IFRS adoption in the EU: stock market reactions

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On 6 June 2002, the Council of Ministers of the EU issued an official statement to require all listed companies12 in the EU to use IAS in their consolidated or simple accounts for the fiscal year starting 1 January 2005. Several studies examine the economic consequences of announcements and other events leading up to or sub- sequent to these announcements. Comprix et al. (2003) identify 11 dates between 2000 and 2002 that signal the likelihood or the timing of IAS adoption in the EU. They find stock markets reacted positively to news that increases the likelihood of IFRS adoption.

Armstrong et al. (2007) identify 16 events between 2002 and 2005 that may change the likelihood of the adoption of IFRS and the controversial fair value

IFRS Adoption and Accounting Quality: A Review 685

accounting on financial instruments, IAS 39. They find that stock market reaction is significantly positive (negative) in reaction to the events that increased (decreased) the likelihood of the adoption, and the reaction is stronger for firms that do not cross-list in the United States. They conclude that equity inves- tors perceive the benefit of the harmonization, but the benefits are expected to be smaller for firms cross-listing in the United States, since US GAAP is closer to IFRS than were most European domestic GAAPs.

In contrast to the three-day short-window test in Armstrong et al. (2007), Pae et al. (2006) focus on the reduction of Tobin’s Q associated with high agency costs in a long-window test over the period when the EU moves to IFRS. They examine differences stemming from the concentration of control (e.g. family or dispersed ownership) and the impact of the divergence between cash flow rights and control rights for related entities. They find that from 1999 to 2003, Tobin’s Q increased more for EU firms that: (1) were not listed in the United States; (2) were family-controlled; and (3) had low analyst following. Pae et al. (2006) attribute their findings to the announcement of IFRS adoption in the EU, which lead to expectations of reduced future agency costs.

The preceding papers examine the stock market’s perception of the economic consequences of mandatory IFRS adoption. Because the earliest financial state- ments under the mandate are for fiscal years ending on 31 December 2005, we are unable to identify any empirical tests of actual accounting harmonization through IFRS adoption. Barth et al. (1999) analytically examine price informa- tiveness after harmonization of accounting standards and find that changes in price informativeness can result from two effects. First, there is a direct informa- tional effect, which is the change in measurement error13 under the new stan- dards. A second, indirect, effect is the change in the amount of information from experts that is incorporated into stock prices. This change is determined by the cost and benefit of information acquisition. For example, if measurement error is decreased by new standards, both the benefit and cost of expertise acqui- sition are reduced. The net impact on price of information from experts will thus depend on the new, relative cost and benefit of expertise acquisition.

The direct and indirect effects may have opposite impacts on price informa- tiveness. Although measurement error decreases, price informativeness may not increase. This is because the amount of information acquired by experts may decrease as a result of a relative reduction in benefits of information acqui- sition. Barth et al. (1999) explore several conditions affecting the direction of the change in price informativeness.

Barth et al. (1999) also suggest that the cost for a country’s investors to become accounting experts for another country is reduced when the GAAP for the two countries become closer to each other. This increase in expertise results in an increase in stock price informativeness in the second country, because there are more investors who are experts in interpreting that country’s financial infor- mation. Once sufficient time has passed following mandatory adoption of IAS in the EU, this analytical result could be tested empirically. Researchers could

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investigate whether the price informativeness of the US stock market changes after EU countries adopt IFRS, which is supposedly more similar to US GAAP than were the country-specific GAAPs.

Another way that adopting IFRS can improve earnings quality is through monitoring by investors, whose costs of acquiring expertise is reduced. Adopting IFRS in EU countries reduces the cost of comparing firms across borders. It also reduces the investor cost to evaluate the quality of financial reports between two firms. The ease of comparison puts pressure on managers to reduce earnings man- agement. To date there is no direct empirical test of this argument.

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