At a time when many barriers to global trade have fallen and the world’s economies have become increasingly linked, countries all over the world are taking steps to harmonize their accounting standards and develop a truly global language of business.
Under the lead of the International Accounting Standards Board (IASB), already more than 100 countries, most notably the European Union and many Asian economies, have either implemented International Financial Reporting Standards (IFRS) or plan to do so.
So far, the United States has been a holdout. But the winds are changing. On November 15, 2007, the U.S. Securities and Exchange Commission (SEC) — which up to then was requiring foreign companies to either report using Generally Accepted Accounting Principles (GAAP) or to reconcile to them — announced that it would promote international compatibility by allowing foreign companies to access U.S. capital markets while reporting under IFRS. At the same time, the SEC is contemplating changes that would grant domestic firms the choice between reporting under GAAP or IFRS.
Proponents of accounting harmonization, and there are many, say that IFRS will enhance the comparability of financial statements, improve corporate transparency, increase the quality of financial reporting and, therefore, ultimately benefit firms and investors.
But Wharton accounting professor Luzi Hail says that from an economic perspective, there are reasons to be skeptical about these high hopes. In particular, he questions the premise that mandating the adoption of accounting standards, even if they are of high quality, actually makes corporate reporting more informative or more comparable.
In a new study titled, “Mandatory IFRS Reporting Around the World: Early Evidence on the Economic Consequences,” Hail and his co-authors — Holger Daske from the University of Mannheim, Christian Leuz from the University of Chicago and Rodrigo Verdi from MIT — are among the first to shed light on the alleged benefits of the ongoing international accounting convergence.
Quest for a Global Accounting Language
“The issue of convergence represents a kind of revolution,” the authors note. “Just a few years ago, most observers would have said there was no chance of converging U.S. accounting rules and IFRS into a single, globally accepted standard. But now it looks like it may actually happen.”
Hail says the primary driver behind the increased acceptance of IFRS is a hoped-for reduction in the cost of capital together with the avoidance of costs that occur when publicly listed companies follow different reporting standards.
“Until the recent move by the SEC allowing IFRS reports, if, for instance, a European company wanted to list on the NYSE or another U.S. exchange, it had to engage in a costly reconciliation between its IFRS-compliant financial records and the results under U.S. GAAP,” says Hail. “In principle, this would not be an issue if all countries followed a single set of accounting standards. Also, if the new accounting regime forces firms to be more forthcoming in what and how they report, investors would be better off, and achieve a clearer picture of what the future holds. That is exactly what the organizations that set the standards on both sides of the ocean argue in their quest for a global accounting language.”
But, adds Hail, “We, as researchers, ask the question whether the International Financial Reporting Standards really live up to their promise.”
The paper notes that on average, market liquidity and firm value do increase by about 2% to 6% for firms that adopt IFRS reporting when it becomes mandatory, at least when compared to the level prior to IFRS adoption or to firms that have not yet switched. Further, total trading costs and the gap between bid and ask prices both generally decline.
“In contrast to the liquidity benefits, the cost of capital results are less clear-cut,” he adds. “It is possible, however, that the weaker cost of capital effects reflect temporary difficulties of forecasting earnings under the new accounting regime.” Yet another possible explanation is that markets reacted earlier, before firms had in fact changed their reporting systems.
An Unequal Sharing of IFRS Benefits
Overall, based on the favorable market reactions, it would appear that IFRS delivers what standard setters, firms and investors hoped for.
A closer look, however, reveals a subtler picture. “Why is it that some publicly listed companies choose to voluntarily adopt International Financial Reporting Standards early on, while others wait until it is mandated?” Hail asks. “Our results show that the greatest positive effects on firm value and liquidity appear to accrue to these early adopters. This makes perfect sense, because for them the benefits of switching to IFRS should outweigh the costs; otherwise they would not have done it.”
The same reasoning helps explain why some firms hold off on implementing IFRS until they are forced to adopt the standards.
“If there were no gains for these firms to adopt IFRS beforehand,” he says, “why should the cost-benefit trade off all of a sudden change when they are left without choice? Obviously, there must exist some other benefits in the form of increased comparability, better risk-sharing among investors or the like that would not have occurred in the absence of the mandate.”
Hail adds that the unequal sharing of benefits points to the importance of reporting incentives when evaluating the consequences of IFRS adoption. Indeed, a look at how the liquidity benefits vary across the countries that have adopted IFRS further confirms this view. “We find that not every country obtains benefits by simply adopting IFRS,” says Hail. “Instead, we note that the improvements in liquidity, valuation and cost of capital are present only in countries with relatively strict enforcement regimes and in countries where the institutional environment provides incentives for more transparent earnings.” In countries with weak enforcements and poor reporting incentives, the introduction of IFRS has no effect.
Such differences raise another important issue, according to Hail. “It is not clear whether the beneficial effects are attributable to the adoption of IFRS alone, or to some other changes in the environment of the firms that switch,” he notes.
In fact, the paper suggests that the use of IFRS alone may not be enough to make corporate reporting more informative or more comparable. Hail and his co-authors note that several recent studies point to the “limited role” of accounting standards and instead highlight the importance of firms’ reporting incentives in determining observed accounting quality.
IFRS, like U.S. GAAP and other sets of accounting standards, give firms substantial discretion, says Hail. “On the one hand this is a good thing, since reporting involves considerable judgment and should allow managers to convey their superior information to outside investors or, alternatively, to keep information private for competitive reasons.”
But the way that firms use this discretion is likely to depend on their reporting incentives, which are shaped by such factors as a country’s legal institutions, various market forces, firms’ operating characteristics and managers’ own personal goals, according to the paper. “Consequently, even when standards mandate superior accounting practices and require more disclosures, it is not clear that firms implement these standards in a way that the reported numbers will indeed be more informative,” the authors conclude.
“We emphasize that this is not just a question of proper enforcement,” says Hail. “Even with perfect enforcement, observed reporting behavior is expected to differ across firms as long as accounting standards — for good reason — offer some discretion andfirms have different reporting incentives.”
Consequences of IFRS Reporting for U.S. Firms
The study also raises questions about the anticipated benefits of allowing U.S. firms to use IFRS in their domestic reporting. “Our findings indicate that the liquidity effects for first-time mandatory adopters are smaller in countries that have fewer differences between local GAAP and IFRS or for countries that, over several years, have been gradually converging towards IFRS reporting,” says Hail. “This is consistent with the notion that, in these cases, the regulatory change is likely to be of smaller magnitude.”
Regarding the U.S., with its already strong enforcement institutions and lively capital markets, Hail expects that allowing a switch to IFRS will likely cause little capital-market benefits. “The infrastructure is already in place, and combined with the strong reporting incentives due to constant pressure from investors, we may not see much of an impact on how U.S. firms report,” he adds. “But perhaps U.S. firms will gain from comparability benefits, which should be more pronounced when you are late in the game and everybody else has already switched to IFRS.”
Overall, he concludes, the consequences of adopting a global accounting language should not be considered a done deal yet. “Our findings indicate that the adoption of IFRS has stirred up the process of financial reporting on a worldwide basis,” says Hail. “But the lessons and merits of a convergence to global accounting standards and how this affects firms’ reporting behavior on a daily basis are still being debated and will remain a major policy issue for years to come.”