An international comparison of accrual quality under IFRS

M. Humayun Kabir Faculty of Business, Auckland University of Technology, Auckland

Fawzi Laswad School of Accountancy, Massey University

Abstract We investigate the variation in accrual quality among IFRS adopting countries. We further investigate the association between enforcement and accrual quality. Using a sample of 1146 observations from 13 IFRS adopting countries, Australia and 12 European countries, for 2007, we find variation in accrual quality exists under IFRS. We use three proxies for enforcement and find a positive association between enforcement and accrual quality. The results are robust to alternative accrual models. Keywords: accrual quality, enforcement, IFRS

An international comparison of accrual quality under IFRS

Abstract We investigate the variation in accrual quality in IFRS adopting countries. We further investigate the association between enforcement and accrual quality. Using a sample of 1146 observations from 13 IFRS adopting countries, Australia and 12 European countries, for 2007, we find variation in accrual quality exists under IFRS. We use three proxies for enforcement and find a positive association between enforcement and accrual quality. The results are robust to alternative accrual models. Keywords: accrual quality, enforcement, IFRS JEL classification: M41

1. Introduction The spread of adoption of International Financial Reporting Standards (IFRS) globally and in particular the adoption by European countries and Australia is one of the most significant development in recent financial reporting history. European and Australian firms started preparing consolidated financial statements using IFRS in 2005.1 The global adoption of IFRS was motivated by the argument that the adoption of a single set of high quality standards would improve reporting quality across the world.2 However, various studies noted that financial reporting quality is the joint product of accounting standards, reporting incentives and institutional factors (Ali and Hwang, 2000; Ball et al.,

Many European firms voluntarily adopted IFRS much before 2005 (Cuijpers and Buijink, 2005). Further, New Zealand followed suit with voluntary early adoption in periods commencing on or after 1 January 2005 and mandatory adoption for periods starting on or after 1 January 2007 (ASRB 2004, para. 20).

Several benefits have been claimed to emanate from the global adoption of IFRS. These include reduction in costs of preparing financial statements according to multiple sets of accounting rules in multiple jurisdictions, free flow of capital across the borders, reduced cost for regulators involved in understanding different reporting regimes, efficient and better training of auditors, and reduction in cost of capital (Tweedie, 2006).

2003; Brown and Tarca, 2005; Burgstahler et al., 2006; Schipper, 2005; Soderstrom and Sun, 2007). The adoption of a single set of high quality accounting standards in all countries would not lead to uniform reporting quality without appropriate reporting incentives and rigorous enforcement arrangements. Since there are wide variations in reporting incentives and institutional environments in IFRS adopting countries, it is predicted that there would be variations in accrual quality even under IFRS. We empirically examine this prediction. We further investigate whether accrual quality is associated with enforcement of standards. One institutional factor that has been of particular concern to regulators (e.g., US SEC, 2000), academics (Daske et al., 2008; Holthausen, 2009), and professionals (FEE, 2001) is the wide variation in enforcement regimes across the adopting countries. It has been argued that the benefits of IFRS adoption may not be realised fully without rigorous enforcement of accounting standards (The European Parliament and the Council of the European Union, 2002; FEE, 2001; Holthausen, 2009; US SEC, 2000). Consistent with this argument, Li (2010) finds that reduction in cost of equity capital for mandatory adopters of IFRS is significant only in countries with strong legal enforcement mechanisms. Enforcement is a system to whenever possible prevent, and thereafter identify and correct, material errors or omissions in the application of IFRS in financial information and other regulatory statements issued to the public (FEE, 2002: 31). Enforcement comprises three major components: (a) company internal control system including internal auditor and board of directors, (b) independent auditor, and (c) an oversight system with expertise and power to monitor and enforce accounting standards (Brown and Tarca, 2005). We focus on the third dimension, oversight and enforcement, in this paper. Our sample comprises 1146 observations from 13 countries- 12 European countries and Australia. The data cover 2007. Following Gul et al. (2009), we use abnormal discretionary
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accruals from the Ball and Shivakumar (2006) model as the measure of accrual quality. We find variation in accrual quality in the IFRS adopting countries. We further find that enforcement and accrual quality are positively associated. The results are robust to alternative accrual models. Our paper contributes to the growing literature on the relative importance of accounting standards vs. financial reporting incentives and institutional arrangements for reporting quality in two ways. Prior studies in this stream fall into one of two categories. Early studies examined voluntary adoption of IFRS (Cuijpers and Buijink, 2005; Gassen and Sellhorn, 2006). Some recent studies examined mandatory adoption of IFRS. These papers either examined both IFRS adopting countries and countries that did not adopt IFRS (Cai et al., 2009), or investigated reporting outcomes other than accrual quality such as value relevance (Clarkson et al., 2009), institutional ownership (Florou and Pope, 2009), properties of analysts forecasts (Horton et al., 2009), and cost of equity (Li, 2010)). Some studies focused on a single country that adopted IFRS (e.g., Asutralia (Goodwin et al., 2008); New Zealand (Kabir et al., 2010)). Unlike earlier studies that examined whether there was any improvement in reporting outcome metric (e.g., value relevance, institutional ownership, cost of equity capital) as a result of adopting IFRS, our research design keeps accounting standards constant and allow institutional factors to vary. Further, using 2007 data, we examined accrual quality as this has construct validity in international settings (Schipper, 2005). Thus, the observed variation in accrual quality can be attributed to factors other than accounting standards. Second, prior studies that examined impact of enforcement employed simple proxies for enforcement. These proxies have been subject to criticisms and there have been calls for refined measures of enforcement (Holthausen, 2009). In addition to using a traditional
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measure of enforcement (i.e., rule of law), we employ two new measures of enforcement different levels of enforcement activity of European national regulators in 2006 or 2005 financial statements and the percentage of firms (market value) sampled for review by European national regulators in 2006 that address enforcement of IFRS directly. These measures have more construct validity than the traditional measures. Using these measures, we find positive relation between enforcement and accrual quality. The remainder of this paper is organised as follows. Section 2 provides a literature review, Section 3 develops the hypotheses and Section 4 discusses the methodology. Section 5 reports the results and a conclusion is provided in the last section. 2. Literature review This study contributes to the rapidly growing literature on the relative importance of accounting standards vs financial reporting incentives and institutional factors for reporting quality (e.g., Ball et al., 2003; Soderstrom and Sun, 2007). However, most of the studies in this stream were conducted under the pre-IFRS reporting regimes. Thus, it was difficult to control for diversity in accounting standards. Adoption of IFRS in Europe and Australia offers a unique opportunity to investigate this issue as all the adopting countries have a single set of accounting standards but vary widely in reporting incentives and institutional factors (Schipper, 2005). There is a limited body of work that examined mandatory adoption of IFRS. Goodwin et al. (2008) find no evidence that IFRS improved the value relevance of book value and earnings in Australia. Jeanjean and Stolowy (2008) find that the pervasiveness of earnings management did not decline after IFRS in the UK, France and Australia. Clarkson et al. (2009) find that value relevance of IFRS and local GAAP numbers remained similar in 14 European countries and Australia. Horton et al. (2009) find that analysts forecast error,
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forecast dispersion and volatility of forecast revision decreased after 2005 for both mandatory adopters and voluntary adopters of IFRS in Europe though the decrease was more for voluntary adopters than for mandatory adopters. Daske et al. (2008) report increases in market liquidity around mandatory IFRS adoption around the world. They, however, find that liquidity benefits are concentrated in countries with strong rule of law. Florou and Pope (2009) find that institutional ownership increased after mandatory adoption of IFRS. However, IFRS-related ownership effects are observed for countries with strong rule of law, and relatively low levels of corruption and earnings management. Cai et al. (2009) find that earnings management is less in years of mandatory adoption and in countries with strict enforcement regimes. Li (2010) finds that mandatory adopters experienced significant reduction in cost of equity after 2005 in Europe but voluntary adopters experienced no significant change in cost of equity after 2005. In contrast to the above studies, we focus on IFRS adopting countries only so that a single set of standards is used in all countries in a single year. Further, in contrast to prior studies, we use discretionary accruals as the outcome variable. We also use three proxies for enforcements while previous studies used only a single proxy. 3. Hypotheses Despite the use of the same set of standards, it is expected that there would be wide variation in reporting incentives and institutional factors across the IFRS adopting countries. Following previous literature (Ball et al., 2003; Burgstahler et al., 2006; Schipper, 2005; Soderstrom and Sun, 2007), we expect variation in accrual quality to continue in the adopting countries even under IFRS. Thus our first hypothesis is: H1: There is variation in accrual quality in the IFRS adopting countries under the IFRS.

