The Effect of Mandatory IFRS Adoption on Conditional Conservatism in Europe

• Published date: 01 April 2015
• Author: Luc Paugam,Andrei Filip,Paul André
• DOI: http://doi.org/10.1111/jbfa.12105
• Date: 01 April 2015

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(3) & (4), 482–514, April/May 2015, 0306-686X

doi: 10.1111/jbfa.12105

The Effect of Mandatory IFRS Adoption

on Conditional Conservatism in Europe

PAUL ANDR´

E,ANDREI FILIP AND LUC PAUGAM∗

Abstract: We study the effect of mandatory adoption of International Financial Reporting

Standards (IFRS) in Europe in 2005 on conditional conservatism. We capture conditional

conservatism with a modified version of the Khan and Watts measure (C Score) that also

controls for potential shifts in unconditional conservatism and cost of capital. From a sample

of 13,711 firm-year observations drawn from 16 European countries spanning the 2000–2010

period, we document an overall decline in the degree of conditional conservatism after the

adoption of IFRS. We show that the decline in conditional conservatism is less pronounced

for countries with high quality audit environments and strong enforcement of compliance with

accounting standards using the Brown et al. audit and enforcement index. As asset impairment

tests are a key mechanism ensuring conditional conservatism in the IFRS framework, we further

examine these. We show that firms booking an asset impairment present a smaller decline

in the degree of conditional conservatism relative to firms that do not. We also demonstrate

that firms that do not book an asset impairment when evidence suggests the probable need

to do so experience a more pronounced reduction in conditional conservatism. We argue

that IFRS are conceptually conditionally conservative but that inappropriate application of

conditional conservatism principles is likely to prevent financial reporting from reaching the

level of conservatism targeted by the International Accounting Standards Board (IASB).

Keywords: conditional conservatism, IFRS, Europe, enforcement, impairment, goodwill, intan-

gibles

1. INTRODUCTION

The mandatory adoption of International Financial Reporting Standards (IFRS) by

a large number of European listed firms in 2005 resulted in a major accounting

change. Domestic generally accepted accounting principles (GAAP), shaped by local

institutions and regulations and embedded into national economies and cultures,

were abandoned for a single set of principle-based accounting standards. One of the

major intended purposes of the adoption of IFRS was to enhance financial reporting

through the requirements of a set of ‘high quality standards’. We examine whether

the adoption of IFRS resulted in an improvement in financial reporting quality, in

particular in the degree of conditional conservatism of financial reporting.

∗The authors are from ESSEC Business School, Cergy-Pontoise, France. (Paper received November 2014,

revised version accepted November 2014)

Address for correspondence:PaulAndr

´

e, ESSEC Business School, Cergy-Pontoise 95021, France. e-mail:

andre@essec.fr

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Conditional conservatism is the greater aggressiveness in the recognition of bad

news than in the recognition of good news and is considered a key qualitative

characteristic of financial reporting (Watts, 2003a; Francis et al., 2004; Ecker et al.,

2006; Ball et al., 2008; Dechow et al., 2010; and Kothari et al., 2010). This form

of news-dependent prudence ensures that potential economic losses are reported in

earnings in a timely fashion, whereas the recognition of potential economic gains is

delayed. Conditional conservatism is distinguished from unconditional conservatism,

also known as ex-ante or news-independent prudence, consisting in systematically

understating the book value of net assets relative to their economic value, independent

from any news (Pope and Walker, 2003; Beaver and Ryan, 2005).

The effect of the adoption of IFRS on conditional conservatism is a priori unclear.

Indeed, it is often argued by observers (like the press) that IFRS are ‘less prudent’

than national GAAP for two main reasons. First, the term ‘prudence’ has been

removed from the conceptual framework (IASB, 2010). Second, IFRS allow various

fair value options that would be imprudent per se. Regarding the first argument

and according to the International Accounting Standards Board (IASB), prudence

conflicts with the quality of neutrality and the Board explained in 2008 that ‘[t]he

exercise of prudence does not allow for deliberate understatement of assets or income

or overstatement of liabilities or expenses. [...] Introducing bias in understatement

of assets (or overstatement of liabilities) in one period frequently leads to overstating

financial performance in later periods – a result that cannot be described as prudent’

(IASB, 2008, §BC2.21). The form of ‘prudence’ that the Board intended to eliminate

from the conceptual framework (and financial reporting) can be clearly related to

unconditional conservatism, not to conditional conservatism. It is also clear that

the Board describes the negative relation between unconditional conservatism and

conditional conservatism which is also discussed in the literature (e.g., Pope and

Walker, 2003; Beaver and Ryan, 2005).1Regarding the second argument, fair value

for financial assets does not significantly affect many industries other than the

financial sector, and if firms decide to follow the fair value option, both unrealized

gains (good news) and unrealized losses (bad news) are recognized in earnings (or

other comprehensive income). Fair value cannot be considered less conditionally

conservative than amortized cost.2

Conversely, IFRS do include various mechanisms ensuring the application of

conditional conservatism, such as the recognition of probable liabilities versus the

non-recognition of contingent assets (IAS 37), the lower of cost or net realizable

values for inventories (IAS 2), or impairment for financial assets and long-lived

assets (IAS 39 and IAS 36), to name a few (see Barker and McGeachin, 2014). For

instance, directly translating the idea of conditional conservatism, IAS 36 §1 states

‘The objective of this standard is to prescribe the procedures that an entity applies

to ensure that its assets are carried at no more than their recoverable amount. [...]

