An important step took place when the European ... traded in the US must prepare a reconcilement for income and equity ... financial statements: balance sheet, income statement and cash flow .... Only a few studies have examined whether there are significant IFRS vs. ..... Table 3 shows that the five largest items account for.
US GAAP and IFRS How Close is “Close Enough”? Frederick Lindahl George Washington University, USA Hannu Schadéwitz Turku School of Economics, Finland May 2009
Acknowledgements The authors would like to thank session participants and discussant Victoria Krivogorsky at the 13th Annual Mid-Year Conference of the International Accounting Section of the AAA 2007, Charleston, 19th Annual International Conference of the Association for Global Business, Washington D. C., the 31st Annual Congress of the EAA 2008, Rotterdam, and 50th Academy of International Business Meeting, Milan. The authors would also like to thank Huihong Tan, Yinka Dare, Jianing Liu and Rami Katajisto for their able research assistance. This research has benefited from funding by the OP Bank Group Research Foundation and the Turku School of Economics.
Electronic copy available at: http://ssrn.com/abstract=1413163
US GAAP and IFRS: How Close is “Close Enough”? Abstract One important aspect of the world economy is the process of implementing uniform financial reporting standards. A leap forward took place when the European Union required that listed companies in all member nations use International Financial Reporting Standards (IFRS) for years beginning 2005. Another aspect of the process is the joint effort between the International Accounting Standards Board and the US Financial Accounting Standards Board to eliminate differences in accounting principles between IFRS and US GAAP. In this study we investigate IFRS vis-à-vis US GAAP from 2004 to 2006, using all three primary financial statements. We find that large differences remain in income calculation and shareholders’ equity, but that the number of items has fallen to a handful. This study contributes to three topics. Academic accounting research often uses reported accounting numbers drawn from companies in different countries, so it is important to understand the comparability of the numbers. Financial analysis uses financial statement data in many profitability and risk measures, so analysts are concerned with how comparable the ratios are when the companies being compared are from different countries with different standards. “Harmonization” has been progressing for several years. Information users will benefit by knowing the degree of convergence. Keywords IFRS, accounting quality, convergence, international accounting, 20-F reconciliation, comparison
2 Electronic copy available at: http://ssrn.com/abstract=1413163
1. Introduction The process of harmonizing accounting standards is an important aspect of globalization. An important step took place when the European Union adopted a common set of accounting standards, International Financial Reporting Standards (IFRS). The Union required that as of 2005 all listed companies issue financial statements prepared according to IFRS. At the same time, there is a continuing effort to reach greater uniformity in accounting and reporting principles between the IFRS standard setter (the International Accounting Standards Board) and U.S. standard setter (the Financial Accounting Standards Board) (Schipper, 2005). In recognition of the increasing similarity, the SEC abandoned the rule that non-US companies traded in the US must prepare a reconcilement for income and equity between U.S. GAAP and IFRS (SEC 2008). We use financial reports of European foreign private issuers that are traded in the US to investigate the differences between IFRS and US GAAP. 1 We ask whether they are “close enough” to mix the accounting numbers in typical research designs and conventional financial analysis. We study the reports of a sample of European firms for all three years when the requirement for EU firms to use IFRS overlapped with the American requirement to US GAAP, and we also make the comparison for all three financial statements: balance sheet, income statement and cash flow statement. Our study is motivated by three concerns. First, accounting research on international topics often makes simplifying assumptions about the comparability of data. We evaluate these assumptions. Second, financial analysis makes use of ratios based on financial statements, and in making across-country comparisons, different accounting systems may limit comparability. We assess the extent of comparability. Third, the use of IFRS by foreign issuers in US markets is now permitted, presumably because they
1
“Foreign private issuer” is the SEC term for non-US companies that are subject to SEC regulation because shares are traded in the US.
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are “close enough” to US GAAP. We offer a snapshot of the state of accounting “harmonization” as of the beginning of widespread use of IFRS. The first and most important of our concerns is the appropriate use of international accounting figures in empirical research. Researchers have increasingly conducted studies in the area of international accounting (e.g., Barth et al. 2008, Ball et al. 2000). These studies use financial reports from many countries. In the case of Barth et al., 21 countries are in the sample. Leuz et al. (2003) use data from 31 countries. Wysocki (2003) has 30 foreign countries. Hail (2007) and DeFond and Hung (2003) have 36. One thing accountants know for sure is that accounting standards differ among countries. Strong conclusions may be hard to draw, say, from the level of accruals as a measure of “earnings management” without first controlling for different accrual methods. Without making this adjustment, the researcher would attribute differences to “earnings management” when in fact what he or she had really observed were different accounting methods. Another thing that accountants know is that accounting principles differ within countries, as alternatives are allowed for, say, inventory or expense capitalization. Within countries that mandate IFRS, there are differences. The European Union requires all 27 member states to apply IFRS to listed companies except for the provisions of IAS 39.2 Some foreign private issuers will have followed this standard while others will have continued to use their country’s GAAP. One reason, then, for studying the accounting effects of the two different accounting regimes is prospectively to guide researchers who will conduct international studies of topics such as “earnings management,” “accounting quality,” “information content,” and “value relevance.” If the differences are small, then their maintained assumption—that accounting is
2
The IASB subsequently amended IAS 39 to eliminate the “carve-out” for fair value accounting, and the amended standard was adopted by the EU in July 2005. It will be applied retroactively to 1 Jan. 2005, but the published reports for 2005 were not required to comply with the previous version. Furthermore, a second carve-out exempted companies from IAS 39 hedge accounting requirements, and this exemption is still allowed (EU 2005).
