Drivers of Earnings Management and Conservatism in the German Stock Market. Effects of IFRS Adoption and Family Governance

Transcription

1 TECHNISCHE UNIVERSITÄT MÜNCHEN Center for Entrepreneurial and Financial Studies (CEFS) KfW-Stiftungslehrstuhl für Entrepreneurial Finance Univ.-Prof. Dr. Dr. Ann-Kristin Achleitner Drivers of Earnings Management and Conservatism in the German Stock Market Effects of IFRS Adoption and Family Governance Nina A. Günther Vollständiger Abdruck der von der Fakultät für Wirtschaftswissenschaften der Technischen Universität München zur Erlangung des akademischen Grades eines Doktors der Wirtschaftswissenschaften (Dr. rer. pol.) genehmigten Dissertation. Vorsitzender: Univ.-Prof. Dr. Gunther Friedl Prüfer der Dissertation: 1. Univ.-Prof. Dr. Dr. Ann-Kristin Achleitner 2. Univ.-Prof. Dr. Christoph Kaserer Die Dissertation wurde am bei der Technischen Universität München eingereicht und durch die Fakultät für Wirtschaftswissenschaften am angenommen.

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5 I Table of Contents LIST OF FIGURES... VI LIST OF TABLES... VIII LIST OF ABBREVIATIONS... XII 1 INTRODUCTION Background and Motivation Organization of the Thesis THEORETICAL FRAMEWORK Theoretical Link between Accounting and Corporate Governance Definition of Accounting and Corporate Governance Accounting Information and the Separation between Ownership and Control Accounting Information and the Board of Directors Accounting Information and the Relationship between Controlling and Minority Shareholders Accounting Information and the Relationship between Shareholders and Creditors Accounting and Corporate Governance in Germany Accounting and Corporate Governance Classifications Ownership Structures Management and Supervisory Board General Shareholders Meeting Accounting Internationalization in Germany Differences between German GAAP and IFRS Overview on Regulatory Reforms in Germany... 64

6 II 2.3 Accounting in Family Firms Overview on Family Firm Definitions Family Firm Definition Applied in this Study Accounting and Corporate Governance in Family Firms CONCEPT AND MEASUREMENT OF EARNINGS QUALITY Definition and Dimensions of Earnings Quality Definition of Earnings Quality Dimensions of Earnings Quality Earnings Management Definition and Dimensions of Earnings Management Earnings Smoothing Concept Measurement Discretionary Accruals Concept Measurement Approaches Real Earnings Management Concept Measurement Conservatism Definition and Dimensions of Conservatism Measurement Serial Dependence Model (Basu, 1997) Accrual-Based Asymmetry Model (Ball and Shivakumar, 2005) C-Score (Khan and Watts, 2009) RELATED RESEARCH ON DRIVERS OF EARNINGS QUALITY Overview on Drivers of Earnings Quality Institutional Environment and Earnings Quality

7 III Cross-Country Differences and Earnings Management Cross-Country Differences and Conservatism Time-Series Properties of Earnings Characteristics among German Firms IFRS Adoption and Earnings Quality Determinants of Voluntary IFRS Adoption Systematization of Research on IFRS Adoption IFRS Adoption, Earnings Management and Conservatism Family Governance and Earnings Quality Systematization of Prior Research on Accounting in Family Firms Family Governance and Earnings Management Family Governance and Conservatism Effects of Outside Blockholders on Earnings Management and Conservatism DATA AND RESEARCH DESIGN Structure and Organization of the Analyses Sample Selection Data Sources Definition of Variables Dependent Variables Explanatory and Control Variables Methodological Remarks IFRS ADOPTION, EARNINGS MANAGEMENT AND CONSERVATISM Conceptual Background and Hypotheses Structure of the Analysis Ownership Structures as Determinants of Voluntary IFRS Adoption

8 IV Voluntary vs. Mandatory IFRS Adoption and Earnings Quality Model Specification Study Design Ownership Structures as Determinants of Voluntary IFRS Adoption Earnings Smoothing Discretionary Accruals Conditional Conservatism Univariate Analysis Multivariate Analysis Ownership Structures as Determinants of Voluntary IFRS Adoption Voluntary vs. Mandatory IFRS Adoption and Earnings Quality Earnings Smoothing Discretionary Accruals Conditional Conservatism Summary of Results EFFECTS OF FAMILY GOVERNANCE ON ACCOUNTING AND REAL EARNINGS MANAGEMENT Conceptual Background and Hypotheses Model Specification Accounting Earnings Management Real Earnings Management Univariate Analysis Multivariate Analysis Accounting Earnings Management Real Earnings Management Robustness Analyses

9 V 7.6 Summary of Results EFFECTS OF FAMILY GOVERNANCE ON CONDITIONAL CONSERVATISM Conceptual Background and Hypotheses Model Specification Univariate Analysis Multivariate Analysis Robustness Summary of Results SUMMARY, IMPLICATIONS AND AVENUES FOR FUTURE RESEARCH Summary Limitations Conclusion, Implications and Avenues for Future Research APPENDIX REFERENCES

