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: [email protected]

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: [email protected]

Thierry Vongphanith Brown Brothers Harriman & CO Institutional Equities - Strategy Research 140 Broadway New York, NY 10005-1101 Phone: (212) 493 7949 E-mail: [email protected]

January 2008

Capital Market Consequences of European Firms’ Mandatory Adoption of IFRS

Abstract This paper examines the capital market’s 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.

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Capital Market Consequences of European Firms’ Mandatory Adoption of IFRS

I. Introduction Globalization of the world’s 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).

1

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).

3

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 Commission’s 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 O’Hara (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 firm’s 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 stakeholder model originating in countries with a code-law legal system (Bartov et al. 2005). Traditional accounting systems in code-law countries such as France, Germany (i.e. most Continental European countries and Japan), have been driven by an emphasis on financial reporting conformity with tax regulations, conservatism, and broad-stakeholder orientation. The government, shareholders, debt holders, employees, and managers are all viewed as stakeholders, relying less on public information because they typically have access to private information. As a result, the incentives (e.g., minimizing taxes) and opportunities (e.g., reserve accounting) to reduce earnings volatility are higher in these countries. We expect that adoption of IFRS would be relatively more beneficial to investors in these countries and have a more significant impact on capital markets, than for common law countries where financial reporting has historically been primarily oriented to the private investor/stockholder. Moreover, book values reported under IFRS should have higher value relevance than book values determined under national GAAP. In common-law countries (i.e. U.S., U.K), accounting systems are determined largely by the disclosure needs of shareholders and potential shareholders (which are primary providers of capital) and require a high standard of public disclosure. We expect that the adoption of IFRS would be relatively less beneficial to investors in these countries because their orientation postulate is similar to that of the IASB. Our primary contribution is evidence on the likely impact of implementing IFRS on the value relevance of book values of earnings and equity, information content of earnings announcements, and cost of capital of a sample of mandatory IFRS adopters in Europe. We are 7

looking at the effects of mandatory as opposed to voluntary adoption of IFRS. Most of the prior research has been conducted on the latter. Our secondary contribution is an investigation of whether the market responds to the announcement of earnings equally for countries with different legal systems, shareholder rights, and quality of enforcement. Finally, we test whether firms adopting IFRS experienced a reduction in cost of capital following adoption of IFRS. The remainder of our paper is presented as follows. Section II is a discussion of prior research on the capital market consequences from adopting IFRS. Section III presents the data and the sample selection process. Section IV describes the research methodology and empirical design, section V presents our findings. Section VI offers concluding remarks and limitations of the study. II. Prior Research With growing prominence of IFRS, the demand for publications on the effects of adopting IFRS, country practical experiences in implementing IFRS, as well as future prospects of global accounting convergence is growing at exponential rates. Several recent studies have examined the benefits of global accounting convergence and the capital market effects of IFRS adoptions. Daske, Hail, Leuz and Verdi (2007a) examined the heterogeneity in economic consequences of voluntary IFRS adoptions around the world, recognizing that firms have considerable discretion in how they adopt IFRS. Some firms may simply adopt a label, while others view the decision as a serious commitment to transparency. They found that the economic consequences of IFRS adoptions depend on the extent to which firms make material changes to their reporting policies or have strong reporting incentives. In another paper Daske at al (2007b) analyzed the

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economic consequences of mandatory IFRS reporting around the world using a large sample that includes over 3,800 first-time adopters. They find that the capital-market benefits from implementing IFRS exist only in countries with strict enforcement regimes and institutional environments that provide strong reporting incentives. Also, the effects are weaker when local GAAP is more comparable to IFRS, in countries with an IFRS convergence strategy and in industries with higher voluntary adoption rates. Daske et al. (2007a) defined heterogeneity as the difference in management incentives to adopt IFRS: “serious” or “label adopters.” We extend Daske et al (2007a) by defining heterogeneity as common law versus code law countries. We believe that this distinction proxies for the strength in protection of shareholder rights and the quality of enforcement of those rights (La Porta et al 1998). Moreover, alternative legal systems, code and common law, have been found to explain the heterogeneity in financial reporting compliance around the world (Francis et al. 2005). Value relevance studies are widely used by researchers to capture the combined attribute of relevance and reliability of accounting information (Schipper and Vincent 2003). The value relevance of different GAAP has been explored in the accounting literature using either an association study or an event study (Holthausen and Watts 2001). We study the association between book values and the market using a long window (value relevance of 12 months) and a short window (information content within 6 days of earnings announcements). Association studies investigate whether financial reporting data explains market capitalizations and changes over long windows (Barth 1994, Choi et al. 1997, Barth et al. 2005). The Ohlson model (Ohlson 1991, Ohlson 1995, Feltham and Ohlson 1995) stipulates that the share price can be written as a linear function of earnings and equity book value, given a 9

