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Mandatory Accounting Standards and the Cost of Equity Capital

By Harvard Law School Program on Corporate Governance

In my forthcoming Accounting Review paper Does Mandatory Adoption of International Financial Reporting Standards in the European Union Reduce the Cost of Equity Capital? I test whether mandatory IFRS 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 of 1995 to 2006. I define firms that do not adopt IFRS until it becomes mandatory in 2005 as mandatory adopters, firms that adopt IFRS before 2005 as voluntary adopters, and I divide the sample period into pre- and post-mandatory adoption periods.

My primary analysis consists of regressing the cost of equity (using average estimates from four implied cost of capital models) 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 that include whether a firm is cross-listed in the U.S., 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 adopters over the period of 1995 through 2006, compares the change in the cost of equity for mandatory adopters before and after the mandatory switch, relative to the corresponding change in the cost of equity for voluntary adopters.

I find that mandatory adopters experience a significant reduction in the cost of equity by 48 basis points after the mandatory introduction of IFRS in 2005, and that voluntary adopters experience no significant change in the cost of equity after mandatory IFRS adoption. The results also show that while voluntary adopters 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 deleting the ?transition period? around the mandatory adoption (i.e., the last year before and the first year of mandatory adoption).

In additional tests, I find 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 IFRS adoption is likely to benefit shareholders. I also find evidence that both increased disclosure and enhanced comparability help explain why mandatory IFRS adoption reduces the cost of equity, and that these factors are only important in the presence of strong legal enforcement.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on January 06, 2010 (boomark / email).