Does Accounting Quality Change Following a Switch from U.S. GAAP to IFRS? Evidence from Germany. Stephen Lin* William Riccardi Changjiang (John) Wang
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1 Does Accounting Quality Change Following a Switch from U.S. GAAP to IFRS? Evidence from Germany Stephen Lin* William Riccardi Changjiang (John) Wang Florida International University January 2012 *corresponding author: Dr. Stephen Lin School of Accounting College of Business Administration Florida International University Miami, Floirda lins@fiu.edu
2 Does Accounting Quality Change Following a Switch from U.S. GAAP to IFRS? Evidence from Germany ABSTRACT This study examines whether accounting quality changed following a switch from U.S. GAAP to IFRS. Using a sample of German high-tech firms that transitioned to IFRS from U.S. GAAP in 2005 (switching firms), we find that accounting numbers under IFRS generally exhibit more earnings management, less timely loss recognition, and less value relevance compared to those under U.S. GAAP. In addition, after analyzing the accounting quality of firms that applied IFRS throughout the entire sample period, we find that, for the metrics suggesting a decline in accounting quality for both groups of firms, the change is significantly more pronounced for firms switching to IFRS from U.S. GAAP. Overall, our findings indicate that the application of U.S. GAAP generally resulted in higher accounting quality than application of IFRS, and a transition from U.S. GAAP to IFRS reduced accounting quality. Our findings provide the first evidence on the potential consequences of a switch from U.S. GAAP to IFRS. Keywords: Accounting Quality; U.S. GAAP; IFRS 1
3 1. INTRODUCTION Prior research provides some supporting evidence on the improvement in accounting quality following a switch from non-u.s. domestic standards to International Financial Reporting Standards (IFRS). However, to our knowledge, no study has examined the extent to which accounting quality changes after a switch from United States Generally Accepted Accounting Principles (U.S. GAAP) to IFRS. We believe that this is an important research question because there are many current debates surrounding the costs and benefits of switching from U.S. GAAP to IFRS. In this study, we examine whether accounting quality changed following a switch from U.S. GAAP to IFRS for a sample of German high-tech firms that applied U.S. GAAP and were required to switch to IFRS in Based on various metrics for earnings management and timely loss recognition used in prior research (Basu, 1997; Lang et al., 2003; Lang et al., 2006; Barth et al., 2008), we find that firms in our sample generally exhibit more earnings management and less timely loss recognition in the post-adoption period when using IFRS relative to the pre-adoption period when using U.S. GAAP. In addition, using the return-earnings model as suggested by Easton and Harris (1991), we find that accounting numbers under U.S. GAAP appear to provide more value relevant information to investors compared to accounting numbers reported under IFRS after controlling for firm-specific and time varying factors. Finally, we perform additional analyses using a sample of similar firms that applied IFRS throughout the entire sample period in order to compare the detected decline in accounting quality of firms that switched accounting standards to those that did not. We find that, for the three metrics suggesting a decline in accounting quality for both groups of firms, the change is significantly more pronounced for firms switching to IFRS from U.S. GAAP. Overall, our findings indicate that U.S. GAAP generally provided 2
4 higher accounting quality than IFRS, and a transition from U.S. GAAP to IFRS reduced accounting quality. This study provides the first evidence on the impact of a switch to IFRS from U.S. GAAP on accounting quality, which should be of interest to the SEC, the FASB, U.S. firms, and academics in evaluating the potential benefits and disadvantages of a switch from U.S. GAAP to IFRS. However, the above findings may not offer direct implications for the U.S. adoption of IFRS and should be interpreted with caution because the sample firms examined in this study may not be representative of firms in the U.S. This study differs from prior studies in at least three aspects. First, there is a large body of research regarding how various aspects of financial reporting are affected by a switch from non- U.S. domestic accounting standards to IFRS. However, there is no direct evidence as to whether firms using U.S. GAAP would experience similar benefits from adopting IFRS because U.S. GAAP are believed to be superior to other domestic standards. Second, some studies compare accounting quality of firms applying U.S. GAAP with those applying IFRS after matching on certain characteristics (such as size and industry). However, the extent to which these firms are comparable is unclear given that they operate in different countries and face various socio-economic and legal environments. Examining the accounting quality effect of a switch from U.S. GAAP to IFRS uses firms themselves as a control to avoid this issue. Third, some studies use the reconciled accounting information of foreign firms crosslisted in the U.S. to compare accounting quality based on US GAAP and IFRS. In these papers, the same firms provide two sets of financial information that are used to assess differences in accounting quality. However, the reconciled information offers limited amounts of data for empirical tests. Further, prior research has found evidence suggesting that firms will attempt to 3