10 VI List of Figures Figure 1: Structure of the Thesis Figure 2: Agency Conflicts Figure 3: Information Asymmetries and the Dual Role of Accounting Figure 4: Ownership Structures in Germany ( ) Figure 5: Accounting Standards Followed by German Firms ( ) Figure 6: German Accounting Enforcement System Figure 7: Overview on Family Firm Definitions Figure 8: Comparison between Family and Insider Ownership Figure 9: Dimensions of Earnings Quality Figure 10: Earnings Management and Fraud Figure 11: Generalized Model of Earnings Management Figure 12: Structure of the Empirical Analyses Figure 13: Voluntary vs. Mandatory IFRS adoption and Earnings Quality Figure 14: Groups of IFRS Adopters Figure 15: Annual Return and Volatility of the CDAX ( ) Figure 16: Variability in Change of Net Income and Annual Volatility of the CDAX ( ) Figure 17: Average Discretionary Accruals and Annual Return Volatility of the CDAX ( ) Figure 18: Observation Periods in Studies on IFRS Adoption and Earnings Quality Figure 19: Cumulative Survival Rate of the HGB ( ) Figure 20: Variability in Net Income for Voluntary and Mandatory Adopters (Simulation) Figure 21: Time-Series of Discretionary Accruals (Large Firms, ) Figure 22: Time-Series of Discretionary Accruals (Small Firms, )

11 VII Figure 23: Time-Series of Discretionary Accruals for Voluntary and Mandatory Adopters incl. New Market Firms Figure 24: Time-Series of Discretionary Accruals for Voluntary and Mandatory Adopters excl. New Market Firms

12 VIII List of Tables Table 1: Control Thresholds in German Corporations Table 2: Continental European and Anglo-Saxon Accounting Model Table 3: Accounting and Corporate Governance Initiatives from Table 4: Comparison between Discretionary Accruals Models Table 5: Studies on IFRS Adoption and Earnings Quality Table 6: Summary of Previous Results on IFRS Adoption and Earnings Quality Table 7: Overview of Studies on Financial Reporting in Family Firms Table 8: Table 9: Summary of Results from Studies on Earnings Management in Family Firms Study Design in Previous Studies on Earnings Management in Family Firms Table 10: Evidence on Earnings Management in Family Firms Table 11: Changes in the Index Composition (CDAX) Table 12: Sample Selection Table 13: Index Composition (CDAX) Table 14: Data Sources Table 15: Summary on Earnings Properties Used in this Study Table 16: Definition of Variables Used in the Estimation of Earnings Quality Metrics Table 17: Definition of Family Firm Variables Table 18: Definition of Ownership Variables Table 19: Predicted Effects of Firm Characteristics on Earnings Management and Conservatism Table 20: Definition of Control Variables Table 21: Accounting Standards Followed by Voluntary and Mandatory Adopters Table 22: Summary Statistics for Voluntary and Mandatory Adopters

13 IX Table 23: Impact of Ownership Structures on Voluntary IFRS Adoption Table 24: Earnings Smoothing by Voluntary and Mandatory Adopters Table 25: Earnings Smoothing by Voluntary and Mandatory Adopters (Robustness) Table 26: Earnings Management by Voluntary and Mandatory Adopters (Discretionary Accruals) Table 27: Conditional Conservatism by Voluntary Adopters Table 28: Conditional Conservatism by Mandatory Adopters Table 29: Conditional Conservatism for Large Voluntary and Mandatory Adopters Table 30: Distribution of Family relative to Non-Family Firms and Family Influence Table 31: Distribution of Family Firm Types Table 32: Summary Statistics for Family and Non-Family Firms Table 33: Industry Distribution of Family Firms Table 34: Distribution of Board Influence in Family Firms Table 35: Correlation Matrix (Earnings Management in Family Firms) Table 36: Family Governance and Accounting Earnings Management (OLS I) Table 37: Family Governance and Accounting Earnings Management (OLS II) Table 38: Non-linearity between Family Ownership and Discretionary Accruals (OLS) Table 39: Effects of Family Governance on Real Earnings Management (OLS I) Table 40: Effects of Family Governance on Real Earnings Management (OLS II) Table 41: Non-linearity between Family Ownership and Discretionary Cash Flows (OLS) Table 42: Summary Statistics for Family and Non-Family Firms Table 43: C-Score and Discretionary Accruals According to Family Ownership Quintiles

14 X Table 44: Correlation Matrix (Family Governance and Conservatism) Table 45: Mean Coefficients from Estimation Regressions (Basu, 1997) Table 46: Family Governance and Conditional Conservatism (OLS I) Table 47: Family Governance and Conditional Conservatism (OLS II) Table 48: Non-Linearity between Family Ownership and Conditional Conservatism (OLS) Table 49: Family Governance, Discretionary Accruals and Conditional Conservatism (OLS I) Table 50: Family Governance, Discretionary Accruals and Conditional Conservatism (OLS II) Table 51: Family Governance, Discretionary Accruals and Conditional Conservatism (OLS III) Table 52: Impact of Ownership Structures on Early Voluntary IFRS Adoption Table 53: Earnings Smoothing by Voluntary and Mandatory Adopters (excl. Firms with IPO ) Table 54: Net Income and Frequency of Losses Table 55: Ownership Structures in Family and Non-Family Firms Table 56: Family Governance and Discretionary Accruals (BE I) Table 57: Family Governance and Discretionary Accruals (BE II) Table 58: Nonlinearity between Family Ownership and Discretionary Accruals (BE) Table 59: Effects of Family Governance on Discretionary Cash Flows (BE I) Table 60: Effects of Family Governance on Discretionary Cash Flows (BE II) Table 61: Non-linearity between Family Ownership and Discretionary Cash Flows (BE) Table 62: Earnings Smoothing by Family and Non-Family Firms Table 63: Effects of Family Governance on Discretionary Expenses (I) Table 64: Effects of Family Governance on Discretionary Expenses (II) Table 65: Family Governance and Conditional Conservatism (I BE)

