Expect a pop in equity valuations, increased liquidity and lower trading costs as foreign companies list stocks in the United States using International Financial Reporting Standards (IFRS). That's according to a working paper published by the University Of Chicago Graduate School of Business.
The Securities and Exchange Commission (SEC) announced last November that foreign companies could tap U.S. capital markets using IFRS reporting standards as opposed to our generally accepted accounting principles (GAAP). Similarly, the SEC was considering allowing domestic companies to choose between reporting under GAAP or IFRS. The comment period on that issue closed in December. As of this writing, a final rule had not yet been issued.
The SEC formerly required foreign companies either to report using GAAP or to engage in the costly procedure of reconciling accounting statements using GAAP via Form 20-F. But the U.S. Financial Accounting Standards Board in Norwalk, Conn., and the International Accounting Standards Board in London, in October 2002 signed the "Norwalk Agreement," aimed at developing a universal accounting standard.
Global accounting standardization, according to the SEC, makes it easier for money managers, analysts and investors to compare financial statements. It creates transparency and improved financial reporting.
The University of Chicago working paper, published last October, looked at more than 3,800 first-time users of IFRS. It analyzed the effects of the rules on the stock market's liquidity, on the cost of equity capital and on a company's value. The paper, "Mandatory IFRS Reporting Around the World: Early Evidence on the Economic Consequences," was by Luzi Hail from the Wharton School of Finance; Holger Daske from the University of Mannheim; Christian Leuz from the University of Chicago and Rodrigo Verdi from MIT.
According to the SEC, 100 countries already either require or use IFRS for financial reporting, including the European Union and Asia. U.S. multinationals and foreign companies were expected to adopt the IFRS standards to maintain their competitive advantage in the capital markets.
The University of Chicago paper indicated that using IFRS results in some improvement. For example, total trading costs and the percentage of bid-ask spreads both declined by 12 basis points. As a result, liquidity increased 3% to 6% from the median level before the adoption.
In addition, equity valuations increased 2% from the median valuations before adoption of IFRS. The companies that chose to list their stocks based on IFRS early on tended to benefit most from increased liquidity and equity valuations, the paper says.
The adoption of IFRS, however, did not, as was anticipated, lower a company's cost of capital. Co-author Luzi Hail says IFRS was expected to reduce a company's cost of capital because a company would not have to follow different accounting standards. However, the researchers found that, on average, the cost of capital was a mixed bag, and it did not decline. The reason: Companies had increased expenses due to the implementation of the new accounting procedures. Also, the new standards created difficulties in forecasting earnings.
The study also found that corporations in countries with strict regulatory enforcement agencies benefited most from the introduction of the international accounting standards. "Not every country obtains benefits by simply adopting IFRS," Hail says. "IFRS, like U.S. GAAP and other sets of accounting standards, give firms substantial discretion. On the one hand, this is a good thing, since reporting involves considerable judgment and should allow managers to convey their superior information to outside investors or, alternatively, to keep information private for competitive reasons."