Master Thesis: The Accounting Quality of IFRS-adopting Private Firms

Abstract This study examines the changes of the accounting quality of private firms over the years around the IFRS adoption event.. While some studies on public firms have shown some pos

Master Thesis: The Accounting Quality of IFRS-adopting Private Firms

Chaolong Guan Tilburg University

Supervisor: Dr Marco Da Rin Tilburg University October 2013

Abstract

This study examines the changes of the accounting quality of private firms over the years around the IFRS adoption event Based on a sample of 7,043 private firms from three European countries who adopted IFRS during the period 2003 to 2010, the tests give strong evidence for the findings that pri-vate firms experience a decrease in accounting quality on the IFRS adoption year and an increase on the year after For measuring accounting quality, the model from Dechow & Dichev (2002) was used The model regresses the working capital accruals with the adjacent three-year cash flows, and the standard deviations of the residuals were characterized as estimation errors, which in turn proxy for ac-counting qualities In order to observe the changes in the acac-counting quality over time, I put the firms with the same IFRS-adoption year into country-year groups Then I take two approaches to measure their accounting qualities The results are consistent with the main findings I also make tests control-ling for firm size and financial leverage In light of the shortcomings of the Dechow & Dichev (2002) model in explaining discretionary accruals, the McNichols (2002) model was also used

I Introduction

Accounting standards have been a focus of accounting studies in recent years They play a cru-cial role in the corporate financing processes The development of the accounting standards is an inter-esting topic in its own right As were summarized in Kothari, Ramanna & Skinner (2011), there are three streams of economic theories on accounting regulation: public interest, capture, and ideology the-ories, which together form an evolutionary viewpoint of the development of accounting standards They rule out the public interest theory due to the lack of support for a “benevolent and omniscient pol-icy maker” They conclude that “competition among standard setters is the most effective means of ad-dressing the concerns over a regulated GAAP highlighted by the capture and ideology theories”

Over the last number of years the adoption of International Financial Reporting Standards (IFRS) has gained considerable momentum around the world The International Accounting Standards Board (IASB) was established in 2001 to develop International Financial Reporting Standards (IFRS)

A year later, European Union (EU) member states committed to requiring IFRS for all listed corpora-tions in their jurisdiccorpora-tions effective year 2005 (EC, 2002) Since then, almost 100 countries require or permit the use of IFRS for financial reporting purposes, and several more have decided to require IFRS

in the near future These countries either mandated IFRS for some listed companies or allow listed companies to voluntarily adopt IFRS

From the point of view of the financing agents, their incentives in choosing an accounting standard for their financial reporting is a topic worth studying Even though the requirements by the IFRS-adopting countries are only subjected to the public firms, many private firms around the world have voluntarily adopted or switched to IFRS While some studies on public firms have shown some positive effects that the IFRS adoption has on the decrease of firms' cost of capital, and other relevant studies shown otherwise, the effects that this switch has on private firms is a rarely explored topic This study investigates the relationship between private firms' accounting qualities with their changes of re-porting standards

While most of the relevant studies were made in the territory of listed firms, this study is based

on a sample of 7,043 private firms who adopted IFRS during the period 1997 to 2010 from three coun-tries: United Kingdom, Italy, and Germany The factors that lead to the differences in the financial re-porting between public firms and private firms lay in their differences in investor-management relation-ships For a public firm, the investors are always ‘at arms' length’, while for a private firm, their inves-tors can deal with the information asymmetry problem via “insider access”, as described in Ball & Shivakumar (2005): “examples of insider access include the German ‘‘stakeholder’’ system, with both labor and capital (bank) represented in corporate governance, the Japanese keiretsu and South Korean chaebol systems of investing and trading largely within internally informed corporate groups, and the Chinese system of family controlled businesses and guanxi (connections) networks.” These differences

in agency relationships indicate that the insider access and high-quality public financial reporting are substitutes in reducing information asymmetry, which leads to the lower demands from investors of private firms for high-quality accounting reports

The findings of this study show that the accounting quality of the private firms decreases at the first year after the IFRS adoption and increase on the second year For measuring accounting quality, the model from Dechow & Dichev (2002) is used The model uses the adjacent three-year cash flows to explain the working capital accruals, and the standard deviations of the residuals were characterized as estimation errors, which in turn proxy for the accounting qualities In order to observe the changes in accounting quality over time, I put the firms with the same adoption years into the same groups for firms of each country Then I take two approaches to measure the accounting qualities of each group I also make tests controlling for the firm sizes and financial leverages In light of the shortcomings of the Dechow & Dichev (2002) model in explaining discretionary accruals, the McNichols (2002) model was also used The results are consistent with the main findings

