Accounting Quality: International Accounting Standards and US GAAP

Transcription

1 Accounting Quality: International Accounting Standards and US GAAP Mary E. Barth* Stanford University Wayne R. Landsman, Mark Lang, and Christopher Williams University of North Carolina November 2007 * Corresponding author: Graduate School of Business, Stanford University, , mbarth@stanford.edu. We appreciate funding from the Center for Finance and Accounting Research, Kenan-Flagler Business School and the Center for Global Business and the Economy, Stanford Graduate School of Business. We appreciate comments from Julie Erhardt, and workshop participants at George Washington University, Oklahoma State University, Shanghai University of Finance and Economics, Singapore Management University, Southern Methodist University, and the 2007 European Accounting Association Congress. We also thank Dan Amiram and Mark Maffett for assistance with data collection.

2 Accounting Quality: International Accounting Standards and US GAAP Abstract We compare accounting quality metrics for IAS firms to those for US firms to investigate whether US GAAP-based accounting amounts are associated with less earnings management, more timely loss recognition, and higher value relevance than IAS-based accounting amounts. We find that US firms exhibit higher accounting quality than IAS firms. Comparisons of accounting amounts for US and IAS firms before and after the IAS firms adopt IAS indicate that application of IAS has no systematic effect on the relative difference in accounting quality, although differences in value relevance decrease after IAS firms adopt IAS. US firms have higher accounting quality than IAS firms before and after The difference in accounting quality between US and IAS firms is largely attributable to firms in countries of German/French legal origin. We also find that the quality of IAS accounting amounts does not differ from that of US GAAP accounting amounts reconciled from domestic standards and reported by non-us firms that cross list on US markets. Our results suggest that although IAS accounting amounts are of lower quality than those of US GAAP reported by US firms, they are of comparable quality to reconciled US GAAP amounts reported by cross-listed firms.

3 1. Introduction The question we address is whether application of US Generally Accepted Accounting Principles (GAAP) results in accounting amounts that are of higher quality than those resulting from application of International Accounting Standards (IAS). 1 In particular, we investigate whether accounting amounts of firms that apply US GAAP exhibit less earnings management, more timely loss recognition, and higher value relevance than accounting amounts of firms that apply IAS. The accounting amounts that we compare result from the interaction of features of the financial reporting system, which include accounting standards, their interpretation, enforcement, and litigation. We refer to the combined effect of the features of the financial reporting system as the effect of application of US GAAP or IAS. As predicted, we find that accounting amounts of US firms applying US GAAP generally are of higher quality than those of non-us firms applying IAS. This finding applies before and after 2005, when application of IAS became mandatory in many countries. Tests comparing the quality of accounting amounts between US and IAS firms in four legal origin groups of countries indicate that our findings are largely attributable to differences in quality between US and German/French legal origin firms. In addition, we find no clear pattern of differences in quality of accounting amounts of non-us firms cross-listing in the US and applying US GAAP in their Form 20-F reconciliations and those of non-us firms applying IAS. This study makes comparisons of accounting quality that are potentially relevant to current policy debates relating to the possibility of permitting firms listed on US exchanges to prepare financial statements based on IAS and that have not been made in prior literature. The 1 The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS), which include standards issued not only by the IASB but also by its predecessor body, the International Accounting Standards Committee, some of which have been amended by the IASB. Because most of our sample period predates the effective dates of standards issued by the IASB, following the convention of Barth, Landsman, and Lang (2008), throughout we refer to IAS rather than IFRS. 2

4 US Securities and Exchange Commission (SEC) presently is considering permitting US firms and non-us firms cross-listing in the US to file financial statements based on IAS. A major reason for this is the possibility that accounting amounts based on IAS may be similar in quality to those based on US GAAP. Two contributing factors underlying this possibility are the increasing use of IAS throughout the world and the restructuring of the International Accounting Standards Committee (IASC) into the International Accounting Standards Board (IASB). These two developments could lead to high quality IAS-based accounting amounts because they likely will lead to higher quality standards and more consistent interpretation, application, and enforcement of the standards. Prior research finds that accounting amounts of non-us firms applying IAS and US firms applying US GAAP generally are of higher quality than those of non-us firms applying domestic standards. Prior research also finds that accounting amounts of US firms applying US GAAP generally are of higher quality than the US GAAP-based amounts of non-us firms presenting domestic to US GAAP reconciliations on Form 20-F. However, the relative quality of US and IAS accounting amounts is an open question, as is the relative quality of IAS accounting amounts and US GAAP accounting amounts of firms cross-listing in the US. To operationalize accounting quality we follow prior research. In particular, we interpret accounting amounts that exhibit less earnings management, more timely loss recognition, and higher value relevance as being of higher quality. Our metrics for earnings management are based on the variance of change in net income, the ratio of the variance of change in net income to the variance of change in cash flows, the correlation between accruals and cash flows, and the frequency of small positive net income. Our metrics for timely loss recognition are based on the frequency of large losses and the association between bad-news returns and earnings, and our 3

