Effects of the adoption of IFRS on the credit market: Evidence from Brazil Vinicius Lima, PhD at USP, Brazilian Federal Reserve Gerlando Lima, PhD at USP, Associate Professor at USP Giorgio Gotti, PhD at the U. of Tennessee, Associate Professor at UTEP Rome, June, 2016 The Illinois International Journal of Accounting Symposium

Acknowledgments My co-authors. Brazilian Federal Reserve for the unique data. Prof. Rashad (UIUC) and Jon Davis (UIUC). Prof. Fiori (LUISS University). The reviewers. Beatriz Garcia (The Autonomous University of Madrid). Organizers and Sponsors. All the other researchers at the conference.

The views expressed in our research are our own and do not represent the views of our universities or the Brazilian Federal Reserve.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Motivation 4 We investigated the effects of mandatory IFRS adoption on credit contracts in Brazil. Why these points? –Great impacts of IFRS in Brazilian GAAP and procedures. –Importance of accounting information for creditors: sensitive to changes and contract parameters (e.g. covenants). –Differences between stock and credit markets. In Brazil, for example, between 2005 and 2014, businesses obtained approximately BRL 15.7 trillion through the National Financial System (SFN), the debenture market and the stock market (primary and secondary issuance), of which 93% was bank credit, 4% issuance of debentures and only 3% issuance of shares. –Within-countries instead of between-countries. More sensitive to data.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil What did we do? 5 We first examined the relevance of accounting information to creditors; Employed corporate credit ratings assigned by both financial institutions and risk assessment agencies, and investigated the pattern of dispersion in credit ratings assigned the same firm by different financial institutions; Evaluated the effects of mandatory IFRS adoption on cost of debt and other loan contract terms (amount, maturity and collateral); Finally, we evaluated differences in the impact of IFRS adoption on the bank credit market versus the debenture market.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil About the hypotheses (H1) 6 IFRS is expected to improve accounting information quality through the disclosure of more detailed financial information, better methods of recognition and measurement, and greater comparability (Hail et al., 2010). However, the potential advantage of such improvement is probably or minor importance in credit risk assessment because banks and risk assessment agencies can compensate for the lack of transparency by privileged access to proprietary company information (Frost, 2007; De Franco et al., 2009). H 1 : Mandatory IFRS adoption, ceteris paribus, does not increase the ability of accounting information to explain corporate credit ratings.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil About the hypotheses (H2) 7 Assuming IFRS introduction is exogenous to the process of risk assessment and that IFRS helps reduce information asymmetry, it may be hypothesized that the dispersion of ratings assigned the same borrower by different financial institutions will decrease after the adoption. In this case, we specifically evaluated the ability of credit market-relevant accounting information in the IFRS format to reduce heterogeneity in corporate credit ratings. H 2 : Dispersion in corporate credit ratings assigned the same borrower by different financial institutions does not decrease after mandatory IFRS adoption.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil About the hypotheses (H4) 8 We would like to understand the firm-level, working with the Accounting Information Quality. H 4 : Decrease in the dispersion of corporate credit ratings following the adoption of IFRS is not conditional on the improvement of accounting information quality.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil About the hypotheses (H5 and H6) 9 Regulating and standardizing agencies have argued that universal adoption of the same accounting standards can help reduce capital costs by mitigating information asymmetry between managers and creditors/investors (IASB, 2008). In fact, some authors have reported negative equity costs following mandatory IFRS adoption (Daske et al., 2008; Li, 2010). However, the impact of IFRS adoption on the cost of debt and other economic consequences for the credit market are still not clearly understood. H 5 : Mandatory IFRS adoption has no positive economic consequences for loan contract terms (cost of debt, maturity, amount granted, demand for collateral). H 6 : Positive effects of mandatory IFRS adoption on loan contract terms (cost of debt, maturity, amount granted, demand for collateral) are not conditional on the improvement of accounting information quality.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil About the hypotheses (H7) 10 In view of the well-established notion that the lack of alternative mechanisms to mitigate agency costs increases the importance of accounting information quality on the debenture market, IFRS may be expected to have stronger economic impact on contract terms in that market. H 7 : Positive effects of mandatory IFRS adoption on contract terms (cost of debt, maturity, amount granted, demand for collateral) are not stronger on the debenture market than on the bank credit market.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Research Design 11 Segregated data: –Two periods: before vs. after IFRS adoption –Two groups: mandatory vs. voluntary adopters Sample CharacteristicNumber The theoretical portfolio IBrX Brazil ʼ s top 200 conglomerates voluntary IFRS adopters30 Eliminated repetitions(63) Sectors of finance and insurance(30) privately held firms(115) Total122 = 29 voluntary and 93 mandatory IFRS adopters

