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International Financial Reporting Standards, institutional infrastructures, and implied cost of equity capital around the world

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Abstract

Using a sample of 21,608 firm-years from 34 countries during 1998–2004, this study evaluates the impact of voluntary adoption of the International Financial Reporting Standards (IFRS) on a firm’s implied cost of equity capital. We find that the implied cost of equity capital is significantly lower for the full IFRS adopters than for the non-adopters even after controlling for potential self-selection bias and firm-specific and country-level factors that are known to affect the implied cost of capital. This result holds irrespective of institutional infrastructure determining a country’s governance and enforcement mechanisms. We also find that the implied cost of equity capital decreases with the efficacy of institutional infrastructure. Moreover, we provide evidence that the cost of capital-reducing effect of IFRS adoption is greater when IFRS adopters are from countries with weak institutional infrastructures than when they are from countries with strong infrastructures. The above results are robust to a battery of sensitivity checks.

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Notes

  1. For convenience, this paper uses the term IFRS to refer to both IAS and IFRS. The IAS refers to standards issued by IASC and revised by IASB, and the IFRS refers to standards issued by the IASB. In 2001, the IASB succeeded the IASC and assumed its standard-setting responsibilities from the IASC. The IFRS encompasses all standards issued by the IASC and the IASB.

  2. See Bolkestein, F. “One currency, one accounting standard: Unless the European Union adopts a single set of rules, it risks losing the benefits of the euro”, Financial Times (June 14, 2000).

  3. Daske et al. (2008) and Li (2010) study the effect of mandatory IFRS adoption on cost of capital. We are interested in examining the voluntary IFRS adoption effect because voluntary adoption can be viewed as a stronger and more credible commitment to enhance disclosure by a firm. While EU mandated the use of IFRS in the preparation of consolidated financial statements starting in 2005, many other countries are still in the process of converging local GAAP with IFRS. On the other hand, studying the effect of IFRS adoption in a mandatory setting can create other problems: using a single year (2005) as the benchmark ignores other regulatory changes that can occur simultaneously with mandatory IFRS adoption. In this regard, our sample of both voluntary adopters and non-adopters is less likely to suffer from this problem, since firms decide to voluntarily adopt IFRS in different years.

  4. Throughout the paper, a country’s enforcement mechanism refers to a country’s institutions that enforce accounting standards, contractual rights and/or laws.

  5. For example, Daske (2006) examines the effect of IFRS adoption on cost of capital using a sample of firms from a single country, Germany, while Cuijpers and Buijink (2005) examine the effect of non-local GAAP adoption on cost of capital using a sample of European Union firms. Both studies fail to document evidence on the cost of capital-reducing effect of IFRS or non-local GAAP adoption.

  6. On the other hand, while Chen et al. (2009) is an interesting study using the Credit Lyonnais Securities Asia survey data, it is also a limitation which restricts the sample within 17 countries in 2001 and 2002. In comparison, our study covers 34 countries and a longer time period from 1998 to 2004.

  7. Our study and Daske et al. (2012) focus on different aspects of IFRS adoption effects. The main focus of Daske et al. (2012) is on the heterogeneity in economic consequences of the “label” versus “serious” adoptions, while the main focus of our study is on the effect of institutional infrastructures on the cost-of-capital effect of full IFRS adoption. However, to provide a direct comparison with their study, we conduct a sensitivity test in Sect. 6.4 by classifying IFRS adopters into “serious” and “label” adopters.

  8. As shown in “Appendix 2”, the Worldscope field 07536 includes 23 different codes that relate to a firm’s choice of accounting standards. As will be further explained in Sect. 4.1, among the 23 codes, this paper considers only two cases coded as 02 (IAS adoption) and 23 (IFRS adoption) as the full IFRS adoption case. We conduct a sensitivity test by classifying partial adoption as IFRS adopters. See Sect. 6.4 for further discussion.

  9. Countries participated in the agreement are Australia, Canada, France, Germany, Japan, Mexico, Netherlands, the UK/Ireland and the US.

  10. For example, in 2002, the IASB and the Financial Accounting Standards Board (FASB) embarked on a joint program to make US GAAP and IFRS converge to the maximum extent (Schipper 2005). Foreign issuers in the US are allowed to use IFRS without reconciliation to US GAAP since 2007. Foreign issuers in Canada are permitted to use IFRS instead of Canadian GAAP. Also, the IFRS has been widely adopted in the Asia–Pacific region. For example, Bangladesh requires companies listed on local stock exchanges to adopt IFRS. Some countries (Australia, Hong Kong and New Zealand) have changed their local standards into new standards that are virtually similar to IFRS. Other countries (e.g. Singapore, India, Malaysia, Thailand, etc.) have changed most parts of local standards that are basically the same word-for-word with IFRS.

  11. More detailed discussions on this issue are provided in Sects. 4.1 and 6.3.

  12. Some countries in our cross-country sample, such as Brazil, experience high inflation and/or return volatility during our sample period, which results in extreme values in our cost of equity estimates.

  13. The five measures include (1) r DIVPREM employed in Botosan and Plumlee (2002), (2) r GLSPREM employed in Gebhardt et al. (2001), (3) r GORPREM employed in Gordon and Gordon (1997), (4) r OJNPREM derived in Ohlson and Juettner-Nauroth (2005), and (5) r PEGPREM also derived in Ohlson and Juettner-Nauroth (2005).

