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1. Introduction
Globalization has broadened the capital markets among different countries and there are many companies cross-listed in one of the biggest economic entity-the United States. These cross-listed companies seek to obtain more source of capital from the U.S. investors. However, firms cross-listed in the U.S. have to deal with more difficulties than their counterparts listed in the domestic capital market.
Specifically, they have to meet strict regulatory environment and be under the Securities and Exchange Commission (SEC) oversight. Also, since the cross-listed firms fall under the U.S. securities laws, the U.S. investors in these companies are protected the same as the investors in the U.S domestic firms. Besides these differences between the cross-listed firms and their counterparts in the home countries, firms cross-listed in the U.S. still have to face more obstacles than the U.S. domestic companies do. First, because the U.S. investors lack local knowledge, they are expected to rely more on the relevant information provided in the financial reports issued by the cross-listed firms. Second, although foreign companies are required to reconcile the financial information prepared under foreign accounting standards into the U.S GAAP through Form 20-F, such reconciliation may not thoroughly eliminate the discrepancies in the accounting information in the views of U.S. investors. As a result, these foreign companies are involved in more difficult information environment and the quality of financial statements provided by these firms is lower perceived by the U.S. investors, and thus the securities mispricing exists among these firms.
Prior research studies document that the cause of mispricing might have been the accruals anomaly and the information environment plays an important role in the formation of mispricing. That is, with more transparent information environment,
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investors and analysts can access to the information more easily, interpret the information revealed in the financial statements more accurately, and distinguish the earning persistence between the accruals component and the cash flows component.
Furthermore, Drake et al. (2007) confirm that better disclosure in the accounting information reduces the mispricing of accruals.
Based on the arguments mentioned above, I examine whether the mandatory adoption of International Financial Reporting Standards (IFRS) in foreign firms’
home countries reduces the mispricing of discretionary accruals among the firms cross-listed in the U.S. Since IFRS is a set of high quality accounting standards (Leuz 2003), is comparable within the U.S. economic system (Barth et al. 2012), improves analyst forecasting environment (Horton et al. 2013), provides greater equity value relevance and information content (Leuz and Wysocki 2008; Landsman et al. 2012), the mandatory IFRS in the home countries of cross-listed firms could have enhanced the information environment and increased the capital market efficiency and thus reduced the mispricing.
I test the prediction using a treatment group of 859 firm-year observations of mandatory IFRS adopters among 23 countries, and two control groups of 846 firm-year observations of non-IFRS adopters that do not adopt IFRS over the testing period and of 859 comparable matched U.S.-domiciled firms respectively. The research methodology consists of hedge portfolio tests that investigate whether the discretionary accruals-based trading strategy implemented by investors produces less abnormal returns among cross-listers from IFRS adopted countries following the mandatory IFRS adoption, and regression-based tests that examine whether the negative return predictability of discretionary accruals decreases among cross-listed firms from IFRS countries in the post-IFRS period.
I find a significant decrease in accruals anomaly among cross-listers from
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mandatory IFRS countries from the pre- to the post-IFRS period. In particular, in the hedge portfolio tests, cross-listers from IFRS countries experience over 78% reduction of annual abnormal returns. The changes associated with two control groups are insignificant, which help to mitigate the possibility that the decreases associated with cross-listers from IFRS countries are due to some unidentified confounding effects.
These findings are consistent with the prediction that the mandatory IFRS adoption reduces mispricing of discretionary accruals among cross-listed firms from IFRS countries.
This study can contribute to the literature in two ways. First, the results provide evidence on whether the regulatory intervention, i.e. the mandatory IFRS adoption, can benefit the capital market by reducing the mispricing. That is, the results can show whether the mandatory IFRS elsewhere in other countries can benefit the U.S investors by providing more comparable information and reducing their information disadvantages, regardless of whether the U.S. adopts IFRS. Second, the findings can reveal evidence for the incentive versus standards debate in the literature. Prior researches (e.g., Ball et al. 2003; Christensen et al. 2008) argue that disclosure incentives are more important than accounting standards in evaluating the financial reporting quality. Because of stricter regulatory environment in the U.S., the cross-listed firms have greater incentives than their domestic counterparts. Therefore, evidence that the accruals anomaly is reduced among a group of firms with higher disclosure incentives adds evidence that accounting standards also play a role in determining the quality of financial reporting.
