How do individual investors react to global IFRS adoption? *

Transcription

1 How do individual investors react to global IFRS adoption? * Ulf Brüggemann Lancaster University Holger Daske University of Mannheim Carsten Homburg University of Cologne Peter F. Pope Lancaster University First Draft: December 2008 This Draft: July 2009 Abstract We examine the impact of global IFRS adoption on cross-border equity investments by individual investors. The Open Market at Frankfurt Stock Exchange, a segment designed for German individual investors to trade a large selection of foreign stocks, provides an ideal setting to address this research question. Using a sample of 4,869 firms from 31 countries around the world, we find that stocks experience an increase in Open Market trading activity following mandatory adoption of IFRS. This increase is both economically and statistically significant. Our results are consistent with the idea that collective IFRS adoption has the potential to reinforce foreign equity investments not only by professional institutional investors (e.g. Covrig et al. (2007), Florou and Pope (2009)), but also by individual investors. JEL classification: G14, G38, K22, M41, M48 Key Words: Individual investors, International accounting, IFRS, Open Market, Trading activity, Foreign equity investments * We appreciate the helpful comments of workshop participants at Erasmus University Rotterdam, Lancaster University, the 2009 AS-VHB/IAAER meeting, the 2009 European Accounting Association meeting, and the INTACCT meetings in Frankfurt, Cyprus and Valencia. Thanks are also due to Paul Rayson for expert advice and Eddie Bell for programming assistance on the collection of Google News archive search results. Ulf Brüggemann, Holger Daske and Peter F. Pope gratefully acknowledge the financial contribution of the European Commission Research Training Network INTACCT (Contract MRTN-CT ). Correspondence: u.bruggemann@lancaster.ac.uk.

2 1. Introduction In November 2008, the U.S. Securities and Exchange Commission (SEC) proposed a Roadmap that, if implemented, could lead to the required use of International Financial Reporting Standards (IFRS) by U.S. issuers from 2014 onwards. 1 This initiative is following a revolutionary trend that has seen IFRS reporting being currently accepted in over 100 countries around the world. Regulators justify the move towards IFRS by the expectation that collective adoption of IFRS will enhance transparency and comparability of financial statements across countries and thus, among other benefits, one single accounting language will reinforce cross-border equity investments (e.g. EC Regulation No. 1606/2002). We evaluate this claim by analyzing IFRS-related changes in cross-border equity investments of individual investors. 2 Despite the focus on institutional investors in prior literature, individual investors play a vital role in financial markets. At the end of 2007, domestic individuals directly owned 14% of the market value of listed stocks in Europe (FESE (2008)). In the United States (U.S.), more than 20% of equity is held directly by individual investors (French (2008)). Anecdotal evidence suggests that individual investors are more likely to pursue long-term objectives than their institutional counterparts. Companies therefore make great efforts to attract individual investors, e.g. via corporate websites and investor relations departments (Vogelheim et al. (2001)). The relevance of individual investors is also recognized by regulators. For example, one of the explicitly stated purposes of the SEC is to extend individual investor protection (SEC (2008)). Mary Shapiro, the current SEC chair, 1 2 For details, see We use the term individual investors to refer to non-institutional investors. Retail investors and private investors are synonymous expressions used in prior studies. It is interesting to note that some of the earliest research examining individual investors use and understanding of financial statement information was provided by Sir David Tweedie, the current IASB Chairman (e.g. Lee and Tweedie (1977)). 1

3 emphasizes that without rules to protect [individual] investors, financial systems will not raise capital and the economy will not grow (FINRA (2008)). A key challenge for any study of individual investors is that data on their investing and trading behavior is not publicly available. Prior studies have adopted several strategies to address this problem, including analysis of small trades using intra-day transactions data (e.g. Lee (1992)), surveys of individual investor opinion (e.g. Elliott et al. (2008)) and examination of a proprietary dataset provided by a U.S. online broker in the 1990s (e.g. Odean (1998)). None of these approaches are capable of providing large-sample evidence on the impact of IFRS adoption on individual investor decisions. Our proxies for cross-border equity investments by individual investors are based on trading activity in the Open Market at the Frankfurt Stock Exchange (FSE). The Open Market is an unofficial trading segment designed for German individual investors to trade foreign (i.e. non-german) stocks. 3 This trading segment provides an ideal setting to study our research question for the following reasons. First, the Open Market rules allow brokerage houses to independently include securities in the Open Market, without any involvement by the issuer. Brokerage houses are not required to inform issuers, let alone seek approval for inclusion of securities in the Open Market. Therefore, self-selection issues that often arise when analyzing firms that cross-list on exchanges abroad do not apply (e.g. Karolyi (2006)). Second, the Open Market comprises nearly one-third of all global stocks (excluding Germany). We are not aware of any other trading segment worldwide that offers such a diversity of foreign stocks. Descriptive statistics show that the Open Market sample favors more visible and transparent companies. To the extent that these characteristics complement 3 The only trading segment outside Germany that is remotely comparable to the Open Market is the Grey Market (or Other OTC) in the United States. However, Grey Market securities are not traded or quoted on an exchange or interdealer quotation system. Since investor s bids and offers are not collected in a central spot, market transparency is very low. For more information, see ( investors_market_tiers.jsp). 2