The rest of this paper will continue as follows Section 2 will describe and summarize the

relat-ed literature Section 3 will explain the method I use to measure the accounting qualities of observa-tions from the data Then I will describe the data and the research design in section 4 In section 5, I will discuss about the results from the tests Section 6 concludes

II Related Literature

The topic of this study is related to some of the fundamental questions in accounting studies, such as the incentives of the agents in financial reporting and earnings management Moreover, many recent literatures have studied the effects of the adoptions of new accounting standard These studies focus on different areas of economic topics and provide a methodology base for this study By studying them, one can get a comparative understanding of existing methodologies and the current progress of economic studies on these issues

One fundamental issue in accounting is: what factors influence the various incentives in corpo-rate financial reporting One of the incentive problems in corpocorpo-rate financial reporting is that the man-agers face a trade-off between short-term need to “deliver earnings” and the long-term objective of val-ue-maximizing investment decisions According to the findings of Graham et al (2005), managers would rather take economic actions that could have negative long-term consequences than make with-in-GAAP accounting choices to manage earnings Their results indicate that CFOs believe that earnings, not cash flows, are the key metric considered by outsiders Ball, Robin, & Sadka (2008) raised the question of whether financial reporting is shaped by equity markets or by debt markets They hypothe-size that debt markets—not equity markets—are the primary influence Their measures of countries’ financial reporting properties (country-level financial reporting timeliness and country-level conserva-tism) are regressed on the countries’ debt and equity market sizes, to estimate where the demand for financial reporting resides Their hypotheses about debt market are: 1 Timely loss recognition

increas-es in the importance of debt markets; 2 Conditional conservatism (asymmetrically timely loss recogni-tion relative to gain recognirecogni-tion) increases in the importance of debt markets; 3 Uncondirecogni-tional con-servatism (low reported earnings and book values, independent of economic gains and losses) does not increase in the importance of debt markets, controlling for conditional conservatism Their hypotheses about equity market are: 1 Timely gain and loss recognition do not increase in the importance of equity markets; 2 Conditional conservatism (asymmetrically timely loss recognition relative to gain recogni-tion) does not increase in the importance of equity markets; 3 Overall gain and loss timeliness does not increase in the importance of equity markets They estimate country-level financial reporting timeliness from Basu (1997) piecewise-linear regressions of earnings on returns The regressions control for vari-ous non-market determinants of financial reporting practice, including countries’ legal system origins and three legal-system variables: Rule of Law, Corruption and Creditors’ Rights They also report re-gressions that control for the market-to-book ratio They argue that firstly MTB contains information about both expected returns and expected earnings Secondly, MTB proxies for the proportion of the variation in the market value of equity that is due to factors (such as synergies and rents) that are not reflected in book value, and hence affect returns but not earnings

Also on the incentives in corporate financial reporting: Burgstahler, Hail, & Leuz (2006) hy-pothesizes that capital markets as well as critical aspects of a firm’s institutional environment determine the role of earnings This role in turn influences how corporate insiders use reporting discretion, which crucially determines the properties of reported earnings They focus on another dimension of account-ing quality other than conservatism, namely, the degree of earnaccount-ings management They rely on an earn-ings management index suggested by Leuz et al (2003), which is based on four different proxies They also conduct sensitivity analyses using alternative earnings management metrics similar to that used by Lang et al (2003) and Lang et al (2006) as well as measures of conservatism They start with an exam-ination of the effect of capital markets on the reporting incentives Next, they explore the interaction

between market forces and other institutional variables that have the potential to differentially affect private and public firms: The first factor is the quality of legal enforcement The quality of legal en-forcement is measured by the average score across three proxies from La Porta et al (1998): (1) an in-dex of the judicial system’s efficiency, (2) an inin-dex of the rule of law, and (3) the level of corruption They also examine the following four factors First, they expect that the degree of tax alignment of fi-nancial accounting has a differential effect on private and public firms As private firms are less reliant

