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Literature Review

This section would consist of five major parts which start from the previous articles in terms of the applications of event studies in the newly issued specific accounting standards as well as full-set accounting standards. Subsequently, the advantages and drawbacks with respect to the adopting IFRS would be extensively discussed. Last but not least, this paper would introduce previous research regarding the relationship between IFRS adoption and market reaction as the premise of following tests.

Previous Research regarding Adopting Specific Accounting Standards

Applying event study in the adoption of accounting standards has been extensively discussed. For instance, Leftwich (1981) tests if there is abnormal return while the two compulsory accounting standards, Accounting Principles Board Opinion No.16: Accounting for Business Combination and Opinion No.17: Accounting for Intangible Assets, are issued. It is found by Leftwich that there is negative impact on stock price provided these new standards cause adverse effect on firms. However, Dechow et al. (1996) indicate that there is no systematic evidence to support that investors reacted to news concerning mandatory expensing of stock options while FASB announcing Exposure Draft regarding stock compensation project. So far as the studies regarding newly accounting standards issued during the period of convergence stage in Taiwan are concerned, numerous domestic academic articles dedicate to uncovering the market reaction via the methodology of event study. For example, Lin (2005) argues that there is negative effect on the equity market while the SFAS No.35: Impairment of Assets is announced. In addition, the higher ratio of fixed assets over total assets, the greater cumulative negative abnormal returns have been found (ibid). Moreover, a negative effect on the equity market is found by Huang (2009) while she tests the market reaction to revised SFAC No.10: Inventory. The effect is more severe on the companies with higher amount of inventories or with lower margin rate.

Previous Research regarding Adopting Full-set Accounting Standards

There are numerous studies discussing the relationship between stock prices and the adoption of single accounting standard; nevertheless, research on the implementing the full set of accounting standard is relatively rare.

Daske et al. (2008) discuss research by Comprix et al. (2003) [1] which investigate abnormal returns of firms domiciled in European Union on four key event dates of public announcements that could raise the possibility of mandatory IFRS reporting. A weakly significant, albeit negative, market reaction to these four event dates has been found by them. Nonetheless, significantly positive returns would exist on certain preceding event dates provided that firms are audited by one of Big 5 auditors, domiciled in countries that are perceived to experience the greatest increase in quality of financial information as a consequence of IFRS adoption, or subject to stricter legal enforcement.

Armstrong et al. (2010) examine the market reaction to 16 events occurred from 2002 to 2005 in relation to the likelihood of mandatory adoption of IFRS in the EU. In comparison with Comprix et al. (2003), which studies the events from 2000 to 2002, Armstrong et al. (2010) analyse later events between 2003 and 2004 that are associated with the endorsement of the IFRS standards in general together with IAS 32/39 particularly. A positive (negative) reaction to events which increase (decrease) the possibility of IFRS adoption has been discovered by them. They also explain that this phenomenon results from evidence that investors anticipate benefits of harmonized accounting standards under IFRS.

Compared with Armstrong et al. (2010), which emphasises on whether mandatory IFRS is good or bad as perceived by investors, Christensen et al., (2007) focus on the differences in the economic consequences of mandatory IFRS among firms that are likely to incur relative benefits and costs due to the decision. Exploiting the extent of similarity with German voluntary IFRS and U.S. GAAP adopters as a proxy for U.K. firms’ intention to adopt IFRS, they argue that this proxy is positively (negatively) associated with the stock price reaction to events increasing (decreasing) the probability of mandatory IFRS reporting. In addition, they find a similar relation for changes in the cost of equity capital as well. In other words, UK firms with similar features to German voluntary adopter would experience greater benefits from accounting harmonisation.

