capital mkt consequences of european's firms' mandatory adoption of ifrs

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Capital Market Consequences of European Firms Mandatory Adoption of IFRS Jenice Prather-Kinsey Associate Professor of Accountancy School of Accountancy College of Business University of Missouri 324 Cornell Hall Columbia, MO 65211 Phone: 573-882-3671 E-mail: Eva K. Jermakowicz Professor of Accounting Department of Accounting and Business Law College of Business Tennessee State University 330 10th Avenue North Nashville, TN 37203-3401 Phone: 615-963-7052 E-mail: Thierry Vongphanith Brown Brothers Harriman & CO Institutional Equities - Strategy Research 140 Broadway New York, NY 10005-1101 Phone: (212) 493 7949 E-mail:

January 2008

Capital Market Consequences of European Firms Mandatory Adoption of IFRS

Abstract This paper examines the capital markets reactions associated with the mandatory adoption of International Financial Reporting Standards (IFRS) by European firms in 2005. We provide insight on the heterogeneity in capital market consequences from IFRS adoption by investigating the value relevance of book values and information content of earnings announcements of firms before and after IFRS adoption. Additionally, the impact of adopting IFRS on the cost of equity capital is examined. We selected a sample of 157 European firms that implemented IFRS in 2005, used domestic GAAP only for financial reporting in 2004, and reported under IFRS only in 2006. We found that capital market participants consider IFRS adopters financial reports more value relevant and informative, and thus resulting in a lower cost of capital after adoption of IFRS. We test whether the heterogeneity in capital market consequences from adopting IFRS can be explained by differences in the legal origin of the country in which firms are domiciled, shareholder rights, and the quality of enforcement. Firms from code law countries experienced more significant market consequences from implementing IFRS than firms from common law countries.


Capital Market Consequences of European Firms Mandatory Adoption of IFRS I. Introduction Globalization of the worlds capital markets has created a need for a single set of accounting standards that can be applied around the world. Such standards should enhance comparability and transparency of financial information for investors, resulting in greater willingness of investors to invest across borders, a lower cost of capital, more efficient allocation of resources and higher economic growth. These have been the goals of the International Accounting Standards Board (IASB). The IASB was created in 2001 with objectives of producing a single set of high-quality, understandable and enforceable International Financial Reporting Standards (IFRS) and encouraging global convergence on these standards. 1 Today almost every country around the world is moving toward IFRS in some way. Many countries have either adopted IFRS or based their local standards on IFRS. World-wide, over 100 nations require IFRS-based financial reporting for listed companies and it is projected that this number will be over 150 by 2011 (Tweedie 2007). It is clear that near-universal use of IFRS by not only the developing nations (including China, India and Russia), but also by the most economically advanced ones (Canada, Japan, USA) is merely a question of time. The existence and influence of the IASB are the result of market demands for global accounting standards focused on user needs - and not upon preparer, auditor or regulatory convenience (Stevenson 2007).


International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board

(IASB) include the International Accounting Standards (IAS) and their interpretations adopted by the IASB from its predecessor, the International Accounting Standards Committee (IASC).


In September 2002, the FASB and the IASB signed the Norwalk Agreement in which each acknowledged their commitment to the development of high quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting. The SEC voted unanimously on November 15, 2007, to eliminate the 20-F requirement for foreign public issuers to reconcile IFRS financial statements to US GAAP, if the financial statements are prepared using IFRS as published by the IASB (SEC, 2007a). This decision signaled the SEC's acknowledgement of the globalization of capital markets and the quality of the IFRS accounting and reporting framework. In August 2007, the SEC published for comment a concept release on whether U.S. listed companies should be permitted to report using IFRS (SEC 2007b). The Commissions thinking is that if foreign companies have a choice between IFRS and U.S. GAAP, U.S. companies could be at a competitive disadvantage unless they have the same option. All publicly traded companies in the European Union (EU) are required to prepare their consolidated financial statements in accordance with IFRS from 2005 (EC 2002). Also, Switzerland, a non-EU member, introduced legislation requiring all multinational companies to prepare their consolidated financial statements in accordance with IFRS or U.S. GAAP from 2005. The non-EU members of the European Economic Area (EEA), Iceland, Liechtenstein and Norway, have also agreed to enact the EU Regulation requiring listed companies to report under IFRS from 2005. Although EU public companies were required to adopt IFRS from 2005, several European listed companies switched to IFRS much earlier. In 1998 seven EU nations (Austria, Belgium, Germany, France, Finland, Italy, and Luxembourg) made provisions allowing companies under specific prerequisites to use IAS, as well as U.S. GAAP for consolidated 4

financial statements to the extent that they comply with the Fourth and Seventh European Directives. The application decrees, however, have never been adopted in France and Italy (Delvaille et al. 2005). Accounting standards differ across countries. A common belief is that these differences reduce the quality and relevance of accounting information. The vision behind IFRS is that a single worldwide set of standards would permit investors anywhere around the world to benefit from a high level of comparability and a consistently high level of quality in financial reporting. It would eliminate the need for investors and analysts to try to understand financial statements that are prepared using different accounting standards from many jurisdictions, and it would eliminate one of the significant barriers to raising capital outside one's borders (Cox 2007). Our research investigates the impact of mandatory adoption of IFRS on a sample of 157 European IFRS adopters in 2005, the year in which the largest number of European firms implemented these standards. Although adopting IFRS is more than an accounting issue, with potential economic, social, political, and cultural outcomes, we examine cross-sectional differences in the adoption effects by analyzing the stock market reaction associated with adopting IFRS by European firms. Following prior research (Barth and Clinch 1996; Ball et al. 2000; Leuz 2003; Barth et al. 2005; Armstrong et al. 2007; Daske et al. 2007a), we analyze whether IFRS adopters financial statements are viewed by investors as more relevant and transparent (informative) than those before IFRS implementation. Since IFRS is primarily aimed at providing information for the efficient working of the capital market, we measure value relevance in terms of the ability of accounting information to explain contemporaneous stock prices. The question of value relevance is important since it reveals the ability of IFRS to reflect economic information 5

incorporated in stock prices. Daske et al. (2007a) explained heterogeneity in stock market effects by classifying firms into label and serious adopters and found that serious adopters experienced stronger positive effects on the cost of capital and market liquidity than label adopters. Ball (2001) notes that improvements in accounting standards will amount to little more than window dressing, unless it is accompanied by wholesale revision of the infrastructure that determines the financial reporting incentives of managers and auditors. We provide insights into heterogeneity in the capital market consequences by analyzing the legal system of the country in which firms are domiciled, shareholder rights, and the quality of enforcement. Easley and OHara (2004) model the impact of information attributes on the cost of capital. They demonstrated that investors demand a higher return to hold stocks with greater private information (i.e. the stakeholder model in countries with a code-law legal system). An important implication of this research is that firms can influence their cost of capital by affecting the precision and quantity of information available to investors. This can be achieved by a firms selection of its accounting standards, as well as through its corporate disclosure practices.

This study will also investigate whether European IFRS adopters experienced a reduction in the cost of capital following adoption. Decreasing cost of capital as an underlying rationale for transition to IFRS has been expressed by the IASB regulators around the world and the European Commission (Levitt 1998; Bolkestein 2000). Francis et al. (2005) found that alternative legal systems can influence the effectiveness of disclosures. We extend this research by assessing the impact of legal systems, shareholder rights, and enforcement on the application of IFRS as measured by market consequences. 6

Extant accounting literature distinguishes between two orientation postulates (Stewart 1989) under which accounting standards are developed: the shareholders model originating in countries with a common-law legal system and the stakeh