4 high-quality adoption of IFRS, this increases the likelihood of finding an effect of IFRS adoption (e.g. Ball (2006), Daske et al. (2007), Christensen et al. (2007)). Third, the majority of listed companies in Germany adopted IFRS well before these accounting standards were introduced in other countries around the world. IFRS adoption by German companies was either voluntary (e.g. Leuz and Verrecchia (2000)) or due to exchange regulation of the former New Market (e.g. Leuz (2003)). In fact, much of the discussion on the benefits and costs of IFRS in the mid to late 1990s took place in Germany. This enabled German investors to familiarize themselves at an early stage with IFRS through their investments in domestic stocks. 4 To the extent that lack of familiarity with IFRS creates costs for IFRS financial statement users, we would expect that these costs are lower in Germany. Therefore we expect that IFRS-related investment effects are more likely to be observable in the Open Market. We predict that IFRS adoption removes entry barriers to investment in foreign stocks by replacing unfamiliar local GAAP s with familiar IFRS. Hence, IFRS adoption moves foreign stocks into the choice set of German investors and is expected to reinforce demand and ultimately trading activity in IFRS-adopting stocks traded in the Open Market. Using a sample of 4,869 firms from 31 countries around the world, we find that stocks experience an economically and statistically significant increase in Open Market trading activity following the mandatory introduction of IFRS. For example, percentage trading volume in stocks of mandatory IFRS adopters increases by more than 20% relative to non- U.S. control firms. Voluntary IFRS adopters also experience enhanced trading activity, but in contrast to mandatory IFRS adopters the effect is not always significant. If we include U.S. firms in the benchmark, the IFRS effect on Open Market trading activity is even stronger, illustrating that U.S. stocks lose trading volume in comparison to firms from IFRS adopting 4 Open Market investors engage in stock picking of foreign shares. Therefore they may be characterized as individual investors that exhibit greater financial literacy, and thus are more likely to actually utilize accounting information (e.g. Bailey et al. (2008)). 3

5 countries. These findings are robust to inclusion of a battery of control variables (e.g. media coverage in Germany based on Google News archive search results) and sensitivity analyses (e.g. a two-step approach to address potential sample selection issues). Further tests show that the trading reaction to global IFRS adoption in the Open Market does not depend on a country s institutional environment, contrary to the findings of most other studies on the economic consequences of IFRS adoption (e.g. Daske et al. (2008)). This finding, taken at face value, may point to a naïve reaction of individual investors towards IFRS adoption. However, we offer and present evidence for the alternative explanation that this result is attributable to the observation that lead brokers select stocks for trading in the Open Market when the firm s reporting incentives fit with high-quality IFRS adoption. Taken together, our analyses provide strong evidence consistent with the idea that IFRS as one global accounting language enhances cross-border equity investments by individual investors. Therefore, our paper complements evidence indicating that professional, institutional investors react positively to IFRS adoption (e.g. Covrig et al. (2007), Florou and Pope (2009)). Prior literature that examines the economic consequences of mandatory IFRS adoption focuses on aggregate capital market reactions (e.g. Daske et al. (2008)), macroeconomic effects (e.g. Beneish et al. (2009)) or asset allocation decisions by institutional investors (e.g. Florou and Pope (2009)). Our study contributes to the literature in a number of ways. First, to the best of our knowledge, we provide the first analysis of individual investors reaction to global IFRS adoption. Thus, we provide evidence on how a single accounting language impacts individual investors, who are an explicit clientele of regulators such as the SEC. Second, we present evidence that Open Market lead brokers play a significant role in screening and filtering-out firms with low quality reporting incentives and opaque financial reporting. We therefore also add to the growing literature studying differential reactions to heterogeneity in reporting incentives and practice. Third, we introduce a novel and unique 4