5 value relevance metrics are the explanatory powers of income and equity book value for prices, and stock return for earnings. We address our research question by making two comparisons of accounting quality. Our primary comparison is of the quality of accounting amounts for a sample of non-us firms that apply IAS (IAS firms) to that for a matched sample of US firms applying US GAAP (US firms). Our second comparison is of the quality of accounting amounts of IAS firms to that for a sample of non-us firms that reconcile earnings and equity book value determined under domestic standards, i.e., neither IAS nor US GAAP, to those determined under US GAAP on Form 20-F (20-F firms). The IAS firms are from 24 countries and adopted IAS between 1995 and Our empirical metrics of accounting quality also reflect the effects of the economic environment that are unattributable to the financial reporting system. The economic environment includes volatility of economic activity and information environment. We utilize two research design features to mitigate these effects. First, for our primary comparison, for each sample firm applying IAS we select a US firm that is of similar size and in the same industry as the firm applying IAS. For our second comparison, because the number of 20-F firms is substantially smaller than the number of IAS firms, we are unable to use a similar matching procedure. However, we require 20-F firms to be from the same countries as IAS firms. Second, when constructing several of our metrics, we include controls for economic environment. We find that US firms generally have higher quality accounting amounts than IAS firms. In particular, US firms have a significantly higher variance of change in net income, a significantly higher ratio of the variances of change in net income and change in cash flows, a 4

6 significantly less negative correlation between accruals and cash flows, and a significantly higher frequency of large negative net income. In addition, US firms have significantly higher value relevance of earnings and equity book value for share prices. However, US and IAS firms exhibit no significant differences in value relevance of earnings for stock returns or frequency of small positive net income. To determine whether this difference in accounting quality diminishes with the application of IAS, we repeat the accounting quality comparison in the period before IAS firms adopted IAS, i.e., when they applied domestic standards. Findings suggest that application of IAS reduces the difference in accounting quality between the IAS and US firms for some metrics, but increases the difference for others. However, application of IAS significantly reduces the difference in accounting quality as indicated by each of the value relevance metrics. Findings from our first comparison indicate that accounting amounts of US firms are of higher quality than accounting amounts of IAS firms, and prior research finds that reconciled US GAAP accounting amounts of cross-listed firms are of lower quality than accounting amounts of US firms. Thus, the natural question to address is that addressed by our second comparison. That is, are reconciled US GAAP-based accounting amounts also of higher quality than IASbased accounting amounts? We find no clear pattern of differences in quality between accounting amounts based on reconciled US GAAP and those based on IAS. In particular, of our eight accounting quality metrics, four are consistent with higher quality for 20-F firms and four are consistent with higher quality for IAS firms. Three of the differences are significant, with two consistent with higher quality for 20-F firms and one with higher quality for IAS firms. Relating to the comparison of accounting quality metrics for US and IAS firms, we conduct two additional analyses. First, because in 2005 IAS adoption became mandatory in 5

7 many countries, we repeat our accounting quality comparison separately between US firms and IAS firms before 2005, and between US firms and IAS firms in 2005 or after. Findings for the two comparisons generally are consistent with those based on the comparison using the combined IAS sample. That is, US firms generally evidence higher accounting quality than IAS firms in both periods. Second, because prior literature suggests that application of IAS can differ based on a country s legal origin, we repeat our accounting quality comparison separately between US firms and IAS firms grouped into four major legal origin groups English, Germanic/French, Scandinavian, and Chinese. This analysis reveals that our findings for the full IAS sample appear to be largely attributable to the German/French legal origin firms, which comprise approximately half of our IAS sample. We find no systematic differences in accounting quality between US and IAS firms in the other three groups. In addition, with the exception of German/French legal origin firms, the findings reveal no clear pattern of differences in accounting quality between IAS firms in the other three groups. The remainder of the paper is organized as follows. The next section discusses institutional background and related literature. Sections three and four develop the hypotheses and explain the research design. Sections five and six describe the sample and data and present the results. Section seven offers a summary and concluding remarks. 2. Institutional Background and Related Literature 2.1 INSTITUTIONAL BACKGROUND The SEC currently requires that US firms file financial statements based on US GAAP, and that non-us firms that list on US exchanges and file financial statements based on domestic standards provide reconciliations to US GAAP-based earnings and equity book value. The premise underlying these requirements is the belief that US investors are best served if firms 6

8 issue financial statements using a uniform set of accounting standards and that financial statements based on non-us standards are of lower quality than those based on US GAAP. 2 The SEC permits non-us firms to file financial statements based on domestic standards with reconciliation to US GAAP only for earnings and equity book value because of its desire not to discourage non-us firms from listing their securities in the US. The use of IAS is becoming widespread, with more than 100 countries requiring or permitting financial statements to be based on IAS ( Many suggest that the SEC should accept financial statements based on IAS for non-us firms because many US investors are becoming familiar with IAS. However, the SEC remains concerned that the quality of IAS-based accounting amounts is not yet high enough to achieve investor protection in the US. In 2005, the SEC staff established a roadmap that would lead to a recommendation that the SEC eliminate the reconciliation requirement for non-us firms applying IAS (Nicolaisen, 2005). The roadmap states that the SEC will evaluate the quality of the standards issued by the IASB, as well as the quality of accounting amounts in IAS-based financial statements with a focus on, among other things, the application and interpretation of IAS in financial statements across countries and firms. 3 The roadmap makes clear that the SEC s decision to accept IASbased financial statements depends on its assessment of the comparability of financial statement information based on IAS and US GAAP in an institutional setting where the two sets of standards coexist. That is, if IAS-based information is comparable to US GAAP-based information, the reconciliation requirement is unnecessary. 2 This concern stems from the belief that US investors can make better investment decisions regarding non-us firms if the investors have access to information about these firms that is similar and of similar quality to that available for US firms (Jenkins, 1999). 3 Chairman Donaldson Meets with EU Internal Market Commissioner McCreevy, Press Release , U.S. Securities and Exchange Commission, Washington, D.C., April 21,

