Without an agreed set of rules governing financial reporting, it is incredibly difficult for the user to understand and interpret the financial statements of any particular enterprise. It can also be quite costly, as the MNE has to include a lengthy and detailed explanation of the rules that has been followed in their preparation. IFRS will remove the need for this, as the rules will be concise and consistent between countries and MNEs within the EU. Therefore, this should increase the ease of the user to understand and interpret the MNE’s financial reports.
However, according to Anon (2004), this may not be achieved easily. IFRS recommends a vastly different approach to the valuation of assets, including property, pensions liabilities and acquisitions. This is because the new rules are based upon using fair or market value in the valuation of assets, as opposed to historical cost, which previous standards are based upon.
One of the main aims of the adoption on a EU-wide standard was to increase the relevance of information for investors. However, it has been argued, particularly by companies, that because the first few years of results under IFRS will be quite volatile, investors may become even more confused as they struggle to determine whether the company’s restated figures makes it a more or less attractive investment (Anon, 2004).
Another concern lies with the financial institutions within the EU. A new standard, IAS 39, requires firms to explicitly record a range of financial instruments, including derivatives and bonds, at fair value on the balance sheet. Any amendments to their value are to be fed through the profit & loss account, or shown in shareholders’ equity, depending on the instrument (Anon, 2004). This is something that has not been required by previous standards and could have a huge impact on banks and financial institutions, particularly due to the change in valuation methods mentioned earlier. Banks and other financial institutions are also concerned that IAS 39 will not match their internal risk management models. Hence, there is large opposition amongst financial institutions about IAS 39. The European Commission has acknowledged this and is therefore allowing companies to opt-out of the most controversial parts of IAS 39. Therefore, this does not signal confidence to MNEs about the quality of the new standards.
There have already been other measures implemented to economically integrate Europe. On the 1st January 1999, eleven Member States created the European Monetary Union (EMU) and a single currency, the Euro, with circulation of banknotes and coins occurring since 1st January 2002. This has increased economic integration across the EU in a number of ways. There are the obvious benefits for the citizens and companies of the, currently, twelve Member States, who can use the same currency across borders. Furthermore, it has also strengthened the EU’s international role amongst organisations, such as the IMF and World Bank, and has increased world trade. In addition, it was believed that the single currency would complement the single market, allowing for more efficient operation and the establishment of a sound macroeconomic framework.
Another measure was the merger of capital markets to create Euronext. Euronext was established in 2000 and is the first integrated exchange organisation in Europe. By integrating markets across Europe this can provide users with a single market that is very broad, highly liquid and cost-effective (Anon, Unknown, a). By developing and integrating Europe’s exchanges, Euronext has been able to generate synergies by incorporating each individual exchange’s strengths and assets (Anon, Unknown, a). Finally, due to the recent Directive on ‘Societas Europaea’, multinationals can now operate as one legal entity, across all the European borders.
However, with regards to accounting standards, in Europe, financial accounting and its framework has changed considerably in the last decade. The first step towards the unification of accounting standards was the Establishment of the European Community (EEC), also known as the Treaty of Rome. The treaty aims to “reach an economic equal level playing field within the Community” (Haller and Kepler, 2002). In order to achieve this, the Fourth (Council of the EC, 1978 cited by Haller and Kepler, 2002) and Seventh (Council of the EC, 1983 cited by Haller and Kelper, 2002) EC Directives’ were introduced, and which Member States were obliged to integrate into national law.
Nevertheless, the Commission stressed that uniformity between Member States would not be achieved purely through the implementation of these directives (Van Hulle, 1992 cited by Haller and Kepler, 2002). Instead, the aim was to create comparable and equivalent financial information between Member States (Commission of the European Communities, 1995; Van Hulle, 1993 cited by Haller and Kepler, 2002). These directives allowed the approaches to present accounting information used across Member States to be rationalized but also, “the impact of the directives was enormous, since it led to an obligatory codification of accounting rules with an identical scope through all national legislations” (Haller and Kepler, 2002). As a result, two million companies across the EU changed and converged their methods of presenting, publishing and auditing financial information. A number of studies have provided empirical evidence indicating that accounting-related integration has increased amongst EU Member States since the implementation of the directives into their national laws (Van der Tas, 1992; Canibano and Mora, 2000; Aisbitt, 2001 cited by Haller and Kepler, 2002).
