Close
About
FAQ
Home
Collections
Login
USC Login
Register
0
Selected
Invert selection
Deselect all
Deselect all
Click here to refresh results
Click here to refresh results
USC
/
Digital Library
/
University of Southern California Dissertations and Theses
/
Does mandatory adoption of International Accounting Standards reduce the cost of equity capital?
(USC Thesis Other)
Does mandatory adoption of International Accounting Standards reduce the cost of equity capital?
PDF
Download
Share
Open document
Flip pages
Contact Us
Contact Us
Copy asset link
Request this asset
Transcript (if available)
Content
DOES MANDATORY ADOPTION OF INTERNATIONAL ACCOUNTING
STANDARDS REDUCE THE COST OF EQUITY CAPITAL?
by
Siqi Li
______________________________________________________________________
A Dissertation Presented to the
FACULTY OF THE GRADUATE SCHOOL
UNIVERSITY OF SOUTHERN CALIFORNIA
In Partial Fulfillment of the
Requirements for the Degree
DOCTOR OF PHILOSOPHY
(BUSINESS ADMINISTRATION)
August 2008
Copyright 2008 Siqi Li
ii
DEDICATION
To Wang, Peng and my parents
iii
AKNOWLEDGEMENTS
I am grateful to my dissertation committee, Mark DeFond (co-chair), Mingyi Hung
(co-chair), KR Subramanyam, Robert Trezevant, and Cheng Hsiao for their invaluable
guidance and support. I am also thankful to Linda Bamber, Rebecca Hann, Annie Li,
Maria Ogneva, Biqin Xie, and workshop participants at Michigan State University,
Purdue University, Santa Clara University, University of California at Irvine, University
of Georgia, University of Illinois at Urbana-Champaign, University of Oregon and
University of Southern California for their helpful comments and suggestions. This
work is supported in part by U.S. Department of Education Title V1-B funds
administered by USC’s Center for International Business, Education, and Research.
iv
TABLE OF CONTENTS
Dedication ii
Acknowledgements iii
List of Tables v
Abstract vi
Chapter 1: Introduction 1
Chapter 2: Motivation 7
Chapter 3: Research Design 11
Chapter 4: Sample Selection and Description Statistics 16
Chapter 5: Empirical Results 24
Chapter 6: Additional Analyses 29
Chapter 7: Robustness Checks 39
Chapter 8: Conclusion 48
References 50
Appendix: Estimates of Implied Cost of Equity Capital 54
v
LIST OF TABLES
Table 1 Sample Distribution and Country-level Descriptive Statistics 19
Table 2 Firm-level Descriptive Statistics 22
Table 3 Pearson Correlation Matrix with Two-sided p-values in Italics 23
Table 4 Primary Analysis on the Cost of Equity Effects of Mandatory IAS
Adoption 25
Table 5 Additional Analyses 31
Table 6 Distinguishing Early versus Late Voluntary Adopters 40
vi
ABSTRACT
This paper examines whether the mandatory adoption of International Accounting
Standards (IAS) in the European Union (EU) in 2005 reduces the cost of equity capital.
Using a sample of 6,456 firm-year observations of 1,084 EU firms during the 1995 to
2006 period, I find evidence that, on average, mandatory introduction of IAS
significantly reduces the cost of equity for mandatory adopters by 48 basis points. I
also find that this reduction is present only in countries with strong legal enforcement,
and that both increased disclosure and enhanced information comparability help explain
why IAS reduces the cost of equity. Taken together, these findings suggest that while
mandatory IAS adoption benefits shareholders, the benefits depend on the strength of
the countries’ legal enforcement.
1
Chapter 1: Introduction
International Accounting Standards (IAS) have become increasingly popular, with the
European Union mandating that all EU-listed firms adopt IAS beginning in 2005. The
proponents of mandatory IAS adoption assert that IAS will “reduce the cost of capital and
open new opportunities for diversification and improved investment returns” (Tweedie
2006). While prior research finds some evidence that voluntary IAS adoption reduces the
cost of equity capital (e.g., Leuz and Verrecchia 2000; Barth et al. 2007b), little empirical
evidence to date supports this assertion for mandatory IAS adoption, and the economic
consequences of mandatory adoption remain largely unclear (e.g., Daske et al. 2007a, b).
Thus, the purpose of this paper is to explore the effects of mandatory IAS adoption on the
cost of equity capital.
There are at least two reasons why mandatory IAS adoption may be expected to
reduce the cost of equity capital. First, prior research finds that IAS requires greater
financial disclosure than most local accounting standards (e.g., Ashbaugh and Pincus
2001) and that increased disclosure reduces the cost of equity capital (e.g., Botosan 1997;
Easley and O’Hara 2004; Barth et al. 2007a; Lambert et al. 2007). Second, prior
literature argues that one set of uniform accounting standards is likely to improve
information comparability across firms, which in turn is expected to reduce the cost of
equity capital (e.g., Armstrong et al. 2007).
Critics of mandatory adoption, however, note that while prior research provides some
evidence that voluntary IAS adoption reduces the cost of equity capital (e.g., Leuz and
Verrecchia 2000; Barth et al. 2007b), these findings are not necessarily generalizable to
mandatory IAS adopters (Ball et al. 2003; Sunder 2007). Unlike voluntary adopters who
2
“self-select” to follow IAS after weighing the related benefits and costs, mandatory
adopters in the EU are forced to switch to IAS by a “one size fits all” regulation, the
effectiveness of which is likely to depend on the underlying economic and political
institutions influencing the incentives of the managers and auditors responsible for
financial statement preparation (e.g., Ball et al. 2003). Thus, whether mandatory IAS
adoption reduces the cost of equity capital for mandatory adopters in the EU is an
empirical question.
I test whether mandatory IAS adoption affects the cost of equity capital using a
sample of 6,456 observations representing 1,084 distinct firms in 18 EU countries during
the period 1995 to 2006. I begin by regressing the cost of equity on a dummy variable
indicating the type of adopter (mandatory versus voluntary), a dummy variable indicating
the time period (pre- versus post-mandatory adoption period), the interaction between
these two dummies, and a set of control variables. Consistent with prior research, I
measure the cost of equity in this analysis using the average estimates from the implied
cost of capital models proposed by Gebhard et al. (2001), Claus and Thomas (2001),
Gode and Mohanram (2003), and Easton (2004). Mandatory adopters are defined as
firms that do not adopt IAS until it becomes mandatory, that is, that do not adopt IAS
until 2005, and voluntary adopters are firms that adopt IAS before 2005. Similarly, the
pre-mandatory period is the 1995 to 2004 subperiod, while the post-mandatory period
corresponds to the 2005 to 2006 subperiod. The control variables include whether a firm
is cross-listed in the U.S., the country-specific inflation rate, firm size, return variability,
financial leverage, as well as industry and country fixed effects. This difference-in-
differences design, which includes the population of both mandatory and voluntary
3
adopters over the full 1995 to 2006 period, compares the change in the cost of equity for
mandatory adopters before and after the mandatory switch to the corresponding change in
the cost of equity for voluntary adopters.
The results of the above analysis show that mandatory adopters experience a
significant reduction in the cost of equity of 48 basis points after the mandatory
introduction of IAS in 2005, and that voluntary adopters experience no significant change
in the cost of equity after mandatory IAS adoption. Further, while voluntary adopters are
found to have a significantly lower cost of equity compared to mandatory adopters in the
pre-mandatory adoption period, this difference becomes insignificant after mandatory
adoption in 2005. I also find similar results after excluding the “transition period” around
the mandatory adoption (i.e., the last year before and the first year of mandatory
adoption). Taken together, these findings suggest that, on average, mandatory IAS
adoption benefits shareholders.
Next, I test whether legal enforcement plays a significant role in the effects of
mandatory IAS adoption on the cost of equity. Specifically, I rerun the multivariate
analysis described above after including a country-level measure of the strength of legal
enforcement (La Porta et al. 1998), along with its interaction with the type of adopter
(mandatory versus voluntary) and the time period (pre- versus post-mandatory adoption).
This analysis indicates that the reduction in the cost of equity for mandatory adopters is
significant only in countries with strong legal enforcement mechanisms, suggesting that
the quality of legal enforcement is an important determinant of whether IAS adoption is
likely to benefit shareholders.
4
In addition, I analyze whether increased disclosure and/or enhanced comparability
help explain why mandatory IAS adoption reduces the cost of equity capital.
Specifically, I rerun the multivariate analysis in the second test described above after
including a measure of the number of additional disclosures required by IAS relative to
local standards (to capture increased disclosure) and a measure of the number of
inconsistencies between IAS and local standards (to capture enhanced comparability).
This analysis shows that both increased disclosure and enhanced comparability help
explain why mandatory IAS adoption reduces the cost of equity. Further, the evidence
suggests that these factors are only important in the presence of strong legal enforcement.
Finally, I perform a set of sensitivity tests and find that the main results are robust to a
number of alternative specifications. In particular, the findings of this paper are robust
to: (1) distinguishing between voluntary adopters that adopted IAS relatively early and
voluntary adopters that adopted IAS relatively late; (2) controlling for potential self-
selection bias in the pre-mandatory adoption period; (3) controlling for differences in
analyst forecast properties; (4) controlling for nominal risk-free interest rates and using
risk premiums instead of cost of equity capital measures as the dependent variable; (5)
controlling for differences in growth expectations; (6) excluding observations from ten
countries in the sample that have no voluntary IAS adopters; (7) excluding observations
that are listed in Germany’s New Market; (8) excluding observations that use U.S.
GAAP; (9) excluding utilities and firms in the financial services industry; (10) restricting
the pre-mandatory IAS adoption sample to the 1999 to 2004 period; and (11) excluding
IAS adopters in Austria after 2001 and in Greece after 2002 as firms in these countries
were required to adopt IAS before 2005.
5
This study contributes to the literature in several ways. First, it provides timely and
relevant insights into the economic consequences of mandatory IAS adoption.
1
Despite
the mandatory adoption of IAS by over 8,000 EU firms, there is little clear evidence on
the capital market effects of mandatory adoption. This study improves our understanding
of the implications of mandatory IAS adoption by providing evidence that it benefits
shareholders by reducing the cost of equity capital.
This study is most closely related to a contemporaneous working paper by Daske et
al. (2007b). Daske et al. (2007b) examine a variety of economic implications of
mandating IAS adoption across 26 countries (including 18 EU countries) from 2001 to
2005, and unlike this study, they find mixed evidence regarding the effects of IAS
adoption on the cost of equity capital. There are several important differences between
my study and Daske et al. (2007b) that are likely to explain this difference in findings.
For example, this study focuses exclusively on EU countries which are affected by the
IAS adoption regulation at the same point in time. As a result, this sample composition is
likely to provide a cleaner and more powerful setting to test the cost of equity effects of
mandatory IAS adoption. Moreover, my sample period includes two post-adoption years
(2005 and 2006) while Daske et al. (2007b) include one (2005). One more year of post-
adoption data helps alleviate the concern that the results are due to transitional effects
surrounding the adoption of IAS.
Second, this study contributes to the limited empirical research on the economic
consequences of disclosure regulation. Despite the extensive and diverse disclosure
1
The International Accounting Standards (IAS) issued by the International Accounting Standards
Committee (IASC) were succeeded by the International Financial Reporting Standards (IFRSs) issued by
the International Accounting Standards Board (IASB) in 2001. For ease of expression, I use IAS to refer to
both IAS and IFRS.
6
regulations that exist around the world, there is surprisingly little evidence on the costs
and benefits of disclosure regulation (Healy and Palepu 2001). This study examines
mandatory IAS adoption, arguably one of the most far-reaching events in the history of
financial reporting regulation, and provides new insights on the important question of
whether governments can play a useful role in mandating disclosures and other
regulations (Coffee 1984).
Third, the findings in this study highlight the importance of institutional arrangements
in shaping the outcomes of financial reporting convergence. One of the ultimate goals of
mandating IAS across the EU is to develop a financial reporting infrastructure for a
common European capital market (Tweedie 2006). Prior studies indicate that high
quality accounting standards do not guarantee high quality financial reporting (e.g., Ball
et al. 2003). Consistent with this view, this paper shows that the cost of equity reduction
is observed only in strong legal enforcement regimes. This result underlines the
substantial variation in outcome convergence across jurisdictions and the significance of
institutional environments in achieving financial reporting convergence. This paper also
provides timely and important insights as the FASB and IASB jointly work toward
achieving consistency, comparability and efficiency in the global capital markets.
