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African Journal of Business Management Vol. 6(1), pp. 200-205, 11 January, 2012Available online at http://www.academicjournals.org/AJBMDOI: 10.5897/AJBM11.1738ISSN 1993-8233 2012 Academic Journals

Full Length Research Paper

Economic benefits of International Financial ReportingStandards (IFRS) adoption in Romania: Has the cost of

equity capital decreased?

Stere MIHAI1, Mihaela IONASCU2and Ion IONASCU 2*

1Quinn School of Business, University College, Dublin, Ireland.

2Bucharest Academy of Economic Studies, Romania.

Accepted 13 October, 2011

The purpose of this paper is to identify a possible economic benefit of International Financial ReportingStandards (IFRS) adoption in Romania. Among the economic benefits of their adoption, the IFRSsincrease transparency, diminish information asymmetry and risk and consequently reduce the cost ofcapital. In order to determine whether the cost of equity capital decreased as a result of IFRS adoptionin Romania, we modeled the cost of equity capital as the expected return on the intrinsic value of ashare, and computed it based on pre- and post-adoption samples. The results showed that the averagecost of equity capital did decrease after the IFRSs were adopted in Romania, from 0.33 (computedbased on a pre-adoption sample) to 0.13, the IFRSs providing the economic benefit of a reduced cost ofcapital for Romanian listed companies.

Key words: Cost of capital, disclosure quality, benefits of International Financial Reporting Standards (IFRS)

adoption in Romania.

INTRODUCTION

The International Financial Reporting Standards(hereafter IFRS) are allegedly high-quality financialreporting standards. Among the economic benefits oftheir adoption, IFRSs increase transparency, diminishinformation asymmetry and risk, and consequentlyreduce the cost of capital. There is wide empiricalevidence that both increased disclosure and informationquality (for example, information precision) reduce the

cost of capital (Botosan, 1997). However, empiricalliterature on the impact of IFRS adoption on the cost ofcapital is in its early stages of formation and hasobviously not yet reached common grounds. This createsincentives to develop further research. Establishing aclear empirical relationship between the IFRS adoptionand the cost of capital, or at least identifying keyinstitutional factors that mediate this relationship istherefore a primary concern for researchers.

The need to document the existence of economicbenefits from IFRS adoption is even more stringent in

*Corresponding author.E-mail: ionascui@cig.ase.ro.

countries where the adoption of IFRS has come as apolitical rather than as a natural move. Here, there arevoices decrying the large costs of implementing the newstandards and some authors have gone even that far tolabel the IFRS adoption, in some jurisdictions likeRomania, a cultural intrusion (Roberts, 2000).

The adoption of IFRS in Romania

In 1999, the Ministry of Finance issued regulations(Ministry of Finance, 1999), which tried to harmonizeRomanian accounting with the Fourth European Directiveand the International Accounting Standards (IAS)/IFRS.At that time, Romanian accounting had already achieveda significant degree of conformity with the FourthEuropean Directive, if one considers the fact that the newaccounting regulations adopted after 1990 were inspiredby French accounting, which were harmonized with therequirements of the European accounting regulations. Infact, the Regulations adopted in 1999 meant a reorien-tation of Romanian accounting towards the IAS/IFRS, asthe conceptual framework and the IAS were integrated in

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the content of these regulations.The application of the IAS/IFRSs was thought of by the

Ministry of Public Finance as a gradual process. To this

aim, at first, for the financial year 2000, the Regulationsissued in 1999, which expressly had in view theharmonization with IAS/IFRS, were applied alongsidewith the previous accounting regulations of the Frenchinfluence through the presentation of two sets of financialstatements by nearly 200 enterprises, in which we foundbusinesses listed at the Bucharest Stock Exchange,some self governing companies, national companies, aswell as businesses listed at the RASDAQ market. But the1999 Harmonization Regulations included requirementsthat stipulated the further application of those to othertypes of enterprises, so that until the end of the financialyear 2005, they should have been applied by all other

enterprises, excepting those considered small. In theyear 2001, the Ministry of Public Finance replaced the1999 Harmonized Regulation with a new one (Ministry ofPublic Finance, 2001), with the same title but with animproved form, maintaining also the IASC/B frameworkand the IAS/IFRSs in its content.