5 manage the magnitude of reported accounting differences, which can seriously affect any empirical results drawn from the use of these reconciled amounts (Tarca, 2002; Landry and Callimaci, 2003; Bradshaw et al., 2004). Moreover, these firms reconcile to U.S. GAAP from IFRS, whereas we examine an actual switch from U.S. GAAP to IFRS. The remainder of this study is organized as follows. The next section review prior literature related to our study. Section three discusses our research design. Section four describes our sample data. Section five presents our empirical results. In section six, we perform additional tests that we find relevant to the setting of our study. In section seven, we offer some implications of our results on the potential adoption of IFRS in the United States. We summarize in section eight and provide implications for future research. 2. PRIOR RESEARCH To our knowledge, no study has examined the extent to which accounting quality changes after a switch from U.S. GAAP to IFRS. However, a number of studies examine change in accounting quality following a switch to IFRS from non-u.s. domestic standards. The findings of these studies are generally supportive. Most notably, Barth et al. (2008) find that firms exhibit higher accounting quality after voluntarily switching to IFRS based on a variety of metrics. There are also a number of papers that examine differences in accounting quality between U.S. GAAP and IFRS in environments where firms are free to choose between multiple sets of standards. For example, Bartov et al. (2005) find no significant difference in earnings quality, measured by the price-earnings relationship, for a sample of German New Market firms that were allowed to choose between IFRS and U.S. GAAP. Similarly, the findings of Van der Muelen et al. (2007) suggest that there is no difference in value relevance between application of IFRS and U.S. GAAP using a similar sample of German firms, though they do find that 4
6 application of U.S. GAAP results in more predictable earnings than application of IFRS. These two studies provide consistent evidence suggesting that investors do not perceive accounting numbers reported under U.S. GAAP compared to those reported under IFRS to provide materially different information. This is consistent with Leuz (2003), which finds that market liquidity and information asymmetry are similar across IFRS and U.S. GAAP firms. Finally, some studies focus on the accounting differences reported via the reconciliation disclosure (Form 20-F) of foreign firms that cross list on U.S. exchanges. Such studies can be classified into two groups. First, a number of studies examine the information content of the accounting differences between IFRS and U.S. GAAP, and provide mixed evidence. Harris and Muller (1999) find that reported differences in net income and shareholders equity are associated with both market value and stock returns, but not price. Conversely, Henry et al. (2009) find that these differences are only associated with returns. Using an abnormal trading volume approach, Chen and Sami (2009) find that in the two-day window surrounding release of reconciliations, abnormal trading volume is positively associated with the absolute magnitude of differences. Overall, these findings suggest that reported differences in net income and shareholders equity have at least some value to investors, implying that market may in fact perceive differences in financial reporting under the two sets of standards. Using the IFRS-U.S. GAAP reconciliation disclosures, Gordon, Jorgensen, and Lithicum (2010) investigate differences in accounting quality between U.S. GAAP and IFRS. Based on nine earnings attributes 1, Gordon et al. (2010) find similar accounting quality between U.S. GAAP and IFRS except that U.S. GAAP appear to be more value relevant than IFRS. However, reconciling firms may attempt to reduce the reported differences between U.S. GAAP and IFRS 1 Specifically, their study examines: (1) accrual quality; (2) earnings persistence; (3) earnings predictability; (4) cash persistence; (5) cash predictability; (6) earnings smoothness; (7) relevance; (8) timeliness; and (9) conservatism. 5
7 accounting information 2 because large differences between U.S. GAAP and non-u.s. GAAP income amounts may increase the uncertainty among market participants about the underlying economic earnings of the firm (Bradshaw et al., 2004; Chen and Sami, 2008). Therefore, inferences regarding the difference in accounting quality between U.S. GAAP and IFRS drawn from this setting may not truly reflect the relative difference in accounting quality between the two sets of standards. Other studies focus on issues more relevant to the current debates surrounding the relative quality between IFRS and U.S. GAAP. A recent study by Barth, Landsman, Lang, and Williams (2011) examine the comparability and the difference in value relevance between firms domiciled in 27 different countries and that adopted IFRS between 1995 and 2006 to a matched sample of U.S. firms applying U.S. GAAP. The findings suggest that comparability has increased between U.S. firms and foreign firms following adoption of IFRS by foreign issuers and more so for firms whose