Inconclusive evidence

By David Godsell + Michael Welker
Illustration: Susanna Denti

What, if any, are the potential economic consequences or benefits of the Canadian IFRS adoption?

As the activities of preparing and auditing the first set of complete annual reports using international financial reporting standards (IFRS) are in full swing, it is easy to identify some costs of transitioning from Canadian GAAP to IFRS. So it is an appropriate time to ask, why are we going through this transition? Are there benefits that my company, my clients or the country as a whole might expect to realize from IFRS adoption?

Recent academic literature has examined IFRS transitions, mainly the European Union (EU) transition, which occurred in 2005, and provides evidence that some benefits have accrued to some IFRS-adopting firms. Here, these benefits are summarized, cases where the evidence to date appears to be relatively inconclusive are highlighted and some cautions about generalizing from the EU transition experience to Canada are noted.

The chief aim of the IASB is to develop a set of “high quality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles [that] require high quality, transparent and comparable information in financial statements and other financial reporting [IASC, 2010].” Most of the academic literature examining the potential consequences of IFRS adoption is guided by this objective and seeks to determine if benefits predicted to result from increased transparency and/or comparability have actually been realized.

IFRS adoption may increase transparency if IFRS-compliant financial statements better reflect a firm’s economic context and contain enhanced disclosures. Increased international comparability may result as about 90 countries have fully conformed with IFRS as promulgated by the IASB (IAS Plus, 2011). Among the potential capital market consequences of increased transparency or comparability are lower costs of capital, increased liquidity, and enhanced analyst and investor participation, particularly among foreign analysts and investors. There is a general expectation that these capital market benefits will result in macroeconomic benefits such as increased employment, foreign direct investment and GDP growth. Reliably documenting direct links between IFRS adoption and such outcomes is difficult, however. Finally, an emerging literature examines how IFRS affects the usefulness of accounting numbers in settings other than capital markets, particularly in contractual settings such as executive performance appraisal and remuneration.

IFRS adoption and capital market consequences
To the extent that IFRS produce more transparent and comparable accounting numbers, IFRS adoption could reduce information asymmetry and investor uncertainty, thereby improving equity valuations and resource allocation. In capital markets, these outcomes are expected to be reflected by lower marketwide cost of capital and enhanced market liquidity. Daske et al. (2008), Li (2010), and Florou and Kosi (2009) conduct empirical tests to see if these results materialize in IFRS-adopting jurisdictions. Li finds that the cost of equity capital declines by 47 basis points on average for EU firms adopting IFRS in 2005. Daske et al. find mixed evidence about the effects of IFRS adoption on the cost of equity capital, but find that equity market liquidity improves after IFRS-based financial statements are released. Florou and Kosi extend the analysis to debt financing and find that IFRS adopters are more likely to issue public bonds than borrow in private debt markets and that IFRS adopters enjoy yield spreads that are on average 39 basis points lower when they do issue public debt.

Combined, the results of these studies suggest lower cost of capital and improved market liquidity. These effects appear to be concentrated among firms located in EU countries with stronger legal enforcement mechanisms. The finding that IFRS adoption has a greater effect in jurisdictions with better legal enforcement is a consistent theme in the literature. A common interpretation of this result is that IFRS permits many accounting choices and requires judgment to implement; therefore strong legal enforcement puts pressure on financial statement preparers to implement IFRS in ways that result in more informative financial statements, enhancing the benefits of IFRS adoption.

Why might we see these capital market effects from IFRS adoption? It is difficult for researchers to provide direct evidence to answer this question. However, additional studies that examine the effects of IFRS financial statements on capital market participants’ decisions provide some insights. Byard et al. (2011) find that both financial analysts’ earnings forecast errors and the dispersion of earnings forecasts across analysts decline after IFRS adoption. Tan et al. (2011) use a database that identifies analysts’ locations to assess how IFRS adoption might impact foreign and local analysts differently. They find that IFRS adoption attracts foreign analysts, particularly those who reside in countries that are also simultaneously adopting IFRS and those with prior experience with (voluntary) IFRS-adopting firms. Foreign analysts are also able to forecast IFRS-based earnings more accurately than they could forecast the prior local GAAP earnings for adopting firms. IFRS adoption also attracts local analyst following but does not improve local analysts’ forecast accuracy. Since earlier research suggested that local analysts could forecast more accurately than foreign analysts under local GAAP reporting, this suggests that IFRS adoption reduces or eliminates the forecasting advantage that local analysts previously enjoyed.

