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Getting on the Same Page
Can a Set of Accounting Standards Lower Equity Cost?
When is a 10 percent profit not a 10 percent profit? When it’s being reported by different companies in different nations that have different accounting and financial reporting standards. That disparity can make it difficult for even the savviest investor to reach a wise conclusion about how well a business is really doing.
To deal with this issue in a way that could improve the investment climate, the European Union (EU) in 2005 made it mandatory for publicly listed firms to report their results using International Financial Reporting Standards (IFRS). For the first time, an investor could look at the financial report for a steel company in England and a steel company in Germany and make a reasonably quick and fair comparison between the two.
“Now we all speak one language financially,” says Siqi Li, Assistant Professor of Accounting at the Leavey School of Business. “This has significant implications, and an interesting and important issue is what the economic consequences will be.”
Li looks at one of the major questions in her paper, “Does Mandatory Adoption of International Financial Reporting Standards in the European Union Reduce the Cost of Equity Capital?” Her conclusion, with some caveats, is that it does.
Simply put, when there is greater financial transparency, investors are more confident in their analysis of a company. That can raise stock values because the securities aren’t being discounted for inadequate or questionable financial information. The higher stock values, in turn, lower the firm’s capital costs.
Furthermore, when accounting standards are the same from country to country, investors can make comparisons between similar firms with greater confidence, and this reduction in information asymmetry can also lead to a lower cost of equity.
IFRS is a principles-based standard rather than a rule-based standard, which is more commonly used in the United States. In a principles-based standard a company would be given a general direction for what it has to report in principle. The rule-based standard would more specifically stipulate exactly what has to be reported and how.
One of her findings, Li says, was that the success of the new standards is clearly linked to a climate of strong enforcement.
“There are different levels of enforcement from country to country,” she says, “and there’s a strong benefit in equity costs only when enforcement is seen as effective. Without that, there’s no significant benefit.”
Li’s paper, one of the first significant attempts to evaluate the impact of IFRS in the European Union, is adapted from her dissertation, begun more than three years ago at the University of Southern California. Using information from various computer databases, she painstakingly, and without help from collaborators, examined more than 6,000 company observations in 18 different European nations to reach her conclusion. The key number is that the average reduction in cost of capital by mandatory adopters of the standards was 4.2 percent.
“It appears that having a single set of high-quality standards does help investors by allowing them to better compare and use financial information,” she says.
But, she adds, that’s only one part of the picture.
“I didn’t attempt to show the cost of adjustment for firms that had to adopt these standards,” she says. “There are significant costs to a firm in terms of the time of managers and executives, and there could be resistance from some managers who may not want to go along with it. I just show one type of benefit, but there are a lot of costs to it.”
ACCOUNTING ACROSS BORDERS: Siqi Li’s research shows that the adoption of universal accounting standards in Europe has reduced the cost of capital, but only where there is strong enforcement.