earnings quality under rules- vs. principles-based accounting standards- a test of the skinner...
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Earnings Quality under Rules- vs. Principles-Based
Accounting Standards: A Test of the Skinner Hypothesis§
Erin Webster [email protected]
Phone: (613) 533-6000 x 75461
Daniel B. Thornton [email protected] Phone: (613) 533-6194
Queen’s University School of Business
Kingston, Canada K7L 3N6
June 2004 §The authors gratefully acknowledge financial support from the Social Sciences and Humanities Research Council of Canada (Grant No. 410-03-1046) and the Canadian Accounting Standards Board. They also appreciate receiving constructive suggestions and comments on previous versions of the paper from Duncan Green, Peter Martin, Katherine Schipper, Michael Welker, and participants at the 2004 CAAA Conference. Thanks for technical advice go to Richard Caruana, Carol Kavanaugh, Juergen Dingel, Jon Wittmer, and Anna Harhay.
Earnings Quality under Rules- vs. Principles-Based
Accounting Standards: A Test of the Skinner Hypothesis
Abstract
We provide preliminary confirmation of Skinner’s (1995) hypothesis that Canada’s relatively principles-based GAAP yield higher accrual quality than the US’s relatively rules-based GAAP. These results stem from a comparison of the Dechow-Dichev (2002) measure of accrual quality for cross-listed Canadian firms reporting under both Canadian and US GAAP. However, we document lower accrual quality for Canadian firms reporting under US GAAP than for US firms, which are subject to stronger US oversight and greater litigation risk, reporting under US GAAP. The latter results are consistent with stronger US oversight compensating for inferior accrual quality associated with rules-based GAAP. Consistent with the positive effect of Canada’s principles-based GAAP and the offsetting negative effect of Canada’s weaker oversight, we find no overall difference in accrual quality between Canadian firms reporting under Canadian GAAP and US firms reporting under US GAAP. Consistent with Skinner’s writings, the results imply that it fallacious to attribute perceived deficiencies in Canadian financial reporting to the leeway allowed by principles-based GAAP without allowing for Canada’s oversight, which is relatively weak due largely to the absence of a national securities regulator. If anything, over our 1990-2002 sample period, principles-based standards and the consequent role of professional judgment enhance the quality Canadian firms’ financial reporting.
Keywords: accounting standards; earnings quality; accrual quality; principles-based GAAP; rules-based GAAP. Data availability: The data used in this study are publicly available from the sources indicated. A list of sample firms is available from the authors.
I. INTRODUCTION
We hypothesize and find that accrual quality, defined as the precision of firms’
working capital accruals mapping into past and future cash flows (Dechow and Dichev,
2002) depends jointly on a jurisdiction’s generally accepted accounting principles (a
GAAP effect) and its regulatory/legal environment (an oversight effect). To test these
hypotheses, we examine the accrual quality of firms in two jurisdictions, Canada and the
United States, which differ along both dimensions.
In our test of the GAAP effect, we confirm the “Skinner hypothesis” (Skinner,
1995) that Canada’s relatively principles-based GAAP yield higher accrual quality than
the United States’ relatively rules-based GAAP by examining accrual quality for a
sample of Canadian firms cross-listed in the US. Cross-listed firms report under both
Canadian and US GAAP (Bandyopadhyay et al., 1994, 2002). Hence, we can measure
accrual quality under both GAAP for the same firms, holding the oversight effect
constant. We then compare the accrual quality of what we call “CC firms” (Canadian
firms reporting under Canadian GAAP) with that of “CU firms” (the same Canadian
firms reporting under US GAAP). We hypothesize and find that CC firms have higher
accrual quality than CU firms.
In our test of the oversight effect, we confirm the hypothesis that the US’s
stronger oversight is associated with higher accrual quality than Canada’s weaker
oversight. To test this hypothesis, we attempt to hold the GAAP effect constant by
comparing the accrual quality of a sample of CU firms (Canadian firms reporting under
US GAAP but subject to Canadian oversight) with that of an industry/size-matched
sample of what we call “UU firms” (US firms reporting under US GAAP and subject to
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US oversight). We hypothesize and find that CU firms have lower accrual quality than
UU firms.
We also compare the accrual quality of larger samples of CC firms with that of
industry/size-matched samples of UU firms. Since the GAAP effect and the oversight
effect offset each other, we state and fail to reject the null hypothesis that there are no
significant differences in accrual quality across any of these samples. These findings
confirm our overall hypothesis that accrual quality depends jointly on the GAAP effect
and the oversight effect and suggest that US oversight compensates for any shortcomings
in US GAAP with respect to accrual quality. They also support the assertions that (a)
policy makers who wish to compare the effectiveness of oversight across jurisdictions
must control for the GAAP effect; and (b) accounting standard setters who wish to
compare the effectiveness of principles- vs. rules-based GAAP must control for
oversight.
The article continues as follows. The next section reviews prior research
motivating the study and underscores its contributions to the literature. Remaining
sections develop the hypotheses, describe the research design, outline sample selection,
and present empirical results. We conclude with a summary of the findings and
suggestions for future research.
II. LITERATURE REVIEW AND MOTIVATION FOR THE STUDY
Skinner (1995) takes issue with a newspaper allegation that principles-based
accounting standards provide Canadian accountants with undue leeway, resulting in
misleading financial reporting:
The complaint, then, is that those responsible for financial reporting are playing games with the rules or they are not applying proper judgment
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when there is room for judgment. The solution proposed by The Financial Post is to take away that room. But is there really a problem? Is it as simple as biased judgment? And if it is, will the proposed solution work? Hard evidence is lacking to answer these questions… (Skinner, 1995: 14)
Our aim is to provide such evidence by comparing the accrual quality of Canadian
companies reporting under a relatively principles-based accounting regime with that of
US companies reporting under a more rules-based accounting regime. We focus on
observations prior to the Enron debacle of 2002 for two reasons. First, the theory of
accrual quality we rely on requires consistent time series data and there are reasons to
believe that the financial reporting environments changed radically in both countries after
Enron. Second, the pre-Enron environment is the one Skinner contemplated, so the data
in that period are appropriate for testing the Skinner hypothesis.
