Value relevance of discretionary accruals under environmental uncertainty: the incidence of IFRS and the country s legal regime

Transcription

1 Int. J. Accounting, Auding and Performance Evaluation, Vol. 11, No. 2, Value relevance of discretionary accruals under environmental uncertainty: the incidence of IFRS and the country s legal regime Denis Cormier*, Marie-Josée Ledoux and Guy Villeneuve ESG, UQAM, P.O. Box 8888, Down Town Station, Montreal, Qc, H3C3P8, Canada cormier.denis@uqam.ca Ledoux.marie_josee@uqam.ca villeneuve.guy@uqam.ca *Corresponding author Abstract: This paper studies whether IFRS adoption and the country s legal regime affect the value relevance of discretionary accruals under environmental uncertainty (measured by sales variabily). The sample includes France and UK domiciles, providing a code/common law legal regime partion. We show that IFRS improve the value relevance of discretionary accruals to a larger extent in France than in the UK. Under local GAAP, discretionary accruals are more valued in the UK than in France while no significant difference is observed under IFRS, suggesting a marginal effect of the country s legal regime. Under high uncertainty, results suggest that IFRS improve investors abily to distinguish between earnings managed opportunistically and earnings management that provides a credible signal about future cash flows. Overall, IFRS would allow stock market participants to better assess properties of earnings management while reducing stock pricing discrepancies between code law and common law regimes. Keywords: earnings management; environmental uncertainty; legal regime; IFRS. Reference to this paper should be made as follows: Cormier, D., Ledoux, M-J. and Villeneuve, G. (2015) Value relevance of discretionary accruals under environmental uncertainty: the incidence of IFRS and the country s legal regime, Int. J. Accounting, Auding and Performance Evaluation, Vol. 11, No. 2, pp Biographical notes: Denis Cormier is an Accounting Professor and Corporate Reporting Chair at ESG UQAM, Canada. He holds a Doctoral in Applied Economics from Universé de Mons, Belgium. His research focuses on the following areas: international accounting; corporate disclosure strategies; corporate governance; business ethics; and environmental accounting. His works have been published through various scientific and professional journals. He is the author of an auding textbook and an international accounting book, and co-author of a book on accounting theory. Copyright 2015 Inderscience Enterprises Ltd.

2 162 D. Cormier et al. Marie-Josée Ledoux is an Accounting Professor at ESG-UQAM, Canada. She holds a PhD in Accounting from Universy of Waterloo, Canada. Her research focuses on corporate disclosure strategies, corporate governance, and performance measurement. Her works have been presented at international forums and published through various scientific journals. Guy Villeneuve is an Accounting Professor at ESG-UQAM, Canada. He holds a PhD in Information Systems from Universé Laval, Canada. His works focus on international accounting and corporate finance. He is the co-author of a book on financial accounting and is involved in the development and teaching of executive MBA programmes. He is also involved in international cooperation organisations. This paper is a revised and expanded version of a paper entled Value relevance of discretionary accruals in France and the UK: the incidence of IFRS presented at the GREDEG Universé de Nice Sophia-Antipolis, France, July Introduction In this paper, focusing on a context of environmental uncertainty, we investigate the effect of International Financial Reporting Standards (IFRS) on the value relevance of discretionary accruals for two different legal systems: France and the UK. Over the years, the UK developed accounting standards focusing primarily on the needs of shareholders and investors while, in France, accounting rules have been largely influenced by taxation laws (before IFRS). Moreover, UK and France operate in two different legal systems, the first based on common law and the second on code law. The paper focuses on the effect of two factors affecting earnings management and s value relevance, i.e., the accounting system s effect (IFRS versus local GAAP) and the country s legal regime effect (common law versus code law), considering environmental uncertainty. The theory of the firm (e.g., Child, 1972; Williamson, 1975) recognises that environmental uncertainty places significant constraints on firms, affecting strategy and decision-making. However, managers do have opportunies to respond strategically to uncertainty. Earnings management is an illustration of these opportunies (Ghosh and Olsen, 2009). It is in a firm s interests to reduce the variabily of reported earnings and, consequently, information asymmetry between managers and investors (Gul et al., 2003; Ghosh and Olsen, 2009). Subramanyam (1996) supports the view that managers use their discretion to improve the abily of earnings to reflect fundamental value. In this case, earnings management may be beneficial because improves the value relevance of earnings by conveying (signalling) private information to investors. However, other studies suggest that misalignment of managers and shareholders incentives could induce CEOs to use the flexibily provided by accounting standards to manage earnings opportunistically (among others, see Healy and Palepu, 1993; Holthausen et al., 1995; DeAngelo, 1988; Teoh et al., 1998a, 1998b; Erickson and Wong, 1999; Jiraporn et al., 2008). In an uncertain environment characterised by sales or earnings variabily, is assumed that earnings management is more difficult to detect because of a lack of