While high quality accounting standards are essential to ensuring high quality financial reporting, it has been consistently argued that the benefits of high quality accounting standards cannot be realised fully without a proper and rigorous enforcement regime (Brown and Tarca, 2005; The European Parliament and the Council of the European Union, 2002; FEE, 2001, 2002; Holthausen, 2009; Schipper, 2005; US SEC, 2000). Since rigorous enforcement is expected to ensure strict compliance with IFRS (FEE, 2001), accrual quality is expected to be positively associated with enforcement (Daske et al., 2008; Cai et al., 2009). Thus, our second hypothesis is: H2: Accrual quality is positively associated with the effectiveness of the enforcement regime. 4. Methodology 4.1. Dependent variable: accrual quality We use accrual quality as the reporting outcome as it has construct validity and can be measured reliably across jurisdictions (Schipper, 2005).3 Accrual quality has been used widely in the literature on earnings management and earnings quality. Accrual quality has consequences for cost of equity (Francis et al., 2004), asset allocation decisions (Florou and Pope, 2009), and IPO underpricing (Boulton et al. 2010). Many accrual models have been used in the literature so far (e.g., Ball and Shivakumar, 2006; DeAngelo, 1986; Dechow and Dichev, 2002; Dechow and Sloan, 1991; Healy, 1985; Jones, 1991; Kothari et al., 2005). However, there is no conclusive evidence on which accrual model is the best. Following Ball and Shivakumar (2006) and Gul et al. (2009), we run the following accrual model and use absolute residuals from the model as our measures of

In contrast, in international setting price-based measures of earnings quality, such as value relevance and Basu (1997) measure of conservatism, suffer from limitations as stock return synchronicity varies significantly across jurisdictions (Morck et al., 2000; Schipper, 2005).

accrual quality (Gul et al., 2009). We use the Ball and Shivakumar (2006) model because conservatism is a documented attribute of accounting earnings (Basu, 1997) and the accrual model incorporates the effect of conservatism on accruals. Further, the accrual model we use incorporates the independent variables that are used as independent variables in Dechow and Dichev (2002) and Jones (1991) models also. We run model (1) for each country and take the absolute residual from the model to indicate absolute discretionary accruals (ABSDACC). We use ABSDACC as the measure of accrual quality on the premise that both upward and downward adjustments of reported earnings are indications of earnings management and, hence, poor earnings quality (Gul et al., 2009). ACCt = + 1REVt + 2PPEt + 3CFOt-1 + 4CFOt + 5CFOt+1 + 6ROAt-1 + 7CFOt + 8DCFOt + 9CFOt*DCFOt + t (1)

Where:
ACCt = Total accruals, measured as profit after tax minus cash flow from operating activities (CFO), deflated by total assets; REVt PPEt CFOt-1 CFOt CFOt+1 ROAt-1 = = = = = = Changes in revenue, deflated by total assets; Property, plant and equipment, deflated by total assets; Lagged cash flow from operating activities, deflated by total assets; Current cash flow from operating activities, deflated by total assets; One year-ahead cash flow from operating activities, deflated by total assets; Lagged return on assets, measured as earnings before interest and tax of the last year divided by total assets at the end of the last year; CFOt = Changes in cash flow from operating activities from the previous year,

deflated by total assets; DCFOt CFOt*DCFOt = = A binary variable, 1 if CFOt is negative, 0 otherwise; Interaction variable between CFOt and DCFOt.