The accounting Regulations issued in 2001 wasgradually applied according to the size of the enterprises,so that until the 31 of December 2005, all the enterprisesconsidered big had to apply the IAS/IFRSs. Thefinancial statements of these enterprises were legallyaudited by financial auditors. For all the other enterprisesconsidered small simplified accounting regulationswere issued harmonized with European directives only,applied from the 1stof January 2003. These latter regula-tions were in fact a simplified version of those applicableto the enterprises considered big. HarmonizedRegulations were also issued for specific domains suchas the banking sector (in 2001), insurance (in 2001) andbrokerage (in 2002) industry. According to the initialstrategy of the accounting regulator, starting with thefinancial year 2006, the accounting of the Romanian firmshad to work in two gears: a group of enterprises con-sidered big which should apply regulations harmonizedwith IAS/IFRS and European directives and anothergroup of enterprises considered small, to apply asimplified version of these regulations.

The year 2005 witnessed a repositioning of the mainRomanian accounting regulator - the Ministry of PublicFinance - that revised its policy, so that starting with thefinancial year 2006, all entities should issue financialstatements according to European Directives only, exceptfor public interest entities, which may/will preparefinancial statements in compliance with IFRS.

Accordingly, the accounting Regulations issued in 2001(Ministry of Public Finance, 2001) that stipulated theharmonization with both the Fourth Council Directive andthe IAS/IFRS were withdrawn and new regulations wereissued conforming to European Directives only (Ministryof Public Finance, 2005a), both for individual and

consolidated financial statements. Starting with the year

Mihai et al. 201

2006, accounting regulations conforming to EuropeanDirectives have been adopted also for bank entities,insurance and brokerage companies.

Thus, starting with the year 2006, only creditenterprises have to issue a set of financial statementsaccording to IFRS and it was up to the other entities ofpublic interest (as insurance and insurance-reinsurancecompanies, entities regulated and monitored by theNational Board of Securities, listed entities, nationalcompanies, legal persons that are part of a group and areconsolidated by a parent entity that applies IFRS, etc.) toexercise this option only if they have the capacity ofreasonable implementation.

Owing to Romanias scheduled accession to the EU on1 January 2007, new regulations concerning theapplication of IFRS by listed groups were adopted in

2005 enacting Regulation (EC) no. 1606/2002 of theEuropean Parliament and of the Council (Ministry ofPublic Finance, 2005b). According to these regulations,starting with the financial year 2007, listed groups andbanking institutions (listed and not listed) will mandatorilyapply IFRS in their consolidated financial statementsonly.

LITERATURE REVIEW

The notion of the cost of equity capital has stimulated agreat deal of research in finance and accounting. Thisresulted in a wealthy literature branching out rapidly, bothconceptually and methodologically. However, up to thispoint, the literature on the cost of capital has not yetreached common grounds on many of the crucialfeatures of this construct: definition and measurement ofthe cost of equity, theoretical relationship betweeninformation and the cost of equity or even empirical linksbetween the quality of disclosures and the level of thecost of equity capital (Botosan, 2006).

For instance, lack of agreement in definition creates alack of agreement in measurement literature. Whethercost of equity capital should be defined as the minimumrate of rate of returninvestors require for providing capitalto the firm or as the risk adjusted discount rate that in-

vestors apply to the expected future cash-flow (dividends)to arrive at the current stock price results in disagreementupon whether to measure the cost of capital based on theCapital Asset Pricing Model (CAPM) or by computing theinternal rate of return (IRR) that equates marketsexpectations of future cash flows to the actual stockprice. Even in each sub-division of the literature (CAPMvs. IRR), consensus is not entirely reached. For instance,estimates of the risk premium have typically rangedbetween 7 and 9%, but recent evidence (Claus andThomas, 2001) claim that risk premium is as low as 3%.On the other side of the coin, Botosan and Plumlee(2005) have reviewed the construct validity of no less

than five internal rate of return measures of the cost of

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202 Afr. J. Bus. Manage.

equity capital and concluded that only two of them createreliable estimates.

On one hand, while the modeling literature investigating

analytically the inverse association between increaseddisclosure and the cost of capital has succeeded to reacha certain degree of consensus, there are still questionsthat this literature left unaddressed. One of theseaddresses the problem of whether estimation risk (therisk associated with the information about the distributionof security payoffs) is diversifiable or non-diversifiableand can be captured by the CAPM. According to Botosan(2006), this question is of an empirical nature rather thana theoretical one.

Finally, perhaps the largest range of results regardingthe relationship between information and the cost ofcapital has been created by the empirical literature. The

work here is vast and for this reason, we only focus onthe literature that investigates the implications of chan-ging the accounting regime on the cost of capital. Moreprecisely, we review the results regarding the impact ofIFRS adoption on the cost of capital.

