The introduction of IFRS. Consequences for investment decisions

Table of Contents

1 Introduction

2 Background

3 Effect on different types of investors and investees
3.1 Retail investors
3.2 Institutional investors
3.3 Corporate finance
3.3.1 Financing decisions
3.3.2 Internal investments
3.3.3 Strategic and financial investment

4 Overall drivers
4.1 Credible implementation and legal enforcement
4.2 Changes in uniformity
4.3 Accounting distance
4.4 Improved quality of accounting information

5 Conclusion

6 References

7 Appendix

1 Introduction

Starting in 2005, “the portion of foreign shareholders in the Dax has risen from 45% to 58%” (Deutsche Bank, 2017) in the last decade. In the same year, the regulation of the European Union from 2002 came into effect which required all listed firms in the European Union to report their consolidated accounts in accordance with the International Financial Reporting Standard (IFRS) from 2005 on instead of each countries’ generally accepted accounting standards (GAAP). This is just one example where the volume of investments increased concurrently with the adoption of IFRS.

Therefore, the question arises if the mandatory adoption of IFRS in the EU in 2005 or in other cases significantly affected and continues to affect investment decisions among adopters or third parties. In order to better account for differences between different types of investors and investees, we differentiate between retail investors, institutional investors and corporate finance activities. Moreover, we focus on the consequence of IFRS adoption on equity investment decisions as most research appears to focus on the equity instead of the credit market (Lourenco & Branco, 2015). Additionally, Lourenco & Branco (2015) point out that most research which finds no significant effects of IFRS adoption on investment decisions appears to focus on voluntary adoption before 2005. Thus, this paper mainly focuses on mandatory IFRS adoption.

In this context, research suggests that mandatory IFRS adopters experience significant capital markets benefits as well as enhanced foreign institutional ownership and enhanced M&A activity. Ultimately, we observe four overarching drivers behind the aforementioned observations that impact investment decisions across different types of investors and investees.

2 Background

In 2001/2002, the International Accounting Standard Boards (IASB) issued "a set of principles companies follow when they prepare and publish their financial statements, providing a standardised way of describing the company's financial performance“ (IFRS Foundation, 2019). These 58 accounting standards, named IFRS, aim to “bring transparency, accountability, and efficiency to financial markets around the world (IFRS Foundation, 2019).¹ Before 2005, only a few major corporations such as Volkswagen chose to voluntarily adopt these new accounting standards. But not later than 2005, the European Union required all listed EU firms to report their consolidated accounts in accordance with IFRS, as stipulated by “EU Directive 1602/2002”, in an attempt to harmonise the individual members’ accounting standard. Thereby, IFRS aimed to “ensure a high degree of transparency and comparability of financial statements and hence an efficient functioning of the Community capital market and of the Internal market” (EU Directive 1602/2002). Concerning these initial objectives of IFRS, Brochet et al (2012) find that “mandatory IFRS adoption [improves] comparability and thus [leads] to capital market benefits by reducing insiders' ability to exploit private information”, despite contradicting findings by Lang et al (2010). In addition, and in regard to transparency, Ball (2006) finds that IFRS “reflects the economic substance of transactions and economic gains and losses in a more timely or appropriate manner”. Therefore, the paper aims to answer the question of whether, and if so, how these improvements in comparability and transparency ultimately affect investment decisions.

In this context, Ashbaugh & Pincus (2001) state that through the enhanced transparency of disclosures “firms' financial information [becomes] more predictable” and thereby mitigates information asymmetries between companies and their shareholders (Florou & Pope, 2012). The resulting decrease in information asymmetry following IFRS adoption combined with the increase in comparability of financial reports causes investors to be more willing to invest (Verrecchia, 2001) and to be more aware of different investment opportunities. This increased awareness of investments thereby leads to more diverse investment portfolio holdings and more widely spread risks according to Easley & O’Hara (2004).

Moreover, Barth et al (2008) find that the accounting principles required by IFRS lead to a company’s economic position to be reflected in a more realistic way and, thus, provide a better basis for decision-making of investors. In consequence, Hail et al (2010) state that “IFRS may be more capital-oriented and therefore, more useful to investors”.² Summing up, relevant research suggests a decrease in the risk inherent in investment decisions of investors following IFRS adoption (Lambert et al, 2007).