country of origin shares similar economic, social and legal characteristics with the U.S. (i.e., common- law countries). Barth et al. (2011) also provide evidence that application of U.S. GAAP results in higher value relevance of accounting information compared to foreign firms using IFRS. However, the results of this study do not offer implications regarding how a switch from U.S. GAAP to IFRS could affect financial reporting. To summarize, prior research provides mixed evidence on the relative quality between IFRS and U.S. GAAP. This study contributes to the literature by investigating the impact on financial reporting quality after a switch to IFRS from U.S. GAAP. 2 For example, cross-listed foreign firms are more likely to apply accounting practices similar to those used under U.S. GAAP than other firms from the same country that are not cross-listed (Tarca, 2002; Landry and Callimaci, 2003; Bradshaw et al., 2004). 6
8 3. RESEARCH DESIGN 3.1 Overview We make no ex ante predictions regarding how accounting quality should change following the switch from U.S. GAAP to IFRS. Although many studies attempt to examine the relative quality between the two, they are generally investigative in nature because there is no clear theory supporting these predictions. Arguably, the differences in the nature of the standards themselves could be used to motivate certain predictions with respect to some of our metrics. Still, it is unclear how managerial incentives may play a role in changes in financial reporting when firms switch standards. Therefore, the nature of this study is purely investigative in order to better understand the potential impacts of a switch from U.S. GAAP to IFRS, which has not been examined in prior empirical research. We classify all firm-year observations prior to the mandatory adoption of IFRS by the European Union (EU) in 2005 as the pre-adoption period and all firm-year observations after as the post-adoption period. Following prior research (Lang et al., 2003; Lang et al., 2006; Barth et al., 2008), we infer differences in a variety of summary statistics (e.g., variances, correlations, R 2 ) relating to our earnings metrics between the pre- and post-adoption periods as evidence of differences in accounting quality. We also directly examine regression coefficients where applicable. 3.2 Accounting Quality Metrics Earnings Management The first three proxies for earnings management relate to earnings smoothing and the remaining one refers to managing earnings to achieve positive income (to avoid losses). Beginning with earnings smoothing, our first metric is based on the variability of the change in 7
9 net income 3 scaled by total assets, ΔNI. If managers take no discretionary action to smooth earnings, then they should be relatively volatile and fluctuate over time. Therefore, we interpret a smaller variance of ΔNI as suggestive of earnings smoothing. As the change in net income is at least partially attributable to factors other than those of the financial reporting system, we follow prior research to analyze the change in net income on variables to controls for such factors (Lang et al., 2003; Lang et al., 2006; Barth et al., 2008) using the following regression model: ΔNI it = α 0 + α 1 SIZE it + α 2 GROWTH it + α 3 EISSUE it + α 4 DEBT it + α 5 DISSUE it + α 6 TURN it + α 7 AUD it + α 8 NUMEX it + α 9 CLOSE it + α 10 CF it + ε it (1) where: SIZE = the natural logarithm of year-end market value of equity; GROWTH EISSUE DEBT DISSUE TURN AUD = = = = = = percent change in sales; percent change in common stock; year-end total liabilities divided by year-end book value of equity; percent change in total liabilities; sales divided by year-end total assets; an indicator variable equal to 1 for observations where the firm s auditor is PwC, Deloitte, E&Y, KPMG, or Arthur Andersen, and zero otherwise; NUMEX = the number of exchanges on which the firm s stock is listed; CLOSE CF = = the percent of closely-held shares of the firm s stock; annual net cash flows from operating activities. We denote our first metric as ΔNI*, the variance of the residuals estimated from the above regression. 4 3 Datastream offers several Net Income definitions for various income line items. We use Net Income before extraordinary and other non-operating items in all of our analyses. 4 In each test in which we use the residuals from regression models, we report results based on regressions run by year. For robustness, we run the same models using a pooled sample with the addition of year indicator variables. Results are similar. 8
10 One concern with the preceding metric of earnings smoothing is that earnings variability may be due to differences in cash flow activities that are not associated with discretionary accounting choices (Lang et al., 2003). We attempt to control for these concerns by examining the variability of NI relative to change in cash flows, CF. As the change in cash flows can also be affected by factors other than those of the financial reporting system, we control for these factors and estimate the following regression 5 : ΔCF it = α 0 + α 1 SIZE it + α 2 GROWTH it + α 3 EISSUE it + α 4 DEBT it + α 5 DISSUE it + α 6 TURN it + α 7 AUD it + α 8 NUMEX it + α 9 CLOSE it + α 10 CF it + ε it (2) From equation (2), we take the variance of the residuals as the measure of variability in cash flows, CF*. Following prior research (Lang et al., 2003; Lang et al., 2006; Barth et