The Skinner Hypothesis
Skinner (1995), like Brown et al. (1993), motivates our study by arguing that
financial reporting benefits from well-trained, ethical accountants applying sound
professional judgment under principles-based GAAP:
The proposition that standards should be written to cover every possible reporting issue or combination of issues stems from a belief that professional judgment on presentation is not now being exercised fairly. But any such multiplication of rules will fail — first, because it is not feasible to write rules covering every possible issue, and second, because the greater the number of detailed rules (downgrading the overall goal of fair presentation), the greater will be the ability of those so minded to dance among the rules drawing support for biased reporting conclusions (Skinner, 1995: 21).
Further motivation for the study comes from the US Sarbanes-Oxley Act of 2002, which
requires an investigation the pros and cons of a principles-based accounting system. In
response, FASB (2002) issued a document outlining the features of a principles-based
approach to standard setting. More recently, the SEC (2003) released a staff study
advocating principles-based standards that are “objective-oriented” and avoid scope
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exceptions, bright-line but arbitrary distinctions, and excessive detail. Neither of those
studies, however, provides any empirical evidence in favor of one system or the other or
even considers how policy makers could glean such evidence.
We argue below that the existing literature supports Skinner’s proposition that, all
else being equal, sound professional judgment exercised in the context of principles-
based GAAP enhances financial reporting quality. To date, however, three factors have
clouded the issues surrounding principles- vs. rules-based GAAP and precluded empirical
testing. First, critics of Canada’s principles-based GAAP almost invariably cite isolated,
extreme examples of misleading financial reporting in Canada while ignoring similar US
reporting failures (Standing Senate Committee, 2003, especially the testimony of L.S.
Rosen). Thus, which country has higher reporting quality on average is an open issue.
Second, only recently has an accepted empirical measure of accrual quality, an aspect of
financial reporting quality, appeared in the academic literature (Dechow and Dichev,
2002). Finally, as far as we know, ours is the first study to employ a research design that
not only uses this new measure but also controls for institutional features other than
GAAP that are likely to spawn differences in accrual quality across jurisdictions. Without
controlling for non-GAAP factors, one cannot test the Skinner hypothesis.
In our test of the Skinner hypothesis, we perfectly control for non-GAAP factors,
which compose the oversight effect, by comparing the accrual quality of CC vs. CU
firms. To test the impact of oversight strength on accrual quality, we imperfectly control
for the GAAP factor by using a quasi-experimental research design: We compare the
accrual quality of CU firms with an industry/size-matched sample of UU firms.
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Prior literature
Several definitions of earnings quality appear in extant literature: high quality
earnings are persistent, accurately represent underlying economic transactions and events,
or map precisely into future cash flows (McNichols, 2002; Francis et al., 2004). The
Dechow-Dichev (2002, henceforth “DD”) model of accrual quality measures the extent to
which accruals map into cash flow realizations. Lower estimation error implies higher
accrual quality. DD derive the following expression for accruals at time t:
111
111 )( −
++−+
− −+++−= tt
tt
tt
tt
tt
ttt CFCFCFCFA εε (1)
where:
At = current accruals recognized in period t.
CFts = cash from operations realized in period t, recognized in earnings in period s.
εts = estimation error associated with accruals recognized in period s and cash flows
realized in period t.
Their empirical version of this equation is:
∆WCt = b0 + b1 × CFOt-1 + b2 × CFOt + b3 × CFOt+1 + εt (2)
The DD measure of accruals is changes in working capital (∆WC); the proxy for cash
flows related to accruals is cash flow from operations (CFO). DD use the standard
deviation of the residuals as a measure accrual quality, higher standard deviation
implying lower accrual quality. This is consistent with accrual quality defined as the
precision of accruals mapping into cash flow realizations.
DD find that certain firm characteristics including length of operating cycle,
volatility of sales and cash flow, and firm size contribute to differences in accrual quality
across firms. One must therefore control for these firm-specific factors when examining
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differences in accrual quality for firms in different accounting regimes such as Canada
and the US. To isolate accrual quality differences resulting from the use of Canadian vs.
US GAAP, we use the same set of firm-year observations for cross-listed Canadian firms
reporting under both types of GAAP. Thus, we match firm characteristics perfectly by
construction in our CC vs. CU comparisons. In our CU vs. UU comparisons, we control
for firm-specific factors by matching firms by industry and size.
III. HYPOTHESIS DEVELOPMENT
We hypothesize that differences between the accrual qualities of firms in any two
regimes, such as the US and Canadian regimes, depend jointly on a GAAP factor and an
oversight factor, which comprises several aspects of countries’ legal/regulatory
environments. In the first part of this section, we argue that Canadian GAAP is more
principles based than US GAAP and hypothesize that this GAAP factor results in higher
accrual quality in Canada. In the second part, we argue that US oversight is stronger than
Canadian oversight and hypothesize that this oversight factor results in higher accrual
quality in the US. In Section IV, we describe in more detail our experimental design,
which disentangles the effects of the GAAP factor and the oversight factor.
GAAP Hypothesis
Both anecdotal and empirical evidence suggest that Canada’s accounting
standards are more principles-based, whereas US standards are more rules-based. Key
contributors to this difference in orientation are the relatively litigious US environment
(Pacini et al., 2000; SEC, 2003) and accounting practitioners’ consequent demands for
standards that they can apply mechanically to avoid lawsuits (Nelson et al., 2002). US
auditors mitigate their liability by complying with detailed rules, clearly violated or not,
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rather than applying standards that provide less detailed guidance but better reflect the
substance of a transaction if applied conscientiously. The SEC staff study admits that
rules-based standards “…can result in financial reporting that is not representationally
faithful to the underlying economic substance of transactions and events” (SEC, 2003, p.
5).
In a legal context, Kaplow (1992) sees the sole distinction between rules and
standards as “the extent to which efforts to give content to the law are undertaken before
or after individuals act.” A rule gives content to the law ex ante; a standard gives content
to the law ex post. A rule specifies permissible conduct, leaving only factual issues to
professional judgment: e.g., “The speed limit is 60 km/h.” In contrast, a standard often
specifies permissible conduct but leaves factual issues to be judged according to case-
specific circumstances; e.g., “Do not drive at an excessive speed,” where “excessive” is
not specified by the standard ex ante. That rules are necessarily more detailed than
standards is a common misconception. The SEC staff study espouses this view as it
advocates “a moderate level of detail” in “principles-based, objectives-oriented”
standards:
…if constructed with the optimal level of detail, such standards would provide users, as well as regulators and others who oversee or monitor the financial reporting process, with sufficient detail to better comprehend and properly gauge the results reported by management and attested to by the auditors (SEC, 2003, p. 6).