3 Effect on different types of investors and investees

Coming from this starting point, it is now imperative to distinguish between several types of investors and investees when further investigating the relationship between comparability as well as transparency and investment decisions. Since investors pursue different goals by making different kinds of investments, they use financial reporting in diverse ways. Thus, the adoption of a common accounting framework as in the case of IFRS also has diverse effects on each type. On the contrary, due to similarities among all types of investors, there are some general implications that apply for all types of investors and investees which will be further discussed in section four.

3.1 Retail investors

Retail or in other words individual investors refer to non-professional individuals who trade securities privately. Critics frequently point out that retail investors typically make less informed decisions than their institutional counterparts following the non-professional nature of their investment decisions. Therefore, the extent of research regarding the effect of the adoption of IFRS on the retail investor is limited since retail investors tend to use simple heuristics to make investment decisions such as earnings announcements as shown by Bhattacharya (2001). Overall, research provides evidence on increasing trading and investment volumes of retail investors following IFRS adoption. In particular, Brüggemann et al (2012) find that the volume traded by retail investors increases in countries where IFRS was adopted. The paper then explains this observation by the increased comparability of financial reports as IFRS adoption results in more investment opportunities which employ the same accounting standards. By controlling for the change in market value of firms, the language of the financial statements and the influence of institutional investors in the sample³, Brüggemann et al (2012) eliminate common determinants, which are no direct effects of IFRS adoption but could impact the volume of securities traded and thus distort the effect of the variable of interest⁴, and proved that the change in trading volume can actually be attributed to the adoption of IFRS. By including firm fixed effects⁵, the paper shows that its findings are robust to the institutional environment of the firm suggesting that factors such as legal enforcement, rule of law or membership in the EU do not have a significant impact on the investment decisions of retail investors following IFRS adoption (Daske et al, 2008; Brüggemann et al, 2012).

Instead of these institutional variables, Brüggemann et al (2012) discover that the increased trading volume was “particularly strong for firms that experience enhanced worldwide media coverage after mandatory IFRS adoption”. Barber and Odean (2008) argue that this increase in trading volume is caused by the fact that retail investors tend to make less informed decisions implying this type of investor is more biased towards “attention-grabbing stocks”. Hence, the question arises whether IFRS adoption in itself was enough of a news event to explain for the increase in media coverage that, ultimately, led to retail investors increasing their trading volume in these securities.

Another rationale for the rapid increase in media coverage of IFRS adopting firms could be the EU transparency directive that became effective around the same time as the mandatory IFRS adoption (Christensen et al, 2013) and which aimed at harmonising information duties between the issuers of financial information and other market participants. Furthermore, since their sample mainly consists of the Open Market⁶, they implicitly look at “more visible and transparent firms”. Following the observations of Brüggemann et al (2012) that retail investors trade those stocks more that receive higher media coverage, we ask ourselves in how far this results in a biased sample. Since the sample mainly consists of companies that already receive significant media coverage, the question arises whether a more appropriate illustration of the population of companies would yield different findings.

Summing up, it can be observed that there is an increase in trading volume after the adoption of IFRS but, according to the current state of research, this effect is not definitely traceable to the adoption of IFRS.⁷

3.2 Institutional investors

In contrast to retail investors, institutional investors invest in securities and other assets on behalf of their clients instead of investing on their own account which means they typically deploy significantly larger amounts of capital. This usually implies that institutional investors possess much more professional information processing capabilities enabling institutional investors to make more informed decisions than e.g. their retail counterpart. Thereby, institutional investors are often grouped into one of six sub-groups including pension funds, insurance companies, endowment funds, commercial banks, hedge funds, and mutual funds.

In this context, most relevant research agrees that IFRS adopters experience increased levels of foreign institutional equity investment or, similarly, foreign institutional ownership among IFRS adopters, they largely disagree about the casual relationship behind this phenomenon.

