IFRS adoption, reporting incentives and financial reporting quality in private firms

• Date: 01 July 2018
• Published date: 01 July 2018
• Author: Moritz Bassemir,Zoltán Novotny‐Farkas
• DOI: http://doi.org/10.1111/jbfa.12315

DOI: 10.1111/jbfa.12315

IFRS adoption, reporting incentives and financial

reporting quality in private firms

Moritz Bassemir1Zoltán Novotny-Farkas2

1GoetheUniversity Frankfurt, Frankfurt,

Germany

2Accountingand Finance, Lancaster University

ManagementSchool, Bailrigg, Lancaster, United

Kingdomof Great Britain and Northern Ireland

Correspondence

ZoltánNovotny-Farkas, Accounting and Finance,

LancasterUniversity Management School, Bail-

rigg,Lancaster, United Kingdom of Great Britain

andNorthern Ireland.

Email:z.novotny-farkas1@lancaster.ac.uk

Fundinginformation

DeutscheForschungsgemeinschaft, Grant

Award/Number: GE 600/5-1; European Com-

missionResearch Training Network INTACCT,

GrantAward/ Number: MRTN-CT-2006-035850

Abstract

This study examines financial reporting quality (FRQ)effects around

voluntary International Financial Reporting Standards (IFRS) adop-

tions by German private firms across two important dimensions,

earnings quality and disclosure practices. To capture differences in

the motivations for IFRS adoptions, we identify four different types

of IFRS adopting firms based on a comprehensive set of firm char-

acteristics. We observe earnings quality improvementsaround IFRS

adoptions primarily for one type of firm, which is young,fast g rowing

and seeking access to public equity markets.Using a matched sample

of private German GAAP and IFRS reporting firms, we find some evi-

dence suggesting that IFRS also contribute to higher earnings qual-

ity.Recognizing that our earnings quality metrics are only incomplete

measures of FRQ, we also compare the disclosure practices of IFRS

and German GAAP firms. We find that all IFRS firm types disclose

significantly more information in their financial reports and show a

higher propensity to publish their financial reports voluntarily on the

corporatewebsite. Our findings indicate that failure to identify earn-

ings quality changes around IFRS adoption cannot be automatically

interpreted as IFRS adoption having no effect on the FRQ of (pri-

vate) firms. Collectively,our results suggest that both incentives and

accounting standards shape private firms’ FRQ.

KEYWORDS

financial reporting quality, international financial reporting stan-

dards (IFRS), private firms, reporting incentives

1INTRODUCTION

In this paper we investigate financial reporting quality (FRQ) effects around the voluntary adoption of International

Financial Reporting Standards (IFRS) by German private firms across two important dimensions, earnings quality

and disclosure practices.1Our paper is motivated by two streams of the accounting literature. First, following the

1Throughout the paper we use the term financial reporting quality (FRQ)as an umbrella term subsuming the terms earnings (or accounting) quality and dis-

closurequality, both of which capture related, but different FRQ aspects. ‘Quality’ refers to the extent to which accounting information reflects the underlying

economicsituation of the firm and is related to the broader concept of ‘transparency’ (Ball, Robin, & Wu, 2003).

J Bus Fin Acc. 2018;45:759–796. wileyonlinelibrary.com/journal/jbfa c

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760 BASSEMIR ANDNOVOTNY-FARKAS

worldwide introduction of IFRS, substantial research has focused on the financial reporting effects of IFRS adoptions

in publicly listed firms. The collective empirical evidence suggests that while high quality accounting standards con-

tribute to earnings quality improvements around voluntaryIFRS adoptions (e.g., Barth, Landsman, & Lang, 2008), such

improvementsare confined to a subset of firms with strong reporting incentives (e.g., Christensen, Lee, Walker,& Zeng,

2015; Daske, Hail, Leuz, & Verdi,2013). Second, a growing literature examining FRQ in the private firm setting shows

that variation in financing, ownership and organizational structure leads to heterogeneity in the earnings quality of

private firms (Ball & Shivakumar,2008; Haw, Lee, & Lee, 2014; Hope, Thomas, & Vyas, 2013, 2017). However, neither

of the two streams speaks to the impact of voluntary IFRS adoptions on the FRQ of private firms and how FRQ varies

with firms’ motivations to switch accounting standards.