on earnings to communicate firm performance, it is less of a concern to private firms if they make earn-ings less informative in the process of minimizing taxes Second, they expect accounting rules that make heavier use of accruals to be associated with less earnings management for public firms than pri-vate firms Third, they expect stricter disclosure rules in securities offerings and associated enforcement which apply only to firms with publicly traded securities make it harder for firms to engage in earnings management and create incentives to reveal economic performance Similarly, strong

minority-shareholder protection rules are designed to facilitate equity financing at arm’s length in public markets and hence are expected to reduce earnings management primarily for publicly traded firms Fourth, they expect that the two capital market features (the extent to which the financial system is relatively more equity market- or bank-based and the degree of financial development) are negatively associated with earnings management primarily for the public firms

Another incentive problem involved in corporate financial reporting is that the managers as in-siders, in order to protect their private control benefits, use earnings management to conceal the firm performance from outsiders However, the ability of insiders to divert resources for their own benefits

is limited by the legal systems that protect the rights of outside investors As outsiders can only take disciplinary actions against insiders if outsiders detect the private benefits, insiders have an incentive to manipulate accounting reports in order to conceal their diversion activities Leuz, Nanda, & Wysocki (2003) propose that earnings management is more pervasive in countries where the legal protection of outside investors is weak To measure the pervasiveness of earnings management in a country, they create four proxies that capture the extent to which corporate insiders use their accounting discretion to mask their firm’s economic performance The first measure is a country’s median ratio of the firm-level standard deviation of operating earnings divided by the firm-level standard deviation of cash flow from operations, which was calculated by subtracting accruals from earnings The second measure is the cor-relation between changes in accounting accruals and operating cash flows The third measure uses the magnitude of accruals as a proxy for the extent to which insiders exercise discretion in reporting earn-ings It is computed as a country’s median of the absolute value of firms’ accruals scaled by the abso-lute value of firms’ cash flow from operations The fourth measure follows Burgstahler and Dichev (1997) to calculate the ratio of ‘‘small profits’’ to ‘‘small losses’’ The aggregate earnings management score is computed by averaging the country rankings for the four individual earnings management measures They begin with a descriptive country cluster analysis, which groups countries with similar legal and institutional characteristics To examine more explicitly whether differences in earnings man-agement are related to private control benefits and investor protection, first, they undertake a multiple regression analysis They measure outside investor protection by both the extent of minority

sharehold-er rights as well as the quality of legal enforcement The proxy for minority shareholdsharehold-er rights is an an-ti-director rights index created by La Porta et al (1998) that captures the voting rights of minority shareholders The legal enforcement measure for each country is the average score across three varia-bles: (1) an index of the legal system’s efficiency; (2) an index of the rule of law; and, (3) the level of corruption The regressions control for the endogeneity of investor protection using countries’ legal or-igins and wealth as instruments for the investor protection variables as suggested by Levine (1999) Then they directly estimate a 2SLS regression on the control benefits proxy using the level of outsider rights and legal enforcement as instruments, explicitly accounting for the effect of investor protection

on the level of private control benefits They use a country’s average block premium estimated by Dyck

and Zingales (2002) as a proxy for the level of private control benefits

The premise in the studies of corporate financial reporting and earnings management is to

measure the quality of financial reporting Dechow, Ge & Schrand (2010) summarized and analyzed the various measures which were used as indicators of “earnings quality” They summarized earnings quality measures including “persistence, accruals, smoothness, timeliness, loss avoidance, investor re-sponsiveness, and external indicators such as restatements and SEC enforcement releases,” which were categorized into three groups: properties of earnings, investor responsiveness to earnings, and external indicators of earnings misstatements Among them, the properties of earnings were mostly used in ac-counting research The measures in properties of earnings could be further classified into five catego-ries: earnings persistence, abnormal accruals and modeling the accrual process, earnings smoothness, asymmetric timeliness and timely loss recognition, and target beating There're two streams to the re-search in earnings persistence The first stream assumes that “more persistent earnings will yield better inputs to equity valuation models, and hence a more persistent earnings number is of higher quality than a less persistent earnings number.” However, this assumption was not very well justified by extant studies yet The second stream attempts to address this problem In this group, the authors distinguished studies on the relative contributions of fundamental performance (X) versus the measurement rule (f)

on the persistence of reported earnings They X and f comes from definitive framework of earnings:

