Who Benefits from the Adoption of IFRS?*
S’ O†Distribution and Communication Sciences
OSAKA GAKUIN UNIVERSITY

ABSTRACTe research objective of this paper is to investigate when the adoption of International
Financial Reporting Standards (IFRS) is beneficial to capital market participants. In
particular, I specify the conditions in which IFRS is superior to domestic accounting
standards from cost of capital and disclosure viewpoint. is paper presents a competitive
equilibrium model to demonstrate who would prefer IFRS to domestic accounting
standards, and when. It shows that in certain conditions, there is a conflict between
firms’ managers and investors, with regard to the adoption of IFRS. It also demonstrates
that although the quality of accounting standards is an important condition, it does notnecessitate IFRS preference by managers and investors. is sheds light on the fact that theratio of foreign investors affects the decision.
JEL Classification: G14; M40; M41
Key Words: International Financial Reporting Standards; Disclosure;
Cost of Capital; Competitive Equilibrium

1. Introduction
e research objective of this paper is to investigate when the adoption of International
Financial Reporting Standards (hereafter IFRS) is beneficial to capital market participants. In
particular, I specify the conditions which IFRS is superior to domestic accounting standards fromcost of capital and disclosure viewpoint. e IFRS discussion is underway in the U.S. and Japan. e* I would like to thank Yasuhiro Ohta, Atsushi Shiiba, Shyam Sunder, Kazumi Suzuki, and participants at Keio University workshop
and the 1st TJAR conference for many helpful suggestions. I would also like to thank the Ministry of Education, Science, Sports,
Culture and Technology (Grant-in-Aid for Young Scientists (B), 18730308, 2006-2008) and the Zengin Foundation for Studies
on Economics and Finance for the financial support extended to me.
† Corresponding Author. Address Osaka Gakuin University, 2-36-1 Kishibe-Minami, Suita-shi, Osaka 564-8511, JAPAN.
Telephone +81 6 6381 8434 E-mail s-okuda@ogu.ac.jp
Received June 30, 2011; accepted October 12, 2011

Copyright©2011 Research Institute for Economics & Business Administration - Kobe University.

62

e Japanese Accounting Review, 1 (2011), 61-69

adoption of IFRS is expected to ensure greater comparability and transparency of financial reporting
around the world. It is also expected to enhance the internationalization of capital markets.
Despite these expectations, there are concerns that the adoption of IFRS increases the cost of
preparation for financial statements or neglects the peculiar business conditions in some countries.1
erefore, the time has come to debate the merits and demerits of IFRS. However, little work has
been done to formally analyze the conditions in which IFRS is superior to domestic accounting
standards. In order to investigate these conditions, I provide a competitive equilibrium model with afirm and two types of investors—domestic and foreign.
A body of empirical research has investigated whether IFRS is beneficial to capital market
participants. Ashbaugh and Pincus (2001) assess the quality of the financial statements using analysts’
forecasts and show that the accuracy of analysts’ forecasts improves once firms adopt IAS. Daske
and Gebhart (2006) assess the quality of disclosure by financial analysts. ey show that whether the
adoption is voluntary and mandatory, the quality of disclosure is superior for firms that adopt IFRS
or the U.S. standard. Covrig et al. (2007) find that voluntary IAS adoption reduces home bias among
foreign investors. is suggests that IFRS improves capital allocation efficiency.
On the other hand, Christensen et al. (2007) and Gebhardt (2006) study whether adoption of
IFRS can reduce the cost of capital, and find that it cannot. is suggests that from the cost of capital
viewpoint, it is not clear that IFRS adoption is preferable. I shall contribute to existing literature bypresenting an interpretation for the differences in findings.
I assume that there is one company which adopts domestic accounting standards or IFRS, andtwo types of investors—domestic and foreign. I also assume that the domestic investors and foreign
investors face different uncertainties. I assume that disclosure by domestic accounting standards
reduces uncertainty more for domestic investors than for foreign investors. Contrary to this,disclosure by IFRS is assumed to reduce uncertainty for domestic investors on par with for foreign
investors. Under one of the accounting standards, a firm’s manager decides the level of disclosurein order to minimize its cost of capital and investors decide how much stock to buy. To compare
the merits of IFRS and domestic accounting standards, I compare the cost of capital and level of
disclosure of the two accounting standards.
In this paper, I only focus on the relative merits of accounting standards and do not specify thequality of accounting standards. In reality, in order to specify quality, it may be essential to discuss thedeterminants of quality of accounting standards. However, this may lead to confusion over the merits
and demerits of adopting accounting standards which are familiar to foreign investors and the merits
and demerits of IFRS. is paper focuses on the former and not on the latter.
e main findings are as follows. ere are certain situations in which investors and firms
experience a conflict of interests regarding the choice of accounting standards. If the fraction offoreign investors in a capital market is not very small or very large, firms tend to prefer domestic
accounting standards, while domestic investors prefer IFRS. is is one reason why some previous
works have found IFRS to be beneficial for investors and others have not been able to suggest thatIFRS is beneficial for firms.
In addition, I prove that the quality of accounting standards does not necessarily decide which
accounting standards are beneficial for capital market participants. Barth et al. (2008) compare
measures of accounting quality for firms applying IAS with U.S. firms, and show that firms applying
IAS have better quality. It is true that the quality of accounting standards is an important factor that1