According to Kaplow, the degree of detail does not distinguish a rule from a standard;
there can be simple rules and complex standards.
Kaplow’s distinction between rules and standards implies a role for professional
judgment and is clearly germane to the principles-vs.-rules debate in accounting. The
SEC staff study, consistent with Brown et al. (1993), recognizes that a rules-based
approach intentionally minimizes (even trivializes) accounting judgment by establishing
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complicated, finely articulated rules that attempt to anticipate all possible application
challenges. The study finds this approach problematic because standard setters cannot
foresee all business situations requiring the application of accounting standards and
detailed rules fail to take advantage of the company-specific knowledge of management,
accountants, and auditors.
Consistent with the SEC analysis, Kaplow concludes that standards are generally
preferable to rules in complex environments since rules are either over- or under-
inclusive, limiting the range of permissible considerations, while standards allow for
adjudicating what is permissible after action occurs. Standards are more costly to apply
than rules because professionals need to interpret standards. Rules-based standards are
more costly to create and cheaper to apply. Overall, however, Kaplow, like Skinner
(1995) and Brown et al. (1993), posits that generally, the hard-to-quantify benefits of
standards outweigh their higher application costs.
In an accounting context, since users know the financial reporting effects of rules-
based standards ex ante, rules-based standards are subject to opportunistic use by
management (Nelson et al., 2002). To the extent that accountants apply their professional
judgment effectively, principles-based standards are superior to rules-based standards in
situations where accountants cannot anticipate managerial opportunism, such as typical
earnings management situations where principles allow for the ex post application of
standards’ intended effect.
Evidence that Canada’s accounting is relatively principles based compared with
US accounting comes from an examination of the CICA Assurance Handbook and the
CICA Accounting Handbook, which are much less prescriptive than US AICPA
assurance guidance and FASB accounting guidance. We identified 134 uses of the term
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“professional judgment” in the current CICA Assurance Handbook. Among the more
important ones are
5400.15 In forming his or her opinion whether the financial statements are presented fairly, in all material respects, in accordance with generally accepted accounting principles, the auditor should exercise professional judgment as to the appropriateness of the selection and application of principles to the particular circumstances of an entity and as to the overall effect on the financial statements of separate decisions made in their preparation.
and
5130.06: A materiality decision ultimately becomes a matter for the auditor's professional judgment. Materiality is not a fine line where one dollar less is not material or one dollar more is material. It represents a grey area between what is very likely not material and what is very likely material.
Both of these passages enjoin Canadian accountants to “stand back” and assess whether
financial statement assertions faithfully reflect the substance of transactions and events
affecting the entity. Similarly, in describing representational faithfulness the CICA
Accounting Handbook’s introductory section, “Financial Statement Concepts,” states
1000.21 …The determination of the substance of a transaction or event will be a matter of professional judgment in the circumstances
The CICA, which set Canadian Accounting Standards until the Canadian
Accounting Standards Board became independent in 2001, published both Gibbins and
Mason’s (1988) Professional Judgment in Financial Reporting and a later staff study
(CICA, 1995), Professional Judgment and the Auditor. Both studies stress the
importance, in practice, of applying sound professional judgment in the context of
principles-based standards. Reinforcing this ethos, Canadian auditors qualify only after
passing a national Uniform Final Examination stressing the application of judgment and
diagnostic skills in realistic case situations. The Canadian CA profession then requires an
articling (apprenticeship) term before admission to membership and auditor certification.
The apprenticeship term aims to develop auditors’ professional judgment in applying
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accounting standards. In contrast, American CPA certification does not require
accountants to meet uniform national entrance standards and the admissions examination
is multiple-choice based. Some states have apprenticeship requirements of varying
lengths; others have none.
The requirement of CAs to article with a public accounting firm, which is not a
consistent requirement for qualification of a CPA in the US, contributes significantly to
auditor performance. Ferguson et al. (2000) find that audit students with articling
experience outperform those with formal education alone in an experimental setting.
More recently, Gibbins et al. (2004) find that chief financial officers (CFOs) exert less
influence on their auditors in Canada’s more principles-based environment than in the
more rules-based US environment. Some key results of this study are as follows:
American and Canadian CFOs have different mindsets. American CFOs feel their auditors must show them rules saying why they can't use the accounting methods they prefer to use. CFOs of domestic Canadian companies feel the shoe is on the other foot: They think the onus is on them to justify their company's accounting to the auditor. CFOs of cross-listed Canadian firms are in the middle (Thornton, 2003).
Although both rules-based and principles-based standards have certain advantages
in various contexts (SEC, 2003), we argue that on balance, the literature supports
Skinner’s hypothesis that principles-based standards, properly applied by ethical
accountants exercising sound professional judgment in Canada, produces higher accrual
quality than rules-based standards applied by US CPAs. Thus, our first hypothesis, stated
in alternative form, is
H1a: All else being equal, accrual quality is higher under Canadian GAAP
than US GAAP.
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Oversight hypothesis
Canada lacks what virtually every other industrialized nation possesses—a
national regulator of publicly traded companies (Brown, 2002). The Ontario Securities
Commission, the largest and most active provincial securities commission, regulates
Canada’s largest securities exchange, the Toronto Stock Exchange (TSX). However,
since each Canadian province has its own securities commission, reforms related to audit
practice, corporate governance, and regulation of public company disclosures are difficult
to harmonize and enforce nationwide because of lack of resources and inconsistent legal
requirements. Thus, regulatory oversight of securities exchanges and firms that trade on
those exchanges is much stronger in the US than in Canada.