Reported Earnings == f(X) The second type of measures for the properties of earnings is to measure

the abnormal accruals “The normal accruals are meant to capture adjustments that reflect fundamental performance, while the abnormal accruals are meant to capture distortions induced by application of the accounting rules or earnings management (i.e., due to an imperfect measurement system).” “The general interpretation is that if the 'normal' component of accruals is modeled properly, then the abnor-mal component represents a distortion that is of lower quality.” Among this category, they summarized five widely used models of accruals: Jones (1991) model, modified Jones model (Dechow et al., 1995), performance matched (Kothari et al., 2005), Dechow and Dichev (2002) approach, and discretionary estimation errors (Francis et al., 2005a) The third category of measures for properties of earnings is based on the tenet that “earnings smooth random fluctuations in the timing of cash payments and re-ceipts, making earnings more informative about performance than cash flows.” The debate on this tenet

is that standard makers don't regard smoothness as a necessary desirable property of earnings The au-thors conclude that “the standard setter’s goal is a representation of fundamental performance that proves cash flow predictability Smoothness is an outcome of an accrual-based system assumed to im-prove decision usefulness; it is not the ultimate goal of the system.” The fourth category of measures for properties of earnings is to separately distinguish the timeliness of loss recognition and profit

recognition The most frequently used measure of timely loss recognition is the reverse

earnings-returns regression from Basu (1997) Basu (1997) provides a second measure of timely loss recognition that is based solely on the reverse regression on the changes in net income As I also noted above, Ball, Robin, & Sadka (2008) makes use of the Basu (1997) reverse regression method and shows that timely loss recognition “has an endogenous component related to firms’ reporting incentives, primarily equity incentives.” “Thus, assuming that managers are responding to investor demand for decision usefulness, these studies suggest that equity markets perceive asymmetric timeliness as improving earnings quality.” The last category of measures for properties of earnings in Dechow, Ge & Schrand (2010) is target beating They suggest that “findings on whether small profits and small loss avoidance represent earn-ings management based on the observed determinants is mixed, which is suggestive that small profits and small loss avoidance may not be an indication of earnings management This indirect evidence is supported by more direct evidence including Dechow et al (2003), who show that discretionary accru-als are no different for small profit versus small loss firms; Beaver et al (2007), who suggest that the

‘‘kink’’ in earnings around zero can be explained by asymmetric taxes, rather than opportunistic choic-es; and Durtschi and Easton (2005, 2009), who show that it is explained by statistical and sample bias

issues related to scaling by price.” They conclude that: “the totality of the evidence indicates that the use of small profits as a proxy for earnings management more generally is unsubstantiated.”

The effects of different reporting choices on the firms were studied in Ball & Shivakumar (2005), which seeks to identify which recognition model (unconditional conservatism or conditional conservatism) is most prevalently used for economic gains and losses, and how this choice differs be-tween public and private companies The international evidence is consistent with insider access and high-quality public financial reporting being substitutes for reducing information asymmetry, so they expect private and public companies to follow a similar pattern In other words, the public firms should have more timely loss recognition than private companies due to lack of insider access from their in-vestors Their principal timeliness measure exploits the transitory nature of economic income (Samuel-son 1965; Fama, 1970) From Basu (1997), they measure timely gain and loss incorporation as the ten-dency for increases and decreases in accounting income to reverse Their hypothesis is that there is less reversal of income decreases in private companies than in public companies Next, they conduct an ac-cruals-based test of loss recognition The role of accruals in the Dechow et al (1998) model is to miti-gate noise in operating cash flow They envision a second role for accruals, timely recognition of eco-nomic gains and losses, and hypothesize that it is a source of positive but asymmetric correlation tween accruals and contemporaneous cash flows Thus they estimate a piecewise-linear relation be-tween cash flows and accruals They found that “average earnings quality is measurably lower in UK private companies than in public companies, even though their financial statements are audited and cer-tified as complying with the same accounting standards Accounting standards are not absolute givens, and their effect on actual financial reporting is subject to market demand.”