3 Value relevance of discretionary accruals under environmental uncertainty 163 stabily in accounting figures, which could affect s information content for investors. In such a context, investors have difficulty to infer whether earnings management reflects corporate fundamental value or opportunistic behaviour. Accounting standards, including IFRS, provide a degree of flexibily that could give opportunistic discretion to managers in reporting earnings in an attempt to reduce the variabily in reported earnings via accrual management (e.g., Bannister and Newman, 1996). However, IFRS are considered more stringent and detailed than the domestic accounting standards they replace, which may allow stock market participants to better assess earnings qualy in an uncertain environment. La Porta et al. (1997, 1998) document that legal rules protecting investors vary systematically among legal tradions or origins, common law countries (originating in English law) being more protective of outside investors, and having less government ownership and regulation than civil law countries (originating in Roman law), and especially French civil law countries. Hence, we pos that a country s legal system may affect the level of earnings management and s value relevance for investors. Based on Feltham and Ohlson (1995), Amir and Lev (1996), and Collins et al. (1999), who model market value as a function of book value and earnings, the main findings are the following. First, we show that IFRS improve the value relevance of discretionary accruals to a larger extent in France than in the UK. Second, we document that IFRS affect the value relevance of discretionary accruals to a larger extent in a context of environmental uncertainty. More specifically, IFRS have a negative effect on the pricing of discretionary accruals in a context of high negative sales variabily and a posive effect on in a context of high posive sales variabily. Such findings suggest that IFRS allow stock market participants to distinguish between opportunistic earnings management and earnings management that provide a credible signal about future cash flows. Third, we show that IFRS reduce discrepancies in investors assessment of earning management between France and the UK. To the best of our knowledge, this paper is the first to study how IFRS affect the value relevance of earnings management both in an uncertain environment and in different legal systems. Our results suggest that IFRS provide to market participants relevant information that contributes to the detection and valuation of earnings management. After IFRS adoption, investors would be in a better posion to assess the properties of earnings management, even in a context of high environmental uncertainty. We also document that IFRS reduce pricing discrepancies between code law and common law regimes, suggesting that there would only be a marginal effect of the country s legal system under IFRS. This is consistent wh IFRS improving comparabily worldwide. In late 2007, the US Securies and Exchange Commission (SEC) unanimously voted to eliminate the requirement that foreign registrants listing in the US reconcile their IFRS financial statements to US GAAP. Our results offer some support for the SEC s decision on that regard. The remainder of this paper is organised as follows. Section 2 presents the theoretical background and the development of research hypotheses. The method is described in Section 3. Results are presented in Section 4. Finally, Section 5 provides a conclusion and discusses the potential implications of the study.

4 164 D. Cormier et al. 2 Background and research hypotheses 2.1 Value relevance of discretionary accruals under IFRS and the incidence of the country s legal regime There is some evidence that a shift from domestic GAAP to IFRS has a modest posive effect on the market liquidy and on the cost of equy capal. Such improvement results from a reduction in information asymmetry between managers and investors following the adoption of IFRS. This reduction in asymmetry is attributable to higher qualy financial reporting, higher analyst following and greater oversight by audors and directors from the use of a common reference in accounting (Daske et al., 2008; Bruggermann et al., 2009; Li, 2010). For example, in the UK, at the transion to IFRS, firms reporting IFRS earnings lower than earnings computed according to the UK GAAP were penalised by the stock market (Horton and Serafeim, 2010). In the Australian context, another country categorised by strong enforcement, using a longudinal study that covers pre-ifrs and post-ifrs periods during 1990 to 2008, Chalmers et al. s (2011) findings show an increase in the value relevance of earnings under IFRS. Their study suggests that even for a country categorised by strong investor protection and highqualy financial reporting and enforcement, IFRS adoption affects the associations between accounting information and stock market value. In the French context, Cormier et al. (2009) show that IFRS mandatory equy adjustments at the adoption date are more valued than equy under French GAAP, suggesting that the first-time adoption of IFRS by French firms is perceived as a signal of increase in the qualy of their financial statements. In the case of earnings reconciliation adjustment following IFRS adoption, Platikanova (2009) shows that the bid/ask spread has decreased in France, but, not in Germany, Sweden, and in the UK. Armstrong et al. (2010) study European stock market reactions to specific events associated wh the adoption of IFRS by 18 countries. Based on a three-day market-adjusted return centred on 16 events, they find an incrementally posive reaction for firms wh lower pre-adoption accounting disclosure qualy, and wh higher pre-adoption information asymmetry. This is consistent wh investors expecting net information qualy benefs from IFRS adoption. They also find an incrementally negative reaction for firms in code law countries, consistent wh investors concerns over enforcement of IFRS in those countries. Some studies examine accounting choices at the transion to IFRS. Essentially, these studies looked at determinants of optional choices at the IFRS adoption (Cazavan-Jeny and Jeanjean, 2007; Cormier et al., 2009). These optional choices are essentially determined by factors such as leverage, profabily, firm size, foreign listing, ownership, stock options, and industry membership. IFRS confer accounting discretion in financial reporting, especially wh the introduction of fair value accounting. Jeanjean and Stolowy (2008) analyse the effect of the mandatory introduction of IFRS standards on earnings management for three countries: Australia, France, and the UK. They find that the pervasiveness of earnings management did not decline after the introduction of IFRS, and, in fact, increased in France. Their findings suggest that management incentives and national instutional factors play an important role in framing financial reporting characteristics. Regarding the information impact of IFRS reconciliations for the UK firms, Christensen et al. (2009) argue that because the Brish capal market is well developed,

