Two Birds with One IAS: Accounting Quality and Investors Trust
The adoption of the International Accounting Standards (IAS) in place of local Generally Accepted Accounting Principles (GAAP) translates into a better accounting quality and is appreciated by investors, who acknowledge a better information content in IAS adopters' balance sheets when earnings are announced.
In Investor Perception of the International Accounting Standards Quality: Inferences from Germany (forthcoming in Journal of Accounting, Auditing and Finance, doi: 10.1177/0148558X11409163) - a paper written with Mascia Ferrari (Università di Modena e Reggio Emilia) - Francesco Momentè and Francesco Reggiani (Department of Accounting) confirm the theoretical literature predictions thanks to the unique German setting of 1998-2005. In this period listed companies were allowed, but not compelled, to adopt the IAS for their consolidated financial reporting. Scholars can thus compare the accounts and the effects of earnings announcements for companies reporting under the two regimes in the same country and in the same period. For operational reasons they end up using only 2000-2004 data and can rely on more than 740 observations when measuring the quality of the accounts and 350 observations when analyzing investors' reaction to earnings announcements.
With their paper, the authors improve the results of past empirical literature, which provided only mixed evidence that IAS imply better quality. They measure quality as an inverse function of the magnitude of the accrual components of earnings because accruals have lower persistence than cash flows and are easier to manipulate. They build two models, comprising total accruals in one case and only working capital accruals in the other. The evidence they present confirms IAS accounts' overall better quality, but, they warn, "the empirical results depend on the model used (...) and on the sample composition by industries": the evidence is stronger considering the total accruals than the working capital accruals and the consumer services industry seems to be an exception to the rule.
They, then, use trading volumes around the earnings announcements to measure investors' perception of accounting quality because trading volume is an index of investors' disagreement with the management and, consequently, of uncertainty. The model confirms that a higher level of earnings management (i.e. bad accounting quality) is associated with higher trading volumes, with an important addition: for the same degrees of earnings management, IAS adopters' trading volumes are lower than GAAP adopters', meaning that the former's accounts are considered more trustworthy than the latter's. This effect, though, decreases for smaller firms. "We interpret this result", the authors write, "as the evidence that IAS regime per se is not sufficient to guarantee an information benefit to investors without a strong enforcement of the rules, which is typically weaker for smaller firms".