The reminder of this study is organized as follows. Section 2 reviews prior literature. Section 3 presents the hypothesis development. Section 4 discusses the sample selection and the descriptive statistics of variables. Section 5 reports the research design and section 6 presents the empirical results. Section 7 concludes.
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2. Literature review
2.1. Information environment and securities mispricing
Sloan (1996) first examines the information revealed in the accrual and cash flow components of earnings and how this information is reflected in stock prices. The results indicate that the accrual component exhibits lower persistence than the cash flow component does and that the investors fail to distinguish the differential persistence between the accrual and cash flow components in reported earnings and thus misprice the securities.
Following this study, many researches examine the underlying causes of this mispricing of accruals and investigate the effects of changes in information environment on the reduction of mispricing. Chan et al. (2009) harnesses a unique set of accounting regulation change in the UK, i.e. the introduction of Financial Reporting Standard No.3: Reporting Financial Performance (FRS3) to examine how changes in accounting information quality affect the accruals anomaly and the mispricing. They compare changes in the magnitude of accruals anomaly before and after FRS3 periods in the UK and find that there is a significant reduction of accruals anomaly from the pre- to post-FRS3 periods and this reduction is driven by the companies with low accounting information quality. These findings are consistent with their predication that companies with lower accounting information quality are more sensitive to the mandatory financial standards change.
Besides cases in the UK, Lee et al. (2014) examines whether the introduction of fair disclosure regulation, SOX, and other analyst regulations reduces security mispricing in the U.S. That is, they investigate whether the regulations introduced in the U.S increase informational efficiency by reducing security mispricing in U.S stock markets. They find that a greater decrease in security mispricing occurs among firms
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with lower accruals quality, smaller size, shorter listing history, lower analyst coverage, higher analyst forecast dispersion, higher cash flow volatility, and higher stock return volatility. Also, from the pre- and post-regulations periods, they observe significant declines in short-term price continuation effects based on analyst forecast revisions and earnings announcements.
However, these two literatures examine the effects of the improved information environment due to changes in regulations and accounting standards on the security mispricing in the country where those changes are implemented. As a result, this study differs from these researches by providing evidences that whether the mandatory IFRS adoption in foreign firms’ home countries reduces the accruals anomaly among firms cross-listed in the U.S, even though U.S still apply US GAAP.
In addition to changes in standards and regulations that can affect the mispricing of accruals, Drake et al. (2007) examine whether higher quality of disclosure reduces the mispricing of accruals and cash flows. In other words, they investigate whether investors price securities more accurately if they better understand the information in accruals and cash flows about future earnings in firms with higher disclosure quality.
Their results show that high-quality disclosure also reduces the mispricing of another component of earnings, namely, cash flow, in addition to accruals component. This evidence is important because it provides a more completed picture of the relationship between disclosure quality and the mispricing of the components of earnings. Finally, they provide the notion that high-quality overall disclosure, rather than the specific disclosure of the accruals component, can reduce the mispricing of earnings component.
Knowing the positive relation between higher accounting information quality and less accruals mispricing, Radhakrishnan et al. (2014) examines whether firms with earnings and cash flow forecast experience less accruals anomaly than those with only
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earnings forecast. They argue that when analysts issue cash flow and earnings forecast for a firm, they indirectly provide forecasts for accruals as well, helping investors better assess the implication of accruals on future earnings. Using cross-sectional and time-series designs, they collectively provide evidence that earnings and cash flow forecast firms have less accruals mispricing and cash flow mispricing than firms with earnings forecast.
2.2. Economic benefits of IFRS adoption
2.2.1. Improvement in information environments
IFRS is a set of high quality financial statements and its objective is to provide relevant and comparable information to users of accounting information (Leuz 2003;
Bartov, Goldberg, and Kim 2005). The mandatory IFRS adaption benefits capital markets in many ways. For example, Horton et al. (2013) observe that prior researches often provide conflicting evidence and fail to separate between information quality and comparability, the benefits of IFRS adoption. Therefore, they investigate which attributes of IFRS cause an improvement in the information environment proxied by decrease in analyst forecast errors. Employing individual analyst level data and isolating settings where analysts would benefit from either improved comparability or higher information quality, they find that the improvement in the information environment is driven both by information and comparability effects.