5 Value relevance of discretionary accruals under environmental uncertainty 165 regulated, and dominated by equy-based financing, and, because the disclosure qualy of the UK GAAP is arguably comparable to that of IFRS, is unlikely that translating the UK GAAP to IFRS earnings will in self convey information about future operating cash flows. However, because accounting information is used in debt covenants, technical changes to how earnings are calculated may affect the distribution of wealth between lenders and shareholders. As expected, the authors find that: 1 stock prices respond to IFRS reconciliation announcements 2 these market reactions are more pronounced among firms wh a greater likelihood, and higher costs, of covenant violation. Landsman et al. (2012) investigate whether the information content of earnings announcements increases after mandatory IFRS adoption, based on observations from 27 countries from 2000 to 2007 (16 countries adoption of IFRS and 11 countries remaining adoption of domestic accounting standards). Abnormal return volatily and abnormal trading volume are used as proxies for the information content of earnings announcements. The authors find that the information content increased in IFRS-adopting countries, but this happens only when they use abnormal return volatily (not abnormal trading volume) as a proxy for information content. Moreover, they find that increases in abnormal return volatily are concentrated in code law countries. Chen et al. (2010) compare the accounting qualy of publicly listed firms in 15 member states of the European Union before and after the full adoption of IFRS in They use five indicators as proxies for accounting qualy, namely, earnings smoothing, earnings management toward targets, the magnude of absolute discretionary accruals, accruals qualy, and timely loss recognion. Their results are mixed. They find that the majory of accounting qualy indicators improved after IFRS adoption in the European Union. However, they find that firms engage in more earnings smoothing and recognise large losses in a less timely manner in post-ifrs periods. Horton et al. (2013), for a European sample, and Tan et al. (2011), for an international sample, find an improvement in the information environment during the mandatory transion period to IFRS. More specifically, investors can be better at detecting earnings management as a result of a change in the information environment following IFRS adoption, i.e., more financial analysts following a firm and lower forecast errors. Prior findings in the UK suggest that IFRS adoption has increased the level of information available to investors but, at the same time, has created more uncertainty among financial analysts about earnings forecasts. In this vein, Iatridis (2010) shows that due to the fair value orientation of IFRS, the transion to IFRS appears to introduce volatily in Brish earnings figures. Moreover, we must keep in mind that earnings and their related components (normal and discretionary accruals) were already value relevant under the UK GAAP, much more than under French GAAP. Overall, based on prior findings, we expect IFRS to have a larger effect on the value relevance of earnings in France than in the UK. 1 It is interesting to note that firms that voluntarily adopt IFRS, ahead of the mandated year of the adoption, experience a stronger improvement in the liquidy of their stock and in their cost of capal than firms that only adopt IFRS at the required date. Therefore, is unlikely that mandatory adoption of IFRS alone drives the improvement in financial reporting. Other regulatory or instutional factors probably take precedence. Hence, in

6 166 D. Cormier et al. the case of the UK, the high level of market oversight regulation prior to IFRS adoption should restrain s impact on the information environment (Christensen et al., 2009). The UK is a common law country wh accounting standards focusing primarily on the needs of shareholders while France has a legal system based on civil law wh accounting rules largely influenced by taxation laws (before IFRS). Ding et al. (2007) analyse determinants and effects of differences between domestic accounting standards and IFRS, so-called missing standards. Their findings show that missing standards are mainly determined by the importance of the stock market and ownership concentration. The authors argue that a higher level of missing standards implies more opportunies for earnings management. In their results, France is ranked as having 21 missing standards while the UK is ranked as having zero missing standard. For the UK, most of the extra disclosures mandated by IFRS are in a narrative form (ICAS, 2008). Leuz et al. (2003) show that opportunies for earnings management are more a matter of investor protection and that earnings management is expected to decrease in countries wh high investor protection such as the UK since strong protection lims an insider s abily to acquire private control benefs through a masking of real performance. Hence, countries instutional factors such as the high level of market oversight regulation may explain market valuation differences. Prior research suggests that the benefs of IFRS adoption primarily accrue to countries wh strong enforcement, being a key component of success in the implementation of a new reporting regime (e.g., Byard et al., 2011). 2 In France, IFRS adoption closely followed the enactment of new corporate governance and market oversight regulations. The promulgation in 2001 of the Law on New Economic Regulations requires listed companies to disclose in their annual report information on employees, plans of downsizing and job protection, the organisation of working time, the length of full-time and part-time employees, absenteeism, compensation and development, payroll taxes, provisions of the Labour Code. Moreover, companies are increasingly required to report in their annual report on their social and environmental management. The legislator also intervened in 2003 wh the adoption of the Law on Financial Secury (LFS) creating L Autoré des Marchés Financiers (AMF), to ensure better corporate governance through new legal obligations: larger transparency in management compensation, strengthened powers to shareholders, and a greater involvement of employees in corporate management. Through the strengthening of internal control, the LFS s objective is to enhance financial reporting qualy and thus better meet the market demand for more corporate transparency. Byard et al. (2011), based on a European sample, find that analysts absolute forecast errors and forecast dispersion decrease relative to a control sample only for those mandatory IFRS adopters domiciled in countries wh both strong enforcement regimes and domestic accounting standards that differ significantly from IFRS. Given the evolution in the market regulation in France over the last few years enhancing oversight regulation, given that IFRS adoption primarily accrues to countries wh strong enforcement, and given the large differences of IFRS wh French GAAP, we can expect IFRS to affect the value relevance of discretionary accruals to a larger extent in France compared wh the UK. 3 This gives rise to the two following hypotheses: Hypothesis 1 IFRS affect the value relevance of discretionary accruals to a larger extent in France than in the UK (IFRS effect).