15 XI Table 66: Family Governance and Conditional Conservatism (II BE) Table 67: Non-linearity between Family Ownership and Conditional Conservatism (BE) Table 68: Family Governance, Discretionary Accruals and Conditional Conservatism (I BE) Table 69: Family Governance, Discretionary Accruals and Conditional Conservatism (II BE) Table 70: Family Governance, Discretionary Accruals and Conditional Conservatism (III BE) Table 71: Summary of Results from the Empirical Analyses

16 XII List of Abbreviations AICPA AG AktG AnSVG APAG APAK BaFin BE BilKoG BilMoG BilReG BiRiLiG BIS CAPM CDAX CEO Cf. COGS CRSP American Institute of Certified Public Accountants Aktiengesellschaft Stock Corporation Code (Aktiengesetz) Investor Protection Improvement Act (Anlegerschutzverbesserungsgesetz) Auditor Oversight Law (Abschlussprüferaufsichtsgesetz) Auditor Oversight Commission (Abschlussprüferaufsichtskommission) Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht) Between Effects Accounting Enforcement Act (Bilanzrechtskontrollgesetz) Accounting Law Modernization Act (Bilanzrechtsmodernisierungsgesetz) Accounting Law Reform Act (Bilanzrechtsreformgesetz) Accounting Directives Act (Bilanzrichtliniengesetz) Bank for International Settlements Capital Asset Pricing Model German Composite Index Chief Executive Officer Confer Cost of Goods Sold Center for Research in Security Prices DRS German Accounting Standard (Deutscher Rechnungslegungsstandard) e.g. Exempli gratia

17 XIII EC EEC European Commission Issued by the European Commission F. Framework to IFRS FASB Financial Accounting Standards Board FMFG Act on the Promotion of Financial Markets (Finanzmarktfördergesetz) FREP GAAP GASB HGB i.e. IAS IASB IASC ICB IfM IFRS IPO KapAEG KapCoRiLiG Financial Reporting Enforcement Panel Generally Accepted Accounting Principles German Accounting Standards Board German Commercial Code (Handelsgesetzbuch) Id est International Accounting Standard(s) International Accounting Standards Board International Accounting Standards Committee Industrial Classification Benchmark Institut für Mittelstandsforschung Internation Financial Reporting Standard(s) Initial Public Offering Raising of Capital Relief Act (Kapitalaufnahmeerleichterungsgesetz) Limited Companies and Co-Regulation (Kapitalgesellschaftenund Co-Richtlinie-Gesetz) KapMUG Capital Markets Model Case Act (Kapitalanleger- Musterverfahrensgesetz) KontraG N.N. OECD Act on the Control and Transparency of Corporations (Gesetz zur Kontrolle und Transparenz im Unternehmensbereich) Nomen nescio/nomen nominatum Organisation for Economic Co-operation and Development

18 XIV OLS PCAOB RoA SE SEC SEO SFAC SFI SG&A SIC SOX Suppl. TransPuG TUG UK US US GAAP VIF VorstOG WpHG WPK WPO WpÜG Ordinary Least Squares Public Company Accounting Oversight Board Return on Assets Societas Europaea Securities and Exchange Commission Secondary Equity Offering Statement of Financial Accounting Concepts Substantial Family Influence Selling, General and Administrative Cost Standard Industrial Classification Sarbanes Oxley Act Supplement Transparency and Disclosure Act (Transparenz- und Publizitätsgesetz) Transparency Directive Ratification Act United Kingdom United States, United States of America United States Generally Accepted Accounting Principles Variance Inflation Factor Management Compensation Disclosure Act (Vorstandsoffenlegungsgesetz) German Securities Trading Act (Wertpapierhandelsgesetz) Chamber of Public Accountants (Wirtschaftsprüferkammer) Wirtschaftsprüferordnung Securities and Acqusition Takeover Act (Wertpapierübernahmegesetz)

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21 Introduction 1 1 Introduction 1.1 Background and Motivation Accounting information 1 aims at facilitating efficient resource allocation in an economy. 2 Earnings as one element of accounting information serve as performance measure and form part of many contractual agreements. Accounting standards are shaped by economic forces and depend on the way in which standard setters and regulators respond to these forces. To the extent that the application of accounting standards requires estimations and judgment by preparers of financial statements, reported earnings reflect accounting choices. 3 Accounting choices by and large depend on managerial incentives and possibilities to interfere in the financial reporting process such as monitoring by outside parties. Together with the set of accounting standards, these factors fundamentally affect earnings characteristics also referred to by the term earnings quality. Research on earnings quality has grown significantly over the past decades. An important reason for the growth of this strand of research lies in significant reforms in accounting and corporate governance. 4 These reforms arose as a consequence to the increasing integration of markets and numerous financial scandals and collapses in the late 1990s. 5 Financial reporting is considered to be on a precipice of change 6, a development accompanied by a notable number of reviews and commentaries on ac Accounting information is referred to in a financial accounting context, not a management accounting context. Cf. Kothari et al. (2010), p This view is expressed in the economics-based accounting literature. Cf. Dechow et al. (2010), p Cf. DeFond (2010), p Cf. Ball (2009). In the USA, enhanced regulation culminated in the introduction of the Sarbanes Oxley Act (SOX) in 2002, cf. e.g. Bartov/Cohen (2009); Leuz et al. (2008); Grasso et al. (2009); Hoitash et al. (2009). An overview on and discussion of regulatory accounting and corporate governance reforms in Germany during the last decade is provided e.g. in Naumann (2000); Tuschke/Sanders (2003); Hackethal et al. (2003); Baums/Scott (2005); Moldenhauer (2007), p For a comprehensive description on earlier deliberations regarding accounting harmonization cf. Achleitner (1995). For a survey of theoretical and empirical analyses on economic consequences of financial reporting and disclosure regulation, cf. Leuz/Wysocki (2008). Kothari et al. (2010), p. 247.