Thornton (2002) describes the SEC’s pervasive involvement in accounting issues,
its proactive investigation of security market violations by its Division of Corporation
Finance, and its continual challenging of registrants’ accounting and disclosure practices
under its Full Disclosure program, which provides real-time feedback and restatement
requirements to registrants. Unlike the Canadian provincial securities commissions, the
SEC has long mandated that firms provide a Management Discussion and Analysis
(MD&A) in their regulatory filings. The MD&A disciplines financial reporting by
ensuring that senior managers review and interpret the numbers on financial statements in
terms of company policy. During our sample period, MD&A requirements in Canada
were virtually absent. For all of these reasons, Thornton (2002) concludes that US GAAP
“cannot be imported like US beef” into Canada without the much stronger regulatory
infrastructure in the US.
The legal environments in Canada and the US differ substantially. Shareholders’
propensity to sue for financial statement misrepresentation exerts pressure on both
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corporate managers and auditors to exercise care in making accruals, thereby limiting
likely litigation losses stemming from allegations of misstated income or net assets. US
securities laws and judicial interpretations create a far more litigious environment in the
US than that in Canada (Baginski et al., 2002). Pacini et al. (2000) find that the scope of
auditors’ liability to non-clients has been narrowing in both countries over the last
decade. However, the US continues to have a far more litigious environment than
Canada.
Holding the GAAP factor constant, we argue that both stronger regulatory
scrutiny and greater litigiousness induce managers and auditors to make higher quality
accruals in the US compared with Canada. Thus, our second hypothesis, stated in
alternate form is:
H2a: All else being equal, Canadian oversight is associated with lower accrual
quality than US oversight.
We stress the importance of holding the GAAP factor constant in this hypothesis. We
expect that under either rules- or principles-based GAAP, stronger oversight and the
higher probability of litigation provide incentives for both company accountants and
public accountants to make higher quality accruals. We can test the hypothesis that
stronger oversight enhances accrual quality by comparing the accrual quality of CU firms
with a matched sample of UU firms. To the extent that principles-based GAAP results in
higher accrual quality than rules-based GAAP (H1), we hypothesize that the combination
of Canada’s principles-based GAAP and US oversight provides the highest accrual
quality of all. Unfortunately, however, owing to the absence of “UC firms” (US
companies reporting under Canadian GAAP), we are unable to test this hypothesis.
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Measurement and decomposition of Canada/US accrual quality differences
We measure the GAAP effect as the difference between the accrual quality for
cross-listed Canadian firms reporting under Canadian GAAP (CC firms) with the accrual
quality of the same firms reporting under US GAAP (CU firms):
GAAP effect = CC accrual quality – CU accrual quality
Hypothesis H1a is that the GAAP effect is positive. We measure the oversight effect as
the difference between the accrual quality of cross-listed Canadian firms reporting under
US GAAP (CU firms) and the accrual quality of industry/size-matched samples of UU
firms:
Oversight effect = CU accrual quality – UU accrual quality
Hypothesis H2a is that the oversight effect is negative. Finally, we measure the total
regime effect as
Regime effect = GAAP effect + oversight effect
= CC Accrual quality – UU accrual quality
Since we hypothesize that the GAAP and oversight effects have opposite signs, we state a
third, regime hypothesis in null form:
H30: There is no difference between the accrual quality of Canadian firms
reporting under Canadian GAAP and the accrual quality of industry/size-
matched samples of US firms reporting under US GAAP.
IV. RESEARCH DESIGN
Sample selection
Panel A of Table 1 summarizes sample selection. Canadian sample firms come
from the 1990-2002 Compustat files. We identify those listed only in Canada and those
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that cross-list. The Canadian sample is significantly smaller than the US sample. Starting
with all firms listed on the Toronto Stock Exchange (TSX), we pare the sample to firms
with complete data for assets, earnings, cash flow from operations (CFO), changes in
accounts receivable, and changes in inventory. Consistent with DD, the last two
requirements ensure sample firms have significant working capital accruals. We use CFO
as reported in the Statement of Cash Flows rather than a balance sheet derivation of
operating cash flow, consistent with Collins and Hribar’s (2002) recommendation.
Requiring at least one year of past and future cash flows and earnings yields a sample of
646 Canadian firms and 5,180 firm-years.
To estimate firm-specific regressions, we need at least six years of data. This
requirement reduces the sample to 947 firm-year observations for 127 firms. Of these
Canadian firms, nearly half are cross-listed on one of three major US exchanges: NYSE,
AMEX, or NASDAQ.
Control Sample
To control for firm-specific characteristics such as size and industry volatility in
comparing CU with UU firms, we assemble a matched control sample of US firms. DD
predict and find that accrual quality varies systematically with firm characteristics such as
volatility of operations or the length of operating cycle. Thus, we attempt to minimize
firm-specific differences between the Canadian and US samples, so that we can infer that
any difference between the total regime effect and the GAAP effect is due to the
oversight effect and not idiosyncratic differences at the firm level.
Panel B of Table 1 lists Canadian firms grouped by industry and summarizes
results of matching US firms as closely as possible to the Canadian firms based on total
operating revenue and SIC code. Panel C summarizes the construction of the CC/CU
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subsamples: we eliminate from these subsamples 10 firms (most of whom made initial
public offerings in the US during the sample period) lacking sufficient US GAAP time-
series data.
V. RESULTS
Data and descriptive statistics
Variables of interest are consistent with those identified by DD. Cash flow from
operations is Compustat item 308. The change in working capital from year t−1 to t
(∆WC) is computed as CFO = ∆AR + ∆Inventory − ∆AP − ∆TP + ∆Other Assets (net),
where AR is accounts receivable, AP is accounts payable, and TP is taxes payable.
Earnings after short-term accruals but before long-term accruals (Earn) is calculated as
Earn = CFO + ∆WC. Earnings is reported as Compustat item 123, Earnings before
extraordinary items as reported on the cash flow statement. All variables are scaled by
average total assets.
Table 2 provides descriptive statistics and correlations for both the Canadian and
US control samples. Descriptive information for variables of interest in Panel A is
consistent with that reported by DD. Total accruals are negative, mainly due to
depreciation, while working capital accruals are positive as scaled current earnings
exceeds scaled cash flow from operations for both countries by 0.011.
Mean earnings before extraordinary items is negative for both countries, whereas
DD report a positive mean. This difference is likely due to the different sample periods.