7 Value relevance of discretionary accruals under environmental uncertainty 167 Hypothesis 2 The country s legal regime affects the value relevance of discretionary accruals (country s effect). 2.2 Value relevance of discretionary accruals under high uncertainty: the effect of IFRS and the country s legal regime Pfeffer and Salancik (1978) define environmental uncertainty as the degree to which future events and states cannot be anticipated or predicted. Environmental uncertainty is likely to lead to earnings management. Ghosh and Olsen (2009) show that managers use discretionary accruals to reduce the variabily in reported earnings for firms wh high sales volatily. Moreover, the market assessment of earnings management is likely to be influenced by environmental uncertainty. In our view, in a suation of high sales volatily, is more difficult for investors to assess earnings qualy. In an uncertain environment characterised by sales or earnings variabily, earnings management is assumed more difficult to detect because of a lack of stabily in accounting figures. Sales variabily is likely to affect reported earnings and, therefore, may induce CEOs to opportunistically manage earnings for several reasons. Healy (1985) and Holthausen et al. (1995) find evidence that executives manage earnings downwards when their bonuses are at their maximum. Incentives to manipulate earnings also exist when managers are faced wh a possibily of losing their jobs especially in a context of poor performance (e.g., Dechow and Sloan, 1991; Murphy and Zimmerman, 1993; Pourciau, 1993). In addion, DeAngelo (1988) reports that, during a proxy contest, incumbent managers use their accounting discretion to show a favourable picture of their own performance. Firms may also manage earnings to meet capal market expectations. In that regard, Teoh et al. (1998a) report that earnings increasing discretionary accruals can be identified prior to inial public offerings. Similar evidence is also found in seasoned equy offerings (Teoh et al., 1998b). In this vein, Degeorge et al. (1999) find clear support for earnings management to exceed each of the three thresholds, i.e., posive profs, sustain-recent-performance, and meet-market-expectations. Finally, in the context of mergers and acquisions, Erickson and Wong (1999) report that, in quarters surrounding the merger, acquiring firms manage earnings upward in an attempt to increase their stock prices. Misalignment of managers and shareholders incentives inducing opportunistic earnings management is likely to be an issue in a context of sales decreasing. In a context of sales increasing, earnings management, especially earnings increasing accruals may signal future prospects to investors. Concerning beneficial earnings management, Louis (2003) examines the signalling function of discretionary accruals around stock spls. He finds evidence suggesting that managers use accruals in conjunction wh stock spls to signal favourable performance. Louis s (2003) findings based on abnormal returns around stock spls also imply that the signal offered by discretionary accruals is deemed credible for investors. We argue that the market assessment of earnings management under environmental uncertainty is likely to differ between domestic GAAP and IFRS. Accounting standards, including IFRS, provide a degree of flexibily that gives opportunistic discretion to managers in reporting earnings in an attempt to reduce the variabily in reported earnings via accrual management (e.g., Bannister and Newman, 1996). However, IFRS are

8 168 D. Cormier et al. considered more stringent and detailed than the domestic accounting standards they replace, allowing stock market participants to assess earnings qualy in an uncertain context. Burgstahler et al. (2006) find that both public and private firms exhib more earnings management in countries wh weak legal enforcement. Out of 13 countries, they show that the lowest earnings management score is in the UK while France is ranked at the fifth highest score. In the same vein, in a comparative study Canada/USA, Tinaikar (2009) finds that firm-level governance mechanisms such as outside directors and country-level ligation environment act as governance substutes in determining unbiased forecasts. Over the years, the UK developed accounting standards focusing primarily on the needs of shareholders and investors while, in France, accounting rules have been largely influenced by taxation laws. These differences in France and the UK legal systems may affect the level of earnings management and s value relevance for investors, especially in an uncertain environment. Therefore, we expect the relationship between discretionary accruals and stock market value to be influenced by sales variabily. We also expect the relationship between discretionary accruals and stock market value in a suation of high sales variabily to be affected by accounting standards, i.e., domestic GAAP versus IFRS, and by the legal regime. Given the lack of prior evidence, we do not make any directional prediction as to how IFRS and the legal regime will affect the value relevance of earnings management in an uncertain context. Hence, the third and fourth research hypotheses: Hypothesis 3 IFRS affect the value relevance of discretionary accruals largely in a context of high sales variabily (IFRS effect under high uncertainty). Hypothesis 4 The country s legal regime affects the value relevance of discretionary accruals largely in a context of high sales variabily (country s effect under high uncertainty). 3 Method 3.1 Sample The sample is based on non-financial firms listed on the SBF250 (Société des Bourses Françaises) in France and FTSE 100 and FTSE250 (Financial Times Stock Exchange) in the UK from 1997 to This gives a starting sample of 2,604 observations (217 firms) for France and 2,796 observations (233 firms) for the UK. We exclude five firms (60 observations) that already comply wh IFRS or US GAAP before 2005 in France and three firms (36 observations) in the UK. This gives 212 firms for 2,544 observations for France and 214 firms for 2,568 observations for the UK. Since we use a lag variable for computing discretionary accruals, we lose one year of observations. Considering missing data and firms listed after 1997, this gives 2,387 firm-year observations for France and 2,527 for the UK. Owing to missing data in the Compustat database, the sample is reduced to 1,847 for the French sample and 2,040 for the Brish sample. Stock markets suffered from a major downturn in 2008 (44% for the French sample and 36% for the UK sample). We decided to exclude the year 2008 from regression analyses.

9 Value relevance of discretionary accruals under environmental uncertainty 169 This leaves us wh 1,657 firm-year observations for France, and 1,874 firm-year observations for the UK. Table 1 shows the details of the sample. 4 Table 1 Sample firm-year observations France UK Inial sample 2,604 2,796 Firms listed after Firms complying wh IFRS or US GAAP before Missing data lag cash flow for operations Other missing data Total sample 1,847 2,040 Year Final sample 1,657 1, Stock market valuation of discretionary accruals Building on the work of Feltham and Ohlson (1995), Amir and Lev (1996), and Collins et al. (1999), who model market value as a function of book value and earnings, we first test the impact of IFRS on stock market valuation of discretionary accruals in France and in the UK. Stock market value = β + β Equy + β Cash flow from operations β Normal accruals + β Discretionary accruals + β Discretionary accruals * IFRS + β IFRS + ε 5 6 (1) The second model tests the impact of IFRS on the stock market valuation of discretionary accruals in a context of high sales variabily, in France and in the UK. Stock market value = β + β Equy + β Cash flow from operations β Normal accruals + β Discretionary accruals + β Discretionary accruals * IFRS + β Discretionary accruals β 7 * High sales variabily Discretionary accruals * High sales variabily * IFRS + β High sales variabily + β High sales variabily * IFRS + β IFRS + ε (2) The third model tests the impact of the country s legal regime on the stock market valuation of discretionary accruals for periods pre versus post IFRS. Stock market value = β + β Equy + β Cash flow from operations β Normal accruals + β Discretionary accruals + β Discretionary accruals * UK + β UK + ε 5 6 (3) The fourth model tests the impact of the country s legal regime on stock market valuation of discretionary accruals, in a context of high sales variabily, for the periods pre versus post IFRS.