The remainder of the paper is organized as follows: Section II discusses the
motivation. Section III presents the research design. Section IV describes the sample
selection process and descriptive statistics. Section V reports the empirical results.
Section VI discusses additional analyses. Section VII reports sensitivity checks and
Section VIII concludes the study.
7
Chapter 2: Motivation
As one of the most far-reaching financial reporting regulations in history, mandatory
IAS adoption in the EU has given rise to substantial controversy. On the one hand,
opponents of mandatory IAS adoption argue that given the importance of institutional
arrangements on the effectiveness of new accounting rules (e.g., Ball et al. 2003;
Burgstahler et al. 2006), and the substantial variation in institutional arrangements across
EU countries, the potential benefits of mandatory IAS adoption are likely to vary across
countries depending on whether the new rules are effectively enforced. Consistent with
this argument, standard setters recognize that a sound financial reporting infrastructure
must be built on “an enforcement or oversight mechanism that ensures that the principles
as laid out by the accounting and auditing standards are followed” (Tweedie and
Seidenstein 2005, 590). In addition, some observers question whether a uniform set of
standards adequately accommodates the economic and political differences across
countries (e.g., Sunder 2007). Thus, given the existing institutional variation across EU
member states, it is unclear ex ante whether mandatory IAS adoption will unambiguously
reduce firms’ cost of equity in all financial reporting environments.
On the other hand, prior research suggests that given proper implementation and
enforcement, mandatory IAS adoption can reduce the cost of equity capital through at
least two mechanisms. The first mechanism is increased financial disclosure. IAS
typically requires greater disclosure than local accounting standards (Ashbaugh and
Pincus 2001).
2
The information asymmetry literature suggests that greater disclosure
2
Indeed, criticism regarding deficient disclosure policies is a frequently cited motive for firms voluntarily
adopting IAS (e.g., Burt and Harnischfeger 2000). For instance, under the German accounting standards
(HGB), there are no specific rules requiring disclosure of a primary statement of changes in equity (IAS
1.7), current cost of inventory when LIFO is used (IAS 2.36), fair values of financial assets and liabilities
8
mitigates the adverse selection problem and enhances liquidity, thereby reducing the cost
of equity through lower transaction costs and/or stronger demand for a firm’s securities
(e.g., Amihud and Mendelson 1986; Diamond and Verrecchia 1991; Easley and O’Hara
2004). Moreover, the estimation risk literature predicts that firms with greater
information disclosure have lower forward-looking betas, which lead to a lower cost of
equity (e.g., Barry and Brown 1985; Lambert et al. 2007). These theoretical predictions
find support in several empirical studies, including Botosan (1997), who shows that
greater disclosure is associated with a lower cost of equity capital for firms with low
analyst following, and Francis et al. (2005), who report that firms with an expanded
disclosure policy enjoy a lower cost of capital.
The second mechanism through which mandatory IAS adoption may reduce the cost
of equity is enhanced information comparability. A uniform set of accounting standards
can result in enhanced comparability of financial information across firms, especially for
firms located in different countries. Enhanced information comparability can reduce the
costs associated with investors using the information and in turn information asymmetry
and/or estimation risk, leading to a lower cost of equity. The theoretical model in Barth
et al. (1999), for example, makes a similar argument by showing that international
accounting harmonization is likely to reduce the expertise acquisition costs incurred
when foreign investors interpret financial statements prepared under domestic GAAP.
Furthermore, the enhanced comparability effects of IAS convergence can also bring
about positive information externalities: because firms’ values and cash flows are
correlated, the information disclosed by firms in one country becomes more comparable
(IAS 32.77), fair values of investment properties (IAS 40.69), related party transactions other than certain
disclosures (IAS 24.22), discontinuing operations (IAS 35), or earnings per share (IAS 33) (GAAP 2001).
9
and hence more useful in valuing firms in another country if both countries adopt IAS,
thus reducing estimation risk and the cost of equity capital (Dye 1990). Such
externalities are magnified as the number of countries converging to IAS increases.
These effects of improved comparability are consistent with Covrig et al. (2007), who
find that average foreign mutual fund ownership is higher among voluntary IAS adopters
as they provide more information or information in a more familiar form to foreign
investors.
The existing research focuses primarily on the economic consequences of voluntary
IAS adoption, and provides some evidence that voluntary adoption reduces the cost of
equity capital (e.g., Leuz and Verrecchia 2000; Barth et al. 2007b). There is little
empirical evidence, however, on the effects of mandatory IAS adoption on the cost of
equity. While providing useful insights, the findings regarding voluntary IAS adoption
are not necessarily generalizable to the case of mandatory IAS adoption. This is because
voluntary adopters choose or “self-select” to follow IAS after considering the related
costs and benefits,
3
whereas mandatory adopters in the EU switch to IAS because this
switch is required by regulation. The effectiveness of this regulation in achieving
benefits such as a reduction in the cost of equity capital is likely to depend on the extent
to which the institutional environment (e.g., the quality of legal enforcement) influences
preparers’ actual reporting incentives (e.g., Ball et al. 2003). Therefore, it is unclear ex
3
Prior research suggests that many factors influence the decision to voluntarily adopt IAS. For example,
voluntary IAS adopters are larger, have more financing needs, have shares that are traded in more than one
equity market, and have better long-run market performance (e.g., Harris and Muller 1999; Leuz and
Verrecchia 2000; Ashbaugh 2001; Leuz 2003). Anecdotal evidence indicates that IAS adoption may be
associated with substantial costs, such as preparation and implementation costs as well as the costs related
to proprietary information disclosed under IAS. Further, the increased disclosure required by IAS can also
make monitoring less costly and hence reduce the private benefits that controlling shareholders and
managers can expropriate (e.g., Stulz 1999).
10
ante how mandatory IAS adoption impacts firms’ cost of equity capital and this remains
an empirical question.
11
Chapter 3: Research Design
I explore the impact of mandatory IAS adoption on the cost of equity by regressing
the cost of equity capital on a dummy variable indicating the type of adopter (mandatory
versus voluntary adopter), a dummy variable indicating the time period (pre- versus post-
mandatory adoption period), the interaction between these dummies, and a set of control
variables. This research design allows me to investigate the change in the cost of equity
in the pre- versus post-mandatory adoption period for mandatory adopters relative to the
change for voluntary adopters over the same time period. This difference-in-differences
design helps alleviate the concern that unspecified macroeconomic and institutional
changes may be responsible for the results.
As in prior research, I use the ex ante cost of equity implied in current stock prices
and analysts’ forecasts of future earnings. This implied cost of equity measure is
generally more suitable in the research setting used in this paper than the alternatives.
4
I
use a measure that relies on four estimation models: the industry ROE model in Gebhardt
et al. (2001), the economy-wide growth model in Claus and Thomas (2001), the
unrestricted abnormal earnings growth model in Gode and Mohanram (2003), and the
restricted abnormal earnings growth model in Easton (2004). Each of these models
represents a different form of the dividend discount valuation model, varying in the use
of analysts’ forecasts and the assumptions of short-term and long-term growth. A
detailed description of each model is provided in the Appendix. Because there is
4
One alternative cost of equity measure is realized return. I do not use this measure because standard
approaches to obtain unbiased estimates of expected returns often require a long time series of past return
data (Stulz 1999). Moreover, IAS adoption is a major corporate event which makes it difficult to obtain
equilibrium estimates of expected returns. Another cost of capital estimate relies on international asset
pricing models (e.g., Bhattacharya et al. 2003). I do not use this estimate because it is less reliable in an
international setting as the necessary assumptions of a similar degree of market segmentation and similar
exposure to the global market portfolio are hard to maintain (Hail and Leuz 2006a).
12
substantial measurement error and potential bias in implied cost of capital estimates
(Easton and Monahan 2005), I use the mean of these four measures as the proxy for the
cost of equity capital (Hail and Leuz 2006a, b; Daske et al. 2007a, b).
5, 6
My independent variables of most interest consist of three dummy variables. The
first dummy variable captures whether the firm is a mandatory IAS adopter, and is coded
one when the firm does not adopt IAS until it becomes mandatory to do in 2005, and zero
otherwise. A firm is classified as a mandatory adopter if the data item “astd” (accounting
standards) in Compustat Global does not equal “DI” prior to 2005.
7
A second dummy
variable captures whether the firm-year observation falls in the post-mandatory adoption
period, and is coded one when the firm-year falls in 2005 or later, and zero otherwise.
8
A
5
In untabulated analysis, I also use the first principal component of the four individual measures as an
alternative proxy for the cost of equity capital (Hail and Leuz 2006b). The results in Table 4 and 5 are
robust to this alternative specification.
6
For example, analyst forecasting behaviors are likely to vary across countries, which might introduce
biases to the implied cost of capital estimates. I include country dummies in the main analysis as well as
control for analyst forecast biases in the sensitivity tests. Another concern is that the cost of equity effects
may be a mechanical result of using forecasted earnings prepared according to different accounting
standards. For instance, earnings under IAS could be systematically smaller than earnings under local
standards, which, ceteris paribus, leads to a lower cost of equity after mandatory IAS adoption. Hung and
Subramanyam (2007), however, suggest that the value and variability of earnings and book value of equity
are higher under IAS than under German GAAP. To the extent that this is true for other local standards
across the EU, ceteris paribus, it biases against finding a reduced cost of equity after the mandatory IAS
introduction in 2005.
7
In Compustat Global, “DI” represents domestic standards generally in accordance with IASC. There are
two other relevant codes related to IAS adoption: “DA” (domestic standards generally in accordance with
IASC and OECD (Organization for Economic Cooperation and Development)) and “DT” (domestic
standards in accordance with principles generally accepted in the United States and generally in accordance
with IASC and OECD guidance). To check the robustness of the results, I redefine IAS adoption using the
codes “DI”, “DA” and “DT” and rerun the analysis in Table 4 and 5. The results (not reported) are robust
to the alternative definitions of IAS adoption. However, for comparability with the IAS adoption code in
the post-mandatory adoption period, the paper’s main inferences are drawn from the results based on the
“DI” code.
8
There are two cases in which EU member states may exempt certain companies from mandatory IAS
adoption in 2005, but only until 2007: (1) companies that are listed both in the EU and on a non-EU
exchange and that currently use U.S. GAAP as their primary accounting standards, and (2) companies that
have only publicly traded debt securities (Deloitte 2005). Additionally, non-EU companies listed on EU
exchanges can continue to use their national GAAP until 2007. The main analysis in this study is based on
the sample after excluding firms in the three preceding cases.
13
third dummy variable captures the interaction of the first two dummy variables. Using
these dummy variables allows for a two-by-two analysis of the effects of mandatory IAS
adoption on the cost of equity for mandatory versus voluntary adopters across the pre-
versus post-mandatory adoption periods.
The multivariate regression also includes several control variables expected to
influence the cost of equity capital: (1) three forms of U.S. cross-listing (from JP Morgan
ADR Analytics) to capture the impact of cross-listing on the cost of equity (Hail and
Leuz 2006a): a dummy variable indicating whether the firm has a private placement
under Rule 144A, a dummy variable indicating whether the firm trades its shares in the
over-the-counter markets, and a dummy variable indicating whether a firm lists its shares
on the NYSE, NASDAQ or Amex;
9
(2) the expected future inflation rate estimated by the
median of next year’s monthly inflation rates (from Datastream and the World Bank), to
capture the cross-country variation in inflation rates because the implied cost of capital
measures are expressed in local currency and in nominal terms (Hail and Leuz 2006a);
(3) variables controlling for firm financial and risk characteristics that are associated with
the cross-sectional variations of returns (Fama and French 1992, 1993): firm size,
measured as the natural logarithm of total assets in U.S. dollars at year-end, return
variability, computed as the annual standard deviation of monthly stock returns at year-
end,
10
and financial leverage, estimated by the ratio of total liabilities over total assets;
9
The results in Table 4 and 5 are robust to using an indicator combining these three cross-listing dummy
variables.
10
Alternatively, I could use market beta to control for risk. However, the estimation of market beta in an
international setting requires a global portfolio, whose validity depends on the degree of market integration.
Moreover, studies have shown that future returns in emerging markets have no (or even a negative) relation
with beta computed using the world market portfolio (e.g., Harvey 1995). Nevertheless, as a sensitivity
test, I also include the market beta in the main analysis. The results in Table 4 and 5 are robust to this
14
and (4) dummy variables to control for industry and country fixed effects (Fama and
French 1997; Hail and Leuz 2006b).