22 2 Introduction counting and corporate governance in highly ranked journals that seek to extract implications for future regulation. 7 The role of accounting information and as a consequence the properties of earnings are determined by the institutional environment of the firm and firm characteristics such as ownership and financing structures. Economics-based accounting theory is strongly shaped by the paradigm of the modern corporation 8 characterized by the separation between ownership and control. 9 The separation of ownership and control leads to information asymmetries between managers and shareholders. Accounting information may lower these information asymmetries and as a result is considered to mitigate agency conflicts such as adverse selection or moral hazard. In most countries other than the USA or the UK ownership structures tend to be more concentrated and families play an important role as shareholders. 10 This implies that conflicts arising from the separation between ownership and control may be mitigated because large shareholders have high monitoring incentives. In family firms, interests between shareholders and managers may even be aligned because the family is frequently involved in the management of the firm. In exchange, agency conflicts could arise between controlling and minority shareholders due to different incentive structures. Large shareholders are presumed to make use of their controlling position to extract private benefits of control. 11 While agency theory mainly focuses on financial private benefits of control, non-financial private benefits of control such as the emotional value of owning the firm and transferring it to the next generation are likely to play an even more important role in family firms. Thereby, family managers may act for the interests of the family but not necessarily for shareholders as a whole. 12 While the role of accounting information in reducing agency costs arising from the separation between ownership and control has been intensely studied in accounting research, little is known how account For example, a large number of reviews and commentaries were recently published in the December 2010 issue of the Journal of Accounting and Economics (Vol. 50, Issues 2-3). Cf. Berle/Means (1932). Cf. Fama/Jensen (1983a). Cf. La Porta et al. (1999); Faccio/Lang (2002); Burkart et al. (2003). Cf. Armstrong et al. (2010), p ; Bebchuk/Weisbach (2009), p Cf. Morck/Yeung (2003), p. 367.

23 Introduction 3 ing information may mitigate information asymmetries between controlling and small shareholders because most studies focus on Anglo-Saxon environments. This thesis aims at contributing to this research gap. It analyzes drivers of earnings characteristics in the German stock market. The focus of the study is on effects of the adoption of International Financial Reporting Standards (IFRS) 13 and family governance on earnings management and conservatism. The following paragraphs outline why these subjects are of particular interest with regard to the financial reporting behavior in German firms. Earnings management and conservatism can be regarded as the two earnings characteristics that have been most intensely studied in empirical accounting research since they are presumed to capture effects of managerial incentives on reported earnings. 14 Earnings management refers to the judgment used by managers to alter financial reports to either mislead some stakeholders about the economic performance of the firm or to influence contractual outcomes that are contingent on accounting numbers. 15 Conservatism corresponds to an accountant s tendency to require a higher degree of verification for good news as compared to bad news. This implies that bad news tends to be incorporated in earnings in a timelier manner as compared to gains. 16 Conservatism not only arises from the requirements of accounting standards but also depends on managerial incentives to defer bad news to later periods. In the context of accounting harmonization, one of the most powerful directives issued by the European Commission was regulation 1606/ It obliged capital market oriented companies in the European Economic Area to release consolidated financial IFRS refers to the set of standards issued by the International Accounting Standards Board (IASB). International Accounting Standards (IASs) were renamed to International Financial Reporting Standards (IFRSs) in In this thesis, the expression IFRS refers to both sets of standards, IAS and IFRS. Cf. e.g. Christensen et al. (2008), p. 2. Cf. Healy/Wahlen (1999), p In this sense, earnings management refers to legal earnings management not illegal earnings manipulation or accounting fraud. Cf. Basu (1997), p. 4. Cf. Regulation (EC) No 1606/2002 of the European Parliament and of the Council of July 19 th 2002 on the application of international accounting standards, Official Journal of the European Communities, L 243/1. Before EC regulation became effective, the 4 th and 7 th EC directive aimed to harmonize financial reporting across European countries.