10 170 D. Cormier et al. Stock market value = β + β Equy + β Cash flow from operations β Normal accruals + β Discretionary accruals + β Discretionary accruals * UK + β Discretionary accruals 5 6 * High sales variabily + β Discretionary accruals* High sales variabily 7 * UK + β High sales variabily + β High sales variabily * UK + β UK + ε (4) Variables are deflated by the number of shares outstanding at year-end. Interaction terms serve to assess how environmental uncertainty, IFRS, and the country s legal regime affect the stock market valuation of discretionary accruals. Variables Sales variabily, IFRS and UK are binary variables Environmental uncertainty Dechow (1994) asserts that change in sales between two consecutive years is a good proxy for a firm s uncertainty. Hence, environmental uncertainty is proxied by a firm s yearly sales variabily. We measure sales variabily by the percentage change in sales from period t to period t 1. To migate industry effects, the firm-specific measure is normalised by subtracting the uncertainty measure for firms two-dig SIC codes for the same time period yielding the net of industry proxy for environmental uncertainty. We compute net of industry sales variabily that we use in absolute value (Abs sales variabily). It is argued that sales variabily at a firm level must take into consideration the uncertainty that faces the whole industry in which the firm operates (Ghosh and Olsen, 2009). The interaction term Discretionary accruals * High sales variabily is introduced. High sales variabily is a binary variable that takes the value of one if the absolute value of net of industry sales variabily is greater than or equal to the sample median Discretionary accruals The estimation of a discretionary accruals determination model requires the specification of potential sources of normal accruals. From the lerature, appears that three key variables are closely linked wh normal accruals: 1 underlying performance 2 level of depreciable fixed assets 3 current or lagged cash flow from operations (e.g., Dechow et al., 1995; Dechow and Dichev, 2002) or lagged accruals (Beneish, 1997; Defond and Park, 1997). First, a firm s underlying performance is expected to influence s level of normal accruals, wh good performance implying higher accruals than poor performance (e.g., receivables or inventories). A comprehensive measure of a firm s underlying performance is the year-to-year change in sales (e.g., Jones, 1991). Second, the variable property, plant and equipment (PPE) is included in order to control for systematic accruals resulting from depreciation, i.e., the normal part of depreciation (Jones, 1991). Third, lagged cash flow from operations (i.e., cash from prior period) is assumed to systematically determine current period normal accruals since changes in cash flow and in accruals are correlated over time (Dechow, 1994).

11 Value relevance of discretionary accruals under environmental uncertainty 171 We measure total accruals as the difference between net earnings and cash flow from operations. Hribar and Collins (2002) argue that the difference between net income and cash flow from operations is the correct measure of total accruals and that the use of a balance sheet approach may lead to a systematic bias in discretionary accruals estimation. They show that balance sheet accruals estimates are predictably biased in studies where the partioning event is correlated wh mergers and acquisions or discontinued operations. The authors demonstrate that tests of market mispricing of accruals will be under-stated due to erroneous classification of extreme accruals firms. 5 While a firm s total accruals are accessible from s financial statements, normal and discretionary accruals are not directly observable and must be inferred through an estimation model. Normal accruals reflect a firm s economic environment, or s underlying level of activy, independent of managerial incentives. The estimation of normal accruals is cross-sectional based on industry-specific observations (nine industries for 12 years, from 1997 to 2008). The industry model removes variation in the normal accruals that is common across firms in the same industry (Dechow et al., 1995). 6 For a given industry, total normal accruals are modelled in the following manner: Total accruals = α Change in sales + α Operating cash flow + α PPE + ε Observations vary considerably among industries: from 60 for utilies to 560 for consumer discretionary in France, and from 39 for telecom to 763 for industrials in the UK. Results are not affected when we estimate normal accruals whout telecommunications and utilies for which there are fewer observations. 4 Results 4.1 Descriptive statistics From Tables 2(a) and 2(b), we observe that sales variabily remains que similar prior and post IFRS adoption wh a mean score of 0.18 (median 0.10) prior IFRS and 0.17 (median 0.09) post IFRS in France and a mean score of 0.14 (median 0.09) prior IFRS and 0.14 (median 0.10) post IFRS in the UK. Moreover, there is no difference in sales variabily prior/post IFRS both in France and the UK when we spl among low and high sales variabily. Tables 3(a) and 3(b) present earnings components in domestic GAAP and according to IFRS. We observe much more discretionary accruals under IFRS compared wh French GAAP (median of 0.23 per share for IFRS versus 0.06 per share for French GAAP). However, a shift from UK GAAP to IFRS does not generate a large difference in discretionary accruals levels (median of 0.02 per share under IFRS versus 0.02 per share for UK GAAP). Que similar results are reached when we scale discretionary accruals by lag assets. Moreover, these results hold in a context of high uncertainty (Abs sales variabily net of industry median) and for both posive and negative sales variabily relative to firms industry. 7

12 172 D. Cormier et al. Table 2(a) Descriptive statistics sales variabily (France) Panel A Total sample (N: 1,657) Min. Max. Mean Median Std. dev. French GAAP (N:1,104) Abs sales variabily IFRS (N:553) Abs sales variabily Panel B Abs sales variabily < median (low sales variabily) French GAAP Abs sales variabily IFRS Abs sales variabily Panel C Abs sales variabily median (high sales variabily) French GAAP Abs sales variabily IFRS Abs sales variabily Table 2(b) Descriptive statistics sales variabily (the UK) Panel A Total sample (N: 1,848) Min. Max. Mean Median Std. dev. UK GAAP (N: 1,248) Abs sales variabily IFRS (N: 600) Abs sales variabily Panel B Abs sales variabily < median (low sales variabily) UK GAAP Sales variabily IFRS Sales variabily Panel C Abs sales variabily median (high sales variabily) UK GAAP Sales variabily IFRS Sales variabily

