IFRS Adoption and Accounting Qualit

IFRS Adoption and Accounting Quality: A Review

Abstract

In 2002, the European Union (EU) Parliament passed a regulation that requires consolidated and simple accounts for all companies listed in the EU to use International Financial Reporting Standards (IFRS) for fiscal years starting after January 1, 2005. This change in accounting systems will have a large impact on the information environment for EU companies. This paper provides a review of the literature on adoption of different GAAPs. We thus provide background and guidance for researchers studying the change in accounting quality following widespread IFRS adoption in the EU. We argue that cross-country differences in accounting quality are likely to remain following IFRS adoption because accounting quality is a function of the firm’s overall institutional setting, including the legal and political system of the country in which the firm resides.














































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IFRS Adoption and Accounting Quality: A Review

1. INTRODUCTION

International accounting literature provides evidence that accounting quality has economic consequences, such as costs of capital (Leuz and Verrecchia, 2000), efficiency of capital allocation (Bushman et al., 2006; Sun, 2006), and international capital mobility (Young and Guenther, 2002). On July 19, 2002, the European Union (EU) Parliament passed a regulation that requires all companies listed in the EU to adopt International Financial Reporting Standards (IFRS)1 for fiscal years starting after January 1, 2005. Widespread adoption of IFRS will result in a fundamental change in the business environment, since prior to 2005, companies followed a variety of country-specific Generally Accepted Accounting Principles (GAAP). In an attempt to provide insight into the effects of the change, this paper reviews literature on the consequences of changing accounting principles and the determinants of accounting quality that are likely to influence the effect of the change. Our discussion focuses on the change from one GAAP to another, rather than changes within a specific set of accounting standards.

Accounting theory argues that financial reporting reduces information asymmetry by disclosing relevant and timely information (e.g., Frankel and Li 2004). Because there is considerable variation in accounting quality and economic efficiency across countries, international accounting systems provide an interesting setting to examine the economic consequences of financial reporting. The EU’s movement to IFRS may provide new insights as



1 IFRS are issued by the International Accounting Standards Board (IASB) since April 2001, when the IASB took over the responsibility of the International Accounting Standards Committee (IASC). The IASC issued International Accounting Standards (IAS), which were later revised and adopted to IFRS.



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firms from different legal and accounting systems adopt a single accounting standard at the same time.
Improvement in the information environment following change to IFRS is contingent on at least two factors, however. First, improvement is based upon the premise that change to IFRS constitutes change to a GAAP that induces higher quality financial reporting. For example, Barth et al. (2006) find that firms adopting IFRS have less earnings management, more timely loss recognition, and more value relevance of earnings, all of which they interpret as evidence of higher accounting quality. Second, the accounting system is a complementary component of the country’s overall institutional system (Ball, 2001) and is also determined by firms’ incentives for financial reporting. La Porta et al. (1998) provide the first investigation of the legal system’s effect on a country’s financial system. They find that common law countries have better accounting systems and better protection of investors than code law countries. Other factors associated with financial reporting quality include the tax system (Guenther and Young, 2000; Haw et al., 2004), ownership structure (Ball and Shivakumar, 2005; Burgstahler et al., 2007; Fan and Wong, 2002), the political system (Leuz and Oberholzer-Gee, 2006), capital structure (Sun, 2006), and capital market development (Ali and Hwang, 2000).2

Therefore, controlling for these institutional and firm-level factors becomes an important task in the empirical research design.
As a result of the interdependence between accounting standards and the country’s institutional setting and firms’ incentives, the economic consequences of changing accounting systems may vary across countries. Few papers have examined how these factors affect the

2 There are many alternative definitions and measures of quality in the accounting literature. For example, Francis et al. (2004) summarize seven common earnings attributes that are often associated with earnings quality (associating these attributes with firms’ cost of capital). We do not offer an exhaustive summary of this literature since there are a number of excellent recent surveys, including Schipper and Vincent (2003) and Dechow and Schrand (2004).



