Upload
nicola-moscariello
View
52
Download
1
Embed Size (px)
Citation preview
Capital Market Consequences of European Firms’ Mandatory Adoption of IFRS
Jenice Prather-Kinsey Associate Professor of Accountancy
School of Accountancy College of Business
University of Missouri 324 Cornell Hall
Columbia, MO 65211 Phone: 573-882-3671
E-mail: [email protected]
Eva K. Jermakowicz Professor of Accounting
Department of Accounting and Business Law College of Business
Tennessee State University 330 10th Avenue North
Nashville, TN 37203-3401 Phone: 615-963-7052
E-mail: [email protected]
Thierry Vongphanith Brown Brothers Harriman & CO
Institutional Equities - Strategy Research 140 Broadway
New York, NY 10005-1101 Phone: (212) 493 7949
E-mail: [email protected]
January 2008
Capital Market Consequences of European Firms’ Mandatory Adoption of IFRS
Abstract This paper examines the capital market’s reactions associated with the mandatory adoption of
International Financial Reporting Standards (IFRS) by European firms in 2005. We provide insight on the heterogeneity in capital market consequences from IFRS adoption by investigating the value relevance of book values and information content of earnings announcements of firms before and after IFRS adoption. Additionally, the impact of adopting IFRS on the cost of equity capital is examined. We selected a sample of 157 European firms that implemented IFRS in 2005, used domestic GAAP only for financial reporting in 2004, and reported under IFRS only in 2006. We found that capital market participants consider IFRS adopters’ financial reports more value relevant and informative, and thus resulting in a lower cost of capital after adoption of IFRS. We test whether the heterogeneity in capital market consequences from adopting IFRS can be explained by differences in the legal origin of the country in which firms are domiciled, shareholder rights, and the quality of enforcement. Firms from code law countries experienced more significant market consequences from implementing IFRS than firms from common law countries.
2
Capital Market Consequences of European Firms’ Mandatory Adoption of IFRS
I. Introduction Globalization of the world’s capital markets has created a need for a single set of accounting
standards that can be applied around the world. Such standards should enhance comparability
and transparency of financial information for investors, resulting in greater willingness of
investors to invest across borders, a lower cost of capital, more efficient allocation of resources
and higher economic growth. These have been the goals of the International Accounting
Standards Board (IASB).
The IASB was created in 2001 with objectives of producing a single set of high-quality,
understandable and enforceable International Financial Reporting Standards (IFRS) and
encouraging global convergence on these standards.1 Today almost every country around the
world is moving toward IFRS in some way. Many countries have either adopted IFRS or based
their local standards on IFRS. World-wide, over 100 nations require IFRS-based financial
reporting for listed companies and it is projected that this number will be over 150 by 2011
(Tweedie 2007). It is clear that near-universal use of IFRS by not only the developing nations
(including China, India and Russia), but also by the most economically advanced ones (Canada,
Japan, USA) is merely a question of time. The existence and influence of the IASB are the result
of market demands for global accounting standards focused on user needs - and not upon
preparer, auditor or regulatory convenience (Stevenson 2007).
1 International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board
(IASB) include the International Accounting Standards (IAS) and their interpretations adopted by the IASB from its
predecessor, the International Accounting Standards Committee (IASC).
3
In September 2002, the FASB and the IASB signed the Norwalk Agreement in which
‘each acknowledged their commitment to the development of high quality, compatible
accounting standards that could be used for both domestic and cross-border financial reporting.’
The SEC voted unanimously on November 15, 2007, to eliminate the 20-F requirement for
foreign public issuers to reconcile IFRS financial statements to US GAAP, if the financial
statements are prepared using IFRS as published by the IASB (SEC, 2007a). This decision
signaled the SEC's acknowledgement of the globalization of capital markets and the quality of
the IFRS accounting and reporting framework. In August 2007, the SEC published for comment
a concept release on whether U.S. listed companies should be permitted to report using IFRS
(SEC 2007b). The Commission’s thinking is that if foreign companies have a choice between
IFRS and U.S. GAAP, U.S. companies could be at a competitive disadvantage unless they have
the same option.
All publicly traded companies in the European Union (EU) are required to prepare their
consolidated financial statements in accordance with IFRS from 2005 (EC 2002). Also,
Switzerland, a non-EU member, introduced legislation requiring all multinational companies to
prepare their consolidated financial statements in accordance with IFRS or U.S. GAAP from
2005. The non-EU members of the European Economic Area (EEA), Iceland, Liechtenstein and
Norway, have also agreed to enact the EU Regulation requiring listed companies to report under
IFRS from 2005.
Although EU public companies were required to adopt IFRS from 2005, several
European listed companies switched to IFRS much earlier. In 1998 seven EU nations (Austria,
Belgium, Germany, France, Finland, Italy, and Luxembourg) made provisions allowing
companies under specific prerequisites to use IAS, as well as U.S. GAAP for consolidated
4
financial statements to the extent that they comply with the Fourth and Seventh European
Directives. The application decrees, however, have never been adopted in France and Italy
(Delvaille et al. 2005).
Accounting standards differ across countries. A common belief is that these differences
reduce the quality and relevance of accounting information. The vision behind IFRS is that a
single worldwide set of standards would permit investors anywhere around the world to benefit
from a high level of comparability and a consistently high level of quality in financial reporting.
It would eliminate the need for investors and analysts to try to understand financial statements
that are prepared using different accounting standards from many jurisdictions, and it would
eliminate one of the significant barriers to raising capital outside one's borders (Cox 2007).
Our research investigates the impact of mandatory adoption of IFRS on a sample of 157
European IFRS adopters in 2005, the year in which the largest number of European firms
implemented these standards. Although adopting IFRS is more than an accounting issue, with
potential economic, social, political, and cultural outcomes, we examine cross-sectional
differences in the adoption effects by analyzing the stock market reaction associated with
adopting IFRS by European firms.
Following prior research (Barth and Clinch 1996; Ball et al. 2000; Leuz 2003; Barth et al.
2005; Armstrong et al. 2007; Daske et al. 2007a), we analyze whether IFRS adopters’ financial
statements are viewed by investors as more relevant and transparent (informative) than those
before IFRS implementation. Since IFRS is primarily aimed at providing information for the
efficient working of the capital market, we measure value relevance in terms of the ability of
accounting information to explain contemporaneous stock prices. The question of value
relevance is important since it reveals the ability of IFRS to reflect economic information
5
incorporated in stock prices.
Daske et al. (2007a) explained heterogeneity in stock market effects by classifying firms into
“label” and “serious” adopters and found that serious adopters experienced stronger positive
effects on the cost of capital and market liquidity than label adopters. Ball (2001) notes that
improvements in accounting standards will amount to little more than “window dressing,” unless
it is accompanied by wholesale revision of the infrastructure that determines the financial
reporting incentives of managers and auditors. We provide insights into heterogeneity in the
capital market consequences by analyzing the legal system of the country in which firms are
domiciled, shareholder rights, and the quality of enforcement.
Easley and O’Hara (2004) model the impact of information attributes on the cost of capital.
They demonstrated that investors demand a higher return to hold stocks with greater private
information (i.e. the stakeholder model in countries with a code-law legal system). An important
implication of this research is that firms can influence their cost of capital by affecting the
precision and quantity of information available to investors. This can be achieved by a firm’s
selection of its accounting standards, as well as through its corporate disclosure practices.
This study will also investigate whether European IFRS adopters experienced a reduction
in the cost of capital following adoption. Decreasing cost of capital as an underlying rationale
for transition to IFRS has been expressed by the IASB regulators around the world and the
European Commission (Levitt 1998; Bolkestein 2000). Francis et al. (2005) found that
alternative legal systems can influence the effectiveness of disclosures. We extend this research
by assessing the impact of legal systems, shareholder rights, and enforcement on the application
of IFRS as measured by market consequences.
