Adoption of IFRS in the Netherlands. Impact on value relevance

Table of contents

Preface

1. Introduction

2. The value-relevance of IFRS
2.1 Relevance defined
2.2 Differences between Dutch GAAP and IFRS
2.3 Value-relevance studies
2.3.1 The link between accounting information and the firm value: the Ohlson (1995) model
2.3.2 Implementation of the Ohlson model in value-relevance studies
2.4 The value-relevance of IFRS studies
2.4.1 Analysis of value-relevance of IFRS studies
2.4.2 Implications for the IFRS – Dutch GAAP value-relevance comparison

3. Research framework and sample selection
3.1 Research Framework
3.1.1 Incremental value-relevance of IFRS
3.1.2 Relative value-relevance of IFRS
3.2 Data collection

4. Empirical results
4.1 Incremental value-relevance of IFRS
4.2 Relative value relevance of IFRS

5. Conclusion
5.1 Conclusion
5.2 Limitations of this study
5.3 Recommendations for further research

Reverences

Appendix

1. Introduction

Listed Dutch firms are required by law to prepare their financial statements in accordance with the International financial Statements (IFRS) since 2005. Before 2005, listed Dutch firms prepared their financial statements using Dutch law, Title 9 of book two of the Dutch Civil Code. It is interesting to investigate the effect of the implementation of IFRS. Is the quality of the financial statements improved by the implementation of IFRS for the users of the financial statements, such as investors, suppliers and banks?

This question can be answered in many ways, looking at different characteristics of the accounting information, for example the comparability, the relevance, the reliability and the understandability. In this thesis the relevance will be studied. Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or conforming, or correcting, their past evaluations. (IFRS Handbook, 2007, p. 40) In order to be relevant the accounting information must reflect the information needs of the users in valuing a company. In order to determine the market price of a company, investors need accounting information that reflects the share price of a company. The research done studying the relevance of accounting information for valuating companies is called value-relevance research.

The implementation of IFRS had consequences for the value-relevance of the accounting information. Whether the value-relevance had improved by the adoption of IFRS is dependent on the differences between the former accounting system and IFRS. The impact on valuerelevance in the Netherlands has not been studied yet. The impact on value-relevance in other countries has been studied however, for example in the United Kingdom (Harris and Muller, 1999), Germany (Hung and Subramanyam, 2007) and Spain Callao et al. (2007). These studies can give a powerful insight in how the difference in value-relevance of two accounting systems can be studied.

The main question that will be answered in this thesis is:

- Has the implementation of IFRS made accounting information more relevant in the Netherlands?

Before this question will be answered the already existing literature will be studied. Using the already existing literature I will answer the following sub questions:

- How can relevance be defined?
- Has the adoption of IFRS influenced the accounting numbers in the Netherlands, and if so, what are the main causes of this difference?
- How can accounting relevance be determined?
- How can the value-relevance of IFRS compared to Dutch GAAP be studied?

After the literature review I will conduct an empirical study to investigate what effect the adoption of IFRS had on the value-relevance in the Netherlands. I will operationalize the main question into the following empirical sub question:

- Which accounting system provides relative more value-relevant information; IFRS or Dutch GAAP?

I will study whether a regression model based on IFRS book value and earnings or a model based on Dutch GAAP book value and earnings provides more value-relevant information. Before this regression analysis is conducted, it is interesting to study whether IFRS provides relevant information that is not incorporated in Dutch GAAP. Therefore I will first test in the empirical study the following sub question:

- Are the IFRS numbers able to provide value-relevant information beyond the
information that is provided by Dutch GAAP?

This would indicate that the IFRS numbers provide useful information that is not incorporated in Dutch GAAP. I will measure the incremental value-relevance of IFRS using a regression model which measures how well the accounting numbers are able to provide value-relevant information of the Dutch firms listed on the AEX under IFRS and under Dutch GAAP.

