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EFFECT OF MANDATORY IFRS ADOPTION ON VALUE RELEVANCE AND PRO-CYCLICALITY OF DEPOSIT MONEY BANKS IN NIGERIA
1.1 Background to the Study
International Financial Reporting Standards (IFRS) has been the focus of many financial accounting studies in recent times. The global convergence to the use of a common set of international accounting standards in business entities to improve financial disclosure has redirected researches towards analyzing the value relevance of financial reports and the change of the standard for the recognition and measurement of loan loss provision which has received considerable attention and debate worldwide, especially in developed economies.
Financial reporting is the record of the business economic activities which aims at making available accounting information to investors, analyst and stakeholders for investment decisions. Prior to 2012, Nigerian banks used Nigerian Generally Accepted Accounting Principles (GAAP) in preparing their financial reports. Value relevance of financial reporting is fundamental as accounting information shows the financial health of the business entity that affects their investment efficiency. The key objective of empirical research on value relevance is to examine the statistical relationship between financial report variables and market variables. Investors, analyst and other users of financial statements rely on a variety of information including earnings, products and data in the economy.
However, fraudulent accounting manipulation threatens the credibility and reliability of financial reporting which affect investors‟ confidence in accounting numbers. Global financial crisis like that of Enron Corporation in 2001, the largest corporate failures in history that led to the dissolution of Author Anderson audit and accountancy partnerships
in the world have put accounting practices and the profession under inspection, as these scandals has made the reliability and effectiveness of accounting standards questionable. Such trend of major accounting scandals also showed its ugly face in Nigeria with the falsification of the financial reports in 2006 by Cadbury Nigeria Plc and in the banking sector, the liquidation of 26 banks in 1997 despite the efforts of the Central Bank of Nigeria (CBN) in enhancing the financial disclosure of Deposit Money Banks (DMBs) by issuing prudential guidelines for supervision and specific directives. It is based on this premise thatthe World Bank (2006) opines that Nigerian banks financial reporting is very poor and some banks are known to falsify their accounts. In addition to the foregoing, Ashamu and Abiola (2012), state that the 2007 economic crisis on the banking industry of Nigeria has caused depression of the country‟s capital market, decreased the quality of some part of the credit given by banks for trading in the capital market. All of the aforementioned events as well as the post consolidation banking crisis of 2009 in Nigeria further increased investment riskiness in the minds of stakeholders and has increased the call for improving financial disclosures.
Whereas, Banks provide financing in economies across the globe as part of their operational activities by giving credit to customers hence, helping in the allocation of resources and Thus act as catalyst to economic growth. However, banks are faced with credit risk arising from default from customers in paying interest on loan as well as the principal. Due to this, credit risk management is crucial to banks because loan defaults could affect their solvency and lead to liquidation. Consequently, Banks are therefore required by law to make Loan Loss provisions (LLP) to cover for loan defaults. The Statement of Accounting Standard (SAS), specifically SAS 10 under Nigerian GAAP, provides that Nigerian deposit money banks recognize and measure reported LLP using expected loss approach, using historical cost accounting. This approach is forward
looking and gives bank managers the discretion to make loan loss provisions based on the expectation that borrowers will default.
It is however argued that the expected loss models allow bank managers to use their discretion to manipulate banks LLP, by increasing their LLPs in good years when profits are high so as to cover up for bad years when profits are low, making stakeholders believe the banks are doing well compared to their competitors. Olusanya (2010), in Ndubuisi (2016) intercontinental bank plc,Oceanic bank plc and Afribank Plc in 2006, were accused of manipulating their financial reports on LLP. Their LLPs in audited reports were different from those reported by the CBN. That of intercontinental bank reads 36billion as against 278.2billion reported by the CBN which may suggest that local GAAP is not transparent enough to provide in details information only known to managers.
More so, The fact thatNigeria‟s economy is also becoming more sophisticated and the wide use of International Financial Reporting Standard (IFRS) by other countries across the globe and noteworthy is the fact that, as stated by Ocansey and Enahoro (2014) foreign donors require that financial reports be prepared in conformity with International Financial Reporting Standard (IFRS) before receiving grants which further trigger the need for unified accounting that conformsto international standards in order to reform the global economy.
