African Journal of Business Management Vol. 6(1), pp.

200-205, 11 January, 2012

Available online at http://www.academicjournals.org/AJBM
DOI: 10.5897/AJBM11.1738
ISSN 1993-8233 2012 Academic Journals



Full Length Research Paper

Economic benefits of International Financial Reporting
Standards (IFRS) adoption in Romania: Has the cost of
equity capital decreased?

Stere MIHAI
1
, Mihaela IONASCU
2
and Ion IONASCU
2
*

1
Quinn School of Business, University College, Dublin, Ireland.
2
Bucharest Academy of Economic Studies, Romania.

Accepted 13 October, 2011

The purpose of this paper is to identify a possible economic benefit of International Financial Reporting
Standards (IFRS) adoption in Romania. Among the economic benefits of their adoption, the IFRSs
increase transparency, diminish information asymmetry and risk and consequently reduce the cost of
capital. In order to determine whether the cost of equity capital decreased as a result of IFRS adoption
in Romania, we modeled the cost of equity capital as the expected return on the intrinsic value of a
share, and computed it based on pre- and post-adoption samples. The results showed that the average
cost of equity capital did decrease after the IFRSs were adopted in Romania, from 0.33 (computed
based on a pre-adoption sample) to 0.13, the IFRSs providing the economic benefit of a reduced cost of
capital 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 financial
reporting standards. Among the economic benefits of
their adoption, IFRSs increase transparency, diminish
information asymmetry and risk, and consequently
reduce the cost of capital. There is wide empirical
evidence that both increased disclosure and information
quality (for example, information precision) reduce the
cost of capital (Botosan, 1997). However, empirical
literature on the impact of IFRS adoption on the cost of
capital is in its early stages of formation and has
obviously not yet reached common grounds. This creates
incentives to develop further research. Establishing a
clear empirical relationship between the IFRS adoption
and the cost of capital, or at least identifying key
institutional factors that mediate this relationship is
therefore a primary concern for researchers.
The need to document the existence of economic
benefits 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 a
political rather than as a natural move. Here, there are
voices decrying the large costs of implementing the new
standards and some authors have gone even that far to
label the IFRS adoption, in some jurisdictions like
Romania, 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 harmonize
Romanian accounting with the Fourth European Directive
and the International Accounting Standards (IAS)/IFRS.
At that time, Romanian accounting had already achieved
a significant degree of conformity with the Fourth
European Directive, if one considers the fact that the new
accounting regulations adopted after 1990 were inspired
by French accounting, which were harmonized with the
requirements of the European accounting regulations. In
fact, the Regulations adopted in 1999 meant a reorien-
tation of Romanian accounting towards the IAS/IFRS, as
the conceptual framework and the IAS were integrated in




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 Regulations
issued in 1999, which expressly had in view the
harmonization with IAS/IFRS, were applied alongside
with the previous accounting regulations of the French
influence through the presentation of two sets of financial
statements by nearly 200 enterprises, in which we found
businesses listed at the Bucharest Stock Exchange,
some self governing companies, national companies, as
well as businesses listed at the RASDAQ market. But the
1999 Harmonization Regulations included requirements
that stipulated the further application of those to other
types of enterprises, so that until the end of the financial
year 2005, they should have been applied by all other
enterprises, excepting those considered small. In the
year 2001, the Ministry of Public Finance replaced the
1999 Harmonized Regulation with a new one (Ministry of
Public Finance, 2001), with the same title but with an
improved form, maintaining also the IASC/B framework
and the IAS/IFRSs in its content.
The accounting Regulations issued in 2001 was
gradually applied according to the size of the enterprises,
so that until the 31 of December 2005, all the enterprises
considered big had to apply the IAS/IFRSs. The
financial statements of these enterprises were legally
audited by financial auditors. For all the other enterprises
considered small simplified accounting regulations
were issued harmonized with European directives only,
applied from the 1
st
of January 2003. These latter regula-
tions were in fact a simplified version of those applicable
to the enterprises considered big. Harmonized
Regulations were also issued for specific domains such
as the banking sector (in 2001), insurance (in 2001) and
brokerage (in 2002) industry. According to the initial
strategy of the accounting regulator, starting with the
financial year 2006, the accounting of the Romanian firms
had to work in two gears: a group of enterprises con-
sidered big which should apply regulations harmonized
with IAS/IFRS and European directives and another
group of enterprises considered small, to apply a
simplified version of these regulations.
The year 2005 witnessed a repositioning of the main
Romanian accounting regulator - the Ministry of Public
Finance - that revised its policy, so that starting with the
financial year 2006, all entities should issue financial
statements according to European Directives only, except
for public interest entities, which may/will prepare
financial statements in compliance with IFRS.
Accordingly, the accounting Regulations issued in 2001
(Ministry of Public Finance, 2001) that stipulated the
harmonization with both the Fourth Council Directive and
the IAS/IFRS were withdrawn and new regulations were
issued conforming to European Directives only (Ministry
of Public Finance, 2005a), both for individual and
consolidated financial statements. Starting with the year
Mihai et al. 201