24 4 Introduction statements under IFRS for fiscal years starting from January 1 st 2005 onwards. 18 This regulation is one of the milestones that turned IFRS into the most widely accepted set of accounting standards in the world. The introduction of IFRS is commonly presumed to result in comparable financial statements across countries and to lower information asymmetries between managers and shareholders through high quality accounting standards and comprehensive disclosure. In the light of these attributes, IFRS are considered to contribute to the efficiency and cost effectiveness of capital markets across Europe. 19 However, a uniform set of financial statements does not necessarily produce uniform financial reporting. 20 Firstly, financial reporting is fundamentally shaped by the prevalent institutional and economic factors. Secondly, there are many drivers that shape financial reporting such as governance structures and firm characteristics that lead to firm-level differences in reported earnings. Consistent with these arguments accounting research suggests that accounting standards need to be regarded as but one driver of reported earnings. 21 Therefore, it is not only interesting to compare domestic standards and IFRS from a de jure perspective but to also analyze actual reporting behavior from a de facto perspective. 22 Germany provides an appealing research setting to investigate changes in earnings quality under domestic accounting standards 23 as compared to IFRS for several reasons. First of all, it is interesting to observe effects of IFRS adoption, a set of accounting standards derived from common law regimes, in a code law regime. In addition, Germany held the highest number of voluntary IFRS adopters in the European Union before EC regulation became effective. 24 This leads to the research question which German companies that are publicly traded both in the European Union and on a regulated thirdcountry market and therefore apply another internationally accepted accounting standard (i.e. US GAAP) in their consolidated accounts were allowed to defer the application of IFRS until fiscal years starting from January 1 st 2007 onwards. Cf. Regulation (EC) No 1606/2002 of the European Parliament and of the Council of July 19 th 2002 on the application of international accounting standards, Official Journal of the European Communities, L 243/1, par Cf. for a detailed discussion on this issue Ball (2006). Cf. Holthausen (2009), p Cf. Nobes (2009), p In the following German domestic accounting standards, the German Commercial Code (HGB) are referred to as German Generally Accepted Accounting Principles, i.e. German GAAP. Cf. Van Tendeloo/Vanstraelen (2005), p

25 Introduction 5 firm characteristics influenced IFRS adoption among German firms. Since prior work only provides limited insight on drivers of voluntary IFRS adoption, 25 this thesis extends extant evidence by analyzing the role ownership structures as a determinant of voluntary IFRS adoption. Mandatory IFRS adoption was described in earlier studies as a unique research setting to compare earnings quality among voluntary as compared to mandatory IFRS adopters. 26 It is a common paradigm that voluntary IFRS adoption may result in superior earnings quality as compared to mandatory IFRS adoption because the decision to adopt IFRS is actively taken. Thereby, voluntary IFRS adopters could have a higher commitment to high quality financial reporting than mandatory adopters. 27 The research in this thesis aims at developing a better understanding on how IFRS adoption affected earnings characteristics among German firms. Following previous studies it analyzes how IFRS affected earnings characteristics among voluntary as compared to mandatory adopters. Difficulties in directly comparing changes in earnings quality between the two groups of adopters arise because the period of voluntary IFRS adoption is marked by a different capital market and regulatory environment as compared to mandatory IFRS adoption. Market timing is likely to affect results on IFRS adoption and earnings characteristics and is hence considered in the analysis. Since accounting standards are only one of the forces driving earnings characteristics, it is interesting to analyze how firm-level differences affect earnings characteristics. Shareholders are considered to be the main constituency of financial reporting according to IFRS. However, shareholders are not a homogeneous group. Differences in ownership structures have been found to strongly influence reporting outcomes in a considerable number of studies. 28 German corporations are by trend characterized by concentrated ownership structures with families and strategic investors acting as main Cf. on earlier work regarding determinants of voluntary IFRS adoption Cuijpers/Buijink (2005); Gassen/Sellhorn (2006); Christensen et al. (2008). Cf. Schipper (2005). Cf. in particular the study by Christensen et al. (2008). Cf. e.g. Warfield et al. (1995); Gabrielsen et al. (2002); Fan/Wong (2002); Ajinkya et al. (2005); Cheng/Warfield (2005); Velury (2006); Wang (2006); Dargenidou et al. (2007); Zhao/Millet- Reyes (2007); LaFond/Roychowdhury (2008); Beuselinck et al. (2009); Bona Sánchez et al. (2009); Jaggi et al. (2009).

26 6 Introduction shareholder groups. 29 While the percentage held by other corporations declined in recent years, family ownership constitues a rather stable phenomenon. 30 Given the high level of family capitalism in the German stock market, family governance is likely to be one of the drivers of earnings characteristics in the German stock market. Notwithstanding the importance of family firms as a particular firm type and the fact that the presence of concentrated ownership in the hands of a controlling family is likely to strongly affect reporting incentives, accounting in family firms met scant attention up to date. 31 Family firms are commonly characterized by a long-term investment horizon and emotional ties in the firm. These non-financial private benefits of control are likely to affect earnings characteristics. Long-term orientation may result in lower levels of earnings management because the family firm is less subject to capital market pressure to meet short term earnings but could also lead to higher levels of earnings management because the family seeks to retain control over the firm. In contrast to their privately held counterparts, listed family firms need to meet the goals of family shareholders and other groups of shareholders such as minority shareholders. Thereby, earnings characteristics are likely to be influenced by the level of family ownership. While the interests of shareholders as a whole may be more pronounced when the family holds low percentages of ownership in the firm, incentives to defend private benefits of control are likely to increase with the level of family ownership. At very high levels of family ownership, earnings may play a less important role to enforce the family s goals. As a whole, incentives to alter reported earnings are likely to take on a different meaning than in non-family firms. While most studies on earnings quality in family firms only build on the common paradigm of agency theory, the analyses in this study are complemented by other theoretical approaches such as stewardship and behavioral theory. Thereby, this is the first analysis on the relation between accruals-based and real earnings management in family firms an issue addressed in previous studies as a Cf. Franks et al. (2006), p Cf. Ampenberger (2010), p ; Franks et al. (2009). According to a study by Achleitner et al. (2009b) family firms represent about one half of all non-financial firms listed in the German regulated capital market. Cf. Salvato/Moores (2010), p. 193.