It is therefore not surprising when Nigeria mandatorily adopted IFRS by the International Accounting Standard Board (IASB) in the year 2012, whose process started in year 2010, joining other countries around the globe to benefit from the use of a single set of international accounting standards. The adoption of IFRS by Nigeria is expected to
reduce the problems associated with the use of Nigerian GAAP by mitigating the trend of fraud and enhancing the reliability of accounting in banks.
IFRS advocate the incurred loan loss model for LLP provided under IAS 39, using fair value accounting for all derivative instruments. Fair value accounting is argued to be an improvement of the historical cost accounting. IAS 39 is a backward looking standard that sets restrictions on the discretionary LLP by managers and only allows the recognition of loan losses when there is objective evidence that they actually occur and considers only identifiable losses at balance sheet date. Ernst and young (2006) emphasized the LLP (impairment) rules provided by IAS 39, stating that the amount to be set aside as provisions for loan loss depends on the state of the economy and are not to be made except when they actually occur.
However, the incurred loss model under IAS 39 is argued to be pro-cyclical. Banks are supposed to increase their LLPs in an expansion so as to cover for loan defaults and reduce LLP in a recession, but because during an economic expansion the Loan portfolio of banks increases as the competition between banks for lending customers‟ increases, businesses flourish with high profits,and the Gross Domestic Product (GDP) of the country is high, banks therefore expects that very few loans will default, thus monitoring efforts and LLPs are reduced.
Conversely, in a recession banks prefers to increase LLPs and reduce lending to customers as business losses are high and GDP of the country is low. Nonetheless, lending risk builds upduring the expansion period but only becomes evident in a recession when the quality of their loan portfolio reduces. Increasing LLPs in a recession and reducing loans to credit worthy customers for investments that may have been otherwise productive leads to credit crisis that worsens and delays a recovery from the recession that affect the financial stability of the entire economy. This means that the restriction set by IFRS on discretionary loan loss provision leading to delay in recognizing LLP makes banks vulnerable to pro-cyclical behavior, by increasing LLP in a recession which directly affects a banks profit and retained earnings that are part of their capital, thus weakens their capital and if their LLPs are not enough to cover loan losses, they are forced to diminish their capital.
Regulators therefore claim that this model for LLP has increase the crisis during economic recession. Gerhardt andFarkas (2006) state that regulators argue that even though fees and risk are incorporated in interest rates charged to borrowers, the recognition of losses is postponed until the borrower actually defaults. As a result, higher earnings are reported during economic expansion and lower earnings in period of economic recession. Furthermore, The World Bank (2010) opine that during the global financial crisis, IAS 39, as currently implemented have shown overstatement of interest on income inperiods before the occurrence of the loss event and provisions that were insufficient to absorb actual losses that emerged during the crisis, leading to pro-cyclical bank earnings.In addition to this, Larson and street (2004) argue that IFRS under IAS 39 have a complex nature making it complicated and difficult to apply in the recognition and measurement of financial instruments.
In relation to the foregoing, IFRS has been extensively criticized for its pro-cyclical effect on the loan loss provisioning behavior of banks influenced by the state of the economy which affects financial stability and worsens economic situation. This has called for a counter cyclical provisioning accounting standard that would be forward looking. IASB and Financial Accounting Standard Board would replace IAS 39 completely with IFRS 9 effective from January 1, 2018. IFRS 9 is an expected loan loss provision model which guides banks to estimate expected credit losses by considering past events, current economic conditions and reasonable forecasts (IAS Plus, 2013a)
The regulatory change in accounting standards especially LLP, as presently measured under IAS 39 has raised a lot of questions about the impacts of IFRS on the credibility and relevance of financial statements. It is therefore desirable to carry out a study in this area so as to establish whether or not the supposed relationship between IFRS and value relevance as well as that of pro-cyclicality holds true for the Nigerian banking industry.