al., 2008), the second earnings smoothing metric is the ratio of variability of NI* to the variability of CF*. Following prior research (Lang et al., 2003; Leuz et al.2003; Lang et al., 2006; Barth et al., 2008), we construct the third earnings smoothing metric as the Spearman correlation between operating cash flows (CF) and total accruals (ACC), where ACC is measured as net income (NI) minus CF. Managers can use accruals to make up for shortcomings in the cash component of income in an attempt to smooth earnings, increasing accruals as the cash components of income decrease. Thus, a more negative correlation between ACC and CF is suggestive of greater use of accruals for this purpose. To mitigate the differences not attributable to the financial reporting system, we measure the correlations of the residuals from the following two equations, denoted as CF* and ACC*, rather than directly comparing correlations between CF and ACC. In the 5 To ease exposition, we use the same notation for regression coefficients and error terms where the same variables are used in multiple regression equations. 9
11 following regressions, CF and ACC are both regressed on control variables, as with equations (1) and (2), excluding CF: CF it = α 0 + α 1 SIZE it + α 2 GROWTH it + α 3 EISSUE it + α 4 DEBT it + α 5 DISSUE it + α 6 TURN it + α 7 AUD it + α 8 NUMEX it + α 9 CLOSE it + ε it ACC it = α 0 + α 1 SIZE it + α 2 GROWTH it + α 3 EISSUE it + α 4 DEBT it + α 5 DISSUE it + α 6 TURN it + α 7 AUD it + α 8 NUMEX it + α 9 CLOSE it + ε it (3) (4) Prior research documents that a common target of earnings management is to achieve positive income, thereby avoiding the reporting of losses (Burgstahler and Dichev, 1997). Our metric for earnings management toward positive income is measured as the coefficient on the time period variable, POST, from the following logistic regression 6 : SPOS it = α 0 + α 1 SIZE it + α 2 GROWTH it + α 3 EISSUE it + α 4 DEBT it + α 5 DISSUE it + α 6 TURN it + α 7 AUD it + α 8 NUMEX it + α 9 CLOSE it + α 10 CF it + α 11 POST it + ε it (5) SPOS is an indicator variable equal to one if net income scaled by total assets is between 0 and 0.01 for a given observation and zero otherwise, and POST is an indicator variable equal to one for observations in the post adoption period and zero otherwise. We base our conclusions on the coefficient of POST rather than directly comparing frequencies because the coefficient takes into account controls for factors not attributable to the financial reporting system. A positive coefficient on POST indicates a higher likelihood of small positive earnings in the post-adoption period than in the pre-adoption period (the opposite holding true for a negative coefficient) 7. 6 Based on Burgstahler and Dichev (1997), only an abnormal frequency of small positive income is suggestive of earnings management. An abnormal frequency occurs when there is a significantly greater frequency of small positive earnings relative to small negative earnings (i.e., there is discontinuity in the distribution of earnings around zero). Accordingly, Leuz et al. (2003) test the frequency of small profits relative to the frequency of small losses. We are precluded from using the latter approach because the actual frequency of both small positive and small negative earnings for our sample of firms makes it unrealistic to draw statistical inferences. 7 Evidence from Beaver, McNichols and Nelson (2007) suggests that can certain income statement items can complicate the examination and comparison of the frequency of small positive and small negative income (i.e., effective tax rates and special items). We use Net Income before extraordinary and other non-operating items, which excludes these items and focuses instead on components of income over which management has more discretion. 10
12 Timely Loss Recognition We measure timely loss recognition metric in two ways. Ball (2001) suggests that firms in different financial reporting environments differ in terms of timely loss recognition. Further, other prior research (Ball, Kothari and Robin, 2000; Lang et al., 2003) suggests that firms exhibiting more timely loss recognition should recognize large losses in the period in which they occur rather than deferring them to future periods. Therefore, we should observe more frequent incidences of extreme negative earnings for firms applying accounting standards that inherently require a higher degree of conservatism. Consistent with prior research (Lang et al., 2003; Lang et al., 2006; Barth et al., 2008), we estimate the following logistic regression: LNEG it = α 0 + α 1 SIZE it + α 2 GROWTH it + α 3 EISSUE it + α 4 DEBT it + α 5 DISSUE it + α 6 TURN it + α 7 AUD it + α 8 NUMEX it + α 9 CLOSE it + α 10 CF it + α 11 POST it + ε it (6) In equation (6), LNEG is an indicator variable equal to one for given observations where net income scaled by total assets is less than and zero otherwise. As with the tests for earnings management to avoid losses, POST is an indicator variable equal to one in the postadoption period and zero otherwise. We base our interpretations on the coefficient of POST after controlling for potential effects other than those of the financial reporting system. A negative coefficient on POST indicates that firms are more likely to recognize large losses in the preadoption period than in the post-adoption period. Our second measure for timely loss recognition is based on Basu (1997), where earnings is regressed on an indicator for bad news (negative returns) in a given period, the actual return, and an interaction of these two variables. Following prior studies, we include control variables for firm-level differences that could lead to differences in conservatism among firms in our sample. Ball and Shivakumar (2005), for example, note that larger firms may have more timely recognition of losses than smaller firms due to increased litigation risk or differences in agency 11