The formal regression model is as follow (firm and year subscripts are suppressed):
Cost of equity capital = α
0
+ α
1
*Dummy for Mandatory IAS adopters + α
2
*Dummy
for Post-mandatory adoption period + α
3
*Dummy for Mandatory IAS adopters *
Dummy for Post-mandatory adoption period + α
4
*Private placement + α
5
*OTC
listing + α
6
*Exchange listing + α
7
*Inflation + α
8
*Log_total assets + α
9
*Return
variability + α
10
*Leverage + α
m
*DIndustry + α
n
*DCountry + ε (1)
where:
Cost of equity capital: the mean of r
mpeg
(implied cost of equity capital estimates based on
modified PEG ratio by Easton (2004)), r
gm
(implied cost of equity capital estimates
based on Gode and Mohanram (2003)), r
ct
(implied cost of equity capital estimates
based on Claus and Thomas (2001)), and r
gls
(implied cost of equity capital estimates
based on Gebhardt et al. (2001));
Dummy for mandatory IAS adopters: a dummy variable equal to one if a firm does not
adopt IAS until 2005, and zero otherwise;
Dummy for post-mandatory adoption period: a dummy variable equal to one if a firm-
year observation falls in 2005 or later, and zero otherwise;
Dummy for mandatory IAS adopters* Dummy for post-mandatory adoption period: the
interaction term between the two dummy variables;
Private placement: a dummy variable equal to one if a firm has a private placement under
Rule 144A according to JP Morgan ADR Analytics;
OTC listing: a dummy variable equal to one if a firm trades its shares in the U.S. over-
the-counter markets according to JP Morgan ADR Analytics;
Exchange listing: a dummy variable equal to one if a firm trades its shares on the NYSE,
NASDAQ or Amex according to JP Morgan ADR Analytics;
Inflation: the yearly median of country-specific, one-year-ahead monthly inflation rates;
Log_total assets: the natural logarithm of total assets in millions of U.S. dollars at year-
end;
specification. As an additional sensitivity test I use book-to-market as an alternative control for risk. The
results in Table 4 and 5 are also robust to this specification.
15
Return variability: the return variability computed as the annual standard deviation of
monthly stock returns at year-end;
Leverage: financial leverage computed as total liabilities divided by total assets at year-
end;
DIndustry: dummy variables indicating a firm’s industry membership based on the
industry classification in Campbell (1996);
DCountry: dummy variables for countries.
16
Chapter 4: Sample Selection and Descriptive Statistics
4.1 Sample Selection
The full sample used to estimate the above regression is obtained from the Compustat
Global database and consists of 6,456 firm-year observations (including 1,783 IAS firm-
year observations) from 18 EU countries from 1995 to 2006. After excluding the
adoption transition period, i.e., the last year before and the first year of mandatory IAS
adoption, the secondary sample includes 2,846 firm-year observations (including 665 IAS
firm-year observations) from 18 EU countries. My investigation period begins in 1995
because this is when the IAS Comparability/Improvement Project was completed by the
International Accounting Standards Committee (IASC) and was endorsed by the
International Organization of Securities Commissions (IOSCO).
11
To be included in the
sample, each firm must have data available for both the pre- and post-mandatory adoption
periods.
To estimate the cost of equity measures, I obtain analyst forecasts and price
information from I/B/E/S. I obtain other estimation inputs, including the dividend payout
ratio and book value of equity, from Compustat Global. These price and forecast data are
in local currencies and are taken seven months after the fiscal year-end to ensure the
financial data are publicly available and priced at the time of estimation (Hail and Leuz
2006a).
12
To be included in the sample, I require each firm-year observation to have
current stock price data and analyst mean consensus earnings forecasts for at least two
11
IAS has undergone constant changes and revisions since the 1970s. Later in the sensitivity tests, I check
the robustness of the results to an alternative sample period, namely, 1999 to 2006, as the Core Standard
Project was completed in December 1998.
12
Hail and Leuz (2006a) use the data as of month +10 as well as month +7 after the fiscal year-end.
However, the specification of month +10 greatly limits the number of qualified observations, especially for
the mandatory adoption period, as analyst forecast data in I/B/E/S was only available until September 2007
at the time I conducted the analyses.
17
periods ahead. All earnings forecasts are restricted to be positive, and the long-term
earnings growth rate forecasts are used if the three-year- through five-year-ahead
earnings forecasts are missing. The dividend payout ratio is computed using the historic
three-year average for each firm, and it is replaced by the country-year median payout
ratio when missing or out of the range of zero to one (Hail and Leuz 2006a). I further
require that all four individual measures of the cost of equity be available in order to
calculate the average cost of equity measure. Cost of equity estimates below zero and
above one are omitted.
The financial statement variables, including accounting standards, are collected from
Compustat Global.
13
I require each observation to have necessary data for computing the
control variables specified in Section III. Finally, to mitigate the influence of outliers, I
winsorize all firm-level continuous variables at the top and bottom 1% of their
distributions, with the exception of firm size (the log of total assets).
Table 1 provides the sample distribution and country-level descriptive statistics for
the test variables used in the full sample. Columns two and four in Panel A report that
the number of observations varies widely across the sample countries. For instance, in
the pre-mandatory adoption period (1995-2004), the U.K. has the largest number of
observations (1,713) while Hungary has the lowest (three). The third column also reports
large cross-country variation in the proportion of firm-year observations that voluntarily
use IAS during the pre-mandatory adoption period. As Covrig et al. (2007) note,
13
Prior studies suggest that Compustat contains many data errors in coding accounting standards (Covrig et
al. 2007). I therefore manually check the following cases based on the corresponding annual reports and/or
company websites: (1) companies that are shown to adopt IAS and later switch back to local standards; and
(2) companies with a fiscal year-end in the months of January to May as well as December but that still use
local standards (“DS”) in 2005. In total, I identify and correct 34 firm-year observations that are
mistakenly classified.
18
countries have specific regulations regarding financial reporting and disclosure, which
imposes different costs on IAS adoption and thus introduces different incentives for firms
to adopt IAS. Ireland and the U.K., for example, require public firms to use local
standards prior to 2005, and thus have no voluntary IAS adopters in the sample (Deloitte
2003). Other countries, such as Germany, have a relatively high proportion of voluntary
IAS adopters (25%), consistent with German regulations allowing firms to use IAS
before 2005 (Leuz and Verrecchia 2000; Deloitte 2003). Finally, column five shows that
all listed firms in the EU use IAS once it becomes mandatory in 2005.
4.2 Descriptive Statistics
Panel B of Table 1 reports the descriptive statistics by country for the test variables
used in the full sample, namely, cost of equity capital, inflation rate, total assets, market
value of equity, return variability, and financial leverage. The panel shows that the
country average of the cost of equity capital measure ranges from a low of 10.02% in
Spain to a high of 15.38% in Luxembourg, with a median of 10.37% and a standard
deviation of 3.48%. The magnitude of these estimates is generally consistent with prior
cross-country studies such as Leuz and Hail (2006a, b). In addition, Panel B indicates
that the one-year-ahead inflation rate across the sample countries is on average 1.89%
with a standard deviation of 0.80%. Total assets and market value of equity are highly
skewed, with mean values of $27.3 B and $5.1 B and median values of $1.0 B and $783
M, respectively. I therefore use the log transformations for these two variables in my
analysis. Finally, the average (median) return variability and financial leverage are 0.094
(0.080) and 0.626 (0.630), respectively.
19
Table 1: Sample Distribution and Country-level Descriptive Statistics (N=6,456
Firm-year Observations, with 1,783 IAS Firm-year Observations)
Panel A: Sample Distribution
Pre-mandatory Adoption
Period
Post-mandatory Adoption
Period
1995-2004 2005-2006
N % using IAS N % using IAS
Austria 63 35% 14 100%
Belgium 167 5% 49 100%
Czech Republic 5 80% 1 100%
Denmark 164 11% 60 100%
Finland 242 11% 109 100%
France 653 2% 226 100%
Germany 457 25% 159 100%
Greece 78 8% 35 100%
Hungary 3 0% 1 100%
Ireland 101 0% 30 100%
Italy 302 0% 143 100%
Luxembourg 7 0% 2 100%
Netherlands 326 0% 94 100%
Poland 16 0% 7 100%
Portugal 44 0% 15 100%
Spain 240 0% 78 100%
Sweden 303 0% 106 100%
United Kingdom 1,713 0% 443 100%
Total 4,884 4% 1,572 100%
20
Table 1 Panel B: Country-level Descriptive Statistics
Cost of
equity
capital Inflation
Total
assets
Market
value of
equity
Return
variability Leverage
Austria 10.14% 1.70% 3,888 2,307 0.085 0.626
Belgium 11.24% 1.82% 28,775 2,921 0.081 0.599
Czech
Republic 10.46% 2.16% 16,523 3,185 0.084 0.922
Denmark 11.35% 2.09% 11,590 1,865 0.089 0.587
Finland 12.54% 1.44% 1,759 1,042 0.098 0.515
France 10.80% 1.52% 35,299 6,506 0.104 0.635
Germany 11.08% 1.51% 42,554 6,132 0.108 0.641
Greece 11.56% 3.49% 11,480 3,221 0.103 0.694
Hungary 11.53% 5.49% 462 617 0.145 0.160
Ireland 11.47% 3.30% 27,511 3,879 0.079 0.726
Italy 10.23% 2.35% 37,062 5,562 0.083 0.711
Luxembourg 15.38% 2.29% 4,468 2,124 0.156 0.590
Netherlands 12.30% 2.19% 42,003 5,410 0.094 0.612
Poland 12.30% 2.96% 8,677 2,423 0.113 0.746
Portugal 11.11% 2.89% 15,728 3,803 0.067 0.811
Spain 10.02% 2.97% 35,753 9,662 0.073 0.702
Sweden 11.27% 1.22% 15,985 3,093 0.108 0.582
United
Kingdom 10.60% 1.68% 23,698 5,405 0.092 0.608
Mean 10.97% 1.89% 27,304 5,114 0.094 0.626
Median 10.37% 1.82% 1,018 783 0.080 0.630
Std Dev 3.48% 0.80% 124,277 14,355 0.053 0.194
Table 1 reports the sample distribution and country-level descriptive statistics. The full sample comprises
6,456 firm-year observations representing 1,084 distinct firms from 18 EU countries during the period 1995
to 2006. Panel A of Table 1 reports the number of firm-year observations and the proportions of IAS users
by country. Panel B of Table 1 reports the descriptive statistics on key variables by country.
Variable definitions:
Cost of equity capital: the mean of r
mpeg
(implied cost of equity capital estimates based on modified PEG
ratio by Easton (2004)), r
gm
(implied cost of equity capital estimates based on Gode and Mohanram
(2003)), r
ct
(implied cost of equity capital estimates based on Claus and Thomas (2001)), and r
gls
(implied cost of equity capital estimates based on Gebhardt et al. (2001)).
Inflation: the yearly median of country-specific, one-year-ahead monthly inflation rates.
Total assets: the firm’s total assets in millions of U.S. dollars at year-end.
Market value of equity: the firm’s market value of equity in millions of U.S. dollars at year-end.
Return variability: the return variability computed as the annual standard deviation of monthly stock
returns at year-end.
Leverage: financial leverage computed as total liabilities divided by total assets at year-end.
21
Table 2 compares the descriptive statistics for IAS and non-IAS users for the firm-
level variables over the full sample period (1995 to 2006). The mean (median) value of
the average cost of equity measure is 10.39% (9.84%) for IAS users, which is smaller
than the mean (median) value of 11.19% (10.60%) for non-IAS users. The differences
are significant in both the t-test of means and Wilcoxon two-sample test of medians (with
two-sided p<1%). Examining the individual measures of cost of equity reveals that all
four estimates are significantly lower for IAS adopters than non-IAS adopters (both mean
and median values) at p<1% (two-sided). Table 2 also indicates that, relative to non-IAS
users, IAS users are more frequently cross-listed in the U.S. (in the forms of private
placements and OTC trading), are larger in size, have less volatile stocks returns, and
have higher financial leverage (all with two-sided p<10%). These results are generally
consistent with prior studies such as Covrig et al. (2007) except for return variability,
which could be due to differences in the sample composition.
Table 3 reports the Pearson correlation coefficients for the test variables of the full
sample. I find a significantly negative correlation between the cost of equity capital and
IAS adoption (with two-sided p<1%). Consistent with Hail and Leuz (2006a), I find that
the cost of equity capital is negatively correlated with U.S. cross-listings in the forms of
OTC trading and exchange listings (both with two-sided p<1%), but not with private
placements under Rule 144A. In addition, the cost of equity capital is negatively
correlated with firm size and positively correlated with the inflation rate, stock return
variability, as well as financial leverage (all with two-sided p<5%).
