Is it IFRS Adoption or Convergence to IFRS that Matters? TIJA Symposium 2012 2/1/12 Is it IFRS Adoption or Convergence to IFRS that Matters? Lei Cai Asheq Rahman Stephen Courtenay School of Accountancy ... 1 060 TIJA Symposium 2012 2/1/12 Is it IFRS Adoption or ...

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<ul><li><p>060 TIJA Symposium 2012 </p><p>2/1/12 </p><p>Is it IFRS Adoption or Convergence to IFRS that Matters? </p><p>Lei Cai </p><p>Asheq Rahman </p><p>Stephen Courtenay </p><p>School of Accountancy </p><p>Massey University </p><p>Auckland </p><p>New Zealand </p><p>Draft Date: 31 Jan 2012 </p></li><li><p>1 </p><p>060 TIJA Symposium 2012 </p><p>2/1/12 </p><p>Is it IFRS Adoption or Convergence to IFRS that Matters? </p><p>Abstract </p><p>Prior Studies find that International Financial Reporting Standards (IFRS) adoption improves </p><p>earnings quality. Some studies also introduce enforcement variables to show the added </p><p>benefits of enforcement. However, we note that some of the countries that have adopted IFRS </p><p>had accounting standards similar to IFRS prior to adopting IFRS while others had accounting </p><p>standards less similar to IFRS. We contend that the latter group benefit more from IFRS </p><p>adoption because their accounting standards undergo greater improvements. We examine the </p><p>effect of IFRS adoption by taking into account the prior dissimilarities a countrys accounting </p><p>standards had with IFRS. We use data from 31 countries and we take into account the effects </p><p>of legal enforcement. We find that when IFRS is adopted or when accounting standards are </p><p>more similar to IFRS, countries have lower levels of earnings management. Also, countries </p><p>with accounting standards less similar to IFRS prior to IFRS adoption have a greater drop in </p><p>earnings management after IFRS adoption. Our results support the contention that countries </p><p>with lower quality accounting standards would benefit more from IFRS adoption. </p></li><li><p>2 </p><p>060 TIJA Symposium 2012 </p><p>2/1/12 </p><p>1. Introduction </p><p>Many countries have begun mandatory adoption of International Financial Reporting </p><p>Standards (IFRS) issued by the International Accounting Standards Board (IASB). IFRS </p><p>removes many allowable accounting alternatives, and some initial evidences show that IFRS </p><p>limit managerial discretion to manipulate earnings, thereby improving earnings quality. </p><p>Research investigating the usefulness of IFRS adoption has shown that countries that adopt </p><p>IFRS have lower earnings management (Jeanjean and Stolowy, 2008; Callao and Jarne 2010; </p><p>Hoque et al. 2012). We contend that the term adoption does not to carry the same meaning </p><p>across countries because the effect of adoption is formed by a countrys distinctive regulatory, </p><p>capital market, accounting, and auditing features. This has been partially studied by recent </p><p>studies through an examination of the effects of enforcement on the adoption of IFRS </p><p>(Jeanjean and Stolowy, 2008; Hoque et al. 2012). These studies, however, do not take into </p><p>consideration the fact that some of the IFRS adopting countries already had accounting </p><p>standards similar to IFRS prior to adopting IFRS. We contend that the benefit of IFRS </p><p>adoption is reaped more by countries whose accounting standards are less similar to IFRS. </p><p>We examine the effect of IFRS adoption by taking into account the prior dissimilarities a </p><p>countrys accounting standards had with IFRS. We take into account the effects of legal </p><p>enforcement as recent studies have done. We also find that when IFRS is adopted or when </p><p>accounting standards are more similar to IFRS, countries have lower levels of earnings </p><p>management. Also, countries with standards less similar to IFRS prior to IFRS adoption have </p><p>a greater reduction in earnings management after IFRS adoption. Our results support the </p><p>contention that countries, in general, benefit from IFRS adoption, and countries that achieve </p><p>greater convergence to IFRS by adopting IFRS benefit more than those countries that </p><p>already had accounting standards similar to IFRS. However, in this milieu, while we find </p><p>legal enforcement to be a significant player in reducing earnings management, its influence </p><p>on enhancing the effects of IFRS on earnings management reduction is not consistently </p><p>significant. The likely cause of this is that countries that had standards dissimilar to IFRS had </p><p>weaker legal enforcement arrangements. Therefore, their reduction in their earnings </p><p>management is primarily due to IFRS adoption and less due to the legal enforcement </p><p>arrangements complementing IFRS. </p><p>A strength of our study is that we have been able to study the effects of IFRS adoption more </p><p>effectively. Previous studies (Jeanjean and Stolowy, 2008; Hoque et al, 2012) were unable to </p></li><li><p>3 </p><p>060 TIJA Symposium 2012 </p><p>2/1/12 </p><p>obtain data for large-sample tests because their studies were conducted too soon after IFRS </p><p>adoption by their sample countries. Regulations take years to unfold and take effect. As </p><p>mandatory IFRS adoption has been use for some years in many countries, it is now possible </p><p>to empirically test how IFRS plays a role in establishing earnings quality. In this regard, we </p><p>note that the