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the same under IFRS and US GAAP—is justified.3 Retrospectively, it will give some context to past studies that assumed accounting was the same no matter what countries were being compared. It might seem that this is a fleeting issue that concerns just one year, but this is not a short-term concern. EU countries first report under IFRS for year 2005. For some years in the future, accounting researchers will use the time series of IFRS earnings in their comparisons of US GAAP with IFRS. The problem they should recognize is that as IFRS and US GAAP converge, the relationship between the two sets of standards will vary from year to year. When future researchers write “We use the time series of US GAAP and IFRS for the years 2005-2007,” they should be aware that it may all be “GAAP” and “IFRS,” but what constitutes GAAP and IFRS in 2007 will differ from what it was in 2005. This paper sets the benchmark for IFRS-US GAAP differences in the first year of widespread IFRS reporting. Our sample comprises firms from European countries with a tradition of high quality financial reports. If future researchers, in a valiant effort to extend their time series, use the 2004 figures (which are presented for the first time in 2005 reports as comparative data), they will increase the non-comparability of IFRS in early years with IFRS in the later years. A number of one-time adjustments are reflected in 2004, so this year is often not comparable even with 2005. Appropriate explanation is given in the notes, but can be overlooked when using large commercial data sets. Volvo, in 2004, for example, had a reconciling transition item that equaled more than 50% of its IFRS net income. It became insignificant in 2005. Not all 2005 reports are free of these transition adjustments either. Allianz Group adopted IAS 39 in 2005, requiring a change in the valuation of available for sale securities. The change entailed (a) a change in the impairment criteria, and (b) discontinuation of their previous, adjusted cost 3
There is a considerable body of research, reviewed in Pownall and Schipper (1999) that finds differences in the “value relevance” of accounting numbers prepared under different sets of standards. A more recent “value relevance” study is DeFond et al. (2007).
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basis following recognition of impairment. The changes were made retroactively. US GAAP allowed these changes only prospectively. The result was a reconciling item that reduced IFRS net income by 17% vis-à-vis GAAP. This illustrates the potential pitfalls of using numbers from transition years and treating them as if they were from a “steady state” application of different accounting principles. Thus, our principal motivation for this study is to assess the appropriateness of reported accounting data for research. To achieve this, we do two things. First, we show descriptive data; for instance how net income under IFRS deviates from net income under US GAAP. Second we calculate the spread between numbers computed under the two systems for quantities often used in accounting research; for instance the ratio of book to market value of equity. A second reason to compare the two sets of accounting standards is that accounting numbers are an important information source for investment decisions. Financial analysis uses accounting data extensively to analyze companies, and as business competition becomes increasingly global, it is increasingly true that competing companies use different accounting standards: US companies use US GAAP while non-US companies will most often use IFRS. Lev and Thiagarajan (1993) show that fundamental information analysis, which rests heavily on financial statement numbers, can have a substantial role in explaining excess returns. Their study is not guided by textbook prescriptions of financial ratios, but rather by what securities analysts actually do. Since the financial statements that analysts use are affected by accounting standards, different conclusions might result from different numbers. For example, the change in inventory compared with the change in sales may reveal unanticipated sales decreases or growth of obsolete inventory items (Lev and Thiagarajan 1993, 194). Between IFRS and GAAP there are different methods of revenue recognition, and different inventory valuation options. One can compare changes in sales and changes in inventory under IFRS and under US GAAP. One gets different ratios. Which one should be used? Unless the two numbers are very close, it is not
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reasonable to assume that it doesn’t matter which number is used. Our contribution is to quantify the differences that arise under the two sets of standards. Many financial ratios assess profitability using net income (Stickney et al. 2007), so valid comparisons among firms’ profitability requires that the net income numbers be comparable. In this paper we first analyze net income, computed according to IFRS and according to US GAAP. Since many ratios use line items (sales and inventory in the example just cited) we also analyze the line items that lead to differences in net income. We compare shareholders’ equity, another measure common in financial analysis, and last we compare cash flow statements. A third reason for comparing reports under the two sets of standards is to gain insight into the degree of “harmonization” of accounting standards. The SEC decision to abandon the reconciliation requirement might suggest that remaining differences must be insignificant. Likewise, investors could be misled by the publicity about “harmonization” and “convergence,” and conclude that the differences by now must have nearly disappeared. An unsupported trust in the comparability of figures could lead to uninformed decision making and misallocation of capital. We study that implication, and our results are information about the actual progress of harmonization as it appeared in the financial statements from 2004 to 2006. This study reveals not just whether important differences persist, but also the origin of those differences in terms of specific items actually reported in financial statements. The next section is the literature review. Section 3 describes the institutional setting that surrounds IFRS and US GAAP accounting. The next two sections describe the data and methods. The set of results from the analysis is section 6. Section 7 summarizes and section 8 concludes. 2. Literature In this section we review three streams of literature that underlie our study. First, we describe papers that analyze IFRS-GAAP differences.