4.2. Test variable: enforcement Designing an empirically valid measure of enforcement is difficult due to the lack of data on enforcement activity (Holthausen, 2009; Jackson, 2007). Prior studies used two major proxies for enforcement. One is some variants of rule of law index (e.g., Daske et al., 2008; Florou and Pope, 2009). Another is the Hope (2003) measure of enforcement, which is constructed by combining five country-level factors- audit spending, insider trading laws, judicial efficiency, rule of law, and shareholder protection. Cai et al. (2009) use a variation of this measure. Following Daske et al. (2008) and Florou and Pope (2009), we use the Kaufmann et al. (2007) rule of law index. We use this proxy because the Kaufmann et al. (2007) rule of law index relates to 2006.4 The rule of law index has normal distribution with mean 0 and standard deviation of 1. This means virtually all the scores lie between -2.5 and 2.5, with higher scores indicating stronger rule of law (Kaufmann et al., 2007: 13). The rule of law score is subject to measurement error. For example, Kaufmann et al. (2007) report standard error for the rule of law indicator. These standard errors indicate that the confidence intervals of rule of law scores for different sample countries overlap. Thus, following Daske et al. (2008) and Florou and Pope (2009), we divide our sample countries into those which are above and below the median rule of law score.

We do not use the Hope (2003) measure of enforcement because we do not have recent data to construct this index. Since there have been efforts after IFRS adoption to strengthen enforcement mechanism in Europe (Brown and Tarca, 2005), it is important to use measures of enforcement that relate to recent time period.

While the above measure has been used widely in prior literature, it has been subject to criticism on the ground that it is a crude proxy for accounting enforcement. Thus, there have been calls for more refined measures of enforcement. Holthausen (2009) suggests using enforcement measures based on enforcement inputs and outputs. In response to calls for enforcement inputs/outputs-based measures, we use two additional measures of enforcement activity. The second proxy measures different levels of enforcement activity of European national regulators in 2006 or 2005 financial statements. The Committee of European Securities Regulators (CESR) issues Standard 1 on Financial Information that proposes 21 principles for setting up an independent body that will enforce and monitor IFRS. The CESR (2007) categorises European countries into three groups based on the extent of application of CESR Standard 1: (a) member countries with full enforcement activity, (b) member countries with partial enforcement activity, and (c) member countries with no enforcement activity. We use two dummy variables to capture the extent of enforcement activity of European countries in our sample. While we use this measure on the assumption that higher degree of compliance with CESR Standard 1 corresponds to higher level of enforcement of IFRS, we recognize that EU member countries that do not comply with CESR Standard 1 may have other effective enforcement and monitoring mechanisms. Our third proxy for enforcement measures the percentage of firms (market value) sampled for review by European national regulators in 2006. The CSER (2007) classifies the member countries into three groups based on the percentage of firms (market value) sampled for review: (a) countries that planned to cover less than 40 percent of their market by capitalisation, (b) countries that planned to cover between 40 and 60 percent of their local market by capitalisation, and (c) countries that planned to cover more than 60 percent
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of their local market by capitalisation. We employ two dummies to capture the different extent of coverage of the review programs. Since the last two measures of enforcement address directly the enforcement of IFRS, these are more valid measures of enforcement than the first proxy. The last two measures relate to enforcement activity in Europe. Hence, Australia is excluded from the sample when we conduct analyses based on these measures. 4.3. Models To test hypothesis 1, we test whether the mean ABSDACC in each sample country is the same using both Analysis of Variance and the non-parametric Kruskal-Wallis test. To test hypothesis 2, we conduct both univariate and multivariate tests. In univariate tests, we compare the mean (median) ABSDACC of different groups of countries based on the degree of enforcement. In multivariate test, we regress ABSDACC on the enforcement variable and control variables. Since the value of ABSDACC cannot be less than zero, we run Tobit for the multivariate regression (Gul et al., 2009). We use the following general model to test hypotheses 2: ABSDACCi = + 1 ENFORCEk + 2 SIZEi + 3 LEVi + 4BIG4i + 5 MARKET_LIQUIDTIYk + 6 TAX_RATEk + INDUSTRY DUMMIES + i (2)

Where: ABSDACCi = Absolute discretionary accruals of firm i estimated using model (1); ENFORCEk = A country-level variable of enforcement. Three proxies of enforcement are used, in models (2a)-(2c);

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SIZEi

= Natural log of the market capitalization of firm i at the end of financial year 2007;

LEVi BIG4i MARKET_LIQUIDTIYk

= Total debt to total assets of firm i; = 1 if firm i is audited by a Big 4 auditor in 2007, 0 otherwise; = A country-level variable, measured as total value of shares traded divided by the GDP of the country in 2007;

TAX_RATEk

A country level variable, measured as the highest marginal corporate tax rate of the country;

INDUSTRY DUMMIES

= Eight Industry dummies.