27 Introduction 7 promising research question but unvisited up to date. 32 Family firms commonly hold large stake in their firms and could hence be less likely to change operating activities to meet a short-term earnings target. Furthermore, to the best of my knowledge this is the first study on accounting conservatism in family firms. The analysis investigates if earnings management in family firms is systematically associated with conservatism as risk aversion and long-term orientation in family firms could create incentives to keep internal funds in the firm. Evidence on accounting practices by family firms found in this study aims at contributing to a better understanding for this particular firm type and may be transferable to other countries characterized by a similar institutional environment and high degrees of family capitalism such as France, Italy or Japan. Evidence on financial reporting practices in family firms and effects of IFRS adoption in Germany is likely to distill interesting implications in the context of current deliberations on accounting harmonization and capital market regulation. 1.2 Organization of the Thesis The remainder of this thesis is organized in eight chapters. Chapters 2 and 3 embed the empirical analysis in chapters 5-8 into a theoretical and methodological framework. Chapter 4 provides an overview on empirical evidence from related research and highlights the contribution of the empirical analysis in this study. The chapters are organized as follows. Chapter 2 focuses on theories that explain the relationship between accounting and corporate governance (section 2.1). These theories mainly build on the theory of the firm. Accounting information is analyzed with regard to its role in the corporate governance process. Emphasis is put on the role of accounting information concerning the agency conflicts arising from the separation between ownership and control, agency conflicts between controlling and minority shareholders as well as between equity and debtholders. Chapter 2.2 focuses on particularities of the German financial system and discusses these particularities with regard to the arguments on the relationship between accounting and corporate governance developed in chapter 2.1. This chapter highlights central elements of the German accounting and corporate governance system and pro- 32 Cf. Hutton (2007), p. 289; Salvato/Moores (2010), p. 198.

28 8 Introduction vides an overview on the process of accounting internationalization in Germany. Given the particularities regarding goal and incentive structure in listed family firms, it provides an interesting field of research how these particularities affect the role of accounting information. Building on the deliberations in chapters 2.1 and 2.2, effects of family governance are discussed from a theoretical perspective in chapter 2.3. Based on accounting theory, accounting literature has developed a large variety of metrics to capture desirable properties of reported earnings also referred to as earnings quality. Chapter 3 provides an overview on the concept of earnings quality as an approach to empirically examine how the relationship between accounting standards and incentives is expressed in reported earnings. The chapter also describes some main measurement approaches focusing on the metrics applied in the empirical analysis in chapters 6-8 of this thesis. Earnings management and conservatism are in the center of the analysis because these dimensions are directly linked to corporate governance and can be regarded as most intensely researched statistical properties of earnings in accounting research. Chapter 4 reviews extant research on drivers of earnings quality. Thereby, this chapter connects chapters 2 and 3 and embeds the empirical analyses in chapters 6-8 into related research. Therefore, the focus of the literature review lays on effects of the institutional framework (4.2), IFRS adoption (4.3.) and family governance on earnings characteristics (4.4). Effects of firm characteristics such as performance, size, growth, firm age, capital structure and industry on earnings management and conservatism are summarized in chapter 5. These firm characteristics are considered as control variables in the empirical analysis. Chapters 5 to 8 form the empirical analysis of this thesis. A description of the data and research design as well as the definition of the variables used in the analysis is provided in chapter 5. This chapter builds the basis for the empirical study on IFRS adoption (chapter 6) and family governance (chapters 7 and 8) as drivers of earnings management and conservatism in the German stock market. All parts of the analysis ground on a main sample that is modified according to the requirements of the respective analyses (two sub-samples). The main sample is based on all German nonfinancial firms listed in the CDAX between 1998 and 2008 (5,145 firm year observations).

29 Introduction 9 The research questions covered in the analyses on IFRS adoption and earnings quality (chapter 6) are as follows: Which firm characteristics increased the likelihood of voluntary IFRS adoption in Germany? What was the particular role of ownership structures in this context? Did IFRS adoption lead to superior earnings quality among German firms as compared to earnings derived under German GAAP? Did voluntary IFRS adoption lead to superior earnings quality as compared to mandatory IFRS adoption? The second part of the empirical analyses in the thesis focuses on effects of family governance (family ownership, management and control) on earnings management and conservatism (chapters 7 and 8). Chapter 7 addresses the following research questions: How do differences in the incentive structures between family firms and nonfamily firms affect the level of accruals-based earnings management? How do differences in the incentive structures between family firms and nonfamily firms affect the level of accruals-based earnings management? How does the level of family ownership influence earnings management? The research questions covered in chapter 8 are as follows: Is family governance systematically associated with conditional conservatism? How does the level of family ownership influence conditional conservatism? Chapter 9 summarizes the main findings from the analyses, discusses limitations and outlines implications and points out to avenues for futures research. Figure 1 illustrates the structure of the thesis.

30 10 Introduction 1. Introduction Background andmotivation Organization of the Thesis Theoretical and Methodological Framework Empirical Analysis 2. Theoretical Framework 3. Earnings Quality 5. Data and Research Design TheoreticalLink between Accounting and Corporate Governance Accounting and Corporate Governance in Germany Accounting in Family Firms Definition and Dimensions of Earnings Quality Earnings Management (Earnings Smoothing, Discretionary Accruals, Real Earnings Management) Conservatism Structure and Organization of the Analyses Sample Selection Data Sources Definition of Variables MethodologicalRemarks 4. Related Research on Drivers of Earnings Quality Overview on Drivers of Earnings Quality InstitutionalEnvironment and Earnings Quality IFRS Adoption and Earnings Quality Family Governance and Earnings Quality 6. IFRS Adoption, Earnings Management and Conservatism 7. Accounting and Real Earnings Management in Family Firms 8. Family Governance and Conservatism 9. Summary, Implications and Avenues for Future Research Summary Limitations Implicationsand Avenues for Future Research Figure 1: Structure of the Thesis Source: Author s illustration.

