CHAPTER ONE
INTRODUCTION
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.
1.2 Statement of the Problem
Prior empirical studies in Nigeria did not focus on the pro-cyclical effects of banks LLP
as a result of adopting IFRS. Rather, they focus on the effect of IFRS on earnings
management, timely loss recognition and value relevance. Dearth of studies in this area
on the pro-cyclical behavior of banks shows that there is a gapin literature to be filled.
Therefore, this study tries to fill the gap by including pro-cyclicality. The problem that
has also prompted carrying out the study is the unanswered question of whether or not the
value relevance of financial reportshas improved with the adoption of IFRS by Banks,
claimed to be to pro-cyclicality, using Nigerian data.
1.3 Research Questions
Based on the problems of the study the research questions are as follows:
- To what extent is the effect of IFRS moderated value relevance of earnings on share
price of DMBs in Nigeria? - What is the effect of IFRS moderated value relevance of book value on share price of
DMBs in Nigeria? - Do IFRS moderated pro-cyclicality have effect on the loan loss provision of DMBs?