New Research at the Bank of Israel: Does a Change in an Accounting Standard Affect the Risk-Pricing of a Firm?
- In 2016, a new accounting standard for Leases (IFRS 16) was issued, which substantially changes the accounting treatment of operating leases and long-term rentals—contracts that are treated as a firm's long term operating liabilities from an accounting perspective.
- The new standard provides important information about these liabilities, which previously had not been shown explicitly in the financial statements. In fact, the standard sheds light on the actual leverage of the firm, a critical parameter for the risk assessment of the firm.
- This study, conducted by Itay Kedmi, indicates that following the information which was provided by the standard, the yield spreads of firms that were affected by the standard increased, compared to firms that were not affected by the standard. Namely, the investors adjusted the prices of traded debt instruments, in a way that reflects a more accurate pricing of the firm's risk of default.
The financial statements of companies, particularly listed ones, play an important role in reducing the information asymmetry between the company and its stakeholders. These financial statements are used by, among others, the company's investors and creditors for their risk assessment of the company. Thus, there is considerable importance in examining whether accounting changes that have implications for the way the information is presented in the financial statements cause a market reaction, and specifically—lead to changes in the risk assessment regarding the company.
In 2016, a new accounting standard for Leases (IFRS 16) was issued, which substantially changes the accounting treatment of operating leases and long term rentals. The new standard provides important information about the firm's long-term liabilities, which previously had not been shown explicitly in the financial statements. In fact, the standard sheds light on the actual leverage of the firm, a critical parameter for the firm risk assessment.
Research conducted by Itay Kedmi of the Bank of Israel Research Department examines whether the new standard impacted on the risk pricing of firms, as reflected in their bond prices that are traded in Tel Aviv Stock Exchange. The results indicate that on the first disclosure date regarding the expected impact of the standard (2018:Q2) the yield spreads of the treated group (the firms that were affected by the standard) increased, compared to the control group (the firms that were not affected by the standard) (see Figure 1). Thereafter, at the next disclosure dates and on the implementation date (2019:Q1)—after creditors’ reactions were reflected in the bond market—no impact was found. The research further indicates that the results are stronger in firms that would have been expected to violate (or nearly violate) financial covenants following the new standard. It means that in those firms the information shock was stronger.
These findings indicate that due to the information that was provided by the standard, investors in the market adjusted the prices of traded debt instruments, in a way that reflects a more accurate pricing of the firm's risk of default. As such, it may be said that this study strengthens the argument that financial statements are used by investors and creditors for risk-pricing, so even a change in a specific accounting standard may have an impact on the market reaction, and particularly on the firm's risk-pricing, a topic that so far has been examined in a limited way in the academic literature.
Average Yield Spreads of the Treated Group vs. the Control Group
(Around the publication date of the financial statements that include the disclosure regarding the expected impact of the standard)
 Until the end of 2018 the information about operating leases and rental contracts over a year, which are known as firm's long term operating liabilities, has not shown explicitly in the financial statements; From 2019 following the standard, those liabilities are shown explicitly in the firm's balance sheet.
 This study uses the yield to maturity, which derived from the market price of bonds. The yield minus the risk free rate ("yield spread") reflects the investors' assessment for the firm's risk of default. Thus, changes in risk assessment of investors causes changes in the yield spreads.
 On the first disclosure date the information was shown in the notes of the financial statements, and it included the expected effect of the standard on financial statements. On the implementation date the standard was assimilated explicitly in the financial statements (e.g., the firm's balance sheet), but as mentioned before, in the first disclosure date the information already flowed to the investors.