Many proponents of IFRS claim that after the adoption of IFRS a firm’s cost of raising capital declines due to the potential for higher international diversification by investors and lower risk to investors arising from higher quality financial information (Ball, 2006). The academic literature highlighted the type of the IFRS adoption whether it is mandatory or voluntary, as a crucial factor that differentiates the impact. The explanation is that companies that adopted IFRS voluntarily were likely to have incentives for higher quality financial reporting and therefore entail lower risk for investors. The models that have been used to estimate the cost of capital have included the residual income valuation model, abnormal earnings growth model (Daske, 2006; Christensen et al., 2007; Daske et al., 2008, Jermakowicz et al., 2008, Li, 2010; Daske et al., 2013) and the Price Earnings Growth ratio (Kim and Shi, 2007)
and stock returns (Christensen et al., 2007; Karamanou and Nishiotis, 2009). In addition to econometric modelling, studies have also used interviews of managers
(Armitage and Marston, 2008) to explore the perceptions of managers about IFRS adoption.
Most of the existing studies investigating the impact of IFRS adoption on the cost of capital employed country-level factors such as the legal system (common law or code law), the differences between local GAAP and IFRS and the level of enforcement (financial reporting and legal) as well as the level of market regulation in each country. They also employed firm-level factors, such as the type of adoption (mandatory/voluntary), firm specific characteristics and firm accounting policies. The studies investigating the impact of IFRS adoption on the cost of capital are relevant to this thesis as follows:
a) They employed valuation models that use analysts’ earnings forecasts as main inputs. Hence, it is possible that changes to the cost of capital post IFRS adoption could be related to changes in the characteristics of the analysts’ forecasts that this research project examines.
b) The existing findings on the role of country-level and firm-level factors assisted in formulating the research questions of this thesis, as well in interpreting the empirical results
In a cost of capital study not focussing on the IFRS impact, Hail and Leuz (2006) investigated whether international differences in the cost of equity capital were associated with the characteristics of legal systems and market regulation. The authors suggested that strong legal institutions provide strong investor protection, limit the opportunities for managerial discretion and therefore reduce the investors’ perception of the firms’ risk and the cost of equity capital. Using samples of firms from 40 countries, between 1992 and 2001, Hail and Leuz (2006) created implied cost of capital estimates using four accounting valuation models and employed proxies for stock market regulation and corporate disclosure regulation. For this purpose, they used proxies for stock market regulation based on a survey from the academic literature of legal professionals in 49 countries.
The authors constructed variables using data on:
a) enforcement, to investigate to proxy the quality of each country’s legal system b) the difficulties in recovering liabilities, to identify differences in each country’s regulation effectiveness
c) the listed firm disclosure requirements, to capture differences in stock market regulation between countries
Their results indicated that jurisdictions with stronger market regulation and detailed mandatory disclosures were likely to have a lower cost of capital. Although higher legal quality appeared to have a relatively small effect, the effect of strong market regulation is greater, particularly for countries with less integrated markets. The study provides evidence on the effect of legislation and regulation on the cost of equity capital but it can be argued that: a) does not consider that many jurisdictions are affected by the same legal institutions and b) does not consider the role of financial reporting standards and disclosure. In a second paper by the same authors, Hail and Leuz (2006) examined whether the implied cost of capital is decreased for foreign firms from 45 countries listed in the US when they adopted IFRS for the first time. Their findings showed that firms from countries with lower disclosure requirements and lower investor protection are likely to have considerably decreased implied cost of capital.
