Intended and Unintended Consequences of Mandatory IFRS Adoption: A Review of Extant Evidence and Suggestions for Future Research

Abstract

This paper discusses empirical evidence on the economic consequences of mandatory International Financial Reporting Standards (IFRS) adoption in the European Union (EU), and provides suggestions on how future research can add to our understanding of these effects. Based on the stated objectives of the EU's so-called ‘IAS Regulation’, we distinguish between intended and unintended consequences of mandatory IFRS adoption. Empirical research on the intended consequences generally fails to document an increase in the comparability or transparency of financial statements. In contrast, there is rich and almost unanimous evidence of positive effects on capital markets and at the macroeconomic level. We argue that certain research design issues are likely to contribute to this apparent mismatch in findings. The literature investigating unintended consequences of mandatory IFRS adoption is still in its infancy. However, extant empirical evidence and insights from non-IFRS settings suggest that mandatory IFRS adoption has the potential to materially affect contractual outcomes. We conclude that both the intended and the unintended consequences deserve further scrutiny to assess the costs and benefits of mandatory IFRS adoption, and we provide specific guidance for future research.

Acknowledgement

We appreciate the helpful comments of Salvador Carmona (the outgoing Editor), two anonymous reviewers, Igor Goncharov, Stefan Hahn, Paul Michas, Maximilian Müller, Eddie Riedl, and the workshop participants at the Ruhr-University Bochum, WHU – Otto Beisheim School of Management and the INTACCT Workshop in Ljubljana, as well as participants at the EAA Annual Congress in Istanbul. Ulf Brüggemann and Jörg-Markus Hitz gratefully acknowledge the financial contribution of the European Commission Research Training Network INTACCT (Contract: MRTN-CT-2006-035850). Ulf Brüggemann also acknowledges the financial support of the German Research Foundation (DFG) under project A7 of the collaborative research center SFB 649 at Humboldt University. Part of this research was carried out while Ulf Brüggemann was visiting the University of Chicago Booth School of Business, and while Thorsten Sellhorn was visiting the University of Arizona Eller College of Management.

Notes

By referring to the (potentially positive) contracting effects of mandatory IFRS adoption as ‘unintended’ consequences, we do not intend to attach a negative connotation to the contracting role of financial reporting. This choice of terminology exclusively reflects the fact that an explicit reference to contracting consequences is absent from the IAS Regulation's stated objectives. Likewise, no normative connotation is attached to our relating what we call ‘intended’ consequences to financial reporting's information (or valuation) role.

The IAS Regulation mandates IFRS adoption only in the consolidated financial statements of publicly traded entities, whereas member states have an option to permit or require IFRS adoption elsewhere.

Consistent with these expectations, some empirical studies find evidence of positive (negative) capital market reactions to events that increased (decreased) the likelihood of mandatory IFRS adoption in the EU (Christensen et al., 2007; Armstrong et al., 2010).

The IASB's objectives are delineated in its Preface to IFRS, including:to develop   …   a single set of high quality  …   financial reporting standards [that]   …   require high quality, transparent and comparable information in   …   financial reporting to help investors, other participants in the various capital markets of the world and other users of financial information make economic decisions. (IFRSF, 2010b, para. 6 (a))

Academic research in accounting has a long tradition of informing regulatory debates by assessing ex post the effectiveness of regulatory changes (Pope and McLeay, 2011; Fülbier et al., 2009). The usefulness of such research hinges on the extent to which the phenomena studied reflect the objectives of the regulation under analysis. Considering regulators' explicit statements made within the regulatory context under investigation represents an effective way for researchers to discern these objectives.

This dichotomy is distinct from the separation of direct and indirect effects. In the context of the IAS Regulation, direct effects are those relating to the Regulation's accounting objectives (transparency and comparability). In contrast, effects relating to the Regulation's capital market and macroeconomic objectives can be viewed as indirect. In our dichotomy, both sets of effects would be viewed as intended.

Naturally, research could show that mandatory IFRS adoption fails to increase, or even decreases, transparency or comparability. A related example from the Chinese context is provided by He et al. (2011).

Doing so requires judgment calls in several instances, including (1) when a paper addresses both sets of consequences, (2) when a paper uses intermediate constructs claimed to relate to the ultimate consequences of interest (e.g. papers addressing information asymmetry effects that proxy for cost of capital effects), (3) when the empirical metrics used measure the consequences of interest imperfectly, and (4) when high-level (e.g. macroeconomic) consequences variables are used and the transmission mechanisms causing the observed effects remain unclear.

We present a subjectively selected subset of studies in a tabulated form. To keep the size of the tables manageable, we restrict them to cross-country studies and, where possible, published papers. In the narrative, we also refer to closely related studies not included in the tables.

We categorise value relevance studies with the literature on financial reporting effects, but acknowledge that changes in value relevance around mandatory IFRS adoption may also reflect capital market effects, e.g., in the form of IFRS-induced changes in the market value of equity.

Note that firms can be potentially selected to avoid the IFRS mandate, for example, by delisting from the stock exchange or by switching to an unofficial trading segment where the EU regulation does not apply. For evidence on increased delisting activity around the introduction of IFRS, see Vulcheva (2011). More subtly, firms could restructure their activities to avoid or dampen the anticipated impact of individual IFRS. For evidence from the Netherlands on preference share buy-backs and restructurings, see de Jong et al. (2006).

Tables 1–3 show that the average mandatory IFRS adoption paper covers two to three (and a maximum of four) post-adoption years, if the transition year (2005 for most firms) is not counted.

Recent studies have started to use reconciliation data to evaluate cross-sectional differences in the capital market effects of mandatory IFRS adoption (Horton et al., 2012). Changes in firm-specific earnings management scores, in contrast, have so far only been used in the context of voluntary IFRS adoption (Daske et al., 2011).

The early announcement of the IAS Regulation in 2002 enabled managers to act opportunistically in anticipation of certain IFRS effects (see Wang and Welker, 2011, for related empirical evidence).

Defining accounting-based performance metrics instead in terms of ‘fixed GAAP’ represents a (potentially costly) way of insulating compensation arrangements from the effects of such changes in GAAP.

de Jong et al. (2006) provide evidence that firms incur costs to alter their financing structures in an effort to avoid certain predictable effects of IFRS adoption on their financial statement ratios, including those assumed to be used in debt covenants.

See, for example, Sellhorn and Gornik-Tomaszewski (2006); for an overview of EU member states’ rules for the determination of corporate taxable income and the relevance of IFRS therein, see Endres et al. (2007, pp. 159–168).

Additional information

Notes on contributors

Ulf Brüggemann

Paper accepted by Salvador Carmona.

Jörg-Markus Hitz

Paper accepted by Salvador Carmona.

Thorsten Sellhorn

Paper accepted by Salvador Carmona.