13 Value relevance of discretionary accruals under environmental uncertainty 173 Table 3(a) Descriptive statistics earnings components and sales variabily (France) In per share Panel A Total sample (N: 1,657) Min Max Mean Median French GAAP (N: 1,104) Std dev. Scaled by lag assets Median Cash flow from operations Normal accruals Discretionary accruals IFRS (N: 553) Cash flow from operations Normal accruals Discretionary accruals Panel B Abs sales variabily < median (low sales variabily) French GAAP Discretionary accruals (sales variabily < 0) Discretionary accruals (Sales variabily 0) IFRS Discretionary accruals (sales variabily < 0) Discretionary accruals (Sales variabily 0) Panel C Abs sales variabily median (high sales variabily) French GAAP Discretionary accruals (sales variabily < 0) Discretionary accruals (Sales variabily 0) IFRS Discretionary accruals (sales variabily < 0) Discretionary accruals (Sales variabily 0)

14 174 D. Cormier et al. Table 3(b) Descriptive statistics earnings components and sales variabily (the UK) In per share Panel A Total sample (N: 1,848) Min. Max. Mean Median UK GAAP (N: 1,248) Std dev. Scaled by lag assets Median Cash flow from operations Normal accruals Discretionary accruals IFRS (N: 600) Cash flow from operations Normal accruals Discretionary accruals Panel B Abs sales variabily < median (low sales variabily) UK GAAP Discretionary accruals (sales variabily < 0) Discretionary accruals (Sales variabily 0) IFRS Discretionary accruals (Sales variabily < 0) Discretionary accruals (Sales variabily 0) Panel C Abs sales variabily median (high sales variabily) UK GAAP Discretionary accruals (sales variabily < 0) Discretionary accruals (Sales variabily 0) IFRS Discretionary accruals (sales variabily < 0) Discretionary accruals (Sales variabily 0) 4.2 Multivariate results We use the Hausman specification test to decide on the use of a random or fixed effects model. We obtain a Chi2 statistic of (p < 0.174), for the French sample and a Chi2 statistic of (p < 0.121), for the UK sample. This suggests that the random effects

15 Value relevance of discretionary accruals under environmental uncertainty 175 model is the most appropriate. We estimate regressions using random effect feasible GLS (GLS regression wh correlated disturbance). This technique allows estimation in the presence of autocorrelation whin panels and cross-sectional correlation and/or heteroscedasticy across panels. The test of Breusch-Pagan/Cook-Weisberg shows the presence of heteroscedasticy (Chi2: 11,823.9; p < for the French sample, and Chi2: 2,020.5; p < for the UK sample). Hence, the error structure among panels is presumed to be heteroscedastic. In addion, we exclude from regressions all observations wh standardised residuals exceeding two Valuation of discretionary accruals: the effect of IFRS Results from the generalised least squares (GLS) cross-sectional regression on the stock market valuation of earnings components in France are reported in Table 4(a) (Model 1). We observe more discretionary accruals under IFRS than under French GAAP [referring to Table 3(a)] and accruals are more valued since the coefficient on the interaction term Discretionary accruals * IFRS is posive (1.14; p < 0.01). In the UK, results presented in Table 4(b) (Model 1) show that discretionary accruals are not valued differently according to UK GAAP and IFRS since the coefficient on the interaction term Discretionary accruals*ifrs is not significant at a conventional level. As a sensivy analysis, we run a separate regression on the combined sample France/UK adding interaction terms to assess differences among countries on the relation between discretionary accruals and the stock market valuation. The model is the following: Stock market value = β0 + β1 Equy + β2 Cash flow from operations + β3 Normal accruals + β4 Discretionary accruals + β5 Discretionary accruals * IFRS + β6 Discretionary accruals * UK + β7 Discretionary accruals * UK * IFRS + β IFRS + β UK + β UK * IFRS + ε Results (untabulated) confirm those presented in Tables 4(a) and 4(b), based on separate country regressions. The coefficient on the interaction term Discretionary accruals * IFRS is posive and significant (1.13; p < 0.014) while the coefficient on the interaction term Discretionary accruals * UK * IFRS ( 1.66; p < 0.033) is negative and significant, which cancels the impact of IFRS in the UK. Moreover, the test for coefficient difference suggests that both coefficients are statistically equals (F = 0.70; p < 0.403). These results are consistent wh Hypothesis 1, i.e., IFRS affect the value relevance of discretionary accruals largely in France than in the UK. Kothari et al. (2005) suggest that the Jones model adding profabily yields erratic performance improvements. As a sensivy analysis, total normal accruals are modelled in the following manner (scaled by the number of shares outstanding): Total accruals = α + α Change in Sales + α PPE + α Lag Earnings Results (not reported) provide que similar results. For France, coefficients on Discretionary accruals (2.37 versus 2.75) and on the interaction term Discretionary accruals*ifrs (1.09 versus 1.14) are que similar. Moreover, we still observe higher earnings increasing discretionary accruals under IFRS wh que similar means of discretionary accruals for both models (0.23 per share for Kothari et al. s (2005) model