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Second, we consider the literature on “conservatism” as it applies to intercountry differences. This is to assess whether the implementation of standards—as opposed to what is written in the standards—demands controls for differential conservatism. Last, we review studies that use data from multiple countries, to see what controls are in the experimental design to adapt to different standards. 2.1. IFRS accounting differences Only a few studies have examined whether there are significant IFRS vs. GAAP differences that might result in non-comparable measurements and interpretations of data from the separate accounting regimes. Because of the small number of foreign private issuers that used IFRS before 2005, there are many more studies that compare US GAAP with local GAAP. Our research question is, “Is it correct to ‘assume away’ accounting differences when comparing financial results in different countries?” Based on the few prior studies, our prior belief is that the answer is no. Ucieda Blanco and García Osma (2004) examined SEC filings and found a number of material differences between IAS and US GAAP.4 They used data from 1995-2001, so their findings are stale in light of all the intervening changes in IAS. As we do, they categorized differences between IFRS and GAAP. For the whole period, the net income under IAS was just 0.3% greater under GAAP than under IAS. Their more detailed analysis showed that the small percentage masks differences among the years, as in 1997 the average net income was 19% higher under US GAAP. In terms of frequency, they found that the most common reconciling items were benefits, expense capitalization, stock compensation and business combinations. They do not show the dollars of the reconciling items, but accounting for business combinations and accounting for stock compensation, about 20% of the time
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Foreign private issuers show a reconciliation of the accounting results in accordance with the basis of preparation (e.g., IFRS) and what the corresponding accounting results would have been under US GAAP. This was required for net income and shareholders’ equity until 2007. The reconciliation was reported on SEC Form 20-F.
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decrease US GAAP net income by at least 10%. In the other direction, expense capitalization and asset revaluations increase GAAP income by 10% at almost the same frequency as the decreases. This inter-year and interitem variability highlights the need to disaggregate the data in order to understand fully the accounting differences. Another point they reveal is the extent of change in IAS over the 1995-2001 period (see a chronology in Soderstrom and Sun 2007). In 1995 the average number of adjustments per firm was 2.5. By 2001 it had increased to 4.3, a 70% increase. This is important because studies discussed in section 2.3 pool data from these years. In other words, these other studies implicitly “assume away” time series differences. Street et al. (2000) examine 20-F information for the years 19951997. They focus on the materiality of the reconciling amounts. “Materiality” is a relative judgment on which not everyone agrees. Furthermore, making a materiality judgment based on a percentage of income allows low levels of income to result in high percentages, even when adjusting amounts are small relative to sales or assets. Following the work reported in Street et al. (1999), Street et al. (2000) analyze violations of IFRS. This was very revealing information about what “IFRS” really meant as used by issuers. However, it is likely that conditions have greatly changed since they analyzed the 1995-1997 sample. The IASB issued IAS 1, which lays down the rule that “Financial statements shall not be described as complying with IFRSs unless they comply with all the requirements of IFRSs” (Deloitte 2006). Furthermore, the auditors are mostly Big Four, and they have accumulated much audit experience in these ten years.5 Street et al. (2000) analyze and report on the size and frequency of the reconciling items. In presenting our findings in section 6, we will compare what they found 8-10 years earlier. 5
As a check on this conjecture, we examined the one firm, Nokia, that is common to both our sample and Street et al. They report that as of 1997, Nokia followed “local practices in accounting for pensions” (Street et al. 2000, p.54). Nokia reports on Form 20-F that in 2005 and 2004 it follows IAS 19.
