Comprehensive analysis of the adoption if IFRS in Germany

Author:. Iloka Benneth Chiemelie
Published: 3-August-2019

Introduction

In the course of time, the financial reporting landscape has witnessed a number of resounding changes, but this came to full light in 2005 as number companies and countries across the world reached the decision to adopting International Financial Reporting Standards (IFRS) which would serve as the basis for preparing financial statements. To be precise, the whole cycle started in 2002 with the decision of the European Union (EU) to approve the regulations upon which all the companies that are listed in its stock market (which totalled about 8,000 as at the time of this decision) would be mandated to adopt in preparing their consolidated financial statement notwithstanding the country in the European Union where such company maintained its business operations (Deloitte, 2014). That is to say, the decision was to adopt a central accounting reporting standard that would be used in the course of reporting the financial performance of companies within the European Union jurisdiction. For such application, it was pointed out that the benefit is that adopting the IFRS would add significant positive influence on the quality of financial report that these companies produce for public consumption (Hibbard, 2012). However, the adoption of this measures also come with a number of challenges which include the fact that the adoption is highly dependent on the economic position of the companies, is affected by issues of coherence of regulatory framework and that the company also need to consider the infrastructure related to its institutions.

However, it should be noted that if a company successfully adopt the IFRS standards, such company will be able to produce financial statements that are of high-quality, and it would attract the intention of global investors as they utilize such information in their investment decisions. Therefore, to ensure that companies are able to produce financial statements that are of the desired quality, a number of high-quality international standards were set out by the International Accounting Standard Board (IASB) in 2001, and the central objective is to enhance the transparency and comparability of financial statements (Ahmed et al., 2013). The investors will also have the needed assistance when deciding on the investments to make across global stock market. Discussions on its implementation have also been highlighted in a number of studies with the global standard setters, business and accounting communities, and accounting professionals making their initiative about the need to converge this international standard with the local accounting standards of countries in different jurisdictions.

Based on this, a number of studies have also been conducted with the aim of determining the quality of accounting information that might be reflected on the quality of earning provided by an entity. In such studies, it have been discovered that entities operating under lower earning management practices were found to produce high earning quality (Levitt, 1998). In the case of high earning management practice being adopted, it was discovered that the financial statement disclosure being made must have gone through the managers for some treatment, in which the managers’ overall aim is to ensure that their interests are accommodated and provide necessary room for them to maximize their compensations and bonuses (Dechow, 1995). Due to this, the IABS established the IFRS with the central aim of making sure that the permissible accounting standards alternatives are eliminated, making it mandatory for entities to adopt accounting measurement capable of offering better reflection of the company’s financial position and performance. Under such setting, the IFRS when rightfully implemented is believed to be capable of yielding significant reduction on the possibility of companies engaging in earnings management and enhancing the quality of information that they are disclosing to the general public (Dimitropoulos, 2013). This is very crucial for investment decisions makers as such position gives them upper hand in relation to deciding on the right company to bet on.

Another research was conducted by Chua et al. (2012), with the finding being that companies that have converged their local standards with the provisions of the IFRS are more capable of enhancing the quality of their accounting practices, and decreasing the evidence showing earnings management. However, one also need to consider the contrary effect, which is that it comes with an opposite effect in the form of being able to limit the managerial discretion and as such capable of impact on the ability of the company to report accounting measure that bring about better reflection of the company’s economic position and performance, and in such cases where the application of this standard is done in a lax manner, it is still possible for the management to in action that will smooth their earnings (Dimitropoulos, 2013).

Based on the discussions provided above, this research paper is designed to offer comprehensive analysis of the adoption if IFRS in Germany. In order to achieve this goal, this paper is divided into three main sections. The first section is the introduction, which offers background discussions on the subject being reviewed. This is followed by a review of the implementation of IFRS in Germany in relation to the factors that are either encouraging or discouraging such. Finally, the paper provides conclusive summary of findings.

Financial reporting practices in Germany

In Germany, the main body responsible for regulating financial reporting practices is the International Federation of Accountants (IFAC), providing training to its members and oversight to on financial reporting practices among entities in the country. They also undertake the function of developing new practices and advancing existing standards (IFAC Germany, n.d).