9 Consistent with the roadmap, in 2007, the SEC issued for public comment a proposal to eliminate the reconciliation requirement for non-us firms applying IAS (SEC, 2007a). Also in 2007, the SEC issued a Concepts Release (SEC, 2007b) to permit US firms to file financial statements based on IAS. Underlying this Concepts Release is the belief that IAS are of high enough quality to achieve investor protection and are comparable to US GAAP. 2.2 RELATED LITERATURE Several studies compare accounting amounts based on, and the economic implications of, non-us firms applying IAS and domestic standards. Using a sample of IAS firms from 21 countries, not including the US, and metrics similar to those employed here, Barth, Landsman, and Lang (2008) finds that accounting quality of firms applying IAS generally is higher than that of firms applying domestic standards. Studies relating to German firms include Bartov, Goldberg, and Kim (2005), Van Tendeloo and Vanstraelen (2005), Daske (2006), and Hung and Subramanyam (2007). With the exception of Bartov, Goldberg, and Kim (2005), these studies generally fail to find differences in accounting quality or economic implications, e.g., cost of capital. Eccher and Healy (2003) finds differences in value relevance of accounting amounts based on IAS and Chinese standards depending on whether firms shares can be owned by Chinese or foreign investors. Daske et al. (2007b) analyzes the economic consequence of mandatory application of IAS in 26 countries and generally capital market benefits. However, the capital market benefits exist in countries with strict enforcement regimes and institutional environments that provide strong reporting incentives. Several studies compare accounting amounts based on, and the economic implications of, US firms applying US GAAP and non-us firms applying domestic standards. Representative studies include Alford, Jones, Leftwich, and Zmijewski (1993), Land and Lang (2002), and 8

10 Leuz, Nanda, and Wysocki (2003). Taken together, the findings from these and other studies provide evidence of higher quality accounting amounts for US firms relative to non-us firms applying domestic standards. Lang, Raedy, and Wilson (2006) obtains similar inferences for a comparison of US GAAP-based accounting amounts of US firms and of non-us firms that crosslist in the US and apply domestic standards but reconcile earnings and equity book value to US GAAP on Form 20-F. That is, Lang, Raedy, and Wilson (2006) finds that US firms have higher accounting quality than non-us firms applying US GAAP in their Form 20-F reconciliations. In contrast to these other comparisons, there are relatively few studies that compare accounting amounts based on, and the economic implications of, US firms applying US GAAP and non-us firms applying IAS. Leuz (2003) compares measures of information asymmetry for German firms trading on Germany s New Market and finds little evidence of differences in bid/ask spreads and trading volume for firms that apply US GAAP relative to those that apply IAS. The fact that these firms do not differ in information asymmetry is indirect evidence regarding whether the quality of their accounting amounts differs because bid/ask spreads and trading volume reflect a variety of factors in addition to the quality of accounting amounts. Bartov, Goldberg, and Kim (2005) documents that for German firms earnings response coefficients are highest for those applying US GAAP, followed by those applying IAS, and followed by those applying German standards. Although the study finds differences in earnings response coefficients for the three samples of firms applying different accounting standards, such evidence also is indirect regarding whether these differences are attributable to differences in the quality of accounting amounts because earnings response coefficients are affected by factors, e.g., risk, that are not necessarily dimensions of accounting quality. Also, because the samples in both studies comprise only German firms, inferences from them are not generalizable to firms in 9

11 other countries. These studies lack of generalizability and use of indirect measures of accounting quality leave open the question of whether IAS- and US GAAP-based accounting amounts are of comparable quality. Harris and Muller (1999) addresses a research question closely related to our second research question. In particular, Harris and Muller (1999) provides evidence that US GAAP reconciled amounts for 31 firms applying IAS are value relevant incremental to IAS-based accounting amounts. An advantage of the Harris and Muller (1999) research design is that, by construction because each firm is its own control, there are no economic differences between the firms applying IAS and those reconciling to US GAAP. Another potential advantage is that to the extent reconciled US GAAP amounts differ depending on whether firms apply IAS or domestic standards in their financial statements, the Harris and Muller (1999) comparison is most closely related to the SEC s decision on removing the reconciliation requirement for IAS firms. However, Harris and Muller (1999) makes this comparison only for firms that cross-list on US exchanges, thereby limiting the generalizability of the study s findings. Because crosslisted firms are required to reconcile to US GAAP, the sample firms may make US GAAPconsistent choices under IAS to minimize reconciling items (Lang, Raedy, and Wilson, 2006). Generalizing the study s inferences is also difficult because the findings differ across empirical specifications, the sample size is small, and the sample period, , pre-dates substantial changes in IAS after The study s lack of generalizability and use of cross-listed firms leave open the question of whether IAS- and reconciled US GAAP-based accounting amounts are of comparable quality. 3. Hypothesis Development 3.1 ACCOUNTING QUALITY OF IAS AND US GAAP 10