22
Table 2: Firm-level Descriptive Statistics (N=6,456 Firm-year Observations, with
1,783 IAS Firm-year Observations)
Variable
Accounting
standards Mean Median
Std
Dev
t-test p-
value
Wilcoxon
p-value
other 11.19% 10.60% 3.63% <0.001 <0.001
Cost of
equity
capital IAS 10.39% 9.84% 2.97%
other 12.13% 11.26% 4.35% <0.001 <0.001
r
mpeg
IAS 11.70% 10.88% 4.02%
other 12.56% 11.71% 4.45% 0.003 0.008
r
gm
IAS 12.21% 11.42% 4.15%
other 9.86% 9.15% 3.85% <0.001 <0.001
r
ct
IAS 9.22% 8.84% 2.86%
other 9.97% 9.30% 4.96% <0.001 <0.001
r
gls
IAS 8.35% 8.21% 3.93%
other 0.007 0 0.086 0.023 0.009 Private
placements
IAS 0.015 0 0.120
other 0.066 0 0.249 <0.001 <0.001
OTC listings
IAS 0.093 0 0.291
other 0.079 0 0.269 0.134 0.123 Exchange
listings
IAS 0.090 0 0.287
other 7.151 6.827 2.144 <0.001 <0.001 Log of total
assets
IAS 7.523 7.241 2.308
other 0.102 0.087 0.057 <0.001 <0.001 Return
variability
IAS 0.075 0.067 0.034
other 0.623 0.624 0.194 0.077 0.028
Leverage
IAS 0.633 0.646 0.193
Table 2 reports the descriptive statistics for key variables across IAS and non-IAS firm-year observations
for the full sample of 6,456 observations representing 1,084 distinct firms from 18 EU countries during the
period 1995 to 2006. The t-test tests the null hypothesis that the mean difference on key variables across
IAS and non-IAS observations is zero. The Wilcoxon test is a non-parametric method testing the null
hypothesis that the median difference on key variables across IAS and non-IAS observations is zero.
Variable definitions:
Private placement: a dummy variable equal to one if a firm has a private placement under Rule 144A
according to JP Morgan ADR Analytics.
OTC listing: a dummy variable equal to one if a firm trades its shares in the over-the-counter markets of the
U.S. according to JP Morgan ADR Analytics.
Exchange listing: a dummy variable equal to one if a firm trades its shares on the NYSE, NASDAQ or
Amex according to JP Morgan ADR Analytics.
Log of total assets: the natural logarithm of total assets in millions of U.S. dollars at year-end.
All other variables are defined as in Table 1.
23
Table 3: Pearson Correlation Matrix with Two-sided p-values in Italics (N=6,456 Firm-year Observations, with 1,783 IAS
Firm-year Observations)
IAS
adoption
Cost of equity
capital
Private
placements
OTC
listings
Exchange
listings Inflation
Log of total
assets
Return
variability
-0.103 Cost of equity
capital
<0.001
0.033 0.015 Private placements
0.008 0.217
0.046 -0.058 0.095 OTC listings
<0.001 <0.001 <0.001
0.019 -0.041 -0.029 -0.084 Exchange listings
0.123 <0.001 0.019 <0.001
0.143 0.031 0.028 -0.004 0.040 Inflation
<0.001 0.012 0.025 0.727 0.002
0.076 -0.174 0.102 0.248 0.337 0.118 Log of total assets
<0.001 <0.001 <0.001 <0.001 <0.001 <0.001
-0.231 0.308 -0.022 -0.067 0.001 -0.099 -0.240 Return variability
<0.001 <0.001 0.084 <0.001 0.936 <0.001 <0.001
0.022 0.105 0.085 0.114 0.097 0.131 0.576 -0.070 Leverage
0.077 <0.001 <0.001 <0.001 <0.001 <0.001 <0.001 <0.001
Table 3 presents the Pearson correlation coefficients among the test variables based on the full sample of 6,456 observations representing 1,084 distinct firms
from 18 EU countries during the period of 1995 to 2006. P-values (in italics) are two-sided.
All variables are defined as in Table 1 and 2.
24
Chapter 5 Empirical Results
Table 4 presents the results of the multivariate regression analysis. Columns two and
three of Panel A report the coefficients and two-sided p-values of the regression model
for the full sample period (1995 to 2006) while columns four and five report those for the
sample after excluding the transition period, 2004 and 2005.
14
To examine the relation
between the cost of equity capital and mandatory IAS adoption, however, I must first
combine some of the coefficients in Panel A and test the significance of the aggregated
coefficients. Therefore, for ease of exposition, Panel B reports the reconstructed
coefficients and the significance levels in a two-by-two analysis for the full sample
period. The columns in Panel B partition the sample by the pre- and post-mandatory IAS
adoption periods, and the rows partition the sample by mandatory and voluntary IAS
adopters. The individual cells as well as the row differences and column differences are
constructed using the coefficients from Panel A.
15
Comparing the two columns in Panel B shows that mandatory adopters experience a
significant reduction in the cost of equity capital after the mandatory adoption (8.76%
versus 9.24%, with two-sided p<1%), suggesting that mandatory IAS adoption does
14
I also estimate Prais-Winsten regressions with panel-corrected standard errors to control for possible
problems such as heteroskedasticity, serial correlation and cross-sectional dependence (Hail and Leuz
2006b). The results in Table 4 and 5 are robust to this alternative specification.
15
For example, the cell for mandatory adopters in the pre-mandatory adoption period in Panel B (9.24%)
equals the sum of the intercept (0.0839) and the coefficient on the dummy variable for mandatory adopters
in Panel A (0.0085). Similarly, the cell for mandatory adopters in the post-mandatory adoption period in
Panel B (8.76%) equals the sum of the intercept (0.0839), the coefficient on the dummy variable for
mandatory adopters (0.0085), the coefficient on the dummy variable for post-mandatory adoption period
(0.0016), and the coefficient on the interaction term (-0.0063) in Panel A.
25
Table 4: Primary Analysis on the Cost of Equity Effects of Mandatory IAS Adoption
Panel A: A Pooled Regression
Full period
Excluding transition
period
(1995-2006) (1995-2003, 2006)
coeff.
2-sided p-
value coeff.
2-sided p-
value
Intercept 0.0839 <0.001
0.0864 <0.001
Dummy for mandatory adopters (1) 0.0085 <0.001
0.0114 <0.001
Dummy for post-mandatory adoption
period (2)
0.0016 0.606
-0.0024 0.602
Dummy for mandatory adopters*Dummy
for post-mandatory adoption period (3)
-0.0063 0.052
-0.0063 0.182
Private placements 0.0100 0.024
0.0151 0.010
OTC listings 0.0005 0.751
-0.0005 0.816
Exchange listings 0.0024 0.134
0.0041 0.065
Inflation 0.4013 <0.001
0.5966 <0.001
Log of total assets -0.0038 <0.001
-0.0044 <0.001
Return variability 0.1687 <0.001
0.1525 <0.001
Leverage 0.0552 <0.001
0.0575 <0.001
Industry dummies
Included
Included
Country dummies
Included
Included
Test: (2) + (3) =0
<0.001
<0.001
Test: (1) + (3) =0
0.475
0.259
N 6,456 2,846
Adj. R
2
0.22 0.25
26
Table 4 Panel B: Two-by-two Analysis of Mandatory versus Voluntary Adopters, by
Period, Using the Coefficients in Panel A
Pre-mandatory
adoption (1995-
2004)
Post-mandatory
adoption (2005-
2006)
Diff.
9.24% 8.76% -0.48% ***
Mandatory
adopters N=4,431 N=1,447
8.39% 8.55% 0.16%
Voluntary
adopters N=453 N=125
Diff. 0.85% *** 0.21% -0.64% *
indeed yield real economic benefits for shareholders. For voluntary adopters, on the
other hand, their cost of equity capital does not change significantly after the imposition
of mandatory IAS adoption in 2005 (8.55% versus 8.39%, with two-sided p=0.61),
indicating that mandatory IAS adoption does not significantly affect the cost of equity
capital of those already using IAS. Moreover, the change in the cost of equity around the
mandatory switch is significantly stronger for mandatory adopters than for voluntary
adopters (-0.48% versus 0.16%, with two-sided p<10%). Consistent with these results,
comparing the two rows in Panel B shows that mandatory adopters have a significantly
higher cost of equity capital than voluntary adopters in the pre-mandatory adoption
period (9.24% versus 8.39%, with two-sided p<1%).
16, 17
Further, these cross-sectional
differences between mandatory and voluntary adopters prior to 2005 become
insignificant after the mandatory IAS adoption (8.76% versus 8.55%, with two-sided
p=0.48), consistent with the assertion that a uniform set of high quality accounting
16
The results for voluntary adopters are consistent with prior studies in that voluntary IAS adoption reduces
the cost of equity capital (e.g., Leuz and Verrecchia 2000; Barth et al. 2007).
17
The results comparing mandatory versus voluntary adopters in the pre-mandatory adoption period could
be subject to potential self-selection bias, which I address later in the sensitivity analysis.
27
standards improves financial reporting convergence across the EU member states
(Tweedie 2006).
Panel C: Two-by-two Analysis of Mandatory versus Voluntary Adopters, by Period,
after Excluding Transition Period (2004 and 2005), Using the Coefficients in Panel
A
Pre-mandatory
adoption (1995-
2003)
Post-mandatory
adoption (2006)
Diff.
9.79% 8.92% -0.87% ***
Mandatory
adopters N=2,003 N=497
8.64% 8.41% -0.23%
Voluntary
adopters N=290 N=56
Diff. 1.15% *** 0.51% -0.64%
Table 4 reports the results of the main analysis. Panel A reports the pooled regression coefficients and two-
sided p-values for the full period sample of 6,456 firm-year observations from 1995 to 2006, as well as for
the sample after excluding the transition period, leaving 2,846 firm-year observations from 1995 to 2003
and 2006. Panel B repots the two-by-two analysis of mandatory adopters versus voluntary adopters by
period for the full sample, constructed using the coefficients in Panel A. Panel C reports the two-by-two
analysis of mandatory adopters versus voluntary adopters by period for the sample after excluding the
transition period, constructed using the coefficients in Panel A. * denotes significant at the 10% level, **
denotes significant at the 5% level, and *** denotes significant at the 1% level, all two-sided.
Regression model: (firm and year subscripts are suppressed):
Cost of equity capital = α
0
+ α
1
*Dummy for Mandatory IAS adopters + α
2
*Dummy for Post-
mandatory adoption period + α
3
*Dummy for Mandatory IAS adopters * Dummy for Post-mandatory
adoption period + α
4
*Private placement + α
5
*OTC listing+ α
6
*Exchange listing + α
7
*Inflation +
α
8
*Log_total assets + α
9
*Return variability + α
10
*Leverage + α
m
*DIndustry + α
n
*DCountry + ε
Variable definitions:
Dummy for mandatory IAS adopters: a dummy variable equal to one if a firm does not adopt IAS until
2005, and zero otherwise.
Dummy for post-mandatory adoption period: a dummy variable equal to one if a firm-year observation falls
on or after 2005, and zero otherwise.
Dummy for mandatory IAS adopters* Dummy for post-mandatory adoption period: the interaction term
between the two dummy variables.
Private placement: a dummy variable equal to one if a firm has a private placement under Rule 144A
according to JP Morgan ADR Analytics.
DIndustry: dummy variables indicating a firm’s industry membership based on the industry classification in
Campbell (1996).
DCountry: dummy variables for countries.
All other variables are defined as in Table 1 and 2.
28
Similarly, Panel C reports the reconstructed coefficients and the significance levels in
a two-by-two analysis for the sample after excluding the transition period (i.e., 2004 and
2005). The results and inferences in Panel C are generally consistent with those in Panel
B, indicating that the transitional period under the new reporting regime does not
influence the results found using the full sample.
18
In summary, the results in Table 4 suggest that mandatory IAS adoption leads to a
significant reduction in the cost of equity capital only for mandatory adopters, and as a
result the cost of equity difference between mandatory and voluntary adopters in the pre-
mandatory adoption period becomes insignificant after 2005. This is consistent with
mandatory IAS adoption, on average, benefiting shareholders by reducing the cost of
equity capital.