dividend valuation model and clean surplus accounting, and has been employed in a number of research studies (Chandra and Balachandran 1992, Harris et al. 1994, Easton and Sommers 2003). We adopt the Ohlson, Juettner-Nauroth (2005) model to study the association between book value and market values. Event studies investigate the association of the financial reporting data and abnormal market capitalization changes over short windows around the date of the financial report publication. These studies measure information content as an unanticipated change in the returns of a firm’s capital (Beaver 1968, Ball and Brown 1968, Auer 2003). Armstrong, Barth, Jagolinzer and Riedl (2007) examined the European stock market reaction to sixteen key events associated with the adoption of IFRS in Europe. They found significant positive (negative) market reactions to events that increase (decrease) the likelihood of IFRS adoption, which indicates that European equity investors perceive net benefits to adoption of IFRS. They also revealed a significantly more positive market reaction to IFRS adoption for firms with lower quality pre-adoption information environments. Aubert and Dumontier (2007) found that analysts were not able to anticipate the consequences of the IFRS adoption on earnings, forecast errors being significantly associated with differences in earnings resulting from compliance with the new financial reporting standards. Their study was based on a sample of 1,412 European companies that complied with IFRS for the first time in 2005. Various accounting items exhibit high-value relevance in common law countries that have effective judicial systems, better investor protection, and higher quality of accounting practices (including more transparent reporting) and auditing systems compared with code law countries. It is expected that the smaller the deviation of a domestic practice from the IFRS, the higher the value relevance of that practice. Accordingly, the EU countries with the largest deviation of a 10

domestic practice from the IFRS should have the most to gain from transition to IFRS (Leuz and Verrecchia 2000, Hung 2001, Francis et al. 2003, Dumontier and Maghraoui 2007, Morais and Curto 2007). We expect that code law countries’ market consequences will be significantly different in 2006 as compared to 2005 than in common law countries. Several country-specific studies examine the value relevance of certain accounting items (Barth and Clinch 1998, Oswald and Zarowin 2004, Hung and Subramanyam 2004). Prior crosssectional studies identify and analyze factors such as disclosure policies and investor protection laws that may cause differences in value relevance levels across countries (Hung, 2001, Zhao 2002). A comprehensive review and critique of the value relevance literature is provided by Holthausen and Watts (2001), Barth et al. (2001) and Beaver (2002). Bartov, Goldberg, and Kim (2004) examine the value relevance of earnings by focusing on the magnitude of its coefficients in regressions of returns on earnings based on U.S. GAAP, IAS and German GAAP. Jermakowicz, Prather-Kinsey and Wulf (2007) study the value relevance of the DAX-30 German companies to determine whether voluntary adoption of IFRS resulted in more value relevant book values after as compared to before adoption of IFRS. These studies provide evidence that accounting earnings based on IAS are more value relevant than those based on German GAAP, although they are less relevant than those based under U.S. GAAP. Financial reporting in accordance with IFRS should lead to higher accounting quality as compared to national GAAP, which should result in lower levels of information asymmetry and thus lead to a firm’s lower cost of capital. Many empirical studies have investigated the effect of IFRS adoption on the cost of equity capital, where the expected cost of capital is calculated using implied estimation methods or proxies such as bid-ask spreads, trading volume or price 11