DeFond et al (2011) find that mutual fund ownership of mandatory IFRS adopters increased by 1.4% from 2003/2004 to 2006/2007 in contrast to a change in mutual fund ownership of 0.1% among the control group which did not adopt IFRS in the same period of time. Therefore, the difference-in-differences model implies a change in mutual fund ownership of 1.3% following mandatory IFRS adoption. The paper then finds that countries where IFRS was credibly implemented experience higher levels of foreign mutual fund ownership than those with a less credible implementation ⁸. Furthermore, DeFond et al (2011) discover a significant difference in foreign mutual fund ownership among those companies whose peer groups experience a large or small increase in the number of industry peers subsequent to the introduction of a uniform set of accounting standards, represented by the coefficient of the intersection term of the variables large increase in uniformity and post (see Exhibit C). DeFond et al (2011) thereby describe the former as a dummy variable, being one if the increase in uniformity exceeds a specific level⁹, while post represents a dummy variable whether an observation took place in the pre-adoption (2003/2004) or post-adoption period (2006/2007).

Exhibit C

Foreign mutual fund ownership = β0 + β1(post) + β2(strong credibility)

+ β3(post*strong credibility) + β4(large increase in uniformity)

+ β5(post*large increase in uniformity) + β6(strong credibility*large increase in uniformity)

+ β7(post*strong credibility*large increase in uniformity) + βj(controlsj)

Following the regression results of Table 3, DeFond et al (2011) conclude that “mandatory IFRS adoption will lead to improved comparability only when there is a credible increase in uniformity” while controlling for country-, industry- and firm-level indicators. This follows the empirical finding that β2(strong credibility) and the interaction term β7 (posts*strong credibility*large increase in uniformity) are significant at the 5% and 1% level, respectively. In result, a company in the post-adoption period which experiences strong credibility of IFRS implementation in its home country that, additionally, yields a large increase in uniformity exhibits, on average, a 4.3% higher foreign mutual fund ownership than a company in the pre-adoption period which did not implement IFRS.

Even though Yu (2014) provides supporting evidence to the observation of significant increases in foreign institutional ownership among IFRS adopters, the paper contradicts DeFond et al (2011) in its explanation of the effect. In contrast to DeFond et al (2011), Yu (2014) argues that increases in foreign mutual fund ownership are caused by changes in accounting distance instead of changes in uniformity and credible implementation. Thereby, companies located in countries where local GAAP and IFRS are significantly different experience higher increases in foreign institutional ownership following mandatory IFRS adoption than firms in countries where local GAAP and IFRS are rather similar. DeFond et al (2011), however, find that the independent variables credible implementation and large changes in uniformity are statistically robust to accounting distance in their model. Both studies, however, agree that the general increase in foreign mutual fund ownership among mandatory IFRS adopters is, ultimately, driven by an increase in financial statement comparability.

Lang et al (2010) refute the idea of comparability being the major driver behind the increase in foreign ownership by arguing it is instead caused by familiarity. The concept of familiarity thereby refers to a study by Bradshaw et al (2004) which found that “firms exhibiting higher levels (changes) of U.S. GAAP conformity have greater levels (changes) of U.S. institutional ownership”. Lang et al (2010) take this idea of investing home bias and transfers it to mandatory IFRS implementation. Thus, the paper claims that enhanced foreign ownership levels are caused by financial statements that are more familiar to investors’ domestic accounting standards, as opposed to more comparable. These findings are consistent with Amiram (2012) who further discovers that this effect of familiarity is enhanced “when investor and investee countries share language, legal origin, culture, and region”. Afterwards, and consistent with other research in the field of equity investments and IFRS adoption, Amiram (2012) finds that “countries with lower corruption and better investor protection experience larger increases in [foreign equity investments] after they adopt IFRS relative to other IFRS users”, similar to the idea of credible implementation as described by DeFond et al (2011).

While also Florou & Pope (2012) observe increased foreign institutional ownership, the paper points to a combination of factors instead of only one as it is suggested by e.g. Lang et al (2010) or Yu (2014). These factors thereby include changes in accounting distance, strong legal enforcement and reporting incentives implying that the findings of DeFond et al (2011), Yu (2014) and Amiram (2012) actually complement in lieu of contradicting each other. Furthermore, Florou and Pope (2009) find that “the positive IFRS effects on institutional holdings are concentrated among investors whose orientation and styles suggest they are most likely to benefit from higher quality financial statements” such active, value and growth investors. Furthermore, Florou & Pope (2012) find that these “changes in holdings are concentrated around first-time annual reporting events” following IFRS adoption.

The bottom line is that even though the observed, statistically significant increase in institutional investment cannot be traced to a specific driver, it can be said that the adoption of the IFRS plaid an imperative role in this development.