6
Extant accounting literature distinguishes between two “orientation postulates” (Stewart
1989) under which accounting standards are developed: the shareholders model originating in
countries with a common-law legal system and the stakeholder model originating in countries
with a code-law legal system (Bartov et al. 2005). Traditional accounting systems in code-law
countries such as France, Germany (i.e. most Continental European countries and Japan), have
been driven by an emphasis on financial reporting conformity with tax regulations, conservatism,
and broad-stakeholder orientation. The government, shareholders, debt holders, employees, and
managers are all viewed as stakeholders, relying less on public information because they
typically have access to private information. As a result, the incentives (e.g., minimizing taxes)
and opportunities (e.g., reserve accounting) to reduce earnings volatility are higher in these
countries. We expect that adoption of IFRS would be relatively more beneficial to investors in
these countries and have a more significant impact on capital markets, than for common law
countries where financial reporting has historically been primarily oriented to the private
investor/stockholder. Moreover, book values reported under IFRS should have higher value
relevance than book values determined under national GAAP.
In common-law countries (i.e. U.S., U.K), accounting systems are determined largely by
the disclosure needs of shareholders and potential shareholders (which are primary providers of
capital) and require a high standard of public disclosure. We expect that the adoption of IFRS
would be relatively less beneficial to investors in these countries because their orientation
postulate is similar to that of the IASB.
Our primary contribution is evidence on the likely impact of implementing IFRS on the
value relevance of book values of earnings and equity, information content of earnings
announcements, and cost of capital of a sample of mandatory IFRS adopters in Europe. We are
7
looking at the effects of mandatory as opposed to voluntary adoption of IFRS. Most of the prior
research has been conducted on the latter. Our secondary contribution is an investigation of
whether the market responds to the announcement of earnings equally for countries with
different legal systems, shareholder rights, and quality of enforcement. Finally, we test whether
firms adopting IFRS experienced a reduction in cost of capital following adoption of IFRS.
The remainder of our paper is presented as follows. Section II is a discussion of prior
research on the capital market consequences from adopting IFRS. Section III presents the data
and the sample selection process. Section IV describes the research methodology and empirical
design, section V presents our findings. Section VI offers concluding remarks and limitations of
the study.
II. Prior Research
With growing prominence of IFRS, the demand for publications on the effects of
adopting IFRS, country practical experiences in implementing IFRS, as well as future prospects
of global accounting convergence is growing at exponential rates. Several recent studies have
examined the benefits of global accounting convergence and the capital market effects of IFRS
adoptions.
Daske, Hail, Leuz and Verdi (2007a) examined the heterogeneity in economic consequences
of voluntary IFRS adoptions around the world, recognizing that firms have considerable
discretion in how they adopt IFRS. Some firms may simply adopt a label, while others view the
decision as a serious commitment to transparency. They found that the economic consequences
of IFRS adoptions depend on the extent to which firms make material changes to their reporting
policies or have strong reporting incentives. In another paper Daske at al (2007b) analyzed the
8
economic consequences of mandatory IFRS reporting around the world using a large sample that
includes over 3,800 first-time adopters. They find that the capital-market benefits from
implementing IFRS exist only in countries with strict enforcement regimes and institutional
environments that provide strong reporting incentives. Also, the effects are weaker when local
GAAP is more comparable to IFRS, in countries with an IFRS convergence strategy and in
industries with higher voluntary adoption rates.
Daske et al. (2007a) defined heterogeneity as the difference in management incentives to
adopt IFRS: “serious” or “label adopters.” We extend Daske et al (2007a) by defining
heterogeneity as common law versus code law countries. We believe that this distinction proxies
for the strength in protection of shareholder rights and the quality of enforcement of those rights
(La Porta et al 1998). Moreover, alternative legal systems, code and common law, have been
found to explain the heterogeneity in financial reporting compliance around the world (Francis et
al. 2005).
Value relevance studies are widely used by researchers to capture the combined attribute of
relevance and reliability of accounting information (Schipper and Vincent 2003). The value
relevance of different GAAP has been explored in the accounting literature using either an
association study or an event study (Holthausen and Watts 2001). We study the association
between book values and the market using a long window (value relevance of 12 months) and a
short window (information content within 6 days of earnings announcements).
Association studies investigate whether financial reporting data explains market
capitalizations and changes over long windows (Barth 1994, Choi et al. 1997, Barth et al. 2005).
The Ohlson model (Ohlson 1991, Ohlson 1995, Feltham and Ohlson 1995) stipulates that the
share price can be written as a linear function of earnings and equity book value, given a
9
dividend valuation model and clean surplus accounting, and has been employed in a number of
research studies (Chandra and Balachandran 1992, Harris et al. 1994, Easton and Sommers
2003). We adopt the Ohlson, Juettner-Nauroth (2005) model to study the association between
book value and market values.
Event studies investigate the association of the financial reporting data and abnormal market
capitalization changes over short windows around the date of the financial report publication.
These studies measure information content as an unanticipated change in the returns of a firm’s
capital (Beaver 1968, Ball and Brown 1968, Auer 2003). Armstrong, Barth, Jagolinzer and Riedl
(2007) examined the European stock market reaction to sixteen key events associated with the
adoption of IFRS in Europe. They found significant positive (negative) market reactions to
events that increase (decrease) the likelihood of IFRS adoption, which indicates that European
equity investors perceive net benefits to adoption of IFRS. They also revealed a significantly
more positive market reaction to IFRS adoption for firms with lower quality pre-adoption
information environments. Aubert and Dumontier (2007) found that analysts were not able to
anticipate the consequences of the IFRS adoption on earnings, forecast errors being significantly
associated with differences in earnings resulting from compliance with the new financial
reporting standards. Their study was based on a sample of 1,412 European companies that
complied with IFRS for the first time in 2005.
Various accounting items exhibit high-value relevance in common law countries that have
effective judicial systems, better investor protection, and higher quality of accounting practices
(including more transparent reporting) and auditing systems compared with code law countries.
It is expected that the smaller the deviation of a domestic practice from the IFRS, the higher the
value relevance of that practice. Accordingly, the EU countries with the largest deviation of a
10
domestic practice from the IFRS should have the most to gain from transition to IFRS (Leuz and
Verrecchia 2000, Hung 2001, Francis et al. 2003, Dumontier and Maghraoui 2007, Morais and
Curto 2007). We expect that code law countries’ market consequences will be significantly
different in 2006 as compared to 2005 than in common law countries.
Several country-specific studies examine the value relevance of certain accounting items
(Barth and Clinch 1998, Oswald and Zarowin 2004, Hung and Subramanyam 2004). Prior cross-
sectional studies identify and analyze factors such as disclosure policies and investor protection
laws that may cause differences in value relevance levels across countries (Hung, 2001, Zhao
2002). A comprehensive review and critique of the value relevance literature is provided by
Holthausen and Watts (2001), Barth et al. (2001) and Beaver (2002).
Bartov, Goldberg, and Kim (2004) examine the value relevance of earnings by focusing on
the magnitude of its coefficients in regressions of returns on earnings based on U.S. GAAP, IAS
and German GAAP. Jermakowicz, Prather-Kinsey and Wulf (2007) study the value relevance of
the DAX-30 German companies to determine whether voluntary adoption of IFRS resulted in
more value relevant book values after as compared to before adoption of IFRS. These studies
provide evidence that accounting earnings based on IAS are more value relevant than those
based on German GAAP, although they are less relevant than those based under U.S. GAAP.
Financial reporting in accordance with IFRS should lead to higher accounting quality as
compared to national GAAP, which should result in lower levels of information asymmetry and
thus lead to a firm’s lower cost of capital. Many empirical studies have investigated the effect of
IFRS adoption on the cost of equity capital, where the expected cost of capital is calculated using
implied estimation methods or proxies such as bid-ask spreads, trading volume or price
11
volatility.
Barth, Landsman and Lang (2005), based on a sample comprising 2,228 firm year
observations for 387 firms adopting IAS over the period 1990 through 2004, investigated
whether applying IAS is associated with less earnings management, more timely loss
recognition, higher value relevance of accounting amounts and a lower cost of capital. They
provide evidence that IAS firms exhibit an improvement in accounting quality and a reduction in
a cost of capital with the application of IAS. However, they do not partition the sample to
explain the heterogeneity in the capital markets between common and code law countries as we
do.