volatility. Barth, Landsman and Lang (2005), based on a sample comprising 2,228 firm year observations for 387 firms adopting IAS over the period 1990 through 2004, investigated whether applying IAS is associated with less earnings management, more timely loss recognition, higher value relevance of accounting amounts and a lower cost of capital. They provide evidence that IAS firms exhibit an improvement in accounting quality and a reduction in a cost of capital with the application of IAS. However, they do not partition the sample to explain the heterogeneity in the capital markets between common and code law countries as we do. Daske and Günther (2006) assessed the quality of the financial statements of Austrian, German and Swiss firms which had already adopted internationally recognized standards (IFRS or U.S. GAAP). They provide evidence that disclosure quality increased significantly under IFRS in the three European countries and this result holds for firms which voluntarily adopted IFRS or U.S. GAAP as well as for firms which mandatorily adopted such standards in response to the requirements of specific stock market segments. Leuz and Verrecchia (2000) revealed that an international reporting strategy was associated with lower bid-ask spreads, which they assumed to be appropriate proxies for the information asymmetry component of the cost of equity capital. Brüggermanan and Homburg (2007) updated and applied the Leuz and Verrecchia model to a much broader sample. Contrary to their expectations, they provided no evidence of a significant effect of an international reporting strategy on bid-ask spreads throughout the whole sample period. Research study conducted by Daske (2006) found no evidence that adopting internationally recognized reporting standards, 12

per se, leads to the economic benefits of lower cost of equity capital for adopting firms. Other research has provided evidence that rather than by the reporting standards, accounting quality is predominately determined by a firm’s incentives created by its institutional environment and market forces (Ball et al. 2003, Leuz et al. 2003). Francis, LaFond, Olsson, and Schipper (2003) found that firms with certain desirable properties of earnings which increase information quality exhibit lower cost of equity capital. Leuz and Verrecchia (2004) presented a capital market model with rational expectations in which better information improves the coordination between firms and outside investors regarding a firm’s investment decisions and thus reduces misalignment risk between the two parties. We provide evidence on these contradictory findings by not only studying the cost of capital before and after IFRS mandatory adoption of IFRS, but also by studying what might explain the heterogeneity in these findings. Most studies suggest that equity investors perceive net benefits from adoption of IFRS. Our research continues work in the area of potential benefits to investors from implementing IFRS and global accounting convergence. Instead of partitioning our sample based on reporting incentives, we partition our sample based on shareholder rights and the quality of enforcement of these rights as defined by La Porta et al. (1998). Francis et al (2005) find that alternative legal systems can influence the effectiveness of disclosures. We extend prior research by not only studying the cost of capital but also the value relevance of book values and information content of earnings announcements of firms before and after adoption of IFRS. We focus on crosssectional differences in IFRS adoption effects and test whether heterogeneity in investor rights and enforcement quality as well as common law versus code law legal origins explain differences in value relevance, information content and cost of equity capital.

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III. THE DATA AND SAMPLE The Dow Jones STOXX 600 index was used as our reference universe to select the population of large publicly traded European firms that only traded on their domestic exchange in 2004-2006, only reported under domestic GAAP in 2004 and only reported in accordance with IFRS in 2006. Precautions were taken to have the historical constituents included in the index as they were originally at the end of years 2004 and 2006. This index was favored over other market indexes for three reasons that we thought important and advantageous for this study. • The financial significance of the index - Its market capitalization was about €7.6 trillion as of June 30, 2006 and represented roughly 88% of the free float market capitalization of the European and Eurozone markets. This index is also favored by finance professionals and provides them with a broad representation of large European companies. • The index relevance and the extent of its geographical coverage - All the developed European markets in Europe are covered by the index: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom. • The availability of financial statements in English for reconciliation purposes - The vast majority of firms in the Dow Jones STOXX 600 index had their annual reports published in English making the reconciliation/reconstitution of numbers possible with documents published by companies. A broader index would include smaller firms not able to produce financial statements in English because of the costs involved with producing financial reporting simultaneously in a foreign language. To provide complete and clean data, different databases were used in our study. The historical constituents of the Dow Jones STOXX 600 index at the end of 2004 were provided by Bloomberg. The Thomson Worldscope database on FactSet was our main source of fundamental data as it provides stock market data and financial reports that are not restated. Bloomberg and Capital IQ from S&P were also used for cross checking purposes. Both databases provided 14

options in how financial statement numbers are shown--as originally filed and/or restated. When these databases gave conflicting numbers, we carefully reconciled all of these differences. We also made sure that the definition of the different items matched the financial statement disclosures. For example, we looked at the annual reports to check which database had the same number as the published consolidated financial statements and its accompanying notes. The availability and the use of different databases also allowed the data to be more complete.