Based on overview of the statutory framework for accounting and auditing, it was discovered that in Germany, the legal framework upon which companies based their financial reporting is established in line with what is applicable in the EU directives and regulation, and these regulations are transposed into the German national laws as well as other legal instruments. For the accounting framework, the companies that have debt or equity securities tradable in the Germany regulated markets are required to make use of their IFRS in their consolidated accounts based on the provisions of the European Commission (EC) Regulation No. 1606/2002. It is also allowed for companies to adopt the IFRS in the course of preparing annual and consolidated financial statements, irrespective of the sector the company operates in. For all the purpose of such reporting, it is manated that the company prepare their financial statement t in line with the national accounting standards, the German Accounting Standards (GAS) as detailed in the German Commercial Code (Handelsgesetzbuch - HGB). In 1998, the regulating body created the Deutsches Rechnungslegungs Standards Committee (DRSC) [Accounting Standards Committee of Germany], and it is recognized as the standard setter in German accounting profession with the responsibilities as: to aid with the development of recommendations for the application of principles for consolidated financial reporting; to provide avice in relation to planned legislation on accounting regulations at both the national and EU levels; to develop the interpretation of the International Account Standards in line with the provisions on section 315a(1) of the HGB, to enhance the quality of accounting and financial reporting, and finally to aid in promotion of education and research on the subject area as discussed above (IFAC Germany, n.d).

The German Accounting Law Modernization Act came into effect in 2009 with the overall aim of helping reduce the burden of regulation being placed on companies and attain a closer level of alignment between the national standards set in Germany and the IFRS, although it is still the standard for the German GAAP to be kept for companies that don’t have public accountability.

The German Accounting Directive Implementation Act was enacted in 2015 and it has the aim of ensuring that accounting laws in Germany are harmonized with that of the EU Accounting Directives (2013/34/EU). On this accord, the possibility of reducing the burden being placed on SMEs was taken good advantage of, to the highest possible extent.

In Germany, this institute also allowed for membership and the members are referred to as Wirtschaftsprüfer and vereidigte Buchprüfer (public accountants / (sworn) auditors, hereinafter known as  “Wirtschaftsprüfer”. For the start, this profession is regulated by the Wirtschaftsprüferordnung (Public Accountant Act (WPO)) 1961 in line with its amendments that highlights the professional duties of the Wirtschaftsprüfer, as well as the creation of the Wirtschaftsprüferkammer (Chamber of Public Accountants (WPK)), and the basic requirement that one must fulfil before the person can become a practicing Wirtschaftsprüfer (IFAC Germany, n.d).

Once they are licensed, the Wirtschaftsprüfer are accorded the powering of undertaking assessment of businesses, with particular reference to performing audit of the annual financial statement of the business entity, as well as the authority to issue auditor’s report in line with the results of such engagement. The other roles of the Wirtschaftsprüfer include providing advice and representation to clients when it comes to tax related issues, acting as experts in the field of business management, and providing advice to business matters as well as playing the role of trustees (IFAC Germany, n.d).

Adoption of IFRS in Germany

Just like every other country in the European Union, Germany adopts the IFRS. However, setting standards for accounting practice is not something that is new to the German accounting profession. This is because, when it comes to keeping organized accounting records for economic transaction, the evolution of German accounting tradition is something that can be traced to the 14^th century. the merchant Hermann Wittenborg of Lübeck opened the oldest extant book on accounts in 1329 and undertook the profession together with his son 1360 (Penndorf, 1913). Just like other contemporary books, the Wittenborgs’ records merely featured unsystematic, single entries of trading and lending transactions (Mollwo, 1901) and looked more like a note book that the outcome from a systematic bookkeeping process (Brown, 1968).

However, the German accounting systems also made a number of innovative moves in line with the provisions of the advancing and dynamic world. In the 20^th century, the accounting regulations in the country was substantially build by the legislative reaction to the Great Depression which brought about the issue of emergency decree in relation to the stock corporation law as passed in 1931(“Aktienrechtsnotverordnung”). In this decree, a stipulation was made for a general layout that should be employed for both balance sheet and statement of profit or loss (§ 261 a–c HGB 1931) together with necessary measures designed to make the process of disclosure more strict towards the overall aim of offering a fair and true view of the performance and financial position of the entity making such disclosure (§ 260 b (2) HGB 1931). On a more important note, it was henceforth demanded by the German authorities that the annual account of a stock corporation should be audited (§ 262 a (1) HGB 1931), and the motivation for this is the numerous cases of accounting fraud recorded in larger corporations across Germany.

Although Germany adopts the IFRS, the standards are converged with the country’s GAAP (HGB) standards, but there is a major different between the two standards. In line with the provisions made earlier, the German accounting policies have been fundamentally based on the requirements provided by the HGB until the companies in the country started to move towards the international standards. In any case, when it comes to the consolidated financial statements, companies also put the statement that has been issued by the German Accounting Standard Board into perspective.