As an important part of financial reporting decision, accounting standards were considered an economically significant factor One stream of views on accounting standard changes believes that fi-nancial statement comparability would increase by switching from local accounting standards to an in-ternational accounting standard As stated in IASCF [2005], one of the objectives of the IFRS is to de-velop a set of “global accounting standards that require high quality, transparent and comparable in-formation in financial statements and other financial reporting.” DeFranco, Kothari, & Verdi (2011) constructs a measure of financial statement comparability to estimate its benefits to users They build their definition of comparability on the idea that the accounting system is a mapping from economic events to financial statements They use stock return as a proxy for the net effect of economic events on the firm’s financial statements, and use earnings as a proxy for financial statements The “closeness” of the functions between two firms represents the comparability between the firms They invoke one im-plication of accounting comparability: if two firms have experienced the same set of economic events, the more comparable the accounting between the firms, the more similar their financial statements They use firm i’s and firm j’s estimated accounting functions to predict their earnings, assuming they had the same return They define accounting comparability between firms i and j as the negative value

of the average absolute difference between the predicted earnings using firm i’s and j’s functions Then they hypothesize that the availability of information about comparable firms lowers the cost of acquir-ing information, and increases the overall quantity and quality of information available about the firm They expect these features to result in more analysts covering the firm In addition, enhanced infor-mation should facilitate analysts’ ability to forecast firm i's earnings Thus they predict that comparabil-ity will be positively associated with forecast accuracy and negatively associated with forecast disper-sion Beuselinck, Joos, & Van Der Meulen (2007) conjectures that earnings comparability is largely affected by the way the accruals system recognizes losses in a timely fashion or smooths income over distinct reporting periods They focus on the accrual accounting system to investigate the association between accruals and positive, resp negative cash flows across different countries In addition, they compare the way accrual accounting functions equally (or, differently) across countries They study the sensitivity of these accruals – cash flow association to firm-specific reporting incentives and business

cycles across a set of countries They choose a sample of all non-financial companies incorporated in one of the 15 EU member states over a 15 year period prior and up to IFRS introduction (1991-2005)

as the research setting They extend the piecewise linear regression model developed by Ball and

Shivakumar (2005; 2006) separating positive and negative cash flow observations The regressions use accounting accruals as dependent variable and cash flow from operations as independent variable Then they deduct accruals from earnings to get an operating cash flow measure They include reporting in-centives related to capital market pressure, debt levels, and labor relation inin-centives (measured by size, leverage, and labor intensity), while controlling for business cycles Next, they investigate how report-ing incentives affect accrual measurement and whether the incentive effects differ across the EU over the period 1991-2005 They check the robustness of their results with respect to controls for sector specification, growth characteristics as well as for including market returns in the piece-wise regression model Finally, they study whether three institutional country features (importance of stock market, domestic bank debt, and labor union membership) affects the observed effect of firm reporting incen-tives on (un)timely loss/gains recognition Taking a different approach, Bae, Tan, & Welker (2008) ap-proach the topic by measuring investors' responsiveness They hypothesize that the costs of following a foreign firm increase with the extent of GAAP differences between the analyst’s domicile country and the home country of the foreign firm They also hypothesize that the costs of providing accurate fore-casts increase with the extent of GAAP differences between the analyst’s home country and the home country of the foreign firm For the dependent variables, they measure the foreign analyst following with the average number of foreign analysts per year from country A who forecast annual earnings for a firm during the seven-year period of 1998–2004 To measure forecast accuracy they use the

price-scaled absolute difference between an earnings forecast and the actual earnings for a firm at time t For the independent variable, they adopt two approaches in measuring the differences in accounting stand-ards between two countries The first approach identify differences in their sample on the 21 account-ing rules which was based on a review of the past literature and relyaccount-ing on a survey of GAAP differ-ences between each of the country-pairs The second approach uses the survey data to identify com-monly occurring differences in accounting across countries Their comprehensive list of country-pair control variables is drawn primarily from Sarkissian and Schill (2004), who construct a comprehensive set of country-pair level variables in their analysis of firms’ cross-listing decisions Their main results show that the extent to which accounting standards differ across countries is negatively related to for-eign analyst following They find a weaker negative relation between GAAP differences and forecast accuracy

More specifically related to the topic of this thesis, several researches studies the effects of the accounting standard changes for public firms Three studies found positive effects: Leuz & Verrecchia (2000), Gkougkousi & Mertens (2010), and Tan, Wang, & Welker (2011) However, three studies found otherwise: Christensen, Hail, & Leuz (2013), Daske, Hail, Leuz, & Verdi (2008), and Daske, Hail, Leuz,

& Verdi (2013)