(Insert Table 1 here)

Our objective was to examine the heterogeneity in market consequences of mandatory IFRS adoption in Europe, where market consequence is defined as value relevance, information content and cost of equity capital. Thus, we excluded from our sample those European firms that reported using U.S. GAAP during the data base period in order to mitigate the effect of U.S. GAAP driving IFRS technical compliance results rather than the home country legal environment, as prior research found that U.S. GAAP compliant financial reports are of higher quality than IFRS (Barth et al. 2005, Armstrong et al. 2006). We included in our sample those European firms that reported using domestic GAAP only prior to 2005 and used IFRS only after 2005. This process resulted in 157 firm-year observations in 2004 and 157 firm year observations in 2006. In summary, we believe that the market will find IFRS adopters’ financial reports more value relevant, informative and thus rewarded with a lower cost of capital for both common law and code law countries but to a greater extent for code law countries. We believe that our sample is more robust as compared to that of Daske et al. (2007a) since we excluded the early adoption effects of year 2005 IFRS adoption and examined the effects in 2006. 15

IV.

METHODOLOGY AND EMPIRICAL DESIGN

Value Relevance We used the Ohlson, Juettner-Nauroth (2005) value-relevance model to determine whether the book values of income and equity increased after the adoption of IFRS and whether that increase is greater for code law than common law countries between 2004 and 2006.

MVj,t/MVj,t-1 = α0t+ β1t BVj,t/MVj,t-1 + βα2t NIj,t/MVj,t-1 + ej,t

(1)

where:

t

=

2004 or 2006,

MVj, t =

market capitalization (market price per share times the number of shares outstanding) for firm j at the end of period t,

BVj,t =

the book value of common equity of firm j at the end of period t,

NIj,t =

income statement reported net income for firm j for the time t-1 to t,

ej,t

residuals or error term for firm j at the end of period t.

=

Information Content Earnings announcements are timely or have information content if they lead to price changes different from those expected before the announcement. Studies that document earnings announcement price adjustments include events studies such as Armstrong et al. (2007), Beaver (1968) and Ball and Brown (1968). We measured information content as an unexpected change in a security’s returns. When announcements are good news, then returns are higher than expected; if the announcements represent bad news, then returns are lower than expected. We began the test for unexpected change during a 6-day window (-1 to 4) by controlling for market movements at the time of the earnings-announcement period. For each firm announcement j, and day t, we estimate αj and ßj for the time period t = -130 to -31 days before 16

the announcement date as follows:

R j ,t = α j + β j Rm ,t

(5)

where Rj,t is the return for stock j on day t, and Rm,t is the return on the market for day t. We had firm trading dates without an accompanying index date. We kept the public holiday as a nonholiday day as long as the European index had a closing price that day. The holiday or missing day was the average closing price of the day before and after the holiday. Since on average the markets are fairly efficient, investors usually catch up with the “events or information” or make up for the day’s difference on the trading day following the holiday. Under this scenario, we assume that the missing day was an arithmetic mean of the day before and after. This approach allowed for the event study to have a “window” with the same number of days even when holidays occur.

This was not perfect, but we believe that the advantages outweigh the

disadvantages. The parameters α and ß were estimated using both Ordinary Least Squares and the method developed in Scholes and Williams (1977). Scholes and Williams’s (1977) estimates of the market-model coefficients were used to compensate for nonsynchronous trading problems associated with infrequently traded securities. The Scholes-Williams beta is estimated as

β jSW =

β j− + β j + β j+ 1 + 2ρ m

(6)

where β j− is the OLS slope estimate from the linear regression of Rj,t on Rm,t−1; β is the OLS slope estimate from the linear regression of Rj,t on Rm,t;

β j+

is the OLS slope estimate from the

linear regression of Rj,t on Rm,t+1; and ρm is the estimated first-order autocorrelation of Rm. As in OLS, the intercept estimator forced the estimated regression line through the sample mean: __

__

α j = R j − ß SW Rm j __

(7) __

where R j is the mean return of stock j over the estimation period and R m is the mean market 17

return over the estimation period. The abnormal return (ARj,t) for firm j on each trading day t of the event period -1 to +4 was calculated as ARj,t = Rj,t – αj - ßj Rm,t.