Daske and Günther (2006) assessed the quality of the financial statements of Austrian,
German and Swiss firms which had already adopted internationally recognized standards (IFRS
or U.S. GAAP). They provide evidence that disclosure quality increased significantly under
IFRS in the three European countries and this result holds for firms which voluntarily adopted
IFRS or U.S. GAAP as well as for firms which mandatorily adopted such standards in response
to the requirements of specific stock market segments.
Leuz and Verrecchia (2000) revealed that an international reporting strategy was associated
with lower bid-ask spreads, which they assumed to be appropriate proxies for the information
asymmetry component of the cost of equity capital. Brüggermanan and Homburg (2007) updated
and applied the Leuz and Verrecchia model to a much broader sample. Contrary to their
expectations, they provided no evidence of a significant effect of an international reporting
strategy on bid-ask spreads throughout the whole sample period. Research study conducted by
Daske (2006) found no evidence that adopting internationally recognized reporting standards,
12
per se, leads to the economic benefits of lower cost of equity capital for adopting firms. Other
research has provided evidence that rather than by the reporting standards, accounting quality is
predominately determined by a firm’s incentives created by its institutional environment and
market forces (Ball et al. 2003, Leuz et al. 2003). Francis, LaFond, Olsson, and Schipper (2003)
found that firms with certain desirable properties of earnings which increase information quality
exhibit lower cost of equity capital. Leuz and Verrecchia (2004) presented a capital market
model with rational expectations in which better information improves the coordination between
firms and outside investors regarding a firm’s investment decisions and thus reduces
misalignment risk between the two parties. We provide evidence on these contradictory findings
by not only studying the cost of capital before and after IFRS mandatory adoption of IFRS, but
also by studying what might explain the heterogeneity in these findings.
Most studies suggest that equity investors perceive net benefits from adoption of IFRS. Our
research continues work in the area of potential benefits to investors from implementing IFRS
and global accounting convergence. Instead of partitioning our sample based on reporting
incentives, we partition our sample based on shareholder rights and the quality of enforcement of
these rights as defined by La Porta et al. (1998). Francis et al (2005) find that alternative legal
systems can influence the effectiveness of disclosures. We extend prior research by not only
studying the cost of capital but also the value relevance of book values and information content
of earnings announcements of firms before and after adoption of IFRS. We focus on cross-
sectional differences in IFRS adoption effects and test whether heterogeneity in investor rights
and enforcement quality as well as common law versus code law legal origins explain
differences in value relevance, information content and cost of equity capital.
13
III. THE DATA AND SAMPLE
The Dow Jones STOXX 600 index was used as our reference universe to select the
population of large publicly traded European firms that only traded on their domestic exchange
in 2004-2006, only reported under domestic GAAP in 2004 and only reported in accordance with
IFRS in 2006. Precautions were taken to have the historical constituents included in the index as
they were originally at the end of years 2004 and 2006. This index was favored over other
market indexes for three reasons that we thought important and advantageous for this study.
• The financial significance of the index - Its market capitalization was about €7.6
trillion as of June 30, 2006 and represented roughly 88% of the free float market capitalization of
the European and Eurozone markets. This index is also favored by finance professionals and
provides them with a broad representation of large European companies.
• The index relevance and the extent of its geographical coverage - All the developed
European markets in Europe are covered by the index: Austria, Belgium, Denmark, Finland,
France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal,
Spain, Sweden, Switzerland, and the United Kingdom.
• The availability of financial statements in English for reconciliation purposes - The
vast majority of firms in the Dow Jones STOXX 600 index had their annual reports published in
English making the reconciliation/reconstitution of numbers possible with documents published
by companies. A broader index would include smaller firms not able to produce financial
statements in English because of the costs involved with producing financial reporting
simultaneously in a foreign language.
To provide complete and clean data, different databases were used in our study. The
historical constituents of the Dow Jones STOXX 600 index at the end of 2004 were provided by
Bloomberg. The Thomson Worldscope database on FactSet was our main source of fundamental
data as it provides stock market data and financial reports that are not restated. Bloomberg and
Capital IQ from S&P were also used for cross checking purposes. Both databases provided
14
options in how financial statement numbers are shown--as originally filed and/or restated. When
these databases gave conflicting numbers, we carefully reconciled all of these differences. We
also made sure that the definition of the different items matched the financial statement
disclosures. For example, we looked at the annual reports to check which database had the same
number as the published consolidated financial statements and its accompanying notes. The
availability and the use of different databases also allowed the data to be more complete.
(Insert Table 1 here)
Our objective was to examine the heterogeneity in market consequences of mandatory IFRS
adoption in Europe, where market consequence is defined as value relevance, information
content and cost of equity capital. Thus, we excluded from our sample those European firms that
reported using U.S. GAAP during the data base period in order to mitigate the effect of U.S.
GAAP driving IFRS technical compliance results rather than the home country legal
environment, as prior research found that U.S. GAAP compliant financial reports are of higher
quality than IFRS (Barth et al. 2005, Armstrong et al. 2006). We included in our sample those
European firms that reported using domestic GAAP only prior to 2005 and used IFRS only after
2005. This process resulted in 157 firm-year observations in 2004 and 157 firm year
observations in 2006.
In summary, we believe that the market will find IFRS adopters’ financial reports more value
relevant, informative and thus rewarded with a lower cost of capital for both common law and
code law countries but to a greater extent for code law countries. We believe that our sample is
more robust as compared to that of Daske et al. (2007a) since we excluded the early adoption
effects of year 2005 IFRS adoption and examined the effects in 2006.
15
IV. METHODOLOGY AND EMPIRICAL DESIGN
Value Relevance
We used the Ohlson, Juettner-Nauroth (2005) value-relevance model to determine
whether the book values of income and equity increased after the adoption of IFRS and whether
that increase is greater for code law than common law countries between 2004 and 2006.
MVj,t/MVj,t-1 = α0t+ β1t BVj,t/MVj,t-1 + βα2t NIj,t/MVj,t-1 + ej,t (1)
where:
t = 2004 or 2006,
MVj, t = market capitalization (market price per share times the number of shares outstanding) for firm j at the end of period t,
BVj,t = the book value of common equity of firm j at the end of period t,
NIj,t = income statement reported net income for firm j for the time t-1 to t,
ej,t = residuals or error term for firm j at the end of period t.
Information Content
Earnings announcements are timely or have information content if they lead to price
changes different from those expected before the announcement. Studies that document earnings
announcement price adjustments include events studies such as Armstrong et al. (2007), Beaver
(1968) and Ball and Brown (1968). We measured information content as an unexpected change
in a security’s returns. When announcements are good news, then returns are higher than
expected; if the announcements represent bad news, then returns are lower than expected.
We began the test for unexpected change during a 6-day window (-1 to 4) by controlling
for market movements at the time of the earnings-announcement period. For each firm
announcement j, and day t, we estimate αj and ßj for the time period t = -130 to -31 days before
16
the announcement date as follows:
tmjjtj RR ,, βα += (5)
where Rj,t is the return for stock j on day t, and Rm,t is the return on the market for day t. We had
firm trading dates without an accompanying index date. We kept the public holiday as a non-
holiday day as long as the European index had a closing price that day. The holiday or missing
day was the average closing price of the day before and after the holiday. Since on average the
markets are fairly efficient, investors usually catch up with the “events or information” or make
up for the day’s difference on the trading day following the holiday. Under this scenario, we
assume that the missing day was an arithmetic mean of the day before and after. This approach
allowed for the event study to have a “window” with the same number of days even when
holidays occur. This was not perfect, but we believe that the advantages outweigh the
disadvantages.