12 The quality of accounting amounts reflects the interaction of features of the financial reporting system, which include accounting standards, their interpretation, enforcement, and litigation. Relating to standards, the IASB has adopted an approach in developing standards different from the Financial Accounting Standards Board (FASB) that could result in different quality of accounting amounts. In particular, the IASB s approach relies more on principles, whereas the FASB s approach relies more on rules. 4 Reliance on principles specifies guidelines, but requires judgment in application. Reliance on rules specifies more requirements that leave less room for discretion. Ewert and Wagenhofer (2005) develops a rational expectations model that shows that accounting standards that limit opportunistic discretion result in accounting earnings that are more reflective of a firm s underlying economics and, therefore, are of higher quality. The inherent flexibility IAS principles-based standards afford can allow firms to manage earnings, thereby decreasing accounting quality. This flexibility has long been a concern of securities markets regulators, especially in international contexts (e.g., Breeden, 1994). Relating to other features of the financial reporting system, Ball (1995, 2006), Lang, Raedy, and Wilson (2006), Bradshaw and Miller (2007), and Daske et al. (2007a) observe that both accounting standards and the regulatory and litigation environment are important to the application of accounting standards. In particular, Cairns (1999), Street and Gray (2001), and Ball, Robin, and Wu (2003) suggest that lax enforcement can result in limited compliance with IAS, thereby limiting their effectiveness. Thus, because of the inherent flexibility of principlesbased standards and potential weakness in other features of the financial reporting system, we 4 The distinction here is more relative than absolute. IAS and US GAAP include both general principles and rules, depending on context (Schipper, 2003). However, the FASB has generally provided more detailed guidance on application of accounting principles than has the IASB. 11

13 predict that accounting amounts resulting from application of US GAAP are of higher quality than those resulting from application of IAS. Although we predict that application of US GAAP is associated with higher accounting quality than IAS, this may not be true. Discretion in accounting can be opportunistic and possibly misleading about the firm s economic performance, but it can be used to reveal private information about the firm (Watts and Zimmerman, 1986). The IASB attempts to limit allowable alternative accounting practices and provides a consistent approach to accounting measurement for the purpose of having a firm s recognized amounts faithfully represent its underlying economics. Thus, it is possible that IAS-based accounting amounts are of comparable quality to US GAAP-based amounts. If this is the case and enforcement in countries in which IAS are applied is comparable to that in the US, then it possible that accounting amounts resulting from the application of the two sets of standards are of equal quality. 5 For the same reasons that we predict US GAAP-based accounting amounts are of higher quality than IAS-based amounts, we also predict that US GAAP-based accounting amounts reconciled from those based on application of domestic standards on Form 20-F are of higher quality than those based on IAS. However, because 20-F firms do not necessarily face the same legal and regulatory environment as US firms applying US GAAP (Bradshaw and Miller, 2007), we do not expect the difference in quality of accounting amounts of 20-F and IAS firms to be as pronounced as the difference in quality of accounting amounts between US and IAS firms. 3.2 MEASURES OF ACCOUNTING QUALITY Following prior research, we operationalize accounting quality using earnings management, timely loss recognition, and value relevance metrics. We predict that higher 5 Because other features of the financial reporting system, e.g., enforcement and litigation environment, are likely to differ across countries in which IAS are applied, we report findings from our comparisons separately for groups in which enforcement is likely to be homogenous within the groups and heterogeneous across the groups. 12

14 quality accounting amounts exhibit less earnings management, more timely loss recognition, and higher value relevance of earnings and equity book value. Therefore, we predict that US GAAPbased accounting amounts of US firms applying US GAAP, i.e., US firms, or non-us firms applying domestic standards but reconciling earnings and equity book value to US GAAP, i.e., 20-F firms, exhibit less earnings management, more timely loss recognition, and higher value relevance of earnings and equity book value than do IAS-based accounting amounts of firms applying IAS, i.e., IAS firms. We examine two manifestations of earnings management earnings smoothing and managing towards positive earnings. Regarding earnings smoothing, following prior research, we expect firms that smooth earnings less exhibit more earnings variability, after controlling for other economic determinants of earnings volatility (Lang, Raedy, and Yetman, 2003; Leuz, Nanda, and Wysocki, 2003; Lang, Raedy, and Wilson, 2006; Barth, Landsman, and Lang, 2008). We predict that US and 20-F firms exhibit more variable earnings than do IAS firms. 6 To test our prediction, we use two earnings variability metrics, variability of change in net income and variability of change in net income relative to variability of change in cash flow. Although we predict that firms applying US GAAP have less earnings management and, thus, higher earnings variability, some studies (e.g., Healy, 1985) suggest that, in the case of big baths, managers may use discretion in ways that result in higher earnings variability. Thus, firms applying IAS could have more discretion for this form of earnings management and thus could exhibit higher earnings variability. Also, higher earnings variability could be indicative of lower earnings quality because of error in estimating accruals. Thus, higher quality accounting can result in lower earnings variability. 6 Our prediction is supported by Ewert and Wagenhofer (2005), which shows that applying accounting standards that limit management s discretion should result in higher variability in accounting earnings. See Barth, Landsman, and Lang (2008) for further discussion. 13