Focussing in the effect of mandatory IFRS adoption in the UK, Christensen et al. (2007) examined the price reaction to news related to the expectations for the forthcoming mandatory adoption of IFRS and at a later point the certainty about the implementation of change in accounting standards. They also examined the possible impact on the implied cost of equity capital before and after the announcement. They explained that previous research on the adoption of IFRS in the UK was restricted by the type of adoption (mandatory) as firms with potential incentives to adopt IFRS were not allowed to adopt before 2005. Their study differentiated itself from other studies in the field by selecting a second sample comprised by firms in Germany where companies had the early adoption option. A similar approach in sample
selection is adopted in our research project as explained later in this thesis. For comparison purposes, we intended to select samples of German voluntary and
mandatory adopters as well as UK and French companies adopting IFRS mandatorily. Christensen et al. (2007) formed the expectation and eventually found that for UK companies and German voluntary adopters, there was a positive correlation between announcements that changed the probability of mandatory IFRS adoption before 2005 and stock prices (Christensen et al. 2007). Also, they further assumed that the higher the degree of similarity of UK firms with German voluntary adopters the lower the implied cost of equity capital post IFRS adoption in the UK.
Thus, the authors in order to determine which firm characteristics influence voluntary IFRS adopters in Germany, employed logistic regressions with 1 if the firm chose IFRS and 0 otherwise as dependent variable and industry indicators, gearing, size and foreign turnover as independent variables. The authors estimated the cost of equity capital using an abnormal earnings growth model and a Price Earnings Growth ratio model. Their independent variables were changes of operating profit margin, book to market ratio, gearing, market value and turnover growth. Their empirical results confirmed their hypothesis that announcements that increased the probability of mandatory IFRS adoption in the UK, were likely to increase the stock price and announcements that reduced the probability were likely to decrease the stock price (Christensen et al., 2007). Their results were consistent with the later studies by Christensen et al. (2009) and Horton and Serafeim (2010) showing that announcements related to IFRS adoption by UK companies were value relevant.
Also, the authors found that UK companies that were more similar to German voluntary adopters based on their firm characteristics were likely to have higher reductions in the implied cost of equity capital post IFRS adoption.
It can be argued that their empirical results could reflect benefits from cross border comparability for UK companies with higher international activities or benefits from the IFRS increased disclosure requirements on companies that already had incentives for transparency. Thus, companies that strived for higher transparency would theoretically expect to gain benefits from better-informed investors and therefore have lower risk. In another study, Armitage and Marston (2008) aimed to investigate if managers themselves expected a reduction in their firm’s implied cost of capital after IFRS adoption.
Armitage and Marston (2008) investigated the connection between disclosure and the cost of capital and collected data from interviews with 16 top executives. The authors explained that the appraisal of corporate disclosure quality and estimation of the cost of equity capital are complex tasks and aim to reveal the managers’ perception and incentives. The researchers asked their interviewees about the benefits and costs of corporate disclosure with respect to the potential reduction in the cost of capital. They selected a diverse set of UK companies of different size and industry between 2005 and 2006; a period that coincides with IFRS adoption and the issue of the EU Market Abuse and Transparency directives. Their research findings showed that company directors do not believe that there is a relation between corporate disclosure and the cost of capital past a certain marginal point of good quality disclosure (Armitage and Marston, 2008). Their results uncovered a potential asymmetry in the supply of disclosure in favour of credit rating agencies and banks. They also found that the corporate directors believe that the higher supply of insider information to these counterparties the lower the firm’s cost of debt. On top of that, Armitage and Marston (2008) stated that the managers’ main objective for disclosure is the improvement of the company’s reputation for transparent disclosure of information. It should also be noted that managers did not tend to believe that additional mandatory disclosure imposed by regulators would have a significant impact on the
Hence, it will be interesting to see later in this thesis if the increase in the quantity of mandatory disclosure by IFRS is likely to affect or not the firms’ information environment and its quality as reflected on the properties of analysts’ earnings forecasts.
In the context of voluntary IFRS adoption Karamanou and Nishiotis (2009) analysed the effect on the cost of capital of the incentives that managers have to disclose information with more transparency. The authors demonstrated how accounting standards can increase firm value through a reduction in information asymmetry. They selected a small sample across 8 countries from 1989 to 2002 and looked at the long and short-term stock returns close to the voluntary IAS/IFRS adoption announcement. They expected that abnormal returns were associated with the IFRS announcement signal, especially for undervalued companies (identified by Tobin’s Q and analysts’ suggestions). Their findings indicated an increase in the stock price following adoption announcements and a significant reduction in the firm’s cost of capital. The fall in the cost of capital was identified as being responsible for the increases in equity value rather than prospective economic performance. Their results were consistent with the later studies on IFRS adoption by Christensen et al. (2007), Christensen et al. (2009), Horton and Serafeim (2010), showing that announcements related to IFRS adoption were value relevant.