An increasing body of research analyzes the quality of accounting information associated with IFRS adoption, and provides mixed evidence whether the accounting amounts from such accounting standards exhibit higher quality than those do from domestic accounting standards (Leuz and Wysocki 2008). Landsman et al. (2012) add to this literature by investigating whether the information content of earnings announcement, one dimension of accounting quality, increases in countries that
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mandate IFRS adoption relative to countries that remain domestic accounting standards. They find that increases in the information content of earnings announcement, abnormal return volatility and abnormal trading volume, for countries mandating IFRS adoption.
DeFond et al. (2011) examines the assertion that the mandatory IFRS adoption increases financial statement comparability, which in turn attracts more cross-border investment, by testing whether the mandatory IFRS adoption in EU in 2005 results in improved comparability that leads to increased investment by foreign mutual funds.
Knowing that the improvement to comparability is likely to vary across adopters, they predict standards uniformity to improve comparability only when the standards are credibly implemented. Using a difference-in-differences test, they find that following the mandatory IFRS adoption foreign mutual funds increase their ownership in mandatory IFRS adopters that are in countries with strong implementation credibility, and that the increase in ownership is more pronounced in firms experiencing greater increases in uniformity.
In addition to focusing on the advantages of increased comparability among IFRS adoption countries, existing literature also address the improved comparability between IFRS adopted countries and non-IFRS adopted countries. Barth et al. (2012) investigates the extent to which the application of IFRS by non-U.S. firms results in accounting amounts that are comparable to those resulting from the application of US GAAP by U.S. firms. Using two approaches to assess the comparability, the results are relevant to the debates relating to possible use of IFRS by U.S. firms. They find that non-U.S. firms applying IFRS have significantly greater accounting system and value relevance comparability with U.S. firms applying US GAAP when they apply IFRS than when they applied non-U.S. domestic standards. This comparability could give better access for U.S. investors to interpret the accounting information presented
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in the financial statements and thus may reduce the mispricing among foreign firms.
2.2.2. Benefits in debt markets
Existing literature has a strong focus on how the improvements in information environment under IFRS benefit the equity and debt capital markets. For example, Beneish et al. (2012) investigate whether the mandatory IFRS adoption has a differential impact on debt and equity markets by providing macroeconomic evidence.
They find that IFRS adoption has a greater effect on foreign debt than on equity investment markets. Moreover, they find that increases in equity markets are limited to countries with high governance quality. Finally, they provide evidence that increases in equity and debt investments derive from the U.S. and other non-IFRS adoption countries, rather than from other adopting countries. This result suggests that the benefits from the mandatory IFRS adoption are more likely attributed to improvement in financial reporting quality rather than greater comparability.
Chan et al. (2013) examine whether the credit ratings of foreign firms cross-listed in the U.S. are affected by the mandatory adoption of IFRS in their home country.
They contend that the switch from domestic standards to IFRS could affect the financial reporting quality for two reasons. First, IFRS provides firms with more flexibility to disclose forward-looking information to reduce the information asymmetry with outsiders. Second, IFRS improves the cross-border comparability of financial information and in turn reduces the ability of firms to distort their performance through their domestic accounting standards. Using a difference-in-difference test design, they find that a significant increase in credit ratings among firms cross-listed in the U.S. from countries that mandated IFRS, relative to their comparable U.S.-domiciled firms. Moreover, they observe that the increase in more pronounced among those firms from countries where the difference
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between the previous domestic standards and IFRS is greater. Therefore, combining these findings, they infer that the increased credit rating effect can be attributed to improved financial information quality under IFRS.
2.2.3. Benefits in equity markets
Daske et al. (2008) examine the economic consequences of mandatory IFRS reporting in equity markets. In particular, they analyze effects in stock market liquidity, cost of capital, and firms’ equity valuations. For the first economic effect, they find that mandatory IFRS adopters experience larger increase in market liquidity than a random sample of non-adopting benchmark firms. Moreover, they document that the cost of capital decreases and valuation increases when they account for the possibility that markets already anticipate the effects of mandatory IFRS adoption and measure the effects one year before the official adoption date.
Prather-Kinsey et al. (2008) investigate the stock market reactions associated with IFRS adoption in EU by comparing the value relevance of book values before and after IFRS adoption and examining the cost of capital effect. Using a sample of 157 European firms in 2005, they find that capital markets participants consider financial reports of IFRS adopters more value relevant and informative. Moreover, they observe that these improvements in information quality lead to a decrease in cost of capital.