Combined, these findings show that the 2005 wave of IFRS adoption in the EU and elsewhere significantly increases the scrutiny of companies’ financial statements by foreign analysts. This will likely enhance the transparency and reliability in those companies’ financial statements, leading to lower costs of capital and increased liquidity.

DeFond et al. (2011) and Yu (2011) find that foreign mutual- fund holdings increase for at least some IFRS-adopting firms. DeFond et al. find that increased foreign ownership is concentrated in firms with a large number of industry peers that also switched to IFRS. Yu finds that the increase in foreign mutual ownership is more pronounced in countries where local GAAP differed more from IFRS prior to IFRS adoption. Florou and Pope (2011) find that expanded institutional ownership after IFRS adoption extends to a broad array of institutions, not just mutual funds. They also find that local funds expand their holdings of IFRS-adopting firms. Interestingly, they document that the increases in institutional holdings are concentrated in funds whose investment style relies more on financial statement data (e.g., the increase is greater in growth and value-oriented funds than in index funds). One interpretation of these studies is that enhanced comparability and/or transparency make it less costly for analysts and investors to analyze and interpret financial statements, particularly across borders. This expansion of analyst and investor interest is a likely mechanism producing the capital market consequences discussed earlier.

A final capital market effect that has been examined is the extent to which markets seem to respond to announcements of earnings prepared using IFRS. Landsman et al. (2011) find that markets exhibit a stronger stock-price response to IFRS- based earnings announcements, consistent with IFRS-based earnings conveying more information to capital markets than earnings based on local GAAP. Extending this analysis to an international setting, Wang (2011) finds that firms’ equity prices react more strongly to the earnings announcements of foreign industry peers after IFRS adoption. This finding is consistent with increased financial statement comparability facilitating transnational information transfer.

IFRS adoption and macroeconomic benefits
As mentioned, it is difficult to design empirical tests that establish clear connections between IFRS adoption and macroeconomic effects. We are aware of only one study that attempts to draw such connections. Márquez-Ramos (2008) finds that both foreign direct investment and trade flows are enhanced between two countries when both countries adopt IFRS. This is an area where more research is needed. The challenges in designing tests of these relations may explain the lack of research.

IFRS adoption and contractual uses of accounting data
Accounting data are used in a variety of contexts outside capital markets. Most notable is the extensive use of accounting data in contractual settings, including debt contracts that may include accounting-based covenants and contracts that govern the compensation and retention of executives. The effects of IFRS adoption on the usefulness of accounting data in these settings is hotly debated in academic circles. Some argue that increased transparency and comparability should not only enhance the usefulness of accounting data in capital-market settings, but should also enhance the usefulness of the data in contractual settings. Others argue that the increased use of subjective fair-value measurements under IFRS will reduce the contractual usefulness of accounting data where harder, less subjective data that better reflect managerial stewardship rather than uncontrollable market movements is called for.

So far the evidence on how IFRS affects the contractual uses of accounting data is sparse and inconclusive. Most of the evidence to date focuses on how accounting data appear to be used in management compensation arrangements. Wu and Zhang (2010) find that firms in Continental Europe appear to use the accounting data of industry peers located in other Continental European countries more for relative performance evaluation of management (in particular, management turnover decisions) after IFRS adoption. Ozcan et al. (2011) examine EU countries that adopt IFRS, reporting that compensation becomes more sensitive to accounting data after IFRS adoption in those jurisdictions that have local GAAP that differs more from IFRS prior to IFRS adoption. They also find that the use of foreign industry peer data in assessing relative performance and determining compensation increases after IFRS adoption. Voulgaris et al. (2011) investigate these issues for UK firms only and find that the firm’s own accounting earnings are less useful for setting compensation after IFRS adoption. They attribute the decline in the reliance on accounting earnings in compensation contracts to the extensive use of fair-value accounting in IFRS, arguing that such use interjects noise into accounting earnings as an indicator of managerial performance.

Conclusions and implications for Canada
The evidence to date appears to suggest that at least some IFRS-adopting firms have experienced lower cost of capital; enhanced equity market liquidity; and increased analyst and institutional investor interest, particularly among foreign analysts and investors. So far, however, the literature with respect to macroeconomic implications or contractual outcomes is inconclusive. So the obvious question is can Canadian IFRS adopters, or at least some portion of them, expect to receive similar benefits?