DD’s sample was from 1987 to 1999 whereas our sample of 1990 to 2001 includes the
post 9-11 period and recent economic downturn. In addition, our mean earnings is
negative but median earnings is positive, indicating a few large losses are skewing the
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mean downwards. Descriptive statistics are similar for Canadian firms and their US
matched firms, but Canadian firms are larger and less profitable.
Pearson correlations provided in Panel B of Table 2 are also consistent with
results reported by DD and with previous research. The correlation between Earn and
CFO is significantly positive, and is slightly larger here than DD’s 0.73. Also consistent
with previous research is the positive correlation between Earn and ∆WC, which is much
higher for the US (0.88) than the Canadian sample (0.25). DD report a correlation of 0.33
for these variables, closer to our Canadian sample estimate. The correlation between CFO
and ∆WC is negative for our Canadian sample, consistent with DD’s finding, yet is
significantly positive for our US control sample. Also consistent with DD’s previous
findings is the statistically insignificant correlation between ∆WC and CFOt+1. DD
explain that the insignificant correlation between ∆WC and CFOt+1, also found in our
Canadian sample, results from the negative correlation between ∆WCt and CFOt in
concert with the positive correlation between CFOt and CFOt+1 , which effectively
counteracts the expected positive relation between ∆WC and CFOt+1. It is therefore
reasonable that the US sample, with its positive correlation between ∆WCt and CFOt
(0.59), also has a statistically significant correlation between ∆WC and CFOt+1.
Regression Analysis
Table 3 presents results of regressions of working capital accruals on past,
present, and future cash flows from operations. Panels A, B, and C summarize firm-level
regressions for all Canadian firms and the US firm control sample. We further partition
the sample into a set of firms that trade only domestically on the TSX and a set of firms
that cross-list on both the TSX and US exchanges. We use firm-level regressions to
estimate sresid, the standard deviations of residuals from the DD model.
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Results of firm-specific regressions are consistent with DD. Current changes in
working capital are negatively associated with current cash flow from operations (mean
regression coefficient –0.36) but positively related to past (0.19) and future (0.20) cash
flow from operations. All mean regression coefficients differ significantly from zero.
Coefficients on both the Canadian sample and the US control sample exceed those
reported by DD. Mean (median) adjusted R2s of 0.36 (0.50) for the Canadian sample are
lower than those DD found but still provide reasonable explanatory power. The US
control sample has higher adjusted R2s, lower positive coefficients on the future cash
flow variable and larger negative coefficients on current cash flow.
Results in Panels B and C show that the model’s explanatory power is higher for
domestically traded Canadian firms (adjusted R2 of 0.46) than cross-listed firms (adjusted
R2 of 0.25). All coefficients in the partitioned sample are statistically significant except
that of future cash flow from operations for the US control sample matched to domestic
Canadian firms. Coefficients on the US firm-level regressions are comparable to those
obtained from firm-level regressions on Canadian firms.
Table 4 gives descriptive statistics for the standard deviation of the residuals from
firm-level regressions of the DD model. A factor that could affect the results is that the
SEC periodically reviews Canadian cross-listed firms’ filings, although with less zeal
than it reviews US firms’ filings. Possibly, then, Canadian cross-listers are subject to
some degree of US oversight. Our experimental design perfectly isolates the GAAP
effect because our CC vs. CU comparison involves comparing accrual quality for the
same set of firms under the two sets of GAAP. Thus, our test of the Skinner hypothesis is
immune from this possibility. However, it could affect the interpretation of our
comparison of accrual quality for CU vs. UU firms. If CU firms are subject to Canadian
18
oversight, any difference between CU accrual quality and UU accrual quality is due to
stronger US oversight. If CU firms are subject to some degree of US oversight, however,
the difference is difficult to interpret. To test for this possibility, in Panel A we compare
the accrual quality of Canada-only listers (CC for pure Canadian firms) with that of
Canadian cross listers (CC for cross listers) and find no differences for:
(a) the full sample of 127 CC firms vs. 62 cross listed CC firms;
(b) the full sample of 127 CC firms vs. 49 cross listed CC firms that have sufficient time
series data to compute accrual quality under US GAAP; and
(c) the 65 Canada-only listed CC firms vs. 49 cross listed CC firms that have sufficient
time series data to compute accrual quality under US GAAP.
These tests enhance our confidence that Canadian firms are subject to Canadian oversight
whether they list in the US or not. Thus, we attribute any difference in CU accrual quality
and UU accrual quality to the oversight effect.
Preliminary hypothesis tests
Panel B of Table 4 reports sresid for the subsample of Canadian firms reporting
under both Canadian and US GAAP. Consistent with H1a, we find that the mean sresid
for CC firms (.026) is significantly lower than the mean sresid for CU firms (.051). In the
same panel, we report the mean sresid for the same 49 Canadian firms under US GAAP
(CU firms) with the mean sresid of the industry/size-matched sample of US firms (UU
firms). Consistent with H2a, we find that the mean sresid for UU firms (.029) is
significantly lower than the mean sresid for CU firms (.051). Both differences are
statistically significant at the .05 level.
Panel C suggests that UU firms have slightly smaller mean sresid than CC firms.
However, the difference is not statistically significant. These insignificant results hold for
19
the full Canadian sample of 127 firms, for the Canadian sample of 65 TSX-listed firms,
and for the Canadian sample of 62 firms cross-listed on US exchanges. Thus, we fail to
reject H30.
Although the results of the above tests are all consistent with our hypotheses, we
extend the analysis by performing (1) paired t-tests and (2) tests for differences between
the two groups of sresid. The latter tests employ the normally distributed statistic,ba
a+
,
where a is sresid for Canadian firms and b is sresid for US firms. Under the null
hypothesis of no difference in sresid, the mean of this statistic is 0.5.
H1a (GAAP Effect)
Panel A of Table 5 gives the results of the above two tests for the 49 CC firms
that had sufficient US-GAAP time-series data and the same firms reporting under US
GAAP (CU firms). Consistent with H1a, results of both tests are significant (p = .021 and
p = .008 for tests 1 and 2, respectively), implying that CC accrual quality is higher than
CU accrual quality. We note that three additional Canadian firms have sufficient CU data
to perform these tests; however, they have extremely high sresid for the US GAAP data,
so we exclude them from tests in both Table 4 and Table 5. When we include the three
outliers, test results are even more significant.
