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Water Partners

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on 26 September 2016

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Transcript of Water Partners

Water Partners
The effects of the adoption of IFRS by organizations in the EU on the cost of equity capital.
Extent of the Effects on the Cost of Equity Capital
The effectiveness of mandatory IFRS adoption regulation leading to reduction in cost of equity capital depends on the extent to which the institutional environment and other mechanisms influence preparers' actual reporting incentives.
Sample Selection Process
Sample Data Collection
6456 firm-year observations (including 1781 IFRS firm-year observations)

1084 distinct firms in 18 EU countries

During 1995 to 2006 period (exclude transition period i.e., the last year before and the first year of mandatory IFRS adoption)
Legal Enforcement Environment
Increased Disclosure Mechanism
Advisory Services
1) S Barathan
2) Lim Zhee Yong
3) Toh Zhen Xi Jessie
4) Chua Shi Jie
Team Members:
Initial Reference:
Li, S. (2010) Does Mandatory Adoption of International Financial Reporting Standards in the European Union Reduce the Cost of Equity Capital? The Accounting Review, 85(2), 607-636.
What is IFRS?
International Financial Reporting Standards (IFRS) is developed maintained by International Accounting Standards Board (IASB)

Seeks to improve and standardize global accounting standards and procedures
Why Standardize?
Users are able to better understand and compare the financial performance across borders

Cost savings
Firms are obligated to follow a more inflexible and narrow set of rules
Why Europe?
Purpose of Research
Definition: Voluntary versus Mandatory
Regulatory homogeneity across EU reduces unspecified cross-country differences.

Relatively strong legal systems and enforcement regime

Important milestone for achieving convergence integration in the EU capital market
Effects on Cost of Equity by adoption of IFRS
Provide insights into the economic consequences of mandatory IFRS adoption

Contributes to the limited empirical research on the economic consequences of disclosure regulation

Highlight the importance of institutional arrangements in shaping the outcomes of financial reporting convergence.
Voluntary Adopter
Firms that adopt the IRFS before 2005

Enhanced Comparability Mechanism
Research Design
Using voluntary adopters as a control group to isolate the effects of IFRS adoption by differencing out possible factors that changes. Comparing the changes in the cost of equity before and after the adoption to mitigate potential self selection bias related to heterogeneous characteristics across mandatory and voluntary adopters
Reduce information asymmetry and estimation risk --> higher quality information --> make better decisions --> markets allocate funds more efficiently --> firms achieve a lower cost of equity capital

Reduce information acquisition costs of global investors --> increase investments in foreign firms

Positive information externalities - because the value of one firm is correlated with that of another firm
Mandatory Adopter
Strong versus Weak Legal Enforcement:
Firms that do not adopt the IFRS until 2005
Limitations of the Research
Summary: Combined Effects on Cost of Equity Capital
No Change:
Reference List
1) Mandatory adoption period limited to 2 years (2005 & 2006).
- Due to data availability at the time research was conducted.

2) IFRS adoption is a costly event.
- There are other indirect costs associated with adoption.
Deegan, C. (2014) Financial Accounting Theory, 4th Edition, McGraw Hill Education, Sydney, Australia.

DeFond, M., Hu, X., Hung, M., & Li, S. (2011) The impact of mandatory IFRS adoption on foreign
mutual fund ownership: The role of comparability.
Journal of Accounting and Economics
51(3), 240-258.

Li, S. (2010) Does Mandatory Adoption of International Financial Reporting Standards in the European Union Reduce the Cost of Equity Capital?
The Accounting Review
, 85(2), 607-636.

Strong legal enforcement:

Ensure financial information disclosure are more reliable (higher accounting quality)

Disclosed information are higher in value (in terms of reliability and transparency)
Weak legal enforcement:

More likely to abuse the discretion afforded by accounting rules

Engage in earnings manipulation
Improves the overall transparency of EU companies' financial reporting --> increases access to information

Reduces uncertainties surrounding the company's prospects

Mitigates selection problems and enhances liquidity --> lowers transaction costs and/or creates stronger demand for firm's securities --> reduce cost of equity
Increased Financial Disclosures Reduces the Cost of Equity Capital
Enhanced Information Comparability Reduces the Cost of Equity Capital
Adopting a common accounting ‘language’ can facilitate cross-border capital flows, therefore reduce the cost of capital.

Improve the information disclosure quality of companies in countries where lower standards of disclosure are required by national generally accepted accounting principles (GAAP). By reducing information asymmetry, investors are able to monitor managerial performance better and therefore demand a lower risk premium.

Uniform accounting standards is likely to improve information comparability across firms, which in turn is expected to reduce the cost of equity capital

Countries with Weak legal enforcement

Increase in disclosures from IFRS adoption to current accounting standard

Eg.Companies may perceive the sudden increase in demand for improved accounting and disclosure as a cost as opposed to a benefit

Voluntary adopter do not experience significant changes as they choose to adopt IFRS much earlier before the mandatory legislation and the decision of adopting IFRS is after considering cost-benefits analysis.

In Countries with weak enforcement mechanisms

Small increase in disclosures from mandatory IFRS adoption experience no significant change in their cost of equity
- Eg.Company in these countries is not enforced and not require to do much changes therefore no significant change
“Cost of Equity Capital” opportunity cost of making a specific investment.
cost of equity capital also known as return required to persuade the investor to make a given investment.

Today, our team discuss consequences on the cost of equity capital if a firm decides to adopt IFRS
Consequences will be measured by using the research by Li (2010).

Cost of Equity
Mandatory Adoption of the IFRS may be beneficial but is everyone really benefiting
Reduction in equity capital is a positive effect of adopting the IFRS

Stable and healthy companies usually have consistently low costs of capital and equity.

High costs of capital and equity are associated with risks.

Creditors and Investors require highers returns to offset the risks.

Similarity: Increased Disclosure & Enhanced Comparability
Two mechanisms' effects on the cost of equity capital were similar

Voluntary adopters do not experience any change in their cost of equity (small statistical power may be due to the small sample size of voluntary adopters in Li’s research)

Given proper implementation and enforcement, both increased financial disclosure and enhanced information comparability mechanisms can reduce the cost of equity capital after mandatory IFRS adoption
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