So far, all that can be said is it depends, and we’ll see. Most of the evidence is based on the adoption of IFRS in the EU in 2005, and the effects appear to be more concentrated in strong legal enforcement countries. Canada is consistently rated as a country with strong legal enforcement in the international rankings we are aware of, and on that basis it might appear poised to experience generally high-quality IFRS implementations with the potential to yield benefits. However, it is important to remember that Canada differs from EU countries that adopted IFRS in 2005 because so much of Canada’s economic activity is conducted with the US, and the US has not adopted IFRS. European firms may have been better poised to benefit from IFRS adoption because so many countries they have significant economic relations with also simultaneously adopted IFRS.

How IFRS adoption might impact US users is unclear. For example, whether moving from Canadian GAAP to IFRS enhances or diminishes comparability between Canadian and US companies is unknown. It probably depends on the industry and how IFRS is implemented. It’s safe to assume that Canadian IFRS-based statements will be more easily understood by EU-based users, but it’s not clear how the change will affect US users and their investment decisions. If enhanced comparability is a key driver of the benefits of IFRS adoption, as suggested by some of the prior academic literature, then the consequences will probably vary depending on how and where the new Canadian financial statements are used.

References
Byard, D., Y. Li, and Y. Yu. 2011. The effect of mandatory IFRS adoption on financial analysts’ information environment. Journal of Accounting Research 49, 69-96

Daske, H., L. Hail, C. Leuz, and R. Verdi. 2008. Mandatory IFRS reporting around the world: early evidence on the economic consequences. Journal of Accounting Research 46: 1085-1142

DeFond, M. L., X. Hu, M. Hung, and S. Li. 2011. The impact of mandatory IFRS adoption on foreign mutual fund ownership: The role of comparability. Journal of Accounting and Economics 51: 240-258

Florou, A., and U. Kosi. 2009. The Economic Consequences of Mandatory IFRS Adoption for Debt Financing. Working paper, University of Macedonia

Florou, A., and P. Pope. 2011. Mandatory IFRS Adoption and Institutional Investment Decisions. Working paper, University of Macedonia

IAS Plus (2011). Use of IFRSs by Jurisdiction. Available at www.iasplus.com/country/useias.htm#? Retreived September 26, 2011. Deloitte Global Services Ltd.

IASC Constitution (2010). Available at www.iasplus.com/iascf/1003constitution.pdf. Retrieved September 29, 2011. IASC Foundation Publications Department, London

Landsman, W., E. Maydew and J. Thornock. 2011. The Information Content of Annual Earnings Announcements and Mandatory Adoption of IFRS, Journal of Accounting and Economics, Forthcoming

Li, S., 2010. Does mandatory adoption of International Financial Reporting Standards in the European Union reduce the cost of equity capital? The Accounting Review 85 (2): 607-636

Márquez-Ramos, L. 2008. The effect of IFRS adoption on trade and foreign direct investments. Working Paper #19, International Trade and Finance Association

Ozcan, N., H. You and Z. Singer. 2011. Mandatory IFRS Adoption and the Contractual Usefulness of Accounting Information in Executive Compensation. Working paper, University of Bristol

Tan, H., S. Wang and M. Welker. 2011. Analyst Following and Forecast Accuracy After Mandated IFRS Adoptions. Journal of Accounting Research, 49: 1307-1357

Voulgaris, G., K. Stathopoulos and M. Walker. 2011. IFRS and the Use of Accounting-Based Performance Measures in Executive Pay. Working Paper, University of Edinburgh

Wang, C. 2011. Accounting Standards Harmonization and Financial Statement Comparability: Evidence from Transnational Information Transfer. Working Paper, University of Pennsylvania

Wu, J., and I. Zhang. 2010. Accounting integration and comparability: evidence from relative performance evaluation around IFRS adoption. Working paper, University of Rochester

Yu, G. 2010. Accounting standards and international portfolio holdings: Analysis of cross-border holdings following mandatory adoption of IFRS. Working paper. Harvard Business School

David Godsell is a PhD student at Queen’s University in Kingston, Ont. Michael Welker is a professor and the KPMG faculty fellow at Queen’s University

Technical editor: Karim Jamal, FCA, PhD, chair of the department of accounting, operations and information systems, School of Business, University of Alberta