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The virtues and vices of IFRS

Ian Welch, ACCA head of policy

The ongoing debate around the virtues and vices of IFRS has been turned up a notch or two recently. In the UK, dissident voices claim the standards are damaging banks and worsening the financial crisis. The Association of Chartered Certified Accountants (ACCA) is addressing this head-on with roundtable debates involving the key players and I will return to this soon in a future blog.

But it should never be forgotten that Europe, and the US (with its reluctance to converge) is not the only game in the global town. As part of a broader initiative to examine the impact of IFRS on the global economy, ACCA has recently published a research report examining the effect of IFRS in China over the past five years. It makes very interesting reading.

In Does IFRS Convergence Affect Financial Reporting Quality in China? academics Edward Lee and Professor Martin Walker of Manchester University, and Colin Zeng of the University of Bristol, look at whether the usefulness of accounting earnings among China's listed firms has changed since the introduction of IFRS-converged Chinese Accounting Standards (CAS) in 2007. The International Accounting Standards Board (IASB) believed CAS to be 'sufficiently converged' with IFRS, and as of 2010, CAS were reckoned to be about three-quarters of the way towards full IFRS.

If reported accounting figures provide information to investors about the value of a company, one would expect them to be correlated with the company's share price. However, this correlation is never perfect, because reported figures are fuzzy signals: part information, and part 'noise.' Accounting noise comes from many sources: one-off events; accounting rules; intangible assets; calculation errors; or intentional manipulation by management.

When published figures are noisy, investors have to make adjustments to them, or assume that companies with noisier accounts are riskier than they look. Both reactions weaken the link between reported figures and the company's share price. 'Value relevance' studies such as the ACCA project take advantage of this in order to estimate how useful the accounts are to investors, and whether they have become more useful over time.

To ensure their findings are truly the result of IFRS convergence, and not other changes to the Chinese economy or capital markets, the researchers took advantage of a very fortunate feature of China's convergence path - a natural experiment - the fact that many companies were already reporting to an IFRS-converged standard even before 2007.

Companies can issue two types of shares in China - 'A' shares, denominated in RMB, which are intended for domestic investors, and 'B'shares, denominated in US or Hong Kong mostly intended for foreign investors. Since 2001, 'B' share issuers have been required to accompany their published accounts with IFRS reconciliations.

This meant that the issuers of A and B shares were like treatment and control groups in a controlled experiment - they have been subject to the same influences in almost every way, apart from reporting requirements. So changes to the value relevance of reporting after 2003 can be calculated for both groups, and pronounced variations could be reasonably attributed to IFRS convergence.

The research found that earnings became significantly more value-relevant under IFRS-converged CAS only in the treatment group:
the A-share issuers who did not have to make IFRS-converged disclosures before 2007. In the control group of B-share issuers, earnings remained about as informative as they were previously.

The research shows that the benefits depend on the extent to which firms listed in Shanghai or Shenzhen have sufficient incentives to give an accurate account of themselves. High-quality disclosures are a valuable tool for manufacturers in particular, which face fierce competition for equity funding. Companies that cannot rely on government funding have improved their disclosures more than others; so have companies in less-developed parts of China, and those with foreign shareholders.

So, in conclusion, the research proved that investors in Chinese firms find earnings more informative post IFRS convergence - and this change is hard to attribute to any factor other than convergence itself. Past research on the impact of IFRS has shown benefits for countries with more developed stock markets and strong institutional frameworks.

For bodies such as ACCA, who have consistently championed the cause of global standards, it is encouraging indeed to see convergence to IFRS strengthening the Chinese economy by making reported earnings more informative and useful to investors - the key audience for any financial reporting regime.

IFRS convergence should help China achieve more balanced, equitable and sustainable growth as well as further integrate into the global economy. It also means that, as the institutional environment of Chinese stock exchanges continues to develop, the benefits of that convergence will grow.

For all the furore over IFRS in the old markets of Europe and the US, studies such as this remind us of how important emerging economies are now realising the true value of standards which inform investors and which are globally comparable.

Ian's previous blog post
The scrutiny of finance professionals

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