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Differences in balance sheet disclosure under IFRS

An analysis of cross-country company balance sheets

Forschungsarbeit 2008 44 Seiten

BWL - Bank, Börse, Versicherung


Table of contents

1 Introduction

2 Literature review
2.1 Adoption of IFRS
2.1.1 Pros and cons of the adoption of IFRS
2.1.2 The balance sheet
2.2 Information in the balance sheet
2.2.1 Materiality
2.2.2 Recognition materiality
2.2.3 Determining recognition materiality
2.3 Countries
2.3.1 High enforcement versus low enforcement
2.3.2 Prior rules-based versus principles-based
2.3.3 Code law versus common law

3 Research design
3.1 Sample selection
3.2 Variables
3.3 Testing the Hypotheses

4 Results
4.1 Relation between variables
4.2 Data analyses
4.2.1 High or low enforcement
4.2.2 Prior rules- or principles-based
4.2.3 Common law or code law

5 Conclusion

6 Limitations and suggestions


1 Introduction

In 2005, a large development appeared in financial reporting of listed companies in the European Union. This development is the adoption of the International Financial Reporting Standards (IFRS). IFRS are standards for financial reporting developed by the International Accounting Standards Board (IASB). The IASB is acknowledged by the European governments as the standard setter regarding financial reporting in Europe and as of January first, 2005, IFRS is mandatory for all listed companies in the European Union (Soderstrom and Sun, 2007). With the adoption of IFRS in the European Union, the IASB only accomplished a part of their primary objective. On the IASB website their principal objective is formulated as follows:

“The goal of the IFRS Foundation and the IASB is to develop, in the public interest, a single set of highquality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles” (

The ambitious nature of this goal becomes more evident when the subject is more elaborated on. Especially the objective to develop globally accepted financial reporting standards has its difficulties, because the economic, political and legal environments in different parts of the world are very diverse. These differences could affect the compliance with the standards and therefore the comparability of the financial statements. This research focuses on countries within the European Union and attempts to clarify differences in post-adoption balance sheet information due to the different backgrounds in this, relatively to global adoption, small and comparable region.

This research is largely based on the materiality concept and more specific the recognition materiality concept. From this angle differences in disclosure in companies’ balance sheets are examined. The research is based on three characteristics of countries and the financial reporting environment. First differences between high and low enforcement countries are examined. The second comparison is based on the domestic GAAP of the countries and whether these were prior rules-based or principles-based. The last distinction is made between the legal systems. Differences are examined between common law countries and code law countries.

To my knowledge, this research has never been conducted before. The concept of recognition materiality has been researched before, as well as the quality of financial statements related to the adoption of IFRS. However, this research and the used variables focuses on one of the fundamental components of financial statements and the variables have, to my knowledge, never been used before. It is also relevant because the same rules and guidelines (IFRS) apply for all researched countries. The adoption of IFRS should increase the comparability of the financial statements, improve corporate transparency and increases the quality of the financial reporting within the European Union (EC Regulation No. 1606/2002). However countries within the EU have different backgrounds and applied prior to the adoption of IFRS their own set of General Accepted Accounting Principles (GAAP). Therefore it is interesting to research whether there are significant differences in the information presented in the balance sheets for these different backgrounds. In order to perform the research, it is based on the following research question:

What differences exist in the disclosure in balance sheets of companies in different countries, which apply the same rules and guidelines?

This research report consists of six sections of which the introduction is the first. The second section is a literature review in which prior research is discussed and the context of this research is clarified. In the third section, the empirical research and the used variables are described. The results of this empirical research are discussed in the fourth section and in the fifth section the conclusions are presented. The last section contains limitations of this research and suggestions for further research.

2 Literature review

IFRS has been a popular subject in studies before, and after the adoption. Even before the adoption of one set of accounting standards became realistic, researchers discussed differences between the domestic GAAP of countries in their studies. The globalization caused an increase in this kind of research, but researchers still do not agree on what principles and standards are the best. IFRS is also not complete and therefore constantly adapted and improved in order to find an optimum in providing a set of rules and principles for financial reporting.

