Cross-Country Analysis of the Impact of Financial Systems on the Accounting Framework

Implementing one set of accounting standards worldwide is challenging because accounting and regulatory frameworks must reflect market dynamics of each country in the world. While the adoption of International Financial Reporting Standards (IFRS) in Georgia and the convergence to IFRS in China were successful in benefiting the banking sectors of those countries, the IFRS adoption promoted earnings management in Hong Kong. The fact that the IFRS was only successful in Georgia and China, where financial markets are not as developed as they are in Hong Kong, raises concerns about the effectiveness of the IFRS in the United States.


Introduction
Globalization increased the need of one unique accounting framework throughout the world to simplify financial reporting for multinational companies.However, the nature of countries' financial system is a major determinant of regulatory effectiveness and crafting an accounting framework that will work in every country is a challenging task.In other words, financial markets in each country must shape countries' regulatory and accounting framework to ensure proper financial reporting.In order to illustrate this argument, Georgia's and China's adoption of the International Financial Reporting Standards are analyzed as positive events because they promoted transparency and accountability in countries that suffered from corruption and authoritarianism throughout the 20 th century.On the other hand, the adoption of the same IFRS standards by Hong Kong had a negative effect because it allowed greater flexibility to manage earnings and to inflate stock price in an economy that has one of the strongest financial markets in the world (So & Smith, 2009, p. 103).Finally, the idea that financial markets shape accounting and regulatory frameworks in different countries will be considered from the point of view of the United States because the IFRS convergence is a highly controversial topic in the US (Kenealy, 2010).

Analysis The Rose Revolution was a turning point for Georgia politically as well as economically
The 2003 Rose Revolution, which displaced Eduard Shevardnadze's government because of his alleged corruption, was a turning point in Georgia's history economically, as well as politically (Political Conditions: Georgia).In 2005, Georgia launched tax reforms to encourage foreign investments: after Georgia replaced a progressive income tax system with a flat income tax of 12%, taxation reached 80% of government revenues in 2008 (PricewaterhouseCoopers, 2009, p. 17).Following the Rose Revolution in 2004, Georgia fully adopted the 2004 version of the IFRS.The IFRS became the reporting standard that all the companies in Georgia must follow, with the exception of small privately-held businesses (p.15).

Financial reporting is governed by the Accounting Standards Commission of Georgia
In Georgia, "accounting is governed by the Law on Regulation of Accounting and Reporting, and is regulated by the Accounting Standards Commission" (p.15).The primary responsibility of the Accounting Standards Commission is to approve Georgian IFRS translations and interpretations, approve temporary accounting standards for organizations that are not covered by the IFRS, and approve chart-of-accounts structure based on the IFRS (p.15).

Audit is governed by Audit Activity Council of the Parliament of Georgia
Audit in Georgia is governed by the state regulatory branch of the Georgian Parliament, called the Audit Activity Council.The Council requires mandatory audits for banks, insurance companies, special state foundations, stock exchanges, security issuers, investing institutions and other organizations that are designated by the Ministry of Finance of Georgia (p.15).In considering the impact of audit on Georgian organizations, it is important to consider that Georgia's financial markets are relatively young and still developing.

Georgia's financial markets are at an early stage of their development
The Georgian Stock Exchange (GSE) was founded in 2000 and as of 2009, there were five companies listed on GSE and 250 companies were admitted to trading (p.10).This implies that equity-financing is not a major source of funding for most Georgian companies and debt-financing is a preferred way of obtaining funds.The fact that Georgian financial markets are not well-developed also suggests that the role of the audit profession in Georgia is different from the role of the audit profession in the United States, where one of the primary responsibilities of an auditor is to ensure transparent financial reporting of publicly-traded companies.
Although the GSE is relatively underdeveloped, the banking sector in Georgia went through tremendous reforms since the early 1990s and es-pecially after the Rose Revolution.For instance, in the early 1990s, political chaos and economic depression significantly reduced liquidity and established a feeling of distrust towards financial institution in Georgia."At the end of 1994, Georgia had 228 banks.Many of these have since been liquidated, as a result of efforts to increase transparency, improve the quality of assets and services, and strengthen the banking system generally" (PricewaterhouseCoopers, 2009, p. 10) In addition to liquidating many of the smaller banks in Georgia, the Central Bank of Georgia (NBG) reported that a series of reforms were being undertaken to bring Georgian banking closer to the European Union standards.In 2003, NBG reported: "To gradually increase a level of capitalization, and move towards the European standards, the National Bank increased minimum amount of required capital for Georgian banks, guided by a Euro Directive for minimum capital requirement of 5 million Euros; the president of the National Bank of Georgia issued a decree on defining the minimum capital requirement at GEL 12 million for commercial banks.Already licensed commercial banks and foreign bank branches should start increasing their capital in a given timeframe in order to fully comply with the new requirement by the end of 2008.Those commercial 66 National Bank of Georgia banks and foreign bank branches seeking to obtain a banking license need to meet GEL 12 million minimum capital requirement as it is one of main preconditions for a license to be granted points.This was due to the risk factors that characterize the developing economies"(Bank of Georgia, p. 65).
Given the fact that the banking sector is far more important to the Georgian economy than Georgia's financial markets, the success of Georgia's IFRS adoption must be analyzed uniquely from the point of view of Georgian economy.

