THE VALUE RELEVANCE OF IFRS IN THE EUROPEAN BANKING INDUSTRY

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THE VALUE RELEVANCE OF IFRS IN THE EUROPEAN
BANKING INDUSTRY

• by
• M. Agostino, D. Drago and D. B. Silipo
• Università della Calabria (Italy)
• This version, October 2008
• PAPER PREPARED FOR
• The European Financial Management Symposium 2009
  Risk Management in Financial Institutions April
  23-25, 2009 Audencia School of
  Management-Nantes, France

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• OUTLINE
• We investigate the market valuation of accounting
  information in the European banking industry
  before and after the adoption of IFRS, compulsory
  since 2005.
• To this aim, we specify a multiplicative
  interaction model in which the partial effects of
  earnings and book value on share prices are
  conditional on the adoption of IFRS. In addition,
  we use panel methods to control for
  time-invariant unobserved heterogeneity.
• Our main finding is that the impact of earnings
  on share prices increased after IFRS became
  compulsory in Europe, while book value did not
  significantly affect market valuation.

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• BACKGROUND
• Since 1 January 2005 all listed companies in the
  European Union have been required to publish
  their consolidated financial statements in
  accordance with International Accounting
  Standards, known as IAS/IFRS rather than national
  requirements (local GAAP).
• The assumption is that financial reporting under
  IAS/IFRS results in better information quality
  than local GAAP, with beneficial effects on the
  cost of capital.

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• An accounting number is value-relevant if it has
  a predicted significant relation to share prices.
  This is the case when the item conveys
  information that investors use in valuing the
  firm and when it is measured reliably enough to
  be reflected in share prices.
• This paper takes market value relevance as a
  proxy for overall information quality and
  investigates whether the value relevance of
  account numbers increased after the adoption of
  IAS/IFRS by listed banks in Europe.

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• A number of studies compare the value relevance
  of IAS, US-GAAP and local GAAP in other
  countries, with contrasting results.
• Barth et al. (2005) found that IAS produce better
  accounting quality than local GAAP outside the
  US, with beneficial effects on the cost of
  capital.
• By contrast, Eccher and Healy (2000), Wu et al.
  (2005) and Hu (2002) find that the accounting
  amounts based on IAS are no more value-relevant
  than those based on Chinese GAAP. Similar results
  are obtained by Dumontier and Labelle (1998),
  comparing IAS and French accounting principles.

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• More interestingly, Ball et al. (2003) studying
  the quality of financial reporting in Hong Kong,
  Malaysia, Singapore and Thailand find that the
  application of accounting standards also depends
  significantly on the regulatory, enforcement, and
  attestation environment.
• The evidence concerning the effects of IAS on
  accounting quality, then, is mixed, both in
  Europe and elsewhere. The qualitative results for
  the banking sector are similar.

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• However, the above results may suffer from sample
  selection bias, as the adoption of IAS was still
  voluntary. The European Union now offers a unique
  opportunity to address the issue of whether the
  earlier findings can be extended to situations in
  which the adoption of IAS is compulsory.
• Preliminary results indicate significant
  positive market reactions to events that
  increased the likelihood of the adoption of IFRS
  (see Armstrong et al., 2006, Horton and Serafeim,
  2007, Morais and Curto, 2007)

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EMPIRICAL QUESTIONS

• Using data from 2000 to 2006, we investigate
  whether replacing local GAAP with IAS improves
  the quality of accounting amounts in Europe.
• We test this prediction on European listed banks,
  for which IAS became mandatory in 2005.
• We investigate value-relevance by estimating a
  panel valuation model to see whether the
  value-relevance of accounting information
  changed.

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THE MODEL

• Building on the Ohlson (1995) framework, we
  estimate the following model
• P stock price six months after fiscal year end
  (robustness three months after)
• BVPS book value per share
• EPS earnings per share
• postIAS dummy coded 1 when IAS become mandatory
  (years 2005 and 2006), and 0 otherwise
• T trend
• e composite error summarizing unobserved
  time-invariant bank characteristics
  idiosyncratic shocks to market value.

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Estimation Method

• A poolability test (Breusch - Pagan test) on our
  sample shows that bank-specific fixed effects are
  statistically relevant.
• In addition, the Hausman test leads to the
  adoption of a fixed effects estimator.
• Although bank-fixed effects subsume all other
  time-invariant effects, the market value of a
  bank is likely to be sensitive to a variety of
  factors reflecting differences in national
  economic environments. So, some of these
  confounding effects may remain and the error
  terms may be correlated for banks belonging to
  same country over time. Accordingly, it is
  reasonable to cluster the observations at country
  level.