H2a (Oversight Effect)
Panel B of Table 5 compares CU firms with the industry/sized-matched sample of
UU firms. Consistent with H2a, the two-sample paired t-test yields significant results (p =
.046), implying that CU accrual quality is lower than UU accrual quality. The second test,
which utilizes the novel statistic,ba
a+
, fails to support H2a. Thus, CU vs. UU results of
20
the first test, while significant on balance, are less so than those of CC vs. CU; results of
the second test are insignificant. The relative weakness of the H2 results likely stems, in
part at least, from the imperfect matching of CU vs. UU firms compared with the perfect
matching of CC vs. CU firms.
H30 (Regime effect)
Results for the regime effect appear in Table 6. Both tests fail to find significant
results for accrual quality differences for CC and UU firms. To ensure that our failure to
reject the null is not due to outliers, we repeat our tests for the full sample after excluding
25 firm-pairs (the top 15% of the sample) where sresid is above 0.06. Still we find no
significant difference, with a t-statistic of –0.73. We repeat the paired t-test for matches
with at least 10 years of data for Canadian firms, and again with at least 7 years of data.
In both cases, we find no significant differences in accrual quality between CC and UU.
Thus, none of our tests reject H30.
Summary of results
In summary, we find a significantly higher accrual quality for CC than CU firms.
Thus, consistent with H1a, the GAAP effect (CC – CU) is positive, favoring Canada’s
principles-based GAAP over the US rules-based GAAP. For the most appropriate
statistical tests (paired t-tests), we find significantly lower accrual quality for CU than
UU firms, favoring the stronger US oversight effect. Thus, consistent with H2a, the
oversight effect (CU – UU) is negative. Since these two effects are offsetting, we cannot
predict whether the total regime effect (CC – UU) is positive or negative and thus state
H30 regarding the regime effect in null form. Indeed, we fail to reject H30: we detect no
overall regime effect.
21
VI. CONCLUSIONS AND LIMITATIONS
Consistent with the Skinner hypothesis, we hypothesize and find strong evidence
that accrual quality is higher for Canadian firms reporting under Canadian GAAP than
for the same firms reporting under US GAAP. We also document that accrual quality is
lower for Canadian firms reporting under US GAAP than for US firms, subject to
stronger US oversight, reporting under US GAAP. Consistent with the offsetting nature
of these two determinants of accrual quality, we hypothesize and find no significant
difference in accrual quality between Canadian firms using Canadian GAAP and US
firms using US GAAP.
A limitation of the study is data availability with respect to Canadian firms. Only
about 1,100 firms trade on the TSX during the period examined, and only about 10% of
them meet our data requirements. Because the accrual quality model requires firm-level,
time-series regression analysis, restrictive data requirements result in few Canadian firms
meeting selection criteria. Using a longer sample period would not be practicable since
cash flow statement data are unavailable pre-1987. A second limitation relates to the
Dechow-Dichev accrual quality model used in this study. The model is among the first to
measure accrual quality and, as such, may contain as-yet undetermined misspecifications.
The model’s accrual quality measure considers only current accruals, ignoring longer-
term accruals such as depreciation. It also ignores balance sheet information and the
information in income statement line items and other required disaggregations.
Despite its possible shortcomings, the results of the study underscore that
improving financial reporting quality involves more than simply proclaiming changes in
GAAP. Rather, GAAP interacts with oversight in any financial reporting regime. An
open question is whether (hypothetically) principles-based GAAP, coupled with stronger,
22
US-style oversight, yields even higher financial reporting quality than that in Canada or
the US. Our results are consistent with stronger oversight compensating for the
shortcomings of rules-based GAAP. However, US GAAP and oversight evolved
simultaneously. Possibly, US oversight would have been weaker had American policy
makers relied more heavily on the accounting profession to exercise professional
judgment.
The strongest implication of the study is what Skinner (1995) would probably
have welcomed most: Don’t blame Canadian GAAP and Canadian accountants for
perceived financial reporting shortcomings in Canada. If anything, they seem to enhance
Canadian financial reporting quality.
23
VII. REFERENCES
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Bandyopadhyay, S., J. Hanna and G. Richardson. 1994. Capital market effects of US-Canada GAAP differences. Journal of Accounting Research 32, 262-277.
Bandyopadhyay, S., A. Hilton, and G. Richardson. 2002. A re-examination of reconciling items between Canadian and United States GAAP. Managerial Finance 28, 37-56.
Brown, D. “Preventing Enron North: Improving Financial Reporting and Corporate Governance in Canada”. Statement to the Conference Board's 2002 Business Outlook Briefings. March 7, 2002.
Brown, G., R. Collins, and D. Thornton. 1993. Professional Judgment and Accounting Standards. Accounting, Organizations and Society 275-289.
CICA. 1995. Professional Judgment and the Auditor. Toronto: Canadian Institute of Chartered Accountants.
Collins, D. and P. Hribar. 2002. Errors in estimating accruals: Implications for empirical research. Journal of Accounting Research 40: 105-134.
Dechow, P. and I. Dichev. 2002. The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review 77, 35-59.
Ferguson, C., G. Richardson, and G. Wines. 2000. Audit education and training: The effect of formal studies and work experience. Accounting Horizons 24(2), 137-167.
Financial Accounting Standards Board (FASB). 2002. Proposal: Principles-Based Approach to US Standard Setting. FASB, Norwalk, CT.
Francis, J., R. LaFond, P. Olsson and K. Schipper. 2004. The market pricing of earnings quality. Working Paper, Duke University.
Gibbins, M. and A. Mason. 1988. Professional Judgment in Financial Reporting. Toronto: Canadian Institute of Chartered Accountants.
Kaplow, L. 1992. Rules versus standards: An economic analysis. Duke Law Journal 42, 557-629.
Gibbins, M., S. McCracken, and S. Salterio. 2004. The auditor-client relationship behind financial reporting negotiation: interviews with matched pairs of audit partners and chief financial officers. Working paper, Queen’s University.
24
McNichols, M. 2002. Discussion of “The quality of accruals and earnings: The role of accrual estimation errors.” The Accounting Review 77, 61-69.