If this is the case, the asset is described as impaired and the standard requires the

1 The new chairman of the IASB, Hans Hoogervorst, reiterated the argument according to which IFRS

include various mechanisms ensuring prudence of financial reporting (Hoogervorst, 2012).

2 Under IAS 16, optional revaluations of property, plant and equipment are recorded as a gain in other

comprehensive income (OCI). Subsequent negative fair value adjustments are first recorded as a loss in

OCI (as a reversal of the previously booked gains), and then as a loss in earnings. Under IAS 40, both gains

and losses of investment properties are included in earnings under the fair value option. Under IAS 39,

both gains and losses on financial instruments designated at fair value affect earnings, while only significant

loss (impairment) affect earnings for financial instruments measured at cost.

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484 ANDR´

E, FILIP AND PAUGAM

entity to recognise an impairment loss [in earnings].’ IFRS introduced relatively more

stringent and systematic impairment testing rules relying on fair value estimates than

local GAAP. This is particularly the case for intangible assets with an indefinite useful

life, including goodwill. Goodwill is tested for impairment systematically once a year

but was amortized under domestic GAAP prior to the adoption of IFRS over periods

ranging from 5 to 20 years (see Nobes and Parker, 2010).3

Therefore, from a conceptual perspective, IFRS can be considered conditionally

conservative. Ceteris paribus, the adoption of IFRS should lead to an increase in the

degree of conditional conservatism. However, there is evidence that the considerable

discretion permitted by IFRS may have prevented financial reporting from reaching

the level of conditional conservatism targeted by the IASB. Examining voluntary versus

mandatory adopters in Germany, Christensen et al. (2008) show that ‘the flexibility

embedded in IFRS might render it ineffective in restricting earnings management of

firms with low incentives to comply.’ Similarly, there are particular concerns about a

potential inappropriate application and enforcement of impairment tests which can

arguably be considered as IFRS’ main mechanism ensuring conditional conservatism

(e.g., Kim et al., 2013; Lawrence et al., 2013; and Roychowdhury and Martin, 2013).

Lawrence et al. (2013) explain that conservatism results (partly) from the requirement

that ‘non-financial assets must be written down when their fair value drops sufficiently

below their carrying value, but generally cannot be written up when their fair value

rises above their carrying values’ (p. 112). Impairment tests are particularly important

in the context of our study for three raisons. First, IFRS introduced more stringent

impairment testing rules in particular for intangible assets with indefinite useful life

such as goodwill. Second, impairment tests need to be applied to a large proportion

of balance sheet items (all tangible and intangible fixed assets, including goodwill).4

Third, they are relevant to firms in non-financial sectors.

However, the implementation of impairment tests (in particular for intangibles

with indefinite useful life) usually relies on valuation models, requires ‘significant

judgment’ from managers (Hilton and O’Brien, 2009; Petersen and Plenborg, 2010,

p. 420), and is prone to manipulation by managers because it relies on unverifiable

fair value estimates (Hayn and Hughes, 2006; Ramanna, 2008; Bens et al., 2011;

Li and Sloan, 2011; and Ramanna and Watts, 2012). Hans Hoogervorst, Chairman

of the IASB, acknowledges his ‘concerns about goodwill resulting from business

combinations’ and admits that ‘[g]iven its subjectivity, the treatment of goodwill is

vulnerable to manipulation of the balance sheet and the P&L’ (Hoogervorst, 2012,

p. 5). The European Securities and Market Authority (ESMA) recently expressed

concerns about insufficient impairment recognition by major listed European com-

panies during the financial crisis (see ESMA, 2013). Various professional reports by

large auditors or other consulting firms have also documented this lack of recognition

of economic impairment for several years (see Ernst & Young, 2010 and Houlihan

Lokey, 2013). Further studies have documented an incomplete and heterogeneous

3 For instance, under local GAAP, goodwill was usually amortized over 20 years in the UK, 15 years in

Germany, less than 20 years in France, 5 years in Italy,and between 5 and 10 years in Spain.

4 According to IAS 36 §2: Impairment testing procedures cover all assets but the following: inventories (IAS

2), construction contracts’ assets (IAS 11), deferred tax assets (IAS 12), post-employment benefit assets (IAS

19), financial instruments (IAS 39), investment property measured at fair value (IAS 40), biological assets

measured at fair value (IAS 41), specific assets that arise from insurance contracts (IFRS 4), and non-current

assets held for sale and discontinued operations (IFRS 5).

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