13 costs. Similarly, firms that have more debt obligations may also have incentives to recognize losses in a timelier manner (Watts, 2003). Prior research also finds that the market-to-book ratio can impact accounting conservatism (LaFond and Roychowdhury, 2008; Khan and Watts, 2009). We include these control variables and interact them with both the return and negative return indicator variables. Since we are interested in the accounting quality for the same sample of firms in two periods that is, before and after the switch from US GAAP to IFRS we further add an indicator variable, POST, and additional two- and three-way interaction terms, presented in the following equation, EPS it = β 0 + β 1 R it + β 2 DR it + β 3 POST it + β 4 SIZE it + β 5 LEV it + β 6 MB it + β 7 (R*DR) it + β 8 (DR*POST) it + β 9 (DR*SIZE) it + β 10 (DR*LEV) it + β 11 (DR*MB) it + β 12 (R*POST) it + β 13 (R*SIZE) it + β 14 (R*LEV) it + β 15 (R*MB) it + β 16 (R*DR*POST) it + β 17 (R*DR*SIZE) it + β 18 (R*DR*LEV) it + β 19 (R*DR*MB) it + ε i (7) EPS = Earnings per share, scaled by beginning of the year price; R = Annual return; DR = An indicator variable equal to 1 if R < 0, and zero otherwise. MB = The market-to-book ratio, measured as the ratio of market value of equity over book value of equity; POST = An indicator variable equal to 1 for observations in the post-adoption period, and zero otherwise. The interaction term R*DR captures the incremental timeliness when the return is negative with the argument that conservative reporting leads to bad news being impounded in earnings in a timelier manner relative to good news (i.e. β 3 is expected to be positive and significant). Our metric based on the Basu s conservatism model is the coefficient on the interaction term R*DR*POST, which captures the magnitude and the direction of the incremental 12
14 timely loss recognition of bad news for observations in the post-adoption period relative to those in the pre-adoption period. A positive coefficient suggests that there is more timely loss recognition in the post-adoption period while a negative coefficient suggests that there is more timely loss recognition in the pre-adoption period Value Relevance To examine changes in value relevance between the pre- and post-adoption periods, we focus on stock returns rather than price because returns are only affected by information and events in the period over which they are calculated. We follow Easton and Harris (1991) and construct the following earnings response coefficient model, R it = γ 0 + γ 1EPS it + γ 2 ΔEPS it + YEAR + ε it (8) where: R = Stock return measured nine months prior to three months after fiscal yearend; EPS = Earnings per share, scaled by beginning of the year stock price; ΔEPS = Annual change in earnings per share, scaled by beginning of the year stock price; YEAR = Year indicator variables. First, we estimate the regression coefficients on both current period earnings (γ 1 ) and annual change in earnings (γ 2 ) in the pre- and post-adoption period. We compute the first returnbased value relevance metric, the earnings response coefficient, ERC, by summing these two coefficients. We interpret a higher ERC as evidence of higher value relevance. Second, we estimate the total explanatory power from the regression of return on current period earnings and annual change in earnings. Thus, we use the adjusted R 2 from equation (9) in the pre- and post- 13
15 adoption period as a second metric for value relevance and test for statistical difference between the two periods. We interpret a higher R 2 as evidence of higher value relevance. Except for the earnings metrics that are measured as regression coefficients, we apply a bootstrapping procedure to compare the significance in difference of our earnings metrics. The bootstrapping procedure requires no assumptions about the distributions of our metrics (Bickel and Freedman, 1981) and it allows us to test those metrics with unknown distributions, such as the ratio of variability of change in net income to variability of change in cash flows. It also mitigates the concern that our inferences are a result of sample bias. To illustrate the bootstrapping procedure, we use the test of differences in variability of change in net income as an example. First, we randomly select, with replacement from the original sample, the same number of firm-year observations as in the original sample to obtain a random sample. Second, we run the regression of change in net income on the control variables on this random sample to obtain the residuals that is, the change in net income unexplained by the reporting environment, managerial incentives, and firm-specific characteristics. We then calculate the variance of these residuals, which is the metric used in this test. Third, we repeat this process 500 times to obtain a sample of the metric (i.e., a sample of variances of change in net income). We perform this procedure separately for the pre- and post-adoption periods. We then apply a t-test for statistical significance of the differences of the metric in the pre- and post-adoption periods. 4. Sample and DATA 4.1 Sample Firms A number of firms (95% of these firms are in hi-tech industries) in Germany applied U.S. GAAP and were required to switch to IFRS in These firms voluntarily chose to apply U.S. GAAP in order to (1) add credibility to their financial statements, (2) report financial information 14
