U.S. Investors and International Diversification
Mandatory IFRS Adoption and the U.S. Home Bias
This study investigates whether the home bias exhibited by investors based in the United States is affected by mandatory adoption of International Financial Reporting Standards (IFRS). Home bias refers to a phenomenon whereby investors do not diversify investment across borders to the most efficient degree. In other words, even though there appear to be benefits to diversifying one's investment portfolio to include more equities of companies located in countries other than the U.S., investors do not seem to make investment choices that take full advantage of such cross-border diversification opportunities. Prior research has suggested that investment frictions such as lack of familiarity with local markets and culture, and differing legal and investor protection laws across countries prevent optimal diversification.
This study investigates whether the magnitude of the U.S. home bias is reduced when publicly-traded companies in a country are required to use IFRS when reporting their financial position and results. Given that IFRS has been widely accepted as a set of high-quality accounting standards around the world, and that it is being increasingly adopted by countries, it is important to investigate whether IFRS adoption affects U.S. investors' diversification decisions. IFRS adoption may affect the U.S. home bias in two main ways. First, the implementation of accounting standards (IFRS) that are presumably of higher quality compared to a specific country's local accounting standards should give investors more confidence that financial reporting is more transparent and of higher quality overall. Second, U.S. investors may find it easier to compare their investment choices when companies issue financial reports using the same accounting standards. Given that learning one set of accounting standards (IFRS) is clearly easier than learning multiple, perhaps even dozens, of sets of local accounting standards, comparability across borders should become easier with IFRS adoption.
The results of the study provide evidence that the U.S. home bias decreases after a country mandates the use of IFRS by publicly-traded companies within its borders. This suggests that IFRS adoption improves financial reporting quality or comparability, or both, which leads to more investment, and thus less home bias, in companies based in foreign countries.Further, the study provides evidence that this effect is present only in countries with other strong institutional features. More specifically, the effect is only present in countries with relatively strong overall rule of law. This suggests that the enforcement of IFRS implementation is just as important as the IFRS adoption itself. The results also show that the overall financial reporting environment in a country is important to the IFRS effect. In other words, in countries with low overall financial reporting quality (possibly due to the lack of incentives in a country for companies to report high quality information), IFRS adoption does not affect the U.S. home bias. Therefore, the presence of incentives to report high-quality information are an important part of the effect of IFRS adoption on the U.S. home bias. Results also show that for countries where the local accounting standards differ from IFRS to a larger extent, the mandatory adoption of IFRS has a more pronounced effect on the reduction of the U.S. home bias. This suggests that increased comparability, and not just an increase in reporting quality, is an important outcome of IFRS adoption. Finally, the results indicate that the home bias effect is not driven by the European adoption of IFRS beginning in 2005. This is important as it shows that adoption by IFRS in any part of the world can impact investment decisions of U.S. based investors.
Inder K. Khurana is KPMG/Joseph A. Silvoso Distinguished Professor at Trulaske College of Business, University of Missouri-Columbia. Paul N. Michas is assistant professor of accounting at the Eller College of Management, University of Arizona.
Published in Accounting Horizons2011 25 (4): 729-753.