16 176 D. Cormier et al. versus 0.24 per share). This similary is also observed under French GAAP ( 0.17 per share versus 0.16 per share). As for the UK, the coefficient on Discretionary accruals is slightly lower wh Kothari et al. s (2005) model (1.40 versus 1.82). Moreover, we still observe similar levels of discretionary accruals under IFRS (0.05 per share for Kothari et al. s model versus 0.06 per share) and a slight difference under UK GAAP ( 0.02 per share Kothari et al. versus 0.03 per share). Table 4(a) GLS Cross-sectional regressions on the stock market valuation of discretionary accruals and sales variabily (effect of IFRS in France) Stock market value = β 0 + β 1 Equy + β 2 Cash flow from operations + β 3 Normal accruals + β 4 Discretionary accruals + β 5 Discretionary accruals * IFRS + β 6 Discretionary accruals * High sales variabily + β 7 Discretionary accruals * High sales variabily * IFRS + β 8 High sales variabily + β 9 High sales variabily * IFRS + β 10 IFRS + ε Model 1 Model 2 Total sample Sales variabily < 0 Sales variabily 0 Equy + ***0.90 ***0.92 ***0.97 Cash flow from operations + ***2.65 ***1.95 ***3.50 Normal accruals + ***2.41 ***1.69 ***3.71 Discretionary accruals + ***2.75 ***1.56 ***4.95 Discretionary accruals*ifrs +/ ***1.14 *** Discretionary accruals*high +/ 0.78 ***-2.22 sales variabily Discretionary accruals*high +/ ** 2.20 ***3.02 sales variabily*ifrs High sales variabily +/ * 1.02 ***3.74 High sales variabily*ifrs +/ * IFRS +/ ***6.35 ***6.50 ***4.23 N 1, Wald test 3,595 (0.00) 6,161 (0.00) 2,279 (0.00) 23 outliers 13 outliers 17 outliers Test of coefficient difference β 5 + β 7 = (0.934) β 5 β 7 = (0.068) Notes: *: p < 0.10; **: p < 0.05; ***: p < One-tailed if directional prediction, twotailed otherwise.

17 Value relevance of discretionary accruals under environmental uncertainty 177 Table 4(b) GLS cross-sectional regressions on the stock market valuation of discretionary accruals and sales variabily (effect of IFRS in the UK) Stock market value = β 0 + β 1 Equy + β 2 Cash flow from operations + β 3 Normal accruals + β 4 Discretionary accruals + β 5 Discretionary accruals * IFRS + β 6 Discretionary accruals * High sales variabily + β 7 Discretionary accruals * High sales variabily * IFRS + β 8 High sales variabily + β 9 High sales variabily * IFRS + β 10 IFRS + ε Model 1 Model 2 Total sample Sales variabily < 0 Sales variabily 0 Equy + ***0.62 ***0.81 ***0.28 Cash flow from operations + ***4.96 ***5.37 ***6.47 Normal accruals + ***1.53 ***5.21 **1.10 Discretionary accruals + ***1.82 ***5.76 *0.77 Discretionary accruals*ifrs +/ 0.45 **2.31 ***3.25 Discretionary accruals*high +/ sales variabily Discretionary accruals*high +/ ***-5.03 *** 3.06 sales variabily*ifrs High sales variabily +/ High sales variabily*ifrs +/ *** IFRS +/ ***0.89 ***0.99 ***1.02 N 1, Wald test 6,770 (0.00) 2,504 (0.00) 5,934 (0.00) 77 outliers 0 outlier 10 outliers Test of coefficient difference β 5 + β 7 = (0.093) 0.90 (0.344) Notes *: p < 0.10; **: p < 0.05; ***: p < One-tailed if directional prediction, two-tailed otherwise Valuation of discretionary accruals under high uncertainty: the impact of IFRS France Table 4(a) (Model 2) presents results for the French sample, relying on GLS cross-sectional regressions on the stock market valuation of earnings components, considering sales variabily. Earnings management in a context of sales decreasing is likely to be opportunistic, while earnings management in a context of sales increasing may signal future cash flows to investors. Based on that argument, we spl the sample between negative and posive sales variabily.

18 178 D. Cormier et al. Results show that IFRS have a negative effect on the valuation of discretionary accruals in a context of high negative sales variabily in France since the coefficient on Discretionary accruals * High sales variabily * IFRS is negative ( 2.20; p < 0.05). This is consistent wh Hypothesis 3 and suggests that, under environmental uncertainty, investors would be in a better posion to detect opportunistic earnings management under IFRS than under French GAAP. 8 Results in a context of high posive sales variabily are also consistent wh Hypothesis 3 since the coefficient on Discretionary accruals * High sales variabily * IFRS is posive (3.02; p < 0.01). Under environmental uncertainty, earnings management would be more informative about future cash flows under IFRS than under French GAAP. Overall, results suggest that, under environmental uncertainty, IFRS provide to market participants relevant information that contributes to the detection and valuation of earnings management. 9 If upward earnings management during negative (posive) economic uncertainty does reflect opportunism (private information), then future performance should decrease (improve). For the French sample, we observe (results not tabulated) that future performance as proxied by change in CFO per share or change in EPS from year t to year t + 1 decreases (increases) for firms that managed their earnings upward in a context of sales decreasing (increasing). The average reduction (increase) in CFO per share is 0.62 (0.05 ) while the reduction (increase) in EPS is 0.47 (0.29 ). These results are consistent wh the view that discretionary accruals, reflecting private information, is associated wh posive future performance while discretionary accruals, displaying managerial opportunism, leads to negative future performance. The UK Table 4(b) (Model 2) reports results for the Brish sample, relying on GLS crosssectional regressions on the stock market valuation of earnings components, taking into account sales variabily. Results show that IFRS have a negative effect on the valuation of discretionary accruals in a context of high negative sales variabily since the coefficient on Discretionary accruals * High sales variabily * IFRS is negative ( 5.03; p < 0.01). This finding supports Hypothesis 3 and is consistent wh the view that Brish investors are in a better posion to detect opportunistic earnings management under IFRS. 10 In a context of high posive sales variabily, the coefficient on Discretionary accruals * High sales variabily*ifrs is negative (3.06; p < 0.01), which does not support Hypothesis 3. However, the Fisher test for the difference between the coefficients Discretionary accruals * IFRS (3.25) and Discretionary accruals * High sales variabily * IFRS ( 3.06) is not different from zero (F = 0.90; p < 0.344), suggesting that UK GAAP and IFRS do not differ in the valuation of discretionary accruals under high posive sales variabily. 11 For the UK sample, as for the French sample, we observe (results not tabulated) that future performance (change in CFO per share or change in EPS from year t to year t + 1) decreases (increases) for firms that managed their earnings upward in a context of sales decreasing (increasing). The average reduction (increase) in CFO per share is 0.32 (0.17 ) while the reduction (increase) in EPS is 0.06 (0.29 ). Discretionary accruals that reflects private information appears to be associated wh posive future performance while negative future performance is observed for managerial opportunistic discretionary accruals.

