The Effectiveness of International Financial Reporting Standards Adoption on Cost of Equity Capital: A Vector Error Correction Model

By Al-Shiab, Mohammad Salam | International Journal of Business, Summer 2008 | Go to article overview

The Effectiveness of International Financial Reporting Standards Adoption on Cost of Equity Capital: A Vector Error Correction Model


Al-Shiab, Mohammad Salam, International Journal of Business


ABSTRACT

The purpose of this paper was to determine empirically whether adopting the International Financial Reporting Standards by Jordanian companies listed on the Amman Stock Exchange influenced its cost of equity capital over the period 1996-2000 using a Vector Error Correction Model. Expected return, extent of disclosure, financial leverage, and company size used as a proxy for cost of equity capital, disclosure, financial risk, and business risk, respectively. Moreover, Dickey-Fuller and Johansen Cointegartion tests were applied. Another tools used were the variance decomposition and Granger Causality tests. Results indicate that none of the independent variables significantly influenced the cost of equity capital.

JEL Classification: G3, G32

Keywords: Cost of equity capital; Disclosure; International financial reporting standards; Financial risk; Business risk

I. INTRODUCTION

There are many reasons for adopting the IFRS. The economic forces of International trade have created the need for a single international standard of financial reporting. International trade is as old as civilization, but until very recently no effort has been made at uniform financial reporting. A single standard would make multinational business much easier. An agreed international standard of reporting would also ease tracking both domestic and international economic growth. Chamisa (2000) demonstrated that growing international trade and investment increased problems produced by different nations using different accounting systems. Studies such as Sharp (1998) and Street et al. (1999) have demonstrated that a) differences in financial accounting measurement and reporting practices do exist; and b) these differences do actually create problems of misunderstandings, inefficiencies, and uncertainties to participants in the global economy (Evans and Taylor, 1982; Arpan and Radebaugh, 1985; Peavey and Webster, 1990; Choi and Levich, 1991; Purvis et al., 1991; Sharp, 1998; Street et al., 1999).

Today many firms wish to list their securities on multiple stock exchanges. This is to obtain exposure to new markets, obtain foreign debt and equity capital for growth and expansion, improving customer recognition, increasing publicity about the firm, having materials and technology and looking to reduce possible political costs (Gary et al., 1995). Prior research concludes that firms competing for foreign resources tend to expand their financial and accounting disclosure (Zarzeski, 1996). This expanded disclosure is assumed to reduce resource providers' uncertainty about transactions with the firm and, in turn enable the firm to obtain resources at lower cost. Improved information reduces uncertainty about a company and therefore, potentially the risk premium required by investors (Demsetz, 1968; Choi, 1973; Copeland and Galai, 1983; Holthausen and Leftwich, 1983; Glosten and Milgrom, 1985; Amihud and Mendelson, 1986; Gary and Gray, 1989; Diamond and Verrecchia, 1991; Gray, 1995; Baiman and Verrecchia, 1996; Verrecchia, 1996; Botosan, 1997; Levitt, 1998; Sengupta, 1998; Barth et al., 1999; Huddart et al., 1999; Botosan and Plumlee, 2000; Brealey and Myers, 2000; Richardson and Welker, 2001). Choi and Levich (1991) argued that diversity in accounting reporting (measurement, presentation, and disclosure) affects capital market participants. In an extensive survey of capital market regulators and rating agencies, almost one-half of the respondents stated that their capital market decisions were affected by accounting diversity. In the absence of common accounting principles and disclosure practices, analyzing foreign financial statements is difficult for investors.

Chamisa (2000) pointed out that the international accounting harmonization objective is important for developing countries because of their significant reliance on inflows of foreign capital to finance economic and industrial developments. This argument is clearly relevant to the Jordanian economy, which is dependent on the international institutions for funding. …

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