The parameters α and ß were estimated using both Ordinary Least Squares and the
method developed in Scholes and Williams (1977). Scholes and Williams’s (1977) estimates of
the market-model coefficients were used to compensate for nonsynchronous trading problems
associated with infrequently traded securities. The Scholes-Williams beta is estimated as
m
jjjSWj ρ
ββββ
21 +++
=+−
(6)
where is the OLS slope estimate from the linear regression of Rj,t on Rm,t−1; β is the OLS
slope estimate from the linear regression of Rj,t on Rm,t; is the OLS slope estimate from the
linear regression of Rj,t on Rm,t+1; and ρm is the estimated first-order autocorrelation of Rm. As in
OLS, the intercept estimator forced the estimated regression line through the sample mean:
−jβ
+jβ
mSWjjj RßR
____−=α (7)
where is the mean return of stock j over the estimation period and is the mean market jR__
mR__
17
return over the estimation period.
The abnormal return (ARj,t) for firm j on each trading day t of the event period -1 to +4
was calculated as
ARj,t = Rj,t – αj - ßj Rm,t. (8)
The mean abnormal return (MARt) on trading day t for a sample of N firms is the sample
mean within each group (sample and control):
∑=
=N
jtjt AR
NMAR
1,
1
. (9)
We aggregate average abnormal returns for all N firms within each group (sample or
control) across event days t = -1 to +4 to calculate a mean Cumulative Abnormal Return (CAR):
∑∑=
+=
−=
=N
j
t
ttjAR
NCAR
1
5
3,
1
. (10)
Cost of Equity Capital
We computed the expected cost of equity capital to determine if it was significantly
different between 2004 and 2006 for the code law and common law European country firms. It
was computed similarly to Easton (2004) and Francis et al. (2005), where CEC is computed as
the square root of the inverse of the price-earnings growth ratio as follows:
t
ttPEG P
epsepsCEC 12 ++ −
=
(3) Where: CECPEG= ex ante cost of equity capital, PEG = price earnings growth model (see Ohlson and Juettner-Nauroth (2005),
2+teps = two year ahead mean analysts’ forecast of earnings per share, 1+teps = one year ahead mean analysts’ forecast of earnings per share,
18
tP = the fiscal year-end price per share.
The additional data constraints required to compute CEC resulted in a reduced sample
size of 142 code law and 142 common law firm-year observations.
If the t-test of difference in means of CEC between groups is significantly different, then
we seek to determine what explains that difference. We use ordinary least squares regression to
ascertain whether the cost of equity capital is explained by firm size, legal origin, shareholder
rights, debt, or economic factors such as inflation or gross national product as follows.
CECj,t = {SIZE, LAW, SR, DEBT, CPI, GDP} (4)
Where:
CECj,t = cost of equity capital,
SIZE = log of total assets,
LAW = 1 if common law country, 0 otherwise
SR = shareholder rights or antidirector rights as defined by La Porta et al., (1999) with 6 indicating the highest shareholder rights and 0 as having no shareholder rights (see Table 3, pages 1130-1131),
DEBT = total debt including long term and short term debt divided by total assets,
CPI = country specific consumer price index,
GDP = gross domestic product per capita as an indicator of level of development as some emerging countries are approaching the developed stage whereas other are not.
V. FINDINGS
Descriptive data about the sample selected is displayed in Table 1. There were 157 firm-
year observations in 2004 and 157 firm-year observations in 2006. Panel A shows that most of
the observations are in the industrial (31%) and consumer discretionary (26%) industries. About
18% of the observations are from energy (4%), consumer staples (10%), and telecommunication
19
services (4%) industries. The sample is evenly distributed between industrial and non-industrial.
Panel B illustrates the country of incorporation of the selected sample. Most of the observations
are from Great Britain (26%), France (18%) and Spain (14%) since firms in these countries were
not allowed to switch to IFRS before 2005 (unless to provide additional disclosure). Only about
1% of the observations are from Austria (0.6%) and Greece (0.6%).
-Table 1-
Table 2 provides the summary descriptive statistics for common and code law
observations both in aggregate (Panel A) and disaggregated between years (Panels B and C).
Difference in mean values for cost of capital, log of assets, GDP per capita, CPI, and market
values were significantly different between 2004 and 2006. Cost of equity capital declined after
mandatory adoption of IFRS in 2006. These univariate results imply that capital market
participants were willing to provide capital at a low cost for firms that provide IFRS disclosures.
Moreover, firm size, total debt, GDP/capita and market values increased significantly from 2004
to 2006.
(Insert Table 2 here)
Panel B and C also support that the cost of equity capital declined significantly after
adoption of IFRS for both common law and code law observations. Additionally, the log of
assets, GDP per capita, CPI, net income, and market values were significantly different between
2004 and 2006 for both code law and common law observations
Table 3 shows Pearson Correlation Coefficients for all of the variables included in this
study with the code and common law samples combined but disaggregated by year. The
correlations are highest between net income and book and market values of equity. Therefore,
the variables used in the regression models are deflated by the market value of common equity to
mitigate heteroscedascity.
20
(Insert Table 3 here)
The ordinary least squares (OLS) regression models for value relevance are displayed in
Table 4 Panels A (code law countries) and B (common law countries). For code law countries
the explanatory power of the value relevance model almost doubled between 2004 (R2 =13%)
and 2006 (R2 =22%). However, for the common law countries the value relevance model did not
improve between 2004 (9%) and 2006 (7%). Moreover, the value relevance (R2 ) between 2004
and 2006 significantly increased for code law countries but not common law countries (Vong test
of difference in R2 is significant as p< 0.06).We conclude that the effects of mandatory IFRS
adoption (the value relevance of income and equity) are stronger for companies domiciled in
code law countries than for companies domiciled in common law countries because companies
domiciled in code law countries experienced greater differences between IFRS and local GAAP
before adopting IFRS. Consequently, companies domiciled in code law countries had to make
more significant progress in financial reporting with the adoption of IFRS for their reports to
become more transparent and oriented toward meeting external investors’ needs, as compared to
companies domiciled in common law countries . Our findings are consistent with Daske et al.
(2007), that countries’ legal environments are just as significant as the introduction of the new
standards per se in explaining market consequences from mandatory adoption of IFRS.
(Insert Table 4 here)
Next, we test the information content of earnings announcements within a six day
window (-1 to 4). For code law countries, in 2004, earnings announcements were only
marginally significant for only day 2 using the ordinary least squares and Scholes-Williams
models. However, after adoption of IFRS, earnings announcements became significant on days
0, 1, 2, and 4. Cumulative abnormal returns increased from 2004 (0.52) to 2006 (0.83) in both
the ordinary least squares and Scholes-Williams models.
(Insert Table 5 here)
21
The qualitative information content findings of common law countries were somewhat
similar to that of code law countries. Earnings announcements were only marginally significant
on days 1 and 3 for common law countries. However, cumulative abnormal returns over the 6-
day period were not significant before adoption of IFRS, only after adoption of IFRS. Again
these results reveal that market participants responded significantly to earnings announcements
after adoption of IFRS more so than before adoption. We conclude that market participants find
the announcement of earnings computed in accordance with IFRS as useful information.
Lastly, we examine the effects of the mandatory IFRS adoption on the cost of equity capital
of companies domiciled in common law and code law countries for 2004 and 2006. The sample
size decreased for the cost of equity capital regression models as some variables had missing
values. The cost of equity capital decreased for common law as well as code law countries after
adopting IFRS. Cost of equity capital was explained by legal origin and anti-director rights after
the mandatory adoption of IFRS but only margially before the adoption. This last result should
be interpreted with caution since shareholder rights or antidirector rights were applied as defined
by La Porta et al. (1999) and major changes in corporate governance were observed in recent
years.
Insert Table 6 here)
Summarizing, our results are consistent with our expectations, that adopting IFRS was
beneficial to the EU capital markets since it is associated with higher value relevance of earnings
and equity, increased information content, and lower cost of capital than before IFRS adoption.
