INVESTMENT DECISIONS
The research reviewed in Chapter 3 demonstrated that significant interna- tional diversity exists in accounting measurement and disclosure standards.
Given these differences, and the fact that accounting information is highly
145
Percent
20 30
10
0
1
Not at all Very much
2 3 4 5
Figure 9.1 International accounting differences affect decisions
important in transnational equity analysis, it would be reasonable to predict that fund managers and analysts perceive their decisions to be affected by international accounting differences. It was also noted in Chapter 3 that what limited prior research there is into the effects of international accounting differences offers little in the way of consensus, other than some analysts and fund managers feel that their decisions are affected by international accounting differences, while others do not.
To directly investigate the effects of international accounting diversity, analysts and fund managers involved in foreign company analysis were asked in the questionnaire to what extent differences in international ac- counting affect their decision making. Respondents were requested to an- swer on a five-point scale, where 1=not at all, and 5=very much.
Figure 9.1 presents the frequencies of the responses to this question from the overall sample. The responses are skewed towards the lower end of the scale, consistent with respondents’ decisions not being affected by international accounting differences. Only nine analysts and fund man- agers (6.3%) stated that international accounting differences affected their decision making very much, whereas 33 respondents (23%) said that ac- counting differences had no impact at all on their decisions. The mean response on the five-point scale was 2.59 – significantly lower than the mid point of 3.
Table 9.1 Views of analysts and fund managers on the effects of accounting diversity
Fund managers Investment analysts Total Mean Std. Dev Mean Std. dev Mean Std. dev Accounting differences
affect decisions 2.64 1.26 2.49 1.12 2.59 1.21
(1=not at all;
5=very much)
9.2.1 Differences between analysts and fund managers
International accounting differences may be expected to be more problem- atic for fund managers than analysts for a number of reasons. First, as shown in Chapter 7, analysts follow fewer companies and are also likely to conduct fewer international comparisons than fund managers. In addition, because analysts do not have to construct and monitor portfolios, they are able to conduct more detailed analysis of company information, and are more likely to be familiar with the intricacies of international accounting systems.
The higher mean response of fund managers shown in Table 9.1 is con- sistent with this prediction (2.64 versus 2.49). Furthermore, and as shown in Table 9.2, whereas only one analyst (2%) indicated that international ac- counting differences affected his decisions very much, eight fund managers (8%) felt very much affected by international accounting differences.
However, the difference between the two groups is marginal and a Mann- Whitney test showed that it was not statistically significant. The evidence therefore suggests that overall, analysts and fund managers do not perceive differences in international accounting systems to have a significant effect on their decision making.
Table 9.2 Effects of international accounting diversity
Not at all Very much
affected affected
1 2 3 4 5
n % n % n % n % n %
Fund managers 23 23.2 25 25.3 24 22.2 19 19.2 8 8.1
Analysts 10 22.2 14 31.1 11 24.4 9 20.0 1 2.2
A potential factor to consider when investigating this issue in this way is the possibility that fund managers and analysts say they are not affected by international accounting differences because they have adopted coping strategies or adjusted their appraisal techniques because of international accounting differences. For example, in the interviews, Analyst 7 noted that the institution which employed him modified its discounted cash flow model to take account of international differences in accounting for depreciation, provisions and extraordinary items; although his response on the five-point scale indicated that he was not at all affected by international accounting differences. The results of the questionnaire should therefore be interpreted with this in mind.
In accordance with Miles and Nobes (1998), who found that country specialists were less affected by international accounting differences than sector specialists, the sample was split into those who specialised by country or geographic region and those who did not. The results indicated that region specialists are less affected by international accounting differences (means of 2.84 and 2.52 for non specialists and specialists respectively), but the difference was not statistically significant. The lack of significant difference may be because geographic specialism can mean that analysts and fund managers cover diverse countries within the region in which they specialise. For example, European, Asian and emerging market specialists will still encounter substantial intra-regional accounting diversity.
9.2.2 International variation in the effects of international accounting differences
The results in Chapters 7 and 8 indicated that the usefulness of information sources and appraisal techniques is partially contingent upon the country of the company being analysed. There was some evidence that the effects of international accounting differences were also country-dependent in the interviews; virtually all respondents stated that the quality of accounting information disclosed by companies varies by country or by geographic region. Germany, Switzerland and Japan were the countries most frequently mentioned as being problematic. These three countries were also singled out in the Choi and Levich (1991) study as being a source of concern for analysts when investing abroad.
In the case of Japan, poor disclosure of cash flow, pension liabilities and company ownership data were the main areas of accounting disclosure defi- ciencies. Japanese accounting measurement principles were also criticised by numerous fund managers and analysts. Specific areas mentioned were out of date fixed asset values, lack of consolidation and off-balance sheet
financing. However, recent changes in Japanese accounting standards mean that some of these issues (particularly consolidated financial statements) are now less problematic (Seki, 2000).