18
Panel C of Table 4 reports that the reduction in the cost of equity around the mandatory switch is not
significantly different between mandatory and voluntary adopters (-0.87% versus -0.23%, with two-sided
p=0.18). This might be explained by the low power of the test that uses only one year in the post-
mandatory adoption period after excluding 2004 and 2005. Consistent with this conjecture, the regression
analysis after excluding only year 2004 (not tabulated) finds that the change in the cost of equity around the
mandatory switch is significantly stronger for mandatory adopters than for voluntary adopters (-0.67%
versus 0.02%, with two-sided p<5%).
29
Chapter 6: Additional Analyses
6.1 Investigating the Role of Legal Enforcement in Explaining the Effects of IAS
Adoption on the Cost of Equity Capital
Prior studies suggest that the outcome of implementing accounting standards is
determined not only by the quality of the standards, but also by the country’s institutional
arrangements (Ball et al. 2003). In particular, firms in countries with weak enforcement
mechanisms are more likely to abuse the discretion afforded by accounting rules and
engage in earnings manipulation (Burgstahler et al. 2006). This suggests that the benefits
from mandatory IAS adoption in terms of a reduction in the cost of equity are expected to
be sensitive to whether the new rules are effectively enforced. To explore the role of
legal enforcement in influencing the impact of mandating IAS, I compare the results of
my primary analysis across countries with strong versus weak enforcement mechanisms.
Following prior studies such as Leuz et al. (2003) and Burgstahler et al. (2006), I
measure the quality of legal enforcement using the average score of the efficiency of the
judicial system, rule of law, and corruption from La Porta et al. (1998).
19
This
enforcement measure ranges from zero to ten, with higher values indicating stronger
enforcement environments. I transform this measure into a dummy variable based on
whether a country-specific value is above or below the sample country median, coding it
as one for strong legal enforcement and zero for weak legal enforcement. I then rerun the
analysis in Table 4 after including this dummy variable in regression equation (1), along
with its interaction with the IAS adopter dummy and the adoption period dummy. I then
use the resulting regression coefficient estimates on the dummy variables to construct
19
The results are qualitatively similar if I use a more recent proxy for legal and enforcement environment,
i.e., the rule of law variable in 2005 from Kaufmann et al. (2007).
30
two-by-two tables partitioned in the strong versus weak enforcement settings. Because
the primary analysis in Table 4 finds a significant reduction in the cost of equity only for
mandatory adopters, I restrict the analysis to mandatory adopters.
Table 5 summarizes the results of this additional analysis. Panel A reports the
descriptive statistics on the legal enforcement variable. This panel indicates that the
sample countries vary significantly in terms of their strength of legal enforcement
mechanisms. For example, Denmark, Finland, Netherlands and Sweden have the highest
scores (ten) while Greece has the lowest (6.82). Panel B of Table 5 presents the results
for the full sample partitioned on the legal enforcement system.
20
The results show that
mandatory adopters in strong enforcement environments experience a reduction in the
cost of equity capital of 91 basis points after IAS becomes mandatory in 2005 (two-sided
p<1%), while mandatory adopters in poor enforcement environments experience no
significant change in the cost of equity capital after 2005. Thus, the results in Panel B
indicate that the cost of equity benefits of mandatory IAS adoption are present only in
strong enforcement environments, consistent with the quality of legal enforcement being
an important factor for effective accounting changes.
20
The results and inferences in Table 5 are robust to excluding the transition period, i.e., 2004 and 2005.
31
Table 5: Additional Analyses
Panel A: Country-level Conditioning Variables
Country Enforcement
Additional
disclosure
required by IAS
relative to local
standards
The number of
inconsistencies
between local
standards and IAS
Austria 9.36 8 20
Belgium 9.44 7 15
Czech Republic . 6 14
Denmark 10 5 13
Finland 10 8 19
France 8.68 6 19
Germany 9.05 7 20
Greece 6.82 9 20
Hungary . 8 17
Ireland 8.36 0 15
Italy 7.07 6 19
Luxembourg . 8 16
Netherlands 10 2 5
Poland . 5 18
Portugal 7.19 7 12
Spain 7.14 9 22
Sweden 10 4 11
United Kingdom 9.22 0 15
Mean 8.74 6 16
Median 9.14 7 17
Std dev 1.21 3 4
Table 5 reports the results for the additional analyses. Panel A reports descriptive statistics for the country-
level conditioning variables. Panel B reports the analysis for the sub-samples conditioned on the
enforcement index. Panel C reports the analysis for the sub-samples conditioned on the enforcement index
and the increase in disclosures due to mandatory IAS adoption. Panel D reports the analysis for the sub-
samples conditioned on the enforcement index and the increase in comparability due to mandatory IAS
adoption. The continuous conditioning variables are transformed into binary variables based on the sample
country median values. * denotes significant at the 10% level, ** denotes significant at the 5% level, and
*** denotes significant at the 1% level, all two-sided.
Variable definitions:
Enforcement index: the average of efficiency of judicial system, rule of law and corruption (La Porta et al.
1998; Leuz et al. 2003).
Increase in disclosures due to mandatory IAS adoption: the number of additional disclosures required by
IAS when compared to local accounting standards, constructed from GAAP (2001).
Increase in comparability due to mandatory IAS adoption: the number of inconsistencies between local
standards and IAS, constructed from GAAP (2001).
All other variables are defined as in Table 4.
32
Table 5 Panel B: The Role of Legal Enforcement in Explaining the Cost of Equity Effects of Mandatory IAS Adoption
Weak enforcement Strong enforcement
Pre-
mandatory
adoption
(1995-2004)
Post-
mandatory
adoption
(2005-2006) Diff.
Pre-
mandatory
adoption
(1995-2004)
Post-
mandatory
adoption
(2005-2006) Diff.
8.87% 9.01% 0.14% 9.61% 8.69% -0.91% ***
Mandatory
adopters N=1,585 N=601
Mandatory
adopters N=2,820 N=836
Regression model in Panel B: (firm and year subscripts are suppressed):
Cost of equity capital = α
1
*Dummy for Voluntary IAS adopters + α
2
*Dummy for Mandatory IAS adopters + α
3
*Dummy for Voluntary IAS adopters * Dummy for
Post-mandatory adoption period + α
4
*Dummy for Mandatory IAS adopters * Dummy for Post-mandatory adoption period + α
5
*Dummy for Voluntary IAS
adopters * Dummy for Strong enforcement + α
6
*Dummy for Mandatory IAS adopters * Dummy for Strong enforcement + α
7
*Dummy for Voluntary IAS adopters
* Dummy for Post-mandatory adoption period * Dummy for Strong enforcement + α
8
*Dummy for Mandatory IAS adopters * Dummy for Post-mandatory
adoption period * Dummy for Strong enforcement + α
9
*Private placement + α
10
*OTC listing+ α
11
*Exchange listing + α
12
*Inflation + α
13
*Log_total assets +
α
14
*Leverage + α
15
*Return variability + α
m
*DIndustry + α
n
*DCountry + ε
33
6.2 Investigating the Mechanisms through Which Mandatory IAS Adoption Affects
the Cost of Equity Capital
Proponents of IAS argue that a common financial language, when applied properly,
can reduce firms’ cost of equity through two non-mutually exclusive mechanisms:
improved financial disclosure and enhanced comparability of financial information
(Tweedie 2006). This section tests whether these two mechanisms do indeed appear to
be responsible for the reduction in the cost of equity by including variables in the
regression analysis that capture the extent to which IAS adoption is likely to increase
disclosure and enhance comparability.
I measure the extent to which IAS adoption increases financial disclosure using the
number of additional disclosures required by IAS (GAAP 2001), with a larger number
indicating a greater increase in disclosure level.
21
For example, the measure of increased
financial disclosure for Austria has a value of eight, because IAS requires eight additional
financial disclosures that are not mandatory under the Austrian accounting standards,
e.g., disclosures of a cash flow statement and earnings per share. I measure the extent to
which IAS adoption enhances information comparability using the number of
inconsistencies between local GAAP and IAS (GAAP 2001), with a larger number of
inconsistencies indicating a greater increase in information comparability.
22
For
21
I also use an alternative measure for increased disclosure, i.e., the number of analysts following a firm
multiplied by firm size in the year before mandatory adoption (Covrig et al. 2007), with a larger number
indicating a smaller increase in disclosure level due to mandatory IAS adoption. The results in Table 5
Panel C are robust to using this measure, except that the change in the cost of equity for mandatory
adopters with a small increase in disclosure and in a weak enforcement environment is no longer significant
at two-sided p=0.11.
22
I also use an alternative measure for enhanced comparability, i.e., the average percentage of voluntary
IAS users in a given industry in the pre-mandatory adoption period (Daske et al. 2007b), with a larger
percentage indicating a smaller increase in information comparability due to mandatory IAS adoption, with
34
example, the measure of enhanced comparability for Austria has a value of 20, because
there are 20 major inconsistencies between the Austrian rules and IAS. One example of
these inconsistencies is that inventories are valued at the lowest of cost, net realizable
value, and replacement cost under the Austrian rules, but are valued at the lowest of cost
and realizable value under IAS. As a result, financial information regarding inventory
values is not directly comparable between the Austrian standards and IAS.
I create dummy variables capturing the increased disclosure and enhanced
comparability measures based on whether a country-specific value is above or below the
sample country median and then rerun the multivariate regression in equation (1) after
including the disclosure and comparability dummies, along with the enforcement dummy
variable and their interaction with the IAS adopter dummy and the adoption period
dummy. Using the resulting estimated regression coefficients, I reconstruct two-by-two
tables that compare the change in the cost of equity in countries with a large versus small
increase in disclosure and comparability, conditioned on the strength of the enforcement
environment. Because the primary analysis in Table 4 finds a significant reduction in the
cost of equity only for mandatory adopters, I restrict the analysis to mandatory adopters.
Table 5 summarizes the results of these additional analyses. Panel A reports the
descriptive statistics on the disclosure and comparability variables, and indicates that the
sample countries vary significantly in terms of increased disclosure and enhanced
comparability from mandatory IAS adoption. For example, Ireland and the U.K. have the
smallest number of additional disclosures required by IAS (zero) while Greece and Spain
industry classification as in Campbell (1996). The results in Table 5 Panel D are robust to using this
alternative measure.
35
have the largest (nine). Also, the Netherlands has the smallest number of inconsistencies
between local GAAP and IAS (five) while Spain has the largest (22).
Panel C of Table 5 presents the results for the full sample partitioned on the increase
in disclosures due to IAS adoption and the strength of the legal enforcement environment.
Consistent with the results in the prior section, mandatory adopters experience a
reduction in the cost of equity after 2005 only in strong enforcement environments (with
two-sided p<1%). Further, in countries with strong legal enforcement, the reduction in
the cost of equity is significantly greater among mandatory adopters in countries with a
large increase in disclosures than in counties with a small increase in disclosures (-1.60%
vs. -0.79%, with two-sided p<5%). This result is consistent with increased disclosure
helping to explain why IAS adoption reduces the cost of equity. In addition, mandatory
adopters in countries with weak enforcement mechanisms and a small increase in
disclosures from mandatory IAS adoption actually experience an increase in their cost of
equity (with two-sided p<10%), consistent with more discretion afforded under IAS
having a detrimental effect to shareholders when the standards are not properly enforced.
Finally, mandatory adopters in countries with weak enforcement mechanisms and a large
increase in disclosures from mandatory IAS adoption experience no significant change in
their cost of equity after 2005.
Panel D of Table 5 presents the results for the full sample partitioned on the increase
in comparability due to IAS adoption and the strength of the legal enforcement
environment. Again, consistent with the results above, mandatory adopters experience a
reduced cost of equity after 2005 only in strong enforcement environments (with two-
36
Table 5 Panel C: Increased Disclosure as a Mechanism behind the Cost of Equity Effects of Mandatory IAS Adoption
Diff. Diff.
-0.79% *** -1.60% ***
Diff. Diff.