6 setting into the currently highly dynamic academic literature on individual investors. This setting allows us to directly observe the aggregate trading activities of a large and homogeneous group of individual investors, i.e. German individual investors trading in foreign stocks. The remainder of the paper is organized as follows. Section 2 describes the Open Market. In section 3, we examine Open Market reactions to global IFRS adoption. Section 4 concludes. 2. The Open Market 2.1. INSTITUTIONAL BACKGROUND The Open Market ( Freiverkehr in German) is an unofficial trading segment at FSE. In contrast to official stock market segments in Europe (e.g. Prime and General Standard at FSE, Main Market at London Stock Exchange), the Open Market is not subject to regulations and directives of the European Union (EU), but is exclusively governed by stock exchange rules. It covers a variety of financial instruments such as stocks (both from Germany and abroad), bonds, certificates and warrants. The stocks segment is structured into the First Quotation Board and the Second Quotation Board. The First Quotation Board contains companies with a primary listing in the Open Market. 5 Companies whose stocks are already listed at another domestic or foreign trading venue (home market) are included in the Second Quotation Board. Since the Open Market is an unofficial trading segment, the EU regulation mandating IFRS is not applicable to companies in the First Quotation Board. In contrast, many companies in the Second Quotation Board are obliged to prepare their financial 5 In 2005, FSE introduced the Entry Standard as a sub-segment of the First Quotation Board. Transparency requirements in the Entry Standard are higher than in the rest of the Open Market, but considerably lower than in official FSE stock market segments. While the Entry Standard is open to all companies, it is specifically targeted at small- and mid-caps that seek low cost access to the capital market. The Entry Standard is marketed as an alternative to the Alternative Investment Market at London Stock Exchange (e.g. Sudmeyer et al. (2005), Schlitt and Schäfer (2006)). At the end of 2008, 104 (11) German (foreign) companies were listed in the Entry Standard (FSE (2008)). 5

7 statements in accordance with IFRS due to regulation in the respective home markets. In this study, we focus on the foreign (i.e. non-german) stocks in the Second Quotation Board. For simplicity, we refer to this sub-segment as the Open Market. 6 Established in 1987, the Open Market has become increasingly popular with German investors in recent years. At the end of 2000, a total of 4,544 foreign stocks were traded in the Open Market. This number doubled to 9,113 by the end of For comparison, the number of domestic stocks traded at FSE increased by only 16% from 905 to 1,054 during the same period (FSE (2000), (2008)). The remarkably high number of foreign stocks available for trading in the Open Market is a consequence of its unique set of rules. 7 These rules permit eligible brokerage houses, i.e. those that are accredited for trading at FSE, to include securities in the Open Market on their own initiative ( 2 (3) AGB). The stock issuing company need not be informed, nor need it approve inclusion of its securities in the Open Market. For the brokerage house, the inclusion process involves two basic requirements. First, it has to guarantee orderly fulfillment of transactions by acting as a lead broker ( 14 (1) AGB). Second, it has to pay a non-recurring fee of 750 Euro ( 35 AGB). Follow-up obligations of the lead broker are confined to informing the FSE about essential company news concerning the issuer that can be acquired by generally accessible information sources in a reasonable way ( 16 AGB). Lead brokers are authorized to exclude securities from the Open Market at any time with a notice period of four weeks, or without notice upon good 6 7 Official resources and the academic literature provide only little information on the Second Quotation Board of the Open Market. Much of the following description is based on the insights we gained from interviews with FSE staff and brokers. For more general information on the Open Market see e.g. Müller-Michaels and Wecker (2005), Harrer and Müller (2006) or the website of FSE: We refer to this set of rules as AGB in the following. AGB stands for Allgemeine Geschäftsbedingungen für den Freiverkehr an der Frankfurter Wertpapierbörse (General Terms and Conditions for the Regulated Unofficial Market). 6

8 cause ( 33 (2) AGB). 8 In summary, brokerage houses face very few constraints or institutional barriers relating to inclusion or exclusion of securities in the Open Market. Once a security has been included, the lead broker holds the exclusive right to set bid and ask quotes. 9 Although officially non-binding ( 79 FSE Exchange Rules), these quotes are defacto tradable up to a size the lead broker specifies (Freihube et al. (1999)). When an investor places an order to trade on the bid (ask) quote, the lead broker buys (delivers) the agreed number of stocks. The resulting position would then be immediately closed with an offsetting order to entirely eliminate inventory risk. However, due to market illiquidity (see below for supporting evidence), perfect offsetting may not be possible for Open Market stocks. The lead broker is then forced to carry out inventory rebalancing countertrades in another market, typically the home market where liquidity is generally much higher. Hence, in setting bid and ask quotes the lead broker faces a trade-off. On one hand, she has an incentive to offer low bid-ask spreads to generate trades and earn brokerage fees. On the other hand, there is the risk of losing out on trades if countertrades at the home markets are carried out at unfavorable prices. The resulting Open Market quotes are therefore likely to be determined by the home market bid-ask spread as a lower bound plus a premium that reflects the price risks faced by lead brokers in executing inventory rebalancing and due to currency risk exposure during trade execution. Other factors with a potential impact on the bid-ask spread premium in the Open Market include trading volume (i.e. the likelihood that the lead broker is able to match offsetting orders) and competition to the lead broker s services. Competition may arise from other German exchanges, e.g. in Berlin, Stuttgart or Munich, where similar but much smaller 8 9 Order books of Open Market securities can also be terminated by FSE ( 33 (1) AGB). For example, in December 2005, FSE suspended trading in Turkish stocks until further notice because of unanswered questions about a planned tax on Turkish equities (Greil (2005)). In case more than one party applies to be the lead broker for a particular stock, the allocation of the order book is decided by lot. Baader Bank AG, mwb fairtrade Wertpapierhandelsbank AG and Wolfgang Steubing AG Wertpapierdienstleister are the leading brokerage houses in the Open Market (Hiller von Gaertringen (2006)), but there are a number of other competitors. Detailed information on the allocation of Open Market order books is not publicly available. 7