The adoption of IFRS in Georgia was effective because it reflected the country's market dynamics
In highly-industrialized countries such as the United States and Hong Kong, the primary concern with the IFRS is that it allows greater flexibility in financial reporting.Some authors like Paola Paglietti argue that IFRS can potentially encourage earnings management, or smoothing, to reduce stock price volatility (Paglietti, 2009, p. 97).Although Paglietti's research findings are mixed regarding a direct relationship between earnings management and IFRS, greater flexibility under IFRS remains a concern in countries with relatively strong financial markets (p.97).On the other hand, the adoption of IFRS in Georgia does not raise concerns about transparency because the adoption coincided with economic liberalization and democratic political change.This reconciles the thesis of this paper in the sense that accounting framework must reflect market dynamism in order to be effective.

China's convergenceto IFRS improved transparency in the banking sector
In addition to the fact that IFRS promoted transparency in Georgia, Ping Luo offers an interesting view about China's financial markets' convergence with the IFRS.He argues that the convergence to IFRS specifically benefitted the banking sector in China because before IFRS, local banks had to comply with regional standards, as well as international accounting standards (Ping, 2007, p. 47).He said that after the adoption of IFRS, "local banks are intended to better allocate their budget along business lines with some consideration for branches rather than branch by branch and region by region" (p.47).Ping concludes by stating that IFRS helped to build investors' confidence and improve transparency in the banking sector of China.

China's banking sector is relatively young
Historical similarity of the financial markets and banking in Georgia and China explains the relative success of IFRS in the banking sectors of both countries.Like Georgia, China has liberalized its economy in the past twenty years."Prior to 1984, commercial banking as we know it (personal & business lending, settlement, transfer of funds, etc.) was virtually non-existent in China.The banking landscape in China was very simple before economic reforms were introduced in 1978 -there was only one bank operating in all of China, the People's Bank of China (PBOC)" (BernsteinResearch, 2010, p. 6).In 2004, People's Bank of China (PBOC), which is the central bank of China and the primary regulator, established Industrial and Commercial Bank of China (ICBOC) to specialize in commercial financing.Notably, ICBOC is the largest bank in the world in terms of market capitalization (Exhibit I illustrates China's loan and deposit growth since 1984) (p. 6).Therefore, given the fact that the financial industries in Georgia and China are relatively young and both countries share the history of authoritarianism throughout the 20 th century, the adoption of IFRS was a significant step in liberalizing their financial markets.

Hong Kong has one of the most developed financial markets in the world
In order to contrast the adoption of IFRS in Georgia and China, where capital markets are not well-developed, one can analyze Hong Kong's adoption of IFRS in 2005 as a country with one of the strongest capital markets in the world.Hong Kong is knows as one of the world's financial centers, with 2007 market capitalization of approximately $2.7 trillion (Datamonitor, 2009, p. 6).Exhibit II illustrates that pre-recession market capitalization of $2.7 trillion was the highest in past 9 years.In addition, Ernst & Young projected that Hong Kong's initial public offerings to reach a record of $47.7 billion in 2010, as the country is emerging from the global financial crisis (Hu, 2009).