  14. We understand that there is no consensus on the best measure of ex ante cost of equity. For example, Easton and Monahan (2005) conclude that the r PEG is the worst performer. However, as pointed out by Botosan and Plumlee (2005), Easton and Monahan (2005)’s “preferred” metric is negatively related to beta and standard deviation of returns, which is contrary to the theory and calls into questions the validity of the metric. Prior cross-country studies also use PEG model to estimate cost of equity, for example, Francis et al. (2005), Chen et al. (2009), etc.

  15. Two important assumptions underlying the Easton formula are: (1) there is no change in abnormal earnings beyond the forecast horizon; and (2) there are no dividend payments prior to the earnings forecasts.

  16. Year 1998 is chosen as the starting point because few IFRS adopters are identified before 1998. Our sample period ends at the end of 2004, because all listed firms in EU member countries are mandated to adopt IFRS starting January 2005. Therefore, our sample does not include firms with mandated IFRS adoptions.

  17. In Sect. 6.3, we conduct a sensitivity test based on Daske et al. (2012) classification of IFRS adopters.

  18. The size of our total sample and the percentage of IFRS adopters in our sample are comparable with those in the sample of Covrig et al. (2007). They use a total sample of 24,592 firm-years with both IFRS adopters and non-adopters from the 1992–2002 period from 29 countries. In their total sample, the percentage of IFRS adopters is 5% (See their Table 1).

  19. The inclusion of observations from these ten countries with no IFRS adopters into our sample is consistent with Covrig et al. (2007) and Kim et al. (2011). As will be further explained in Sect. 6.9, we also re-estimate our main regressions after excluding observations from these ten countries and find that their exclusion does not alter our statistical inferences on the variables of interest.

  20. We follow Hail and Leuz (2006) approach to calculate SecReg. They argue that it is appropriate to construct the comprehensive measure in such a way because “the various enforcement mechanisms considered by La Porta et al. (2006) could be substitutes……by aggregating the enforcement indices into a comprehensive measure we allow for substitution among the various enforcement mechanisms”.

  21. The unreported Spearman correlation shows qualitatively similar correlation.

  22. When we estimate Eq. (2) without DIFRS*Institution, the coefficient on DIFRS remains significant across cases except when INST = AudSanction, while the coefficient on Institution are significantly negative across all cases.

  23. A possible reason why results are weak when INST = AudSanction may be that the effects of AudSue and AudSanction substitute for each other.

  24. We prefer evaluating the change in CoE associated with IFRS adoptions in this fashion to comparing the CoE only for adopters between the two periods, i.e., pre-adoption and post-adoption years for the following reasons: (1) the use of only the adopters does not allow us to compare the intergroup (adopters vs. non-adopters) difference in CoE between the pre- and post-adoption periods, it also causes a substantial reduction in our sample size, and thus the statistical power of our tests drastically; and (2) the change analysis requires changes in Institution, but our proxies for Institution do not vary over time. This pre-adoption and post-adoption comparison approach is similar to Barth et al. (2008) approach to examine the effect of adopting IFRS on accounting quality.

  25. An important assumption is clean surplus, i.e., future book values are imputed from current book values, forecasted earnings and dividends. Dividends are set equal to a constant fraction of forecasted earnings.

  26. Though not reported in the paper for brevity, the tabulated results of the sensitivity tests in this section are available from the authors upon request.

  27. For example, Kim et al. (2012) suggests that mandatory IFRS adoption leads to an increase in audit fee.

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Acknowledgments

We thank helpful comments from Jong-Hag Choi, Francis Kim, Jung H. Lee, Cameron Morrill, Aini Qiu, Byron Song, Xiaodong Xu, Cheong H. Yi, Liandong Zhang and participants of Ph.D. and DBA Research Seminars at Concordia University, Fudan University, Shanghai University of Finance and Economics, The Hong Kong Polytechnic University, Seoul National University, the Annual Conference of CAAA, and the Annual Meeting of AAA. Jeong-Bon Kim acknowledges partial financial support for this project from the CERG of the Hong Kong SAR Government and the SSHRCC via the Canada Research Chair program. Haina Shi is grateful for financial support from the Humanities and Social Science Research Project of the Ministry of Education in China (No. 12YJC630169). Both Haina Shi and Jing Zhou gratefully acknowledge the financial support from the National Natural Science Foundation of China (No. 71202056, No. 71072036 and No. 71272012). All errors are our own.

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Authors and Affiliations

  1. College of Business, City University of Hong Kong, Kowloon, Hong Kong

    Jeong-Bon Kim

  2. School of Management, Fudan University, Shanghai, 200433, China

    Haina Shi

  3. School of Accountancy, Shanghai University of Finance and Economics, Shanghai, China

    Jing Zhou

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  1. Jeong-Bon Kim
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  2. Haina Shi
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Correspondence to Haina Shi.

Appendices

Appendix 1

See Table 6.

Table 6 Variable definitions and data sources
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Appendix 2

See Table 7.

Table 7 Worldscope description of Accounting Standards Followed (Field 07536)
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Kim, JB., Shi, H. & Zhou, J. International Financial Reporting Standards, institutional infrastructures, and implied cost of equity capital around the world. Rev Quant Finan Acc 42, 469–507 (2014). https://doi.org/10.1007/s11156-013-0350-3

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