Advantages of IFRS Adoption

The advantages of adopting IFRS would mainly be discussed in this section. In general, uniform accounting standards with better quality would result in financial reports with higher quality, and furthermore, it could foster higher liquidity of financial market and reduce information asymmetry. Ultimately, it could be predicted that the cost of capital also would decrease; namely, investor would accept lower return from their investment given that they have the belief that perceived riskiness would be reduced. So far as riskiness is concerned, Epstein (2009) mentions that there are numerous dimensions of riskiness and accounting risk is one of relevant concerns. He regards accounting risk as “the risk in investing derived from difficulties in understanding the accounting principles applied by reporting entity, and the possibility that financial reporting standards might not be uniformly adhered to.”

Followings are the details of significant merits regarding IFRS adoption which have been suggested in pervious literatures.

Enhance quality of Financial Information

Historically opposition to permitting IFRS based financial statement was attributed to the concern that the quality of IFRS is not as good as it of US GAAP. With the evolvement of IASB from former IASC in 2001 and substantially identical adopting due process to that of the FASB, IFRS has been gradually recognised as a label of better quality and IFRS-based financial reporting would make sure reasonable purposes of accomplishment of financial statements (Epstein, 2009). Similarly, regulators expect that as long as enterprise adopts IFRS, the comparability of financial statements, corporate transparency and the quality of financial reporting would be reinforced, and therefore IFRS adoption could benefit investors (e.g., EC Regulation No. 1606/2002).

Tarca (2004) finds that competitive market pressure could facilitate firms to exert international standards because numerous enterprises believe employing international standards would enable comparable information and better communication with users.

Through the aid of ‘quality score’ extracted from the yearly ‘Best Annual Report,’ Daske and Gebhardt (2006) suggest that disclosure quality experiences significant increase while adopting IFRS in the some European countries. Their result is applicable not only to firms which voluntarily adopt IFRS or U.S. GAAP, but also to firms which suffer from mandatory adoption of such standards. Their findings render extensive evidence on the ‘missing link’ in the line of argument that ‘higher quality’ international accounting standards result in higher quality accounting reports which should eventually contribute to higher liquidity in the capital markets (Leuz and Verrecchia, 2000) [2] and lower the cost of capital to the enterprises (Daske, 2006) [3] .

Curb Earning Management

In comparison with many local GAAP, IFRS are usually regard as a set of accounting standards with better quality and could reduce reporting discretion. Ewert and Wagenhofer (2005) contest that tightening the accounting standards could curb the degree of earnings management as well as improve reporting quality. Similar argument has been contended by following research that firms which adopt IFRS exhibit less evidence of earnings smoothing together with managing earnings; additionally, these firms usually recognise losses more timely and have more value relevance of accounting figures (Barth et al., 2008; Iatridis, 2010). Above-mentioned papers also sustain that quality of financial statements would be reinforced after adoption IFRS.

Foster International Capital Market and Cross-border Capital Flows

Nowadays, many major stock exchanges around the world (e.g., London, Frankfurt, Bangkok, Hong Kong, and Kuala Lumpur stock exchange) accept that foreign-listed firms prepare their financial reports in accordance with IFRS without any reconciliation (Hope et al., 2006). They also find that IFRS could be deemed as a vehicle for countries to reinforce investor protection and enhance the accessibility of capital markets to foreign investors. According to Hope et al. (2006), it is held by Carnachan (2003) [4] that adopting IFRS could not only lessen costs of reconciling financial reports from original GAAP to foreign GAAP for companies which seek to finance overseas but save investors efforts to comprehend multiple sets of standards.

In addition, Covrig et al. (2007) demonstrate evidence that the global convergence towards IFRS reporting may foster cross-border investment as well as the integration of capital markets. They also find that IAS adopters could provide more information and/or more familiar form of information with foreign investors. Hence, adopting IFRS could alleviate the cost of information about foreign investment and facilitate investors to put their money in cross-border investment. That is to say, a common set of accounting standards would assist investors in differentiating between lower and higher quality firms; simultaneously, it would lower estimation risk and ameliorate information asymmetries among investors (Daske et al, 2008). Besides, Merton (1987) contends that making foreign investors easily invest a country’s firms easier would result in certain merits such as reinforcing the liquidity of the capital markets and expanding firms’ investor base, which enhances risk sharing and reduces the cost of capital.