Hong Kong fully adopted IFRS in 2005
Hong Kong fully adopted IFRS in 2005, a year after Georgia's 2004 adoption."Starting in 2005, Hong Kong Financial Reporting Standards (HKFRSs) are identical to International Financial Reporting Standards."While Hong Kong had adopted many of the earlier International Accounting Standards (IASs) as Hong Kong standards, some had not been adopted, including IAS 32 and IAS 39.And all of the December 2003 improvements and new and revised IFRSs issued in 2004 and 2005 will take effect in Hong Kong beginning in 2005" (Deloitte).Before fully adopting IFRS in 2005, one of the primary differences between Hong Kong accounting standards and IFRS was the treatment of investment property, where IFRS allowed companies to report their investment income on the balance sheet, whereas gains and losses would show up on other comprehensive income section of the balance sheet under previous Hong Kong accounting rules (So & Smith, 2009, p. 104).

The adoption of IFRS in Hong Kong could have promoted earnings management
The issue of reporting gains from investment property on the income statement instead of reporting it under other comprehensive income is very important because it can fundamentally alter the firm's financial position.Considering the fact that fair value measurements are based on subjective criteria, management can use its bias to report higher earnings in order to beat the analysts' expectation.NiuWuijun claims that Hong Kong's adoption of IFRS treatment for property investment increased HSE companies' financial ratios such as return on assets, return on equity, and debt to assets (Weijun, 2007, p. 3).Therefore, one could argue that management is incentivized to use the fair value treatment to exaggerate their companies' financial position, and by doing so, increase stock price.

IFRS has a tendency to promote undue price volatility
While there is a concern that management can use its discretion to manage earnings under International Accounting Standard (IAS) 40 for investment property, So and Smith point out that the introduction of HKAS 40, which is an equivalent of IAS 40, could cause undue volatility in stock price (So & Smith, 2009, p. 104).They state: "The former International Accounting Standards Committee (IASC) argues, however, in its Basis for Conclusions on IAS 40 (2000) that such presentation provides the most relevant and transparent view of the financial performance of investment properties (IASCF, 2008c).After all, the objective of financial statements is not to smooth profit figures (McBride, 2006), but to reflect economic reality for economic decision making (IASCF, 2008b)" (p.104).This point of view is radically different from the point of view in the previous paragraph that suggested that fair value measurements can be used to manage earnings.In order to understand the impact of IFRS on Hong Kong's financial markets, So's and Smith's paper will be analyzed in the subsequent paragraphs.

So and Smith studied 92 companies in Hong Kong's property industry to examine the impact of IAS 40
So and Smith conducted a study to analyze if reporting fair value gains and losses on income statements had any impact on stock price.They chose companies from the property industry.The stated: "Companies are eligible for selection if throughout the sample period 2003-2006: (1) they are in the property industry; (2) they are listed in the Main Board of the Hong Kong Stock Exchange; (3) they report investment properties in their financial statements; and (4) there is no change of accounting yearend.This sampling criteria yields an initial sample of 92 companies" (p.107).First, they analyzed those companies' financial position before the IFRS adoption and then after the IFRS adoption.Furthermore, they analyzed the impact of IAS 40 in the short-term, which was defined as a period less than 12 months, and then they studied the impact in the longterm, defined as a period longer than 12 months period.Additional variables that So and Smith considered were firm size and leverage because they claimed that firm size and leverage are commonly used in valuerelevance studies (P.107).

Investors respond positively to reporting fair value gains on income statement in Hong Kong's property industry
The biggest finding of So's and Smith's research was the notion that investors react positively to fair value income reporting on the income statement (p.117).In other words, the fact that companies report changes in fair value on income statement is viewed positively by investors because it maximizes their value.One could argue that this gives management a tremendous market manipulative power because they can manage investors' expectation by reporting higher earnings based on questionable fair value estimates.While discussing So's and Smith's study, it is important to mention that all of the companies in their sample choice chose to adopt the fair value method and they did not research companies that did not follow the fair value method for investment property (p.115).Exhibit III provides a complete list of the companies in So's and Smith's sample.

The adoption of IFRS damaged transparency in Hong Kong, whereas it promoted transparency in Georgia and China
In contrast with Georgia and China where the adoption and convergence to IFRS was a shift towards greater transparency, the adoption of IFRS provided means for managers of property companies in Hong Kong to report higher earnings under IAS 40.This finding reaffirms the thesis of this paper in the sense that financial markets shape the nature of accounting and regulatory frameworks.While the adoption of IFRS was a success story in a country with relatively underdeveloped financial markets, the adoption of the same accounting framework damaged transparency in one of the strongest financial markets in the world.Therefore, it would be hard to implement one unique set of accounting standards worldwide because of extreme dynamism of global financial markets.

