Does IFRS adoption in Canada reduce the information gap between managers and investors?

Does the actual implementation and enforcement of IFRS bring informational benefits to investors and other market participants?

As of 2011, Canadian companies prepare and report their financial statements according to international financial reporting standards (IFRS). However, the adoption and subsequent implementation of IFRS raises some critical questions (Cormier et al., 2007). For instance, does IFRS adoption lead to realization of the stated goals with respect to financial statements such as improving relevance, quality and comparability? In other words, beyond IFRS adoption, does the actual implementation and enforcement bring informational benefits to investors and other market participants?

Toward that end, we analyze if IFRS-based earnings bring incremental information benefits to investors compared with made-in-Canada generally accepted accounting principles (GAAP) used prior to 2011. The model we use to conduct our analysis is inspired by the work of Feltham and Ohlson (1995) and Amir and Lev (1996). Such a model maps a firm's book value and earnings into its stock market valuation. Our main findings are as follows: first, we find that migrating from GAAP to IFRS reduces the information asymmetry between managers and investors, as measured by an increase in analyst following and by a reduction in bid-ask spread, less analyst earnings forecast error, less earnings forecast dispersion, and a lower cost of equity capital. Second, investors seem to assign greater value to IFRS-based earnings than to GAAP-based earnings. Third, we observe a slight decrease in earnings management under IFRS, thus suggesting that IFRS better constrains managers' ability to manipulate reported earnings. Overall, it appears that IFRS provides Canadian investors with more relevant information than our previous GAAP.

Background: IFRS adopting countries' prior experience

The relevance of accounting information can be evaluated through various measures such as its impact on stock prices, on the accuracy of analyst forecasts, the cost of capital and analyst following. Results of studies conducted in Europe indicate that, first, with respect to stock prices; it appears that IFRS-based financial statements better map into how investors assess a firm's stock market value than GAAP. Second, there is some evidence that a switch from domestic accounting standards to IFRS has a modest positive impact on market liquidity and the cost of equity capital, most likely resulting from the reduction in information asymmetry between investors and managers following the implementation of IFRS. This reduction in asymmetry is attributable to higher quality financial reporting, higher analyst following and greater oversight by auditors and directors (Daske et al. 2008; Bruggermann et al. 2009). Third, the use of IFRS information allows firms to improve their coverage by foreign financial analysts as well as the accuracy of their forecasts, especially in countries with high investor protection (Byard et al. 2011). This increase in relevance for stock markets is observed for firms highly followed by analysts.

Overall, prior evidence suggests that even for a country categorized by strong investor protection and high-quality financial reporting and enforcement, IFRS adoption improves the value relevance of financial reporting for stock market participants. Considering that Canada is a country with a strong enforcement, we do expect IFRS adoption to translate into a positive outcome for Canadian investors.

Sample

The sample comprises firms from the S&P/TSX index for 2009 (GAAP) and 2011 (IFRS). From the initial 233 firms, data is incomplete for 13 firms. From the remaining 220 firms, 36 use the same set of GAAP for 2009 and 2011 (so-called no-change firms): 17 firms are complying with US-GAAP and 19 firms have a year-end after April 30 or IFRS adoption is postponed for different reasons (e.g. regulated industries). For firms with year-end after April, the data in Compustat database are for 2009 and 2010, i.e. prior to IFRS adoption. We do not include 2010 data to focus on clear Canadian GAAP and IFRS years.

Results

Table 1 provides the financial profile of sample firms under GAAP and IFRS. It appears that information asymmetry decreases under IFRS. Hence, analyst earnings forecasts' dispersion, forecast error, cost of capital and bid-ask spreads are lower under IFRS compared with GAAP. Consistent with prior research in Europe, Canadian firms are followed by more analysts under IFRS than under local GAAP.

Table 1: Descriptive statistics

  GAAP (2009) IFRS (2011)
  Mean Median Mean Median
Price 23.38 18.55 25.69 19.41
Equity per share 14.61 10.7 13.11 10.83
Earnings per share 1.1 0.57 1.49 1.02
Number of analysts 6.79 6 8.68 8
Forecast dispersion 0.01 0.026 0.008 0.011
Forecast error 0.085 0.028 0.031 0.014
Cost of equity capital1 0.148 0.128 0.11 0.103
Bid-ask spread  0.686 0.444 0.386 0.258

Results from an ordinary least square regression (not tabulated) show that $1 in shareholders' equity is valued at 84¢ under both IFRS and GAAP. Hence, it does appear that the balance sheet conveys similar information under both reporting regimes. However, investors value $1 of earnings at $2 in 2009 (GAAP) and at $3.36 in 2011 (IFRS). The higher stock market value assigned to IFRS-based earnings is consistent with investors finding such information more relevant than previous GAAP-based earnings.

To ensure that our results are not confounded by concurrent economic events or trends, we use firms that are not affected by a change in the set of GAAP as a control or benchmark sample (i.e., these firms use the same set of GAAP for 2009 and 2011). Overall, our evidence is still consistent with IFRS adoption enhancing earnings value relevance, even for firms that were already subject to SEC oversight as US filers. Pre-2011, if these firms were using pre-IFRS Canadian GAAP, they needed to reconcile their reported earnings to US GAAP-based earnings. Using IFRS allows them to avoid that requirement.

