided, or an omission could cause false or misleading, neutrality means that information cannot be selected to favor one set of users over another, and free from error means the financial items should be represented correctly and appropriately complying with relevant regulations (Kieso, 2009). Obviously, transparency and economic stability would be positively affected by faithful representation.

Comparability – it means information is reported and measured in a similar manner for different periods in the same firm or different companies in the same period (Kieso, 2009). By comparing financial information, abnormal changes can be observed and analyzed, and deeper understanding and more correct expectation about the firm would be formed which will further enhance transparency and economic stability.

Timeliness – it means to make information available to decision-makers before it loses its capacity to influence decisions (Kieso, 2009). Having relevant information available sooner can enhance its capability to convey information and increase transparency for investors, which will speed up the stock price adjusting to real value and enhance the economic stability.

Understandability – it is the quality of information that lets knowledgeable users see its significance. Understandability would be enhanced when information is characterized, classified, and presented clearly and concisely (Kieso, 2009). The more the information is understandable, the more concise and clearer information can be got, and the more the transparency can be increased, so does economic stability as mentioned above.

  • IFRSs can not only provide financial information with these qualities as other regulations can, but also can provide financial informationwith enhanced faithfulness, comparability, timeliness, and understandability. 

IFRSs can provide more faithful financial information for it can regulate the information more completed, neutral and more likely free from error. For more completeness, IFRSs set the minimize information disclosure requirements, but not the maximize requirements, which means that financial information would be more completed if it did not meet the minimize requirements based on other than IFRSs before, but financial information would not be reduced or become less completed if it exceeded the minimize requirements. By the requirements, the average level of completeness would be improved to some extent. For more neutral, IFRSs can bring more interest groups into the process of standard settings and consider the interests of all parties more fairly and neutrally. Financial information standard setters can be guided by decision usefulness and reduction of information asymmetry. However, these criteria are not sufficient to ensure successful standard setting. The legitimate interests of management and other constituencies also need to be considered, and the actual process of standard setting is better described by the interest group theory of regulation. The more an interest group is influential than other groups, the more the standard would be set partially, and the less the regulation would be neutral. By bringing in more interest groups with balanced influential power, IFRSs makes the regulation standards setting more neutral. For more likely free from error, IFRSs can make the produce process of financial information less complex by allowing the information makers mastering only one set of standards rather than many sets of standards which exhausted and confuse makers.

IFRSs would make financial information more comparable. By setting financial information complying with one standard in wider region, IFRSs would make financial information more comparable between the firms in different nations and countries. The comparability would allow users to dig out more information of business condition about the firms to improve their understanding.

IFRSs could also make financial information more understandable and timely. By using only one set of reporting standards, IFRSs allow users to focus their energy on the studying of the standards so as to improve the understanding about the regulations and the information based on the regulations. In return, more understandable information allows users to get the essence of the information more easily and timely.

With the help of the positive connection between the qualities of financial information and transparency and economic stability as described in paragraph 1), it can be seen that IFRSs gets the aim to increase transparency for investors and economic stability with these enhanced qualities listed above.

Part 5 Conclusion

Though the positive effect the IFRSs brings to transparency for investors and economic stability is predictable, some other key issues are not fully considered in this text, like cost of application of IFRSs, the effect the IFRSs motivates manager performance, and the fitness the IFRSs and economic patterns and so on, which would increase the uncertainty of application of IFRSs around the world. If IFRSs is looked up to be applied internationally, some further research and analysis on the uncertainties would be necessary.

 

References

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Kieso, Donald E., Weygandt, Jerry J. & Warfield, Terry D. (2009). Intermediate Accounting. 14th edition. USA: John Wiley & Sons.

 

Elliott, Barry & Elliott, Jamie (2011). Financial Accounting and Reporting. 14th edition. London: Pearson Education.

 

Stice, Earl K., Stice, James D. & Skousen, K. Fred (2008). Intermediate Accounting. 17th edition. USA: South – Western Cengage Learning.

 

Brealey, Richard A. & Myers, Stewart C. (2003). Principles of Corporate Finance. 7th edition. London: the McGraw – Hill Companies.

 

Atrill, P. & McLaney, E. (2008). Accounting and Finance for Non-Specialists. 6th edition. London: Prentice Hall Financial Times.

 

Black, G. (2005). Introduction to Accounting and Finance. London: Prentice Hall Financial Times.

 

Castro, N. R. & Chousa, J. P. (2006). An Integrated Framework for the Financial Analysis of Sustainability.

 

Chadwick, L. (1996). The Essence of Financial Accounting. 2nd edition. Hertfordshire: Prentice Hall.

 

Ball, Ray & Brown, Philip (1968). An Empirical Evaluation of Accounting Income Numbers. Journal of Accounting Research, 6(2):159-178

 

Fama, Eugene, F. (1998). Market Efficiency, Long-term Returns, and Behavioral Finance, Journal of Financial Economics, 49:283-306

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