(8)

The mean abnormal return (MARt) on trading day t for a sample of N firms is the sample mean within each group (sample and control):

MARt =

1 N ∑ AR j ,t N j =1 .

(9)

We aggregate average abnormal returns for all N firms within each group (sample or control) across event days t = -1 to +4 to calculate a mean Cumulative Abnormal Return (CAR):

CAR =

1 N

N t = +5

∑ ∑ AR j =1 t = −3

j ,t

.

(10)

Cost of Equity Capital We computed the expected cost of equity capital to determine if it was significantly different between 2004 and 2006 for the code law and common law European country firms. It was computed similarly to Easton (2004) and Francis et al. (2005), where CEC is computed as the square root of the inverse of the price-earnings growth ratio as follows:

CEC PEG =

epst + 2 − epst +1 Pt

(3) Where: CECPEG= ex ante cost of equity capital, PEG = price earnings growth model (see Ohlson and Juettner-Nauroth (2005), epst + 2 = two year ahead mean analysts’ forecast of earnings per share, epst +1 = one year ahead mean analysts’ forecast of earnings per share, 18

Pt = the fiscal year-end price per share. The additional data constraints required to compute CEC resulted in a reduced sample size of 142 code law and 142 common law firm-year observations. If the t-test of difference in means of CEC between groups is significantly different, then we seek to determine what explains that difference. We use ordinary least squares regression to ascertain whether the cost of equity capital is explained by firm size, legal origin, shareholder rights, debt, or economic factors such as inflation or gross national product as follows. CECj,t = {SIZE, LAW, SR, DEBT, CPI, GDP}

(4)

Where: CECj,t =

cost of equity capital,

SIZE =

log of total assets,

LAW =

1 if common law country, 0 otherwise

SR

shareholder rights or antidirector rights as defined by La Porta et al., (1999) with 6

=

indicating the highest shareholder rights and 0 as having no shareholder rights (see Table 3, pages 1130-1131), DEBT =

total debt including long term and short term debt divided by total assets,

CPI

country specific consumer price index,

=

GDP =

gross domestic product per capita as an indicator of level of development as some emerging countries are approaching the developed stage whereas other are not.

V. FINDINGS Descriptive data about the sample selected is displayed in Table 1. There were 157 firmyear observations in 2004 and 157 firm-year observations in 2006. Panel A shows that most of the observations are in the industrial (31%) and consumer discretionary (26%) industries. About 18% of the observations are from energy (4%), consumer staples (10%), and telecommunication 19

services (4%) industries. The sample is evenly distributed between industrial and non-industrial. Panel B illustrates the country of incorporation of the selected sample. Most of the observations are from Great Britain (26%), France (18%) and Spain (14%) since firms in these countries were not allowed to switch to IFRS before 2005 (unless to provide additional disclosure). Only about 1% of the observations are from Austria (0.6%) and Greece (0.6%). -Table 1Table 2 provides the summary descriptive statistics for common and code law observations both in aggregate (Panel A) and disaggregated between years (Panels B and C). Difference in mean values for cost of capital, log of assets, GDP per capita, CPI, and market values were significantly different between 2004 and 2006. Cost of equity capital declined after mandatory adoption of IFRS in 2006. These univariate results imply that capital market participants were willing to provide capital at a low cost for firms that provide IFRS disclosures. Moreover, firm size, total debt, GDP/capita and market values increased significantly from 2004 to 2006. (Insert Table 2 here) Panel B and C also support that the cost of equity capital declined significantly after adoption of IFRS for both common law and code law observations.