9 trading segments exist. Within the FSE, trading volume can shift from floor trading where the lead broker operates to the fully electronic platform XETRA where quotes are automatically determined by an open limit order book. We analyse the Open Market competitors in more detail in section 3.5. Despite high bid-ask spreads, the Open Market provides a cost-efficient alternative to the home markets under certain circumstances. German retail banks and brokers pass on high, mostly fixed order fees when local clients choose to trade directly on a foreign exchange, whereas fixed charges for trading at FSE are considerably lower. Hence, for small trade sizes the higher bid-ask spreads (i.e. variable transaction costs that increase with trade size) are outweighed by lower order processing costs (i.e. mostly fixed transaction costs that are independent of trade size) in the Open Market. Appendix A provides an illustrative example on these links. The combination of low fixed and high variable fees in the Open Market is likely to be particularly attractive for German individual investors who trade small sizes of foreign stocks. 10 Put differently, the Open Market lead broker provides German individual investors with cheaper access to foreign stocks DATA AND DESCRIPTIVE STATISTICS In this section, we describe the quantitative characteristics of the Open Market. The analysis is based on two main samples: 1) a main sample defined as the Datastream (DS) Universe, and 2) the Open Market sample - a subset of the DS Universe. The DS Universe spans fiscal-years 2001 to 2007 and includes all firms covered by Datastream that meet the Here and in the following, we refer to Open Market investors as German individual investors for two reasons. First, the economics of the Open Market show that Open Market investors trade through German retail banks and brokers (see Appendix A). Due to institutional barriers most German retail banks and brokers require their clients to be domiciled in Germany. Second, German retail banks and brokers typically target their services at investors who speak German. For example, the web-portal of comdirect bank ( the leading online broker in Germany, provides information in German language only. Note that institutional investors typically 1) have preferred and cheaper access to foreign markets through their lead brokerage houses and 2) trade in volumes well above the break-even where the foreign market turns into the more cost-efficient trading alternative. 8

10 following requirements: At the country-level, we focus on firms domiciled in countries that either introduced IFRS in 2005 (the treatment group) or mandated domestic accounting standards throughout the sample period (the control group). 12 At the firm-level, the DS Universe is restricted to companies that have their primary listing on the main exchange of their country of domicile (home markets) 13 and for which sufficient data on trading volume, stock returns and required accounting data is available for both fiscal-years 2004 and We only include companies in the treatment group that switched from local GAAP to IFRS in 2005 (mandatory IFRS adopters) or before 2005 (voluntary IFRS adopters). 14 The control group consists of companies that used domestic accounting standards throughout the sample period. The Open Market sample covers all firm-years within the DS Universe during which the respective stock could be traded on the FSE. We identify this sample using a proprietary dataset from FSE containing daily trading volume data (both in Euros and in number of shares traded) as well as the number of ticks for every stock traded in the Open Market during the sample period. 15 The FSE trading volume dataset spans the period January 2002 to We deliberately exclude Germany (our focus is on foreign, i.e. non-german, stocks), New Zealand (IFRS introduction in 2007), Singapore (IFRS introduction in 2003) and Turkey (IFRS introduction in 2006) from the DS Universe. Other countries such as China or Argentina are not included, because requirements on the firm-level are not met, usually because of missing information on accounting standards followed for firms listed on the main domestic exchange. The main exchange is defined as the trading venue with the largest number of companies listed. We consider only one exchange per country except for the United States where firms from both New York Stock Exchange (NYSE) and NASDAQ are included. By focusing on the main exchange(s) in each country, we exclude companies listed at less regulated trading venues (such as the OTC Bulletin Board in the U.S.) and thus ensure a minimum level of transparency among sample firms. Thus, in order to obtain a clean sample, companies from the treatment group countries that did not switch to IFRS during the sample period (e.g. firms that need not prepare consolidated financial statements), did so after 2005 (e.g. firms listed in the Alternative Investment Market at London Stock Exchange) or applied U.S.-GAAP (e.g. due to a cross-listing in the U.S.) are not considered. Information on Open Market trading volume at FSE is also available via Datastream. However, using Datastream trading data is less reliable in this particular setting. First, Datastream does not allow identification whether a stock is traded in the Open Market or in an official FSE stock market segment (Prime Standard, General Standard). Second, Open Market coverage in Datastream is incomplete. Trading volume information is missing for nearly 20% of all firm-years in the Open Market sample. Finally, Datastream data is rounded, i.e. information on the number of stocks traded is reported in thousands rounding to one decimal place. This method inherently induces a measurement error which is more 9