To further confirm that potential future earnings surprises were not responsible for the rises in equity returns, they included a term reflecting analysts’ earnings forecast error and found no statistical significance. The authors mainly attributed their results to the increased disclosure that IFRS offered but they also highlighted that the impact of increased mandatory disclosure requires further investigation, as the costs of the additional disclosure requirements could potentially be higher than the benefits. Several papers suggested the importance of firms’ incentives and countries’ legal enforcement systems in determining whether IFRS are fully adopted and applied, or just adopted in name rather in substance (label adopters). Daske et al. (2008) drew this distinction and identified a substantial decline in the cost of capital but found that this applied only to serious adopters rather than to label adopters.
Kim and Shi (2007) looked at the partial IFRS adopters and, similar to Karamanou and Nishiotis (2009), aimed to identify if the cost of capital was different for companies with incentives for higher quality financial reporting.
Kim and Shi (2007) looked at the effect of voluntary adoption of IAS (IFRS) from 1998 to 2004, in 34 countries and compared the implied cost of equity capital between companies reporting under international standards or not. They also took into account a third group of companies that adopted some international standards and called them partial IFRS adopters. The Easton Price Earnings Growth model (Easton, 2004) was used to estimate the implied cost of capital. Also, the robustness of the results was
confirmed with reference to estimates from a number of alternative models. The analysis concentrated on the role of institutional factors that affect corporate
governance (legal system, compulsory disclosures, investor safeguard system) and enforcement (market regulation, difficulties of prosecuting an auditor). Kim and Shi (2007) found that companies reporting under IAS/IFRS were likely to have lower cost of capital but only when they fully adopt them. Their results are consistent with Daske et al. (2008) but contradict with Li (2010) who did not find a reduction in the cost of capital for voluntary IFRS adopters. Kim and Shi (2007) suggested that the cost of capital difference between companies reporting under IFRS was higher in countries with weaker institutional factors. Possibly, the market compensated with lower costs of raising finance the firms that demonstrated higher transparency and quality by voluntarily adopting IAS/IFRS.
While most studies identify a decrease in cost of capital associated with IFRS
adoption, some of the evidence presented in the literature is contradictory. Daske (2006) found that the cost of capital increased in Germany post IFRS adoption.
The paper investigated the impact on German firms reporting under German GAAP, US GAAP and IAS/IFRS between 1993 and 2002. The author established that German accounting is amongst the least transparent in the European Union and assumed that the adoption of international standards was likely to provide strong benefits arising from higher mandatory disclosure. Monthly data was used in order to increase the statistical power of the results, in versions of the abnormal earnings growth model and the residual income valuation model.
As it will be explained later in this thesis, following Daske (2006) monthly data of analysts’ earnings forecasts is used in the empirical analysis of our research project in order to increase the explanatory power of the results.
Contrary to his expectations, Daske (2006) showed that firms reporting under international standards in Germany experienced a rise in the cost of capital during this time frame. The reasons that Daske (2006) attributed to these results are the uncertainty of investors due to the diversity of accounting standards in Germany that reduced comparability, the firm incentives that remained unchanged by IFRS adoption and the use of international standards just for illustratory purposes (similar to the “label adopters” discussed earlier. Germany is a mainly bank-based economy which creates an insider-orientation with respect to disclosure and in this environment
analysts could possibly lack expertise with foreign accounting standards. Daske (2006) noted, however, that one limitation of his model is that that the implied
cost of capital models rely heavily on analysts’ forecasts and their inaccuracies can affect the estimations. Similarly to Daske (2006), Horton et al. (2013) found that the effect of IFRS adoption on the cost of capital can be negative for some firms due to the effect of debt covenants and decreased credit rating. The authors concluded that results can vary depending on the firm’s country.