Additionally, the log of

assets, GDP per capita, CPI, net income, and market values were significantly different between 2004 and 2006 for both code law and common law observations Table 3 shows Pearson Correlation Coefficients for all of the variables included in this study with the code and common law samples combined but disaggregated by year.

The

correlations are highest between net income and book and market values of equity. Therefore, the variables used in the regression models are deflated by the market value of common equity to mitigate heteroscedascity. 20

(Insert Table 3 here)

The ordinary least squares (OLS) regression models for value relevance are displayed in Table 4 Panels A (code law countries) and B (common law countries). For code law countries the explanatory power of the value relevance model almost doubled between 2004 (R2 =13%) and 2006 (R2 =22%). However, for the common law countries the value relevance model did not improve between 2004 (9%) and 2006 (7%). Moreover, the value relevance (R2 ) between 2004 and 2006 significantly increased for code law countries but not common law countries (Vong test of difference in R2 is significant as p< 0.06).We conclude that the effects of mandatory IFRS adoption (the value relevance of income and equity) are stronger for companies domiciled in code law countries than for companies domiciled in common law countries because companies domiciled in code law countries experienced greater differences between IFRS and local GAAP before adopting IFRS. Consequently, companies domiciled in code law countries had to make more significant progress in financial reporting with the adoption of IFRS for their reports to become more transparent and oriented toward meeting external investors’ needs, as compared to companies domiciled in common law countries . Our findings are consistent with Daske et al. (2007), that countries’ legal environments are just as significant as the introduction of the new standards per se in explaining market consequences from mandatory adoption of IFRS. (Insert Table 4 here)

Next, we test the information content of earnings announcements within a six day window (-1 to 4). For code law countries, in 2004, earnings announcements were only marginally significant for only day 2 using the ordinary least squares and Scholes-Williams models. However, after adoption of IFRS, earnings announcements became significant on days 0, 1, 2, and 4. Cumulative abnormal returns increased from 2004 (0.52) to 2006 (0.83) in both the ordinary least squares and Scholes-Williams models. (Insert Table 5 here) 21

The qualitative information content findings of common law countries were somewhat similar to that of code law countries. Earnings announcements were only marginally significant on days 1 and 3 for common law countries. However, cumulative abnormal returns over the 6day period were not significant before adoption of IFRS, only after adoption of IFRS. Again these results reveal that market participants responded significantly to earnings announcements after adoption of IFRS more so than before adoption. We conclude that market participants find the announcement of earnings computed in accordance with IFRS as useful information.

Lastly, we examine the effects of the mandatory IFRS adoption on the cost of equity capital of companies domiciled in common law and code law countries for 2004 and 2006. The sample size decreased for the cost of equity capital regression models as some variables had missing values. The cost of equity capital decreased for common law as well as code law countries after adopting IFRS. Cost of equity capital was explained by legal origin and anti-director rights after the mandatory adoption of IFRS but only margially before the adoption. This last result should be interpreted with caution since shareholder rights or antidirector rights were applied as defined by La Porta et al. (1999) and major changes in corporate governance were observed in recent years.

Insert Table 6 here)

Summarizing, our results are consistent with our expectations, that adopting IFRS was beneficial to the EU capital markets since it is associated with higher value relevance of earnings and equity, increased information content, and lower cost of capital than before IFRS adoption.

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VI.

CONCLUDING REMARKS AND LIMITATIONS

This study investigates capital market consequences of European firms’ mandatory adoption of IFRS by examining whether the value relevance of earnings and information content of earnings announcements increased, and cost of equity capital decreased for European firms after mandatory adoption of IFRS in 2005. Overall, our results reveal that investors perceive net benefits from adopting IFRS. Cost of equity capital decreased significantly for European firms after adoption of IFRS. In addition, there was an increase in value relevance and information content of earnings announcement (using a 6-day window) after mandatory adoption of IFRS. We also investigate how value relevance of accounting information is influenced by the legal system, code law versus common law, of the country in which firms are domiciled. The cost of equity capital decreased for firms domiciled in common law as well as code law countries after adopting IFRS. Decreasing cost of capital as an underlying rationale has been expressed by the IASB and regulators around the world to reason the adoption of IFRS. Cost of equity capital was explained by legal origin and anti-director rights after the mandatory adoption of IFRS but only marginally before adoption. We find that market consequences differ for firms in code law legal origin countries than in common law legal origin countries in 2006, after implementing IFRS. Firms applying code law-based domestic accounting standards have a more significant reaction to IFRS adoption than do those applying common law-based domestic standards. The value relevance of earnings and book value of equity for firms domiciled in common law countries did not significantly change between 2004 and 2006. We conclude that common law-based domestic standards were more