11 June For consistency, we confine capital market data from Datastream (e.g. trading volume for the home markets) to the same period. Depending on the fiscal-year end and the resulting measurement period (-6 to +6 months relative to the fiscal-year end), coverage for fiscal-year 2001 and/or fiscal-year 2007 can therefore be incomplete for some firms. We only include firm-years into the DS Universe (Open Market sample) with at least 100 daily observations of home market trading volume (FSE trading volume) during the measurement period to ensure consistency across fiscal-years. Table 1 presents details on the composition of the DS Universe and the Open Market sample. Panel A focuses on the treatment group, i.e. countries that introduced IFRS in The DS Universe consists of 363 (5,121) voluntary (mandatory) IFRS adopters from 22 countries. The Open Market sample covers 55% (29%) of all voluntary (mandatory) IFRS adopters in the DS Universe. Panel B shows that the DS Universe comprises 4,198 (5,487) U.S. (non-u.s.) firms within the control group. 55% (16%) of these companies are part of the Open Market sample. 16 Open Market coverage differs substantially across countries and firms. For example, while the majority of Austrian and U.S. stocks are tradable in the Open Market, some countries (e.g., Poland, South Korea or Morocco) are not represented at all. At the firm-level, the considerable difference in coverage rates across accounting standards and IFRS adopter types gives a first indication that the lead brokers do not randomly choose the securities they offer in the Open Market. From Panel C, we learn that the number of Open Market firms covered in the DS Universe increases over time, both in absolute as well as in relative terms. The total number of unique Open Market firms (Open Market share) climbs from 2,229 (21%) in fiscal-year 2001 to 4,060 (32%) in fiscal-year In total, the Open 16 significant when trade sizes are small like in the Open Market. We compare daily Open Market trading volume data from Frankfurt Stock Exchange and Datastream for those stocks both databases cover. After taking the rounding errors in Datastream into account, both databases provide consistent numbers on 99.51% of all trading days. U.S. firms account for approximately 50% of the Open Market sample. Here and in the following, we therefore distinguish between U.S. and non-u.s. firms within the control group. 10

12 Market sample (DS Universe) comprises 4,869 (15,169) unique firms and 23,366 (94,797) firm-years. 17 Table 2 shows descriptive statistics of various firm characteristics for the Open Market sample (Panel A) as well as for the rest of the DS Universe (Panel B). Panel A presents trading volume, number of trades, trade size and bid-ask spread statistics from FSE and the respective home markets for the same set of firm-years. Panel B is naturally confined to data from the home markets, because the covered sample (DS Universe excluding the Open Market sample) is not traded at FSE. In addition to liquidity measures, both panels show statistics on variables that are independent of the trading venue (other variables). Liquidity in stocks from the Open Market sample is quite low at FSE. During the average firm-year, trading occurs on slightly less than 25% of all trading days - during 2,307 firm-years (nearly 10% of the Open Market sample) there is no trading at all. On average, each stock is traded little more than twice per day, average daily trading volume is about 18,000 Euro. In contrast, daily trading volume in the home markets averages nearly 30 Million Euro. These massive liquidity differences across exchanges are hardly surprising. While trading at FSE is confined to a small subset of individual investors (i.e. German individual investors), institutional investors who account for most trading volume will prefer to trade in the respective home market. 18 Average trade size at FSE is about 2,700 Euro which is well below the threshold typically used in the prior literature to distinguish between individual and institutional investors (e.g. Bhattacharya (2004), Malmendier and Shantikumar (2007)). Comparison of bid-ask spreads across exchanges indicates that the variable fee the lead broker charges on Differences in the size of the Open Market sample and the official numbers from the FSE Factbooks stem from the data requirements we impose on the DS Universe. Untabulated statistics show that trading volume at FSE aggregated over the whole Open Market sample varies between 10 and 20 billion Euros per year. Hence, despite its relative lack of liquidity the Open Market offers substantial income opportunities for its participants. For example, with an average brokerage fee of 0.08% of the order volume (see Appendix A) Open Market lead brokers earn a total of 8 to 16 million Euros per year for their services. 11