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Research Design 12 Corporated credit ratings – External credit ratings used in the study were assigned by three major risk assessment agencies Fitch, Standard & Poor ʼ s, and Moody’s: Thomson Reuters and manual search; – Altogether, 1,969 unique observations of ratings (company-trimesters) were made, covering all 122 conglomerates in the period ; – The ratings were converted to a scale from 1 to 9, with higher numbers indicating credit of higher quality; – Credit ratings assigned by financial institutions were retrieved from the Credit Information System (SCR), maintained by the Brazilian Federal Reserve. The sample consists of 3,496 mandatory adopters x trimesters and 1,140 voluntary adopters x trimesters; Bank loan contracts –Comprising 136,697 observations related to loans granted by 141 different financial institutions, the sample of loan contracts was limited to operations involving unsubsidized resources: Given by the Credit Information System (SCR), maintained by the Brazilian Federal Reserve. Debentures –Our sample consisted of 587 debenture contracts issued by 122 conglomerates in the period Contract terms were accessed through the SND/ANBIMA database.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Research Design 13 H 1 : Mandatory IFRS adoption, ceteris paribus, does not increase the ability of accounting information to explain corporate credit ratings.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Research Design 14 H 2 : Dispersion in corporate credit ratings assigned the same borrower by different financial institutions does not decrease after mandatory IFRS adoption.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Research Design 15 For H4, we developed the variable AIQ (Accounting information quality) from 3 models: the model of Barth, Landsman, Lang, and Williams (2006), the modified Jones model (1995) and the model of Kang and Sivaramakrishnan (1995). Put each model in a rank order, took the mean and took the difference between these means. Positive difference – improved; negative difference – deteriorated.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Research Design 16 H 5 : Mandatory IFRS adoption has no positive economic consequences for loan contract terms (cost of debt, maturity, amount granted, demand for collateral). H 6 : Positive effects of mandatory IFRS adoption on loan contract terms (cost of debt, maturity, amount granted, demand for collateral) are not conditional on the improvement of accounting information quality.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Research Design 17 H 7 : Positive effects of mandatory IFRS adoption on contract terms (cost of debt, maturity, amount granted, demand for collateral) are not stronger on the debenture market than on the bank credit market.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Results 18 H 1 : Mandatory IFRS adoption, ceteris paribus, does not increase the ability of accounting information to explain corporate credit ratings. – rejected.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Results 19 H 2 : Dispersion in corporate credit ratings assigned the same borrower by different financial institutions does not decrease after mandatory IFRS adoption. – cannot be rejected.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Results 20 H 4 : Decrease in the dispersion of corporate credit ratings following the adoption of IFRS is not conditional on the improvement of accounting information quality – rejected.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Results 21 H 5 : Mandatory IFRS adoption has no positive economic consequences for loan contract terms (cost of debt, maturity, amount granted, demand for collateral). – cannot be rejected.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Results 22 H 6 : Positive effects of mandatory IFRS adoption on loan contract terms (cost of debt, maturity, amount granted, demand for collateral) are not conditional on the improvement of accounting information quality.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Results 23 H 6 : Positive effects of mandatory IFRS adoption on loan contract terms (cost of debt, maturity, amount granted, demand for collateral) are not conditional on the improvement of accounting information quality.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Results 24 H 6 : Positive effects of mandatory IFRS adoption on loan contract terms (cost of debt, maturity, amount granted, demand for collateral) are not conditional on the improvement of accounting information quality. –We used instrumental variables because possible simultaneities. We reestimated model 3 with 2SLS. Results are very similar to those presented. Thus, again H5 cannot be rejected and H6 can.

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Results 25

Effects of the adoption of IFRS on the credit market: Evidence from Brazil May be the end? We think no The results of the first part of our analysis suggest that the ability of accounting information to explain corporate credit ratings increased after mandatory IFRS adoption. The evidence was the same regardless of whether the corporate credit ratings were assigned by financial institutions or risk assessment agencies (Fitch, Standard & Poor ʼ s, and Moody’s). Consistent evidence shows that dispersion in credit ratings assigned by lenders was reduced for firms with improved accounting information quality after the time of transition. The results of the second part of our analysis suggest that mandatory IFRS adoption may have positive or negative consequences for firms on the credit market depending on the presence of incentives. In both credit scenarios (bank loans and debentures), firms with incentives to improve earnings quality displayed i) reduced cost of debt, ii) longer maturity, iii) greater loans, and iv) less demand for collateral after the transition. In addition, for such firms, the effects (i-iv) tended to be stronger on the debenture market than on the bank credit market, supporting the notion that the weaker the alternative mechanisms of mitigating agency costs (e.g., access to proprietary information, such as managerial reports, budgets and forecasts), the greater the reliance on accounting information (Fama, 1985; Diamond, 1991; Yosha, 1995; Bhattacharya et al., 2003).

Effects of the adoption of IFRS on the credit market: Evidence from Brazil May be the end? We think no In all the aspects of our analysis, the evidence indicates that the existence of economic benefits associated with the transition to IFRS does not depend solely on the publication of financial reports in the mandatory format, but also on how earnestly firms adopt recommended disclosure practices. Along with evidence from earlier studies on the capital market (e.g., Daske et al., 2008; Li, 2010; DeFond et al., 2011; Byard et al., 2011; Tan et al., 2011; Lima, 2011; Brochet et al., 2013), our findings confirm the crucial role of firm-level incentives in the evaluation of potential economic benefits of changes in accounting format. Finally, our evidence counters the notion that financial reports in IFRS put emphasis on abstract models of measurement and contemporary information in detriment to the contractibility of accounting information (Ball et al., 2015).

Effects of the adoption of IFRS on the credit market: Evidence from Brazil Grazie mille ! 28 Contacts: Vinicius Lima - Gerlando Lima – Giorgio Gotti –