19 Value relevance of discretionary accruals under environmental uncertainty 179 In summary, under IFRS, the French market reacts negatively (posively) to high negative (posive) sales variabily. Our results suggest that IFRS play an important role in the market assessment of earnings qualy in France especially in a context of high sales variabily, no matter the sense of the variabily. In the UK, discretionary accruals are less valued for high negative sales variabily firms under IFRS while under high posive sales variabily, UK GAAP and IFRS do not differ in the stock market valuation of discretionary accruals. The impact of IFRS on the stock market valuation of accruals in a context of environmental uncertainty is notable considering that earnings management reflecting private information (managerial opportunism) appears to be associated wh posive (negative) future performance. Compared wh local GAAP, IFRS would allow stock markets to better assess the impact of earnings management on future performance, i.e., would allow for a better anticipation of future cash flows and earnings Valuation of discretionary accruals: the impact of the country s legal regime Relying on GLS cross-sectional regressions, Table 5 (Model 3) reports results on the impact of the country s legal regime on the stock market valuation of discretionary accruals for periods pre (Panel A) versus post IFRS (Panel B). The interaction term Discretionary accruals*uk allows to test differences between France and the UK in the stock market valuation of discretionary accruals. Results reported in Panel A suggest that under local GAAP (pre IFRS), discretionary accruals are more valued in the UK than in France since the coefficient on Discretionary accruals * UK is posive (0.84; p < 0.05). This is consistent wh prior evidence suggesting that the value relevance of earnings under French GAAP is que low compared wh Anglo-Saxon countries. Hence, Cormier et al. (2001) show that association between earnings and explain stock returns is much lower for French firms compared wh US firms or even Swiss firms (R 2 of 3.3% for France, 4.3% for Swzerland and 28.2% for the Uned States). However, under IFRS (Panel B), the stock market valuation of discretionary accruals does not statistically differ in France and the UK since the coefficient on Discretionary accruals * UK is not statistically significant at a conventional level. This only provides partial support to Hypothesis 2. Although there were differences in the valuation of earnings management between France and the UK under local GAAP, these differences fade away under IFRS. These results suggest that IFRS would reduce stock pricing discrepancies between code law and common law regimes. They also suggest that, under IFRS, the country s legal regime would have a marginal effect on the market valuation of discretionary accruals. Table 5 (Model 4) reports the stock market valuation of discretionary accruals, considering sales variabily, for pre (Panel A) versus post (Panel B) IFRS period. For both periods, results show that the country s legal regime affects the value relevance of discretionary accruals to a larger extent in a context of high negative sales variabily since coefficients on Discretionary accruals * High sales variabily * UK are negative ( 2.11; p < 0.05 for pre IFRS period and 2.87; p < 0.01 for post IFRS period). Under environmental uncertainty, investors would be in a better posion to detect opportunistic earnings management in the UK than in France, irrespective of the accounting rules

20 180 D. Cormier et al. taking place. These results are consistent wh the view that common law regimes are more capal market oriented that code law regimes. The country s legal regime also affects the value relevance of discretionary accruals largely in a context of high posive sales variabily, but only under local GAAP. While the coefficient on Discretionary accruals * High sales variabily * UK is posive (8.05; p < 0.01) in pre IFRS period (Panel A), is not significant in post IFRS period (Panel B). In other words, discretionary accruals are more valued in the UK than in France under local GAAP but there is no difference between the two countries in the valuation of discretionary accruals in a context of high posive sales variabily under IFRS. This is not consistent wh Hypothesis 4. Overall, these results suggest that, to some extent, IFRS reduces discrepancies in market valuation of earnings management between code law and common law regimes. Table 5 GLS cross-sectional regressions on the stock market valuation of discretionary accruals (France and the UK combined country s effect) Stock market value = β 0 + β 1 Equy + β 2 Cash flow from operations + β 3 Normal accruals + β 4 Discretionary accruals + β 5 Discretionary accruals * UK + β 6 Discretionary accruals * High sales variabily + β 7 Discretionary accruals * High sales variabily * UK + β 8 High sales variabily + β 9 High sales variabily * UK + β 10 UK + ε Panel A Model 3 Model 4 Total sample Pre IFRS Sales variabily < 0 Sales variabily 0 Equy + ***0.74 ***0.80 ***0.91 Cash flow from operations + ***2.27 ***1.88 ***2.99 Normal accruals + ***1.35 ***1.10 ***2.58 Discretionary accruals + ***2.23 ***2.48 ***4.89 Discretionary accruals*uk +/ **0.84 ***1.74 ***-4.73 Discretionary accruals*high sales +/ 0.26 *** 3.38 variabily Discretionary accruals*high sales +/ ** 2.11 ***8.05 variabily*uk High sales variabily +/ 0.04 ***4.78 High sales variabily*uk +/ 0.42 *** 5.22 UK +/ *** 8.34 *** 7.32 *** 4.42 N 2,308 1,208 1,048 Wald test 1,108 (0.00) 2,268 (0.00) 1,875 (0.00) 44 outliers 47 outliers 49 outliers Test of coefficient difference β 4 β 5 = (0.042) Notes: *: p < 0.10; **: p < 0.05; ***: p < 0.01.One-tailed if directional prediction, twotailed otherwise.