The Impact of Mandatory IFRS Adoption on Equity Valuation of Accounting Numbers for Security Investors in the EU

Abstract

Motivated by the European Union (EU) decision to mandate application of the International Financial Reporting Standards (IFRS) to the consolidated financial statements of all EU listed firms (Regulation (EC) 1606/2002), starting in December 2005, we compare the value relevance of accounting information in 14 European countries in the year prior to and the year of the mandatory adoption of the IFRS. We focus on three accounting information items for which measurements under IFRS are likely to differ considerably from measurements under domestic accounting practices across the EU countries prior to the introduction of the international standards: goodwill, research and development expenses (R&D), and asset revaluation. These three items, selected on an a priori basis, have been shown in previous research to differ in the effect of uncertainty on their future benefits. We use valuation models that include these three variables and in addition the book value of equity and earnings. Overall, our study suggests that the adoption of the IFRS has increased the value relevance of the three accounting numbers for investors in equity securities in the EU. Association tests support our two hypotheses: (1) in the year prior to the mandatory adoption of the IFRS, the incremental value relevance to investors of the three domestic GAAP-based accounting items was greater in countries where the respective domestic standards were more compatible with the IFRS; and (2) the higher the deviation of the three domestic GAAP-based accounting items from their corresponding IFRS values, the greater the incremental value relevance to investors from the switch to IFRS. These associations prevail when considering cross-country differences in the institutional environments, which tend to provide complementary effects.

Acknowledgements

We acknowledge comments by two anonymous reviewers, participants in the European Accounting Review Research Conference, Segovia (Spain), participants in a concurrent session of the annual meeting of the American Accounting Association, workshop participants at the Faculty of Management, Tel Aviv University, the University Research Award and financial support by the Division of Research and Graduate Studies (RAG) at Kent State University, and partial funding from the Henry Crown Institute of Business Research in Israel at Tel Aviv University. All potential remaining errors are of course ours.

Notes

One exception is Daske et al. (2008), who examine 26 countries (including 14 EU countries) and find that capital market effects are stronger in the EU. A more detailed discussion of prior studies can be found below (see pp. 541–3).

Hung and Subramanyam (2007) conduct a detailed examination on a sample of 80 German firms that voluntarily adopted IAS between 1998 and 2002, and Horton and Serafeim (2009) conduct an examination on a sample of 297 UK firms that adopted mandatory IFRS reporting in 2005. Gjerde et al. (2008) compare the value relevance of IFRS accounting figures versus the corresponding figures for a sample of Norwegian public companies; Callao et al. (2007) conduct a similar examination for Spanish firms, while Devalle et al. (2009) conduct a comparative analysis among five EU countries: Germany, Spain, France, the UK and Italy.

With respect to intangibles, Wyatt (2008) establishes three broad resource categories: technology, human capital and production. Due to lack of empirical data, we excluded human capital intangibles from our study.

The International Accounting Standards Board (IASB) defines and titles all previous and amended standards as International Accounting Standards (IAS) unless a standard has been replaced (e.g. IAS 22 has been replaced by IFRS 3). As of December 2009, the IASB has issued nine new IFRS. Thus, the IFRS include the IAS and new IFRS. Generally, we use the term IFRS, but refer to IAS where applicable.

From 1988 to 1998, IAS were not permitted for domestic reporting by most EU countries. Even in 2003, IAS were not permitted in 8 of the 14 countries examined in our study: France, Italy, Norway, Spain, Portugal Sweden, Ireland and the UK (Deloitte Touche Tohmatsu, 2003).

Using a large sample of companies from 51 countries (including 26 countries that mandatorily adopted IFRS by December 2005), Daske et al. (2008) find that specific capital market effects for mandatory adopters are smaller in countries that have fewer differences between local GAAP and IFRS and a pre-existing convergence strategy towards IFRS. These effects are largest for countries with large GAAP differences that also have strong legal regimes.

Aboody et al. (2002) argue that differences in market efficiency across time and countries affect the coefficient estimates in value-relevance regressions and that this effect is potentially most pronounced in return regressions.

Our main comparability index is a measure of comparability of accounting outcomes based on differences in accounting standards (i.e. IFRS versus GAAP).

We also construct an alternative comparability index based on goodwill, R&D expenses and revaluation of PPE. Our results and conclusions remain unchanged.

For example, prior studies discuss the EU's recognition of the need to establish and enforce the high quality international accounting standards (Sunder, 2002; Carmona and Trombetta, 2008) in general and the potential problems with the adoption of IAS by the EU countries in particular (Stolowy and Jeny-Cazavan, 2001; Haller, 2002; Chua and Taylor, 2008).