15 We also expect firms with less earnings smoothing to exhibit a more negative correlation between accruals and cash flows (Lang, Raedy, and Yetman, 2003; Leuz, Nanda, and Wysocki, 2003; Ball and Shivakumar, 2005, 2006; Lang, Raedy, and Wilson, 2006; Barth, Landsman, and Lang, 2008). Because accruals reverse over time, accruals and cash flows tend to be negatively correlated even in the absence of earnings management (Dechow, 1994). However, Land and Lang (2002) and Myers and Skinner (2007), among others, posit that a more negative correlation indicates earnings smoothing because managers respond to weak (strong) cash flow outcomes by increasing (decreasing) accruals. In addition, Ball and Shivakumar (2005, 2006) show that timely gain and loss recognition, which is consistent with higher earnings quality, attenuates the negative correlation between accruals and current period cash flow. Consistent with Land and Lang (2002), Myers and Skinner (2007), and prior studies testing for earnings smoothing, we predict that US and 20-F firms exhibit a less negative correlation between accruals and cash flows than do IAS firms. Regarding our second manifestation of earnings management, prior research identifies positive earnings as a common target of earnings management. Evidence of managing towards positive earnings is a larger frequency of small positive earnings (Burgstahler and Dichev, 1997; Leuz, Nanda, and Wysocki, 2003). The notion underlying this target is that management prefers to report small positive earnings rather than negative earnings. If applying US GAAP reduces managerial discretion relative to applying IAS, we predict that US firms and 20-F firms report small positive earnings with lower frequency than do IAS firms. Regarding timely loss recognition, we expect firms with higher quality earnings to exhibit a larger frequency of large losses. This is consistent with Ball, Kothari, and Robin (2000), Lang, Raedy, and Yetman (2003), Leuz, Nanda, and Wysocki (2003), and Lang, Raedy, 14

16 and Wilson (2006) that suggest one characteristic of higher quality earnings is that large losses are recognized as they occur rather than deferred to future periods. This characteristic is closely related to earnings smoothing in that if earnings are smoothed large losses should be relatively rare. Thus, we predict that US firms and 20-F firms report large losses with higher frequency than do IAS firms. Although we predict higher quality accounting results in a higher frequency of large losses, the opposite could be true. In particular, a higher frequency of large losses could be indicative of big bath earnings management. Also, a higher frequency of large losses could result from error in estimating accruals. Thus, higher quality accounting can result in a lower frequency of large losses. Regarding value relevance, we expect firms with higher quality accounting amounts to have a higher association between stock price and earnings and equity book value because higher quality accounting amounts better reflect a firm s underlying economics (Barth, Beaver, and Landsman, 2001). First, higher quality accounting amounts are the product of applying accounting standards that require recognition of amounts that are intended to faithfully represent a firm s underlying economics. Second, higher quality accounting amounts are less subject to opportunistic managerial discretion. These two features of higher quality accounting are linked together by Ewert and Wagenhofer (2005), which shows that accounting standards that limit opportunistic discretion result in accounting earnings that have higher value relevance. Third, higher quality accounting has less non-opportunistic error in estimating accruals. Consistent with these three features of higher quality accounting, prior research also suggests that higher quality accounting amounts are more value relevant (Lang, Raedy, and Yetman, 2003; Lang, Raedy, and Wilson, 2006; Barth, Landsman, and Lang, 2008). Accordingly, we predict that US 15

17 firms and 20-F firms exhibit higher value relevance of earnings and equity book value than do IAS firms. 7 We examine whether the quality of accounting amounts of US firms and 20-F firms is higher than that of IAS firms by conducting tests relating to earnings management, timely loss recognition, and value relevance. Following Barth, Landsman, and Lang (2008), we infer higher quality from a consistent pattern of evidence provided by the portfolio of tests Research Design 4.1 OVERVIEW To test our predictions, we first compare accounting quality metrics for non-us firms that apply IAS (IAS firms) to those of a matched sample of US firms that apply US GAAP (US firms). To compare IAS and US firms, following Barth, Landsman, and Lang (2008), we identify each IAS firm s industry and IAS adoption year. We then select as the matched US firm a US firm in the same industry as the IAS firm whose size as measured by equity market value is closest to the IAS firm s at the end of the year of its adoption of IAS. Our analyses include all firm-years for which the IAS firm and its matched US firm both have data. For example, if the IAS firm has data from 1994 through 2000, and its matched US firm has data for 1995 through 2002, then our analysis includes data from 1995 through 2000 for the IAS firm and its matched US firm. We employ this matching procedure to mitigate the effects on accounting quality of economic differences unattributable to the financial reporting system, including country-level differences in economic activity and size-related differences, such as information environment. 7 Examining value relevance in this context is subject to at least two caveats. First, it presumes the pricing process is similar across firms and across countries. Second, earnings smoothing can increase the association between earnings and share prices. See Wysocki (2005) for a discussion of various approaches to assessing accounting quality. 8 See Barth, Landsman, and Lang (2008) for a fuller discussion of advantages of using several metrics. 16