Sunder (2011) discusses the possibility that an IFRS monopoly is evolutionarily disadvantageous in that it eliminates theopportunity to compare alternative practices and learn from them

Okuda: Who Benefits from the Adoption of IFRS?

63

determines the preference of accounting standards. However, my model suggests that the fraction offoreign investors and the uncertainty faced by them are also important factors.
e remainder of this paper is organized as follows. I set up the model in Section 2 and provide
the solution in section 3. Finally, the conclusions are presented in Section 4.

2. e Modelis paper compares domestic accounting standards with IFRS. e players in the modelare domestic investors, foreign investors, and the firm’s manager. For simplicity, the total numberof investors is normalized to 1, consisting of I , foreign investors, and (1–I) , domestic investors. I
also assume that each investor exhibits constant absolute risk aversion (CARA) with risk tolerance
parameter τ.
I assume that foreign investors have two distinct characteristics. First, they do not have agood understanding of disclosure by domestic accounting standards. is means that disclosure byadopting domestic accounting standards reduces the uncertainty less effectively than that by adopting
IFRS. To address this disadvantage, firms are assumed to engage in IR activities specialized forforeign investors. Contrary to domestic accounting standards, disclosure by IFRS can decrease thelevel of uncertainty for foreign investors as well as domestic investors.
Second, there is assumed to be home bias. is means that foreign investors face more
uncertainty about firms than domestic investors. is is because 1) apart f rom accounting
information, foreign investors do not have easy access to other information sources and 2) they mustbear foreign exchange risk.
e manager issues one stock and maximizes the firm’s stock price.2 e market value is not a
random variable in this model and therefore, the manager is assumed to be risk neutral. Investors
prefer a firm that accurately discloses information because accurate disclosure reduces the uncertainty
for them. is increases the firm’s stock price. However, the firm incurs more costs by accurate
disclosure. is then decreases stock price. e manager takes this trade off into consideration when
determining the level of disclosure.
~
Let E fd be the firm’s future cash flow for foreign investors under domestic accounting standards.
~
I assume E fd is a normal random variable with a mean of μ – Cd Dd Df and a standard deviation of (Vf+ Vd)/((1/a)Dd Df ). μ refers to the expected value of cash flow from operations and Cd Dd Df is thetotal cost of disclosure. is suggests that the expected value of cash flow for investors is cash flowfrom operation minus cost of disclosure. Cd is the marginal cost of disclosure by domestic accounting
standards and indicates the inverse of the quality of accounting standards. e level of disclosure forboth domestic and foreign investors is Dd and the level of disclosure specialized for foreign investors
is Df.
e uncertainty faced by foreign investors in terms of domestic accounting standards is (Vf +Vd)/((1/a)Dd Df ). Both types of investors face Vd and the uncertainty faced only by foreign investors is
Vf . e manager can reduce it by two sets of disclosure, Dd Df . However, because foreign investors are
not familiar with domestic accounting standards, the effect of disclosure is partly offset by 1/a(<1). I
use a as a parameter of difficulty for domestic accounting standards.
~
If a firm adopts IFRS, I assume E fa, which is the firm’s future cash flow for foreign investors
under IFRS, is a normal random variable with a mean of μ – Ca Da and a standard deviation of (Vf2