Daske et al., (2013) in a study of the capital market benefits of IAS/IFRS classified sample companies in serious and label IFRS adopters. Their study used a large sample of 30 countries from 1990 to 2005. The authors’ rationale was that firm incentives matter more than financial reporting standards and therefore they divided the companies according to their reporting policies. The aim of their analysis was to investigate whether companies adopting IAS voluntarily experience a reduction in the cost of capital and higher market liquidity compared to companies reporting under national GAAP. The authors explained that they expected positive capital market benefits because of increased harmonisation among the adopting firms but noted that they did not anticipate any improvements for label adopters. For this purpose they manually coded each firm’s accounting policies and a set of compliance combinations that reflected the magnitude of reconciliation information between local GAAP, US GAAP and IFRS in annual reports.
Using these scores they placed the companies in two groups, those above and those below the median, and construct a serious/ label adopters binary variable. The Ordinary Least Squares regression results showed that serious IFRS adopters experience higher market liquidity and lower cost of equity capital compared to non- adopters and label adopters, consistent with the findings of Kim and Shi (2007) and Daske et al. (2008). Similarly to Karamanou and Nishiotis (2009), Daske et al. (2013) concluded by explaining that their results for serious adopters did not represent the “clean effect” of the accounting standards as they reflect the companies’ reporting incentives too because they voluntarily adopt IAS/IFRS and fully comply.
As stated above, Daske et al. (2008) examined the consequences of IFRS adoption from 2001 to 2005, using a difference in difference method that involved a control sample of non-adopting firms. The authors constructed a combined proxy for market liquidity that included trading costs, bid-ask spreads, non-trading days and prices. They also employed four valuation models to construct proxies for the implied cost of capital. The results demonstrated an increase in market liquidity and equity valuations and a decrease in the cost of capital but only in countries with strong enforcement mechanisms and where the infrastructure provided incentives for the firms report transparently. The empirical evidence showed that the benefits were higher for firms that voluntarily adopted IFRS and the effect was stronger in countries where local GAAP had big differences with IFRS (contrary to Li, 2010). Significant benefits were also observed in countries that did not have a convergence strategy prior to the IFRS adoption and in EU countries that were affected by coinciding EU policies.
The findings indicated that around the IFRS adoption, the effects were stronger for companies that voluntarily adopted IFRS and the authors argued that this could reflect either increased comparability with mandatory IFRS firms or simultaneous market developments. It should be noted that Daske et al. (2008) acknowledged that their data spans across the initial transitional period and their estimates for cost of capital and equity valuations were potentially influenced by reconciliation adjustments by both firms and analysts.
A study by Jermakowicz et al. (2008) examined the effects of IFRS adoption on a sample of 157 European firms and looked at the cost of equity capital, the value relevance of book values and earnings releases information content. Using the Ohlson, Juettner-Nauroth (2005) model, the researchers identified increased value relevance and information content of earnings in mandatory IFRS adopters.
The authors examined cumulative abnormal returns at the time of earnings releases, and the cost of equity capital implied using the Price Earnings Growth ratio model. Their results confirmed their hypotheses and showed that the cost of equity capital decreased significantly after IFRS implementation in countries operating under both code law and common law. A higher market reaction was observed to earnings releases in code law countries and this was attributed to the fact that companies in code law countries were obliged to implement larger changes in their financial reporting standards than common law countries. Contrary to Hail and Leuz (2006), Daske et al. (2008), Li (2010), the findings supported the idea that code law countries (with relative weaker legal enforcement) decreased their cost of equity capital and gained considerable benefits by adopting IFRS because they improved their financial information quality and reliability. Limitations of the study included the small sample size (157 firms) that in conjunction with the large number of countries (16 countries), could make the data inconsistent and biased. The concentration on the time frame