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 3 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 4 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.
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 gap in 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
reports has improved with the adoption of IFRS by Banks, claimed to be to
pro-cyclicality, using Nigerian data.
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