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Lee, Walker and Christensen, 2008

Executive summary

Background

The mandatory adoption of International Financial Reporting Standards (IFRS) across the European Economic Area (EEA) commenced in 2005. Empirical evidence of the economic consequences of this 'big bang' informs a continuing debate about the pros and cons of international accounting harmonisation, among both academics and practitioners. In this report, we analyse the impact of mandatory IFRS adoption on the cost of equity capital. This is an essential metric for the decision making of professional investors and corporate financial managers alike. From a regulatory point of view, a key function of the corporate security market is to supply capital to companies as cheaply as possible. In fact, proponents have often advocated IFRS on this basis. For instance, the former SEC chairman, Arthur Levitt, once stated that 'The truth is, high quality standards lower the cost of capital' (Levitt 1998).

Competing theories

There are currently two main schools of thought in the debate on mandatory accounting harmonisation. On the one hand, proponents suggest that accounting standards determine accounting quality. Based on this argument, mandatory regulatory intervention provides two key benefits. First, by adopting a common accounting 'language' the international comparability of financial statements should improve. This should facilitate cross-border capital flows and therefore reduce the cost of capital. Second, imposing the disclosure requirements of IFRS should improve the information disclosure quality of companies domiciled in countries where lower standards of disclosure are required by national generally accepted accounting principles (GAAP). By reducing information asymmetry, investors are able to monitor managerial performance better and therefore demand a lower risk premium. If this supposition is correct, then we should expect to see the greatest impact of IFRS among smaller European countries with lower quality accounting and disclosure standards, such as Greece and Portugal.

The alternative argument is that preparers' incentives and institutional context affect the quality of financial reporting more than accounting standards. Although IFRS adoption is mandatory across Europe, there are significant differences between countries in the importance of the stock market as a source of finance. Moreover, even within individual countries, companies differ in the extent to which they are reliant on external funding and in their costs of compliance with financial disclosure requirements. Despite mandatory adoption, companies with little to gain from IFRS may choose to exploit any embedded flexibility in IFRS implementation and 'box-tick' their way through the process with a minimum degree of compliance. On the other hand, some companies with relatively high reliance on the stock market as a source of finance, and relatively low costs of complying with IFRS disclosure requirements, may choose to comply enthusiastically with IFRS. Low-incentive companies are more likely to exist in countries where equity market financing is less important and where domestic accounting standards traditionally demand lower-quality disclosure. Conversely, high-incentive companies are more likely to be found in countries where equity market financing is more important and where domestic accounting standards traditionally demand higher-quality disclosure. If this is the case, then we would expect to see the greatest impact of IFRS adoption among European countries where equity financing dominates, along with high-quality national GAAP.

Key findings

In this report we classify 17 European countries into those with high or low financial reporting incentives and enforcement, based on five key institutional characteristic indicators:

• outsider rights
• the importance of the equity market
• ownership concentration
• disclosure quality, and
• earnings management.

For the sample period of 1995 to 2006, we have calculated company-specific cost of equity capital derived from the consensus forecasts of sell-side analysts and market prices. Between the extreme groups of countries, we compare changes in corporate cost of capital from before the enactment of IFRS until after this had been introduced. Based on the predictions from the two aforementioned schools of thought, we would expect the impact to be concentrated towards one extreme. The pro-standard argument predicts there will be cost of capital reduction in countries with low financial reporting incentives and enforcement. The pro-incentive argument, on the other hand, predicts cost of capital reduction in countries with high financial reporting incentives and enforcement. If we observe similar patterns between the two extreme groups of countries after 2005, then it will be difficult to draw the inference that our observed changes are brought about by IFRS as opposed to other confounding reasons beyond the scope of IFRS, such as business cycles or globalisation.

Our findings are as follows. In countries where all five institutional characteristic indicators are below the pan-European median, ie those that have low financial reporting incentives and enforcement, we find limited and mixed evidence of a cost of equity capital reduction from the pre- to post-IFRS periods. In stark contrast, in the country where all five institutional characteristic indicators are above the pan-European median, ie the UK, we observe a significant reduction in the cost of equity capital following the implementation of IFRS. These results are robust when tested against different valuation models from which cost of equity capital is derived, and controls for company-specific characteristics such as size, growth, leverage and ownership, as well as different test specifications.

Implication

The empirical evidence from our analyses provides little support for the pro-standard school of thought. If mandatory regulatory intervention is effective, then imposing higher quality accounting standards should produce greater changes for companies in countries with low financial reporting incentives and enforcement. By the same argument, companies that are based in the UK, where previous domestic GAAP was considered to be roughly equivalent in disclosure quality to IFRS, the change should have limited impact. Our finding that UK companies enjoy a greater cost of equity capital reduction following IFRS than other European countries lends support to the pro-incentive school of thought. In countries where equity-based financing dominates, and corporate disclosure quality is already high, the implementation of IFRS appears to be more effective. This outcome has important implications for the regulators and auditors, as well as end-users of financial statements. In other words, imposing on debt-based capital markets the accounting standards developed for equity-based markets may not be effective, at least in the short-run. Our overall inference is broadly consistent with those of other academic studies on this topic. Accounting standards that are designed for equity-based capital markets bring the most benefits to stock-market-based economies.

Given our evidence, to reinstate the pro-standard school of thought one would have to assume that economic consequence indicators used in studies such as ours do not measure the true benefit of IFRS. Alternatively, one could also argue that our sample period limits us to reliance on only short-run evidence of the impact of mandatory IFRS adoption over the transition or initial 'settling down' period. Perhaps the impact on bank-based economies shows up later than in their stock-market-based counterparts. Thus, the benefit of IFRS for smaller countries with lower financial reporting incentives and enforcement may only be revealed over a longer period. Nonetheless, we believe our short-run evidence is useful in the sense that it documents the original impact from an external shock to the existing system, without the influence of subsequent amendments and reforms to enhance incentives and enforcements, which may crop up in longer-run studies.

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