As India Inc prepares its transition to financial reporting based on the International Financial Reporting Standards (IFRS), shall we step back and ask a pertinent question: Will IFRS improve the quality of financial reporting done by India Inc? The Satyam, Enron and other scandals highlighted that managers and auditors can beat chefs hands down in being able to cook elaborately. Never mind the fact that managers and auditors used earnings and profit numbers while the traditional chefs use more edible stuff. Can IFRS put an end to or at the very least reduce this malaise? Though IFRS will harmonize our financial reporting standards to those employed internationally, I doubt if it will have a material effect on the quality of our financial reporting. Changing accounting standards is relatively easy. Achieving a high quality of financial reporting is not. Before discussing their impact, let us review what the IFRS is. The standards are accounting rules issued by the International Accounting Standards Board (IASB) and have become the mandated financial reporting standards for public companies in close to 70 countries.
To assess its impact, let us draw an analogy between IFRS and the metric system of uniform weights and measures. Necessitating all public companies to report using IFRS translates into requiring all butchers to use an internationally produced weighing balance instead of the locally made one. However, changing the measurement tool cannot preclude the slick butchers from cheating by cleverly applying the weight of their thumb. Similarly, adopting IFRS cannot prevent the ?closeted Satyams? from continuing to shame the traditional cooks with their accounting sleight of hand.
IFRS draw heavily on the current financial reporting regulations of developed countries such as the US and the UK. Despite their recent scandals, these countries have institutional infrastructures that complement the reporting regulations that have developed in these countries. Among these are (i) well developed markets for corporate control, i.e. an active market for takeover of poorly performing companies; (ii) a large and active base of institutional shareholders that are effective in monitoring and disciplining management; (iii) stronger investor protection laws that are enforced more diligently; (iv) tax authorities that can detect suspicious instances and ensure compliance with mandated financial reporting regulations; and (v) liberal rules governing stockholder and lender litigation combined with quick court processes to punish the guilty companies.
In contrast, India lacks such institutional infrastructure. Recall that the World Bank Indicators place India in the bottom half with respect to every measure that relates to conducting business, be it the quality of corporate governance, accounting norms, corruption, or the rule of law. In all these measures, the US and UK rank in the top deciles.
While these institutional features may take longer to develop, the quality of financial reporting can be improved nevertheless in the immediate future. To prevent the butcher from cheating on the weight that he reports for the meat, his incentives to fudge measurement need to be addressed. For example, his misdemeanour can be curtailed by the practised eye of the customer as well as if butcher is concerned about his reputation and in turn the long-run viability of his business. Also, his transgressions can be limited if he is monitored carefully and is penalised when caught employing his nefarious methods.
Similarly, the real problems lie with the incentives of those preparing the financial statements?the managers and the auditors. Improve these incentives and better financial reporting will follow. What steps will help in this regard? First, caveat emptor (buyer beware). The practised eye of the investors and equity analysts is a key in limiting accounting manipulation. As important is proficient oversight by auditors, members of the board?s audit committee and finally regulators. Therefore, adequate training of all these market participants on the intricacies of the IFRS system is essential. The second factor affecting the quality of financial reporting involves the company?s concern for its cost of capital and, in turn, its economic viability in the long run. Existing research in accounting highlights that companies that voluntarily report transparent financial numbers significantly expand access to financial markets and considerably reduce their cost of capital. For companies intending to raise capital in international markets, IFRS provide an opportunity to shun opaqueness and embrace transparency in their financial reporting. Such prudent changes can enable them to access international capital markets and lower their cost of capital. Last but not the least, accounting manipulation can be restrained by imposing severe penalties on those perpetrating such disreputable practices.
?The author is an assistant professor of finance at Emory University, Atlanta, and a visiting scholar at the Indian School of Business, Hyderabad