Nelson, M, J. Elliott, and R. Tarpley. 2002. Evidence from auditors about managers’ and auditors’ earnings management decisions. The Accounting Review 77 (Supp.), 175-202.
Pacini, C., M.J. Martin, and L. Hamilton. 2000. At the interface of law and accounting: an examination of a trend toward a reduction in the scope of auditor liability to third parties in the common law countries. American Business Law Journal 37, 171-235.
SEC. 2003. Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System Submitted to Committee on Banking, Housing, and Urban Affairs of the United States Senate and Committee on Financial Services of the United States House of Representatives Office of the Chief Accountant Office of Economic Analysis. Washington, DC: United States Securities and Exchange Commission. Skinner, R. (1995) “Judgment in Jeopardy,” CA Magazine (November), pp. 14-21.
Standing Senate Committee on Banking, Trade and Commerce. June 2003. Navigating through “The Perfect Storm”: Safeguards to restore investor confidence.
Thornton, D. 2002. Financial Reporting Quality: Implications of Accounting Research (‹‹Qualité de l’information financière: incidences de la recherche comptable››). Testimony to the Senate Standing Committee on Banking, Trade and Commerce, Study on the State of the Domestic and International Financial System. May 29, 2002.
__________. 2003. The GAAPs in their logic. Financial Post (September 25), p. FP 15.
TABLE 1
Sample Firm-Years, 1990–2001 Panel A: Canadian sample Firms traded on TSX with available cash from operations, earnings, and changes in accounts receivable and inventory and total assets reported in the statement of cash flows 719 Firms with both lead and lag values of cash from operations and earnings 646 Firms with 6 or more annual observations Firms traded only in Canada 65 Cross-listed firms 62 Total 127 Firm-years available for the firms used in the remaining analysis 947 Panel B: Industry Composition: Canadian firms and matched US firms Canadian Number of US firms matched
Industry firms to 4-digit SIC to ±75%
of Revenue Metal mining 22 20 5 Chemicals and allied products 11 11 8 Electronic and electric equipment 10 10 5 Oil and gas extraction 7 7 4 Primary metal industries 7 7 4 Paper and allied products 6 6 4 Transportation equipment 6 6 5 Food and kindred products 5 5 2 Wholesale trade-durable goods 5 5 5 Business services 5 5 4 Other 43 38 30 127 120 76 Panel C: Subsample of cross-listed Canadian firms matched to US GAAP firm-years Cross-listed firms 62 Firms with insufficient US data 10 Available cross-listed firms 52 Firm-year observations 380
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TABLE 2 Descriptive Statistics and Pearson Correlation Matrix for Selected Variables
947 Canadian (1055 US) Firm-Year Observations 1990 to 2001 Panel A: Descriptive Statistics Standard Lower Upper Mean Deviation Quartile Median Quartile
Cash flow from operations (CFO) 0.041 0.167 0.000 0.066 0.119 US matched sample 0.057 0.185 0.019 0.084 0.138
Change in working capital (∆WC) 0.011 0.088 -0.016 0.005 0.034
US matched sample 0.011 0.095 -0.017 0.009 0.040 Earnings before long-term accruals (Earn) 0.052 0.171 0.017 0.078 0.130
US matched sample 0.068 0.184 0.042 0.095 0.152 Earnings before extraordinary items (Prof) -0.029 0.210 -0.042 0.022 0.062
US matched sample -0.019 0.235 -0.014 0.034 0.084 Accruals (Prof-CFO) -0.070 0.163 -0.104 -0.051 -0.003
US matched sample -0.076 0.166 -0.107 -0.057 -0.014 Total assets (in millions - CDN$) 3,599 17,879 72 380 2,610
Matched US sample (in CDN$) 2,748 7,003 83 511 2,149
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TABLE 2 (continued)
Panel B: Pearson Correlations Earnt CFOt ∆WCt CFOt+1 CFOt-1 Earnt+1 Accrualst
Proft 0.818 * 0.692 * 0.252 * 0.501 * 0.456 * 0.508 * 0.590 * US firms 0.964 * 0.869 * 0.849 * 0.452 * 0.271 * 0.298 * 0.891 *
Earnt 0.878 * 0.245 * 0.639 * 0.603 * 0.631 * 0.134 *
US firms 0.904 * 0.879 * 0.509 * 0.279 * 0.349 * 0.799 * CFOt -0.249 * 0.648 * 0.648 * 0.603 * -0.174 *
US firms 0.590 * 0.439 * 0.439 * 0.279 * 0.551 * ∆WCt 0.623 -0.055 0.048 0.623 *
US firms 0.123 * 0.072 0.131 * 0.892 * CFOt+1 0.531 * 0.873 * -0.033
US firms 0.290 * 0.925 * 0.109 * CFOt-1 0.484 * -0.089
US firms 0.165 * 0.085 Earnt+1 0.026
US firms 0.086 * Significant at the 0.0005 level. Variable definitions:
Cash flow from operations (CFO) = item 308 from the Compustat Statement of Cash Flows; Change in working capital (∆WC) = ∆AR + ∆Inventory − ∆AP − ∆TP + ∆Other Assets (net), where AR is accounts receivable, AP is accounts payable, and TP is taxes payable Earnings before long-term accruals (Earn) = CFO + ∆WC; Earnings before extraordinary items (Prof) = Compustat item 123; and Accruals
= Prof − CFO.
All variables are scaled by average total assets.