The International Accounting Standards Committee (IASC) revised IAS 22 (‘Business Combinations’) in 1995 and in 1998, and IAS 16 in 1995 and 1998. The IASC issued IAS 38 on R&D in 1999, suppressing IAS 9 which was revised in 1995. These standards have recently been revised again by the IASB. IAS 16 was revised in December 2003 (effective January 2005) and IAS 38 in March 2004 (effective then). In addition, the IASB issued IFRS 3 in March 2004 and suppressed IAS 22 (Deloitte Touche Tohmatsu, 2003, 2005).

Goodwill could also be capitalized and immediately written off against reserves (e.g. Germany and the UK). Immediate write off became the preferred method in the UK due to its favorable effect on reported future earnings (Radebaugh and Gray, 1997, p. 275). This practice was later amended in the UK to apply a systematic amortization in most cases via the profit and loss account, effective on or after 31 December 1998 (FRS 10, 1997).

Van Tendeloo and Vanstraelen (2005) find that voluntary adopters of IAS in Germany engaged less in earnings management compared with those reporting under German GAAP. Radebaugh et al. (2006) provide evidence on countries in the French and German accounting regimes, and Hung and Subramanyam (2007) examine deviations of German GAAP from IAS.

The discussion on accounting standards versus incentives draws on the comprehensive analysis in Daske et al. (2008, Section 2).

Hail et al. (2009) examine the potential of adoption of IFRS in the USA and show that it involves cost–benefit tradeoff between comparability benefit to investors, recurring future cost savings, particularly for large multinational companies, and one-time transition costs for all firms and the whole economy.

Our study is not designed to provide explicit standard setting inferences (Holthausen and Watts, 2001) or participate in the well-known, ongoing debate in the literature on the merits and shortcomings of the value-relevance concept in this context. Recent studies examine the value relevance of accounting disclosures across countries (e.g. Alford et al., 1993; Ali and Hwang, 2000; Guenther and Young, 2000; Hope, 2003; Daske et al., 2008; Devalle et al., 2009).

In the UK, Aboody et al. (1999) find that revaluation is positively associated with returns and future earnings, though being value relevant revaluation is costly (Dietrich et al., 2000).

Powell (2003) argues that accounting for intangible assets is one of the least developed areas of international accounting theory and regulation. Prior studies use valuation models and find that R&D expenditures are value relevant and have significant future economic benefits (Ballester et al., 2003; Oswald and Zarowin, 2007). Godfrey et al. (2006) show that differences in GAAP across four countries affect the value relevance of goodwill, R&D and brands.

The accounting treatments under IFRS and under domestic GAAPs differ for these three accounting items. Further, depending on the country, the international standards for these categories are quite different from the firm's domestic GAAP. We, therefore, selected one specific typical asset type from each of the three main asset categories encompassing the balance sheet for the analysis in this study: tangible assets, assets in the developing stage and intangible assets.

Devalle et al. (2009) also report mixed results for the impact of IFRS on value relevance for Germany, and Callao et al. (2007) report similar results for Spain.

It should be noted that unlike Germany (and some other EU countries) UK regulation did not permit early implementation of IFRS prior to 2005.

Horton and Serafeim (2009) selected the six items based on their actual size and the frequency with which they were applied by the majority of the companies within their sample. They provide evidence that investors view share-based payments, goodwill impairment, financial instruments and deferred taxes as value relevant, supporting their claim that IFRS appears to reveal timely value-relevant information in the UK.

Similarly, some research also compares relevance level across legal regimes rather than by individual countries. For example, Ball et al. (2000) compare earnings timeliness across several countries and between common law and civil code countries.

Ginger and Rees (2005) discuss three themes of IFRS adoption in the EU: convergence, enforcement and future research.

Assuming that the IFRS result in financial reporting of higher quality, we may test hypotheses in regimes where accounting data have previously been considered less transparent and of lower quality; further, increasing the sample size may provide more powerful tests. Focusing on the benefits of IFRS adoption, Cuijpers and Buijink (2005) find that EU firms voluntarily using non-local GAAP during 1999 are more likely to be domiciled in countries with lower quality financial reporting. Renders and Gaeremynck (2007) explicitly incorporate the costs for company insiders resulting from early IFRS adoption. They suggest that these costs may offer an explanation why only 15% of the EU companies had adopted IFRS in 2002. We neither address issues related to enforcement of security regulations in the EU (Brown and Tarca, 2005; Schipper, 2005) nor examine or report implications of early adoption of IFRS across the EU countries.

Street (2002), Street and Gray (2002), and Larson and Street (2004) discuss problems impeding the worldwide acceptance of and compliance with IAS, such as the location of the listing exchange and industry effects. They suggest several factors that could mitigate such problems.

La Porta et al. (1998, 2002), Ball et al. (2000) and Barniv et al. (2005), for example, used a similar category distribution.

About 72% of the firms in our initial database and about 71% in the final sample are calendar year firms.

Norway is also included in our sample, as a member of the European Economic Area, committed to follow the EU accounting directives and IAS for consolidated financial statements (Johnsen, 1993; Alexander and Schwencke, 2003; Larson and Street, 2004).