The literature review consists of three sections. The first section contains information concerning the adoption of IFRS. This section contains a brief description of the road to adoption of IFRS, the most considerable pros and cons and the requirements for the balance sheet. The second section is focused on information in the balance sheet. In this section all considerable factors of information in the balance sheet are described and particular attention is focused on materiality and recognition materiality. The last section contains characteristics of the researched countries and explains the context in which companies from these countries are examined.

2.1 Adoption of IFRS

Prior to the adoption of IFRS, there were extremely diverse, country-specific accounting systems. In the late 1970’s and 1980’s, the European Commission started the harmonization of accounting standards. The EC issued several directives with the objective to harmonize financial reporting practices, reduce diversity and facilitate cross-border listings and cross-border investments. However, the results regarding the success of these directives are mixed[1].

The harmonization of accounting standards progressed in the 1990’s with the development and later the improvement of the International Accounting Standards (IAS), harmonization events in the European Union economy (e.g. the adoption of a single currency) and political changes (e.g. the disappearance of border control within the Schengen area). IAS is the precursor of IFRS and developed by the International Accounting Standards Committee (IASC). The IASC was in 2001 replaced by the IASB to reduce political influence. This mirrors a change of 1972 in the U.S. where the American Institute of Certified Public Accountants (AICPA) was replaced by the Financial Accounting Standards Board (FASB) to improve independence of the standard setters. IAS is later revised and adopted to IFRS (Soderstrom and Sun, 2007).

The most important change was on June 6, 2002, when the European Parliament passed a regulation that requires all listed companies within the EU to report according to IFRS for fiscal years starting after January 1, 2005. In the period from 2000 until the official statement of the Council of Ministers of the EU in 2002, Comprix et al. (2003) indentified eleven dates that signal the likelihood or the timing of IAS/IFRS adoption in the EU. They found positive stock market reactions to news that increases the likelihood of IFRS adoption, which implies investors foresee more pros than cons of IFRS adoption. The most considerable pros and cons are discussed in the next paragraph.

2.1.1 Pros and cons of the adoption of IFRS

The adoption of IFRS caused many changes in financial reporting within the EU. Because every country had its own set of General Accepted Accounting Principles (GAAP), the adoption of IFRS affected every country differently. Barth et al. (2011) stated that IFRS are largely derived from financial accounting standards developed in common law countries, therefore it could be argued that the changes in common law countries were less severe, than in code law countries.

Besides different changes for different countries, there are multiple stakeholders affected by the adoption of IFRS. The financial statements are used by companies itself, banks, governments, investors, creditors, labor unions etc. The accompanying different interests of these stakeholders may contradict and the adoption of IFRS has therefore pros and cons that are not equal for all stakeholders. In the accounting literature the pros and cons are for the larger part discussed from the investors’ perspective, but even than some pros and cons are discussable. For example Barth et al. (2008) found that the adoption of IFRS caused earnings management to decrease. Naturally the interests of managers and investors contradict on this subject, but the advantage for investors can also be the subject of discussion. The general opinion on earnings management is that it has a negative influence on the quality of financial statements, but it could be argued that earnings management can also be used for signaling, which provides investors with additional information (Healy and Wahlen, 1999).

For this research the most considerable advantage of the adoption of IFRS is the intended higher comparability between companies in different countries. This should make cross-border investments and cross-border listing easier (Gehrig, 1993 and Ball, 2006). This advantage affects investors in two ways. First, investors are better able to make cross-border investments and second, investors should be rewarded with higher takeover premiums due to the easier cross-border investments and acquisitions of companies (Bradley et al., 1988).

Barth et al. (2008) suggest that the quality of financial reporting within the European Union should increase. This should be caused by less earnings management, more timely loss recognition and more value relevance of earnings. In theory this advantage of IFRS should also lead to a decrease of firms’ cost of capital, due to the increased quality of information available to creditors. Daske et al. (2008) researched this and found that the adoption of IFRS did indeed lead to a decrease of cost of capital. However, they only found a decrease in countries where firms have incentives to be transparent and where legal enforcement is strong. This implies differences between countries beyond accounting standards.