Since we use three proxies for enforcement, the above regression model is transformed into the following three regression models, each containing one proxy for enforcement at a time. Model 2(a) includes RULEk a dummy that takes 1 if the countrys rule of law score is above the median rule of law score. Model 2(b) includes two dummies, PART_ENFk and FULL_ENFk, to capture three levels of enforcement in European countries. PART_ENF and FULL_ENF are dummies for partial and full enforcement activity in financial statements in 2005 or 2006. Model 2(c) includes two dummies, MEDIUM_COVk and HIGH_COVk, to capture three

different levels of coverage of the formal review programs of European national regulators. MEDIUM_COVk and HIGH_COVk are dummies for countries that planned to review between 40 and 60 percent, and more than 60 percent, respectively, of their local market by capitalisation. ABSDACCi = + 1 RULEk + 4 SIZEi + 5 LEVi + 6BIG4i + 7 MARKET_LIQUIDTIYk + 8 TAX_RATEk + INDUSTRY DUMMIES + i (2a)

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ABSDACCi

= + 1 PART_ENFk + 2 FULL_ENFk + 3 SIZEi + 4 LEVi + 5BIG4i + 6 MARKET_LIQUIDTIYk + 7 TAX_RATEk + INDUSTRY DUMMIES + i (2b)

ABSDACCi

= + 1 MEDIUM_COVk + 2 HIGH_COVk + 3 SIZEi + 4 LEVi + 5BIG4i + 6 MARKET_LIQUIDTIYk + 7 TAX_RATEk + INDUSTRY DUMMIES + i (2c)

Where: RULEk = 1 if the countrys rule of law score is above the median, 0 otherwise; PART_ENFk = 1 if the country complies partially with CESR Standard 1, 0 otherwise; FULL_ENFk = 1 if the country complies fully with CESR Standard 1, 0 otherwise; MEDIUM_COVk = 1 if the enforcement body of the country reviews between 40 and 60 percent of the companies (in terms of market capitalization), 0 otherwise; HIGH_COVk = 1 if the enforcement body of the country reviews more than 60 percent of the companies (in terms of market capitalization), 0 otherwise. All other variables are defined in model 2. Since a higher ABSDACC indicates poor accrual quality, we expect negative relationship between enforcement variables and ABSDACC. Thus, negative coefficients of enforcement variables in models (2a)-(2c) will be consistent with hypothesis 2. Soderstrom and Sun (2007) posit that six factors are associated with accounting quality. These are (a) accounting standards, (b) legal and political system, (c) financial market
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development, (d) capital structure, (e) ownership, and (f) tax system. We use market liquidity, leverage and maximum marginal tax rate as control variables. We further include firm size and Big 4 auditor as control variables as prior research shows that these variables are associated with accrual quality (Becker et al., 1998; Francis et al., 1999; Hope, 2003; Watts and Zimmerman, 1986). Following prior literature (Burgstahler et al., 2006; Li, 2010), we include industry fixed effects because (a) accrual quality may vary according to industry, (b) we did not run the accrual model for each industry, and (c) sample firms vary widely among industries. We do not include accounting standards as a control variable as the same accounting standards, i.e., IFRS, are used in the sample countries. We do not include any variable for legal and political system as legal and political system is a summary measure that is associated with other variables in the model (e.g., capital structure, financial market development) (Burgstahler at al., 2006; La Porta et al., 2000; Soderstrom and Sun, 2007) and we include different proxies for enforcement as independent variables. Further, we do not include ownership as a control variable in our main analysis as our sample size is drastically reduced when we include this variable. We, however, include ownership as a control variable in sensitivity analysis. 4.4. Data and sample Our sample covers 13 countries - Australia, and 12 European countries. The European countries are Austria, Belgium, Denmark, Finland, Greece, Luxemburg, Netherlands, Norway, Portugal, Spain, Sweden, and Switzerland. We use data for one year, 2007. Prior studies suggest that it takes time to realise the benefits of IFRS/foreign GAAP (Cuijpers and Buijink, 2005), and the latest year for which data were available at the time of collecting

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data is 2008, which, because of recession, does not appear to be a normal year. So we chose to use 2007. We collect data from OSIRIS, company annual reports, the World Bank, and the CESR (2007). Table 1 describes the measurement of model variables and the sources of data. We include a firm in our sample if (a) the firm has all the data to calculate the model variables, (b) revenue and fixed assets are greater than zero5, and (c) the audit report states that the financial statements comply with IFRS and renders a clean opinion on the financial statements. Following Florou and Pope (2009) and Li (2010), we delete top and bottom 1 percent of the distributions of all firm-level continuous variables. This yields a final sample of 1146 firms. Table 1 about here Our sample size is reasonable considering the fact that we collected some data (i.e., data on auditor and auditor opinion on compliance with IFRS) manually from company annual reports and other studies6 have similar sample sizes. Table 2 provides sample information. Panel A describes how the sample is derived. Panel B shows that Australia has the

maximum number of firms (i.e., 468 firms) in the sample. The remaining 678 firms are European. Among the European countries, Sweden has the largest number (i.e., 128) of firms. Panel C shows the distribution of the sample firms according to industries. Table 2 about here

5. Results 5.1. Descriptive statistics

Francis et al. (1999) include observations in sample if sales are greater than zero. For example, Hopes (2003) sample is comprised of 1309 observations from 22 countries and Lis (2010) sample size is 1084 EU firms.
6