0.32% * -0.18% 8.95% 8.78%
N=1,028 N=391 N=557 N=210
Mandatory
adopters
8.28% 8.60% Mandatory
adopters
Pre-mandatory
adoption (1995-
2004)
Post-mandatory
adoption (2005-
2006)
Pre-mandatory
adoption (1995-
2004)
Post-mandatory
adoption (2005-
2006)
Small increase in disclosures due to IAS adoption and
Weak enforcement
Large increase in disclosures due to IAS adoption and
Weak enforcement
9.17% 7.58%
N=2,459 N=693 N=361 N=143
Mandatory
adopters
9.70% 8.91%
Mandatory
adopters
Pre-mandatory
adoption (1995-
2004)
Post-mandatory
adoption (2005-
2006)
Pre-mandatory
adoption (1995-
2004)
Post-mandatory
adoption (2005-
2006)
Small increase in disclosures due to IAS adoption and
Strong enforcement
Large increase in disclosures due to IAS adoption and
Strong enforcement
Regression model in Panel C: (firm and year subscripts are suppressed):
Cost of equity capital = α
1
*Dummy for Voluntary IAS adopters + α
2
*Dummy for Mandatory IAS adopters + α
3
*Dummy for Voluntary IAS adopters * Dummy for
Post-mandatory adoption period + α
4
*Dummy for Mandatory IAS adopters * Dummy for Post-mandatory adoption period + α
5
*Dummy for Voluntary IAS
adopters * Dummy for a large increase in disclosures + α
6
*Dummy for Mandatory IAS adopters * Dummy for a large increase in disclosures + α
7
*Dummy for
Voluntary IAS adopters * Dummy for Post-mandatory adoption period * Dummy for a large increase in disclosures + α
8
*Dummy for Mandatory IAS adopters *
Dummy for Post-mandatory adoption period * Dummy for a large increase in disclosures + α
9
*Dummy for Voluntary IAS adopters * Dummy for Strong
enforcement + α
10
*Dummy for Mandatory IAS adopters * Dummy for Strong enforcement + α
11
*Dummy for Voluntary IAS adopters * Dummy for Post-
mandatory adoption period * Dummy for Strong enforcement + α
12
*Dummy for Mandatory IAS adopters * Dummy for Post-mandatory adoption period *
Dummy for Strong enforcement + α
13
*Dummy for Voluntary IAS adopters * Dummy for Strong enforcement * Dummy for a large increase in disclosures +
α
14
*Dummy for Mandatory IAS adopters * Dummy for Strong enforcement * Dummy for a large increase in disclosures + α
15
*Dummy for Voluntary IAS
adopters * Dummy for Post-mandatory adoption period * Dummy for Strong enforcement * Dummy for a large increase in disclosures + α
16
*Dummy for
Mandatory IAS adopters * Dummy for Post-mandatory adoption period * Dummy for Strong enforcement * Dummy for a large increase in disclosures +
α
17
*Private placement + α
18
*OTC listing+ α
19
*Exchange listing + α
20
*Inflation + α
21
*Log_total assets + α
22
*Leverage + α
23
*Return variability + α
m
*DIndustry
+ α
n
*DCountry + ε
37
Table 5 Panel D: Increased Comparability as a Mechanism behind the Cost of Equity Effects of Mandatory IAS Adoption
Diff. Diff.
-0.80% *** -2.02% ***
Diff. Diff.
-0.77% 0.23% 8.30% 8.52%
N=145 N=45 N=1,440 N=556
Mandatory
adopters
9.08% 8.31%
Mandatory
adopters
Pre-mandatory
adoption (1995-
2004)
Post-mandatory
adoption (2005-
2006)
Pre-mandatory
adoption (1995-
2004)
Post-mandatory
adoption (2005-
2006)
Small increase in comparability due to IAS adoption and
Weak enforcement
Large increase in comparability due to IAS adoption and
Weak enforcement
9.34% 7.32%
N=2,604 N=735 N=216 N=101
Mandatory
adopters
9.71% 8.91%
Mandatory
adopters
Small increase in comparability due to IAS adoption and
Strong enforcement
Large increase in comparability due to IAS adoption and
Strong enforcement
Pre-mandatory
adoption (1995-
2004)
Post-mandatory
adoption (2005-
2006)
Pre-mandatory
adoption (1995-
2004)
Post-mandatory
adoption (2005-
2006)
Regression model in Panel D: (firm and year subscripts are suppressed):
Cost of equity capital = α
1
*Dummy for Voluntary IAS adopters + α
2
*Dummy for Mandatory IAS adopters + α
3
*Dummy for Voluntary IAS adopters * Dummy for
Post-mandatory adoption period + α
4
*Dummy for Mandatory IAS adopters * Dummy for Post-mandatory adoption period + α
5
*Dummy for Voluntary IAS
adopters * Dummy for a large increase comparability + α
6
*Dummy for Mandatory IAS adopters * Dummy for a large increase comparability + α
7
*Dummy for
Voluntary IAS adopters * Dummy for Post-mandatory adoption period * Dummy for a large increase in comparability + α
8
*Dummy for Mandatory IAS adopters
* Dummy for Post-mandatory adoption period * Dummy for a large increase comparability + α
9
*Dummy for Voluntary IAS adopters * Dummy for Strong
enforcement + α
10
*Dummy for Mandatory IAS adopters * Dummy for Strong enforcement + α
11
*Dummy for Voluntary IAS adopters * Dummy for Post-
mandatory adoption period * Dummy for Strong enforcement + α
12
*Dummy for Mandatory IAS adopters * Dummy for Post-mandatory adoption period *
Dummy for Strong enforcement + α
13
*Dummy for Voluntary IAS adopters * Dummy for Strong enforcement * Dummy for a large increase in comparability +
α
14
*Dummy for Mandatory IAS adopters * Dummy for Strong enforcement * Dummy for a large increase in comparability + α
15
*Dummy for Voluntary IAS
adopters * Dummy for Post-mandatory adoption period * Dummy for Strong enforcement * Dummy for a large increase in comparability + α
16
*Dummy for
Mandatory IAS adopters * Dummy for Post-mandatory adoption period * Dummy for Strong enforcement * Dummy for a large increase in comparability +
α
17
*Private placement + α
18
*OTC listing+ α
19
*Exchange listing + α
20
*Inflation + α
21
*Log_total assets + α
22
*Leverage + α
23
*Return variability + α
m
*DIndustry
+ α
n
*DCountry + ε
38
sided p<1%). Importantly, in countries with strong legal enforcement, the reduction in
the cost of equity is significantly greater among mandatory adopters in countries with a
large increase in comparability than in countries with a small increase in comparability (-
2.02% vs. -0.80%, with two-sided p<1%). This result is consistent with increased
comparability helping to explain why IAS adoption reduces the cost of equity. Finally,
mandatory adopters in countries with weak enforcement mechanisms experience no
significant change in their cost of equity after 2005, regardless of the increase in
comparability from mandatory IAS adoption.
In summary, the findings in Panel C and D of Table 5 provide evidence consistent
with both increased disclosure and enhanced comparability helping to explain why
mandatory IAS adoption reduces the cost of equity capital. The results in these panels
also reinforce the importance of strong legal enforcement in achieving a cost of equity
capital reduction as a result of mandatory IAS adoption.
39
Chapter 7: Robustness Checks
7.1 Distinguishing between Voluntary Adopters That Adopted IAS Relatively Early
and Voluntary Adopters That Adopted IAS Relatively Late
In June 2002, the Council of the European Union adopted the IAS Regulation
requiring all EU-listed firms to prepare their consolidated accounts in accordance with
IAS from 2005 onwards. In addition, firms in some countries were allowed to adopt IAS
early, in anticipation of the mandatory IAS introduction in 2005. Accordingly, I perform
additional tests to check whether my primary findings are impacted by classifying
voluntary adopters as either early or late voluntary adopters. Following Daske et al.
(2007b), I distinguish early voluntary adopters (firms that adopt IAS before June 2002)
from late voluntary adopters (firms that do not adopt IAS until June 2002 or later but
before 2005). I then rerun the multivariate regression analysis in equation (1) by
regressing the cost of equity capital on dummy variables capturing three types of adopters
(mandatory, early voluntary and late voluntary) and their interactions with the post-
mandatory adoption period. Based on these regression coefficients, Table 6 Panel A
reports the reconstructed coefficients and the significance levels in a three-by-two
analysis for the full sample period.
This analysis finds that while mandatory adopters experience a significant reduction
in their cost of equity after 2005, neither early nor late voluntary adopters experience any
significant change in their cost of equity around the mandatory switch. Panel A also
finds that while the cost of equity among these three types of adopters differs
significantly in the pre-mandatory adoption period, this difference between mandatory
adopters and late voluntary adopters narrows after the mandatory adoption. Additionally,
40
after excluding the transition period, the results in Panel B of Table 6 are generally
consistent with Panel A except that there is a greater convergence in the cost of equity
among the three types of adopters in the post-mandatory adoption period. Thus, the
results in Table 6 suggest that early voluntary adopters enjoy a lower cost of equity than
late voluntary adopters prior to 2005, but that the mandatory IAS introduction does not
appear to affect the cost of equity capital for either subset of voluntary adopters,
consistent with voluntary adopters experiencing no significant change in the cost of
equity around the mandatory switch.
Table 6: Distinguishing Early versus Late Voluntary Adopters
Panel A: Analysis Using Full Sample Period (1995-2006)
Pre-mandatory
adoption (1995-
2004)
Post-mandatory
adoption (2005-
2006)
Diff.
9.32% 8.85% -0.47% ***
A
Mandatory
adopters
N=4,431 N=1,447
8.84% 9.12% 0.28%
B
Late Voluntary
adopters
N=232 N=74
8.02% 7.86% -0.16%
C
Early Voluntary
adopters
N=221 N=51
A-B
0.48% ** -0.27% -0.75% *
A-C
1.30% *** 0.99% ** -0.31%
Diff.
B-C 0.82% *** 1.26% ** 0.44%
41
Panel B: Analysis after Excluding Transition Period (2004 and 2005)
Pre-mandatory
adoption (1995-
2003)
Post-mandatory
adoption (2006)
Diff.
9.82% 8.96% -0.86% ***
A
Mandatory
adopters
N=2,003 N=497
9.09% 8.99% -0.10%
B
Late Voluntary
adopters
N=136 N=32
8.27% 7.67% -0.60%
C
Early Voluntary
adopters
N=154 N=24
A-B
0.73% ** -0.03% -0.76%
A-C
1.55% *** 1.29% * -0.26%
Diff.
B-C 0.82% ** 1.32% 0.50%
Table 6 reports the analysis of mandatory adopters versus late voluntary adopters versus early voluntary
adopters by period. The tables are constructed using coefficients from the pooled regression as follows.
Panel A reports the analysis for the full sample of 6,456 firm-year observations from 1995 to 2006. Panel B
reports the analysis for the sample after excluding the transition period, leaving 2,846 firm-year
observations from 1995 to 2003 and 2006. * denotes significant at the 10% level, ** denotes significant at
the 5% level, and *** denotes significant at the 1% level, all two-sided.
Regression model: (firm and year subscripts are suppressed):
Cost of equity capital = α
1
*Dummy for Mandatory IAS adopters + α
2
*Dummy for Late voluntary IAS
adopters + α
3
*Dummy for Early voluntary IAS adopters + α
4
*Dummy for Mandatory IAS adopters *
Dummy for Post-mandatory adoption period + α
5
*Dummy for Late voluntary IAS adopters * Dummy for
Post-mandatory adoption period + α
6
*Dummy for Early voluntary IAS adopters * Dummy for Post-
mandatory adoption period + α
7
*Private placement + α
8
*OTC listing+ α
9
*Exchange listing +
α
10
*Inflation + α
11
*Log_total assets + α
12
*Leverage + α
13
*Return variability + α
m
*DIndustry +
α
n
*DCountry + ε
Variable definitions:
Dummy for late voluntary IAS adopters: a dummy variable equal to one if a firm adopts IAS after June
2002 but before 2005, and zero otherwise.
Dummy for early voluntary IAS adopters: a dummy variable equal to one if a firm does not adopt IAS until
June 2002, and zero otherwise.
Dummy for late voluntary IAS adopters* Dummy for post-mandatory adoption period: the interaction term
between the two dummy variables.
Dummy for early voluntary IAS adopters* Dummy for post-mandatory adoption period: the interaction
term between the two dummy variables.
All other variables are defined as in Table 4.
42
7.2 Controlling for Potential Self-selection Bias in the Pre-mandatory Adoption
Period
As suggested in prior research, firms that voluntarily adopt IAS do not represent a
randomly selected sample (Leuz and Verrecchia 2000). As a result, the cross-sectional
comparison between voluntary versus mandatory adopters in the pre-mandatory period is
subject to potential self-selection bias. I therefore implement the Heckman (1979) two-
stage regression procedure to control for the self-selection effect. For the sample period
1995 to 2004, the first stage models the voluntary adopters’ decisions to follow IAS by
estimating a probit model in which the dependent variable is a dummy variable with a
value of one for voluntary adopters and zero for mandatory adopters, and the independent
variables are the factors influencing firms’ voluntary IAS adoption decisions: financial
performance (ROA), firm size (log of market value of equity), whether the firm is cross-
listed in the U.S., financing needs (earnings growth), industry competitiveness (industry
Herfindahl index), country-specific regulations regarding IAS adoption (with a value of
two if a country requires IAS, one if a country permits IAS, and zero if a country does not
permit IAS, according to Deloitte 2003), as well as industry and year fixed effects.