2006, accounting regulations conforming to European
Directives have been adopted also for bank entities,
insurance and brokerage companies.
Thus, starting with the year 2006, only credit
enterprises have to issue a set of financial statements
according to IFRS and it was up to the other entities of
public interest (as insurance and insurance-reinsurance
companies, entities regulated and monitored by the
National Board of Securities, listed entities, national
companies, legal persons that are part of a group and are
consolidated by a parent entity that applies IFRS, etc.) to
exercise this option only if they have the capacity of
reasonable implementation.
Owing to Romanias scheduled accession to the EU on
1 January 2007, new regulations concerning the
application of IFRS by listed groups were adopted in
2005 enacting Regulation (EC) no. 1606/2002 of the
European Parliament and of the Council (Ministry of
Public Finance, 2005b). According to these regulations,
starting with the financial year 2007, listed groups and
banking institutions (listed and not listed) will mandatorily
apply IFRS in their consolidated financial statements
only.


LITERATURE REVIEW

The notion of the cost of equity capital has stimulated a
great deal of research in finance and accounting. This
resulted in a wealthy literature branching out rapidly, both
conceptually and methodologically. However, up to this
point, the literature on the cost of capital has not yet
reached common grounds on many of the crucial
features of this construct: definition and measurement of
the cost of equity, theoretical relationship between
information and the cost of equity or even empirical links
between the quality of disclosures and the level of the
cost of equity capital (Botosan, 2006).
For instance, lack of agreement in definition creates a
lack of agreement in measurement literature. Whether
cost of equity capital should be defined as the minimum
rate of rate of return investors require for providing capital
to 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 disagreement
upon whether to measure the cost of capital based on the
Capital Asset Pricing Model (CAPM) or by computing the
internal rate of return (IRR) that equates markets
expectations of future cash flows to the actual stock
price. Even in each sub-division of the literature (CAPM
vs. IRR), consensus is not entirely reached. For instance,
estimates of the risk premium have typically ranged
between 7 and 9%, but recent evidence (Claus and
Thomas, 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
202 Afr. J. Bus. Manage.