31 Theoretical Framework 11 2 Theoretical Framework 2.1 Theoretical Link between Accounting and Corporate Governance Definition of Accounting and Corporate Governance The individual parts of financial statements including balance sheets, income statements, and cash-flow statements as well as supporting disclosure form a distinct information set. 34 As such, financial reporting documents the temporal financial history of the organization or entity under consideration. 35 However, the recording of past events and transactions is not the only purpose of financial reporting. Accounting also involves judgment and estimations on future developments. This chapter analyzes why the field of accounting is complex and challenging and which roles accounting information may play in a corporate governance context. Economic theory describes the ideal of a perfect market as one in which assets are tradable without restriction under known, constant terms of trade. 36 In this context, the market value of the firm corresponds to the present value of the stream of future cash flows. Net income is equal to the change in the firm s present value. Firms are important actors in the market but treated like a black box. 37 The underlying finance theory is the framework shaped by Modigliani/Miller (1958) and the capital asset pricing model (CAPM). 38 In this framework, information is costless and there are no information asymmetries or transaction costs. Under such ideal or first best conditions accounting numbers correspond to the expected present value of future cash flows and financial statements are completely reliable. However, in such a setting accounting is Bushman/Smith (2003), p. 65. Christensen/Demski (2003), p. 2. Accounting comprises financial and management accounting. The focus of the arguments in this thesis is on financial accounting. Financial reporting as product of financial accounting not only comprises the set of financial reports but also public filings and mandatory other disclosure about the company addressed to external parties, cf. Armstrong et al. (2009), p. 4. Cf. Demski (2003), p. 9. Cf. Jensen/Meckling (1976), p Cf. Sharpe (1964); Lintner (1965); Mossin (1966).

32 12 Theoretical Framework unable to affect firm value and becomes irrelevant because all relevant information is incorporated in stock prices. 39 In practice ideal conditions do not prevail. Markets are imperfect and incomplete and only allow for second best solutions. Net income is no longer a well-defined economic construct when conditions are real 40 and the preparation of financial statements requires trade-offs. Earnings as one element of accounting information can take on different roles including valuation and stewardship. 41 Earnings may also serve as metric to calculate the basis for payouts (e.g. dividend payout or calculation of taxable income) and can be used for managerial self-information. The different roles of earnings arise because there are various constituencies of financial reporting characterized by different needs. However, these needs do not only differ among the various parties to the firm but also within particular groups of constituencies. This particularly holds to be true for shareholders. 42 Different types of shareholders require different types and levels of accounting information. 43 The trade-off accounting information needs to meet may be described as a trade-off between relevant and reliable information. There are different ways of accounting to recognise and measure the same business transaction depending on the weight put on relevance or reliability of accounting information. This explains why there is a difficulty of agreeing on accounting policies. 44 Accounting and corporate governance are inexorably linked. Sloan (2001) argues that attributes of financial accounting may only be understood when a corporate governance perspective is adopted. 45 The link between accounting and corporate governance can be analyzed best by taking a look on some main aspects of the theories underlying the development of corporate governance research Cf. Watts/Zimmerman (1990), p ; Fields et al. (2001), p This coherence is illustrated based on formal arguments in Beaver/Demski (1979). Cf. for a survey and discussion Hettich (2006), p Cf. Armstrong et al. (2010), p This aspect will be explored in more detail in chapter 2.3. Furthermore, the demand for accounting information is contingent on the institutional framework in which the firm operates (chapter 2.2). Cf. e.g. Scott (2003), p. 41. Cf. Sloan (2001), p. 336.

33 Theoretical Framework 13 The academic discussion on corporate governance is considered to have its origin in the publication by Berle/Means (1932). 46 Observing large publicly-held firms in the USA, they found the modern corporation to be held by a large number of small shareholders and controlled by the management. 47 This development is considered to be the result of the industrialization and the development of markets. Increasing capital needs were satisfied by broadening the basis of capital providers, i.e. shareholders. 48 However, although the separation between ownership and control outlined in Berle/Means (1932) may be applicable to a large number of publicly held firms in the USA or the UK, it is not necessarily transferable to a large proportion of firms with concentrated ownership structures as prevalent in most other countries around the world. Using data on ownership structures of large corporations in 27 economies that were considered to be wealthy, LaPorta et al. (1999) found that except for countries with very high levels of shareholder protection such as the USA or the UK, the main part of firms around the world are controlled by families or the government. 49 Although the image of the modern corporation may not hold for a large number of firms around the world, the publication by Berle/Means (1932) has enhanced the thinking about the way firms are owned, managed and controlled. 50 This field of research caught a lot of attention in the academic literature. An important body of work concerns the large number of studies on the theory of the firm. This theory was developed under the framework of the new institutional economy Cf. Shleifer/Vishny (1997), p As a consequence this type of firm is described as widely-held or management-controlled. Cf. Berle and Means (1932), p It should be noted that the phenomenon of separation between ownership and control described in Berle/Means (1932) was already identified about a century ago by Smith (1838). Cf. also Faccio/Lang (2002); Burkart et al. (2003). La Porta et al. (1999) also highlight several studies that question the image of the modern corporation among US firms including Eisenberg (1976), Demsetz (1983), Demsetz/Lehn (1985), Shleifer/Vishny (1986) and Morck et al. (1988). These studies point out that there is also a modest concentration of ownership among the largest American firms. Holderness/Sheehan (1988) identify a considerable number of listed firms in the USA that even have majority shareholders (i.e. holding more than 51 percent of shares). Furthermore, Holderness et al. (1999) find that the percentage held by managers of the firm is higher than at the time of the study by Berle/Means (1932). Cf. La Porta et al. (1999), p Cf. Mallin (2007), p. 14. The new institutional economy comprises the property rights theory, the transaction cost theory, the principal agent theory and the incomplete contracts approach, cf. for fundamental studies