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economic consequences of changing accounting standards. For example, Pincus et al. (2007) find that accrual anomaly is more prevalent in common law countries. Guenther and Young (2000), and Haw et al. (2004) find that accounting quality is associated with tax reporting incentives. Exploration of the interaction between these factors and accounting standards, can provide insights into differences in the economic consequences of changing accounting principles across countries.
We adopt a historical approach and focus on accounting literature published in leading accounting journals and selected working papers beginning in the 1990s.3 In section 2, we discuss research concerning the effects on companies of a change in GAAP. We begin with the effects of the European Commission’s accounting directives in the 1980s, followed by a discussion of voluntary adoption of non-local accounting standards in the 1990s and early 2000s. We then review papers concerning stock market reaction to news of the mandatory adoption of IFRS by the EU around 2002. Section 3 provides a discussion of the effects of the IFRS adoption after 2005. Because mandatory adoption of IFRS is fairly recent, researchers do not yet have enough data for large-sample empirical tests of the change in accounting standards. We thus discuss factors from the international accounting and finance literatures that may affect financial reporting quality and should be considered in any future research. We believe that understanding these factors is important for developing expectations about effects of the change in regime. Section 4 concludes the paper.









3 Bushman and Smith (2001) include a subset of this literature. Their focus, however, is on the economic effects of corporate governance and financial reporting.



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2. EFFECTS OF CHANGING ACCOUNTING PRINCIPLES

Historically, legal systems, combined with other political and economical differences, created a vast diversity of accounting systems, which makes meaningful comparison of financial reports across borders difficult. Europe is the origin of many legal systems: English, German, French and Scandinavian, and thus, prior to harmonization, there were extremely diverse, country-specific accounting systems. Recognizing this, members of the EU were the first countries to move toward harmonization of accounting standards.
In the late 70s and 80s, the European Union issued several directives to harmonize financial reporting practices to reduce diversity and facilitate cross-listings and cross-border investment. Accounting harmonization progressed in the 1990s with the improvement of IAS (the precursor of IFRS), harmonization events in the EU economy (e.g., adoption of a single currency), and political changes (e.g., disappearance of border control within the Schengen area). Although IFRS adoption was not mandatory until 2005, in the late 1990’s, firms in some European countries were allowed to use IAS as a substitute for domestic accounting standards.

In this section, we trace the history of harmonization and then describe research associated with its different stages. This presents a clear picture of historical differences between national accounting standards in the EU relative to IFRS, as well as an understanding of the economic consequences of past accounting harmonization. Results from past literature can provide insights about the effects of mandatory IFRS adoption.4

4 A monopolistic view of accounting harmonization argues that using one single set of accounting standards will reduce the competition and thus the incentives of standard-setters to improve. However, Sunder (2002) argues that rather than using a single set of accounting standards, countries should allow firms to choose among several competing sets of accounting standards. Investors and firm managers will then choose accounting standards so as to reduce the firm’s costs of capital. The competition among different standard-setters to attract firms’ adoption will improve standard quality. Huddart et al. (1999) analytically model a situation where investors decide which exchange to list on based upon required disclosure level and personal risk aversion. In their model, stock exchanges competing for trading volumes will “race to the top” and raise disclosure requirements to attract risk-averse investors. Dye (2002) models the probability of the success of accounting standards from different



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2.1 EC-directives related to accounting principle change

Historically, the European Commission’s (EC) directives were aimed at making financial statements increasingly comparable in terms of format and general recording and measurement rules. The Fourth Directive, enacted in 1978, and the Seventh Directive, enacted in 1983, were the most influential directives during the early stage

Hasil (Bahasa Indonesia) 1:

IFRS adopsi dan kualitas akuntansi: ReviewAbstrakPada tahun 2002, parlemen Uni Eropa (UE) mengesahkan peraturan yang mengharuskan account konsolidasi dan sederhana untuk semua perusahaan yang terdaftar di Uni Eropa menggunakan International Financial Reporting standar (IFRS) untuk tahun fiskal dimulai setelah 1 Januari 2005. Perubahan ini dalam sistem akuntansi akan memiliki dampak yang besar pada lingkungan informasi untuk perusahaan-perusahaan EU. Karya tulis ini menyediakan review di dalam literatur di adopsi dari GAAPs yang berbeda. Kami dengan demikian menyediakan latar belakang dan bimbingan bagi para peneliti yang mempelajari perubahan kualitas akuntansi yang mengikuti adopsi IFRS luas di Uni Eropa. Kami berpendapat bahwa lintas negara perbedaan dalam kualitas akuntansi mungkin untuk tetap mengikuti IFRS adopsi karena kualitas akuntansi adalah fungsi pengaturan kelembagaan secara keseluruhan perusahaan, termasuk sistem hukum dan politik negara di mana perusahaan berada. 2 IFRS adopsi dan kualitas akuntansi: Review1. PENDAHULUANInternational accounting literature provides evidence that accounting quality has economic consequences, such as costs of capital (Leuz and Verrecchia, 2000), efficiency of capital allocation (Bushman et al., 2006; Sun, 2006), and international capital mobility (Young and Guenther, 2002). On July 19, 2002, the European Union (EU) Parliament passed a regulation that requires all companies listed in the EU to adopt International Financial Reporting Standards (IFRS)1 for fiscal years starting after January 1, 2005. Widespread adoption of IFRS will result in a fundamental change in the business environment, since prior to 2005, companies followed a variety of country-specific Generally Accepted Accounting Principles (GAAP). In an attempt to provide insight into the effects of the change, this paper reviews literature on the consequences of changing accounting principles and the determinants of accounting quality that are likely to influence the effect of the change. Our discussion focuses on the change from one GAAP to another, rather than changes within a specific set of accounting standards.Accounting theory argues that financial reporting reduces information asymmetry by disclosing relevant and timely information (e.g., Frankel and Li 2004). Because there is considerable variation in accounting quality and economic efficiency across countries, international accounting systems provide an interesting setting to examine the economic consequences of financial reporting. The EU’s movement to IFRS may provide new insights as1 IFRS yang dikeluarkan oleh International akuntansi standar Board (IASB) sejak April 2001, ketika IASB mengambil alih tanggung jawab dari International akuntansi standar Komite (IASC). IASC dikeluarkan internasional akuntansi standar (IAS), yang kemudian direvisi dan diadopsi untuk IFRS. 3 perusahaan dari sistem hukum dan akuntansi yang berbeda mengadopsi satu standar akuntansi pada waktu yang sama.Improvement in the information environment following change to IFRS is contingent on at least two factors, however. First, improvement is based upon the premise that change to IFRS constitutes change to a GAAP that induces higher quality financial reporting. For example, Barth et al. (2006) find that firms adopting IFRS have less earnings management, more timely loss recognition, and more value relevance of earnings, all of which they interpret as evidence of higher accounting quality. Second, the accounting system is a complementary component of the country’s overall institutional system (Ball, 2001) and is also determined by firms’ incentives for financial reporting. La Porta et al. (1998) provide the first investigation of the legal system’s effect on a country’s financial system. They find that common law countries have better accounting systems and better protection of investors than code law countries. Other factors associated with financial reporting quality include the tax system (Guenther and Young, 2000; Haw et al., 2004), ownership structure (Ball and Shivakumar, 2005; Burgstahler et al., 2007; Fan and Wong, 2002), the political system (Leuz and Oberholzer-Gee, 2006), capital structure (Sun, 2006), and capital market development (Ali and Hwang, 2000).2Therefore, controlling for these institutional and firm-level factors becomes an important task in the empirical research design.As a result of the interdependence between accounting standards and the country’s institutional setting and firms’ incentives, the economic consequences of changing accounting systems may vary across countries. Few papers have examined how these factors affect the2 There are many alternative definitions and measures of quality in the accounting literature. For example, Francis et al. (2004) summarize seven common earnings attributes that are often associated with earnings quality (associating these attributes with firms’ cost of capital). We do not offer an exhaustive summary of this literature since there are a number of excellent recent surveys, including Schipper and Vincent (2003) and Dechow and Schrand (2004). 