The impact of mandatory IFRS reporting on institutional trading costs: Evidence from Australia

• Author: Andrew Lepone,Jin Boon Wong
• Date: 01 July 2018
• DOI: http://doi.org/10.1111/jbfa.12320
• Published date: 01 July 2018

DOI: 10.1111/jbfa.12320

The impact of mandatory IFRS reporting on

institutional trading costs: Evidence from Australia

Andrew Lepone Jin Boon Wong

MacquarieGraduate School of Management,

Sydney,2113, Australia and CMCRC, Level3 55

HarringtonStreet, Sydney, NSW 2000

Correspondence

AndrewLepone, Macquarie Graduate School of

Management,99 TalaveraRd, North Ryde, NSW

2113,Australia.

Email:andrew.lepone@mgsm.edu.au

Fundinginformation

CapitalMarkets CRC Limited

Abstract

This study examinesthe impact of mandatory International Financial

Reporting Standards (IFRS) on the market quality of the Australian

Securities Exchange (ASX) 200 constituent stocks. Using traditional

metricsthat are consistent with prior literature (i.e., bid-ask spreads),

the first stage analysis confirms that stock liquidity has improved.

However,when the analysis is extended to consider the trading costs

incurred bymarket participants (i.e., execution shortfall), results sug-

gest liquidity has not changed significantly. The paper utilizes rich

unique datasets that contain detailed trade information, and find-

ings are robust after controlling for trade difficulty and market con-

ditions. In the era of High Frequency Trading(HFT) and occurrences

of ‘fleeting’ liquidity, this paper provides some evidence that while

IFRS may have enhanced ‘visible’ bid-ask spreads, tangible liquid-

ity for marketparticipants, particularly global institutional investors,

has not improved significantly.

KEYWORDS

accounting standards, Australian Securities Exchange, bid-ask

spreads, execution shortfall, fleeting liquidity, high frequency

trading, IFRS, institutional investors,liquidity, market quality

1INTRODUCTION

In 2002, the European Union (EU) and Australia formalized their decision to require all listed companies to adopt the

International Financial Reporting Standards (IFRS) for fiscal years beginning on or after 1 January 2005. Even though

the International Accounting Standards Board (IASB) developed IFRS1overa long time period, the official acceptance

by these developedcountries initiated the global harmonization process. Subsequently, over the past decade, IFRS has

been successfully introduced in over 100 countries. The move towards IFRS adoption in Australia was given momen-

tum through strong support by some key private sector regulators, such as the Australian Securities Exchange(ASX)

and by the Financial Reporting Council (FRC). Despite this, the Corporate Law Economic Reform Program (CLERP)

proposals on IFRS were highly controversial in Australia (similar to the EC's 1995 recommendations in Europe) and

1Consistent with the definition of IFRS as stated in IAS 1.11 (Deloitte, 2009), the term IFRS is used in this paper to include both old and new versions of

internationalaccounting standards (including IAS).

J Bus Fin Acc. 2018;45:797–817. wileyonlinelibrary.com/journal/jbfa c

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798 LEPONE ANDWONG

the literature has been filled with debate on the pros and cons of harmonization in both Australiaand E urope (seee.g.,

Cairns, 1997; Fearnley & Hines, 2003; Flower, 1997; Jones et al., 2004; Nobes, 1998). The objective of this paper is

to provide empirical evidence to analyze the touted benefits of mandatory IFRS adoption, such as improving commu-

nication among market participants, reducing the cost of capital, enhancing the quality of accounting standards and

improving access to international capital markets, incentives which have been persistently questioned (see Brown &

Clinch, 1998; Collett et al., 1998; Dunk & Kilgore, 2000; Haswell & McKinnon, 2003).

From an economic perspective, the proposition that simply mandating IFRS makescorporate reporting more infor-

mativeor more comparable is not apparent. It is possible that investors in firms would take a positive view towards IFRS

adoption if they expect IFRS to produce higher quality financial reports which improveinformation communication to

the market, and thereby reduces the cost of capital. Investors may also believethat the harmonization of accounting

standards has convergencebenefits which make comparison of the financial position and performance of cross-border

companies’ performance more cost-efficient. This enables capital markets to be more competitive globally, and can

consequently increase the market liquidity of listed firms. Conversely,investors in firms may react negatively towards

the IFRS adoption if they believe that this will result in lower quality financial reporting information compared to the

former standards. Further, if theyexpect opportunistic managerial discretion to increase through the potential vari-

ation in the implementation and enforcement of IFRS, or that the adoption and transition costs associated with IFRS

would exceedany benefits, then the market will react adversely.

Todate, research analyzing the impact of IFRS adoptions on market liquidity relies on various traditional measures

such as bid-ask spreads which may be inadequate to capture ‘true’ liquidity changes (see Christensen, Hail, & Leuz,

2013;and Leuz, 2003; Leuz & Verrecchia, 2000). In particular,when analyzing changes in disclosure policies, Heflin et al.

(2005) highlighted the inadequacy of inferring how market liquidity has changed bymerely examining bid-ask spreads.

The authors suggest that improving disclosures can lead to tighter spreads but disincentivize market makers as the

pay-off decreases (Diamond & Verrecchia,1991) which leads to a reduction in quoted depth and overall liquidity (Lee

et al., 1993). Further,Baciadore et al. (2002) observe that orders larger than the prevailing depth face more uncertainty

and higher execution costs. The concept that large institutional orders are more informed (Easley & O'Hara, 1987)

and challenging to execute is also well-documented in Anand, Irvine, Puckett, and Venkataraman (2012). Hence, it is

important to extendthe analysis of IFRS's impact on the liquidity of financial markets beyond the use of various bid-ask

spreads as liquidity measures, and consider the trading costs of marketparticipants, particularly institutional investors

with sizeable orders.

The concept of execution shortfall which seeks to measure changes in market liquidity by capturing the market

impact costs incurred by investors is well-documented in financial market literature (see Anand et al., Anand et al.,

2012, 2013; Conradet al., 2001; Jones and Lipson, 2001; and Keim and Madhavan, 1997). This measure considers both

bid-ask spreads and market depth which is particularly useful as financial markets have evolvedtremendously over

the past two decades with the rapid advancement of technology.These developments have inspired the advent of high

frequency trading (HFT) which has progressively dominated financial markets worldwide and fundamentally altered

the dynamics of modern markets. In the context of this study,it is noteworthy that participation by HFT can poten-

tially obscure the analysis of marketliquidity using bid-ask spreads (and simple market depth), as non-HFT participants

(especially institutional investors that regularly place and executelarge orders) have increasingly expressed concerns

of liquidity fade (quotes disappearing) when they endeavour to executelarger order parcels (see O'Hara, 2015 for a

literature review on HFT).

The concept of ‘fleeting orders’ or liquidity fade was highlighted byHasbrouck and Saar (2009) where they observed

that approximately 37% of limit orders are cancelled within two seconds of submission on Nasdaq's primary elec-

tronic trading platform, INET.2The authors note that fleeting orders are relatively new in US markets,and demon-

strate that improved trading technology,the emergence of an active trading culture, fragmentation of market struc-

tures, and increased utilization of latent liquidity,are the predominant drivers of this phenomenon. More importantly,

2There is a lower prevalence of ‘fleeting orders’ on the ASX. However,in a review of high frequency trading and dark liquidity by ASIC in 2015, ASIC stated

thatthey are working with market participants to reduce small and fleeting orders.