There was also some criticism on the adoption of IFRS. The most considerable disadvantage of the adoption of IFRS is that a single set of standards may not be suitable for all countries. For example, Ball (2006) points out that companies differ in strategy, investment policy, financing policy, industry, technology, capital intensity, growth, size, political scrutiny, geographical location and the types of transactions they enter into. Countries differ in how they run their capital, labor and product markets, and in the extent and nature of governmental and political involvement in them. Ball further states that it has never been convincingly demonstrated that there exists a unique optimum set of rules. All these differences could influence the comparability and quality of financial statements across countries.

The concept of “fair value accounting” is strongly emphasized by the IASB. It is currently used in multiple standards within IFRS, which have significant influence on the balance sheet[2]. The IASB has signaled the intention to expand the use of fair value accounting in the future. There has been a lot of discussion on this subject and the discussion is still going. The opinion on the concept of fair value accounting is positive, equity value can be read from the balance sheet without further analysis needed and the income statement reports realizations for determining value and risk (Penman, 2007). In practice however, researchers foresee more problems. Fair value accounting only contains more information than historical cost accounting whenever there exist either (Ball, 2006):

1. Observable market prices that managers cannot materially influence due to less than perfect market liquidity; or
2. Independently observable, accurate estimates of liquid market prices.

When either of these conditions exist, fair value accounting reduces opportunities for managers to influence the financial statements by exercising their discretion over realizing gains and losses through the timing of asset sales. In illiquid markets however, managers can influence prices and hence manipulate fair value estimates. Furthermore when liquid market prices are not available, fair value accounting becomes “mark to model” accounting. Firms then report estimates of market prices, instead of real market prices. This introduces “model noise,” due to imperfect pricing models and imperfect estimates of model parameters. When this occurs, fair value accounting increases opportunities for manipulation, because managers can influence both the choice of models and the parameter estimates (Ball, 2006 and Penman, 2007).

Because of the diversity of the pros and cons, it is difficult to judge whether there are more pros or cons. This is strengthened by the fact that not all pros and cons are elaborated on in this research. According to Ball (2006), the IASB achieved extraordinary success in developing a comprehensive set of high quality IFRS standards. The impression of the overall advantage of IFRS is strengthened by the fact that almost 100 countries adopted IFRS and the IASB obtained strong convergence with important non-adopters like the US (Ball, 2006). Therefore the IASB largely achieved their principal objective.

2.1.2 The balance sheet

The adoption of IFRS naturally also affects the balance sheets of the listed companies within the EU. Because of the adoption of IFRS the comparability of the balance sheets should increase. The balance sheet is one of the fundamental components of the financial statements. It provides users of the financial statements the opportunity to evaluate the financial condition of a company. When a company has relative high or low borrowings, banks and other creditors can adapt the conditions in contracts for additional borrowings. It can also be an advantage for the company itself, because when a company has relatively low borrowings, it can negotiate low interest payments on borrowings. Governments require information for tax purposes and labor unions use it to negotiate labor contracts. There is also a large range of financial ratio’s which is based on the balance sheet and often used by investors and rating agencies[3].

According to many local GAAP, assets should be recognized on the balance sheet against historical costs and additionally be depreciated every year. IFRS requires the use of fair value for the most balance sheet accounts. Naturally this had its effect on the amounts recognized on the balance sheet, but it should provide more information and increase the comparability of companies which report according to IFRS.

Besides the valuation of items on the balance sheet, IFRS provides guidelines for the presentation of the financial statements in IAS 1. It requires all financial statements to contain a statement of the financial position (i.e. balance sheet). The minimum requirements for the balance sheet are described in IAS 1.54 (IFRS, 2010):

54. As a minimum, the statement of financial position shall include line items that present the following amounts:

(a) property, plant and equipment;
(b) investment property;
(c) intangible assets;
(d) financial assets (excluding amounts shown under (e), (h) and (i));
(e) investments accounted for using the equity method;
(f) biological assets;
(g) inventories;
(h) trade and other receivables;
(i) cash and cash equivalents;
(j) the total of assets classified as held for sale and assets included in disposal groups classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations;
(k) trade and other payables;
(l) provisions;
(m) financial liabilities (excluding amounts shown under (k) and (l));
(n) liabilities and assets for current tax, as defined in IAS 12 Income Taxes;
(o) deferred tax liabilities and deferred tax assets, as defined in IAS 12;
(p) liabilities included in disposal groups classified as held for sale in accordance with IFRS 5;
(q) non-controlling interests, presented within equity; and
(r) issued capital and reserves attributable to owners of the parent.

