Wharton accounting professor Brian Bushee remembers talking to the CFO of a large Australian consumer products company which was having trouble attracting much interest from U.S. analysts and institutional investors.
Part of the problem, the CFO had decided, was that his company chose to comply with Australian accounting methods. For example, Australian companies “can amortize research and development (R&D) expenditures over time, while in the U.S. these expenses must be run through the income statement immediately,” says Bushee. Even though the Australian company’s accounting was consistent with Australia’s rules, the U.S. market viewed the company’s methods with a degree of skepticism because they didn’t conform to U.S. Generally Accepted Accounting Principles (GAAP).
As a consequence, the CFO began to change his accounting methods so that they more closely resembled the U.S. GAAP system. He soon began to attract more U.S. investors and analysts.
The CFO’s initial failure to connect with outside investors illustrates what researchers call “home bias” – the tendency of investors to under-invest in firms located outside their local markets. Explanations for home bias often focus on informational issues, such as the lower visibility of foreign companies, the trouble that investors have monitoring these foreign companies and the perceived lower quality of the financial information that these companies disclose, says Bushee.
Because accounting is a primary source of information about companies, Bushee, along with colleagues Mark T. Bradshaw and Gregory S. Miller from Harvard Business School, decided to research the relationship between foreign investment and accounting method choice. Specifically they looked at whether foreign firms that use accounting methods consistent with U.S. GAAP attract more U.S. institutional investors.
Their research found that U.S. investment in foreign firms does in fact increase when these firms opt to rely on U.S. GAAP. “One of the ways that a foreign firm can overcome home bias in the U.S. is to try and make their accounting more familiar to U.S. investors,” says Bushee, adding that home bias is expensive for firms. “Research suggests that firms with predominantly domestic investors face a higher cost of raising equity capital as all of the risk of a downturn in the domestic economy is borne by local investors. Thus, there are clearly substantial benefits to foreign firms that are able to attract U.S. investors in terms of lowering the cost of capital.”
Bushee and his colleagues have summarized their research in a working paper titled, Accounting Choice, Home Bias, and U.S.Investment in Non-U.S. firms.
IAS vs. U.S. GAAP
Underlying the findings of Bushee’s research is the clear perception among U.S. investors that U.S. GAAP is the best accounting system in the world – a perception underlined by the fact that the U.S. Securities and Exchange Commission (SEC) requires any firm that wants to be listed on a U.S. exchange to file statements that conform to U.S. accounting methods.
Former New York Stock Exchange chairman Richard Grasso “wanted to let as many foreign companies list on the exchange as possible because he was competing with exchanges in London and Tokyo,” says Bushee. “His view was always ‘caveat emptor.’ But the SEC would never allow it. The Commission has always insisted that any company trading in the U.S. market has to use U.S. GAAP.”
The major competing system is International Accounting Standards (IAS) – internationally agreed upon principles, standards and codes of best practice which are already endorsed by many countries that participate in global capital markets. (Within the European Union, the European Commission is in the process of requiring all listed companies to prepare their financial statements in conformance with IAS.)
“One of the problems with IAS vs. U.S. GAAP is that IAS is almost a compromise system,” says Bushee. “It allows a lot of alternatives. Although the IAS Board is working to reduce the alternatives, the perception in the U.S. is that IAS is lower quality. In addition, every country has its own domestic GAAP. All in all, U.S. investors face a confusing range of alternative accounting procedures when they invest overseas, which is why they may be more comfortable with accounting methods that are the same as what we see here.”
In doing their research, Bushee and his colleagues focused their analysis on institutional investors. Not only have they become the largest source of capital in the world, but “extensive data exists on their holdings in non-U.S. firms (including direct investment on foreign exchanges). Also, as sophisticated investors, they are the class of U.S. investors most likely to base their investment decisions on a detailed analysis of financial statements,” the researchers write.
Data for the study came from the Worldscope database, which covers most large firms traded on the world capital markets and collects financial statement data from regulatory agencies – such as the Japanese Ministry of Finance – and from the companies directly. The sample which the researchers used consisted of 12,934 foreign firms in 50 countries between 1989 and 1999. The researchers also obtained data on analyst following, on American Depository Receipt (ADR) securities and on U.S. institutional holdings.
The study is based on an examination of “13 accounting issues for which Worldscope provides multiple options regarding accounting method choice. For each of the 13 issues, some of the options provided are allowed under U.S. GAAP, while others are not,” the researchers write.
“We looked at 13 instances where a foreign company could choose to use a method that was consistent with U.S. standards vs. using a method that was not consistent with U.S. standards,” says Bushee. “Take the case of accounting for goodwill, which is what you get when you make an acquisition. At the time we did our research, companies in the U.S. had to amortize goodwill – i.e. put it on their income statement – over a period of 40 years. In other countries, companies had the choice of writing goodwill off immediately, so that it never went through income. That method didn’t conform to U.S. GAAP.”