Considering that the main objective of this paper is to describe and quantify the implementation of the IFRS in German companies as well as the impact of such, it is also necessary to offer a framework in line with the major differences that exist between the German GAAP and the IFRS. The first difference, which is rather philosophical is based on the notion that the German accounting models have been conventional based on conservation and tax, while the provisions of the IFRS is based on accounting model that have strong inspiration from the Anglo-Saxon principle of relevance which prevails over the provisions made by the national accounting principles of the countries adopting it (Lamb et al., 1998). This divergence is actually adopted in order to offer explanation on the numerous issues that have been pointed out earlier. In Germany, the accounting regulations are quite advanced, and normally, the specific application of these conservatism don’t actually emerge from the HGB, but it is also important to note that it does form a well established practice.  In any case, the differences that have been detected can actually be classified into different categories (Nobes, 2001), which include asset and liability recognition and measurement, and consolidation of procedures.

Studies have also looked at the effects of implementation of the IFRS in Germany on companies that operate in the jurisdiction. The findings have shown that there are effects on the retained earnings (RE). when it comes to that, the quantitative effects differ among companies because there are some visible general principles but the predominant factors are company-specific. On the same note, there is no relationship between the size of the effect of IFRS and the year of initial application and this does serve as a reinforcement of the observation that have been made above. On the third note, the categorization of companies in the samples by the relevant net effect was expressed in the form of percentage.

Generally speaking, the effects of IFRS on German companies were found to be significant and they normally bring about pivotal increase on the retained earning within the first year of adoption. The main reason for these effects were found to be due to the highly conservative philosophy which the HGB had that brought about some of the assets of a company being understated (which h included inventories, PPR, and deferred taxes) as well as some provisions being overstated. In any case, many of the companies in German made the decision of understating their pension liability by a significantly large level.  When viewed from the industry level, the specific effects were also found to yield similar conclusions.

The motivator for adoption

While discussions have shown that right from the course of time, Germany has always enacted a number of measures geared towards transforming their financial systems and institutions, these measures were normally based on the rigid nature of the HGB, which meant that companies can actually overstate or understate some elements in their financial statement. Therefore, there was always the case of smoothing by the managers are they either sort their personal earnings or did so in order to attract the interest of investors. However, the overall impact of this was that numerous large corporations in the country were involves in a number of scandals that eventually lead to financial crisis with many of them falling. In order to address these issues, following a number of consistent lobbying, the German accounting institutions decided to advance their framework and converge their local procedures in line with the EU provisions based on the IFRS. The overall motivation for this was to address the issues of financial statement smoothing and bringing about sector neutrality.  Another reason was that the previous standards were ubiquitous and normally difficult to articulate because different sectors adopted different measures. As a result of these issues, the managers can easily apply account smoothing in order to attain their personal interest and the impact of such was that numerous companies in German were effect and a resulting economic crisis followed. As a result of these issues, the German jurisdiction began to search for a way to neutralize the accounting systems and this was the main motivation. Through sector neutralization, it was made impossible for the managers to enact smoothing in the accounting process and the investors were provided with better information about the companies they are considered (Devonport and van Zijl, 2010),

Aside from this motivation, it is also important to point out that as an EU country, Germany was also mandated to function in line with the provisions of the commission and one of such provision is that the companies operating within the EU jurisdiction were mandated to adopt financial reporting based on the IFRS. Therefore, Germany also had the obligation of fulfilling its part of the EU consensus by adopting the standards within its sphere, and this need to fulfil the obligation can also be considered as a motivating factor. In any case, studies have also pointed out success with the adoption in Germany, serving as a further validation on the importance of implementing IFRS in companies within the German jurisdiction (Nobes, 2001).

Conclusion

From the onset, the purpose of this research was set out as to analyze the adoption of IFRS in the Germany jurisdiction in relation to the motivators for such adoption. On that ground, the paper pointed out that in the past, a number of financial scandals occurred among large corporations in EU region and in Germany in particular. As a result of this, there emerged the need for companies and countries to neutralize the sector in order to ensure better protection for the investors and sustainable economic performance. This pushed Germany into adopting the accounting standards. In any case, the research pointed out that Germany didn’t wait for the scandals to occur before working to address its accounting systems as right from 1937, the country has started enacting a number of practices geared towards making its accounting systems reliable and comparable. However, the EU provisions required that all countries within the region adopt IFRS standards and Germany was no exception to that. Since its implementation, a number of positive stories have also been recorded and this have further helped in validating the importance of IFRS in the German jurisdiction. In conclusion, it is stated that the IFRS has helped neutralize the accounting sector in Germany, bringing about a true and fair view of the financial position and performance of companies in the region and ensuring that the reoccurrence of the issues that brought the financial scandal in the jurisdiction doesn’t occur again.

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