18 We next compare accounting quality metrics for IAS firms to those relating to the US GAAP amounts of non-us firms applying domestic standards and reconciling accounting amounts to US GAAP on Form 20-F, 20-F firms. When making this comparison we limit 20-F firms to those that do not apply IAS. We require 20-F firms to be from the same countries as the IAS firms and observations to be from 1989 to Ideally, we would follow a matching procedure for IAS and 20-F firms, i.e., matching on industry, size, and country. However, data limitations preclude us from doing so because the resulting matched sample would be too small to conduct meaningful tests. Following Barth, Landsman, and Lang (2008), for both comparisons we include controls for firm characteristics that could affect our metrics but are unattributable to the financial reporting system because it is possible that our matching procedures fail to control for these differences. 9 However, because matching and including controls could also control for some effects attributable to the financial reporting system, such as enforcement and litigation, it is unclear that they are desirable design features. The SEC is concerned with the quality of reported accounting amounts, which is affected by all features of the financial reporting system, not just accounting standards. If the SEC decides to accept IAS-based financial statements without reconciliation to US GAAP from non-us firms, such financial statements would be subject to the influence of all features of the financial reporting systems to which the firms are subject. If the SEC decides to accept IAS-based financial statements from US firms, such financial statements would be subject to the influence of the US financial reporting system. Although matching and including controls can mitigate differences in the financial reporting system, there is no obvious means to include the effects of features of the US financial reporting 9 Untabulated findings indicate that inferences are insensitive to inclusion of the controls. 17

19 system on accounting quality for non-us firms. Thus, our findings cannot provide direct evidence regarding accounting quality for US firms that would result if they were to apply IAS. With the exception of the tests for the frequency of small positive earnings and large negative earnings, we test for differences in each metric using a t-test based on the empirical distribution of the differences. Specifically, for each test, we first randomly select, with replacement, firm observations that we assign to one or the other type of firm, depending on the test. For example when comparing IAS firms and US firms, we assign firm observations as either IAS or US firms. We then calculate the difference between the two types of firms in the metric that is the subject of the particular test. We obtain the empirical distribution of this difference by repeating this procedure 1,000 times. An advantage of this approach for testing significance of the differences is that it requires no assumptions about the distribution of each metric. Another advantage is that it can used for all of our metrics, even those with unknown distributions, e.g., the ratio of variability of change in net income to variability of changes in cash flow. 10 Our comparison of accounting quality for IAS and US firms is relevant to the SEC s decisions to permit non-us firms to file financial statements based on IAS without reconciliation to US GAAP and US firms to file financial statements based on IAS. The comparison is relevant to the SEC s reconciliation requirement decision because the comparison provides evidence on the relative quality of accounting amounts of US firms and those of non-us firms based on IAS. We limit IAS firms to those that do not cross-list in the US to eliminate effects on the IAS accounting amounts associated with the reconciliation requirement (Harris and Muller, 1999; Lang, Raedy, and Wilson, 2006). Studying the quality of accounting amounts of firms that are 10 When applicable, we also test for significance using the Cramer (1987) test. In every case, that test results in the same inferences as the empirical distribution test. 18

20 potential candidates for cross-listing is relevant because, as Pownall and Schipper (1999) notes, one of the SEC s goals in permitting non-us firms to file financial statements based on IAS is to attract US listings by removing impediments. However, although our IAS firms are large, global firms, we cannot be certain that they would cross-list in the US if there were no reconciliation requirement. The comparison of accounting quality for IAS and US firms also is relevant to the SEC s decision to permit US firms to apply IAS because the comparison provides evidence on the relative quality of IAS-based and US-based accounting amounts. However, because no US firms apply IAS, our IAS firms are not US firms. Thus, as noted above, we cannot be certain that our findings would obtain for a sample of US firms. Nonetheless, it is presently the only comparison of quality of IAS- and US GAAP-based accounting amounts that can be made, and our study is the first to do so for a broad sample of non-us firms. Our comparison of accounting quality for IAS and 20-F firms also is relevant to the SEC s decision to remove the reconciliation requirement because the comparison provides evidence on the relative quality of accounting amounts in the reconciliation and in financial statements based on IAS. However, US GAAP-based accounting amounts of firms that have made the decision to cross-list in the US could be affected by their incentives to cross-list in the presence of a reconciliation requirement. As a result, their US GAAP-based amounts may not be representative of those of firms that would cross-list in the absence of the reconciliation requirement. Nonetheless, our study is the first to provide a comparison of the quality of IASbased and reconciled US GAAP-based accounting amounts of a broad sample of non-us firms. 4.2 ACCOUNTING QUALITY METRICS Earnings Management 19