IFRS is implemented in the Netherlands in 2005. According to IFRS one, companies who adopt IFRS for the first time are required to prepare reconciliation statements. The reconciliation statement encompasses the result, the opening value and the closing value of the equity under the previous GAAP and under IFRS. Since Dutch firms were required by law to adopt IFRS in 2005, the result of 2004 and the book value at the end of the year of 2004 are presented in the reconciliation statement. This is the only time when the book value and the earnings are both measured in Dutch GAAP and IFRS, so this study can only be done using the annual statements of 2005. The study can not be repeated using newer numbers, because after 2005 the Dutch GAAP numbers are not available.

The remainder of this thesis is organized as follows: In chapter two the literature will be reviewed. The chapter will start by a discussion of how the relevance of accounting information can be defined. Then I will discuss the differences between Dutch GAAP and IFRS. After that I will explain the link between accounting information and the market value, using the Ohslon (1995) model, and its implications for the value-relevance studies. Then I will analyze 4 studies which compared the relevance of IFRS with another accounting system, in order to develop a research framework. In chapter 3 the research framework and the sample selection will be discussed. The results will be presented and discussed in chapter four, followed by the conclusion, limitations and recommendations for further research in chapter

five.

2. The value-relevance of IFRS

In this chapter the literature concerning value-relevance and IFRS will be discussed. I will answer the following sub questions in this chapter:

- How can relevance be defined?

In paragraph 2.1 I will discuss how relevance is defined and what is meant by this term when it is used in relevance studies.

- Has the adoption of IFRS influenced the accounting numbers in the Netherlands, and if so, what are the main causes of this difference?

In paragraph 2.2 the differences between IFRS and Dutch GAAP will be discussed. I will also analyze what the causes are for these differences and whether it can be expected that these differences result in a higher value-relevance of the accounting numbers because of the adoption of IFRS.

- How can accounting relevance be determined?

In paragraph 2.3 the determination of accounting relevance will be discussed. The paragraph will start with a discussion of which accounting numbers are needed to valuate a company, using the Ohlson (1995) model. In the second part of this paragraph I will discuss how the Ohlson model is used in value-relevance studies.

- How can the value-relevance of IFRS compared to Dutch GAAP be studied?

In paragraph 2.4 I will discuss how the value-relevance of IFRS compared to Dutch GAAP can be studied. I will analyze 4 studies which compared IFRS with another accounting system, in order to build a framework for the value-relevance study of IFRS compared to Dutch GAAP.

2.1 Relevance defined

Before anything can be said about the relevance of IFRS or Dutch GAAP, relevance has to be defined. When has accounting information the quality of relevance? As mentioned in the introduction, according to the IASB accounting information is relevant when it influences the economic decisions of users by helping them evaluate past, present or future events or conforming, or correcting, their past evaluations. (IFRS Handbook, 2007, p. 40) According to the FASB (the standards board of the United States) accounting information is relevant when it is capable of making a difference in a decision by helping users to form predictions about past, present, and future events or to confirm or correct their expectations. (Scott, 2006, p. 75) Scott also gives his own definition of relevant information: relevant information is information about the firm’s future economic prospects, that is, its dividends, cash flows and profitability. (Scott, 2006, p. 18)

The users of the financial statements, as mentioned by the IASB and FASB, are primarily investors, because investors are the most interested in the cash flows, dividends and profitability. The future economic prospects give the investors information whether the share price of a company has the right value. Accounting information is useful for determining the share price of a company, because the share price can be linked to the accounting information.

(Nichols and Wahlen, 2004)

According to Barth et al. (2001) value-relevance as used in the literature can be seen as the operational variable of the term relevance. Value-relevance research studies the relationship between the share price as dependent variable and accounting numbers as independent variable. The accounting numbers are value-relevant if they are significantly related to the dependent variable, the share price, because they contain relevant information in valuing companies. (Beaver, 2002)

2.2 Differences between Dutch GAAP and IFRS

In paragraph 2.1 the term relevance was defined. Accounting information provides valuerelevant information when it is significantly related to the share price. In this thesis the valuerelevance of Dutch GAAP is compared to the value-relevance of IFRS. Before these two accounting systems can be compared, I will take a closer look at these two accounting systems in order to determine whether the adoption of IFRS in 2005 has influenced the accounting numbers in the Netherlands, and if so, can we then expect that the implementation made the accounting numbers more value-relevant?