According to IAS 1.54 every balance sheet should contain 18 different accounts, but IAS 1.55 and 1.57 (IFRS, 2010) state:

55. An entity shall present additional line items, headings and subtotals in the statement of financial position when such presentation is relevant to an understanding of the entity’s financial position.

57. This Standard does not prescribe the order or format in which an entity presents items. Paragraph 54 simply lists items that are sufficiently different in nature or function to warrant separate presentation in the statement of financial position. In addition:

(a) line items are included when the size, nature or function of an item or aggregation of similar items is such that separate presentation is relevant to an understanding of the entity’s financial position

IAS 1.55 states that a balance sheet can contain additional line items, headings and subtotals, therefore a balance sheet can be as extensive as a company ought it to be. IAS 1.57 however, states that items are only included when the size, nature or function of an item is relevant to the understanding of the financial position, but this is the preparers’ decision. Therefore the standard leaves some room for interpretation. In essence, IFRS require the inclusion of a balance sheet into the financial statements of companies, but further only provide guidelines which companies may or may not follow.

2.2 Information in the balance sheet

The guidance for information in the balance sheet is limited. Besides the minimal requirements presented in IAS 1.54, there is not much guidance for the structure and content of the balance sheet and therefore the amount of information in the balance sheet can be very different for various companies. The amount of information in the balance sheet is for the larger part decided upon by the preparers of the financial statements. The opinion of auditors also influences the information in a balance sheet, because the information in a balance sheet has a significant influence on the audit opinion. However, preparers of the financial statements primary recognize balance sheet accounts which in their opinion contain material information for users of the financial statements. Therefore the amount of information in a balance sheet largely depends on the interpretation of materiality by the preparers of financial statements. Because materiality is a complex concept and often misunderstood, it is more extensively discussed in the next paragraphs (Brennan and Gray, 2005).

2.2.1 Materiality

Every listed companies’ annual report contains a statement that it is the managements’ and auditors’ responsibility to provide financial statements which are free from material misstatements. Every investor has some kind of estimation of a material misstatement, but a clear definition of materiality is not provided in the financial statements. In the literature, different definitions of materiality are available. The definition of materiality according to the IASB is defined in International Accounting Standard (IAS) 8.5 (2010), it states:

“Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor.

The distinction between omissions and misstatements is in practice more evident. Figure 1 shows the process of materiality-decisions for the preparers and auditors. The preparers first apply some level of materiality in producing the financial statements. The auditors then apply their level of materiality on the audit of the financial statements. However, in financial reporting the level of materiality is also important to users of the financial statements and although the actual level of materiality is decided upon by auditors and preparers, the definition has a user-orientation (Brennan and Gray, 2005).

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: Four-stage materiality decision process in financial reporting cycle (Brennan & Gray, 2005, pp. 10).

According to Brennan and Gray (2005) the auditors have the incentives to choose a high level of materiality possibly at the expense of the user-orientation. This is because there is a cost-benefit trade-off. Lower levels of materiality require more audit effort and are therefore more expensive, pressuring the profit of the audit. Conversely, higher levels of materiality are cheaper and therefore more profitable. Holstrum and Messier (1982) researched the levels of materiality utilized by the three groups of stakeholders. They found that preparers of financial statements utilize the highest level of materiality, compared to auditors and investors. Investors utilize the lowest level of materiality. Jennings et al. (1987) researched the levels of materiality utilized by auditors and users of financial statements. They also found differences between these groups, but their research also indicated differences within the group of auditors and within the group of users. The results are interesting because preparers and auditors are assumed to work in the best interests of the investors, but generally the investors expect more information than preparers and auditors provide. It is however difficult to assess the users’ preferences for information due to the diversity of preferences within the group.


[1] E.g. Joos and Lang, 1994; Harris et al., 1994 and Auer, 1996.

[2] See Ball, 2006, pp. 19 for a list on how fair value accounting exactly is used in different standards.

[3] E.g. Feng and Wang, 2000 and Turner, 1997.


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Titel: Differences in balance sheet disclosure under IFRS