This literature documents divergent results regardingthe relationship between the adoption of IFRS and thecost of capital. On the German capital market, Leuz andVerrecchia (2000) report evidence that the switch fromlocal GAAP to IFRS or US GAAP reduces the informationasymmetry component of the cost of capital. On thecontrary, also on the German market, Daske (2006)recently reports that the adoption of IFRS and US GAAPhas not created the expected economic benefit of areduction in the cost of capital. Finally, Bruggemann andHomburg (2007) expand the Leuz and Verrechia (2000)study but cannot document a clear relationship betweenthe switch to IFRS or US GAAP reporting policy and thecost of capital.

Of particular importance for all the studiesaforementioned is the paper developed by Easton (2006)which investigates analytically and empirically the biasesin the analysts forecasts induced by the change in thereporting regime. Easton (2006) draws attention that forcompanies that switch from domestic to internationalstandards, the analysts forecasts may tend to have adifferent degree of optimism than for companies that do

not operate this change. Easton claims that a change inthe reporting regime creates differences in the esti-mations of the book value of equity which is consideredby analysts when estimating the terminal value of thebusiness. Overall, Easton (2006) concludes that theinterpretation of the results in the studies just reviewed(especially Daske, 2006) should be cautious since thosepapers do not control for these possible shifts in analystsforecast and therefore may have possibly misestimatedthe cost of equity capital.

In respect to the Romanian capital market, severalauthors have discussed the issues related to themeasurement of the cost of capital. Dragot (2007) and

Ciobanu (2008) emphasized the limits of applying theCAPM model on the Romanian capital market, whereas

Cruntu (2006, 2009) tried to empirically evaluate thecost of capital for Romanian listed companies based onthe CAPM model. Pascu-Nedelcu and Pun (2009)

proposed different models for the measurement of thecost of capital for Romanian companies taking intoaccount the interdependency of financial markets in thecontext of the global financial crisis.

Determining the cost of capital based on the CAPMmodel was seen as problematic especially in the case ofemergent markets, such as the Romanian one.Difficulties relate to both data unavailability (for evaluatingthe volatility coefficient and the risk premium) and to therationales used in constructing a reliable model for thecost of capital. However, there were attempts to estimatethe cost of capital based on the CAPM model. Forinstance, Cruntu (2009) proposed computing the cost ofequity capital for Romanian companies using the CAPMmodel in Euros or USD and then converting it in localcurrency only in the last stage of the process in order toavoid certain parameters with values that could bearbitrary considered and thus difficult to be quantified(Cruntu, 2009). Based on these assumptions, taking intoaccount the expected inflation rate for the year 2010 forRomania and the Euro zone, the cost of equity capital forRomanian companies was estimated to 9.97% in Eurosand 13.34% in lei.

Although the link between the quality of financialinformation and the cost of capital is discussed in theRomanian literature (Dragot, 2006), there are very fewattempts to document this relationship empirically. For

instance, Ionascu et al. (2008) revealed that afteradopting IFRS based GAAP, companies listed on theRomanian stock exchange market exhibited levels of thecost of capital that were lower, compared to the levelsprior to the adoption. However, the results in Ionascu etal. (2008) were affected by an ex-post operationalizationof the cost of capital. The study was only meant to createan initial set of beliefs about the adoption of IFRS and thecost of capital in Romania. We revisit that set of beliefsthrough the present study.

ECONOMETRIC MODEL

We begin our econometric modeling with the one-period definitionof the cost of capital as the expected return on the intrinsic value ofa share. Denote the intrinsic value of a share of firm i in year tthrough Vit. Likewise, let rit be the cost of capital of firm iin year tand Et[eit+1] the expectation at time tof the time t+1 earnings pershare. Given these notations, the definition of the cost of capitaltranslates into equation (1):

it

ittit

V

eEr

]1[ += (1)

Traditionally, the empirical estimation of cost of equity capitalunderlying this approach rests on a series of assumptions about themarket efficiency, dividend payout ratio, information available on

the market and the earnings process. These assumptions (A1through A4) are worth discussing:

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A1: Market efficiency Information is instantly and totallyimpounded in prices;A2: Dividends payout ratio The dividend payout ratio is 1. Allearnings are distributed as dividends;A3: Information - Earnings represents the only source of informationavailable on the market;A4: Random walk of earnings The earnings process is assumed tofollow a random walk with no lags. That is et+1 = et+ t where etisearnings in year t and t is a zero mean random error term.