This paragraph will start with a brief discussion of the history of IFRS and Dutch GAAP, followed by an analysis of the differences between IFRS and Dutch GAAP, based on a study of Vergoossen (2006)

The first legislation in the Netherlands on the form and contents of published financial statements came with the Act of 10 September 1970 on the Annual Accounts of enterprises. (Camfferman, 1995) The act was incorporated in civil code in 1975, and has been amended twice, first by the fourth Directive of the European Union in 1983 and later by the seventh Directive of the European Union in 1988. The relevant legislation is now contained in Title 9, book 2 of the Dutch Civil Code. (Nobes and Parker, 2000)

Since 2005 all listed companies in the European Union are required to prepare their financial statements in accordance with IFRS. It is also optional to prepare the financial statements in accordance with IFRS if a firm is not listed on a capital market in the Netherlands. (Art. 2:362 lid 8 BW)

The IFRS are made by the International Accounting Standards Board (IASB). The IFRS contains also the older International Accounting Standards (IAS) made by the International Accounting Standards Committee (IASC). The IASC was founded in 1973 by ten accounting bodies, including the Netherlands. The IASC became the IASB in 2001. Since then, all the new standards are called IFRS instead of IAS. In 2003 the first IFRS, IFRS 1was completed. Nowadays there are 29 standards made by IASC and 8 standards made by the IASB. The IFRS are adopted by a lot of countries. Other counties, like the United States, have accounting systems similar to those of IFRS. Figure 1 gives an overview of those counties who have adopted IFRS.

Figure 1: Adoption of and harmonization with IFRS. (www.finharmony.net)

illustration not visible in this excerpt

The differences between Dutch GAAP and IFRS have been studied by Vergoossen (2006) He studied 46 companies listed on the Amsterdam Exchange-Index (AEX) and Amsterdam Midkap Index (AMX). According to IFRS one, companies who adopt IFRS for the first time are required to prepare reconciliation statements. The reconciliation statement encompasses the result, the opening value and the closing value of the book value under the previous GAAP and under IFRS. Since Dutch firms were required by law to adopt IFRS in 2005, the result of 2004 and the opening value in 2005 were presented in the reconciliation statement. Vergoossen studied the differences between IFRS and Dutch GAAP in both earnings and book value.

Vergoossen found that 65% of the Dutch companies reported higher earnings under IFRS than under Dutch GAAP. 27% Of the companies reported a higher book value under IFRS. The reconsolidation statements also contain an overview of the causes of the change in book value and the earnings. In total he found that the companies together mentioned 18 causes for the change in earnings and 22 causes for the change in book value. The causes which were found in 20% or more companies will be discussed below, using a paper of KPMG (2006).

Pensions (IAS 29)

Under IFRS, multi-employer defined benefit plans should be recognized as defined benefit plans on the balance sheet. Under Dutch GAAP, a multi-employer defined benefit plan may be accounted for as a defined contribution plan if two conditions are met; the risks between the company and the pension found are evenly spread and the will not be any future payments to the pension found except for higher future premiums. When a multi-employer defined benefit plan is recognized as a defined contribution plan, the contributions are expensed when the obligation to make the payments is occurred. When a multi-employer defined benefit plan is recognized as a defined benefit plan, it will be recognized on the balance sheet and be measured at fair value, so it makes a difference whether a multi-employer defined benefit plan is recognized as a defined benefit or a defined contribution plan.

Business combinations (IFRS 3)

According to both IFRS and Dutch GAAP, a business combination is the bringing together of separate entities or businesses into one reporting entity, which will be measured at the cash paid by the acquiring company plus the fair value of the other purchase consideration given. According to IFRS non current assets held for sale should be measured at fair value less the costs to sell, while Dutch GAAP measures these assets as costs. The goodwill is not amortized under IFRS, while it is amortized under Dutch GAAP.