Somewhat unsurprisingly, the most severe problems with accounting standards were encountered by fund managers who were responsible for portfolios of companies from emerging markets. Both measurement and disclosure standards were often viewed as problematic. Fund Manager 10 was originally an analyst of US companies, but is now a senior emerging markets analyst. He noted that:
After working in US markets, [the difference in disclosure] is particularly noticeable – from getting quarterly financial statements days after the period to getting three pieces of paper at the year end if you are lucky! You therefore have to try and rely more on that subjective part of the analysis where you are working on countries that do not have decent accounting information;
in developed markets, disciplined systems are used with investment rules and financial models. In emerging markets you probably invest across more companies than you would normally do and you should diversify out of sectors because there may be accounting irregularity across the whole sector.
Despite their concerns in this context, most analysts and fund managers stated that in general, the quality of disclosure is improving over time. Fur- thermore, there was widespread acknowledgement that the ‘country effect’
was not the only determinant of disclosure quality; size and maturity of the company being the additional key factors mentioned.
9.2.3 Accounting standards and the cost of capital
One of the open ended sections of the questionnaire asked analysts and fund managers what they regarded as the additional costs (if any) of dealing with international accounting differences. Comments on a number of question- naires indicated that companies reporting figures under non-IAS/US GAAP were categorised as higher risk.1Therefore, in the interviews, respondents were asked whether they agreed with this, and to elaborate further on this is- sue. Many respondents revealed a certain reluctance to invest in companies not reporting under IAS and US GAAP and both analysts and fund man- agers referred to a ‘quality effect’ added by recognised accounting stand- ards. Specifically, standards such as IAS or US GAAP were often perceived to lead to improvements on local standards in respect of both measurement and disclosure of accounting information. Additionally, recognisable stand- ards were sometimes seen as a ‘stamp of approval’ for the accounts, and
1In this context, reference to overseas companies reporting under US GAAP excludes US companies.
as a signal of managements’ attitudes towards shareholders. This applied both to developing markets and to developed markets, including Japan and Western Europe. The following quote is illustrative:
Using recognised accounting standards can give companies a better, broader, more international fundamental shareholder base. It shows a will to try and disclose information and to suggest some kind of shareholder friendly be- haviour, and wanting to give shareholders some information, and that is a good step for Europe, whether it is IAS or US GAAP. (Fund Manager 7).
A consequence of this is that risk premia are attached to the securities of these companies by analysts and fund managers, effectively translating into a relationship between the accounting standards used and the cost of capital through a higher discount rate. This viewpoint was summed up by Analyst 7:
Companies in Europe who move to IAS or US GAAP have a premium at- tached to their share price. I have seen that happen where the share price moves up on the announcement that they were changing accounting standards.
A similar phenomenon was mentioned in Marton (1998), who noted that this additional premium was required to take account of additional
‘accounting risk’. Interestingly, part of the responsibility for this was attributed to the reluctance of US investors to invest in companies with accounting standards which are unfamiliar to them. Given the significance of the funds available for investment in the US,2 and the home bias documented in previous literature, where US investors hold excessive levels of domestic shares in their portfolios, this appears highly plausible.
As noted by Fund Managers 10 and 12:
If you want to attract investors, then use the standard that those investors are familiar with. You need to make the job easier for fund managers and analysts to get them to invest in your company. (Fund Manager 10)
As a financial manager who invests on the basis of fundamentals, the less risk there is associated with the balance sheet and earnings in terms of prediction risk, the higher the price. You have to apply a discount for all the ‘nasties’
that might be there that you can’t see. (Fund Manager 12)
Although there was widespread agreement that a premium exists on the shares which report under more familiar accounting standards, many fund managers and analysts acknowledged that this premium may also be at- tributable to other factors. In particular, non-US companies that report under US GAAP are generally US listed, which brings other significant benefits.
As discussed in Chapter 2, US markets are characterised by high liquidity,
2US institutional investors’ financial assets in 1998 were US$18,005 million (OECD, 2000).
and US listings result in high firm visibility. Furthermore, many companies reporting under US GAAP are successful multinational firms whose higher share price (resulting from a lower discount rate) may also be attributable to sound fundamentals, in addition to their use of recognisable accounting standards for their financial statements.
These findings are, however, consistent with the literature that demon- strates a link between disclosure and the cost of equity capital (Botosan, 1997; Leuz and Verrecchia, 2000). They are also supported by the results of Aggrawalet al.(2004), who found that investment in overseas firms by US mutual funds is positively related to whether the firm complies with US GAAP/IAS in preparing its financial statements, and to the quality of the firm’s disclosure.
In sum, the results of this section are consistent with analysts’ and fund managers’ decisions not being materially affected by international account- ing differences, although this depends, at least in part, on where the company being analysed is based. Moreover, and in line with Choi and Levich (1991), fund managers and analysts have developed ways of coping with interna- tional accounting differences. The following section examines the related issue of analysts’ and fund managers’ levels of support for the harmonisation of international accounting standards.
9.3 VIEWS ON THE INTERNATIONAL