23
In
the second stage, I include the Inverse Mills Ratio from the first stage as an additional
explanatory variable, and regress the cost of equity on the dummy variable for voluntary
adopters and the same set of control variables as in equation (1).
The results (not tabulated) show that in the first stage the coefficients on size,
earnings growth and the country-specific IAS regulations are significantly positive while
the coefficient on ROA is significantly negative (with two-sided p<5%). This indicates
23
These independent variables are selected based on prior studies such as Harris and Muller (1999) and
Leuz and Verrecchia (2000).
43
that firms that are larger, with more financing needs, in a more lax regulation
environment, and performing poorly are more likely to follow IAS voluntarily. The
second-stage regression indicates that, after controlling for the self-selection bias,
mandatory adopters still have a significantly higher cost of equity than voluntary adopters
prior to 2005 (with two-sided p<5%).
24
Thus, the conclusion on the cross-sectional
differences in the cost of equity between mandatory and voluntary adopters in the pre-
mandatory adoption period is robust to controlling for the self-selection effect.
7.3 Controlling for Differences in Analyst Forecast Properties
Prior research shows that analyst forecasting behavior differs over time and across
industries and countries, and that this may affect the implied cost of capital estimates
(Easton and Monahan 2005). While I include fixed effects in the model to pick up these
effects, I also test whether the primary results are sensitive to these forecasting
differences. Specifically, I repeat the multivariate regression analyses in section V and
VI after including proxies for forecast bias (the difference between the earnings forecast
and actual earnings deflated by the price as of last fiscal year-end), forecast accuracy
(absolute value of forecast bias), and earnings growth projections (forecasted one-year-
ahead earrings growth rate). The results (not tabulated) are consistent with those reported
in Table 4 and 5.
25,26
Thus, the primary conclusion is robust to controlling for differences
in analyst forecast properties.
24
The results are quantitatively similar for the sample that excludes the transition period.
25
I define “results consistent with those reported in Table 4” to mean that (1) the first row difference and
the first column difference in the two-by-two analysis for the full sample as well as for the sample after
excluding the transition period are significantly positive at p<10% (two-sided), and (2) the second row
difference and the second column difference in the two-by-two analysis for the full sample as well as for
the sample after excluding the transition period are not significant at conventional levels.
44
7.4 Controlling for Nominal Risk-free Interest Rates and Using Risk Premiums
Instead of Cost of Equity Capital Measures
The tests in Table 4 and 5 control for expected inflation rates under the assumption
that these are the only source causing variation in nominal risk-free rates. However,
another source of variation is that real interest rates vary over time and across countries,
which affects the cost of equity capital. Following prior studies (e,g, Hail and Leuz
2006a, b), I explicitly control for the local nominal risk-free rates, computed as the
country-year median of the monthly risk-free interest rates using yields of local treasury
bills, central bank papers, or inter-bank loans provided by Datastream. Furthermore, I
use the risk premium computed by subtracting the expected inflation rates (or the
nominal risk-free interest rates) from the raw implied cost of equity capital estimates as
the dependent variable, instead of including the inflation rates (or the nominal risk-free
interest rates) as separate control variables. These sensitivity analyses (not tabulated)
find results consistent with those reported in Table 4 and 5. Thus, the primary conclusion
is robust to controlling for nominal risk-free interest rates and using risk premiums
instead of the cost of equity capital measures.
26
I define “results consistent with those reported in Table 5” to mean that (1) mandatory adopters
experience a significant reduction in the cost of equity after mandatory IAS adoption only in countries with
strong enforcement environment (two-sided p<10%) in Panel B, (2) mandatory adopters in strong
enforcement countries experience a significantly larger reduction in the cost of equity after mandatory IAS
adoption if they have a larger increase in disclosures due to mandatory IAS adoption (two-sided p<10%),
and mandatory adopters in weak enforcement countries either experience no significant change or an
increase in the cost of equity after mandatory IAS adoption in Panel C, and (3) mandatory adopters in
strong enforcement countries experience a significantly larger reduction in the cost of equity after
mandatory IAS adoption if they have a larger increase in comparability due to mandatory IAS adoption
(two-sided p<10%), and mandatory adopters in weak enforcement countries either experience no
significant change or an increase in the cost of equity after mandatory IAS adoption in Panel D.
45
7.5 Controlling for Differences in Growth Expectations
Two of the valuation models used to estimate the implied cost of equity measures
make certain assumptions about the growth in abnormal earnings beyond explicit forecast
horizons (i.e., r
gm
in Gode and Mohanram (2003) and r
ct
in Claus and Thomas (2001)).
However, growth expectations might be different between mandatory and voluntary
adopters and/or before and after the mandatory switch, which can bias the cost of equity
estimates and mechanically produce the desired results (Hail and Leuz 2006a, b). To
check whether the results in Table 4 and 5 are robust to controlling for these differential
growth expectations, I include as additional explanatory variables analysts’ long-run EPS
growth estimates provided by I/B/E/S, analysts’ one-year-ahead forecasted growth rates
in EPS, and ex post realized growth rates, computed as the historic two-year geometric
average of annual percentage growth in net sales (Hail and Leuz 2006a). These
sensitivity analyses (not tabulated) find results consistent with those reported in Table 4
and 5. Thus, the primary conclusion is robust to controlling for differences in growth
expectations.
7.6 Excluding Observations from Countries with No Voluntary Adopters
The sample distribution by country in Table 1 Panel A indicates that ten countries
have no voluntary IAS adopters during 1995 to 2004. To ensure that the cost of equity
effects of mandatory IAS adoption are not driven by these countries without any
voluntary adopters, I exclude observations in these ten countries and repeat the
multivariate regression analyses in section V and VI. The analysis (not tabulated) finds
results consistent with those reported in Table 4 and 5. Thus, the primary conclusion is
robust to excluding observations from sample countries with no voluntary IAS adopters.
46
7.7 Excluding Observations That Are Listed in Germany’s New Market
Firms listed in Germany’s New Market have to use IAS or U.S. GAAP in preparing
their financial statements (Leuz 2003). As a result, these firms could be inherently
different from other voluntary IAS users. I therefore exclude these observations and
repeat the multivariate regression analyses in section V and VI. The analyses (not
tabulated) find results consistent with those reported in Table 4 and 5. Thus, the primary
conclusion is robust to excluding firms listed in the German New Market.
7.8 Excluding Observations That Use U.S. GAAP
Prior studies suggest insignificant differences between U.S. GAAP and IAS in
producing high quality financial information (Leuz 2003). To ensure that my results are
not driven by observations using U.S. GAAP, I exclude these observations and repeat the
multivariate regression analyses in section V and VI. The analyses (not tabulated) find
results consistent with those reported in Table 4 and 5. Thus, the primary conclusion is
robust to excluding observations using U.S. GAAP.
7.9 Excluding Utilities and Firms in the Financial Services Industry
Relative to industrial firms, utilities and banks are subject to different regulations and
thus may experience a different cost of equity impact as a result of mandatory IAS
adoption. To ensure that my results are not driven by these regulated firms, I exclude
firms in the financial services and utilities industries (SIC codes 4900-4999 and 6000-
6999) and repeat the multivariate regression analyses in section V and VI. The analyses
(not tabulated) find results consistent with those reported in Table 4 and 5.
27
Thus, the
27
One exception is that, in Panel D of Table 5, mandatory adopters in countries with weak enforcement and
with a small increase in comparability experience a reduction in the cost of equity after mandatory IAS
adoption (two-sided p=0.07).
47
primary conclusion is robust to excluding utilities and firms in the financial services
industry.
7.10 Restricting the Pre-mandatory IAS Adoption Sample Period to 1999 to 2004
By the end of 1998, the International Accounting Standards Committee (IASC)
completed the Core Standards Project, which led to substantial revisions to IAS. As a
result, the quality of the IAS standards and the resulting financial reporting and disclosure
may have improved along with these revisions (Holthausen 2003). To explore whether
the results in Table 4 are sensitive to the standards revisions, I restrict the pre-mandatory
adoption sample period to 1999 to 2004 and repeat the multivariate regression analyses in
section V and VI. The analyses (not tabulated) find results consistent with those reported
in Table 4 and 5. Thus, the primary conclusion is robust to varying the pre-mandatory
adoption period.
7.11 Excluding IAS Adopters in Austria after 2001 and in Greece after 2002
All domestically listed companies in Austria and Greece are required to follow IAS
beginning in 2002 and 2003, respectively (Deloitte 2003).
28
To ensure that my results are
not driven by these adopters, I exclude the firms that adopt IAS in Austria (and Greece)
after 2002 (and 2003) and repeat the multivariate regression analyses in section V and VI.
The analysis (not tabulated) finds results consistent with those reported in Table 4 and 5.
Thus, the primary conclusion is robust to excluding firms adopting IAS in Austria
beginning in 2002 and in Greece beginning in 2003.
28
In Austria, the Vienna Stock Exchange requires all domestic and foreign companies listed on the A-
Market and the Austrian Growth Market (AGM) to submit consolidated financial statements under either
IAS or U.S. GAAP since April 2001. Other listed companies are permitted to use IAS or U.S. GAAP or
they may use Austrian GAAP (for details see http://www.iasplus.com/country/austria.htm#0105).
48
Chapter 8: Conclusion
This study explores the cost of equity effects of mandatory IAS adoption in the
European Union. I find that, on average, mandatory adopters experience a significant
reduction in the cost of equity of 48 basis points after the mandatory introduction of IAS
in 2005. Voluntary adopters, in contrast, do not experience any significant change in the
cost of equity after the mandatory introduction of IAS in 2005. Additional analysis finds
that mandating IAS has a significant cost of equity impact only in countries with strong
enforcement mechanisms, consistent with the quality of legal enforcement being an
important factor for effective accounting changes. I further identify two channels
through which mandatory IAS adoption reduces the cost of equity: increased disclosure
and enhanced comparability.
This study is subject to several caveats. First, prior research suggests that it is
difficult to empirically measure the cost of equity capital, and various proxies are shown
to have different advantages and drawbacks (e.g., Easton and Monahan 2005). For this
reason, although the implied cost of equity is arguably more suitable in the cross-country
setting (Hail and Leuz 2006a), and my results are robust to many sensitivity checks, the
findings should nevertheless be interpreted with caution. Second, compared to the longer
time period of voluntary adoption (1995 to 2004), the mandatory adoption period
examined in this study is limited to two years, i.e., 2005 and 2006 due to data availability.
Thus, the results may not fully capture the long-run cost of equity consequences of
mandatory IAS adoption, and hence should be interpreted as preliminary. Finally, as the
EU countries have been making continuous efforts to strengthen their legal and
enforcement systems along with mandating IAS, the finding of a reduced cost of equity
49
might be a joint outcome of IAS adoption and recent improvements in enforcement and
governance. However, to the extent that the enforcement and governance improvement
in strong enforcement environments is not systematically greater than the improvement in
weak enforcement environments, the improvement in institutional environments is less
likely to be responsible for the main results in this paper.
29
29
To illustrate, I compare the rule of law index in 2006 versus 1996 (Kaufmann et al. 2007) for strong and
weak enforcement environments, and find that the index remains statistically unchanged in both
environments, consistent with the notion that countries’ institutional environments tend to change slowly
over time (Burgstahler et al. 2006).
50
REFERENCES
Amihud, Y., and H. Mendelson. 1986. Asset pricing and the bid-ask spread. Journal of
Financial Economics 17: 223-249.
Armstrong, C., M. Barth, A. Jagolinzer, and E. J. Riedl. 2007. Market reaction to the
adoption of IFRS in Europe. Working paper, Stanford University and Harvard
Business School.
Ashbaugh, H. 2001. Non-US firms’ accounting standard choices. Journal of Accounting
and Public Policy 20: 129-153.
Ashbaugh, H., and M. Pincus. 2001. Domestic accounting standards, International
Accounting Standards, and the predictability of earnings. Journal of Accounting
Research 39: 417-434.
Bekaert, G., and C. Harvey. 2000. Foreign speculators and emerging equity
markets. Journal of Finance 55: 565–613.
Ball, R., A. Robin, and J. Wu. 2003. Incentives versus standards: Properties of
accounting income in four East Asian countries. Journal of Accounting and
Economics 36: 235-270.
Barry, C., and S. Brown. 1985. Differential information and security market equilibrium.
