Early Adopters of IFRS Signal Commitment to Quality Financial Reporting
In a recently published article in the Accounting & Finance journal (subscription required), Dean Katselas of the Australian National University and I report on our investigation into the impact of the adoption of the International Financial Reporting Standards (IFRS) around the world. Adoption of IFRS became mandatory in various jurisdictions beginning in the mid-2000s — for example, firms in the EU had to comply beginning 2005. So, a review of the impact has been possible only relatively recently.
IFRS and Reduction in Adverse Selection Costs
Typically, an assessment of the benefits of IFRS adoption focuses on their ability to improve information transparency. That transparency then enables cross-border trading and investment, increases market efficiency, and reduces the cost of capital by reducing the costs of adverse selection that arise from information asymmetry. The reduction in the costs of adverse selection is the focus of our investigation.
When a company improves the transparency of its reporting by adopting IFRS, the expectation is that there will be a reduction in the adverse selection component of a company’s bid–ask spread (the costs of adverse selection are estimated by decomposing the bid–ask spread into order processing costs, inventory holding costs, and adverse selection costs). The reason for the reduction would be that with a lower risk of an unforeseen negative shock to the firm’s business because of better financial transparency, market makers would be taking on less risk when trading the stock and thus should be able to offer tighter bid–ask spreads. In our investigation, we used a novel options-based approach to estimate the adverse selection component of the bid–ask spread, which is one of the contributions of the paper to existing literature on this subject.
We look at a sample of 16 countries and find that the benefits of IFRS adoption accrue mainly to firms that adopted IFRS early — that is, prior to deadlines imposed in their jurisdiction. We find that there is no reduction in adverse selection following mandatory adoption. As a result, we argue that the benefits of IFRS adoption take the form of signalling effects: early adoption provides a way for high-quality firms to credibly signal their commitment to quality financial reporting.
Local Reporting Standards Make a Difference
The purely technical aspects of IFRS do not seem to be as important. There is no improvement in adverse selection costs accruing to firms in jurisdictions that already have well-developed local reporting standards (e.g., Australia) or in jurisdictions with poor enforcement. This finding is consistent with IFRS adoption decreasing adverse selection through a signalling effect. The reason is that when firms operating in a jurisdiction with high-quality incumbent reporting standards adopt IFRS, they are not signalling a commitment to significantly improved financial reporting transparency. Instead, they are exchanging like for like. Similarly, in a jurisdiction with poor enforcement, adopting IFRS may not be a credible signal because firms could adopt these standards knowing they are unlikely to be enforced.
In summary, our paper argues that IFRS adoption increases the production of public information and reduces information asymmetry. But the extent of these benefits depends on the relative quality of IFRS versus incumbent domestic standards and the strength of enforcement in the local jurisdiction.
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