Improve Liquidity and Information Asymmetry

Epstein (2009) contests that if investors become more assured that reporting entities’ financial statement precisely represent their economic positions and results of operation, the market for those firms’ securities would be more liquid. He further defines liquidity as “the ease of selling assets, as evidenced by lower transaction costs and narrower bid-ask spreads.” Daske et al. (2008) perform the empirical tests and find that the market liquidity of mandatory adopters witness statistically significant increases after IFRS reporting changes into mandatory. Similar result has been asserted by Leuz and Verrecchia (2000), which examine German firms which alter from national to international standards. They assert that the information asymmetry and liquidity, which is estimated by the proxy variables, bid-ask spread and trading volume, is reduced.

Lower the Cost of Capital

It has been suggested by several seminal papers (Botosan, 1997; Hail, 2002; Botosan and Plumlee, 2002; and Francis et al., 2008) that companies are equipped with high levels of disclosure would enjoy low information risk; simultaneously, it is more likely for them to have a lower cost of capital, compared with those firms with low disclosure levels and high information risk. In addition, as noted by Ding et al. (2007), IFRS usually requires more comprehensive disclosures than do most counties’ accounting standards. Hence, it is extensively asserted that adopting IFRS would lessen the cost of capital by many seminal papers. For example, Daske et al. (2008) figures out a decrease in firms’ cost of capital with a corresponding increase in Tobin’s q, but only if they account for the likelihood which these effects occur before the official IFRS adoption date; therefore, this situation indicate that the market could predict the economic consequences of the mandate.

Other Merits

Apart from above-mentioned advantages, there are also some positive effects of adopting IFRS are asserted by numerous studies. Take El-Gazzar et al. (1999) for example, they state that exposing to new market, obtaining overseas debt and equity capital, enhancing customer recognition and lessening political costs could be the reasons why enterprises voluntarily comply with IFRS.

Enforcement

Although the merits of adopting IFRS have been comprehensively discussed above, there are numerous studies indicating that enforcement is a crucial factor which would impede the anticipated effects derived from IFRS adoption. Daske et al. (2008) find that the capital-market effects on the mandatory implication of IFRS reporting are not identical across countries and firms. These effects around mandatory IFRS adoption exist only in countries equipped with stricter enforcement regimes and in countries which the institutional environment renders strong incentives to firms so as to render transparent financial information. Furthermore, Daske et al. (2009) divide firms into ‘serious’ and ‘label’ [5] in according to their attitudes towards adopting IFRS. They notice that serious firms would enjoy significantly stronger effects than label ones in terms of the cost of capital and market liquidity. Namely, market participants could distinguish these two categories of firms.

Ball (2006) argues that uneven implementation, which derived from the inevitable political and economic factors around the world, would curtail the ability of common set of standards to lessen information costs as well as information risk. In addition, information processing costs might increase by immersing accounting inconsistencies at a less transparent and deeper level than more-readily observable differences in standards (ibid.). Ball believes that the foresaid situation would considerably influence the potential benefits of IFRS adoption. Similar result has been asserted by KPMG (2006) who surveys 187 firms across 10 countries in order to realise the different accounting principles or practices selected although these firms have prepared their accounting reports in accordance with IFRS. This survey indicates that despite substantial convergence, a strong national identity is still included in IFRS financial statements, which complies with the views regarding reporting incentives.

Drawbacks of adoption of IFRS

In the foresaid section, the merits of adopting IFRS have been comprehensively discussed. On the contrary, it is possible that investors would react negatively to the IFRS adoption when they anticipate that the costs come from adoption outweigh the benefits of it. Followings are the details of potential disadvantages regarding the implementation of IFRS.

