A cost effective big bang

Edward Lee and Martin Walker outline research into the impact of IFRS adoption on the cost of company capital across Europe

The mandatory adoption of International Financial Reporting Standards (IFRS) across European Union listed companies from 2005 onward has been hailed as a ‘big bang’ in the history of financial reporting as well as a significant step towards global GAAP convergence. The primary objective of this policy is to enhance the quality of corporate disclosure and the comparability of financial statements across countries. Despite the initial preparation costs, proponents of IFRS adoption argue that companies will ultimately benefit from the reductions in the cost of capital that ensue. After all, the fundamental purpose of corporate security markets is to offer risk capital to companies as cheaply as possible.

However, the promised cost of capital benefits will not necessarily follow the GAAP switch both instantly and uniformly across companies. In order to assess such policy assertions, it is necessary to track the accounting harmonisation process as it evolves through time over different stages from expectation, through transition and into maturity. This calls for the analysis of the evolution of the corporate cost of capital from before the mandatory adoption of IFRS, through the big bang’ transition period following the release of the first set of accounts, to the settling down period as the market adapts to the new financial reporting regime. During the transition period, the cost of capital benefit may not be apparent, since the market may need time to adjust to the new set of standards. In the longer term the main positive impact of the switch to IFRS is likely to be greatest among the types of companies that had the highest costs of capital during the pre-IFRS period.

As part of ongoing research commissioned by ACCA on the cost of capital impact of IFRS adoption, we evaluate the distribution of the corporate cost of capital for a large sample of European quoted companies for the decade before IFRS implementation. We compare UK companies with their counterparts in the rest of Europe and conduct analyses based on industry as well as company-specific attributes. We infer the cost of capital measure from analysts’ earnings forecast and market price, which is an approach promulgated in recent years in the accounting and finance academic literature. To address the fact that companies in most European countries apart from the UK are financed primarily by debt, we compute the weighted average cost of capital (WACC), which also accounts for the cost of debt and the level of gearing.

The results show that the UK is systematically lower than the rest of Europe in terms of its equity premium, that is, the cost of equity capital minus the risk-free rate of interest. This supports the view that the higher disclosure requirements and general dominance of equity-based finance in the UK lower the costs of raising equity capital in the UK. However, companies are not only concerned about their cost of equity capital. What is more crucial to a company is its overall cost of capital that accounts for the cost of financing both through equity and debt. In contrast to our findings on the costs of equity, we find no systematic difference in the WACC premium, that is,. the level of WACC above the risk-free rate, between the UK and the rest of Europe. Due to their lower borrowing costs and higher leverage, companies in the rest of Europe do not necessarily face higher financing cost than companies in the UK.

Over the period of our study the cost of capital in Europe remains fairly stable. This trend persists despite a continuing decline in the risk-free rate in the sampled countries, which implies a relative increase in the risk premium through time over the corresponding period.

At an industry–level, we observe that the IT hardware and software, steel and materials, and mining sectors appear to have consistently higher median costs of capital, while the utilities, electricity, and beverages sectors appear to have consistently lower costs of capital. This supports the hypothesis that the market demands a higher rate of expected return for high growth and cyclical sectors, which are perceived to be riskier. Our analyses based on company-specific attributes further confirm this by showing that small-cap companies with a higher degree of intangible growth are systematically associated with higher costs of capital.

These results have potentially interesting implications for the way we should measure the cost of capital impact of IFRS adoption. First, if disclosure quality and equity investor interest do increase for companies in the rest of Europe following the GAAP switch, then in subsequent studies we should observe them to narrow the existing gap in the cost of equity capital with UK companies. Second, if companies in the rest of Europe can indeed achieve this reduction in cost of equity capital, while at the same time sustaining their lower cost of debt capital relative to their UK counterparts, they will then enjoy an overall cost of capital advantage over UK companies. In contrast UK companies should examine and address the reasons for their relatively high costs of debt capital if they wish to maintain cost of capital competitiveness. Finally, the cost of equity capital benefits that follow from mandatory IFRS adoption may not necessarily be enjoyed uniformly across all companies. Rather it is possible that the main benefits will accrue to the small-cap/high-growth companies in continental European countries, where the variability of accounting and disclosure quality and the low quality of domestic GAAP hampered the attraction of foreign equity investors in the past.

In conclusion, while advocates of global financial reporting harmonisation remain upbeat about its benefits and the international accounting community awaits the outcome of the EU experiment, the tangible economic consequences of the mandatory IFRS adoption in Europe may not be observable immediately or uniformly across all companies. The bottom line from our precursor study is that there appears to be scope for further convergence in the components of the costs of capital within the EU, and we also hypothesise that convergence in the cost of equity capital will be spearheaded by the small but high-growth companies of continental Europe.

Edward Lee is a lecturer in accounting and finance at the Manchester Business School. Martin Walker is professor of finance and accounting and deputy director (research) of Manchester Business School.