Externalities of Financial Reporting Regulation: Evidence from Investment Efficiency of Voluntary Adopters of IFRS Before and After Mandatory Adoption Requirements

Abstract

Financial disclosures have externalities; a disclosure by one firm can directly alter the cash flows of other firms, and can also can alter investors' beliefs about the distribution of other firms' cash flows and thereby affect their market values (Foster 1980, Foster 1981, Dye 1990). In seeking empirical evidence of such externalities, this study uses mandatory adoption of International Financial Reporting Standards (IFRS) as an exogenous event to examine how the changes in publicly available information of peer firms (mandatory IFRS adopters) impact upon the investment efficiency of other firms (prior voluntary IFRS adopters). We find that the probability of inefficient investment by prior voluntary adopters declines after IFRS adoption is mandated. Further, the probability of over- (under-) investment by voluntary adopters declines, relative to that of efficient investment, after mandatory adoption. Overall, we document positive externalities of mandatory IFRS adoption on the investment efficiency of prior voluntary adopters. However, we observe heterogeneity in these spillover effects at the firm level. Following Daske et al (2013)'s classification, we document that the observed improvements in investment efficiency are limited to 'serious' voluntary adopters. This finding is consistent with the argument that in the absence of effective enforcement mechanisms across all countries, the adoption of IFRS may be a 'cheap-talk game' for some voluntary adopters. Finally, we find that spillover effects are limited to the prior voluntary adopters from countries with large differences between local GAAP and IFRS. This suggests that the externalities of financial disclosures increase with improvements in the comparability of accounting information.