DA (Domestic Adjusted) is defined on Compustat as domestic standards that are only generally in accordance with IFRS. DA is reported only for a small number of companies and further comparisons with actual financial statements indicate partial adoption of IFRS reflected only in selected items.

In Germany, IAS was adopted by many domestic listed companies between 1998 and 2003. More than 50% of the German companies in our initial sample had voluntarily adopted IFRS by November 2005. In Austria, IFRS were adopted by many domestic listed companies by 2003, but US GAAP was also permitted, though it was used by only a few (Deloitte Touche Tohmatsu, 2005).

Similar comparability indices have been used in prior studies (e.g. Adams et al., 1999; Street et al., 2000, Haverty, 2006; Henry et al., 2009). One variant was previously termed the index of conservatism (Radebaugh et al., 2006).

The IFRS data for year t − 1 are based on IFRS comparative (transitional) financial statements reported for each company in year t.

In a similar manner, we also constructed alternative comparability indexes to CI_T. First, formulated like CI_T, we constructed indices only for net income and only for shareholders' equity (see equation (1)). Similarly, we constructed a three-variable summary index that sums CI_GW, CI_RD and CI_REVAL for goodwill, R&D and revaluation of PPE, respectively. We then use the median sample firms' overall comparability index in each of the 14 EU countries. The correlation between the alternative three-variable summary index and that of CI_T across the 14 countries is 0.97.

The index is formed by aggregating the following attributes: (1) the country allows shareholders to mail their proxy vote, (2) shareholders are not required to deposit their shares prior to the General Shareholders' Meeting, (3) cumulative voting or proportional representation of minorities on the board of directors is allowed, (4) an oppressed minorities mechanism is in place, (5) the minimum percentage of share capital that entitles a shareholder to call for an Extraordinary Shareholders' Meeting is less than or equal to 10% (the sample median), and (6) shareholders have preemptive rights that can only be waived by a shareholders' meeting. The range for the index is from zero to five (La Porta et al., 1998, 2006).

La Porta et al. (2002) and Djankov et al. (2008) show that cross-country anti-director rights affect corporate valuation. Specifically, anti-director rights affect value relevance of earnings and book values across countries (Barniv and Myring, 2006). Further, we show that anti-director rights tended to be higher in countries where the domestic GAAP was more compatible with IFRS. However, the theory does not yet predict the impact of IFRS adoption on the relation between anti-director rights and value relevance.

The only exception is Portugal for which the median value of REVALPS is positive in year t.

Numerous studies employ this type of price model to test the impact of specific accounting items (e.g. Aboody and Lev, 1998; Barth and Clinch, 1998; Aboody et al., 1999; Horton and Serafeim, 2009).

The five-month period following the fiscal year-end is used to assure that the fiscal year-end financial information was available to investors. Our results are robust for prices obtained more than five months subsequent to the fiscal year-end.

We use R&D expenses as reported by Compustat Global Vantage (GV) and/or the annual reports. R&D capitalization was not reported on GV and was not disclosed on annual reports for most companies.

The annual returns include dividends. Empirical sensitivity analyses suggest that our results are robust across alternative annual returns measured starting from three to eight months after the fiscal year-end.

Price regression model (2) may be subject to potential scale effect factor bias, which induces interpretation problems in comparing values of adjusted R ² (Easton, 1998; Brown et al., 1999; Gu, 2005). As we compare only two consecutive years for each country included in our sample, and the comparison of the values of adjusted R ² is only one of the four tests used in the study, the results of this test must be interpreted cautiously. It is for this reason that we also use a market-to-book value regression model suggested by Core et al. (2003) as a robustness test, as discussed in the additional analyses in Section 6.

The only exception is a negative but statistically insignificant coefficient of EPS for Austria, using domestic-GAAP-based data (D _t−1).

The null hypothesis is that b ₃ = b ₄ = b ₅ = 0.

An F-test provides similar results, that is, both the χ ² and F-tests reject the null hypothesis for most countries in our sample, except for Austria and Germany (see Maddala, 2001, ch. 4).

The only three exceptions are GWPS in Italy and RDPS in the UK and Denmark (which are not statistically significant at the 5% level).

The only exception is a statistically insignificant F-Chow for Denmark in the return model (Table 5).

As is typically the case with return models, their explanatory powers are considerably lower than those of price models.

We examine several other controls for institutional environment (e.g. log of GNP, GDP growth, GDP per capita growth, research and development expenditure as a percentage of GDP and other WDI Time Series Indicators (World Bank, 2009)) and find insignificant effects (at the 10% level).

Again, having only 14 cross-country observations, any such multivariate analysis is limited for obvious statistical reasons. Also, note that since each dependent variable does not provide an explicit economic measure, we may draw only limited conclusions from the association between the dependent variable and the respective sets of independent variables. Thus, this analysis is of limited scope and should be interpreted cautiously.

These findings tend to be consistent with Daske et al. (2008).