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Problems with Mandatory Adoption of International Financial Reporting Standards

Tags: Finance , Market , Corporation , Standards , Tax

January 11, 2011

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The Tokyo Foundation has issued a research paper identifying the basic features and problem areas of the International Financial Reporting Standards, which Japan is moving to adopt. What will introducing the IFRS cost? How will the new standards affect taxes? And what accounting strategies should Japan embrace? The paper addresses these and other issues from various angles. The following is a summary of the report.

Japan’s accounting standards have come to a turning point. The Financial Services Agency is expected to come to a final decision on the mandatory adoption of the International Financial Reporting Standards sometime around 2012. If the standards are adopted, they will likely be applied from 2015 or 2016. While the FSA is strongly inclined to make such a decision, this will have serious repercussions. There are a number of concerns regarding the IFRS, one pertaining to their theoretical shortcomings as a set of accounting standards, and the other relating to the mandatory nature of their adoption.

The first concern is with the key IFRS concept of “fair value.” According to basic economic theory, the fair value of an asset should be its fundamental value, equivalent to the present value of future cash flow calculated using all available information. First, the collapse of Lehman Brothers and the ensuing global financial crisis have clearly shown that market prices have the potential of diverging widely from fundamental values. Second, under the IFRS, assets without market prices will be assigned values based on mathematical projections of future earnings. This will leave the door open for unscrupulous managers to manipulate calculation models and basic statistical data.

The IFRS are known as “principle based” standards that do not prescribe detailed rules, leaving the task of actual accounting processing to the discretion of individual companies and auditors. Transactions of similar nature may, therefore, be processed quite differently according to how they are interpreted by each company. This can easily give rise to window dressing. It is also highly conceivable that companies and auditors in Japan, out of lawsuit fears, would choose to be overly conservative in processing their accounts, as was the case in the recent introduction of the Japanese SOX law.

Adoption of the IRFS will ultimately give companies more discretion over how they present their financial standing, leading to a diversification of processing formats. This is hardly likely to be in investors’ interests. One often-mentioned justification for the mandatory adoption of the new standards is that international uniformity would facilitate cross-border comparisons. But given the greater leeway companies would have in processing the figures, the validity of such comparisons would be tenuous at best. These concerns have been voiced by both researchers and business people in Japan, but the FSA does not seem to hear them.

The mandatory adoption of the IFRS is also problematic from the viewpoint of the global accounting system. The emphasis has been on achieving uniformity, and no attention has been paid to whether the standards are actually appropriate. Business environments differ widely from one country to the next, and so there is no guarantee that the IFRS are the best for all countries.

Let us suppose that all states opted for mandatory adoption. The IFRS would then enjoy a monopoly in the absence of any competition. People have noted that the standards are ill matched for industries in which fixed assets claim a high share of corporate balance sheets (typically, the manufacturing sector). Should the IFRS emerge as the sole set of standards, though, comparisons with other standards would become impossible. Without competition, the quality of the accounting standards could very well decline.

Until now, companies in Japan have been able to choose whether to apply Japanese accounting standards or adopt US ones, and investors have never complained. They should continue to be given a choice, with the IFRS being fully exposed to competition in the accounting standards market.

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