13 Open Market transactions is in fact substantial: the median bid-ask spread is 3.17% at FSE compared to only 0.29% in the respective home markets. 19 Taken together, these descriptive statistics confirm that the Open Market at FSE is a trading segment that is specifically designed for individual investors DETERMINANTS OF OPEN MARKET INCLUSION In this section we analyse the characteristics of stocks that are tradable in the Open Market. Stocks are tradable in the Open Market if they have been included by the lead broker. This decision depends on a stock s potential to generate sufficient Open Market trading volume and thus brokerage fees. Potential trading volume in the Open Market is ultimately determined by individual investors demand for a particular stock. Detailed descriptions of all variables used in the analysis are provided in Table 2 (firmlevel variables) and Table 3 (country-level variables). 20 Table 4 presents results from probit regressions relating the likelihood of inclusion of a stock in the Open Market to various firmand country-specific variables. When compared with stocks that are not tradable at FSE, firms in the Open Market feature higher volatility (Return Variability), higher trading volume in the home market (Home Trading Volume), more analyst activity (Up-/Downgrades), greater media coverage in Germany (Google Ratio) 21 and higher market values (Market Value (Firm Level)). These results are consistent with the observation that individual For FSE, we use bid-ask spreads from the floor, because this is where most Open Market takes place (see section ). We retrieve spread data from Datastream (CRSP) for non-u.s. (U.S.) exchanges. Datastream started coverage of bid and ask quotes for U.S. exchanges in March Comprehensive comparison of daily spread data for the U.S. shows that Datastream and CRSP provide the same information on 98.57% (62.82%) of all trading days for NASDAQ (NYSE) stocks. While Datastream/CRSP offer information on home market bid-ask spreads for large parts of the Open Market sample, coverage for FSE is limited. To ensure comparability, we demand that bid-ask spreads are available for both the home market and FSE. This reduces the number of firm-years with spread data to 13,589 (58.16% of the Open Market sample). Note that most country- and firm-level variables are highly skewed. We transform highly skewed variables using natural logarithms to mitigate the influence of outliers. Our proxy for media coverage is the number of search results in Google News archive. See Appendix B for details. 12

14 investors are net-buyers of attention-grabbing stocks (Barber and Odean (2008)). At the country-level, Open Market companies are more likely to come from countries with a developed capital market (MCAP/GDP) 22, domestic accounting standards that are similar to IFRS (Distance to IFRS) 23, the Euro as the national currency (Euro), a main exchange that is geographically close to FSE (Distance btw Exchanges) 24 and economies that are closely linked to Germany (Imports + Exports). Finally, transparent reporting practices are significant determinants for Open Market inclusion, both at the country- and at the firm-level (EM Measure). To the extent that a strict enforcement system and generally transparent reporting practices are a prerequisite for high-quality application of IFRS (e.g. Daske et al. (2008), Garcia Osma and Pope (2009)), our findings indicate that the lead brokers prefer serious over label IFRS adopters for Open Market inclusion. Taken together, our results provide strong evidence that the Open Market sample is a nonrepresentative subset of the DS Universe. Specifically, the Open Market sample is significantly tilted towards more visible and transparent companies with reporting incentives that support high-quality adoption of IFRS. Thus, it seems that the lead broker acts as a gatekeeper to the Open Market, either proactively acting as a screening intermediary or explicitly responding to demand from individual investors. These findings have implications Measures of capital market development are also viewed as useful proxies for the quality of the enforcement system (Jackson (2008)). This view is based on the argument that capital markets cannot develop without a legal system that effectively protects investors. Alternative measures for capital market development (Turnover/GDP) or the strength of the enforcement system (Control of Corruption, Rule of Law, Regulatory Quality) are similarly significant determinants of Open Market inclusion. Alternative measures for the (dis-)similarity between domestic accounting standards and IFRS (Absence and Divergence) yield similar results. Due to multicollinearity the coefficient estimate on the IFRS distance measure flips signs when all country-level variables are included. For example, the correlation between Distance to IFRS and EM Measure (Country Level) is 0.66 measured at the firm-year level. The results are unchanged if we use the distance between the respective capitals (Distance Berlin Capital) as a proxy for geographic proximity. The coefficient estimate on the geographic distance measure flips signs when all country-level variables are included. The reason for this change of sign again is multicollinearity. For example, the correlation between Log(Distance btw Exchanges) and Log(Imports + Exports) is measured at the firm-year level. 13