Journal of Financial and Quantitative Analysis 20: 407-422.
Barth, M., G. Clinch, and T. Shibano. 1999. International accounting harmonization and
global equity markets. Journal of Accounting and Economics 26: 201-235.
Barth, M., Y. Konchitchki, and W. Landsman. 2007a. Cost of capital and financial
statement transparency. Working paper, Stanford University and University of North
Carolina.
Barth, M., W. Landsman, and M. Lang. 2007b. International Accounting Standards and
accounting quality. Working paper, Stanford University and University of North
Carolina.
Bekaert, G., and C. Harvey. 2000. Foreign speculators and emerging equity markets.
Journal of Finance 55: 565-613.
Bhattacharya, U., H. Daouk, and M. Welker. 2003. The world price of earnings opacity.
The Accounting Review 78: 641-678.
Botosan, C. 1997. Disclosure level and the cost of equity capital. The Accounting Review
72: 323-349.
51
Burgstahler, D., L. Hail, and C. Leuz. 2006. The importance of reporting incentives:
earnings management in European private and public firms. The Accounting Review
81: 983-1016.
Burt, T., and U. Harnischfeger. VW Switches Accounting Model. Financial Times,
2/21/2000.
Campbell, J. 1996. Understanding risk and return. Journal of Political Economy 104:
298-345.
Claus, J., and J. Thomas. 2001. Equity premia as low as three percent? Evidence from
analysts’ earnings forecasts for domestic and international stock markets. Journal of
Finance 56: 1629-1666.
Coffee, J. 1984. Market failure and the economic case for a mandatory disclosure system.
Virginia Law Review 70: 717–753.
Covrig, V., M. DeFond, and M. Hung. 2007. Home bias, foreign mutual fund holdings,
and the voluntary adoption of International Accounting Standards. Journal of
Accounting Research 45: 41-70.
Daske, H., L. Hail, C. Leuz, and R. Verdi. 2007a. Adopting a label: Heterogeneity in the
economic consequences of IFRS adoptions. Working paper, Goethe University of
Frankfurt, the Wharton School, University of Chicago, and MIT.
Daske, H., L. Hail, C. Leuz, and R. Verdi. 2007b. Mandatory IFRS reporting around the
world: Early evidence on the economic consequences. Working paper, University of
Mannheim, the Wharton School, University of Chicago, and MIT.
Diamond, D., and R. Verrecchia. 1991. Disclosure, liquidity and the cost of capital.
Journal of Finance 66: 1325-1355.
Deloitte. IFRS in Your Pocket 2003, 2005. Deloitte Touche Tohmatsu. 2003, 2005.
Dye, R. 1990. Mandatory versus voluntary disclosure: The cases of real and financial
externalities. The Accounting Review 65: 1-24.
Easley, D., and M. O’Hara. 2004. Information and the cost of capital. Journal of Finance
59: 1553-1583.
Easton, P. 2004. PE ratios, PEG ratios, and estimating the implied expected rate of
returns on equity capital. The Accounting Review 79: 73-95.
Easton, P., and S. Monahan. 2005. An evaluation of accounting based measures of
expected returns. The Accounting Review 80: 501-538.
52
Fama, E., and K. French. 1992. The cross sections of expected stock returns. Journal of
Finance 47: 427-466.
Fama, E., and K. French. 1993. Common risk factors on the returns of stocks and bonds.
Journal of Financial Economics 33: 3-57.
Fama, E., and K. French. 1997. Industry costs of equity. Journal of Financial Economics
43: 153–194.
Fama, E., and K. French. 2002. The equity premium. Journal of Finance 57: 637–659.
Francis, J.R., I. Khurana, and R. Pereira. 2005. Disclosure incentives and effects on cost
of capital around the world. The Accounting Review 80: 1125-1163.
GAAP. 2001. A survey of national accounting rules benchmarked against International
Accounting Standards. Anderson, BDO, Deloitte Touche Tohmatsu, Ernst & Young,
Grant Thornton, KPMG, PricehouseCoopers, Editor Christopher W Nobes.
Gebhardt, R., C. Lee, and B. Swaminathan. 2001. Toward an ex ante cost-of-capital.
Journal of Accounting Research 39: 135-176.
Gode, D., and P. Mohanram. 2003. Inferring cost of capital using the Ohlson-Juettner
model. Review of Accounting Studies 8: 399-431.
Hail, L., and C. Leuz. 2006a. Cost of capital and cash flow effects of U.S. cross-listings.
Working paper, the Wharton School.
Hail, L., and C. Leuz. 2006b. International differences in the cost of equity capital: Do
legal institutions and securities regulation matter? Journal of Accounting Research
44: 485-531.
Harris, M., and K. Muller. 1999. The market valuation of IAS vs. U.S. GAAP accounting
measures using Form 20-F reconciliations. Journal of Accounting and Economics 26:
285-312.
Harvey, C. 1995. Predictable risk and returns in emerging markets. Review of Financial
Studies 8: 773-816.
Healy, P., and K. Palepu. 2001. Information asymmetry, corporate disclosure, and the
capital markets: A review of the empirical disclosure literature. Journal of Accounting
and Economics 31: 405-440.
Heckman, J. 1979. Sample selection bias as a specification error. Econometrica 47: 153-
161.
53
Holthausen, R. 2003. Testing the relative power of accounting standards versus
incentives and other institutional features to influence the outcome of financial
reporting in an international setting. Journal of Accounting and Economics 36: 271-
283.
Hung, M., and K.R. Subramanyam. 2007. Financial statement effects of adopting
International Accounting Standards: The case of Germany. Review of Accounting
Studies 12: 623-657.
Kaufmann, D., A. Karaay, and M. Mastruzzi. 2007. Governance matters VI: Aggregate
and individual governance indicators 1996-2006. Working paper, the World Bank.
La Porta, R., F. Lopez-de-Silanes, and A. Shleifer. 2006. What works in securities laws?
Journal of Finance 61: 1-32.
Lambert, R., C. Leuz, and R. Verrecchia. 2007. Accounting information, disclosure, and
the cost of capital. Journal of Accounting Research 45: 385-420.
Leuz, C. 2003. IAS vs. U.S. GAAP: Information asymmetry-based evidence from
Germany’s New Market. Journal of Accounting Research 41: 445-472.
Leuz, C., and R. Verrecchia. 2000. The economic consequences of increased disclosure.
Journal of Accounting Research 38: 91-124.
Stulz, R. 1999. Globalization, corporate finance, and the cost of capital. Journal of
Applied Corporate Finance 12: 8-25.
Sunder, S. 2007. Uniform financial reporting standards: Reconsidering the top-down
push. The CPA Journal 77: 6-9.
Tweedie, D. 2006. Prepared statement of Sir David Tweedie, Chairman of the
International Accounting Standards Board before the Economic and Monetary Affairs
Committee of the European Parliament.
http://www.iasplus.com/resource/0601tweedieeuspeech.pdf
Tweedie, D., and T. Seidenstein. 2005. Setting a global standard: The case for accounting
convergence. Northwestern Journal of International Law and Business 25: 589-608.
54
APPENDIX
Estimates of Implied Cost of Equity Capital
1. Gebhardt, Lee and Swaminathan (2001): r
GLS
11
11
12
11
1
) 1 ( ) 1 (
+
+
=
+
+
−
+
+
−
+ =
∑ t
GLS GLS
GLS t
t
GLS
GLS t
t t
BV
r r
r FROE
BV
r
r FROE
BV P
τ
τ
τ
For the first three years, future ROE is estimated as FROE
t
=FEPS
t
/BV
t-1
. From years 4 through 12, future
ROE is computed by linear interpolation to the sector-specific (industrial, service and financial sectors)
median ROE. Negative ROEs are replaced by the historic three-year average in a given country and year.
Beyond year 12, abnormal earnings are assumed to be constant.
2. Claus and Thomas (2001): r
CT
5
4 5
5
1
) 1 )( (
) 1 )( (
) 1 (
CT CT
t GLS t
t
CT
CT t
t t
r g r
g BV r FROE
BV
r
r FROE
BV P
+ −
+ −
+
+
−
+ =
+ +
=
+
∑
τ
τ
τ
For the first five years, future ROE is estimated as FROE
t
=FEPS
t
/BV
t-1.
Beyond year 5, the abnormal
earnings growth rate g is equal to the expected inflation rate. I use the yearly median of country-specific,
one-year-ahead realized monthly inflation rates.
3. Gode and Mohanram (2003): r
GM
) (
)) * ( (
1 1 1 2 1
g r r
FEPS k FEPS r FEPS FEPS
r
FEPS
P
GM GM
t t GM t t
GM
t
t
−
− − −
+ =
+ + + + +
so, )) 1 ( (
2
0
1 2
− − + + = γ g
P
FEPS
A A r
GM
where,
+ − ≡
0
1
*
) 1 (
2
1
P
FEPS k
A γ ;
1
1 2
2
) (
FEPS
FEPS FEPS
g
−
= .
The long-term growth rate, γ is estimated as the yearly country-specific median of one-year-ahead realized
monthly inflation rates. The model requires positive earnings forecasts.
4. Modified PEG ratio by Easton (2004): r
MPEG
2
1 2 2
*
MPEG
t t MPEG t
t
r
FEPS d r FEPS
P
+ + +
− +
=
This model assumes that abnormal earnings persist in perpetuity. The model requires positive earnings
forecasts.
Notes:
P
t
: stock price at year t.
BV
t
: book value of equity per share at the beginning of year t.
BV
t+τ
: expected future book value of equity per share at the beginning of year t+
τ
, where
BV
t+τ
= BV
t+τ
+FEPS
t+τ
-k* FEPS
t+τ
.
FEPS
t+τ
: expected future earnings per share at year t+
τ
.
FROE
t+τ
: expected future return on equity at year t+
τ
.
k: dividend payout ratio estimated as the historic three-year average for the firm.
Abstract (if available)
Abstract
This paper examines whether the mandatory adoption of International Accounting Standards (IAS) in the European Union (EU) in 2005 reduces the cost of equity capital. Using a sample of 6,456 firm-year observations of 1,084 EU firms during the 1995 to 2006 period, I find evidence that, on average, mandatory introduction of IAS significantly reduces the cost of equity for mandatory adopters by 48 basis points. I also find that this reduction is present only in countries with strong legal enforcement, and that both increased disclosure and enhanced information comparability help explain why IAS reduces the cost of equity. Taken together, these findings suggest that while mandatory IAS adoption benefits shareholders, the benefits depend on the strength of the countries' legal enforcement.
Linked assets
University of Southern California Dissertations and Theses
Conceptually similar
PDF
Does mandatory adoption of international financial reporting standards decrease the voting premium for dual-class shares: theory and evidence
PDF
Accrual quality and expected returns: the importance of controlling for cash flow shocks
PDF
Costs and benefits of "friendly" boards during mergers and acquisitions
PDF
Why go green? Cities' adoption of local renewable energy policies and urban sustainability certifications
PDF
The political economy of implementation: intellectual property rights protection across the world
Asset Metadata
Creator
Li, Siqi
(author)
Core Title
Does mandatory adoption of International Accounting Standards reduce the cost of equity capital?
School
Marshall School of Business
Degree
Doctor of Philosophy
Degree Program
Business Administration
Publication Date
06/11/2008
Defense Date
05/05/2008
Publisher
University of Southern California
(original),
University of Southern California. Libraries
(digital)
Tag
cost of equity capital,International Accounting Standards (IAS),International Financial Reporting Standards (IFRS),OAI-PMH Harvest
Language
English
Advisor
DeFond, Mark (
committee chair
), Hung, Mingyi (
committee chair
), Hsiao, Cheng (
committee member
), Subramanyam, K. R. (
committee member
), Trezevant, Robert (
committee member
)
Creator Email
siqili@usc.edu
Permanent Link (DOI)
https://doi.org/10.25549/usctheses-m1264
Unique identifier
UC1279219
Identifier
etd-Li-20080611 (filename),usctheses-m40 (legacy collection record id),usctheses-c127-69550 (legacy record id),usctheses-m1264 (legacy record id)
Legacy Identifier
etd-Li-20080611.pdf
Dmrecord
69550
Document Type
Dissertation
Rights
Li, Siqi
Type
texts
Source
University of Southern California
(contributing entity),
University of Southern California Dissertations and Theses
(collection)
Repository Name
Libraries, University of Southern California
Repository Location
Los Angeles, California
Repository Email
cisadmin@lib.usc.edu
Tags
cost of equity capital
International Accounting Standards (IAS)
International Financial Reporting Standards (IFRS)