16 that is more comparable and of similar quality to their U.S. counterparts, and (3) attract U.S. investors in a time when use of IFRS was not as widespread as it is now 8. Further, even after the subsequent failure of the New Market on which many of these firms had initially listed (2002), they continued to report their financial statements using U.S. GAAP rather than switching to German GAAP or IFRS. Despite the similarities between these German firms and their U.S. counterparts, our results may not offer direct evidence on the accounting quality consequences of a switch from U.S. GAAP to IFRS for firms in the U.S. 4.2 Data We use Worldscope to identify the accounting standards used by firms during our sample period. We identify 153 publicly listed German high-tech firms who applied U.S. GAAP in the pre-adoption period ( ) and have accounting and market data available from We eliminate firms that: voluntarily adopted IFRS before 2005 (30); used German GAAP in the years immediately preceding adoption of IFRS; have unverifiable standards data (11); postponed adoption of IFRS, or changed accounting standards before 2005 (18); and firms that are not in high-tech industry (3). Our main sample size comprises 582 firm-year observations representing 63 firms. For Basu s test of conservatism and the value relevance of earnings, we require additional data (e.g., monthly stock price and return data). After excluding observations with missing stock price and returns, we are left with 533 firm-year observations representing 58 firms for these tests. Table 1 presents the sample selection process. [Table 1] 8 The German government allowed German firms to prepare their financial statements in accordance with U.S. GAAP, IFRS, or German GAAP before These companies voluntarily adopted U.S. GAAP for reasons stated. 15
17 Table 2 presents descriptive statistics for variables used in our analyses. To mitigate the effects of outliers, we winsorize all continuous variables used in our analyses at the top and bottom 1% level. On average, firms in our sample exhibit a greater (less negative) change in earnings (change in cash flows) in the post-adoption period compared to the pre-adoption period. There is also a higher amount of both cash flows and absolute accruals in the post-adoption period compared to the pre-adoption period. In the pre-adoption period, firms tend to have more debt relative to equity, higher growth rates, and greater issuance of both debt and equity. Stock prices, returns, and earnings are, on average, higher in the post-adoption period. [Table 2] 5. EMPIRICAL RESULTS 5.1 Earnings Management Panel A of Table 3 shows the results for our earnings management metrics. The first finding relating to earnings smoothing shows that our sample firms exhibits a significantly higher variability of change in net income, NI*, in the pre-adoption period, , than in the post-adoption period, (p <.0001). The ratio of the variance of NI* to the variance of CF* in the pre-adoption period, , is also significantly higher than that in the postadoption period, (p <.0001). This result suggests that net income variability is not simply a result of cash flow variability. As we infer more earnings variability to be indicative of less earnings smoothing, these results suggest that there is higher accounting quality under U.S. GAAP in the pre-adoption period. Our third finding is also consistent, suggesting less earnings smoothing in the pre-adoption period. Specifically, the correlation between accruals, ACC*, and cash flows, CF*, is in the pre-adoption period and it is significantly less negative than the correlation in the post-adoption period of (p <.0001). 16
18 Panel B of Table 3 shows the results of the likelihood of small positive earnings regression. Interestingly, the coefficient on POST, , is negative and statistically significant (p = ), suggesting that firms in our sample manage toward positive earnings more often in the pre-adoption period than in the post-adoption period. Limitations in our sample preclude us from statistically testing small positive earnings relative to small negative earnings. However, without drawing statistical inferences, the actual frequency of small positive earnings relative to small negative earnings is higher in the post-adoption period for our sample. [Table 3] Overall, our results indicate that there is generally less earnings management in the preadoption period than in the post-adoption period. 5.2 Timely Loss Recognition Panel A of Table 4 presents the results of our first measure of timely loss recognition metric based on the frequency of large negative income. The negative and significant coefficient on POST, (p = ) is suggestive of more timely loss recognition in the pre-adoption period. The results from our second measure of timely loss recognition based on Basu s model are reported in Panel B of Table 4. The coefficient on the interaction term POST*R*DR, , is negative and marginally significant (p = ), which suggests a higher degree of conservatism and higher accounting quality in the pre-adoption period. Consistent with the debt contracting demand for accounting conservatism (Watts, 2003), the coefficient on LEV*R*DR is positive and significant, and the coefficient on MB*R*DR is negative, which is consistent with the arguments of Roychowdhury and Watts (2007). [Table 4] 17