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Table 3 presents descriptive statistics. Panel A reports descriptive statistics for firm-level variables at for the full sample while Panel B shows the means of the firm-level variables for each country. Panel A shows that the mean (median) ABSDACCi is 0.047 (0.028) and is significant at 1 percent level. Panel B shows that the mean ABSDACCi of Australia is 0.070, which is the highest among the sample countries. Even among the European sample countries, there is wide variation in ABSDACCi. The minimum is 0.004 for Portugal and the maximum is 0.046 for Norway. We also observe some variation in SIZEi, LEVi, and BIG4i though the variation is not much. This is expected as all the sample countries are developed economies and 11 of the sample countries are civil law countries (La Porta et al., 1998). This may act against finding any significant difference in ABSDACC in our sample. Table 3 about here Panel C reports the country level variables- three measures of enforcement, market liquidity and tax rate. It shows that the Kaufmann et al. (2007) rule of law score is available for all countries. Since we divide the sample countries into those whose rule of law scores are above and below the median, the country (Luxembourg) having the median rule of law score is omitted from analysis when we use this proxy for enforcement. We exclude Australia and Switzerland when we use the extent of enforcement activity in financial statements as reported by CESR (2007). Australia, Austria, Luxembourg, Sweden and Switzerland are excluded from analysis when we use the percentage of issuers covered by the review of financial statements as the proxy for enforcement. Panel C shows that there is variation in all the country level variables- three measures of enforcement, market liquidity and tax rate. 5.2. Earnings quality across the countries

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The explanatory powers of the country-specific accrual models are reasonably good. The median adjusted R2 is 0.55. Out of the thirteen regressions, eleven are statistically significant at less than 1 percent, one is significant at less than 5 percent and the remaining one is insignificant.7 Table 4 reports absolute discretionary accruals for each country. The mean absolute discretionary accruals ranges from 0.004 (Portugal) to 0.070 (Australia). The median ranges from 0.003 (Portugal) to 0.041 (Australia). The differences in mean (median) absolute discretionary accruals are statistically significant at less than 1 percent. The results are consistent with H1. Table 4 about here Table 4 shows that the mean (median) absolute discretionary accruals of Australia is much higher than the corresponding amounts of European countries. This might be the cause of statistically significant differences in mean (median) absolute discretionary accruals among the sample countries. So we test for the equality of mean (median) absolute discretionary accruals among the European sample countries only. This is important because the Australian and European firms may not apply the same versions of IFRS. The audit reports of European sample firms report compliance with IFRS as adopted in Europe. Since

This compares favourably with two alternative accrual models. To assess the performance of our accrual model, we ran the following two models: ACCt = + 1REVt + 2PPEt + 3CFOt-1 + 4CFOt + 5CFOt+1 + t (3) = + 1REVt + 2PPEt + 3ROAt-1 + t (4) ACCt The variables in models (3) and (4) are defined in Table 1. Following McNichols (2002), model (3) combines independent variables from Jones (1991) and Dechow and Dichev (2202) models. Model (4) augments Jones (1991) model by including lagged return on assets as an additional independent variable as Kothari et al. (2005) match discretionary accruals from Jones (1991) model on performance. We could not use Kothari et al. (2005) model as this would have reduced our sample size by half. 2 The median adjusted R is 0.264 for model (3) and 0.067 for model (4). Further, two of thirteen countryspecific regressions are statistically insignificant when we ran model (3). The corresponding number is 6 for model (4). Since the explanatory power of model (4) is low and a significant number (6 out of 13) of country specific regressions are insignificant, we do not use this model in sensitivity analysis. Rather we employ model (3) in sensitivity analysis.