3.3 Corporate finance

Looking at the types of investors and investees, a third main type of investors has to be considered. Thereby, this third consideration includes corporations that make investments and financing decisions which are driven by diverse strategic rationales. Thus, we differentiate between financing decisions, internal investments as well as strategic and financial investments. While financing decisions refer to the capital structure and the associated cost of capital a company incurs, internal investments refer to those investments made within a corporation such as the acquisition of new machinery or other operating assets. In the case of financing decisions, we particularly examine the impact of IFRS adoption on initial public offerings, or IPOs, due to the scientific magnitude of the findings. Lastly, strategic and financial investments refer to the acquisition (merger) of one (two) firms. In this respect, we do not further differentiate between acquisitions and mergers that happen out of strategic rationales, such as the merger of two retailers, and those that happen due to financial rationale with private equity investments being the prominent example since the effect regarding the IFRS adoption does not significantly differ.

3.3.1 Financing decisions

In the context of financing decisions, Li (2010) finds that increased disclosure levels leading to a reduction in information asymmetries and following mandatory IFRS adoption lowered the respective firms’ cost of equity by an average of 0.47%. Consistent with this finding, Doukakis et al (2017) state that both mandatory and voluntary IFRS adopters in Europe experienced a significant reduction in their cost of equity. Daske et al (2008) further argue that mandatory IFRS adoption does not only reduce a firm’s cost of equity but also increases its equity valuations despite the fact that these findings are conditional of legal enforcement and transparent incentives for managers.¹⁰

Beyond the cost of equity capital, Hong et al (2014) investigated the impact of IFRS adoption on the equity capital raised globally from initial public offerings (IPOs)¹¹. A common practice in IPOs which yields lower amounts of capital raised is the phenomenon of underpricing as first discovered by Ibbotson & Jaffe (1975) which refers the listing of an IPO below its estimated market value. Underpricing thereby reflects a price discount following the underlying information asymmetry between the firm/managers and the investor about the true performance of the company as well as the uncertainty about the future performance of the firm’s share price. Thus, Hong et al (2014) particularly examine the change in underpricing after the IFRS adoption in 2005. For this purpose, they use a difference-in-differences design to account for overall changes that also occurred in non-adopting countries. By controlling for i.a. country- and certain firm-level variables they ensured that the observed effect is not biased by omitted variables that play an important role in the degree of underpricing of a company. A major finding of Hong et al (2014) thereby is the significant decrease in IPO underpricing experienced by companies in IFRS adopting countries. Hence, when being compared to non-adopters, companies that implemented IFRS experience a significant¹² decrease in the underpricing of their stocks of at least 38%¹³ depending on the analysis benchmark¹⁴ (Hong et al, 2014). By rerunning this regression in different settings, they find that the magnitude of the effect on IPO underpricing depends on the credible implementation of IFRS.¹⁵

Following the observed decrease in IPO underpricing, IFRS adopters are able to raise significantly more capital through an IPO than previously, particularly from foreign investors since they benefit the most from the reduction in information asymmetry subsequent to IFRS adoption. Hong et al (2014) elaborate that the amount of capital raised from foreign investors increased by at least 49% if the home country of the to-be-listed entity adopted IFRS. Thereby, the paper does not distinguish if the increase in capital raised comes from the decrease in IPO underpricing or an increased number of foreign investors. This is especially critical following the findings of Chen et al (2015) which point out IFRS adopters increased their listings on foreign markets, in particular in countries that adopted IFRS as well and which have larger and more liquid capital markets. In consequence, the increased probability of attracting foreign investors is a further crucial reason for the increased amount of capital that was raised by IPOs of IFRS adopters.

By not completely neglecting the other part of the capital market, Kim et al (2010) examine the role of price and non-price terms of debt capital in the form of bank loans. Even though, the paper uses a sample of voluntary instead of mandatory IFRS adopters, Kim et al (2010) reveal that adopters do not only enjoy lower interest rates on bank loans than non-adoptors¹⁶ but also experience less restrictive debt covenants. Finally, Kim et al (2010) also find that voluntary IFRS adaptors attract significantly larger amounts of debt capital.