19 5.3 Value Relevance Table 5 presents the results of the return value relevance regression. The ERC (the sum of the regression coefficients γ 1 and γ 2 ) in the pre-adoption period, , is significantly greater than the ERC in the post-adoption period, (p <.0001). We also compare the explanatory power of the return regression and find that the adjusted R 2 in the pre-adoption period, 58.35%, is significantly higher than the adjusted R 2 in the post-adoption period, 53.47% (p <.0001). Based on these results, earnings appear to have higher value relevance to investors in the preadoption period than in the post-adoption period. [Table 5] Overall, our results are suggestive of higher accounting quality for our sample firms in the pre-adoption period while applying U.S. GAAP than in the post-adoption period after adoption of IFRS. All earnings smoothing metrics suggest higher quality for our sample in the pre-adoption period. We also find evidence of increased timely loss recognition in the preadoption period. With respect to value relevance, our results suggest that the value relevance of current period earnings and annual change in earnings decrease following the switch from U.S. GAAP to IFRS. 5.4 Sensitivity Tests We consider two potential factors that may have a confounding effect on the inferences drawn from our previous results. First, there are inherent differences between U.S. GAAP and IFRS that could lead to the detected differences in earnings quality after firms switched to IFRS. We identify Research and Development expense (R&D) as a key difference because our sample firms are high-tech firms that may heavily invest in R&D. Under U.S. GAAP, all R&D is expensed in the period in which it is incurred, whereas part of R&D (i.e., development costs) is 18
20 capitalized under IFRS. This could lead to less volatile earnings when firms apply IFRS even if managers do not use discretionary actions to smooth earnings. Therefore, we include R&D scaled by year-end total assets as an additional control variable and repeat all tests reported in Table 3. 9 Untabulated results yield inferences consistent with our main findings. Second, our sample period overlaps with the recent global financial crisis, which could have a significant impact on our results. We eliminate all firm-year observations in 2009 and 2010 from the post-adoption period in our sample 10 and repeat all the tests used in our main analyses. Although most of our results (untabulated) remain intact, we note two major differences. First, after we eliminate these years, our timely loss recognition metric based on Basu s model is no longer significant (p = ), implying that firms may have adopted more aggressive (i.e., less conservative) accounting practices in periods of economic distress. Second, we find the correlation of ACC* and CF* in the post-adoption period ( ) is significantly less negative (p <.0001) than that of the pre-adoption period ( ). This finding implies that firms attempt to smooth earnings more during periods of financial crisis or that accruals and cash flows are less perfectly matched during economic downturns due to firms altered operations and consumer behavior. Overall, the above sensitivity tests show that our main findings of a decline in accounting quality of U.S. GAAP firms are generally robust after controlling for R&D expenditure and the effect of the recent financial crisis. 9 An ideal method to address this issue would be to restate the income amount used in our analyses to exclude R&D. However, this would likely result in significant measurement error since we would need to estimate only the portion of R&D reported under U.S. GAAP that would be capitalized under IFRS. 10 We deleted all the observations in 2009 and 2010 because the financial crisis should affect non-u.s. firms after
21 6. ADDITIONAL ANALYSES In order to confirm that the decrease in the accounting quality of U.S. GAAP firms is mainly caused by the change from U.S. GAAP to IFRS and not due to other factors, we investigate the accounting quality change for firms that applied IFRS throughout the entire sample period ( IFRS firms ). We also compare the changes in accounting quality of U.S. GAAP firms with any changes of IFRS firms by applying difference-in-differences tests. We would expect that the financial reporting quality of IFRS firms should be either constant or increasing throughout the sample period for three reasons. First, there is no evidence from prior research suggesting that the accounting quality of IFRS has reduced during the sample period. Second, the SEC s Roadmap clearly states that the ongoing convergence projects between IASB and FASB should have increased the quality of IFRS. Third, since these firms applied IFRS even before it was mandatory, their reporting incentives should remain consistent. We identify 63 high-tech German firms that had applied IFRS during the sample period ( ) 11 and have all the accounting and market data available for further analyses. Panel A of Table 6 