Li (2010) provides further evidence for the cost of equity capital effects of mandatory IFRS adoption. She tests whether the mandatory IFRS adoption affects the cost of equity capital in 18 EU countries during the period from 1996 to 2006. The findings are that the mandatory adopters experience significant decreases in the cost of equity of 47 basis points and that these decreases are significant only in countries with strong legal enforcement. Finally, she finds that increased disclosure and
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improved comparability associated with the adoption of IFRS are two mechanisms behind the reduced cost of equity.
3. Hypotheses development
Given the evidences regarding the association between the improved information environment and the reduced mispricing of accruals, I predict that the mandatory IFRS adoption reduces the mispricing of foreign firms cross-listed in the U.S. for three reasons. First, IFRS is recognized as a high quality set of accounting standards, which can improve the information environment and provide relevant information for investors so that they can better distinguish the difference between the earnings components. Second, IFRS requires more extent to which financial and nonfinancial information are disclosed and prior researches have suggested that high-quality disclosure can reduce the mispricing of securities. As a result, with more required disclosure in IFRS, the mispricing could also decrease due to the mandatory IFRS adoption. Finally, since prior literature suggests that the IFRS-based and the US GAAP-based amounts are comparable, implying that IFRS can fit well in the U.S.
economic system, the mandatory IFRS adoption in foreign firms’ home countries could potentially affect the accruals anomaly of those firms cross-listed in the U.S.
Thus, the hypothesis is:
H1: Foreign firms cross-listed in the U.S market exhibit lower mispricing of discretionary accruals following the mandatory IFRS adoption.
4. Research design
To test the prediction that the mandatory IFRS adoption would affect the mispricing of discretionary accruals, I perform hedge portfolio tests and
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return-discretional accruals regressions and compare the results of firms cross-listed in the U.S. from countries that mandate IFRS with their comparable U.S.-domiciled firms and with cross-listers from non-IFRS adoption countries.
4.1. Hedge portfolio tests
The hedge portfolio test mimics trading strategies based on accruals that are implemented by investors. I develop portfolios by independently sorting stocks into terciles based on levels of discretionary accruals, where discretionary accruals are estimated from the modified Jones (1991) model following Kothari et al. (2005). The hedge portfolio returns are the returns spread between the lowest and highest discretionary accruals terciles. Based on the modified Fama-French (1996) four-factor model (FFM), the portfolio abnormal returns are equivalent to the intercept of the following time-series regression:
𝑅𝑝,𝑡 − 𝑅𝑓𝑡= 𝛼𝑝+ 𝛽𝑝(𝑅𝑚𝑡− 𝑅𝑓𝑡) + 𝑠𝑝𝑆𝑀𝐵𝑡+ ℎ𝑝𝐻𝑀𝐿𝑡+ 𝑢𝑝𝑈𝑀𝐷𝑡+ 𝜀𝑝,𝑡 (1) where 𝑅𝑝,𝑡 is the return of the test tercile portfolio p in month t, 𝑅𝑓𝑡 is the risk-free return in month t proxied by the U.S. 30-days treasury bill yield, 𝑅𝑚𝑡 is the return of market portfolio in month t proxied by NYSE value-weighted yield, 𝑆𝑀𝐵𝑡 is the month t value-weighted return measured by the return of (S)mall (M)inus (B)ig companies, 𝐻𝑀𝐿𝑡 is the month t value-weighted return constructed by the return of (H)igh (M)inus (L)ow book-to-market value companies, 𝑈𝑀𝐷𝑡 is the momentum factor, factor coefficients 𝛽𝑝, 𝑠𝑝, ℎ𝑝, and 𝑢𝑝 capture portfolio risk exposures, and 𝛼𝑝 is interpreted as the portfolio abnormal return after controlling four risk-factors. I annualize the alpha by multiplying 12 and expect that there is a decline in hedge portfolio abnormal returns from the pre- to the post-IFRS period.
To mitigate the possibility that the evidence is driven by some confounding factors, I also report the results of two sets of control samples. The first set of control
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firms is cross-listed companies from non-IFRS adoption countries. The second set of control groups is matched U.S.-domiciled firms. I identify a set of comparable U.S.
firms for each cross-listers from IFRS countries by matching with year, industry, and sales growth. I do not expect to find any abnormal return differences from the pre- to the post-IFRS period among these two control groups.
4.2. Regression-based tests
This regression provides evidence for time-series unobservable impact and
This regression provides evidence for time-series unobservable impact and