In this paper, stock price and market value are equal because the firm is assumed to issue only one stock.

e Japanese Accounting Review, 1 (2011), 61-69

64+ Vd)/Da. Cash flow from operation, μ , and the uncertainty faced by foreign investors, Vf + Vd , arethe same as when the firm adopts domestic accounting standards. e cost of disclosure, Ca Da , andthe level of disclosure, Da , are different. Ca is the marginal cost of disclosure by IFRS. e level of
disclosure for both domestic and foreign investors is Da . e firm engages in the same type and levelof disclosure for domestic investors and foreign investors because both types of investors are familiar
with IFRS.
~
Next, let E dd be the firm’s future cash flow for domestic investors under domestic accounting~
standards. I assume E d is a normal random variable with a mean of μ – Cd Dd Df and a standard
deviation of Vd / Dd . is means that the expected value of cash flow for domestic investors is thesame as that for foreign investors because the cash flow from operation and the cost of disclosure
are the same. Contrarily, the uncertainty is different for both types of investors because the original
uncertainty and the effect of disclosure are different. e original uncertainty faced by domestic
investors, Vd , is less than that faced by foreign investors because domestic investors can easily accessfirms operating in their own country. e effect of disclosure is only Dd because Df is specialized forforeign investors and is assumed to be useless for domestic investors. is also assumes that domestic
investors bear the cost of disclosure for foreign investors but do not receive the benefits of doing so.
~
If the firm adopts IFRS, I assume E da is a normal random variable with a mean of μ – Ca Da anda standard deviation of Vd / Da . is means that the expected value of cash flow and the effect of
disclosure by IFRS are the same as for foreign investors. Only the original uncertainty, Vd , is different.

3. e Solution
3.1 Equilibrium Prices
e combination of normally distributed cash flows and CARA preferences yields the certainty
equivalent utility functions as follows;� τ �X d ���V �D D �����X d �������P dµ
U dd = Xdd �������Cd Dd Df �������
d f
d
d
d
d
�
� τ �X a ���V �D �����X a �������P cµ
U da = Xda �������Cdddda Da �������
a
�
2
1
d
d µ
d
U f = Xf ( – Cd Dd Df ) – – τ (Xf ) ((Vd + Vf )/((1/a)Dd Df )) – (X fd – f )P d2� τ �X a ����V ��V ��D �����X a �������P cµ
U fa = Xfa �������C
D�������
f
f
f
a a
f
d
a
�

(1)
(2)
(3)
(4)

Where
i. Uij is the certainty equivalent of preferences of investors’ type of i, which is d if they are domestic
investors and f if they are foreign investors, when the firm adopts a set of accounting standardsof category j, which is a if the firm adopts IFRS and d if the firm adopts domestic accounting
standards,
ii. Xij is the number of shares of the firm of category j held by a type of i investor, andiii. i is the endowment of investors of type i.
iv. τ is the parameter of risk aversion.
I now derive the optimal investing choices of investors. e first order conditions for optimal
investments follow from taking the derivative of Uij with respect to Xij , and can be written as

Okuda: Who Benefits from the Adoption of IFRS?