15 for our analysis of Open Market trading activities following global IFRS adoption, because we are dealing with a selected sample. 3. Global IFRS Adoption and Trading Activities in the Open Market 3.1. PREDICTIONS In this section, we form predictions as to how global IFRS adoption affects trading activities in the Open Market. The previous section showed theoretical and empirical support for viewing the Open Market as a trading segment designed for German individual investors to trade foreign stocks. Our dataset described above does not allow us to directly observe if and how accounting information influences individuals trading behavior in the Open Market. However, prior literature and official statistics provide useful insights. Official statistics show that similar to evidence from other countries the majority of German individuals do not actively invest in stocks and that those who do exhibit a considerable degree of home bias when selecting individual stocks. For example, in 2004 the number of individual shareholders over 14 years in Germany amounted to only 4.6 Million or 6.5% of the whole population (DAI (2008)). Despite the well known benefits of international diversification, German individual shareholders invested a total of 145,495 Million Euro in domestic, but only 36,873 Million in foreign stocks (20.2% of all investments in stocks; Deutsche Bundesbank (2005)). These macro-level statistics suggest that the small subset of German individuals that actively trades individual foreign stocks possesses more financial literacy, on average, than those who focus on domestic equity or entirely refrain from stock picking. Consistent with this observation, recent research shows that individual investors are more likely to have internationally diversified portfolios if they are highly educated, wealthy and/or have more trading experience (e.g. Abreu et al. (2009), Bailey et al. (2008), Graham et al. (2009)). German individual investors are also more likely to trade in foreign stocks if they 14

16 consult financial advisors (e.g. Bluethgen et al. (2008), Gerhardt and Hackethal (2009)). Comprehensive survey evidence by Ernst et al. (2009) reveals that German individual investors use business media and financial statements as central information sources. While usage of accounting information varies considerably, more experienced investors tend to analyse financial reports more carefully. We argue that it is likely that Open Market investors engaging in active picking of individual foreign stocks exhibit greater financial literacy, and therefore have a higher likelihood of actually utilizing financial statement information in their investment decisions as compared to the average individual investor in the economy. Taken together, these insights suggest that accounting information affects Open Market trading through two non-mutually exclusive channels: either Open Market investors utilize financial statements by themselves and/or they consult other information sources such as the business media or financial advisors that in turn rely on information disclosed in financial statements. Individual investors are presumably most familiar with their local GAAP. In Germany, however, the majority of listed companies voluntarily switched from local GAAP to IFRS or U.S.-GAAP around the turn of the millennium (e.g. Leuz and Verrecchia (2000), Daske (2006)). 25 In addition, exchange regulation required companies listed at the New Market, a former IPO platform at FSE for high-tech growth firms, to report under either IFRS or U.S.- GAAP (e.g. Leuz (2003)). These combined developments enabled German investors to become familiar with IFRS and U.S.-GAAP through their investments in domestic stocks well before global IFRS adoption took off. We argue that German individual investors are more likely to invest in foreign firms that apply accounting standards with which they are familiar. This argument is supported by the observation that voluntary IFRS adopters as well 25 We confirm this observation by analyzing the accounting standard strategy of all German firms that match the firm-level sample selection criteria outlined in the previous section. We find 322 (177) voluntary (mandatory) IFRS adopters and 122 firms that used U.S.-GAAP at some point before fiscal-year In fiscal-year 2001, already around 60 percent of all German firms in our sample prepared financial statements according to IFRS or U.S.-GAAP. 15

17 as U.S.-GAAP users (i.e. U.S. stocks) are overrepresented in the Open Market sample (see Table 1). Conversely, unfamiliar accounting standards impose prohibitive (true or perceived) information processing costs on individual investors and thus deter them, among other reasons, from trading in foreign stocks. We predict that by replacing unfamiliar local GAAP s with familiar IFRS global IFRS adoption removes the entry barrier to foreign stocks that is caused by cross-country accounting diversity (see also Beneish and Yohn (2008) for a conceptual discussion). Hence, stocks of IFRS adopting companies are pushed into the choice set of Open Market investors, triggering more demand and ultimately more trading activity in these stocks. More trading in IFRS stocks may affect both the supply as well as the demand side in the Open Market. On the supply side, the lead broker is more (less) likely to include (exclude) foreign IFRS stocks after global IFRS introduction, either because she anticipates the increased demand or Open Market investors explicitly express their interest in such stocks. On the demand side, Open Market trading in stocks that had been included pre-ifrs is likely to increase after the adoption of IFRS, because the lower (true or perceived) information gathering costs of individual investors decrease after IFRS adoption. The inclusion decision involves low immediate costs and little follow-up obligations for the lead broker. In contrast, the wealth of individual investors is substantially influenced by their stock trading decisions. We therefore believe that the demand side offers a more powerful test of the impact of global IFRS adoption on Open Market trading. Stated in alternative form, our first two predictions are as follows: P1: Global IFRS adoption enhances the likelihood of Open Market inclusion for foreign IFRS stocks. 16