equity capital and concluded that only two of them create
reliable estimates.
On one hand, while the modeling literature investigating
analytically the inverse association between increased
disclosure and the cost of capital has succeeded to reach
a certain degree of consensus, there are still questions
that this literature left unaddressed. One of these
addresses the problem of whether estimation risk (the
risk associated with the information about the distribution
of security payoffs) is diversifiable or non-diversifiable
and can be captured by the CAPM. According to Botosan
(2006), this question is of an empirical nature rather than
a theoretical one.
Finally, perhaps the largest range of results regarding
the relationship between information and the cost of
capital has been created by the empirical literature. The
work here is vast and for this reason, we only focus on
the literature that investigates the implications of chan-
ging the accounting regime on the cost of capital. More
precisely, we review the results regarding the impact of
IFRS adoption on the cost of capital.
This literature documents divergent results regarding
the relationship between the adoption of IFRS and the
cost of capital. On the German capital market, Leuz and
Verrecchia (2000) report evidence that the switch from
local GAAP to IFRS or US GAAP reduces the information
asymmetry component of the cost of capital. On the
contrary, also on the German market, Daske (2006)
recently reports that the adoption of IFRS and US GAAP
has not created the expected economic benefit of a
reduction in the cost of capital. Finally, Bruggemann and
Homburg (2007) expand the Leuz and Verrechia (2000)
study but cannot document a clear relationship between
the switch to IFRS or US GAAP reporting policy and the
cost of capital.
Of particular importance for all the studies
aforementioned is the paper developed by Easton (2006)
which investigates analytically and empirically the biases
in the analysts forecasts induced by the change in the
reporting regime. Easton (2006) draws attention that for
companies that switch from domestic to international
standards, the analysts forecasts may tend to have a
different degree of optimism than for companies that do
not operate this change. Easton claims that a change in
the reporting regime creates differences in the esti-
mations of the book value of equity which is considered
by analysts when estimating the terminal value of the
business. Overall, Easton (2006) concludes that the
interpretation of the results in the studies just reviewed
(especially Daske, 2006) should be cautious since those
papers do not control for these possible shifts in analysts
forecast and therefore may have possibly misestimated
the cost of equity capital.
In respect to the Romanian capital market, several
authors have discussed the issues related to the
measurement of the cost of capital. Dragot (2007) and
Ciobanu (2008) emphasized the limits of applying the
CAPM model on the Romanian capital market, whereas




Cruntu (2006, 2009) tried to empirically evaluate the
cost of capital for Romanian listed companies based on
the CAPM model. Pascu-Nedelcu and Pun (2009)
proposed different models for the measurement of the
cost of capital for Romanian companies taking into
account the interdependency of financial markets in the
context of the global financial crisis.
Determining the cost of capital based on the CAPM
model was seen as problematic especially in the case of
emergent markets, such as the Romanian one.
Difficulties relate to both data unavailability (for evaluating
the volatility coefficient and the risk premium) and to the
rationales used in constructing a reliable model for the
cost of capital. However, there were attempts to estimate
the cost of capital based on the CAPM model. For
instance, Cruntu (2009) proposed computing the cost of
equity capital for Romanian companies using the CAPM
model in Euros or USD and then converting it in local
currency only in the last stage of the process in order to
avoid certain parameters with values that could be
arbitrary considered and thus difficult to be quantified
(Cruntu, 2009). Based on these assumptions, taking into
account the expected inflation rate for the year 2010 for
Romania and the Euro zone, the cost of equity capital for
Romanian companies was estimated to 9.97% in Euros
and 13.34% in lei.
Although the link between the quality of financial
information and the cost of capital is discussed in the
Romanian literature (Dragot, 2006), there are very few
attempts to document this relationship empirically. For
instance, Ionascu et al. (2008) revealed that after
adopting IFRS based GAAP, companies listed on the
Romanian stock exchange market exhibited levels of the
cost of capital that were lower, compared to the levels
prior to the adoption. However, the results in Ionascu et
al. (2008) were affected by an ex-post operationalization
of the cost of capital. The study was only meant to create
an initial set of beliefs about the adoption of IFRS and the
cost of capital in Romania. We revisit that set of beliefs
through the present study.


ECONOMETRIC MODEL

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

it
it t
it
V
e E
r
] 1 [ +
=
(1)

Traditionally, the empirical estimation of cost of equity capital
underlying this approach rests on a series of assumptions about the
market efficiency, dividend payout ratio, information available on
the market and the earnings process. These assumptions (A1
through A4) are worth discussing:




A1: Market efficiency Information is instantly and totally
impounded in prices;
A2: Dividends payout ratio The dividend payout ratio is 1. All
earnings are distributed as dividends;
A3: Information - Earnings represents the only source of information
available on the market;
A4: Random walk of earnings The earnings process is assumed to
follow a random walk with no lags. That is et+1 = et + t where et is
earnings in year t and t is a zero mean random error term.
In terms of empirical estimation, assumption A1 ensures that the
actual share price Pt is a good proxy for the intrinsic value of the
firm Vt. On the other hand, assumptions A2 through A4 ensure that
the best proxy for the estimated future earnings (et+1) is the
observed value of current earnings (et). The argument here is fairly
simple. Denote Et[et+1|It] the time t expectation of time t+1 earnings
in light of total information available on the market at time t (It).
Assumption A3 postulates 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 t expectation of time t+1 earnings is equal to et. If all of
these assumptions are met, then a simple and straightforward
empirical estimation of the cost of equity capital would be the
inverse of price/earnings ratio.
Our modeling however is constrained by the low degree of
efficiency of the Romanian market (as documented by Dragot
(2006), as well as by the data availability. Our aim is to tease out
the cited definition of the cost of capital so that we isolate the effect
of market efficiency and express the cost of capital in terms of
observable data such as earnings and share prices. This is
accomplished further. Also denote:

eit+1 as the actual earnings per share of firm i in year t+1;
Pit the actual share price of firm i in year t.
Now, develop equation (1) by introducing the actual figures for
the earnings per share and the share price, under the following
form:

it
it
it
it
it
it t
it
P
P
V
e
e
e E
r
1
1
1
] [
+
+
+
= (2)

Rearranging the terms in the equation we get:

1
1
1
] [
) )( (
+
+
+
=
it
it
it t
it
it
it it
e
e
e E
P
V
P r
(3)

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

) log( )
] [
log( ) log( ) log(
1
1
1
+
+
+
= +
it
it
it t
it
it
it it
e
e
e E
P
V
P r (4)

Two observations need to be made at this point. First, equation (4)
shows that, in order to estimate the cost of capital rit from
observable variables like Pit, the actual share price and eit+1, the
earnings per share, one needs to control for market inefficiencies
and 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 Pit reflects the intrinsic value of the firm Vit. If the market were
efficient (which is not case in Romania), the intrinsic value of the
firm will fully be reflected in the share price, Vit would equal Pit and
the term

) log(
it
it
P
V
would disappear. Likewise, also in equation (4),
the variable
)
] [
log(
1
1
+
+
it
it t
e
e E
captures the precision of analyst
forecast (tendencies to over or under-estimate future profits, noisy
information, etc.). If the estimates were perfectly accurate then
Et[eit+1] would equal the actual eit+1, and the term
)
] [
log(
1
1
+
+
it
it t
e
e E

would disappear. Consequently, the economic model in equation
(4) naturally shows the need to control for market inefficiency and
analyst forecast precision.
Second, to allow an empirical implementation of our econometric
model (equation 4), we need to disentangle the cost of equity
capital and the share price in the logarithm formula of the first term
of the left-hand side of the equation log(ritPit). We do this by
applying the Taylor formula for the linear approximation of a
function f(x) when x is around a:

) ( ) ( ) ( ) (
'
a f a x a f x f + (5)

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

a
a x
a x

+ ) log( ) log(
(6)

Given the magnitude of share prices in our sample and estimating
that the ex-ante cost of capital is usually ranging between 0 and 1,
we forecast that our variable x =ritPit will range somewhere between
(0, 2). Therefore, in equation (6), we make a = 1 which changes it
into log(x) x-1 which further translates into:

it it it it
P r P r + 1 ) log( (7)

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

)
] [
log( ) log( 1 ) log(
1
1
1
+
+
+
+ +
it
it t
it
it
it it it
e
e E
P
V
P r e

(8)


Empirical implementation

The cost of capital is by excellence an ex-ante or forward-looking
concept. It requires information about the future value of an
enterprise as well as information about the expectations regarding
future dividends or at least future profits. As the econometric model
shows, on a possibly inefficient capital market like the Romanian
market, the estimation of the cost of capital will necessarily have to
control for both market inefficiencies and the precision of the
forecast. However, due to the lack of data availability, we leave the
impact of these two frictions to the error term.
From the econometric model stated earlier (equation 5), we
derive our statistical model in its simple form:

+ + =
+ it it
P eps ) log(
1
(9)

where: epsit+1 = the actual earnings per share of firm i in year t+1;
204 Afr. J. Bus. Manage.