Leuz & Verrecchia (2000) hypothesizes that a switch to an international reporting regime leads

to lower bid-ask spreads, more trading volume, and less share price volatility of listed firms By esti-mating a cross-sectional relation between their proxies of a firm’s cost of capital and the firm’s report-ing strategy well after firms have switched the disclosure regime, they should be able to separate the

“information-asymmetry” effect from the “news” effect In addition, an “event study” design observes the behavior of their proxies around the reporting change and hence mitigates the possibility that some other unobserved variable (and not the disclosure policy) is responsible for the cross-sectional differ-ences in the proxies A key problem in estimating the cross-sectional regression is that firms choose their reporting strategy considering the costs and benefits of international reporting Therefore, an OLS regression of the proxy for cost of capital on firm characteristics and a dummy for the firm’s reporting strategy would suffer from self-selection bias They deal with this problem with a two-equation method

Their cross-sectional sample comprises 102 firms included in the DAX 100 index during 1998 They studied the annual reports to identify the firms’ reporting strategy They also conducted a survey to con-firm their classification Their evidence in German con-firms is consistent with the notion that con-firms com-mitting to increased levels of disclosure garner economically and statistically significant benefits

Gkougkousi & Mertens (2010) examines the effect of IFRS adoption on banks and insurance compa-nies Doing so is particularly interesting due to the controversial impact of fair-value accounting on the cost of equity They measure the cost of equity averaging over the estimates of four different implied cost-of-equity models from Hail & Leuz (2006) For their proxy for liquidity they use the Amihud 2002 illiquidity measure The independent variable is a dummy which takes the value 1 if the company re-ports under IFRS Their analysis shows a statistically and economically significant decrease in cost of equity and a statistically and economically significant increase in liquidity for European banks and in-surance companies that report under IFRS after 2005 Their additional analyses indicate an increase in earnings volatility of financial institutions in the post-2005 period, while their risk-taking behavior de-creases Contrary to the predictions of recent theoretical studies, they find that banks and insurance companies with higher exposure to fair-value accounting enjoy lower cost of equity Similar to Bae, Tan, & Welker (2008) described above, Tan, Wang, & Welker (2011) takes an approach on investors' responsiveness to accounting standard switch Their first hypothesis is that IFRS adoption is associated with increased coverage by foreign analysts and an improvement in foreign analysts’ earnings forecast accuracy The second hypothesis is that increases in foreign analyst following and improvements in foreign analysts’ forecast accuracy following IFRS adoption are more pronounced for analysts located

in countries that adopt IFRS at the same time as the firm’s home country and for analysts with previous IFRS experience Their last hypothesis is that increases in foreign analyst following and improvements

in foreign analysts’ forecast accuracy following IFRS adoption are more pronounced for firms from countries with local GAAP that differed more from IFRS prior to IFRS adoption, and are positively as-sociated with the extent to which GAAP differences between the analyst’s home country and the firm’s home country are reduced by IFRS adoption The main dependent variables are foreign analyst follow-ing and foreign analysts’ earnfollow-ings forecast accuracy surroundfollow-ing each firm’s mandatory IFRS adoption

In the analysis of foreign analyst following, they control for firm size, cross-listing in the United States, market value to book value of equity, intangible assets, stock return volatility, security issuance, stock turnover, and stock return In the analysis of earnings forecast accuracy, they also control for the num-ber of analysts following the firm, earnings forecast horizon, analysts’ general experience and firm-specific experience, the number of analysts working for the brokerage that an analyst is associated with, and the number of firms covered by an analyst For their last hypothesis, they use the Bae, Tan, and Welker (2008) measures to construct two related but distinct measures of the extent to which IFRS adoption eliminates accounting standard differences First, they use the number of differences between local GAAP and IAS as a measure of the extent to which the mandatory adoption of IFRS produces more comparable reporting (relative to other IFRS firms internationally) for firms in each country Then they use the number of differences between local GAAP and IFRS prior to IFRS adoption as a measure of the number of accounting differences relative to IFRS that are eliminated by IFRS adoption

in each country They find that firms located in countries where local GAAP differed more from IFRS prior to IFRS adoption gain more foreign analysts than do firms located in countries with local GAAP more similar to IFRS They also find that foreign analyst following increases more when IFRS adop-tion causes a greater reducadop-tion of GAAP differences between analysts’ home countries and firms’ home countries