22
VI. CONCLUDING REMARKS AND LIMITATIONS
This study investigates capital market consequences of European firms’ mandatory
adoption of IFRS by examining whether the value relevance of earnings and information content
of earnings announcements increased, and cost of equity capital decreased for European firms
after mandatory adoption of IFRS in 2005.
Overall, our results reveal that investors perceive net benefits from adopting IFRS. Cost
of equity capital decreased significantly for European firms after adoption of IFRS. In addition,
there was an increase in value relevance and information content of earnings announcement
(using a 6-day window) after mandatory adoption of IFRS. We also investigate how value
relevance of accounting information is influenced by the legal system, code law versus common
law, of the country in which firms are domiciled.
The cost of equity capital decreased for firms domiciled in common law as well as code
law countries after adopting IFRS. Decreasing cost of capital as an underlying rationale has been
expressed by the IASB and regulators around the world to reason the adoption of IFRS. Cost of
equity capital was explained by legal origin and anti-director rights after the mandatory adoption
of IFRS but only marginally before adoption.
We find that market consequences differ for firms in code law legal origin countries than
in common law legal origin countries in 2006, after implementing IFRS. Firms applying code
law-based domestic accounting standards have a more significant reaction to IFRS adoption than
do those applying common law-based domestic standards. The value relevance of earnings and
book value of equity for firms domiciled in common law countries did not significantly change
between 2004 and 2006. We conclude that common law-based domestic standards were more
23
comparable to IFRS while code law-based accounting standards deviated more from IFRS and,
consequently, firms domiciled in code law countries had to make more significant changes in
financial reporting with the adoption of IFRS. Also, the institutional infrastructure required to
support high-quality financial reporting is more developed in common-law countries such as the
UK. Therefore, adopting IFRS resulted in more significant market consequences to firms
domiciled in code law rather than common law countries.
We test the information content of earnings announcements within a six day window.
For code law countries, earnings announcements were more significant after adoption of IFRS.
Cumulative abnormal returns over the 6-day period as well were not significant before adoption
of IFRS, only after adoption of IFRS. Again these results reveal significantly more positive
market reactions to earnings announcements after adoption of IFRS than before adoption,
especially for firms from code law countries, having lower pre-adoption information quality. We
conclude that market participants find the announcement of earnings determined in accordance
with IFRS as useful information. The adoption of IFRS improved the transparency of financial
reporting in European countries, as well as the reliability and the relevance of the reported
numbers, resulting in higher value relevance of accounting information and increased
information content, ultimately leading to a lower cost of equity capital.
Our findings are subject to four limitations. First, there is considerable heterogeneity
between the firms in our sample resulting in cross-sectional variation in the impact of IFRS.
Second, our sample does not include firms representing the banking industry and financial
institutions since those firms are more likely to not report under IFRS, as published by the IASB,
because of their “carve-out” provisions of IAS 39. Third, we have a small sample size because
we included only those firms listed on their domestic stock exchange that reported under local
24
GAAP only in 2004 and reported in accordance with IFRS only in 2006. Consequently, we
excluded from our sample those European firms that reported using U.S. GAAP during the data
base period in order to mitigate the effect of U.S. GAAP driving IFRS technical compliance
results rather than the home country legal environment. Fourth, the role of IFRS alone in
improving the value relevance of accounting information is not clear. For example,
implementing IFRS could be associated with more rigorous audit, reporting incentives or
enforcement scrutiny.
Our findings add to the literature on the benefits of implementing IFRS by providing
evidence that investors perceive benefits from the adoption of IFRS in Europe. Future research
may focus on the economics of changing accounting standards, including the costs of
implementing IFRS, as well as on differences in interpretation and application of IFRS across
firms, industries, countries and time. Further, the U.S. capital market consequences of foreign
private issuers reporting in accordance with IFRS without reconciliation to U.S. GAAP merit
investigations.
25
REFERENCES
Armstrong, Ch., M. Barth, A. Jagolinzer, and E. Riedl. 2007. Market Reaction to Events Surrounding the Adoption of IFRS in Europe. Stanford University. Research Paper No. 1937...
Aubert, F., and P. Dumontier. 2007. Analyzing analysts’ expertise: Did analysts fully anticipate the impact of IFRS adoption on earnings? The European evidence. Proceedings of the 30th Annual Congress of the European Accounting Association, Lisbon, Portugal, April 25-27.
Auer, K. 2003. Capital market reactions to earnings announcements: empirical evidence on the difference in the information content of IAS-based earnings and EC-Directives-based earnings. European Accounting Review 5 (4): 587-623.
Ball, R., and P. Brown. 1968. An empirical evaluation of accounting income numbers. Journal of Accounting Research 6: 159-178.
Ball, R., S. Kothari, and A. Robin. 2000. The effect of international institutional factors on properties of accounting earnings. Journal of Accounting and Economics 29: 1-51.
Ball, R. 2001.Infrastructure requirements for an economically efficient system of public financial reporting and disclosure, Brookings-Wharton Papers on Financial Services, 127-169.
Ball, R., R. Ashok, and J.S. Wu. 2003. Incentives versus standards: properties of accounting income in four East Asian countries. Journal of Accounting and Economics 36: 235-270.
Barth, M.E. 1991. Relative Measurement Errors among Alternative Pension Asset and Liability Measures. The Accounting Review 66 (3): 433-463.
______. 1994. Fair Value Accounting: Evidence from Investment Securities and the Market Valuation of Banks. The Accounting Review 69 (1): 1-25.
______, and G. Clinch. 1996. International differences and their relation to share prices: Evidence from U.K., Australian, and Canadian firms. Contemporary Accounting Research 13: 135-170.
______, and ______. 1998. Revalued Financial, Tangible, and Intangible Assets: Association with Share Prices and Non-Market-Based Value Estimates. Journal of Accounting Research (Supplement) 36 (3): 199-233.
______, W.H. Beaver, and Landsman, W.R. 2001. The Relevance of Value-relevance literature for financial accounting standard setting: Another View. Journal of Accounting and Economics 39: 77-104.
26
______, W.R. Landsman, and M. Lang. 2005. International Accounting Standards and Accounting Quality. Working paper, Stanford University and University of North Carolina.
Bartow, E., S. Goldberg, and M. Kim. 2005. Comparative Value Relevance among German, U.S. and International Accounting Standards: A German Stock Market Perspective. Journal of Accounting, Auditing and Finance 20: 95-119.
Beaver, W. 1968. The information content of annual earnings announcements. Journal of Accounting Research 6 (Supplement): 67-92.
Biddle, G. C., and S. M. Saudagaran (1991). Foreign Stock Listings: Benefits, Costs, and the Accounting Policy Dilemma. Accounting Horizons (September): 69-80.
Bolkestein, F. 2000. One currency, one accounting standard: Unless the European Union adopts a single set of rules, it risks losing the benefits of the euro. Financial Times (June 14).
Buchanan, R.F. 2003. International accounting harmonization: Developing a single world standard. Business Horizons, May-June.
Chandra, R., and V. Balachandran. 1992. More powerful portfolio approaches to regressing abnormal returns on firm-specific variables for cross-sectional studies. The Journal of Finance (1992): 2055-2070.
Choi, B., D.W. Collins, and W.B. Johnson. 1997. Valuation implications of reliability differences: The case of nonpension retirement obligations. The Accounting Review 72 (3): 351-383.
Cox, Ch. 2007. Speech by SEC Chairman: Address to the Security Traders Association 11th Annual Washington Conference (May 7). U.S. Securities and Exchange Commission.
Daske, H. 2005. Economic benefits of adopting IFRS or U.S. GAAP – Have the expected costs of equity capital really decreased? Journal of Business Finance & Accounting 33 (3-4): 329-373.
______, and G. Günther. 2006. International Financial Reporting Standards and Experts’ Perceptions of Disclosure Quality. Abacus 42 (3-4): 461-498.
______, L. Hail, Ch. Leuz, and R. Verdi. 2007a. Adopting a Label: Heterogeneity in the economic consequences of IFRS adoptions. Working paper.