In terms of empirical estimation, assumption A1ensures that theactual share price Pt is a good proxy for the intrinsic value of thefirm Vt. On the other hand, assumptions A2through A4ensure thatthe best proxy for the estimated future earnings (et+1) is theobserved value of current earnings (et). The argument here is fairlysimple. Denote Et[et+1|It]the time texpectation of time t+1earningsin light of total information available on the market at time t (It).Assumption A3postulates the identity It = et.Therefore Et[et+1|It] =Et[et+1|et]. But by assumption A4: et+1 = et + t. Hence Et[et+1|It] =Et[et+1|et]= Et[et+ t |et]and since the error term is zero mean then

the time texpectation of time t+1 earnings is equal to et. If all ofthese assumptions are met, then a simple and straightforwardempirical estimation of the cost of equity capital would be theinverse of price/earnings ratio.

Our modeling however is constrained by the low degree ofefficiency of the Romanian market (as documented by Dragot(2006), as well as by the data availability. Our aim is to tease outthe cited definition of the cost of capital so that we isolate the effectof market efficiency and express the cost of capital in terms ofobservable data such as earnings and share prices. This isaccomplished further. Also denote:

eit+1as the actual earnings per share of firm iin year t+1;Pitthe actual share price of firm iin year t.

Now, develop equation (1) by introducing the actual figures forthe earnings per share and the share price, under the following

form:

it

it

it

it

it

itt

it

PP

V

ee

eE

r

1

1

1][+

+

+

= (2)

Rearranging the terms in the equation we get:

1

1

1][

))((

+

+

+

= it

it

itt

it

ititit

e

e

eE

P

VPr

(3)

Finally, applying the natural logarithm to equation (3), we deriveequation (4) as follows:

)log()][

log()log()log( 11

1+

+

+

=+ it

it

itt

it

it

itit ee

eE

P

VPr (4)

Two observations need to be made at this point. First, equation (4)shows that, in order to estimate the cost of capital rit fromobservable variables like Pit, the actual share price and eit+1, theearnings per share, one needs to control for market inefficienciesand analyst forecast precision. More precisely, in equation (4), the

variable)log(

it

it

P

V captures the degree to which the actual share

Mihai et al. 203

price Pitreflects the intrinsic value of the firm Vit. If the market wereefficient (which is not case in Romania), the intrinsic value of thefirm will fully be reflected in the share price, Vitwould equal Pitand

the term )log(

it

it

PV would disappear. Likewise, also in equation (4),

the variable )][

log(1

1

+

+

it

itt

e

eE captures the precision of analyst

forecast (tendencies to over or under-estimate future profits, noisyinformation, etc.). If the estimates were perfectly accurate then

Et[eit+1]would equal the actual eit+1, and the term )][

log(1

1

+

+

it

itt

e

eE

would disappear. Consequently, the economic model in equation(4) naturally shows the need to control for market inefficiency andanalyst forecast precision.

Second, to allow an empirical implementation of our econometricmodel (equation 4), we need to disentangle the cost of equity

capital and the share price in the logarithm formula of the first termof the left-hand side of the equation log(ritPit). We do this byapplying the Taylor formula for the linear approximation of afunction f(x)when xis around a:

)()()()( '

afaxafxf + (5)

Making f(x) = log (x)in (5) above we get:

a

axax

+ )log()log( (6)

Given the magnitude of share prices in our sample and estimatingthat the ex-ante cost of capital is usually ranging between 0 and 1,

we forecast that our variable x =ritPitwill range somewhere between(0, 2). Therefore, in equation (6), we make a =1 which changes itinto log(x) x-1 which further translates into:

itititit PrPr + 1)log( (7)

Finally, plugging equation (7) in (4), our cost of capital modelbecomes:

)][

log()log(1)log(1

11

+

+

+ ++

it

itt

it

itititit

e

eE

P

VPre

(8)

Empirical implementation

The cost of capital is by excellence an ex-ante or forward-lookingconcept. It requires information about the future value of anenterprise as well as information about the expectations regardingfuture dividends or at least future profits. As the econometric modelshows, on a possibly inefficient capital market like the Romanianmarket, the estimation of the cost of capital will necessarily have tocontrol for both market inefficiencies and the precision of theforecast. However, due to the lack of data availability, we leave theimpact of these two frictions to the error term.

From the econometric model stated earlier (equation 5), wederive our statistical model in its simple form:

++=+ itit

Peps )log( 1 (9)

where: epsit+1= the actual earnings per share of f irm i in year t+1;

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Table 1.Descriptive statistics.

