International Accounting Standard

1. Introduction

The question we address is whether application of International Accounting Standards (IAS) is associated with higher accounting quality than application of non-US domestic standards.1 In particular, we investigate whether accounting amounts of firms that apply IAS exhibit less earnings management, more timely loss recognition, and higher value relevance than accounting amounts of firms that apply domestic standards. The accounting amounts that we compare result from the interaction of features of the financial reporting system, which include accounting standards, their interpretation, enforcement, and litigation. Because our interest is in the quality of the accounting amounts that result from the financial reporting system, we make no attempt to determine the relative contribution of each of its features. We refer to the combined effect of the features of the financial reporting system as the effect of application of IAS. Our results indicate that firms applying IAS have higher accounting quality than firms that do not and that accounting quality improves after firms adopt IAS.

A goal of the International Accounting Standards Committee (IASC), and its successor body the International Accounting Standards Board (IASB), is to develop an internationally acceptable set of high quality financial reporting standards. To achieve this goal, the IASC and IASB have issued principles-based standards, and taken steps to remove allowable accounting alternatives and to require accounting measurements that better reflect a firm's economic position and performance. Accounting quality could increase if these actions by standard setters limit management's opportunistic discretion in determining accounting amounts, e.g., managing earnings. Accounting quality also could increase because of changes in the financial reporting system contemporaneous with firms' adoption of IAS, e.g., more rigorous enforcement. Thus, we predict that accounting amounts based on IAS are of higher quality than those based on domestic standards.

However, there are at least two reasons why our predictions may not be borne out. First, IAS may be of lower quality than domestic standards. For example, limiting managerial discretion relating to accounting alternatives could eliminate the firm's ability to report accounting measurements that are more reflective of the firm's economic position and performance. In addition, the inherent flexibility in principles-based standards could provide greater opportunity for firms to manage earnings, thereby decreasing accounting quality. Second, the effects of features of the financial reporting system other than the standards themselves could eliminate any improvement in accounting quality arising from higher quality accounting standards. This could occur, for example, if enforcement of accounting standards is lax.

We interpret earnings that exhibit less earnings management as being of higher quality. Our metrics for earnings management are based on the variance of the change in net income, the ratio of the variance of the change in net income to the variance of the change in cash flows, the correlation between accruals and cash flows, and the frequency of small positive net income. We interpret a higher variance of the change in net income, higher ratio of the variances of the change in net income and change in cash flows, less negative correlation between accruals and cash flows, and lower frequency of small positive net income as evidence of less earnings management. We also interpret earnings that reflect losses on a more timely basis as being of higher quality. Our metric for timely loss recognition is the frequency of large negative net income. We interpret a higher frequency as evidence of more timely loss recognition. Finally, we interpret accounting amounts that are more value relevant as being of higher quality. Our metrics for value relevance are the explanatory powers of net income and equity book value for prices, and stock return for earnings. We interpret higher explanatory power as evidence of more value relevance. All of our accounting quality metrics are based on those used in prior research.

We base our inferences on a sample of firms in 21 countries that adopted IAS between 1994 and 2003. Ideally, we would base on our inferences on a sample of firms that were randomly assigned to apply IAS. However, our sample period preceded the mandatory application of IAS for most sample firms, and thus firms may have adopted IAS in response to changed incentives. Thus, we could detect an improvement in accounting quality for firms that apply IAS that is attributable to changes in incentives and not to changes in the financial reporting system. To mitigate the effects of changes in incentives, when constructing our accounting quality metrics relating to earnings management and timely loss recognition,