Other examples cited in the study where companies have a choice of conforming vs. non-conforming accounting methods include: accounting for long-term financial leases, accounting for long-term investments greater than 50%, recording deferred taxes, valuing marketable securities, and accounting for R&D costs.
The researchers divided up their sample based on the visibility of the firm to U.S. investors. Foreign firms tend to have high visibility when, for example, they are included in a stock index, have a significant following among analysts, are large in size or have an American Depository Receipt (ADR) cross-listing.
(Foreign firms listed as American Depository Receipts have chosen not to list their securities on a U.S. exchange due to the burden of complying with SEC regulations. Instead they list as an ADR, which means the company shares are not directly traded in the U.S. but instead go through a U.S. bank. The bank buys the shares on the foreign market and trades a claim on those shares. U.S. investors are thus able to buy shares in a foreign company indirectly rather than having to purchase them directly on a foreign exchange. The SEC’s rules for ADRs are less stringent than for companies listed on U.S. exchanges, although ADR firms are required to reconcile their local GAAP information to U.S. GAAP for certain financial statements. In general, ADRs that want to encourage U.S. investments will use accounting methods similar to U.S. GAAP.)
The Elusive Goal of Harmonization
The researchers found that the association – between U.S. GAAP conformity and U.S. institutional investment – holds regardless of firm visibility, but is significantly stronger for more visible firms. They also concluded, however, that while increases in U.S. GAAP conformity attract a higher level of U.S. institutional investment in future periods, changes in U.S. institutional holdings do not lead to changes in accounting methods. “A foreign firm’s decision to change over to U.S. GAAP did attract more U.S. investors,” says Bushee, “but if U.S. investors choose to come in on their own, that doesn’t cause the firm to change its accounting methods. This makes sense, given that U.S. investors tend to own small percentages of foreign companies and therefore don’t have that much influence over what the firm does.”
The study also found that while conforming to U.S. GAAP tends to generate more investments from U.S. firms, this does not hold true once the investment is made. “This suggests that U.S. GAAP conformity is an important factor in choosing to invest in a firm, but once a U.S. institution has invested in, and developed a familiarity with, a non-U.S. company, its sales decisions are based on factors other than accounting choice, such as firm performance metrics,” the authors write.
Bushee and his colleagues draw a number of conclusions from their research. “First, we show that choices in accounting methods affect the allocation of equity capital … Second, our evidence that diversity in accounting choices reduces international investment contributes to the substantial debate regarding the value of international harmonization of accounting standards. Our study suggests that reducing the diversity could reduce barriers to cross-country investment,” the authors write.
“Third, we contribute to the home bias literature by providing evidence that the accounting choices of managers could affect home bias. Further, we show that accounting choice has greater impact once attention has been drawn to the firm through another mechanism,” such as an ADR listing.
As for the goal of international harmonization of accounting standards, “it is nice in theory to think we could clear the decks and start over,” says Bushee. “The stumbling block will always be that the SEC seems unwilling to budge from U.S. GAAP.” And U.S. investors, for their part, “view foreign firms’ accounting as different enough that they have to make a lot of adjustments to understand it. They also think other systems are inferior and therefore not as credible.”
Bushee cited a McKinsey global investor opinion survey done last year in which investors were queried about their support for a single global accounting standard. According to the survey, 90% of the respondents favored such a standard. Asked “if an existing global standard were to be chosen as a global one, which one would you prefer?,” the response was the following: 78% of the respondents from Western Europe favored IAS; 76% of the respondents from North America favored U.S. GAAP. “Investors want one set of rules as long as it is their set of rules,” says Bushee. “This highlights the reluctance of investors to embrace foreign accounting standards, which is why accounting practices contribute to the home bias problem.
“One thing I like to point out is that we know all the games that U.S. companies play with U.S. GAAP, but we don’t know all the games that foreign companies can play with other GAAPS,” Bushee adds. “For example, the scandals at Worldcom and Healthsouth have U.S. investors very attuned to potential abuse of U.S. accounting rules for expenditures on long-lived assets. But U.S. investors have almost no exposure to upward asset revaluations or statutory reserves – practices common in other countries but not in the U.S. – and don’t know what ‘red flags’ to look for to determine whether the numbers are credible. As a result, U.S. investors are likely to conclude that it is safer to just shy away from investing in firms that use these accounting practices.”
The bottom line, Bushee says, “is that the manager of a non-U.S. firm can significantly reduce the cost of raising capital by tapping the U.S. markets. Our research suggests that preparing financial statements in a format more familiar to U.S. investors is an important step in that direction.”
Accounting Choice, Home Bias, and US Investment in Non-US Firms