IFRS provide managers with extensive discretion in financial reporting. For instance, while US GAAP contains numerous rules and bright lines to specify the application of a particular standard, IFRS defers to professional judgment to a greater extent. Moreover, in many respects, IFRS is less conservative than Canadian or US GAAP, providing the possibility to revalue capital assets being a key illustration. In that regard, Jeanjean and Stolowy (2008) analyze the effect of the mandatory introduction of IFRS standards on earnings management for three countries: Australia, France and the UK. They find that the pervasiveness of earnings management did not decline after the introduction of IFRS, and, in fact increased in France. Their findings suggest that management incentives and national institutional factors play an important role in framing financial reporting characteristics.

We refer to country-level measures developed by Leuz et al. (2003) to assess earnings management under GAAP and IFRS. The first measure of a country-level earnings management is the standard deviation of earnings divided by the standard deviation of cash flow from operations: a high (low) ratio implies a low (high) level of earnings management. The intuition underlying that measure is that, absent managerial intervention, cash flow from operations and earnings should in general move in tandem. The second measure is the magnitude of accruals, i.e., the difference between cash flow from operations and reported earnings, the greater the different, the higher the level of earnings management. The third measure is the ratio of ''small profits'' to ''small losses,'' using net earnings scaled by total assets. Small losses are defined to be earnings per share down to 1¢ (0.01) below break-even while small profits are defined to be earnings per share up to 1¢ (0.01) above break-even. This last measure is qualified as an earnings-smoothing measure by Leuz et al. (2003).

Our results presented in Table 2 suggest that earnings management does vary in Canada under IFRS compared to GAAP. The first and second measures exhibit lower earnings management under IFRS. It is possible that the level of detail disclosed under IFRS may restrain managers from engaging in accruals management. However, we observe a slightly larger earnings smoothing under IFRS since, under Canadian GAAP, our sample firms exhibit a proportion of 2.625 small profits compared to small losses (if random, they should both be equally likely); whereas this measure is 2.80 under IFRS. However, considering the small sample this result must be interpreted with caution.

Table 2: Earnings management measures

1)     ơ Earnings / ơ CFO (-)
>GAAP (2009) 0.849
>IFRS (2011) 1.179
2)     |Accruals|/|Cash Flow|   (+)
>GAAP (2009) 0.697
>IFRS (2011) 0.598
3)     # small profits / # small losses   (+)
>GAAP (2009) 2.625
>IFRS (2011) 2.8

Conclusion

Our aim is to investigate whether IFRS adoption benefits Canadian investors. We bring some evidence that migrating from Canadian GAAP to IFRS provides investors with more relevant information by reducing the information gap between managers and investors. First, the advent of IFRS coincides with an increase in analyst following, a reduction in bid-ask spread, less analyst forecast error and less dispersion in analyst forecasts, as well as a reduction in the cost of equity capital. Second, IFRS enhances the value relevance of earnings. Third, we observe a slight decrease in earnings management under IFRS. The improvement in the information set available to market participants under IFRS is likely driven by incremental note disclosure which increased from an average of 33 pages under GAAP to 48 pages under IFRS.

The current study provides some preliminary evidence that IFRS adoption has improved the information environment for Canadian investors, and made it easier and cheaper for Canadian companies to access capital.

Denis Cormier, D.Sc., FCPA, FCGA, CA, is a professor at ESG UQAM (Cormier.denis@uqam.ca).

Michel Magnan, PhD., FCPA, FCA, is a professor at the John Molson School of Business, Concordia University (mmagnan@jmsb.concordia.ca)

Technical editor: Karim Jamal, FCA, PhD, chair of the department of Accounting, Operations and Information Systems, School of Business, University of Alberta

References

Amir, E. and M. Lev, M. 1996. Value-Relevance of Non-Financial Information: The Wireless Communication Industry. Journal of Accounting and Economics 22 (1-3): 3-30.

Bruggermann, U., Daske, H., Homberg, C., and P.F. Pope. 2009. How Do Individual Investors React to Global IFRS Adoption? Available at SSRN: http://ssrn.com/abstract=1458944.

Byard, D., Li, Y. and Y. Yu. 2011. The Effect of Mandated IFRS Adoption on Analyst' Forecast Error. Journal of Accounting Research 49 (1): 69-96.

Cormier, D., Lapointe-Antunes, P., and M. Magnan. 2007. Le référentiel IFRS: nous dirigeons-nous vers une comptabilité au-delà du réel? Comptabilité-Contrôle-Audit 13 (special issue): 43-56.

Daske, H., Hail, L., Leuz, C., and R. Verdi. 2008. Mandatory IFRS Reporting around the World: Early Evidence on the Economic Consequences. Journal of Accounting Research 46 (5): 1085-1143.

Easton, P. 2004. PE Ratios, PEG Ratios, and Estimating the Implied Expected Rate of Return on Equity Capital. The Accounting Review 79 (1): 73-95.

Feltham, G. and Ohlson, J. 1995. Valuation and Clean Surplus Accounting for Operating and Financial Activities. Contemporary Accounting Research 11 (2): 689-731.

Jeanjean T. and Stolowy, H. 2008. Do Accounting Standards Matter? An Exploratory Analysis of Earnings Management before and after IFRS Adoption. Journal of Accounting and Public Policy 27 (6): 480-494.

Leuz, C., Nanda, D., and P.D. Wysocki. 2003. Earnings Management and Investor Protection: An International Comparison, Journal of Financial Economics 69 (3): 505-527.

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.

About the Authors

Denis Cormier


Michel Magnan


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