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the European Union adopted IFRS with a curveout provision from IAS 39, the IFRS that Europe adopted is slightly different from the IFRS adopted by Australia. We find statistically significant differences in mean (median) absolute discretionary accruals even among the European firms. Thus, data support H1. 5.3. Enforcement and earnings quality 5.3.1. Univariate analysis Table 5 reports the relation between enforcement and accrual quality. Panel A shows that the mean and median absolute discretionary accruals (ABSDACC) of countries with abovemedian rule of law scores is 0.035 and 0.025, which are significantly less than the corresponding amounts (0.054 for mean and 0.030 for median) of countries with belowmedian rule of law scores. Thus, the relationship between enforcement and ABSDACC is negative. Since higher ABSDACC denotes poor accrual quality, the negative relation between rule of law and ABSDACC suggests a positive relation between enforcement and accrual quality. This is consistent with H2. Table 5 about here Panel B shows that the mean ABSDACC of firms in countries with full enforcement activity is lower than the corresponding amounts in countries with partial and no enforcement activity. The difference is significant at less than 1 percent. The median ABSDACC of firms in countries with full enforcement activity is less than the corresponding amounts in countries with partial or no enforcement activity and the difference is statistically significant at less than 5 percent. Thus, firms in countries with full enforcement activity have lower ABSDACC and hence, higher accrual quality than firms in other countries. These results are consistent with H2.
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Panel C again shows that a positive relation exists between enforcement and accrual quality. The mean (median) ABSDACC of firms in countries whose national regulators planned to review the financial statements of more than 60% of their local market by capitalisation is lower than the corresponding amounts in other sample countries. These results are again consistent with H2. 5.3.2. Multivariate analysis Table 6 reports the results of multivariate Tobit regressions. All the models are significant at 1 percent level. In the second column, RULEk is negative but not significant at conventional levels. This suggests that countries with stricter rule of law have lower absolute discretionary accruals and hence, poor accrual quality than countries with weaker rule of law though the relationship is not significant. Table 6 about here The third column shows that the coefficient of FULL_ENFk is negative and marginally significant. This suggests that countries with full enforcement activity have lower absolute discretionary accruals than countries with no enforcement activity, suggesting a negative (positive) relation between enforcement activity and absolute discretionary accruals (accrual quality). This is consistent with H2. However, the coefficient of PART_ENFk is not significant. The last column shows that the coefficient of HIGH_COVk is negative and significant at less than 1 percent. This indicates that countries that planned to review more than 60 percent of their local market (by capitalisation) have lower absolute discretionary accruals than countries that planned to review less than 40 percent of their local market. This again suggests negative (positive) relation between the extent of coverage of the review of financial statements program and absolute discretionary accruals (accrual quality). The results are consistent with H2. However, the coefficient of MEDIUM_COVk is not
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significant. 5.3.3. Sensitivity analysis Alternative accrual model Our accrual quality measure may be subject to measurement error. To check the robustness of our results to the accrual model, we re-do the analyses using absolute discretionary accruals estimated from model (3) mentioned in footnote 7. Even with this alternative accrual model, variation in absolute discretionary accruals remains. The mean (median) absolute discretionary accruals of the sample countries are statistically different, thus supporting H1. In univariate tests, results are very similar to those reported in Table 5 when we use rule of law and extent of coverage of firms in review program as proxies for enforcement. However, the results do not hold when we use extent of enforcement activity as the proxy for enforcement. In multivariate regressions using absolute discretionary accruals from model (3) as the dependent variable, the coefficient of RULEk in model (2a) remains negative but not significant. The coefficient of PART_ENFk in model (2b) is positive and significant, and the coefficient of FULL_ENFk is negative but not significant. The coefficients of MEDIUM_COVk and HIGH_COVk in model (2c) are negative and significant, suggesting negative (positive) relation between extent of coverage of formal review of financial statements and absolute discretionary accruals (accrual quality). Ownership percentage as an independent variable Ownership percentage is associated with accrual quality (Soderstrom and Sun, 2007). Thus, the results reported above may suffer from omitted variable problem. We augment models 2(a)-2(c) by including ownership percentage as an additional independent variable. However, our sample size is reduced as many European firms in the sample do not report
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ownership percentage in annual reports.8 We define ownership percentage as percentage of shares of a firm held by the top three shareholders. The results remain qualitatively similar even when we include ownership percentage as an additional independent variable in models 2(a)-2(c). The only major difference is that the FULL_ENFk variable in model (2b) becomes insignificant though the sign remains negative. 6. Conclusions We investigate whether there is any variation in accrual quality in 13 IFRS adopting countries- Australia and 12 European countries. We further investigate the association between enforcement and accrual quality. The sample size is 1146 firms and the data come from 2007. We measure accrual quality as the absolute discretionary accruals estimated using Ball and Shivakumar (2006) model. We find that there is variation in absolute discretionary accruals among the sample countries. We further find that enforcement and accrual quality are positively associated. The results are largely robust to accrual models. We contribute to the growing literature on the relative importance on accounting standards vs reporting incentives and institutional environments. This literature documents that accounting quality is jointly determined by accounting standards, reporting incentives and institutional environments (Ali and Hwang, 2000; Ball et al., 2003; Brown and Tarca, 2005; Burgstahler et al., 2006; Schipper, 2005; Soderstrom and Sun, 2007). This literature predicts that accounting quality will vary even under the IFRS regime. The observed variation in accrual quality is consistent with this prediction. While prior studies investigate
8

In many European countries shareholders have to report their ownership percentage if that exceeds a threshold. For example, shareholders in Danish companies have to report their ownership percentage if they hold 5% or more of the share capital or voting rights. So, companies do not report the percentage of shares held by top three shareholders if the shareholders do not report their ownership percentage. Thus, there is an upward bias in our share ownership data in European companies in that the percentage of shares held by the top three shareholders in companies in our sample for which we do not have any ownership data is, by implication, less than the percentage of shares held by the top three shareholders in sample companies for which we have ownership data.

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both IFRS adopting and non-adopting countries, we study IFRS adopting countries only. Thus, the reporting standards are the same across the sample countries. Thus, the observed variation in accrual quality may be confidently attributed to variation in reporting incentives and institutional environments. Earlier studies on enforcement use crude proxies for enforcement. There have been calls for use of refined measures of enforcements. We contribute to the literature by using two new measures of enforcement that directly address enforcement of IFRS. The new proxies for enforcement are extent of enforcement activity in 2005 or 2006 financial statements in Europe and the extent of coverage of review of financial statements program of European national regulators in 2006. When we use a crude proxy for enforcement (i.e., Kaufmann et al. (2007) rule of law score), the relation between enforcement and absolute discretionary accruals (accrual quality) is negative (positive) but not significant. We also find that countries with full enforcement activity have lower absolute discretionary accruals than countries with no enforcement activity, suggesting negative (positive) relation between extent of enforcement activity and absolute discretionary accruals (accrual quality), though the significance depends on the accrual model used. The relation between enforcement and accrual quality is positive when we use the extent of coverage of review of financial statements program of European national regulators and the relation is robust to accrual models. Thus, this study documents the need to use refined measure of enforcement. We investigate quite a homogeneous group of countries. La Porta et al. (1998) classify 11 our 13 sample countries as having civil law tradition. Given this homogeneity of our sample countries, the observed variation in accrual quality and the positive association between enforcement and accrual quality may be considered as strong results.

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Caveats are in order now. First, we could not examine the impact of enforcement on accrual quality for voluntary adopters. Prior research documents that the impact of IFRS adoption varies depending on the nature of adoption- voluntary or mandatory (Christensen et al., 2008; Daske et al., 2008; Li, 2010). Prior research argues that voluntary adopters of IFRS have different reporting incentives than the mandatory adopters. It could be argued that the impact of enforcement on accrual quality will be different for voluntary adopters and mandatory adopters. We could not investigate this because of lack of data on voluntary adoption. Future research can investigate this issue. Second, it is difficult to control for all factors that affect accounting quality in international settings. Thus, while we have included control variables that capture reporting incentives and institutional environments, we may not have controlled for all factors affecting accrual quality.