4 economic consequences of changing accounting standards. For example, Pincus et al. (2007) find that accrual anomaly is more prevalent in common law countries. Guenther and Young (2000), and Haw et al. (2004) find that accounting quality is associated with tax reporting incentives. Exploration of the interaction between these factors and accounting standards, can provide insights into differences in the economic consequences of changing accounting principles across countries.We adopt a historical approach and focus on accounting literature published in leading accounting journals and selected working papers beginning in the 1990s.3 In section 2, we discuss research concerning the effects on companies of a change in GAAP. We begin with the effects of the European Commission’s accounting directives in the 1980s, followed by a discussion of voluntary adoption of non-local accounting standards in the 1990s and early 2000s. We then review papers concerning stock market reaction to news of the mandatory adoption of IFRS by the EU around 2002. Section 3 provides a discussion of the effects of the IFRS adoption after 2005. Because mandatory adoption of IFRS is fairly recent, researchers do not yet have enough data for large-sample empirical tests of the change in accounting standards. We thus discuss factors from the international accounting and finance literatures that may affect financial reporting quality and should be considered in any future research. We believe that understanding these factors is important for developing expectations about effects of the change in regime. Section 4 concludes the paper.3 Bushman and Smith (2001) include a subset of this literature. Their focus, however, is on the economic effects of corporate governance and financial reporting. 5 2. EFFECTS OF CHANGING ACCOUNTING PRINCIPLESSecara historis, sistem hukum, dikombinasikan dengan perbedaan lainnya politik dan ekonomi, menciptakan keragaman luas sistem akuntansi, yang membuat bermakna perbandingan laporan keuangan di seluruh perbatasan sulit. Eropa adalah asal-usul banyak sistem hukum: bahasa Inggris, Jerman, Perancis dan Skandinavia, dan dengan demikian, sebelum harmonisasi, ada sistem akuntansi sangat beragam, negara tertentu. Menyadari hal ini, anggota Uni Eropa adalah negara pertama yang bergerak menuju harmonisasi standar akuntansi.Pada akhir 70an dan 80an, Uni Eropa mengeluarkan beberapa arahan untuk menyelaraskan praktek-praktek pelaporan keuangan untuk mengurangi keragaman dan memfasilitasi cross-daftar dan lintas-perbatasan investasi. Akuntansi harmonisasi berkembang pada 1990-an dengan perbaikan IAS (prekursor IFRS), harmonisasi peristiwa dalam ekonomi EU (misalnya, adopsi mata uang tunggal), dan perubahan politik (misalnya, hilangnya kontrol perbatasan dalam wilayah Schengen). Walaupun IFRS adopsi tidak wajib hingga 2005, di akhir 1990-an, perusahaan di beberapa negara Eropa yang diizinkan untuk menggunakan IAS sebagai pengganti domestik standar akuntansi.Dalam bagian ini, kami menelusuri sejarah harmonisasi dan kemudian menjelaskan penelitian terkait dengan tahap yang berbeda. Ini menyajikan gambaran yang jelas dari sejarah perbedaan antara standar akuntansi nasional di Uni Eropa relatif terhadap IFRS, serta pemahaman tentang konsekuensi ekonomi dari masa lalu harmonisasi akuntansi. Hasil dari masa lalu sastra dapat memberikan wawasan tentang efek wajib IFRS adoption.44 A monopolistic view of accounting harmonization argues that using one single set of accounting standards will reduce the competition and thus the incentives of standard-setters to improve. However, Sunder (2002) argues that rather than using a single set of accounting standards, countries should allow firms to choose among several competing sets of accounting standards. Investors and firm managers will then choose accounting standards so as to reduce the firm’s costs of capital. The competition among different standard-setters to attract firms’ adoption will improve standard quality. Huddart et al. (1999) analytically model a situation where investors decide which exchange to list on based upon required disclosure level and personal risk aversion. In their model, stock exchanges competing for trading volumes will “race to the top” and raise disclosure requirements to attract risk-averse investors. Dye (2002) models the probability of the success of accounting standards from different 6 2.1 EC-directives related to accounting principle changeHistorically, the European Commission’s (EC) directives were aimed at making financial statements increasingly comparable in terms of format and general recording and measurement rules. The Fourth Directive, enacted in 1978, and the Seventh Directive, enacted in 1983, were the most influential directives during the early stage