effects of IFRS adoption take about three to four years to take effect. </p><p>Our sample covers data from 2000 to 2009 across 31 countries. We use the theory </p><p>frameworks of Soderstrom and Sun (2007), Leuz et al. (2003), and Hope (2003). Our results </p><p>show that firm reporting incentives are shaped by the institutional environments of countries </p><p>(Ball et al., 2000; Hope, 2003; Bhattacharya et al. 2003; Beneish and Yohn, 2008; Jeanjean </p><p>and Stolowy, 2008), and IFRS has the strongest effect on earnings quality when </p><p>convergence is large due to IFRS adoption. </p><p>Our paper contributes to the accounting literature in three ways. First, most IFRS adoption </p><p>papers (Callao and Jarne, 2010; Houqe et al. 2011) do not consider the differences between </p><p>local GAAP and IFRS. Simply coding IFRS adoption as an indicator variable to measure the </p><p>quality of accounting standards is not sufficient because it does not capture how much IFRS </p><p>adoption affects the state of accounting policies in a country. In this paper, we capture the </p><p>degree of variation in GAAP differences to get a better measurement of IFRS adoption. </p><p>Second, previous studies only provide preliminary evidence on the effect of IFRS adoption </p><p>because their data cover only one or two years after mandatory adoption of IFRS, or cover </p><p>fewer countries. We use a large sample that covers data up to five years after mandatory </p><p>adoption of IFRS. Third, our study focuses on the issue of which countries benefit more from </p><p>IFRS adoption. Currently, much attention is being placed on the convergence between IFRS </p><p>and the US accounting standards. The question that arises from this focus is whether this </p><p>should be the main direction of the IASBs efforts or should the IASB provide more attention </p><p>to those countries that need assistance in improving the quality of their accounting standards? </p><p>The remainder of the paper is organized as follows. Section 2 provides the literature review </p><p>and leads to the hypothesis. Section 3 describes the research design, including the measures </p><p>for the dependent, independent, and control variables, the model specifications, and the </p><p>sample selection process. Section 4 presents the descriptive statistics and empirical analysis. </p><p>Finally, the conclusion of this study is drawn in Section 5. </p></li><li><p>4 </p><p>060 TIJA Symposium 2012 </p><p>2/1/12 </p><p>2. Literature review and hypotheses development </p><p>Adopting a common set of high quality accounting standards can improve earnings quality </p><p>through the ease of monitoring and comparison of financial reports across borders, which </p><p>puts pressure on management to report faithfully and truthfully and engage less in earnings </p><p>management activities (Soderstrom and Sun 2007). Daske and Gebhardt (2006) find </p><p>significant increases in disclosure quality under IFRS in three European countries (namely, </p><p>Austria, Germany, and Switzerland) scored by independent academic accounting scholars. </p><p>Using a sample in 21 countries, Barth, Landsman, and Lang (2008) show that international </p><p>accounting standards (IAS) adopting firms have less earnings management, more timely loss </p><p>recognition, and more value relevant earnings than non-adopting firms in post-adoption </p><p>period. They suggest that adopting IAS improves accounting quality and potentially reduces </p><p>the cost of equity capital. More recently, Chen et al. (2010) find that accounting quality has </p><p>marginally improved after IFRS adoption in the 15 European Union countries. They suggest </p><p>that the improvement in accounting quality is due to IFRS restricting alternative accounting </p><p>choices, reducing the ambiguity in local standards, and changing the managerial incentives. </p><p>In contrast, opponents argue that adopting high quality accounting standards per se does not </p><p>necessarily improve accounting quality. For example, Ball, Robin, and Wu (2003) find that </p><p>the accounting quality is low in four Asian countries/regions (Hong Kong, Malaysia, </p><p>Singapore, and Thailand), even though their accounting standards are derived from common </p><p>law countries. Lin and Paananen (2006) examine changes in the patterns of earnings </p><p>management activities over time, and suggest that IASB has not been effective in decreasing </p><p>overall earnings management activities. Callao and Jarne (2010) compare discretionary </p><p>accruals in periods preceding and immediately after IFRS adoption for firms listed on 11 </p><p>European stock markets. Their findings suggest that IFRS encourages discretionary </p><p>accounting and opportunistic behaviour. </p><p>Besides accounting standards, accounting quality is also determined by a countrys overall </p><p>institutional system and firms incentives for financial reporting (Ball et al., 2000; Ball et al., </p><p>2003; Boonlert-U-Thai, Meek, and Nabar, 2006; Jeanjean and Stolowy, 2008). Leuz et al. </p><p>(2003) use cluster analysis with La Porta et als (1998) nine institutional variables to identify </p><p>systematic differences in earnings management across 31 countries. They report lower </p><p>earnings management in countries with stronger investor protection, since strong protection </p><p>limits insiders ability to acquire private control benefits, and reduces their incentives to mask </p></li><li><p>5 </p><p>060 TIJA Symposium 2012 </p><p>2/1/12 </p><p>firm performance. Similarly, Burgstahler, Hail, and Leuz (2006) examine the relation </p><p>between earnings management and the interaction among ownership structure, capital market </p><p>structure and development, the tax system, accounting standards, and investor protection. </p><p>They document that strong legal systems are associated with lower earnings management. </p><p>Boonlert-U-Thai et al. (2006) explore the effects of investor protection on reported earnings </p><p>quality, and find that earning smoothness is less prevalent in strong investor protection </p><p>countries. Ding, et al. (2007) examine how a countrys legal system, economic development, </p><p>importance of stock markets, and ownership concentration shape the countrys accounting </p><p>standards, which in turn affect the countrys quality of financial reporting. Soderstrom and </p><p>Sun (2007) argue that cross-country differences in accounting quality are likely to remain </p><p>following IFRS adoption, because accounting quality is a function of the institutional setting </p><p>in which firms operate. Although conversion to IFRS is likely to improve earnings quality, it </p><p>is only one of several determinants. Even after mandatory IFRS adoption, country-level </p><p>institutional variables continue to vary across countries. </p><p>Many researchers argue that the enforcement of accounting standards is as important as the </p><p>accounting standards (e.g. Shleifer and Vishny, 1997). Strong IFRS enforcement puts </p><p>pressure on management and auditors to act faithfully and truthfully to comply with the </p><p>standards, and contributes to comparability of financial statements across countries (FEE, </p><p>2002, 29). Enforcement of standards also helps investors perceive that financial reports </p><p>reflect a firms fundamentals, which can increase the relevance of the accounting information. </p><p>Ewert and Wagenhofer (2005) find that tightening enforcement of accounting standards </p><p>reduces earnings management and improves reporting quality. </p><p>Ball et al. (2003) and Holthausen (2003) predict that IFRS adoption by countries with weak </p><p>enforcement mechanisms will lead to lower perceived quality of the standards, and suggests </p><p>that it would be useful for the literature to begin to structure and quantify the country </p><p>descriptions by developing more informative tests. Similarly, Leuz et al. (2003) and Beneish </p><p>and Yohn (2008) argue that countries with strong outsider1 protection are expected to enact </p><p>and enforce accounting and securities laws that limit the manipulation of accounting </p><p>information. Jeanjean and Stolowy (2008) provide early evidence of the importance of the </p><p>institutional environment in reducing earnings management after IFRS adoption. They find </p><p>that earnings management did not decline in Australia and the UK after the introduction of 1 Outsiders are distinguished from those insiders such as managers and controlling shareholders, who have </p><p>incentives to conceal their private control benefits from outsiders (See Leuz et al. 2003). </p></li><li><p>6 </p><p>060 TIJA Symposium 2012 </p><p>2/1/12 </p><p>IFRS, and in fact increased in France. In a pre-IFRS setting Hope (2003) had found that </p><p>accounting standards enforcement is needed to encourage or forces managers to follow the </p><p>rules. In a more recent study, Hoque et al (2012) find that legal enforcement (a proxy for </p><p>accounting enforcement) had a positive influence on the effects of IFRS adoption on the </p><p>reduction of earnings management. </p><p>The studies on the influence of IFRS adoption and enforcement often simply assume that all </p><p>countries adopting IFRS will benefit from IFRS adoption and that enforcement along with </p><p>IFRS adoption will provide further accounting quality improvements. These studies do not </p><p>take into account that among the countries that have adopted IFRS there is a large proportion </p><p>that already had accounting standards similar to IFRS and had strong enforcement </p><p>arrangements, in particular, with regards to securities law disclosure requirements and </p><p>auditing. We contend that countries that had accounting standards divergent2 from IFRS are </p><p>likely to have more significant effects from the adoption of IFRS. Also, countries that have </p><p>not adopted IFRS but have standards relatively similar to IFRS will enjoy lower levels of </p><p>earnings management. In this respect, two countries, USA and Canada, stand out. These two </p><p>countries have more extensive standards than IFRS. Likewise, we hypothesize that </p><p>H1 Earnings management is negatively associated with IFRS adoption and greater </p><p>convergence of local standards to IFRS. </p><p>As discussed above, legal enforcement arrangements are likely to have a direct positive </p><p>influence on earnings quality. Legal enforcement is also likely to enhance the influence of </p><p>IFRS and convergence to IFRS. Therefore, we hypothesise that </p><p>H2 Earnings management is negatively associated with legal enforcement. </p><p>H3 The stronger the legal enforcement the greater will be the influence of IFRS adoption and </p><p>convergence of local standards to IFRS on the reduction of earnings management. </p><p>IFRS adoption is not simply the replacement of local accounting standards. M...</p></li></ul>