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Table 1 Measurement of variables and sources of data Variables Measurement ACCt Earnings after tax minus cash flow from operating activities (CFO); REVt PPEt CFOt-1 CFOt CFOt+1 ROAt-1 Changes in revenue Property, plant and equipment Lagged cash flow from operating activities Current cash flow from operating activities One year-ahead cash flow from operating activities Lagged return on assets, measured as earnings before interest and tax of the last year divided total assets at the end of the last year ; CFOt Changes in cash flow from operating activities from the previous year DCFOt CFOt*DCFOt ABSDACCi A binary variable, 1 if CFOt is negative, 0 otherwise Interaction variable between CFOt and DCFOt. Absolute discretionary accruals of firm i, measured as the absolute value of the residual from model (1).

Source of data OSIRIS

OSIRIS OSIRIS OSIRIS OSIRIS OSIRIS OSIRIS

OSIRIS

OSIRIS OSIRIS All data on variables in model (1) are from OSIRIS

ENFORCEk

Enforcement of country K. Three proxies for enforcement are used.

Source

of

data

depends on the proxy for enforcement.

SIZEi

Natural log of the market capitalization of firm i at the end of financial year 2007

OSIRIS

LEVERAGEi BIG4i

Total debt to total assets of firm i 1 if firm i was audited by a Big4 auditor in 2007, 0 otherwise.

OSIRIS Company reports annual

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Table 1 (contd.) Variables MARKET_LIQk Measurement A country-level variable, measured as total value of shares traded divided by the GDP of the country in 2007 TAX_RATEk INDUSTRY DUMMIES RULEk 1 if the countrys rule of law score is above the median, 0 otherwise; PART_ENFk 1 if the country complies partially with CESR Standard 1, 0 otherwise; FULL_ENFk MEDIUM_COVk 1 if the country complies fully with CESR Standard 1, 0 otherwise; 1 if the enforcement body of the country reviews between 40 and 60 percent of the companies (in terms of market capitalization), 0 otherwise; HIGH_COVk 1 if the enforcement body of the country reviews more than 60 percent of the companies (in terms of market capitalization), 0 otherwise. CESR (2007) CESR (2007) CESR (2007) Kaufmann (2007) CESR (2007) et al. Country Ks maximum marginal tax rate Indicator variable for industry World Bank OSIRIS Source of data World Bank

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Table 2 Sample Panel A: Sample derivation Number of firms on Osiris Less missing data on Osiris Less missing annual report Firms with complete data Less 1% at each end of the firm-level variables Final sample Panel B: Sample of firms by countries Country Australia Austria Belgium Denmark Finland Greece Luxembourg Netherlands Norway Portugal Spain Sweden Switzerland Total Panel C: Sample firms by industry Industry Consumer discretionary Consumer staples Energy Healthcare Industrials Information technology Materials Telecommunications service Utilities Total

3091 1237 1854 533 1321 175 1146

Number of firms 468 41 48 55 76 82 13 64 19 17 52 128 83 1146

Number of firms 190 81 62 111 335 169 145 26 27 1146

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N
1146 1146 1146 1146 1146 1146 1146 1146 1146 1146 1146 1146 1146 1146

Table 3 Descriptive statistics Panel A: Firm-level variables Variables ACCt REVt PPEt CFOt-1 CFOt CFOt+1 ROAt-1 CFOt DCFOt CFOt*DCFOt ABSDACCi SIZEi LEVi BIG4i Panel B: Firm-level variables by country Variables N ACCt REVt Mean -0.031*** 0.212*** 0.532*** 0.054*** 0.055*** 0.048*** 0.042*** 0.014*** 0.350*** -0.024*** 0.047*** 5.690*** 0.513*** 0.737*** CFOt 0.039 0.080 0.070 0.071 0.086 0.030 0.103 0.081 0.019 0.062 0.052 0.063 0.089 0.055 0.029 0.093 0.078 0.048 0.099 0.022 0.067 0.086 0.004 0.071 0.011 0.055 0.088 0.048 0.018 0.072 0.050 0.040 0.091 0.064 0.028 0.065 0.024 0.040 0.058 0.047 0.069 0.042 0.008 0.013 0.018 0.029 0.018 0.002 0.013 0.018 0.015 0.014 0.003 0.023 0.029 0.014 CFOt+1 ROAt-1 CFOt DCFOt 0.339 0.341 0.354 0.327 0.342 0.451 0.308 0.328 0.368 0.176 0.500 0.367 0.277 0.350 SIZEi CFOt* DCFOt -0.032 -0.016 -0.017 -0.012 -0.021 -0.024 -0.011 -0.017 -0.021 -0.009 -0.037 -0.020 -0.008 -0.024 4.824 6.475 6.263 6.334 5.930 5.629 6.796 6.547 5.360 6.952 7.549 5.967 6.732 5.690 LEVi 0.444 0.597 0.575 0.511 0.541 0.607 0.609 0.579 0.527 0.732 0.663 0.517 0.496 0.513 Median -0.020*** 0.182*** 0.533*** 0.067*** 0.068*** 0.066*** 0.064*** 0.014*** 0.000 0.000*** 0.028*** 5.616*** 0.539*** 1.000*** SD 0.102 0.281 0.206 0.127 0.124 0.137 0.165 0.090 0.477 0.054 0.067 1.982 0.199 0.440 Minimum -0.733 -3.259 0.059 -0.667 -0.516 -1.000 -1.000 -0.4.000 0.000 -0.400 0.000 1.099 0.047 0.000 PPEt 0.584 0.513 0.527 0.499 0.454 0.481 0.576 0.520 0.524 0.589 0.591 0.474 0.444 0.532 0.040 0.088 0.062 0.038 0.085 0.044 0.113 0.076 0.005 0.063 0.067 0.054 0.076 0.054 CFOt-1 ABS DACCi 0.070 0.027 0.031 0.040 0.032 0.022 0.028 0.040 0.046 0.004 0.018 0.042 0.024 0.047