Following all the aforementioned observations, we can conclude that IFRS adopters experience a lower cost of equity and debt. Thus, IFRS adoption reduces a company’s weighted average cost of capital, or WACC, following a significant reduction of information asymmetries that had adverse consequences on a firm’s WACC before IFRS adoption (e.g., Daske et al, 2008; Kim et al, 2010; Doukakis et al, 2017).

3.3.2 Internal investments

Since a firm’s WACC represents a critical hurdle rate for internal investment decisions, we can conclude from the previous chapter on financing decisions that IFRS implementation significantly reduces this hurdle rate, indirectly encouraging additional investment.

However, IFRS adoption does not only affect the availability and cost of capital associated with internal investments but also the investment efficiency of said investments. This corporate investment efficiency is often measured by the cash flow sensitivity of investment (e.g., Fazzari et al, 2000; Malmendier & Tate, 2005). This implies that companies whose investment decisions in a certain period are heavily insensitive towards the cash flow of that, or previous, periods employ less efficient investment policies. Another measure of corporate investment efficiency is value-enhancing risk-taking as described by John et al (2008) which follows the idea that a higher risk for investors has to be compensated by a higher WACC of the company. They argue that those companies with higher investor protection experience a more optimal level of value-enhancing risk-taking and hence, have a higher investment efficiency.

[...]

¹ The term IFRS refers to 41 International Accounting Standards (IAS) and 17 International Financial Reporting Standards (IFRS).

² This quote is taken from a paper of Florou and Pope (2012) where the authors summarise the findings of Hail et al (2010).

³ All those variables impact the volume traded in a different way. An increase in the market value tends to be an indicator for future growth potential, the language of a firm can improve the understandability of the financial statements for an individual investor and contingent institutional investors in the sample could distort the results.

⁴ In this case, the variable of interest is the intersection term of the dummy variables POST-FY2005 and Mandatory whose coefficient reflects the impact of the mandatory IFRS adoption on the volume traded.

⁵ Firm fixed effects in this context are i.a. the credibility of IFRS implementation and familiarity with accounting principles.

⁶ The Open Market is an “unofficial trading segment at FSE” (Brüggemann et al 2012) without EU regulations and directives. Brokerage houses that are eligible for trading at the FSE are allowed to include securities in the Open market without asking the issuing company for permission or even informing them. Thus, in particular, popular securities are traded in the Open Market. Stocks can be either primarily listed on the Open Market (First Quotation Board) or already been listed on another market (Second Quotation Board). Since the IFRS regulation does not apply for the First Quotation Board, the sample of Brüggemann et al focuses on stocks in the Second Quotation Board.

⁷ In addition to this, further critics states that since mainly active investors trade on the Open Market the effects observed are not valid for all kind of retail investors.

⁸ This phenomenon will be further discussed in section four.

⁹ DeFond et al (2011) do not specify where they set the threshold level.

¹⁰ These findings are only statistically relevant if the statistical model accounts for the possibility that the observed capital market benefits already started to occur prior to the respective company actually introducing IFRS. Daske et al (2008) explain this by stating that the capital market already prices for the adoption of IFRS even before the relevant company has actually adopted IFRS. This is the case since even those companies who had to mandatorily adopt IFRS in 2005 did so at different points throughout the year because of different fiscal years.

¹¹ An IPO refers to the first-time offering of a company’s shares to the public.

¹² Depending on the benchmark they refer to the significance level is at least 10%.

¹³ The variable of interest is the intersection term of the dummy variables Post and Mandatory adopters. By using the difference-in-differences design, Hong et al (2014) figured out that the coefficient β3 of this intersection term (Exhibit 2) is -0.061, meaning that compared to non-adopters the underpricing of IFRS adopters decreased by this value (Table 1). Comparing it with the Underpricing mean of IFRS-adopters of 0.161 (Table 2) leads to a decrease of 38% (-0.061/0.161).

¹⁴ Hong et al (2014) used three geographically different non-adopter groups, all being „propensity-score-matched for better comparability, as benchmarks to account for accounting-related issues.

¹⁵ This phenomenon will be further explained in section four.

¹⁶ The difference in bank loan interest rates between IFRS adaptors and non-adoptors amounts to “20 basis points for all loans and nearly 31 basis points for London Interbank Offered Rate (LIBOR)-based loans” (Kim et al, 2010).