Christensen, Hail, & Leuz (2013) first examines whether there are differential capital-market effects in EU and non-EU countries around mandatory IFRS adoption In the second test, they intro-duce indicators to distinguish between countries with and without bundled changes in enforcement and examine whether the liquidity effects around IFRS adoption are stronger for the bundled countries The

third test attempts to separate the effects of IFRS adoption and changes in financial reporting enforce-ment by exploiting the fact that some firms are not affected by the IFRS mandate because they already report under IFRS on a voluntary basis Yet, these firms are affected by enforcement changes support-ing the IFRS mandate because their financial statements are subject to the (proactive) review process The final test exploits the fact that some EU countries made changes to the enforcement of financial reporting at a different time and not concurrent with the IFRS mandate They find that, across all coun-tries, mandatory IFRS reporting had little impact on liquidity The liquidity effects around IFRS intro-duction are concentrated in the EU and limited to five EU countries that concurrently made substantive changes in reporting enforcement There is little evidence of liquidity benefits in IFRS countries with-out substantive enforcement changes even when they have strong legal and regulatory systems Moreo-ver, they find similar liquidity effects for firms that experience enforcement changes but do not concur-rently switch to IFRS Daske, Hail, Leuz, & Verdi (2008) examines the economic consequences of mandatory IFRS reporting They employ four proxies for market liquidity, that is, the proportion of

ze-ro returns, the price impact of trades, total trading costs, and bid–ask spreads, four methods to compute the implied cost of equity capital, and use Tobin’s q as a proxy for firms’ equity valuations “Aside from its policy relevance, the study provides rare evidence on the economic consequences of forcing firms to change an entire set of accounting and disclosure standards.” Daske, Hail, Leuz, & Verdi (2013) examines the economic consequences associated with voluntary and mandatory IAS/IFRS adoptions around the world They hypothesize that an increased commitment to transparency is expected to re-duce information asymmetry and estimation risk, and hence should be rewarded with higher market liquidity and a lower cost of capital They analyze a large panel of voluntary IFRS (and IAS) adoptions from 1990 to 2005 across 30 countries To analyze the heterogeneity in the economic consequences across firms, they use two proxies to create variables indicating major changes in firms’ reporting in-centives around IFRS adoptions The first proxy is input-based and focuses directly on firm characteris-tics that shape firms’ reporting incentives They use factor analysis and extract a factor that has con-sistent loadings for these firm characteristics, and then use the distribution of changes in factor scores around IFRS adoption to split the sample into ‘serious’ and ‘label’ adopters The second proxy is out-put-based and measures changes in reporting behavior around IFRS adoptions They use changes in accruals-cash flow metric to capture improvements in reporting behavior They find little evidence that voluntary IAS adoptions are, on average, associated with an increase in market liquidity or a decline in the cost of capital If anything, the effects go in the opposite direction

III The Measurement of Accounting Quality

To measure the accounting qualities of the firms during the sample period, I use the accrual-cash flow relation as a proxy for measuring accounting quality Specifically, I tested on the financial data of IFRS adopting firms by the method devised by Dechow & Dichev (2002) to derive the measure

of working capital accrual quality with the following firm-level regression:

𝛥𝑊𝐶𝑡= 𝑏0+ 𝑏1∗ 𝐶𝐹𝑂𝑡−1+ 𝑏2∗ 𝐶𝐹𝑂𝑡+ 𝑏3∗ 𝐶𝐹𝑂𝑡+1+ 𝜀𝑡 𝛥𝑊𝐶 is the change in working capital as the dependent variable while 𝐶𝐹𝑂 is the cash flows from op-erations of the lagged-, current- and forward- year as the explanatory variables The residuals from the regressions reflect the accruals that are unrelated to cash flow realizations, and the standard deviation

of these residuals 𝜎(𝜀𝑡) is the firm-level measure of accruals quality, where higher standard deviation denotes lower quality This method takes advantage of the linkage between current accruals and cash flows in the immediately adjacent periods The basis for this method is that accruals may arise follow-ing some cash flows and in anticipation of others The difference between the amount accrued and the amount realized is characterized as the estimation error which in this study is measured by 𝜎(𝜀𝑡)

A shortcoming of this method is that it doesn't incorporate the management incentives in earn-ings management According to the surveys and interviews to corporate executives made by Graham et