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."
Despite some encouraging results in liquidity and valuations, the study raised questions about the anticipated benefits to IFRS. If the foreign company is mainly using GAAP and IFRS standards the same way, then the impact on liquidity is negligible.
Meanwhile, Hail sees little capital markets benefit from U.S. firms switching from GAAP to IRFS. "The infrastructure is already in place, and combined with the strong reporting incentives due to constant pressure from investors, we may not see much of an impact on how U.S. firms report," Hail says. "But perhaps U.S. firms will gain from comparability benefits, which should be more pronounced when you are late in the game and everybody else has already switched to IFRS."
Others in their SEC comment letters say that it is too premature to implement global international accounting. The differences between U.S. GAAP and IFRS standards need to be addressed, they say.
Russell Read, chief investment officer of the California Public Employees' Retirement System, Sacramento, Calif., outlined his biggest problem: The current source of funding for the International Accounting Standards Board may pose a conflict of interest. IASB operations, the SEC has noted, is funded largely through voluntary contributions from companies, accounting firms, international organizations and central banks.
"We are concerned that the independence of the IASB may be compromised by its current source of funding," Read says. "CalPERS also questions whether the IASB currently has the enforcement infrastructure to ensure [a company's] compliance with international standards."
On the plus side, he says that multinational firms with a large percentage of revenue derived from overseas operations would gain a competitive advantage over their foreign competitors.
Allan C. Nichols, international equity strategist at Morningstar Inc., Chicago, says the accounting change overall will have a minor impact on investors. Stock analysts will benefit from uniform accounting standards, which will improve data consistency and make global peer comparisons better. Stock analysts will also be able to better evaluate a company's fundamentals.
But there are some differences between GAAP and IFRS that analysts need to recognize. On the plus side, IFRS standards recognize the underfunded pensions on the balance sheet more conservatively than GAAP accounting. But foreign companies that list in the United States using IRFS do not have to comply with the Sarbanes-Oxley Act of 2002, which established stronger standards for all U.S. company boards, management and public accounting firms.
Another major issue is that the fair-value accounting used in international accounting standards may be more helpful to analysts in evaluating corporate financial statements.
Fair-value accounting uses market prices or estimated market prices to value a company's assets and liabilities. In this case, financial analysts consider what the value of the company would be if it were sold or liquidated.
Say an insurance company sells a portfolio of policies. Investors want to know what the policies are worth in the marketplace. Under International Accounting Standards Board rules, insurance companies would have to revalue their assets, investment portfolios, liabilities and claims reserves quarterly.
The change in the value of the assets would also result in changes on the income statement. By contrast, under GAAP rules, assets are reported on a historical cost basis.
"Although fair-value accounting would make it easier for investors, analysts and insurance company safety rating agencies to evaluate insurance companies, corporations are concerned that fair-value accounting would make earnings and the value of reserves more volatile," says Kurt Schacht, CFA, managing director of the CFA Institute, Charlottesville, Va. "IFRS is not quite ready for prime time in U.S. markets. We fully support mutual recognition at some point. However, we believe that the (Form) 20-F elimination is premature."
Schacht also expressed concern about enforcement oversight, as well as the way auditing standards are adopted. There are other issues he says must be addressed if U.S. and international accounting standards converge: He says that there are major gaps in the financial reporting standards for significant classes of information, such as revenue recognition, pension plans and leasing.
He says more time is needed by the SEC to evaluate companies' effectiveness in implementing international accounting standards.
Inconsistent company application leads investors to lack confidence in current claims of IFRS compliance.
High quality, independent audits for full IFRS compliance have yet to be achieved and could pose a long-term problem. Regulators' coordinated efforts to enforce full IFRS compliance are still being implemented, and thus the overall effectiveness of regulatory oversight has not yet been fully demonstrated.
The current funding structure of the IASB remains a major issue. The International Accounting Standards Board is funded by companies and accounting firms. So there could be a conflict of interest.
Investors and investment professionals have little representation on the IASB and IASC Foundation, the body that appoints the IASB.
Standard & Poor's Neri Bukspan, managing director and chief accountant, and Ronald Joas, director of financial reporting, say they support the move to a global standard; however, they indicated that the IFRS disclosure framework is substantially incomplete.
"The importance of disclosures becomes much more evident during periods of transition, when reported financial information may change meaningfully for many, hindering analysts' ability to perform peer and period-over-period comparisons," they say.