Expect a pop in equity valuations, increased liquidity and lower trading costs as U.S. and foreign corporations list stocks using International Financial Reporting Standards (IFRS). That's according to a working paper published by the University Of Chicago Graduate School Of Business.
The Securities and Exchange Commission proposed late last month that U.S companies will have to use IFRS reporting standards as opposed to our Generally Accepted Accounting Principles (GAAP) in the near future. The SEC would permit some multinational companies to report earnings based on the international standards in 2010 and by 2014 require U.S. companies to use the IFRS standards.
Meanwhile, the SEC announced last November that foreign companies could tap U.S. capital markets using IFRS reporting standards as opposed to our Generally Accepted Accounting Principles (GAAP).
The SEC formerly required foreign companies either to report using GAAP or engage in the costly procedure of reconciling accounting statements using GAAP via Form 20-F. The same would be true for U.S. companies in the future.
All this activity stems from efforts to standardize accounting worldwide. The U.S. Financial Accounting Standards Board, Norwalk, Conn., and the International Accounting Standards Board, London, in October 2002 signed the "Norwalk Agreement," aimed at developing a universal accounting standard. Global accounting standardization, according to the SEC, makes it easier for money managers, analysts and investors to compare financial statements. It creates transparency and improved financial reporting.
The University of Chicago working paper, published last October, looked at more than 3,800 first-time users of IFRS. It analyzed effects in stock market liquidity, cost of equity capital and firm value.
The paper, "Mandatory IFRS Reporting Around the World: Early Evidence on the Economic Consequences," was by Luzi Hail from the Wharton School of Finance; Holger Daske from the University of Mannheim; Christian Leuz from the University of Chicago and Rodrigo Verdi from MIT.
According to the SEC, 100 countries already either require or use IFRS for financial reporting, including the European Union and Asia. U.S. multinationals and foreign companies were expected to adopt the IFRS standards to maintain their competitive advantage in the capital markets.
The University of Chicago paper indicated that using IFRS results in some improvement. For example, total trading costs and the percentage of bid-ask spreads both declined by 12 basis points. As a result, liquidity increased between 3% and 6% relative to the median level prior to the adoption. In addition, equity valuations increased 2% relative to the median valuations before adoption of IFRS.
The companies that chose to list their stocks based on IFRS early on tended to benefit most from increased liquidity and equity valuations, the researchers said.
The adoption of IFRS, however, did not, as was anticipated, lower a company's cost of capital. Co-author Hail said the companies had increased expenses due to the implementation of the new accounting procedures. Plus, the new standards created difficulties in forecasting earnings.
The study also found that corporations in countries with strict regulatory enforcement agencies benefited most from the introduction of the international accounting standards.
"Not every country obtains benefits by simply adopting IFRS," Hail said.
Others have some concerns about the accounting standards. Russell Read, chief investment officer of the California Public Employee's Retirement System, Sacramento, Calif., is concerned about foreign companies listing in the U.S. using the international accounting standards because the current source of funding of the International Accounting Standards Board may be a conflict of interest. And the enforcement infrastructure may not be good enough to ensure compliance of international accounting standards.
IASB operations, the SEC has noted, are funded largely through voluntary contributions from companies, accounting firms, international organizations and central banks.
Overall, Allan C. Nichols, international equity strategist at Morningstar, Chicago, said the accounting change will have a minor impact on investors. Stock analysts, on the other hand, will benefit from uniform accounting standards, improving data consistency and enabling enhanced global peer comparisons on companies' fundamentals, Nichols said.
But there are some differences between GAAP and IFRS that analysts need to recognize. On the plus side, IFRS standards recognize the underfunded pensions on the balance sheet more conservatively than GAAP accounting. But, foreign companies that list in the United States using IFRS do not have to comply with rules of the Sarbanes-Oxley Act of 2002, which established enhanced standards for all U.S. company boards, management and public accounting firms.
Another major issue is fair-value accounting used in international accounting standards may be more helpful to analysts in evaluating corporate fundamentals. Fair-value accounting uses market prices or estimated market prices to value a company's assets and liabilities. Financial analysts consider the value of the company if it were sold or liquidated. The change in the value of the assets would also result in changes on the income statement. By contrast, under GAAP rules, assets are reported on an historical cost basis.
"Although fair-value accounting would make it easier for investors, analysts and insurance company safety rating agencies to evaluate insurance companies, corporations are concerned that fair-value accounting would make earnings and the value of reserves more volatile," said Kurt Schacht, CFA, managing director of the CFA Institute, Charlottesville, Va.
Some other issues Schacht said must be addressed if United States and international accounting standards converge include:
* Major gaps in the financial reporting standards for significant classes of information, such as revenue recognition, pension plans and leasing.
* High-quality, independent audits for full IFRS compliance have yet to be achieved and could pose a long-term problem. Regulators' coordinated efforts to enforce full IFRS compliance still are being implemented.
* The International Accounting Standards Board is funded by companies and accounting firms. So there could be a potential conflict of interest.
* The investor and investment professional community has little representation on the IASB and IASC Foundation, the body that appoints the IASB.
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