______. Hail, Ch. Leuz, and R. Verdi. 2007b. Mandatory IFRS Reporting Around the World: Early Evidence on the Economic Consequences. (October 2007). Chicago GSB Research Paper No.12.
Davis-Friday, P., & J. Rivera. 2000. Inflation accounting and 20-F disclosures: Evidence from Mexico. Accounting Horizons 14: 113-135.
27
Delvaille, P., G. Ebbers, and C. Saccon. 2005. International financial reporting convergence: Evidence from three continental European countries. Accounting in Europe 2: 137-164.
Dumontier P. and R. Maghraoui. 2007. Does the adoption of IAS-IFRS reduce information asymmetry systematically? Proceedings of the 30th Annual Congress of the European Accounting Association, Lisbon, Portugal, April 25-27.
Easley, D., and M. O’Hara. 2004. Information and the cost of capital. Journal of Finance 59, 1552-1583.
Easton, P. 2004. PE ratios, PEG ratios, and estimating the implied expected rate of return on equity capital. The Accounting Review: 79 (2): 73-95.
______, and G.A. Sommers. 2003. Scale and the scale effect in market-based accounting research. Journal of Business, Finance and Accounting (January/March): 25-55.
EC (Commission of the European Communities). 2002. Regulation (EC) No. 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards. Official Journal of the European Communities L243/1 (11.9.2002). Brussels, Belgium: EC.
Ernst & Young. 2006. Observations on the Implementation of IFRS.
Feltham, G.A., and J.A. Ohlson. 1995. Valuation and Clean Surplus Accounting for Operating and Financial Activities. Contemporary Accounting Research 11 (2): 689-731.
Flower, J. 2005. European Financial Reporting. Palgrave.
Francis, J., R. LaFond, P. Olsson, and K. Schipper. 2003a. Cost of Capital and Earnings Attributes, The Accounting Review, 79 (4): 967-1010.
______, I. Khurana, and R. Pereira. 2003b. Investor laws, accounting and auditing around the world. Asia-Pacific Journal of Accounting & Economics 3 (1): 1-30.
______, _______, and _______. 2005. Disclosure Incentives and Effects on Cost of Capital around the World. The Accounting Review 80 (4): 1125-1162.
Harris, T.S., M. Lang, and H.P. Mőller. 1994. The Value Relevance of German Accounting Measures: An Empirical Analysis. Journal of Accounting Research 32 (2): 187-209.
Holthausen, R., and R. Watts. 2001. The Relevance of Value Relevance Literature for Financial Accounting Standard Setting. Journal of Accounting and Economics 31: 3-75.
Hoogendoorn, M. 2006. International Accounting Regulation and IFRS Implementation in Europe and Beyond – Experiences with First-time Adoption in Europe. Accounting in Europe 3: 23-27.
28
Hung, M. 2001. Accounting Standards and Value Relevance of Financial Statements: An International Analysis. Journal of Accounting and Economics 30: 401-420.
______, and K.R. Subramanyam. 2004. Financial Statement Effects of Adopting International Accounting Standards: The Case of Germany. Working Paper, University of Southern California – Marshall School of Business.
Jermakowicz, E., J. Prather-Kinsey and I. Wulf. 2007. The Value Relevance of Accounting Income Reported by DAX-30 German Companies. Journal of International Financial Management and Accounting Vol 18 (3)
Lang, M., J. Raedy, and W. Wilson. 2006. Earnings Management and Cross Listing: Are Reconciled Earnings Comparable to U.S. Earnings? Journal of Accounting and Economics 42: 149-165.
La Porta, R., F. Lopez-de-Silanes, and A. Shleifer. 1998. Law and Finance. The Journal of Poitical Economy 106 (December, 6): 1113-1155.
La Porta, R., F. Lopez-de-Silanes, and A. Shleifer. 1999. Corporate ownership around the world. The Journal of Finance 54 (April): 471-517.
Larson, R. K. and D. L. Street. 2004. Convergence with IFRS in an expanding Europe: Progress and obstacles identified by large accounting firms’ survey. Journal of International Accounting, Auditing and Taxation, 13: 89-119.
Levitt, A. 1998. The Importance of High Quality Accounting Standards. Accounting Horizons 12 (2): 79-82.
Leuz, Ch., and R.E. Verrecchia. 2000. The Economic Consequences of Increased Disclosure. Journal of Accounting Research 38 (Supplement): 91-124.
____, and J. Wüsteman. 2003. The Role of Accounting in the German Financial System. Working Paper 2003/16, Center for Financial Studies, Frankfurt/M.
____, Ch. 2003. IAS versus U.S. GAAP: Information Asymmetry Based Evidence from Germany’s New Market. Journal of Accounting Research 41 (3): 445-472.
____, Ch., and R.E. Verrecchia. 2004. Firms’ Capital Allocation Choices , Information Quality, and the Cost of Capital. Working Paper, The Wharton School (January).
Meek, G.K., and W.B Thomas. 2003. A review of market-based international accounting research. Journal of International Accounting Research 3 (1): 21-41.
Morais A., and J.D. Curto. 2007. IASB standards adoption: Value relevance and the influence of country-specific factors. Proceedings of the 30th Annual Congress of the European Accounting Association, Lisbon, Portugal, April 25-27.
29
Ohlson, J.A. 1991. Earnings, Book Values, and Dividends in Security Valuation. Working Paper, Columbia University.
______. 1995. Earnings, Book Values, and Dividends in Equity Valuation. Contemporary Accounting Research 11 (2): 661-687.
______, and B. Juettner-Nauroth. 2005. Expected EPS and EPS growth as determinants of value. Review of Accounting Studies 10: 349-365.
Oswald, D., and P. Zarowin. 2004. Capitalization of R&D and the Informativeness of Stock Prices. Working Paper, New York University.
Pownall, G., and K. Schipper. 1999. Implications of accounting research for the SEC’s consideration of International Accounting Standards for U.S. securities offerings. Accounting Horizons 13: 259-280.
Prather-Kinsey, J. 2006. Developing Countries Converging with Developed-country Accounting Standards: Evidence from South Africa and Mexico. The International Journal of Accounting 41 (2): 141-162.
Schipper, K., and L. Vincent. 2003. Earnings quality. Accounting Horizons 17: 97-110.
Scholes, M., and J. Williams. 1977. Estimating betas from nonsynchronous data. Journal of Financial Economics 5: 309-327.
Securities and Exchange Commission. 2007a. Acceptance From Foreign Private Issuers of Financial Statements Prepared in Accordance With International Financial Reporting Standards Without Reconciliation to U.S. GAAP.
Securities and Exchange Commission. 2007b. Concept Release On Allowing U.S. Issuers To Prepare Financial Statements In Accordance With International Financial Reporting Standards. File No.: S7-20-07.
Stevenson, K.M. 2007. The IASB: Some Personal Reflections. In: Globalisation of Accounting Standards, edited by Godfrey, J.M. and K. Chalmers, Edward Elgar.
Stewart, J. 1989. The Significance of an Orientation Postulate. Abacus (September): 97-115.
Street, D.L., N.B. Nichols, and S.J & Gray. 2000. Assessing the acceptability of International Accounting Standards in the U.S.: An empirical study of the materiality of U.S. GAAP reconciliations by non-U.S. companies complying with IASC Standards. The International Journal of Accounting 35 (1): 27-63.
Tarca, A. 2004. International convergence of accounting practices: Choosing between IAS and U.S. GAAP. Journal of International Financial Management and Accounting, 15 (1): 60-91.
30
Thomson Financial. 2003. Accounting for Estimates.
Tweedie, D. 2007. Quest for a global language. KPMG.
Van Hulle, K. 2004. From Accounting Directives to International Accounting Standards, in Leuz, C.; Pfaff, D.; & Hopwood, A. International Perspectives on Research Trends, Policy and Practices. Oxford: Oxford University Press.
Zhao, R. 2002. Relative Value Relevance of R & D Reporting: An International Comparison. Journal of International Financial Management and Accounting 13: 153-174.
