The non-diversifiable risk of financial reporting system: Evidence from the German market

Zhang (2013) proposes a theoretical model to argue that financial reporting system is a non-diversifiable risk for investors. However, there is little empirical evidence to support this argument. We use German data to empirically test the validity of Zhang's (2013) argument. Our results show that investors would require systematic premiums on the non-diversifiable risks related to financial reporting systems, and the findings are consistent with the argument of Zhang (2013). Furthermore, this study compares International Financial Reporting Standards (IFRS), German Generally Accepted Accounting Principles (German GAAP), and U.S. Generally Accepted Accounting Principles (U.S. GAAP) from the perspective of systematic risk. Our results show that firms that switched their accounting systems from German GAAP or U.S. GAAP to IFRS experience significant declines in the premiums on non-diversifiable accounting risk and costs of capital after adopting IFRS. The findings suggest that the systematic risk of IFRS is perceived to be lower than the systematic risks of German GAAP and U.S. GAAP. Moreover, we also find that firms with high accounting sensitivities before adopting IFRS have benefited more from adopting IFRS in the form of reduced premiums on systematic accounting risk and cost of capital than firms that had low accounting sensitivities before adopting IFRS.