Secrecy and the impact of mandatory IFRS adoption on earnings quality in Europe
Introduction
As of June 2016, over 130 countries around the world have adopted International Financial Reporting Standards (IFRS) in one form or another (Deloitte, 2016). These countries reflect a wide range of different cultures and institutional settings. Ball et al. (2003) and Ball (2006) suggest that differences in institutional environment are likely to lead to differences in quality of financial reporting even where the same accounting standards are applied. Specifically, there is mixed evidence on the quality of financial reporting following IFRS adoption. While several studies document improved earnings quality following IFRS adoption (e.g., Barth et al., 2008, Leuz et al., 2003), others provide evidence of either no improvement or decline in earnings quality (e.g., Gebhardt and Novotny-Farkas, 2011, Jeanjean and Stolowy, 2008). In this paper, we investigate the effect of national culture, as indicated by secrecy, on earnings quality following IFRS adoption.
Our study is motivated by strong evidence that culture plays an important role in financial reporting choices and quality (Callen et al., 2011, Desender et al., 2011, Doupnik and Perera, 2009, Feleaga et al., 2010, Gray and Vint, 1995, Gray, 1988, Salter and Niswander, 1995). Given that the vast majority of the countries that have adopted IFRS have diverse national cultures (in addition to other institutional differences), it is likely that IFRS adoption will not have the same effect on earnings quality across all these countries. We are also motivated by lack of any evidence on the interaction between national culture and IFRS adoption. Thus our study may inform the debate on why earnings quality varies across countries that have adopted IFRS.
We analyse 24,034 firm year observations across 16 countries over the period 1998–2014. We measure earning quality by the magnitude of signed abnormal accruals and financial secrecy by the Financial Secrecy Index (FSI) of the Tax Justice Network (2015). We find that the higher the level of secrecy in a country the lower the level of earnings quality of firms. We find that mandatory adoption of IFRS improves earnings quality in all countries. However, our study also indicates that the impact of mandatory adoption of IFRS on earnings quality is stronger the higher the level of secrecy in a country. Our analysis includes controls at the firm level for audit quality, sales, capital structure, growth, cash flow from operations, and losses, and at the country level for investor protection. Our results are robust to several sensitivity tests including alternative measures for earnings quality, secrecy, investor protection, and also to alternative sample compositions.
Our study makes a single but important contribution to the cross-country literature on IFRS adoption. Specifically, our study provides evidence of how IFRS adoption can have differential impact on earnings quality depending on national culture, as indicated by the level of financial secrecy. Although the differential impact of IFRS adoption on earnings quality due to differences in institutional environments such as investor protection and enforcement of accounting standards have been documented, our study is the first one to document an interaction between IFRS adoption and national culture.
The remainder of our paper is organized as follows. In Section 2 we set out the theoretical framework and in Section 3 the hypothesis development. In Section 4, we present the research design and in Section 5 the sample selection process and results. Finally, our conclusion is presented in Section 6.
Section snippets
Theoretical framework
Many researchers have addressed issues related to the importance of macro level factors and their impact on economic activity. Macro level factors include investor protection, taxation system, judicial independence and the legal system, the financing system, and national culture. Several studies report that the legal regime of a country can influence the level of financial disclosures and accounting quality (Ball et al., 2000, Jaggi and Low, 2000). The investor protection regime is also a
Hypothesis development
We draw on the relationship between cultural dimensions such as power distance, uncertainty avoidance, individualism and masculinity and earning management to hypothesize the relation between secrecy and earnings quality.
The relationships between cultural values and earnings management is a significant topic in accounting literature but there is mixed evidence on the direction of the relationships. Han et al. (2010) observe that earnings management decreases (increases) with uncertainty
Macro-level variables
The Financial Secrecy Index (FSI) from the Tax Justice Network (2015) was introduced in an effort to understand global financial secrecy, corruption and illicit financial flows. The FSI is a comprehensive indicator of secrecy which comprises of both qualitative and quantitative measurements. The qualitative side of the FSI considers laws, regulations, cooperation with information exchange process, and other verifiable data sources (Tax Justice Network, 2015). Quantitatively, a global score of
Descriptive statistics
Table 2 shows the number of firms and the number of firm-year observations for each country and descriptive statistics for the country level variables. Most of the firm year observations are for UK with 8248 observations (34.3%) while 16.1% of the total sample comes from France and 12.7% come from Germany and 6.5% from the Netherlands. Ireland and Portugal have the lowest representation with 1.2%. In a robustness test we exclude the larger countries.
The level of secrecy (SEC) has a wide range
Conclusion
We hypothesize that culture influences financial reporting quality. Specifically, we test whether the extent of secrecy in a country negatively impacts on earnings quality. Using 24,034 firm year observations from 16 European countries, our evidence indicates that there is a negative relation between secrecy and earnings quality. Our study adds to the discussion of the effects of mandatory IFRS adoption across countries. We find support for mandatory adoption of IFRS having a positive on
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