23

comparable to IFRS while code law-based accounting standards deviated more from IFRS and, consequently, firms domiciled in code law countries had to make more significant changes in financial reporting with the adoption of IFRS. Also, the institutional infrastructure required to support high-quality financial reporting is more developed in common-law countries such as the UK. Therefore, adopting IFRS resulted in more significant market consequences to firms domiciled in code law rather than common law countries. We test the information content of earnings announcements within a six day window. For code law countries, earnings announcements were more significant after adoption of IFRS. Cumulative abnormal returns over the 6-day period as well were not significant before adoption of IFRS, only after adoption of IFRS. Again these results reveal significantly more positive market reactions to earnings announcements after adoption of IFRS than before adoption, especially for firms from code law countries, having lower pre-adoption information quality. We conclude that market participants find the announcement of earnings determined in accordance with IFRS as useful information. The adoption of IFRS improved the transparency of financial reporting in European countries, as well as the reliability and the relevance of the reported numbers, resulting in higher value relevance of accounting information and increased information content, ultimately leading to a lower cost of equity capital. Our findings are subject to four limitations. First, there is considerable heterogeneity between the firms in our sample resulting in cross-sectional variation in the impact of IFRS. Second, our sample does not include firms representing the banking industry and financial institutions since those firms are more likely to not report under IFRS, as published by the IASB, because of their “carve-out” provisions of IAS 39. Third, we have a small sample size because we included only those firms listed on their domestic stock exchange that reported under local 24

GAAP only in 2004 and reported in accordance with IFRS only in 2006. Consequently, we excluded from our sample those European firms that reported using U.S. GAAP during the data base period in order to mitigate the effect of U.S. GAAP driving IFRS technical compliance results rather than the home country legal environment. Fourth, the role of IFRS alone in improving the value relevance of accounting information is not clear. For example, implementing IFRS could be associated with more rigorous audit, reporting incentives or enforcement scrutiny.

Our findings add to the literature on the benefits of implementing IFRS by providing evidence that investors perceive benefits from the adoption of IFRS in Europe. Future research may focus on the economics of changing accounting standards, including the costs of implementing IFRS, as well as on differences in interpretation and application of IFRS across firms, industries, countries and time. Further, the U.S. capital market consequences of foreign private issuers reporting in accordance with IFRS without reconciliation to U.S. GAAP merit investigations.

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Table 1 Sample Selected Panel A: Industry Classification Number of Firm Year Observations

Consumer Discretionary Consumer Staples Energy Health Care Industrials Information Technology Materials Telecommunication Services Utilities Totals

2004 (n = 157) Frequency 41 16 6 6 48 7 17 6 10 157

Percent 26.11 10.19 3.82 3.82 30.57 4.46 10.83 3.82 6.37 100

2006 (n = 157) Frequency Percent 41 26.11 16 10.19 6 3.82 6 3.82 48 30.57 7 4.46 17 10.83 6 3.82 10 6.37 157 100

Panel B: Country of Incorporation Number of Firm Year Observations

Austria Belgium Denmark Finland France Germany Gr. Britain Greece Ireland Italy Netherlands Norway Portugal Spain Sweden Switzerland

2004 (n = 157) Frequency 1 2 3 6 29 1 41 1 3 15 10 3 2 22 15 3

Percent 0.64 1.27 1.91 3.82 18.47 0.64 26.11 0.64 1.91 9.55 6.37 1.91 1.27 14.01 9.55 1.91

2006 (n = 157) Frequency 1 2 3 6 29 1 41 1 3 15 10 3 2 22 15 3

Percent 0.64 1.27 1.91 3.82 18.47 0.64 26.11 0.64 1.91 9.55 6.37 1.91 1.27 14.01 9.55 1.91