shows that, like U.S. GAAP firms, ΔNI* is significantly less negative in the preadoption period (p <.0001), suggesting less smoothing in earlier years. However, the ratio of NI* to CF* is significantly greater in the post-adoption period (p <.0001), suggesting an increase in accounting quality for these firms. We focus on the latter result because this metric adjusts for earnings volatility resulting from cash flow volatility. Consistent with this supposition, the correlation of ACC* and CF* is significantly less negative in the post-adoption period (p <.0001). Taken together, our results suggest that IFRS firms have less earnings smoothing in more recent years, suggesting higher accounting quality. With respect to earnings 11 To be consistent with the results from our most strict specification, we eliminate the financial crisis years from tests in our additional analyses. 20
22 management to avoid losses, the result suggests that there has not been a significant change in the frequency of reporting small positive income. Turning to Panel B, the test for the frequency of large negative income and Basu s conservatism both yield insignificant positive coefficients. Therefore, we do not find evidence of a change in timely loss recognition for IFRS firms over the sample period. Lastly, Panel C summarizes the results of our value relevance tests. The earnings responsive coefficient (ERC) is significantly greater (p <.0001) in the post-adoption period (1.335) than in the pre-adoption period (0.7052). However, the return model adjusted R 2 of 44.06% is significantly lower (p <.0001) in the post-adoption period of 54.11%. Since some metrics (ΔNI*; the Correlation of ACC* and CF*; return model adjusted R 2 ) suggest that the accounting quality of IFRS firms may have declined in the post-adoption period, 12 we perform a difference-in-differences test to examine whether the decline in accounting quality is more pronounced for firms that switched from U.S. GAAP to IFRS relative to IFRS firms. In all three cases, the results reported in Table 7 show that the change is significantly greater for firms that switched from U.S. GAAP to IFRS. Our robustness tests confirm an overall decrease in accounting quality when German firms switched from U.S. GAAP to IFRS. Most metrics show that there was little change in accounting quality for IFRS firms, suggesting that our results are driven by the switch from U.S. GAAP to IFRS. Further, any potential decline in the accounting quality of IFRS firms captured by our metrics is significantly less than the decline in accounting quality for firms that experienced the change from U.S. GAAP to IFRS. 12 Each of these tests relies on the previously described bootstrapping procedure to compare summary statistics. To calculate the change, we first match each observation from the pre-adoption period with the equivalent observation in the post-adoption. We then obtain a distribution of the change in the metric and test for significant differences between the two samples of firms. 21
23 7. IMPLICATIONS FOR U.S. Our findings suggest that a switch from U.S. GAAP to IFRS could lead to a decline in accounting quality. However, there are a number of reasons why adoption of IFRS by U.S. firms may have different consequences. First, the convergence projects between the IASB and FASB should continue to reduce the accounting differences between IFRS and U.S. GAAP, leading to similar quality between the two sets of standards. Second, these convergence efforts may lead to a reduction in the amount of managerial discretion allowed by IFRS. Since it is not certain when the U.S. will adopt IFRS, the passage of time may allow for further changes to be made to converge the two sets of standards and reduce accounting quality differences. Third, it is unlikely that the reporting incentives of U.S. managers will change following adoption of IFRS. As argued by Hail et al. (2010), managers of U.S. firms should still strive to provide accounting information that is of a high enough quality to be useful to users of financial information in U.S. capital markets. Finally, it is possible that in the absence of further improvements to IFRS, the SEC may take some regulatory action to circumvent a potential decline in the accounting quality of U.S. firms. 8. CONCLUSION A few studies have provided mixed evidence on the relative quality between IFRS and U.S. GAAP. This study contributes to the literature by examining the change in accounting quality following a switch from U.S. GAAP to IFRS for a sample of German high-tech firms that applied U.S. GAAP and were required to switch to IFRS in We find that accounting numbers under IFRS generally exhibit more earnings management, less timely loss recognition, and less value relevance after controlling for firmspecific and time varying factors. We also find that for the three metrics suggesting a decline in 22
24 accounting quality for both switching and non-switching firms, the change is significantly more pronounced for firms switching to IFRS from U.S. GAAP. Overall, our findings indicate a switch from U.S. GAAP to IFRS could reduce accounting quality. Although our findings may contribute to the debates surrounding the possible consequences of a switch from U.S. GAAP to IFRS, this study does not attempt to infer potential financial reporting consequences of a switch to IFRS by U.S. firms. 23
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