Understandability

Epstein (2009) argues that accounting risk consists of several underlying phenomena. One is risk that accounting principles exerted could not fully and accurately reflect the real economic constructs. (e.g., historical cost could not measure the economic value of long-lived assets). On the other hands, Epstein believes that the inability of users to process information is also a reason for producing accounting risk. As long as investors could not fully comprehend the measures and disclosures of some complicated accounting information, they call for higher returns to compensate higher risk they bear. Hence, it is still possible that adopting IFRS would deteriorate the cost of capital due to the fact that users of financial statements are not capable of understanding information presented in accordance with IFRS, relatively strange to them.

Direct and Indirect Cost

According to Carnachan (2003), it is held by Hope et al. (2006), that converging to IFRS will generate “both one-time transitional costs and the on-going costs of maintaining a standard-setting system.” The one-time transitional costs manifests a huge amount of money and time spending because successful convergence calls for involvement of negotiations among the IASB, government authorities, national standard-setters, regulators, and professionals in participating in the convergence process. Simultaneously, direct compliance costs derived from retraining preparers, investors, auditors, and regulators to apply and interpret IFRS are inevitable. Apart from that, there will be on-going costs (e.g., mechanisms need to come up with the latest IFRS and interpretations and future standards) after the convergence. Jermakowicz et al. (2007) discuss the survey conducted by Ernst and Young (2002), which argue certain obstacles in the process of adopting IFRS. For example, adopting IFRS usually require paralleled accounting system in the periods of transition. Furthermore, it is mandatory to prepare comparative financial reports for past years. Apart from that, the necessary training for accountants, managements and auditors is also noteworthy. On the other hand, although adopting IFRS would increase disclosed information and, in turn, enhance the information quality, Dumontier and Raffournier (1998) contest that application IAS to Swiss firms would cost more. It results from the fact that firms apply IAS entail to prepare additional disclosure and give up vital discretion in accounting choices.

The foresaid paragraph primarily describes the direct costs of IFRS adoption; however, the indirect costs of it are also worth noticing. Hail and Leuz (2007) mention that proprietary costs could be a concern while consider indirect costs. Propriety costs are the costs come from the disclosure of propriety information to other parties (e.g., competitors, regulator and tax authorities) in the market. Firms which adopt IFRS would disclose more information than they used to doing under domestic GAAP. The additional disclosure might include significant competitive information (e.g., segment information), which not only would produce propriety costs but discourage companies’ disclosure incentives (Verrecchia, 1983).

Discretion

There are numerous papers discussing that firms’ reporting incentives (e.g., nations’ legal institutions, a variety of market forces, and firms’ characteristics of operating) truly cause significant effects on the reporting quality; conversely, the accounting standards only play a limited role (e.g., Ball et al., 2000; Leuz, 2003; and Burgstahler et al., 2006). With regard to this phenomenon, Daske et al. (2008) contents the reason for that is the application of accounting standards involves material judgments and exerting private information. As a result, it is likely that IFRS provide firms with substantial discretion which is related to their reporting incentives. Leuz (2006) further indicates that reporting behaviour is still expected to differ across firms provided that accounting standards offer some discretion and enterprises have inconsistent reporting incentives even under the assumption of perfect enforcement. Moreover, material discretion could be detrimental to the comparability of financial reports.

Mandatory Adopter

Daske et al. (2008) assert that capital-market effects would be different across voluntary and mandatory adopters. They believe that voluntary adopters regards adoption IFRS as a boarder strategy that enhances transparency of financial reporting and its quality; therefore, these firms could have more intention to make considerable changes in their reporting practices, such as engaging auditors with higher quality, reinforcing corporate governance, seeking cross-listing and etc. On the contrary, mandatory adopters are essentially compelled to adopt IFRS, and thereby they would experience less response to the treatment (Daske et al., 2008). In sum, the capital-market effects regarding voluntary adoptions are more likely to be prominent, but they cannot be ascribed to IFRS alone. As mentioned in the Section 2.1, Taiwan has converged towards IAS/IFRS since the late 1990s; therefore, it would worth noticing that if the full-set IFRS mandatory adoption would arouse significant influence in its capital market.

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