18 P2: Global IFRS adoption enhances Open Market trading activity in foreign IFRS stocks that had been included pre-ifrs. These predictions imply Open Market reactions regardless of how global IFRS adoption affects actual reporting practices. However, there are reasons to expect a more differentiated response. Prior literature provides strong theoretical arguments (e.g. Ball (2006), Hail et al. (2009)) as well as empirical evidence that mandating IFRS changes very little in reporting practices in case of adverse reporting incentives (e.g. Christensen et al. (2008), Garcia Osma and Pope (2009)). Thus, if reporting practices remain unchanged following a switch from local GAAP to IFRS, it is questionable whether true information processing costs of investors actually decrease. In fact, the information processing costs might even increase if discretion in reporting standards and lack of enforcement make it difficult for investors to figure out the extent to which firms are serious about their IFRS adoption. Assuming full financial literacy and rationality of individual investors, we would therefore expect a heterogeneous Open Market reaction where trading increases only in those stocks where IFRS fits with a firm s institutional environment and can really be expected to decrease the true information processing costs of such investors (Hail et al. (2009)). However, it could well be the case that there are limits to the extent to which individual investors have the time or the ability to understand and unravel the details of the accounting regulation and practice (e.g. Bartlett and Chandler (1997)). Given the vast literature on individual investors naivety (e.g. Bhattacharya (2004)), and their usage of simple heuristics in decision making (e.g. De Bondt (1998)), it is also conceivable that individual investors simply perceive information processing costs to be lower following IFRS adoption, even if reporting practices might not have changed more than in providing a common format and familiar style of the annual report. If so, a homogeneous Open Market response as implied by our first two predictions is to be expected. 17

19 In addition, recall that lead brokers mainly consider stocks of visible and transparent companies for Open Market inclusion (see section 2.3.). If Open Market lead brokers do not broadly add stocks from IFRS mandating countries, but go one step further and add only stocks from those firms which are likely to seriously adopt IFRS, and therefore really increase their transparency, the Open Market universe does not exhibit the same crosssectional variation as the overall universe of stocks. Again, a homogeneous Open Market response as implied by our first two predictions is to be expected. Given that the above mentioned conflicting arguments both have merit, we test the following hypothesis, but leave the prediction open: P3: The effect of global IFRS adoption on Open Market trading activity is homogeneous in reporting incentives. In the next sections, we successively test our three predictions with empirical data OPEN MARKET INCLUSION ANALYSIS Research Design In this section, we test our first prediction, i.e. we investigate whether global IFRS adoption enhances the likelihood of a stock being included in the Open Market. 26 The dependent variable Inclusion is a binary variable that equals one (zero) for all firm-years in the Open Market sample (the rest of the DS Universe). The key independent variable is Post- IFRS, a dummy variable that takes on value one (zero) for fiscal-years ( ). To test the impact of global IFRS adoption, we define non-u.s. control firms as our benchmark group and interact Post-IFRS with binary variables that indicate voluntary IFRS 26 Untabulated statistics show that a total of 2,027 (69) firms have been included into (excluded from) the Open Market sample during fiscal-years 2002 to Due to the infrequency of Open Market exclusions and for simplicity, we refer to Open Market inclusions here and in the following when, more precisely, in- and exclusions are analyzed. 18

20 adopters (Voluntary), mandatory IFRS adopters (Mandatory) and U.S. firms (USA), respectively. These interaction terms capture the average effect of global IFRS adoption on the likelihood of Open Market inclusion for the respective group of companies relative to the benchmark (i.e. non-u.s. control firms). Combining these variables results in the following basic regression specification: Inclusion = β 0 + β 1 Post-IFRS + β 2 Post-IFRS*Voluntary + β 3 Post-IFRS*Mandatory + β 4 Post-IFRS*USA + Σ β j Controls j + ε (1) where Controls j denotes the set of control variables. The set of control variables includes non-ifrs determinants of Open Market inclusion as used in section 2.3. We estimate regression specification (1) at the firm-year level using a fixed effects linear probability model, a pooled probit model and a random effects probit model. The fixed effects linear probability model has the desirable property that potential biases in coefficient estimates caused by unobserved firm characteristics are mitigated, because firm effects are estimated explicitly. One of the downsides of this approach is that it imposes strong restrictions on the estimated firm effects that may result in inconsistent estimates of the other coefficients. Moreover, the predicted values for the dependent variable may lie outside the interval [0, 1]. In contrast, predicted values from probit models are bounded between 0 and 1 by construction. However, probit models do not allow controlling for unobserved firm effects because of the incidental parameters problem. The difference between the pooled and the random effects probit model is that the latter makes an explicit assumption about the correlation structure between unobserved firm effects and covariates, while the former is 19