Maximum 0.293 1.726 0.952 0.471 0.454 0.425 0.500 0.393 1.000 0.000 0.708 10.466 1.00 1.00 BIG4i 0.602 0.756 0.625 0.964 0.868 0.341 0.923 0.906 0.947 0.941 0.904 0.977 0.964 0.737

Australia Austria Belgium Denmark Finland Greece Luxembourg Netherland Norway Portugal Spain Sweden Switzerland All countries

468 41 48 55 76 82 13 64 19 17 52 128 83 1146

-0.044 -0.030 -0.043 -0.032 -0.023 0.010 -0.070 -0.035 -0.018 -0.028 -0.013 -0.024 -0.019 -0.031

0.235 0.252 0.168 0.199 0.267 0.133 0.180 0.224 0.251 0.144 0.149 0.185 0.214 0.212

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Panel C: Country-level variables Country Rule of law in 2006 (Kaufmann et al., 2007) ENFORCEk Extent of enforcement activity in 2005 or 2006 (CESR, 2007) Percentage of issuers covered by review in 2006 (CESR, 2007) MARKET_ LIQUIDTIYk TAX_ RATEk

Between 40% and 60% Less than 40% More than 60% Less than 40% Between 40% and 60% Less than 40% More than 60% More than 60%

Australia Austria Belgium Denmark Finland Greece Luxembourg Netherland Norway Portugal Spain Sweden Switzerland None Full Full Full Full None Partial Full Full Full None

1.81 1.87 1.45 2.03 1.95 0.64 1.83 1.75 2.02 0.97 1.10 1.86 1.96

154.3881 32.76268 55.77569 77.93812 221.1188 48.89508 0.447957 231.7124 121.7655 64.74188 205.5835 209.4714 409.5474

0.300 0.250 0.340 0.280 0.260 0.250 0.296 0.255 0.280 0.250 0.325 0.280 0.213

Note: ***, **, and * indicate statistical significance at 1 percent, 5 percent, and 10 percent, respectively. All variables are defined in Table 1.

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Table 4 Magnitude of absolute discretionary accrual by country Country Number of firms 468 41 48 55 76 82 13 64 19 17 52 128 83 1146 Absolute discretionary accrual Mean 0.070 0.027 0.031 0.040 0.032 0.022 0.028 0.040 0.046 0.004 0.018 0.042 0.024 0.047 9.726*** Median 0.041 0.019 0.021 0.033 0.024 0.016 0.027 0.023 0.032 0.003 0.014 0.030 0.020 0.028 STD 0.091 0.030 0.028 0.041 0.031 0.022 0.019 0.051 0.038 0.005 0.015 0.047 0.021 0.067

Australia Austria Belgium Denmark Finland Greece Luxembourg Netherland Norway Portugal Spain Sweden Switzerland All countries ANOVA F - statistic Kruskal-Wallis statistic

159.438***

Note: Absolute discretionary accruals are defined in Table 1.

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Table 5 Relationship between enforcement and accrual quality- Univariate analysis Panel A Measure of Rule of law in 2006 (Kaufmann 2007) enforcement Below median rule of law Above the median rule of law score score Enforcement level Low High Countries Australia, Belgium, Greece, Austria, Denmark, t-statistic (MannNetherlands, Portugal, Spain Finland, Norway, Sweden, Whitney statistic) and Switzerland, Mean (Median) 0.054 0.035 4.756*** Absolute discretionary (0.030) (0.025) (3.527***) accrual Panel B Measure of Extent of enforcement activity in 2005 or 2006 enforcement None Partial Full Enforcement level Low High Countries Austria, Luxembourg, Netherland Belgium, Denmark, ANOVA Fand Sweden Finland, Greece, Norway, statistic Portugal, and Spain (Kruskal-Wallis statistic) Mean (Median) 0.037 0.040 0.028 5.432*** Absolute (0.027) (0.023) (0.019) (7.509**) discretionary accrual Panel C Measure of Extent of coverage of firms in formal review enforcement Less than 40% Between 40% and More than 60% 60% Enforcement level Low High Countries Denmark, Greece, and Belgium, and Finland, ANOVA F- statistic Norway Netherland Portugal, and (Kruskal-Wallis Spain statistic) Mean (Median) 0.031 0.036 0.024 4.514*** Absolute discretionary (0.021) (0.023) (0.016) (8.665***) accrual

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Table 6 Multivariate Tobit regression Variables Rule of law 0.023 (1.062) Extent of coverage of formal review

CONSTANT

Measure of enforcement Extent of enforcement activity 0.049 (2.487**)

RULEk

0.034 (1.164) -0.007 (-1.432)

PARTIAL_ENFK 0.004 (0.757) -0.006 (-1.882*)

FULL_ENFK

MEDIUM_COVK

HIGH_COVK

-0.009 -0.005 (-8.390***) (-5.059***) LEV -0.021 -0.013 (-2.027**) (-1.525*) BIG4 0.005 0.007 (1.090) (1.802*) MARKET_LIQUIDTIYK 0.000 0.000 (1.652*) (1.011) 0.002 0.000 TAX_RATEK (2.772***) (0.670) INDUSTRY FIXED EFFECTS Included Included Log likelihood 1530.758 1155.276 2 0.148 0.128 R N 1133 595 Note: ***, **, and * indicate significance at 1 percent, 5 percent and 10 percent, respectively. All variables are defined in Table 1.

SIZE

-0.007 (-1.234) -0.028 (-3.891***) -0.002 (-2.284**) -0.006 (-0.645) 0.005 (1.233) 0.000 (2.779***) 0.001 (1.538) Included 835.601 0.120 413

37