X ji =µ –Pj –C i D i
τ (Vd /Di )

65

(5)

Equilibrium share prices are derived by substituting the above investments in the following
market clearing conditions:(1– I ) Xdj + IXfj = 1(6)e resulting prices are as follows.
Lemma 1. Equilibrium prices are as follows:
Pd* = µ –Cd Dd Df –aτ Dd Vd (Vd +Vf )(7)

τ Vd (Vd +Vf )(8)

ID f Vd +a(1-I)(Dd )2(Vd +Vf )Pa* = µ –Ca Da –Da (Vd +(1-I )Vf )I define cost of capital (K) as the difference between μ and the equilibrium price because this iscaused by the information uncertainty for investors.
3.2 Optimal Level of Disclosure
e manager decides the level of disclosure to maximize the firm’s stock price. e first orderconditions for optimal level of disclosure follow from taking the derivative of P j* with respect to Dd ,Df , and Da . e resulting levels of disclosure are as follows.3
Lemma 2. Optimal levels of disclosure are as follows:���τ������������� ��� � � �τ������ �����
�����������
�
�
� τ
�
����
�
����������������
� �
�
� �
����
�

�������

�

i.
ii.
iii.
iv.
3

(9)

(10)

ese equations show thatwhen risk aversion (τ) increases, the level of any disclosure increases,
when the cost of any disclosure decreases, the level of any disclosure increases,
when the uncertainty for all investors (Vd ) increases, Dd* and Da* increase but Df* doesn’t change,
when the uncertainty for foreign investors (Vf ) increases, D*d decreases, D*a increases, but D*fdoesn’t change,

Because the function of equilibrium prices is always concave for Dj , the first order condition is necessary and sufficient to getglobal minimum condition.

e Japanese Accounting Review, 1 (2011), 61-69

66

v. when the ratio of foreign investors (I) increases, Dd* and Da* increase but Df* decreases, andvi. when the difficulty of domestic accounting standards (a) increases, Dd* decreases but Df* increases.
Domestic investors prefer accounting standards which can further reduce their uncertainty. ismeans that they would prefer a set of accounting standards that induce greater disclosure by thefirm’s manager. Proposition 1 shows the condition in which accounting standards induce a manager
to disclose more information, as preferred by domestic investors.
Proposition 1. If the following expression is positive, the level of disclosure is higher when adopting
domestic accounting standards than when adopting IFRS. If not, the level of disclosure is higher
when adopting IFRS.

(

)

2

(

4(Ca)2I Vd +(1– I )Vf –9Cd (1– I )2 Vd +Vf

)a
3

τ

(11)

is suggests that when the cost of domestic accounting standards becomes higher, whendomestic accounting standards become more difficult, and when investors become more risk averse,
IFRS is likely to superior from disclosure viewpoint because they can acquire more information
through disclosure. However, the effect of the ratio of foreign investors and the uncertainty is more
complicated. I discuss this in a subsequent section with numerical examples.
3.3 Equilibrium Cost of Capitale equilibrium costs of capital (Kd* and Ka* ) can be obtained when Dd and Df or Da are assigned
to Pd* or Pa*.
Lemma 3 Equilibriums cost of capital are as follows:���� � �������� �������������� � ����������������������� ��������� τ ��� � ��� ��������������������� ��������

Ka* �

���C
� aVd �Vd �Vf �τ�Vd �����I �Vf

(12)
(13)

If you differentiate the equilibrium cost of capital, you can show thatwhen risk aversion (τ) increases, cost of capital of capital increases,
when cost of disclosure (Cj) decreases, the cost of capital increases,
when the uncertainty for all investors (Vd ) increases, the cost of capital increases,
when the uncertainty for foreign investor (Vf ) increases, K a* increases but the effect on Kd*
depends on other conditions,v. when the ratio of foreign investors (I) increases, Ka* increases but theeffect on Kd* depends on other conditions, andvi. when the difficulty of domestic accounting standards (a) increases, Kd* decreases.
i.
ii.
iii.
iv.

Managers prefer a set of accounting standards which can further reduce the cost of capital.
Proposition 2 shows the condition in which accounting standards can reduce the cost of capital, as
preferred by managers.

Okuda: Who Benefits from the Adoption of IFRS?