This research question is particularly interesting since private firms are typically characterized by concentrated

ownership,insider orientation and low demand for high FRQ (Ball & Shivakumar, 2005; Burgstahler,Hail, & Leuz, 2006).

Yet,in recent years, an increasing number of private firms have voluntarily adopted IFRS. Empirical studies show that

the decision to adopt is associated with external financing needs (as indicated by Initial Public Offerings (IPOs), public

bond issuances, high sales growth), certain governance features such as private equity (PE) ownership and incorpo-

rated status, and internationalization (Bassemir, 2018; Francis,Khurana, Martin, & Pereira, 2008). However, it is not

clear which of the numerous motives to adopt IFRS represent a commitment to higher FRQ and whether IFRS per se

contribute to changes in FRQ of private firms in the first place.

Based on prior evidence, we expect FRQ effects to be jointly determined by the quality of IFRS and private firms’

reporting incentives. Germany offers an ideal setting to investigate our research question. German GAAP or the Ger-

man Commercial Code (Handelsgesetzbuch; hereafter, HGB) is insider-oriented and dominated by the prudence prin-

ciple with limited recognition of assets and the discretionary use of provisions resulting in pervasive earnings man-

agement (Hung & Subramanyam, 2007; Leuz & Wüstemann, 2004).2In contrast, IFRS are perceived as higher quality

accounting standards because IFRS limit managerial discretion, promote more conditionally conservative accounting

and require more disclosure (André, Filip, & Paugam,2015; Leuz, 2003). Hence, to the extent that accounting standards

matter,financial statement effects are likely to be strong in this setting. However, given the lack of enforcement in the

private firm setting and the flexibilityembedded in IFRS (e.g., Kvaal & Nobes, 2010), firm-level reporting incentives are

potentially important in shaping FRQ effects around IFRS adoptions (Christensenet al., 2015; Daske et al., 2013).

Incentives for high FRQ arise primarily for two reasons (Beyer,Cohen, Lys, & Walter,2010). First, when (potential)

external capital providers want to evaluate the profit potential of the firm theyneed high FRQ to resolve information

asymmetries with managers (valuation role). Second, when capital providers (e.g., owners, suppliers) cannot directly

observe the actions of managers, they rely on financial reporting as a monitoring tool to alleviate agency problems

(stewardship role). Yet, insiders to the firm often prefer opacity to protect their private benefits of control or infor-

mational rents (of relationship lenders) (Rajan & Zingales, 1998). Therefore, we posit that in the private firm setting,

incentives for higher FRQ around IFRS adoptions will depend on the relativeimportance of valuation and stewardship

problems and the insider–outsider conflict. Tocapture variation in the incentives for high FRQ, we identify different

types of IFRS adopters.

For our empirical analysis, we identify 273 German private firms that voluntarily adopted full IFRS intheir consoli-

dated financial statements between 1998 and 2010. We start our analysis by identifying the motivations of IFRS firms

to switch accounting standards. Specifically, we classify private firms into different types of IFRS adopters using fac-

tor and cluster analysis based on a comprehensive set of firm characteristics and economic events that prior studies

found to coincide with the accounting switch (e.g., Bassemir,2018). Since many of these observable firm characteris-

tics and economic events are highly interdependent, we intentionally refrain from partitioning firms based on single

characteristics and from drawing conclusions based on dichotomous classifications. Instead, we use factor analysis to

identify latent factors based on the common variance among firm characteristics, which we interpret as the primary

motivations for IFRS adoptions. Then, we perform cluster analysis on the factor scores to group firms into four types

2Weuse the term ‘German GAAP’ broadly to refer to all legal rules, principles and standards that German companies have to apply in the preparation of their

financialstatements. ‘HGB’ refers to specific legal rules as codified in the German Commercial Code.