34 14 Theoretical Framework Accounting theory was most deeply influenced by contracting and agency theory. 52 Both theories form part of the theory of the firm. Based on the publications by Coase (1937) and Alchian/Demsetz (1972) firms are depicted by the image of a nexus of contracts. 53 Viewing the firm as a nexus of contracting relationships means that the firm needs to be regarded as a legal fiction in which the diverse interests of the parties to the firm are brought into equilibrium via contracts that specify how costs and rewards are allocated. 54 Nevertheless, this equilibrium is always accompanied by an efficiency loss given that it is impossible to perfectly align interests between all parties. 55 Conflicts between the parties to the firm create demand for monitoring and bonding mechanisms that may be incorporated via explicit or implicit contracts. 56 Explicit contracts include any type of formally written contract such as compensation, debt or supply contracts. In contrast, implicit contracts are represented by any informal contract that serves as monitoring or bonding mechanism. While explicit contracts mostly refer to a limited time period and are rather limited in scope, implicit contracts encompass multi-period relationships and allow for activities in areas where explicit contracts are not efficient or possible. 57 It is useful to think about organizations as a nexus of contracts to understand the role of financial reporting. Since complete contracts to align interests among all contracting parties cannot be written and enforced, 58 accounting information can be used to make contracts less incomplete because it assists in recording and monitoring the contribu- Coase (1937); Coase (1960); Alchian/Demsetz (1972); Ross (1973); Williamson (1975); Jensen/Meckling (1976); Holmström (1979); Fama/Jensen (1983a); Fama/Jensen (1983b); Hart/Holmström (1985); Hart/Moore (1990); For an overview on the new institutional economy, cf. e.g. Shleifer/Vishny (1997); Zingales (2008); Bebchuk/Weisbach (2010) Cf. Lambert (2001), p. 5. There is a large body of theoretical literature on contractual relations between the firm and its parties, in particular on the relationship between the firm and its investors. These financial contracting models build on economic principles such as costly-state verification, adverse selection, moral hazard, allocation of control rights and risk sharing. This strand of literature is summarized and discussed in a number of surveys including e.g. Smith (1980); Harris/Raviv (1995); Hart (2001); Lambert (2001); Christensen et al. (2005); Roberts/Sufi (2009). Cf. Jensen/Meckling (1976), p Cf. Jensen (1986), p Cf. Sloan (2001), p. 342; Armstrong et al. (2009), p Cf. Sloan (2001), p Cf. Hart/Holmström (1985).

35 Theoretical Framework 15 tions and rewards by each party. 59 Accounting information represents an externally reported metric that can be accessed by all parties to the firm. It is observable and enforceable by an outsider to the contract such as the court. These characteristics make accounting information suitable in the context of both explicit and implicit contractual agreements. 60 Accounting information may be incorporated in mechanisms to mitigate conflicts between the parties to the firm 61 and hence takes a central role in the corporate governance process. However, an important aspect that needs to be considered is that accounting information does not only serve as an input factor to the corporate governance process. Financial accounting in itself can also be regarded as an output or a product of the governance process. 62 For example, accounting numbers are presumed to be fundamentally affected by managerial incentives. From a theoretical perspective, managers are commonly viewed as rational and self-interest pursuing individuals. The preparation of financial statements is commonly exercised by the management and commonly involves judgment and estimations. This implies that to a certain extent financial reporting is subject to discretion. Managers know that accounting information will be incorporated in different governance mechanisms that will personally affect them. Therefore, they seek to influence accounting information accordingly. These activities can be thought of as earnings management. For instance, given the limited time-horizon of managers, managers may be tempted to defer bad news to later periods or invest in projects with negative net Cf. Sunder (2002), p Accounting information may for example form part of the following explicit contractual agreements: executive compensation schemes, cf. e.g. Healy (1985); for a survey cf. Bushman/Smith (2001); debt covenants, cf. e.g. DeFond/Jiambalvo (1994); taxation, cf. e.g. Boynton et al. (1992); Guenther (1994); Guenther et al. (1997); regulation, c.f. e.g. Jones (1991); accounting information may form part of the following implicit contracts: dividend payout, cf. e.g. Kasanen et al. (1996); labor union contracts, c.f. e.g. Liberty/Zimmerman (1986); management buyouts, c.f. DeAngelo (1986); Perry/Williams (1994); auditing contracts, c.f. e.g. Antle (1984); DeFond/Subramanyam (1998); Chaney et al. (2004); executive changes, c.f. e.g. Pourciau (1993), equity offerings, c.f. e.g. Teoh et al. (1998); Shivakumar (2000); Ball/Shivakumar (2008) or general stakeholder relationships, c.f. e.g. Bowen et al. (1995). Cf. Armstrong et al. (2010), p Cf. Sloan (2001), p. 341.