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TABLE 2 Descriptive Statistics (Mean Median Standard Deviation and t-tests) Panel A: Code and Common Law Observations Combined 2004 Variable N Mean Median Std Dev Cost of capital Log of Assets Total Debt GDP/ capita Antidir Rights Code/Common CPI Net income Book value of equity Market value

142 157 157 157 157 157 157 157 157

0.097 8.564 3,914.550 29,538.460 3.344.000 0.720 1.806 891.296 4,970.650

157

12,523.210

0.089 8.437 1,246.900 29,541.000 3.000 1.000 1.375 210.000 1,466.000 4,209.330

N

Mean

2006 Median

Std Dev

0.050 1.384 7,088.650 3,015.140 1.324 0.451 0.776 2,788.820 12,220.240

143 157 110 157 157 157 157 157 157

0.087 8.834 3,758.910 33,564.100 3.344 0.720 2.239 1,141.780 6,206.330

0.080 8.657 1,591.000 34,800.300 3.000 1.000 2.217 312.748 1,894.770

0.035 1.421 5,746.210 3,405.080 1.324 0.451 0.656 2,878.400 13,606.230

Total t-test of difference 3.96*** 3.42*** 0.38 22.18*** N/A N/A 10.66*** 1.56 1.70

33,251.850

157

18,274.140

6,494.760

43,870.06

2.62*

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Panel B: Code Law Firm Year Observations 2004 Variable N Mean Median Cost of capital Log of Assets Total Debt GDP/ capita Antidir Rights Code/Common CPI Net income Book value of equity Market value

103 113 113 113 113 113 113 113 113 113

0.097 8.949 5,114.49 28,826.52 2.726 1.000 1.959 1,162.06 6,443.19 16,211.61

0.086 9.057 2,174.700 29,300.000 3.000 1.000 2.283 269.000 2,613.35 5,928.27

Std Dev

N

0.056 1.335 8,007.330 3,039.420 1.020 0 0.856 3,243.46 14,086.55 38,531.45

105 113 79 113 113 113 113 113 113 113

Mean 0.090 9.241 4,864.190 32,893.47 2.726 1.000 2.198 1,425.770 8,010.140 23,574.160

2006 Median 0.083 9.361 2,414.74 33,408.22 3.000 1.000 1.908 452.667 3,378.65 8,966.91

Std Dev 0.039 1.362 6,415.180 3,641.68 1.020 0 0.767 3,297.420 15,517.650 50,589.500

Total t-test of difference 2.04* 3.36** 0.46 18.22***

4.21*** 1.22 1.58 2.46*

Panel C: Common Law Observations Variable Cost of capital Log of Assets Total Debt GDP/ capita Antidir Rights Code/Common CPI Net income Book value of equity Market value

N

Mean

2004 Median

39 44 44 44 44 44 44 44 44 44

0.098 7.574 832.907 31,366.860 4.932 0 1.415 195.909 1,188.900 3,050.74

0.093 7.300 361.578 30,821.000 5.000 0 1.350 93.341 521.400 1,626.580

Std Dev 0.030 0.958 1,339.31 2,041.300 0.255 0 0.0.242 357.422 2,143.480 4,087.32

N

Mean

38 44 31 44 44 44 44 44 44 44

0.078 7.787 942.224 35,286.400 4.932 0 2.343 412.420 1,573.840 4,662.720

2006 Median 0.076 7.599 559.300 34,800.300 5.000 0 2.317 143.950 660.816 2,344.14

Std Dev 0.020 0.966 1,245.690 1,817.790 0.255 0 0.100 990.580 3,732.320 7,261.40

Total t-test of difference 6.54*** 2.04* 0.72 19.02***

27.02*** 2.72* 1.18 2.56*

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Table 3, Pearson Correlations, 2004 Parameter, Cost of Log of p-value, n Equity Assets Cost of 1.000 0.04019 Equity Capital 0.6349 142 142 Log of 0.04019 1.00000 Assets 0.6349 142 157 Total Debt 0.03105 0.72917 0.7137