Descriptive statisticEarnings per share (RON/share) Share prices (RON)

1999 2006 1999 2006Mean 0.34 0.13 0.61 2.23

Standard deviation 0.78 0.19 1.07 2.67

Minimum 0.00 0.00 0.01 0.04

Maximum 3.69 0.62 4.96 10.00

Observations 27 27 27 27

Table 2.Regression results.

Statistic Before IFRS adoption After IFRS adoption

R 0.422 0.47

R2 0.178 0.221

-1.367 -1.693

(t) (-7.557)**** (-9.536)****

0.333 0.132

(t) (2.280)* (2.610)*

F 5.197* 6.815*

Durbin-Watson 2.278 2.193

Observations 26 26

Significant at *0.05; and ****0.00001.

Pit= the actual share price of firm iin year t.

The model will be estimated at two different times: time t(prior tothe adoption of IFRS standards), and time t+(after the adoption ofIFRS standards). Since harmonization of Romanian accounting withthe IFRS standards started in the year 1999, and reached the fullcompliance stage starting with 2005, we have selected as relevantdates for our sample years t=1998 (pre-adoption) and t+ =2006(post-adoption).

The coefficient of interest in the model is , which is a directestimate of the cost of capital. We expect the value of to bepositive and lower than 1. Likewise, if the adoption of IFRS hascreated the economic benefit of a reduced cost of capital, weexpect the estimation offor the post-adoption sample (t+) to belower than the estimation offor the pre-adoption sample.

A word of caution needs to be told before proceeding with theempirical assessments of the model. The estimation of in the

previous regression represents only a gross estimate of the cost ofequity capital because there are no control variables for marketinefficiencies and forecast precision. However, these estimates,unrefined as they are, still offer a first impression on the magnitudeof the cost of equity capital as well as a starting point in comparingthe cost of capital before and after IFRS adoption.

Due to objective reasons further discussed, our sample size ismoderate. First, the Romanian capital market is not very large. Thenumber of companies listed on both tires (I and II) of the stockexchange has never exceeded 70 companies. Although thisdecision may come with some company size effect, to avoidsubstantial reduction of our samples, we decided to retain in ourpre- and post- adoption samples, companies from both tires.However, companies that were listed in 1998 but no longer listed in2006 as well as new companies listed after 1998 have been takenout of our sample. Finally, some of the companies remaining in the

sample displayed negative earnings in at least one of the two yearsof our analysis. This further reduced our sample to a final size of 27

companies. Data was analyzed with the functions of SPSS.

Descriptive statistics regarding the levels of earnings per share andstock prices are presented in Table 1.

RESULTS

The regression results are summarized in Table 2. Thecoefficient is positive and lower than 1 for both beforeand after the IFRS adoption samples. Moreover, fromthe pre-adoption sample (0.33) is bigger than from thepost-adoption sample (0.132) which supports an inverserelationship between reporting quality and the cost ofcapital in Romania as a result of IFRS adoption by listed

companies.The ex-post calculation of ritPitreports no value outsidethe benchmark interval of (0, 2) assumed in thedevelopment of the econometric model.

CONCLUSION AND LIMITATIONS

The purpose of this paper was to identify a possibleeconomic benefit of IFRS adoption in Romania. Priorliterature reveals that a high-quality accounting andreporting system (such as the one based on IFRS)determines entirely the very quality of financialinformation, resulting in increased transparency and

comparability of financial information reported, and finallyin a decreased cost of capital.

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In order to determine whether the cost of equity capitaldid decrease as a result of the IFRS adoption inRomania, we have modeled the cost of equity capital as

the expected return on the intrinsic value of a share,andcomputed it based on pre- and post-adoption samples.The results showed that the cost of equity capitaldecreased after the IFRSs were adopted in Romania,from 0.33 (computed based on a pre-adoption sample) to0.13 (estimated on a post-adoption sample). We cancomment on the fact that the cost of capital of Romanianlisted companies computed for the year 2006 (after theadoption of IFRS) is comparable to the one estimated byCruntu (2009) based on a CAPM model for the year2010.

However, the figures stated previously are only grossestimates of the cost of equity capital because the

econometric model tested had no control variables formarket inefficiencies and forecast precision. Yet, theseestimates, unrefined as they are, still offer a firstimpression on the magnitude of the cost of equity capitalas well as a starting point in comparing the cost of capitalbefore and after IFRS adoption.

ACKNOWLEDGEMENT

The authors gratefully acknowledge the financial supportoffered by CNCSIS UEFISCSU through the projectPNCDI II: ID_1840/IDEI II: The benefits of IFRSadoption: an exploratory research regarding the impact ofthe internationalization of Romanian accounting on thecost of capital.

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