Deferred Taxes (IAS 12)

According to IFRS and Dutch GAAP, deferred ax assets and liabilities are recognized for the estimated future tax effects of temporary differences and tax loss carry-forwards. A temporary tax difference arises because the carrying amount of an asset (liability) in the financial statement differs from the tax based carrying amount. Unlike IFRS, temporary tax differences are not recognized when it arises because of goodwill or when it will not lead to tax liabilities or recoveries in future periods.

Provisions (IAS 37)

According to IFRS and Dutch GAAP, a provision shall be recognized if there is a legal or constructive obligation which can leads to a probable outflow of recourses and can be measured reliably. Under IFRS, it not allowed to recognize a provision for periodic maintenance or major overhauls, which is allowed under Dutch GAAP.

Share-based payments (IFRS 2)

Under IFRS, goods or services acquired in a share-based payment transaction should be measured at fair value. Share-based payments to employees should be measured at fair value at the grant date. Dutch GAAP does not give a guidance of how to measure goods or services acquired in a share-based transaction other than share-based payments to employees. Unlike IFRS, share-based payments to employees are measured at their intrinsic value.

Intangible assets (IAS 38)

Goodwill is measured as the excess of cost of an acquired company less the fair value of the identifiable assets. According to IFRS, acquired goodwill will not be amortized, but will be impaired each year. According to Dutch GAAP, acquired goodwill will be amortized over the useful live, which can not be longer than 20 year.

Property, plant and equipment (IAS 16)

According to IFRS and Dutch GAAP, property, plant and equipment (PPE) are initially measured at cost. Under IFRS, it is possible to revaluate PPE to fair value if all the items in the same class are revaluated at the same time and the revaluations are kept up to date. Dutch

GAAP gives no guidance concerning the timing and frequency of the revaluations. Under IFRS, the residual value, depreciation method and useful live should be reviewed annually.

This is not required according to Dutch GAAP.

Financial instruments (IAS 32, 39 and IFRS 7)

According to IFRS, all derivatives are measured at fair value. Under Dutch GAAP, derivatives are measured at fair vale or at cost. Changes in the fair value of available-for-sales are recognized directly into equity under IFRS, while it is under Dutch GAAP also allowed to recognize the changes into profit and loss.

The study of Vergoossen (2006) showed that the adoption of IFRS caused major differences in book value and earnings for Dutch firms listed on the AEX and AMX. The overall tendency in the differences between IFRS and Dutch GAAP is that under IFRS fair value is more frequently used, as we saw in IFRS 2, 3, 7 and IAS 16, 32, 38, and 39. Fair values of assets and liabilities are of greater interest to investors than their historical costs, since fair values provide the best indication of future firm performance and investment returns. (Scott, 2006, p. 15) Therefore, I expect IFRS to be more value-relevant than Dutch GAAP. In the following paragraph I will discuss how value-relevance can be measured.

2.3 Value-relevance studies

In this paragraph I will analyze how value-relevance can be studied. As described earlier, accounting information is relevant when it is significantly related to the share price. In order to determine which accounting information is needed to link accounting information to the market value of a company, I will use the Ohlson (1995) model, because the Ohlson model can be used to link accounting information to the market value of a company. The model will be discussed in sub paragraph 2.3.1. How this model can be used to determine the valuerelevance of accounting information will be discussed in sub paragraph 2.3.2.

2.3.1 The link between accounting information and the firm value: the Ohlson (1995) model

Ohlson developed a model to link accounting information to the firm value of a company. His model contains 3 steps, which will de discussed in this sub paragraph. The first step is the discounted cash flow model, the second step is the clean surplus theory and the third step is the first two steps combined. I will now discuss each of these 3 steps.

The first step is the traditional link between the value of a firm and the financial statements, the discounted dividends model. (Bernard, 1995) Using the discounted dividends model, the value of a firm is equal to the present value of the future dividends. The discounted dividends model can be seen in equation 1.

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