67

Proposition 2. If the following expression is positive, the cost of capital is higher when adopting
domestic accounting standards than when adopting IFRS. If not, the cost of capital is higher when
adopting IFRS.4
Cd I (Vd +(1–I )Vf ) (1+9Vd +9Vf +√Vd +Vf ) aτ
2

4–2916(Ca ) (1–I )2I (Vd +Vf )(2Vd +2Vf +√ Vd +Vf )
2

(14)

4

is suggests that when the cost of domestic accounting standards becomes higher, whendomestic accounting standards become more difficult, and when investors become more risk averse,
firms are likely to prefer IFRS because they can reduce the cost of capital by adopting IFRS.
However, the effect of the ratio of foreign investors and uncertainty is more complicated. I discuss
this in a subsequent section with numerical examples.
3.4 Numerical Example
I examine the effect of distribution of investors, I, on the differences of disclosure, Dd* – Da* , andof cost of capital, K *a – K *d . If these values are positive, adopting domestic accounting standards issuperior. If not, adopting IFRS is superior. e parameters used in my example are as follows:
Difficulty of domestic accounting standards; a = 1.2
Uncertainty for all investors; Vd = 50
Uncertainty only for foreign investors; Vf = 20
Parameter of risk aversion; τ = 0.02
ese parameters are chosen to exhibit conflicts between IFRS and domestic accounting
standards. Figure 1 shows the case when domestic accounting standards are superior to IFRS. In
this example, I set Ca = 6 and Cd = 4. Figure 1 indicates that from the cost of capital viewpoint,
adopting domestic accounting standards is superior to adopting IFRS in most ranges and that fromthe disclosure viewpoint, the advantages of domestic accounting standards increases as the ratio of
foreign investors increases.
F 1: D A S  S  IFRS (Ca = 6 and Cd = 4).
�
�
���

���

���

���

��

��
��
��
4

����������
���������������

To solve this problem, I calculate each cost of capital to the power four, subtract from the cost of domestics standards to IFRS, andsimplify it.

e Japanese Accounting Review, 1 (2011), 61-69

68

Figure 2 shows the case when IFRS are superior to domestic accounting standards. In thisexample, I set Ca = 4 and Cd = 6. Compared to Figure 1, there is a shorter range in which adopting
domestic accounting standards is preferable to adopting IFRS, not only from the cost of capital
viewpoint but also from the disclosure viewpoint. Nonetheless, there are some ranges in which
adopting domestic accounting standards is preferable to adopting IFRS, from both the cost ofcapital and disclosure viewpoints. is suggests that the quality of standards is not the only factor
in the adoption of IFRS and that the distribution of investors must take this into account when in
discussion about IFRS adoption.
F 2: IFRS  S  D A S (Ca = 4 and Cd = 6)
���

���

���

���

���

�

����
����
����

����������
���������������

Each figure shows that if the ratio of foreign investors is small, there is a conflict between firms
and domestic investors. In such conditions, firms prefer domestic accounting standards because oflower cost of capital, while domestic investors prefer IFRS because they get more information fromfirms and can reduce their uncertainty. is may be consistent with previous empirical results, whichindicate that IFRS is likely to be beneficial to investors but cannot reduce the cost of capital.

4. Conclusion
is paper investigates the relationship between IFRS adoption, level of disclosure, and costof capital. e adoption of IFRS is likely to be preferable from the cost of capital viewpoint, when
the ratio of foreign investors is very high or very low. is is because the diversification of investors
is too narrow to provide two sets of financial statements. Some countries such as Japan, in which
the average ratio of foreign investors is approximately 60 percent, may prefer domestic accounting
standards. From the information flow viewpoint, the higher the ratio of foreign investors, the more
preferable domestic accounting standards are likely to be. is suggests that there may be a conflict
between firms and domestic investors in countries in which the ratio of foreign investors is not soOkuda: Who Benefits from the Adoption of IFRS?

69

high.
is paper also indicates that even if IFRS is superior to domestic accounting standards fromthe quality viewpoint, it does not necessitate the adoption of IFRS. e ratio of foreign investors
is also significant for the preference of accounting standards. ese results suggest that whether
adoption of IFRS is beneficial to firms or investors depends not only on the quality of the accounting
standards but also on the fraction of foreign investors.
One of the limitations of this paper is that the utility function cannot be compared. is meansthat it is not clear whether investor prefers IFRS or domestic accounting standard.5 So this can beleft for future research.

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5

e effects of other parameters cannot be determined because the utility of investors depends on the mean cash flow and theendowments.