31
32
Table 1 Sample Selected Panel A: Industry Classification Number of Firm Year Observations
2004 (n = 157)
2006 (n = 157)
Frequency Percent Frequency Percent Consumer Discretionary 41 26.11 41 26.11 Consumer Staples 16 10.19 16 10.19 Energy 6 3.82 6 3.82 Health Care 6 3.82 6 3.82 Industrials 48 30.57 48 30.57 Information Technology 7 4.46 7 4.46 Materials 17 10.83 17 10.83 Telecommunication Services 6 3.82 6 3.82 Utilities 10 6.37 10 6.37 Totals 157 100 157 100 Panel B: Country of Incorporation Number of Firm Year Observations
2004 (n = 157)
2006 (n = 157)
Frequency Percent Frequency Percent Austria 1 0.64 1 0.64 Belgium 2 1.27 2 1.27 Denmark 3 1.91 3 1.91 Finland 6 3.82 6 3.82 France 29 18.47 29 18.47 Germany 1 0.64 1 0.64 Gr. Britain 41 26.11 41 26.11 Greece 1 0.64 1 0.64 Ireland 3 1.91 3 1.91 Italy 15 9.55 15 9.55 Netherlands 10 6.37 10 6.37 Norway 3 1.91 3 1.91 Portugal 2 1.27 2 1.27 Spain 22 14.01 22 14.01 Sweden 15 9.55 15 9.55 Switzerland 3 1.91 3 1.91
33
TABLE 2 Descriptive Statistics (Mean Median Standard Deviation and t-tests)
Panel A: Code and Common Law Observations Combined
2004 2006 Total Variable N Mean Median Std Dev N Mean Median Std Dev t-test of
difference Cost of capital 142 0.097 0.089 0.050 143 0.087 0.080 0.035 3.96*** Log of Assets 157 8.564 8.437 1.384 157 8.834 8.657 1.421 3.42*** Total Debt 157 3,914.550 1,246.900 7,088.650 110 3,758.910 1,591.000 5,746.210 0.38 GDP/ capita 157 29,538.460 29,541.000 3,015.140 157 33,564.100 34,800.300 3,405.080 22.18*** Antidir Rights 157 3.344.000 3.000 1.324 157 3.344 3.000 1.324 N/A Code/Common 157 0.720 1.000 0.451 157 0.720 1.000 0.451 N/A CPI 157 1.806 1.375 0.776 157 2.239 2.217 0.656 10.66*** Net income 157 891.296 210.000 2,788.820 157 1,141.780 312.748 2,878.400 1.56 Book value of equity
157 4,970.650 1,466.000 12,220.240 157 6,206.330 1,894.770 13,606.230 1.70
Market value 157 12,523.210 4,209.330 33,251.850 157 18,274.140 6,494.760 43,870.06 2.62*
34
Panel B: Code Law Firm Year Observations
2004 2006 Total Variable N Mean Median Std Dev N Mean Median Std Dev t-test of
difference Cost of capital 103 0.097 0.086 0.056 105 0.090 0.083 0.039 2.04* Log of Assets 113 8.949 9.057 1.335 113 9.241 9.361 1.362 3.36** Total Debt 113 5,114.49 2,174.700 8,007.330 79 4,864.190 2,414.74 6,415.180 0.46 GDP/ capita 113 28,826.52 29,300.000 3,039.420 113 32,893.47 33,408.22 3,641.68 18.22*** Antidir Rights 113 2.726 3.000 1.020 113 2.726 3.000 1.020 Code/Common 113 1.000 1.000 0 113 1.000 1.000 0 CPI 113 1.959 2.283 0.856 113 2.198 1.908 0.767 4.21*** Net income 113 1,162.06 269.000 3,243.46 113 1,425.770 452.667 3,297.420 1.22 Book value of equity 113 6,443.19 2,613.35 14,086.55 113 8,010.140 3,378.65 15,517.650 1.58 Market value 113 16,211.61 5,928.27 38,531.45 113 23,574.160 8,966.91 50,589.500 2.46*
Panel C: Common Law Observations 2004 2006 Total Variable N Mean Median Std Dev N Mean Median Std Dev t-test of
difference Cost of capital 39 0.098 0.093 0.030 38 0.078 0.076 0.020 6.54*** Log of Assets 44 7.574 7.300 0.958 44 7.787 7.599 0.966 2.04* Total Debt 44 832.907 361.578 1,339.31 31 942.224 559.300 1,245.690 0.72 GDP/ capita 44 31,366.860 30,821.000 2,041.300 44 35,286.400 34,800.300 1,817.790 19.02*** Antidir Rights 44 4.932 5.000 0.255 44 4.932 5.000 0.255 Code/Common 44 0 0 0 44 0 0 0 CPI 44 1.415 1.350 0.0.242 44 2.343 2.317 0.100 27.02*** Net income 44 195.909 93.341 357.422 44 412.420 143.950 990.580 2.72* Book value of equity 44 1,188.900 521.400 2,143.480 44 1,573.840 660.816 3,732.320 1.18 Market value 44 3,050.74 1,626.580 4,087.32 44 4,662.720 2,344.14 7,261.40 2.56*
35
Table 3, Pearson Correlations, 2004 Parameter, p-value, n
Cost of Equity
Log of Assets Total Debt
GDP/ Capita
Anti-Director Rights
Code/ Common
Consumer Price Index
Net Income
Book Value of Equity
Market Value
Cost of Equity Capital
1.000 142
0.04019 0.6349 142
0.03105 0.7137 142
0.14746 0.0799 142
0.02968 0.7258 142
-0.00615 0.9421 142
-0.16238 0.0535 142
-0.110520.1904 142
-0.01169 0.8901 142
-0.06672 0.4302 142
Log of Assets
0.04019 0.6349 142
1.00000 157
0.72917 <.0001 157
-0.03367 0.6755 157
-0.30816 <.0001 157
0.44739 <.0001 157
-0.00458 0.9546 157
0.49075 <.0001 157
0.59057 <.0001 157
0.51645 <.0001 157
Total Debt 0.03105 0.7137 142
0.72917 <.0001 157
1.00000 157
0.00215 0.9787 157
-0.19354 0.0152 157
0.27214 0.0006 157
-0.04091 0.6110 157
0.58115 <.0001 157
0.74349 <.0001 157
0.61753 <.0001 157
GDP/Capita 0.14746 0.0799 142
-0.03367 0.6755 157
0.00215 0.9787 157
1.00000 157
0.09328 0.2452 157
-0.37961 <.0001 157
-0.63629 <.0001 157
0.12900 0.1073 157
0.08858 0.2699 157
0.03785 0.6379 157
Anti-Director Rights
0.02968 0.7258 142
-0.30816 <.0001 157
-0.19354 0.0152 157
0.09328 0.2452 157
1.00000 157
-0.75081 <.0001 157
-0.11441 0.1536 157
-0.080990.3133 157
-0.12920 0.1068 157
-0.11192 0.1628 157
Code/ Common Law Dummy
-0.00615 0.9421 142
0.44739 <.0001 157
0.27214 0.0006 157
-0.37961 <.0001 157
-0.75081 <.0001 157
1.00000 157
0.31580 <.0001 157
0.15609 0.0509 157
0.19373 0.0151 157
0.17833 0.0254 157
Mean Consumer Price Index
-0.16238 0.0535 142
-0.00458 0.9546 157
-0.04091 0.6110 157
-0.63629 <.0001 157
-0.11441 0.1536 157
0.31580 <.0001 157
1.00000 157
-0.196440.0137 157
-0.19771 0.0131 157
-0.16353 0.0407 157
Net Income
-0.11052 0.1904 142
0.49075 <.0001 157
0.58115 <.0001 157
0.12900 0.1073 157
-0.08099 0.3133 157
0.15609 0.0509 157
-0.19644 0.0137 157
1.00000 157
0.91908 <.0001 157
0.86222 <.0001 157
Book Value of Equity
-0.01169 0.8901 142
0.59057 <.0001 157
0.74349 <.0001 157
0.08858 0.2699 157