26
TABLE 3
Summary Statistics from Firm-Specific Regressions of the Change in Working Capital on Past, Current, and Future Cash Flow from Operations, 1990 to 2001
Regression model: ∆WCt = b0 + b1CFOt-1 + b2CFOt + b3CFOt+1 + εt
Intercept b1 b2 b3 Adjusted
R2
Panel A: 127 Canadian (127 matched US) firms Means (t-statistics)
-0.009 0.186 -0.355 0.203 0.357 Canadian firms (-0.61) (3.01) (-6.69) (4.31) 0.024 0.190 -0.464 0.118 0.425 Matched US firms (2.30) (5.29) (-12.75) (2.88)
Lower quartile Canadian firms -0.021 -0.050 -0.688 -0.058 -0.006 Matched US firms -0.021 -0.004 -0.744 -0.046 0.164 Median Canadian firms 0.011 0.077 -0.370 0.137 0.500 Matched US firms 0.022 0.140 -0.466 0.108 0.529 Upper quartile Canadian firms 0.040 0.291 -0.087 0.366 0.844 Matched US firms 0.056 0.365 -0.187 0.343 0.788
Panel B: 65 Canadian TSX-listed (65 matched US) firms Means (t-statistics)
-0.034 0.251 -0.275 0.273 0.459 Canadian firms (-1.17) (2.23) (-3.07) (3.30) 0.025 0.200 -0.447 0.112 0.451 Matched US firms (1.29) (4.37) (-8.32) (1.60)
Panel C: 62 Canadian cross-listed (62 matched US) firms Means (t-statistics)
0.017 0.117 -0.438 0.129 0.250 Canadian firms (2.55) (2.57) (-8.26) (3.18)
0.023 0.180 -0.481 0.125 0.397 Matched US firms (3.15) (3.20) (-9.81) (2.96) The t-statistics in Panels A to C are determined based on the distribution of the 127 coefficients obtained from the firm-specific regressions requiring a minimum of six observations per firm. All variables are defined as in Table 2.
27
TABLE 4
Quality of Working Capital Accruals Measured by Standard Deviation of Residuals (sresid) – 1990 to 2001
Standard Lower Upper Mean Deviation Quartile Median Quartile Panel A: Tests for differences in mean sresid across subsamples of CC firms t-statistic Significance Full sample of 127 firms vs. 62 cross-listed firms 0.327 0.744 Full sample of 127 firms vs. 49 cross-listed firms with sufficient US data 1.140 0.256 65 TSX-traded firms only vs. 49 cross-listed firms with sufficient US data 1.230 0.221 Panel B: 49 Canadian firms reporting under both Canadian (CC firms) and US GAAP (CU firms) compared with 49 matched US firms reporting under US GAAP (UU firms) – outliers excluded
CC 0.026 0.031 0.007 0.016 0.036 CU 0.051 0.072 0.012 0.022 0.076 Matched UU 0.029 0.028 0.010 0.020 0.037
Panel C: CC firms (Canadian firms reporting under Canadian GAAP) compared with UU firms (matched sample of US firms reporting under US GAAP) 127 CC firms 0.034 0.042 0.008 0.018 0.044 127 UU firms 0.030 0.037 0.010 0.020 0.034 65 TSX-listed CC firms 0.036 0.047 0.007 0.018 0.049 65 matched UU firms 0.033 0.045 0.011 0.021 0.034 62 Cross-listed CC firms 0.032 0.037 0.011 0.019 0.041 62 matched UU firms 0.027 0.026 0.009 0.019 0.036
The standard deviation of the residuals (sresid) is calculated based on the residuals from the following firm-specific regressions. All variables are scaled by average total assets: ∆WCt = b0 + b1CFOt-1 + b2CFOt + b3CFOt+1 + εt where: Cash flow from operations (CFO) = item 308 from the Compustat Statement of Cash Flows; Change in working capital (∆WC) = ∆AR + ∆Inventory − ∆AP − ∆TP + ∆Other Assets (net), where AR is accounts receivable, AP is accounts payable, and TP is taxes payable Earnings before long-term accruals (Earn) = CFO + ∆WC.
28
TABLE 5
Panel A: Tests for GAAP Effect (H1a) Differences in sresid from Firm-Specific Regressions
for 49 Canadian firms reporting under Canadian GAAP (CC) vs. US GAAP (CU), 1990 to 2001
n t-statistic Significance
Two-sample paired T-tests Canadian cross-listed firms, CC vs. CU 49 -2.392 0.021 Test for a /(a+b) = 0.5 Canadian cross-listed firms 49 -2.769 0.008 (mean a /(a+b) is 0.403, median 0.439)
Panel B: Tests for Oversight Effect (H2a) Differences in sresid from Firm-Specific Regressions
for 49 Canadian firms reporting under US GAAP (CU) vs. matched US firms (UU), 1990 to 2001
n t-statistic Significance
Two-sample paired T-tests Canadian cross-listed firms, CU vs. UU 49 2.046 0.046 Test for a /(a+b) = 0.5 Canadian cross-listed firms 49 0.819 0.417 (mean a /(a+b) is 0.532 , median 0.559) The standard deviation of the residuals (sresid) is calculated based on the residuals from the following firm-specific regressions: ∆WCt = b0 + b1CFOt-1 + b2CFOt + b3CFOt+1 + εt where: Cash flow from operations (CFO) = item 308 from the Compustat Statement of Cash Flows; Change in working capital (∆WC) = ∆AR + ∆Inventory − ∆AP − ∆TP + ∆Other Assets (net), where AR is accounts receivable, AP is accounts payable, and TP is taxes payable Earnings before long-term accruals (Earn) = CFO + ∆WC. a = sresid for Canadian firms b = sresid for US firms All variables are scaled by average total assets.
29
TABLE 6 Tests for Regime Effect (H30)
Differences in sresid from Firm-Specific Regressions for Canadian Firms and Matched Samples of US firms, 1990 to 2001
n t-statistic Significance
Canada and US two-sample paired T-tests Full sample of Canadian vs. Matched US firms 127 0.923 0.358 TSX-traded Canadian vs. Matched US 65 0.409 0.684 Cross-listed Canadian vs. Matched US 62 0.980 0.331 Test for a /(a+b) = 0.5 Full sample 127 -0.345 0.731 (mean a /(a+b) is 0.492, median is 0.493)
The standard deviation of the residuals (sresid) is calculated based on residuals from the firm-specific regressions ∆WCt = b0 + b1CFOt-1 + b2CFOt + b3CFOt+1 + εt where: CFO = Cash flow from operations (item 308 from the Compustat Statement of Cash Flows) ∆WC = Change in working capital (∆AR + ∆Inventory − ∆AP − ∆TP + ∆Other Assets (net), where AR is accounts receivable, AP is accounts payable, and TP is taxes payable) Earn = Earnings before long-term accruals (CFO + ∆WC.) a = sresid for Canadian firms b = sresid for US firms All variables are scaled by average total assets.