Instead of establishing European accounting standards, the Commission decided to support and co-operate with the IASC to integrate European accounting rules with international standards. The objective of integrating accounting standards, according to the Commission (1998, cited by Haller and Kepler, 2002), was to stimulate cross-border investment through increased transparency and comparability of multinationals accounts. Haller and Kepler (2002) argue that most EU Member States are incredibly aware of the importance of achieving “international comparability”, so much so, in fact, that “Member States obviously anticipated market needs and company demands and therefore proactively opened up the accounting systems on the national level for international influences – in part, significantly earlier than the EU decided to actively support the IASC” (Haller and Kepler, 2002). Haller and Kepler (2002) also believe that these recent developments in the internalisation of European accounting standards are believed to be as a result of economic and financial market forces.
With regards to the rationale behind this decision, it can be argued that it is in fact MNEs who have driven the EU to adopt the new accounting standards. Kennedy (2006) believes “it is clear that multinationals are effectively integrating the European economy” at an economic level, through: trade and investment; external financing; and outsourcing, but also at an internal level (J. Kennedy, pers. comm., 12th April 2006; Flower and Ebbers, 2002). Therefore, I will now present the rational supporting this argument at both levels, and will then present arguments contradicting this.
Rapid growth since the early 1990s in both trade and investment, including a steady increase in foreign direct investment (FDI), has also influenced the EU’s decision to adopt IFRS. This increased FDI has been due to ‘Greenfield’ investments, although the majority was the result of cross-border merger and acquisition (M&A) activities. A specific example of economic integration is the merger between Daimler Benz and Chrysler. Bruns (2001, cited by Delvaille et al., 2005) believes that this merger had a significant impact on German financial reporting standards as Daimler Benz, amongst other German corporations, realised that the traditional German approach was inadequate in times of increasing globalisation and could have been a driving force in accounting standards reform. However, The Economist (Anon, 2006a) notes that cross-border mergers in Europe is provoking a nationalistic backlash amongst politicians, suggesting that technical issues, such as accounting standards, may not be the sole barrier to increasing FDI across Member States.
Additionally, the increased importance of equity capital markets has led to firms applying to foreign stock exchanges. Van Hulle (2003, cited by Delvaille et al., 2005) believes that it is the pressures to integrate Europe’s capital markets that have lead to the Commission adopting IFRS. Delvaille et al. (2005) states that IFRS has been introduced as mandatory standards due to the potential advantages of listing outside of the EU by European MNEs, which would be much simpler under international financial reporting harmonisation.
There are numerous reasons as to why a MNE would seek listing on a foreign exchange. Daimler Benz looked to Wall Street for external financing and was finally accepted onto the exchange in 1993 (Mitchener, 1993). According to Radebaugh and Gebhardt (1994, cited by Flower and Ebbers, 2002), the key factors that led to Daimler Benz seeking listing were: increased marketability of their shares; reduced dependence on German banks for finance; convenience for American shareholders; and investment in America. Although the US has not yet been accepted IFRS, the principles remain the same for Europe and will be more easily achieved through the use of IFRS.
Another aspect is outsourcing. Many MNEs are currently outsourcing functions from developed economies, such as the UK, to emerging markets, like Poland and the Czech Republic. Unilever’s decision earlier this year to outsource significant parts of its financial transactions services in partnership with IBM is an example of this (Anon, 2006b). IBM plans to locate the accounting function of this in Poland. IFRS will assist in this process by providing common rules and standards.