21 Our first earnings management metric is based on the variability of change in net income divided by total assets, Δ NI (Lang, Raedy, and Wilson, 2006; Barth, Landsman, and Lang, 2008). 11 A smaller variance of change in net income is evidence consistent with earnings smoothing. However, net income is likely to be sensitive to a variety of factors associated with firms economic environments that are unattributable to the financial reporting system. Although our matching procedures mitigate these effects, some may remain. Therefore, our variability metric is the variance of the residuals from the regression of change in net income on variables identified in prior research as controls for these factors (Ashbaugh, 2001; Pagano, Röell, and Zehner, 2002; Lang, Raedy, and Yetman, 2003; Lang, Raedy, and Wilson, 2006; Barth, Landsman, and Lang, 2008), ΔNI * : ΔNI it = α 0 + α 1 SIZE it + α 2 GROWTH it + α 3 EISSUE it + α 4 LEV it + α 5 DISSUE it + α 6 TURN it + α 7 CF it + ε it (1) SIZE is the natural logarithm of end-of-year market value of equity, GROWTH is percentage change in sales, EISSUE is percentage change in common stock, LEV is end-of-year total liabilities divided by end-of-year equity book value, DISSUE is percentage change in total liabilities, TURN is sales divided by end-of-year total assets, and CF is annual net cash flow from operating activities divided by end-of-year total assets. Equation (1) also includes country and industry fixed-effects, as do equations (2) through (4). We estimate equation (1) pooling observations that are relevant to the particular comparison we test. For example, when comparing IAS and US (IAS and 20-F) firms, we pool all firm-year observations for IAS and US 11 DataStream provides several definitions of income. The one we use is operating income, which does not include extraordinary items and other non-operating income. However, because the criterion for extraordinary items differs across countries and excluding extraordinary items could result in differences based on the location on the income statement of one-time items, we replicate the analysis including extraordinary and non-operating items. Experimental inferences are unaffected. 20

22 (IAS and 20-F) firms. The variability of ΔNI * is the cross-sectional variance of the IAS or US (20-F) firms residuals from equation (1). Our second earnings smoothing metric is based on the ratio of variability of change in net income, Δ NI, to variability of change in operating cash flows, Δ CF. Firms with more volatile cash flows typically have more volatile net income, and our second metric controls for this. If firms use accruals to manage earnings, variability of change in net income should be lower than that of operating cash flows. As with Δ NI, ΔCF is likely to be sensitive to a variety of factors unattributable to the financial reporting system. Therefore, we estimate an equation similar to equation (1), but with Δ CF as the dependent variable: 12 ΔCF it = α 0 + α 1 SIZE it + α 2 GROWTH it + α 3 EISSUE it + α 4 LEV it + α 5 DISSUE it + α 6 TURN it + α 7 CF it + ε it (2) As with equation (1), we pool observations appropriate for the particular comparison. The variability of ΔCF * is the cross-sectional variance of groups of residuals from equation (2), where the composition of the groups depends on the particular comparison we test. Our resulting second metric is the ratio of variability of ΔNI * to variability of ΔCF *. Our third metric of earnings smoothing is based on the Spearman correlation between accruals, ACC, and cash flows. ACC is NI minus CF. As with the two variability metrics based on equations (1) and (2), because the accruals and cash flows correlation may be sensitive to factors unattributable to the financial reporting system, we compare correlations of residuals from equations (3) and (4), CF * and ACC *, rather than correlations between CF and ACC directly. As with the equations (1) and (2), both CF and ACC are regressed on the control variables, but excluding CF: 12 For ease of exposition, we use the same notation for coefficients and error terms in each equation. In all likelihood they differ. 21

23 CF it = α 0 + α 1 SIZE it + α 2 GROWTH it + α 3 EISSUE it + α 4 LEV it + α 5 DISSUE it + α 6 TURN it + ε it (3) ACC it = α 0 + α 1 SIZE it + α 2 GROWTH it + α 3 EISSUE it + α 4 LEV it + α 5 DISSUE it + α 6 TURN it + ε it (4) Our metric for managing towards positive earnings is the coefficient on small positive net income, SPOS, in equation (5). IAS(0,1) it = α 0 + α 1 SPOS it + α 2 SIZE it + α 3 GROWTH it + α 4 EISSUE it + α 5 LEV it + α 6 DISSUE it + α 7 TURN it + α 8 CF it + ε it (5) IAS (0,1) is an indicator variable that equals one for IAS firms and zero for US firms or 20-F firms, depending on the comparison we test, and SPOS is an indicator variable that equals one if net income divided by total assets is between 0 and 0.01 (Lang, Raedy, and Yetman, 2003). Equation (5) also includes industry fixed effects for the IAS and US firms comparison, and country and industry fixed effects for the IAS and 20-F firms comparison. 13 A positive coefficient on SPOS indicates that IAS firms manage earnings toward small positive amounts more frequently than do US, or 20-F, firms. We use the coefficient on SPOS from equation (5) rather than comparing the percentages of small positive income for each group of firms to assess whether IAS firms are more likely to manage earnings. This is because equation (5) includes controls for firm characteristics unattributable to the financial reporting system Timely Loss Recognition We measure timely loss recognition as the coefficient on large negative net income, LNEG, in equation (6) (Lang, Raedy, and Yetman, 2003; Lang, Raedy, and Wilson, 2006; Barth, Landsman, and Lang, 2008). 13 It is not possible to include country fixed effects for the IAS and US firms comparison because all US firms are from the same country. 22