Table 1. Descriptive statistics.

Descriptive statistic
Earnings per share (RON/share) Share prices (RON)
1999 2006 1999 2006
Mean 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
R
2
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 i in year t.
The model will be estimated at two different times: time t (prior to
the adoption of IFRS standards), and time t+ (after the adoption of
IFRS standards). Since harmonization of Romanian accounting with
the IFRS standards started in the year 1999, and reached the full
compliance stage starting with 2005, we have selected as relevant
dates for our sample years t=1998 (pre-adoption) and t+ =2006
(post-adoption).
The coefficient of interest in the model is , which is a direct
estimate of the cost of capital. We expect the value of to be
positive and lower than 1. Likewise, if the adoption of IFRS has
created the economic benefit of a reduced cost of capital, we
expect the estimation of for the post-adoption sample (t+) to be
lower than the estimation of for the pre-adoption sample.
A word of caution needs to be told before proceeding with the
empirical assessments of the model. The estimation of in the
previous regression represents only a gross estimate of the cost of
equity capital because there are no control variables for market
inefficiencies and forecast precision. However, these estimates,
unrefined as they are, still offer a first impression on the magnitude
of the cost of equity capital as well as a starting point in comparing
the cost of capital before and after IFRS adoption.
Due to objective reasons further discussed, our sample size is
moderate. First, the Romanian capital market is not very large. The
number of companies listed on both tires (I and II) of the stock
exchange has never exceeded 70 companies. Although this
decision may come with some company size effect, to avoid
substantial reduction of our samples, we decided to retain in our
pre- and post- adoption samples, companies from both tires.
However, companies that were listed in 1998 but no longer listed in
2006 as well as new companies listed after 1998 have been taken
out of our sample. Finally, some of the companies remaining in the
sample displayed negative earnings in at least one of the two years
of 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 and
stock prices are presented in Table 1.


RESULTS

The regression results are summarized in Table 2. The
coefficient is positive and lower than 1 for both before
and after the IFRS adoption samples. Moreover, from
the pre-adoption sample (0.33) is bigger than from the
post-adoption sample (0.132) which supports an inverse
relationship between reporting quality and the cost of
capital in Romania as a result of IFRS adoption by listed
companies.
The ex-post calculation of r
it
P
it
reports no value outside
the benchmark interval of (0, 2) assumed in the
development of the econometric model.


CONCLUSION AND LIMITATIONS

The purpose of this paper was to identify a possible
economic benefit of IFRS adoption in Romania. Prior
literature reveals that a high-quality accounting and
reporting system (such as the one based on IFRS)
determines entirely the very quality of financial
information, resulting in increased transparency and
comparability of financial information reported, and finally
in a decreased cost of capital.




In order to determine whether the cost of equity capital
did decrease as a result of the IFRS adoption in
Romania, we have modeled the cost of equity capital as
the expected return on the intrinsic value of a share, and
computed it based on pre- and post-adoption samples.
The results showed that the cost of equity capital
decreased after the IFRSs were adopted in Romania,
from 0.33 (computed based on a pre-adoption sample) to
0.13 (estimated on a post-adoption sample). We can
comment on the fact that the cost of capital of Romanian
listed companies computed for the year 2006 (after the
adoption of IFRS) is comparable to the one estimated by
Cruntu (2009) based on a CAPM model for the year
2010.
However, the figures stated previously are only gross
estimates of the cost of equity capital because the
econometric model tested had no control variables for
market inefficiencies and forecast precision. Yet, these
estimates, unrefined as they are, still offer a first
impression on the magnitude of the cost of equity capital
as well as a starting point in comparing the cost of capital
before and after IFRS adoption.


ACKNOWLEDGEMENT

The authors gratefully acknowledge the financial support
offered by CNCSIS UEFISCSU through the project
PNCDI II: ID_1840/IDEI II: The benefits of IFRS
adoption: an exploratory research regarding the impact of
the internationalization of Romanian accounting on the
cost of capital.


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