BASSEMIR ANDNOVOTNY-FARKAS 761

that differ in terms of their primary motivations for IFRS adoption which are access to public equity markets(which we

label EQUITY firms), access to public debt markets(DEBT firms), ownership and reorganization by private equity firms

(FINCON-PE firms), and internationalization (REPUTATIONfirms). We argue that the valuation and stewardship prob-

lems are highest in EQUITY firms, because of the entranceof outside investors and the largest separation of ownership

and control, and lowest in REPUTATIONfirms that do not tap public capital markets. While DEBT (FINCON-PE) firms

face higher (intermediate) valuation problems, stewardship problems are relatively low because of the tight grip of

family (private equity) controlling owners. Takentogether, we expect incentivesfor high FRQ to be highest in EQUITY

and lowest in REPUTATIONfirms.

We focus on two dimensions of private firm FRQ, earnings quality and disclosure. We measure earnings quality

using two manifestations of earnings management, income smoothing and managing towards positive earnings, and

one timely loss recognition metric (e.g., Ahmed, Neel, & Wang, 2013; Barth et al., 2008; Christensen et al., 2015). We

measure disclosure using the length of financial reports and the length of notes sections therein, the levelof disclosure

detail related to goodwill and deferred taxes,two balance sheet items that are particularly different between IFRS and

German GAAP,and firms’ propensity to voluntarily publish financial reports on their websites. Since IFRS are outsider

oriented, we take the perspective of outsiders and consider less earnings management, more timely loss recognition

and more disclosure as high FRQ.

Forour earnings quality analysis, we perform two sets of empirical tests. The first set of tests examines heterogene-

ity in earnings quality across different types of IFRS adopting firms. First, we make a cross-sectional comparison of the

earnings quality of different types of IFRS adopters in the post-adoption period with the average earnings quality of a

pooled (unmatched) benchmark sample of private German GAAP firms over the sample period. We find that EQUITY

firms exhibitsignificantly less income smoothing and more timely loss recognition in the post-adoption period than the

average German GAAP firm and other types of IFRS adopters. In contrast,DEBT firms generally smooth income more

than German GAAP firms suggesting that despite their capital market orientation insiders create incentives for man-

agers to conceal firm performance. FINCON-PE and REPUTATIONfirms exhibit a similar level of income smoothing

and timely loss recognition as the averageGerman GAAP firm. Interestingly, all IFRS firm types generally show a lower

incidence of small profits than German GAAP firms.

Second, for a subsample of firms where pre- and post-adoption data are available, we examine whether the differ-

ent IFRS-adoption types experience a within-firm improvement of earnings quality.Again, we find that EQUITY firms

experience the largest improvement in earnings quality around IFRS adoption consistent with these firms facing the

greatest valuation and stewardship problems. Furthermore, neither DEBT nor FINCON-PE firms evidence improve-

ments in earnings quality around IFRS adoption. Interestingly,REPUTATION firms experiencean improvement in their

earnings quality in the post-adoption period.

Toisolate the incremental effect of IFRS, our second set of tests repeats the two previous analyses using a propen-

sity score-matched sample of private IFRS and German GAAP firms. While the matched sample tests are the most rig-

orous in terms of empirical validity,they come at the cost of a significantly reduced sample size, which prevents us from

running these tests separately for each type of firm. We find evidence that IFRS firms exhibit higher earnings quality

(improvements) after (around) the adoption of IFRS than their German GAAP counterparts indicating an incremental

effect of accounting standards. Finally,a differences-in-differences analysis provides weak statistical support for IFRS

firms improving their earnings quality more than German GAAP firms.

Our earnings quality analyses have several caveats.First, given that we rely on balance sheet accruals, important

economic events like IPOs can mechanically lead to large changes in the earnings quality proxies (Hribar & Collins,

2002). We mitigate this concern by excludingthe first IFRS year, but cannot entirely eliminate it. Second and related,

the empirical proxiesemployed in our analyses contain substantial measurement error that increases the possibility of

Type1 and Type 2 errors. Finally,earnings quality proxies are only incomplete measures of overall FRQ.

In order to capture other aspects of FRQ where IFRS adoption effects are presumably easier to detect, we also

examine the disclosure practices of private firms. We find that financial reports prepared by IFRS firms and in

particular their notes sections contain significantly more pages than those of matched German GAAP firms. Since

page numbers is a quantitative measure potentially influenced by boilerplate-type disclosure, we further construct a