Attention is now turned to the internal level. Globalisation of the world’s economy has lead to increased interconnections and integrations between countries and firms alike (Flower and Ebbers, 2002). Flower and Ebbers (2002) believe that “MNEs are the principal actors in the globalization of the world economy…The principal problems faced by the MNEs in the area of financial reporting stem from the diversity of law and practice throughout the world. The financial reporting of an enterprise is governed by the law and practice in which it is registered.” This diversity of national accounting standards has produced problems for MNEs within internal management. (Flower and Ebbers, 2002).
An MNE typically has a number of subsidiaries situated around the globe. Flower and Ebbers (2002) suggest that “to assure effective management of the group, it is essential that all corporations use the same principles in drawing up their accounts”. However, previous to IFRS, subsidiaries have had to submit financial reports to the parent enterprise using the group’s standardised accounting principles, but have also had to produce another set according to the GAAP followed in the country in which they are situated in. This can create two problems for internal management, as recognised by Flower and Ebbers (2002): consistency of the measurement of performance; and cost involved in the preparation of two sets of financial reports. MNEs within the EU may be hoping that the adoption of IFRS will reduce, if not one day eliminate, these problems to aid them to become increasingly efficient organisations.
In addition to this, internal functions of MNEs, for example, accounting, marketing, production and supply chains, are no longer manager nationally; they are regionally based. This is supported by IFRS due to the new ‘segment reporting’ policy. It distinguishes two reporting formats, business and geographic segments, of which MNEs are required to provide information about both (Anon, 2002). This means that MNEs can produce financial reports based on the business segment within the region, the EU, as opposed to nationally. This should encourage more cross-border M&A and outsourcing, leading to further integration within the EU.
However, Guiso et al. (2004) suggests that integration should allow the development of financial markets in the most backward of countries to accelerate, enabling companies from within these countries will have the opportunity to access more sophisticated credit and security markets. On the flipside of this argument, it is possible that services of the most financially developed states’ financial system will be shared with other integrating countries (Guiso et al., 2004).
With specific focus on less developed countries within the EU, it is believed that financial integration will drive the efficiency of their financial intermediaries and markets (Guiso et al., 2004). Increased efficiency should stimulate demand for funds and for financial services, which in turn should increase the size of the domestic financial market (Guiso et al., 2004). As suggested by Guiso et al. (2004), the process of financial integration generally requires improvements in national regulation, which is especially true in those countries that are less developed. In the case of IFRS, the accounting standards of those countries within the EU that are less developed will need to be brought into line with the rest of the Member States, in order for all states to be on a ‘level playing field’. Therefore, this convergence of regulatory standards should result in an improvement of standards in the lesser-developed countries (Guiso et al., 2004).
However, there are also incentives for the financial sector of more developed countries. Increased financial integration will allow banks of more developed states to provide cross-border loans to companies of less developed states (Guiso et al., 2004). I believe that the likelihood of this will now be increased in the era of IFRS, as public companies from within the EU will be more easily understood and interpreted by foreign banks.
By primarily expanding the financial sector in those states that are already financially developed, integration may increase competition for available funds between their non-financial firms and foreign firms for such funds (Guiso et al., 2004). This should increase the efficiency of financial centres due to their increased activity and therefore, financial integration will have increased the availability of funds and efficiency of financial services in all integrating countries (Guiso et al., 2004).
In conclusion, it can therefore be seen that the adoption of IFRS will be a significant step in the harmonization of accounting standards across the EU. However, I believe to a certain extent that MNEs have driven the Commission to adopt IFRS. This is due to the increasing importance of trade and investment, external financing and outsourcing, which I believe has put significant pressure on the EU. Although there are other reasons as to why the EU has adopted this policy, but I believe these do not carry as much weight as the MNE arguments. Nevertheless, according to Anon (2004), “While the goal of the IFRS remains admirable, the short-term result could be confusion, especially if the EU continues to allow companies to opt-out of those regulations they don’t like”. Anon (2004) suggests that the sooner the IASB and the European Commission can reach an agreement over the evasion of regulations by firms, the sooner the benefits of IFRS will be fully achieved.
Word Count: 2,751 excluding all quotes and references.
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