-0.12920 0.1068 157
0.19373 0.0151 157
-0.19771 0.0131 157
0.91908 <.0001 157
1.00000 157
0.87499 <.0001 157
Market Value
-0.06672 0.4302 142
0.51645 <.0001 157
0.61753 <.0001 157
0.03785 0.6379 157
-0.11192 0.1628 157
0.17833 0.0254 157
-0.16353 0.0407 157
0.86222 <.0001 157
0.87499 <.0001 157
1.00000 157
36
Panel B Pearson Correlations, 2006 Parameter, p-value, n
Cost of Equity
Log of Assets Total Debt
GDP/ Capita
Anti-Director Rights
Code/ Common
Consumer Price Index
Net Income
Book Value of Equity
Market Value
Cost of Equity Capital
1.00000 143
0.09730 0.2476 143
0.03576 0.7253 99
0.06276 0.4565 143
-0.03230 0.7017 143
0.15003 0.0737 143
-0.12020 0.1527 143
-0.121860.1471 143
0.04255 0.6138 143
-0.04735 0.5744 143
Log of Assets
0.09730 0.2476 143
1.00000 157
0.69027 <.0001 110
0.01488 0.8532 157
-0.31047 <.0001 157
0.46100 <.0001 157
-0.23373 0.0032 157
0.52964 <.0001 157
0.61334 <.0001 157
0.52276 <.0001 157
Total Debt 0.03576 0.7253 99
0.69027 <.0001 110
1.00000 110
0.06765 0.4825 110
-0.21460 0.0244 110
0.30847 0.0010 110
-0.16881 0.0779 110
0.30874 0.0010 110
0.48793 <.0001 110
0.34905 0.0002 110
GDP/Capita 0.06276 0.4565 143
0.01488 0.8532 157
0.06765 0.4825 110
1.00000 157
0.12621 0.1152 157
-0.31663 <.0001 157
-0.59854 <.0001 157
0.12488 0.1192 157
0.17092 0.0323 157
0.12570 0.1167 157
Anti-Director Rights
-0.03230 0.7017 143
-0.31047 <.0001 157
-0.21460 0.0244 110
0.12621 0.1152 157
1.00000 157
-0.75081 <.0001 157
0.35712 <.0001 157
-0.066560.4075 157
-0.12829 0.1093 157
-0.11093 0.1666 157
Code/ Common Law Dummy
0.15003 0.0737 143
0.46100 <.0001 157
0.30847 0.0010 110
-0.31663 <.0001 157
-0.75081 <.0001 157
1.00000 157
-0.10001 0.2127 157
0.15862 0.0472 157
0.21313 0.0074 157
0.19423 0.0148 157
Mean Consumer Price Index
-0.12020 0.1527 143
-0.23373 0.0032 157
-0.16881 0.0779 110
-0.59854 <.0001 157
0.35712 <.0001 157
-0.10001 0.2127 157
1.00000 157
-0.181190.0231 157
-0.22102 0.0054 157
-0.20590 0.0097 157
Net Income
-0.12186 0.1471 143
0.52964 <.0001 157
0.30874 0.0010 110
0.12488 0.1192 157
-0.06656 0.4075 157
0.15862 0.0472 157
-0.18119 0.0231 157
1.00000 157
0.88914 <.0001 157
0.92613 <.0001 157
Book Value
0.04255 0.6138 143
0.61334 <.0001 157
0.48793 <.0001 110
0.17092 0.0323 157
-0.12829 0.1093 157
0.21313 0.0074 157
-0.22102 0.0054 157
0.88914 <.0001 157
1.00000 157
0.93253 <.0001 157
Market Value
-0.04735 0.5744 143
0.52276 <.0001 157
0.34905 0.0002 110
0.12570 0.1167 157
-0.11093 0.1666 157
0.19423 0.0148 157
-0.20590 0.0097 157
0.92613 <.0001 157
0.93253 <.0001 157
1.00000 157
TABLE 4 Regression Tests of Value Relevance
Ordinary Least Squares Regression Model
Panel A: Code Law where n = 113 firm year observations Dependent Variable is MVj, t/MVj, t-1
2004 2006 Parameter Estimate
t-Value
Parameter Estimate
t-Value
Intercept 10.9 27.3*** 1.01 19.37***BV j,t/MV j,t-1 1.23 3.72*** 1.60 4.25*** NI j,t/MV j,t-1 0.04 0.65 .030 3.55***
F-Value 9.07 *** 16.43 Adj R2 0.13 .22
Vong test of difference in Adj R2, p < 0.06 Panel B: Common Law where n-113 Dependent Variable is MVj, t/MVj, t-1
2004 2006 Parameter Estimate
t-Value
Parameter Estimate
t-Value
Intercept 1.18 9.01*** 1.09 18.52*** NIj,t/MVj,t-1 -1.50 -1.49 -0.82 -1.75 BVj,t/MVj,t-1 0.53 2.37* 0.37 2.18* F-Value 3.25 0.05* 2.59 0.09* Adj R2 0.09 0.07
Vong test of difference in Adj R2, p < 0.70
37
TABLE 5 Information Content of Earnings Announcement
Mean and Cumulative Abnormal Returns
Panel A = Code Law Countries Code Law Group (n = 113)
Abnormal Returns Common Law Group (n = 227)
Abnormal Returns
Ordinary Least Squares
Scholes-Williams
Ordinary least squares
Scholes-Williams
2004
2006
2004
2006
2004
2006
2004 2006
Day
MAR
MAR
MAR
MAR
MAR
MAR
MAR
MAR
-1 0.03 0.07 0.05 0.05 0.32 -0.10 0.29 -0.15
0 0.35 -0.39* 0.35 -0.39 0.18 1.29*** 0.19 1.30**
1 0.09 0.62*** 0.01 0.62*** -0.42** 0.14 -0.48** 0.16
2 0.20* 0.34*** 0.21** 34** -0.02 0.29 0.02 0.31
3 -0.07 -0.06 -0.08 -0.06 0.26* 0.49** 0.23 0.52**
4 -0.08 0.24** -0.06 0.22** -0.14 0.16 -0.13 0.16
CAR CAR CAR CAR CAR CAR CAR CAR -1 to +4
0.52*
0.83***
0.56*
0.78***
0.17
2.26***
0.11
2.30***
Legend: MAR = daily mean abnormal returns for a sample of N firms. CAR = mean cumulative abnormal return from day -1 to 1 days within the announcement
period.
38
39
TABLE 6 Cost of Equity Capital
For years 2004 and 2006
Legal Origin Code Law Common Law Year 2004 2006 2004 2006 Number of Observations 103 105 103 105 Mean value of Cost of Equity Capital 0.097 0.090 0.098 0.078***
Panel B CECj,t = {SIZE, LAW, SR, DEBT, CPI, GDP}
2004 N=142
2006 n = 142
Variable Parameter Estimate
t-Value Parameter Estimate
t-Value
Intercept 0.02 0.50 -0.05 01.12 Log (assets) 0.00 0.30 0.00 0.57 Code/ Common dummy 0.02 2.18* 0.04 5.04*** AntiDir Rights 0.01 2.00* 0.01 3.70**** Mean CPI -0.01 -2.24* -0.01 -0.90 GDP/Capita 0.00 1.86 0.00 2.64* Total Debt -0.00 -0.08 -0.00 -11.22 F-Value 0.96 1.95 Adj R-squared .00 .04
Where: N = number of firm year observations ,
CECj,t = cost of equity capital, SIZE = log of total assets, LAW = 1 if common law country, 0 otherwise
SR = shareholder rights or antidirector rights as defined by La Porta et al., (1999) with 6 indicating the highest shareholder rights and 0 as having no shareholder rights (see Table 3, pages 1130-1131),
DEBT = total debt including long term and short term debt divided by total assets, CPI = country specific consumer price index,
GDP = gross domestic product as an indicator of level of development as some emerging countries are approaching the developed stage (like South Africa) whereas other are not.