The United States is concerned about the impact of adopting IFRS
The United States is particularly concerned about sharing the destiny of Hong Kong because the adoption of IFRS and fair value accounting has a potential of damaging the quality of US companies' earnings.However, the opinion about the IFRS convergence in the United States is rather mixed: on one hand, authors like Anne Fosbre, Ellen Kraft, and Paul Fosbre argue that it is an imperative to have a globalized set of accounting standards in the midst of globalization (Fosbre, Kraft, & Fosbre, 2009, p. 61).On the other hand, authors like Sidney Gray, Cheryl Linthicum, and Donna Street state that the adoption of IFRS will create serious problems for US financial markets in terms of significant gaps in earnings between US GAAP and IFRS (Gray, Linthicum, & Street, 2009, p. 431).Exhibit IV provides the list of countries that have adopted IFRS.

Fosbre, Kraft, and Fosbre argue that convergence between US GAAP and IFRS is inevitable
Fosbre, Kraft, and Fosbre claim that "the movement of world economies and the expansion of corporate America overseas with dramatic financial results brought forward the need for a single set of global accounting standards that could be used for domestic and cross border financial reporting of foreign and US multinational companies" (p.431).They discuss that more than 50% of revenues of Honeywell International, Coca Cola, Pepsi Cola, and IBM come from overseas.In addition, convergence to IFRS will bring the worlds' regulators together in fighting fraud and corruption throughout the world.The authors cite that in 2007 the Securities and Exchange Commission enabled foreign companies listed in the United States to issue their financial statement according to IFRS, instead of mandating them to use US GAAP (Fosbre, Kraft, & Fosbre, 2009).They conclude their paper by stating that it is almost inevitable for the US GAAP and IFRS to converge because US multinational companies have reached a point where more than half of their revenues come from abroad.

Gray, Linthicum, and Street are concerned about earnings quality during the convergence process of US GAAP and IFRS
Gray, Linthicum, and Street take a different approach in their research in the sense that their argument revolves around the notion that the adoption of IFRS in the United States will provide an opportunity for management to manipulate earnings through the application of fair value accounting.They also don't disagree with the idea that IFRS is effective for some countries.For instance, they state that the adoption of IFRS for most of the EU countries was a success story because "the European Union's (EU) adoption of International Financial Reporting Standards (IFRS) for the consolidated accounts of listed companies from 2005 marked a major shift fromthe use of numerous national accounting standards towards the acceptance of globalstandards established by the International Accounting Standards Board (IASB)" (Gray, Linthicum, & Street, 2009, p. 431).The authors discuss the SEC's roadmap that plans to mandate IFRS reporting for publicly listed companies in the United States by 2014.Gray, Linthicum, and Street also mention that Senate Banking Committee Chair Dodd and Senator Reed are critical of the SEC's plan to mandate the US companies to use IFRS (p.432).Furthermore, the authors outline that when the SEC developed a roadmap in august of 2008, the agency was led by a different chairperson and the current chairperson of the SEC, Mary Schapiro, is very concerned about the implementation of the roadmap (p.432).
In conclusion, Gray, Linthicum, and Street find by examining data set from 2001 to 2006 that a significant gap exists between reporting of equity and income under US GAAP and IFRS (p. 444).However, the authors do not oppose the idea of US GAAP and IFRS converging at some point in the future, but rather they argue that fundamental issues need to be resolved before the convergence can happen.

Conclusion
The major finding of this paper is that crafting a one set of unique accounting standards is a complex task because of dynamism of financial markets worldwide.While IFRS help to improve transparency in the banking sectors of Georgia and China, this study suggests that IFRS has a potential to damage transparency in financial markets of Hong Kong and the United States.After considering positive contributions that IFRS has made to Georgian and Chinese economies, one could argue that IFRS has been very successful in economies that suffered from corruption and authoritarianism throughout the 20 th century, whereas in economies such as the United States and Hong Kong with strong financial markets, IFRS has a tendency to promote earnings management.In summary, it is hard to implement one set of financial reporting standards for multinational companies because accounting standards should reflect financial systems of different countries.