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Turning to the parameters of interest

• We specify a multiplicative interaction model
  the partial effects of book value and earnings
  are dependent on IAS adoption.
• The marginal effects of earnings and book value
  depend on the postIAS dummy.
• when postIAS 0 the marginal effects coincide
  with the estimated coefficients a1 and a2, and
  significance is given by the t-statistic
• when postIAS 1, we compute the appropriate
  marginal effects a1a4 and a2a5 (sum of the
  regressor and postIAS coefficients), and the
  relative standard errors.
• So the marginal effects may change sign and gain
  or lose significance depending on IAS adoption.

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SAMPLES

• The panel includes the listed banks in EU-15 in
  the period 2000-2006
• 1.1 The unbalanced panel (all available
  observations) is a sample of 1201 annual
  observations for 221 European listed banks.
• 1.2 The balanced panel (only the banks with data
  available for every year) falls from 1201 to 567
  observations and from 221 to 81 banks.
• We can compare the effects of IAS adoption on
  the same set of banks
• but data points are drastically reduced, so that
  the unbalanced sample may involve a gain in
  efficiency.

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Results Unbalanced panel estimates

• Before IAS adoption
• book value marginal effect positive and
  insignificant in itself, but tends to be
  significant jointly with its interaction term
  (see the F-test)
• earnings marginal effect positive and
  significant
• After IAS adoption
• book value marginal effect negative but not
  always significant (see march price estimates).
• earnings marginal effect positive and
  significant, its magnitude increases.

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Results Balanced panel estimates

• Before IAS adoption
• book value marginal effect positive but not
  always significant, even jointly with its
  interaction term (see the F-test)
• earnings marginal effect positive and
  significant
• After IAS adoption
• book value marginal effect positive (June
  price) and negative (March price) but always not
  significant
• earnings marginal effect positive and
  significant, its magnitude increases

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Country-by-country analysis

• Some heterogeneity of market reactions but a
  common pattern emerges
• The earnings interaction term is always positive,
  and from 2005 on the partial effect of earnings
  is positive and statistically significant
• the book value interaction term is mostly
  negative and the marginal effect of book value
  tends to become insignificant in the years
  following IFRS adoption (except in Denmark).
• In short, there is evidence that the impact of
  earnings data increased after IFRS were made
  compulsory. The largest additional effect of
  earnings data was in Germany and Italy, the
  smallest in Britain.

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• What drive these results?
• We take separate sub-samples of
• High and low-capitalization banks
• (On the ground that problems of information
  asymmetry are more severe for the smaller
  institutions)
• Cooperatives and public limited companies
• (As the former are expected to be more opaque)
• Rated and non-rated banks.
• (As the latter are expected to be more opaque)

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High and low-capitalization banks

• Low-capitalization banks
• pattern comparable to that for the entire
  sample earnings tend to have a greater impact,
  book value to turn negative and statistically
  insignificant.
• High-capitalization group
• the coefficients of both earnings and book
  value are positive and their marginal effects
  increase after IAS adoption

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Cooperatives and public limited companies

• Cooperatives
• earnings tend to have a significant greater
  impact, book value to turn negative and
  statistically significant.
• Public limited companies
• the increase in the impact of earnings and the
  decrease in that of book value again emerge, but
  both variables exert a positive marginal effect
  subsequent to IFRS introduction

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Rated and non-rated banks

• The results of the rated banks (105 banks and
  406 obs) are similar to those of the capitalized
  group (46 banks, 295 obs) even though the
  sub-samples are different.
• Non-rated banks confirm the results of the whole
  sample the (positive) earning coefficient
  increases and the book value coefficient becomes
  lower and not statistically significant.

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Robustness

• Alternative way of coping with extreme values
• Excluding the banks that voluntarily adopted IFRS
  before 2005.

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Concluding remarks

• Did the mandatory application of IAS/IFRS
  increase the value relevance of accounting
  information of the European banks?
• As we expected, the marginal effect (value
  relevance) of earnings on share prices after the
  IFRS were made compulsory increased for the
  entire sample. This is a robust result. The
  largest incremental effect was in Germany and
  Italy, the smallest in the United Kingdom.
• For equity book value, our results are less
  clear-cut. The marginal effect of this variable
  became negative (for the unbalanced panel) or
  insignificant (the balanced panel).
• The last result is driven by small and more
  opaque banks.

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• The segmentations results suggest that data for
  more opaque banks explain the negative effect of
  the book valueRestricting the field to the
  biggest or more transparent banks the
  value-relevance of both earning and book value
  increases with the switch-over. By contrast,
  the introduction of the new accounting standards
  does not appear to have enhanced the quality of
  accounting information for the smaller and more
  opaque banks.
• However, the results for the entire sample do not
  support the thesis that IAS produced a
  significant increase in the value relevance of
  book value.
• This calls for future research connected with
  possible effects of two recent developments in
  the banking industry the diversification of some
  banks (money centre//financial marketplace banks)
  into trading more liquid securities and the
  enormous growth of securitization and financial
  crash.