24 IAS(0,1) it = α 0 + α 1 LNEG it + α 2 SIZE it + α 3 GROWTH it + α 4 EISSUE it + α 5 LEV it + α 6 DISSUE it + α 7 TURN it + α 8 CF it + ε it (6) LNEG is an indicator variable that equals one for observations for which annual net income divided by total assets is less than 0.20, and zero otherwise. As does equation (5), equation (6) also includes industry fixed effects for the IAS and US firms comparison, and country and industry fixed effects for the IAS and 20-F firms comparison. A negative coefficient on LNEG indicates that IAS firms recognize large losses less frequently than US, or 20-F, firms. As with equation (5), we use the coefficient on LNEG rather than directly comparing the percentages of large losses across the comparison groups of firms to assess whether IAS firms are more likely to manage earnings because equation (6) includes control variables Value Relevance Our primary value relevance metric is based on the explanatory power from a regression of stock price on earnings and equity book value. To obtain a measure of price that is unaffected by mean differences across countries and industries, which could affect our comparisons of explanatory power, we first regress stock price, P, on country and industry fixed effects. 15 We regress the residuals from this regression, P*, on equity book value per share, BVE, and net income per share, NI, separately for IAS and US firms, and for IAS and 20-F firms. Following prior research, to ensure accounting information is in the public domain, we measure P six months after fiscal year-end (Lang, Raedy, and Yetman, 2003; Lang, Raedy, and Wilson, 2006; 14 Following Lang, Raedy, and Wilson (2006) and Barth, Landsman, and Lang (2008), in the analyses of small positive and large negative net income, we report results from OLS estimation rather than from logit estimation because Greene (1993) reports that logit models are extremely sensitive to the effects of heteroscedasticity. 15 As noted in Barth, Landsman, and Lang (2008), we could permit BVE and NI coefficients to reflect cross-industry differences in the relation between price and accounting amounts (Barth, Konchitchki, and Landsman, 2007). However, small sample sizes in many of our industries make this impractical. 23

25 Barth, Landsman, and Lang, 2008). Our primary value relevance metric is the adjusted R 2 from equation (7). 16 P * it β BVE NI + ε = 0 + β1 it + β2 it it (7) Our other value relevance metric is based on the explanatory power from regressions of net income on annual stock return. We estimate the earnings-returns relation separately for positive and negative return subsamples. Because we partition firms based on the sign of the return, we estimate two reverse regressions with earnings as the dependent variable, where one is for good news firms and the other is for bad news firms. As with price, to obtain a measure of net income that controls for mean differences across countries and industries, we first regress net income per share divided by beginning-of-year price, NI/P, on country and industry fixed effects. We regress the residuals from this regression, NI/P*, on annual stock return, RETURN. Following Lang, Raedy, and Wilson (2006) and Barth, Landsman, and Lang (2008), we measure RETURN as the natural logarithm of the ratio of stock price three months after fiscal year end to stock price nine months before fiscal year end, adjusted for dividends and stock splits. Our good and bad news value relevance metrics are the R 2 s from equation (8) estimated separately for good news and bad news firms. 17 * [ NI / P] it = β 0 + β1return it + ε it (8) As with equation (7), we estimate equation (8) separately for IAS and US firms and for IAS and 20-F firms. 16 We also estimated versions of equation (7) using undeflated amounts. Inferences from the untabulated findings are the same as from the tabulated findings. 17 Because RETURN is the log of a price ratio and therefore can be negative even when stock prices increase during the twelve month window, when determining whether an observation belongs in the good news or bad news regression, we measure return as the stock price three months after fiscal year end to stock price nine months before fiscal year end, adjusted for dividends and stock splits. 24

26 5. Data and Sample We obtain our sample of IAS firms from Worldscope, which identifies the set of accounting standards a firm uses to prepare its financial statements and its industry. The two Worldscope standards categories that we code as IAS based on the Worldscope Accounting Standards Applied data field are international standards and IASC or IFRS. 18 There are two sources of potential error in classifying a firm as applying IAS. The first is that firms do not always indicate clearly the accounting standards that they apply in their financial statements. The second is that Daske et al. (2007a) reports that the Worldscope data field has classification error. If a substantial portion of firms we classify as IAS firms are affected by these sources of classification error, it is likely that our findings are biased in favor of our prediction that US firms have higher accounting quality that IAS firms. This is because Barth, Landsman, and Lang (2008) finds that IAS firms have higher accounting quality than non-us firms applying domestic standards and it is likely that any non-ias applied by misclassified IAS firms are domestic standards. 19 We gather data for IAS firms from DataStream and data for US firms from Compustat and CRSP. We obtain data for 20-F firms from Datastream, except net income and equity book value based on US GAAP, which we obtain from Forms 20-F. 20 We winsorize at the 5% level all variables used to construct our metrics to mitigate the effects of outliers on our inferences. The resulting sample of IAS firms comprises 11,443 firm year observations for 2,212 firms that adopted IAS between 1995 and Of the 11,443 firm years, 2,804 are post-ias adoption observations, and 8,639 are pre-adoption observations. 18 Worldscope category 23 was IASC prior to 2004 and IFRS in 2005 and Limiting our comparisons to IAS firms classified by Worldscope as applying IASC or IFRS results in inferences similar to those we obtain from our tabulated findings. 20 We eliminate ten 20-F firm year observations with negative equity book value. 25