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Our study differs from the earlier ones in a number of ways. We have a bigger sample. Earlier data come from 1995-2001, well before the European Union mandated IFRS for listed firms. Ucieda Blanco and García Osma (2004) found only 30 firms that used IFRS from among all 639 firms throughout the world that filed Forms 20-F. Street et al. (2000) use between 28 and 33 in the three years of their study. We have 42 from just our nine (eight of which are small) European countries covering years 2004 through 2006. We use a sample from a group of countries with a homogeneous and uniformly high tradition of financial reporting. Because of scarcity of data, countries represented in previous samples were as diverse as Papua New Guinea, Mexico, Cayman Islands, Russia, Finland, China and Jordan (Street et al. 2000, Ucieda Blanco and García Osma 2004). Adherence to standards was problematic during an earlier period. Street et al. (1999) discovered that many companies that stated that their 1996 reports were in accordance with IFRS did not follow those standards. They discovered many important deviations. Since then, IAS 1 has been revised to tighten the language and prevent misleading implications. The conditions that underlay earlier work have changed in recent years. The changes in accounting standards have been rapid. For example, since 2000, 19 of the International Accounting Standards (IAS) have been revised, and the IASB has issued seven new International Financial Accounting Standards (IFRS).6 Accordingly, we expect that the items in the earlier studies by Ucieda Blanco and García Osma (2004) and Street et al. (2000) will not be the same as those under a greatly revised body of standards. For example, Street et al. found frequent differences arising from deferred tax accounting, but the IASC revised IAS 12 in 1996 to become very similar to GAAP. Henry et al. (2008) analyze differences between US GAAP and IFRS net income and shareholders’ equity. They access the three years (20042006) of EU adoption data from all the European companies that file Forms 20-F. Their sample is from American Depositary Rights issuers (n=75). They find higher net income under IFRS and lower shareholders’ equity. They analyze both net income and stockholders’ equity, but not cash 6
Together, IAS and IFRS are referred to by the IASB and by us as “IFRS.”
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flow statements. Since the biggest part of stockholders’ equity is the accumulation of previous periods’ earnings, its measurement as of the end of 2004, 2005 or 2006 is to combine the earnings from years or decades of income computed according to local GAAP with earnings in 2004, 2005 or 2006 under IFRS. Furthermore, IFRS allows “first time adoption” provisions that further distort comparability.7 Under these conditions, we believe the comparison of IFRS and GAAP equity numbers is hard to interpret. Nevertheless, many research studies use book values of equity, and so it is useful to see the differences. Furthermore, studies use cash flow measures to assess accounting quality and value relevance (e.g., Gordon et al. 2008). We compare difference in cash flow statements. Gordon et al. (2008) use a larger sample of firms that report both IFRS and GAAP sample than previous studies. They use 156 Forms 20-F that reconcile IFRS and GAAP for three years, 2004-2006. Their study continues the traditions of using financial statement numbers to evaluate accounting quality and value relevance. They conclude that GAAP still differs from IFRS, showing “incremental informativeness” over and above the IFRS numbers, and further that GAAP has higher “cash persistence” and value relevance. They suggest that IFRS and GAAP are different, even in a recent period when convergence is well advanced. They establish that differences exist, and in that sense complements the first of our three research objectives. Our work is complementary: we explore how and why the differences exist. Their study uses cash flow measures, but does not adjust for differences in reporting between GAAP and IFRS. In addition to the question of whether accounting policies differ is the question of the “true and fair override” (Benston et al. 2006). Under IFRS, it is sometimes allowable—indeed mandatory—for a company and its auditor to violate an accounting standard if to do otherwise would present a false or 7
As an example, IFRS 1 (First Time Adoption of IFRS) recognizes that it is sometimes difficult to measure the cost of an investment in a subsidiary when adopting IFRS, so it allows an option that states the asset value at a “deemed cost” that is not the same as if the investment had been accounted for using IFRS at the time of the investment. The footnotes to the 20-F reconciliations report the use of this option for some companies.
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misleading statement of financial position, earnings, or cash flow. This creates the possibility that earnings under IFRS cannot be used by financial analysts to compare directly with US GAAP earnings (since the true and fair override does not occur under US GAAP). One cannot know the problems that this might cause until data are analyzed. 2.2. Accounting conservatism Studies of inter-country accounting conservatism are relevant to our work because if there are differences in the numbers, not because of the standards but because of different degrees of conservatism, then we would design our comparisons with controls for the sample countries. There have been some studies on “conservatism” that bear on cross-country accounting differences. Garcia Lara and Mora (2004) test conservatism in eight European countries. They hypothesize that in civil law countries balance sheets will be more conservative since financial institutions demand reduced values of shareholders’ equity to be certain that, in case the firm has any kind of financial distress, they will recover their investment in the firm through the liquidation of assets. It is not necessarily true that the priority of asset distribution in liquidation is tied to numbers reported on the balance sheet. It is usual that debtors have priority over equity claimants in liquidation, entirely independent of what amounts appear on the published financial reports.8 Another limitation is that there is no discussion of the means by which conservatism is implemented. If balance sheets or income statements are conservative, there must be certain items that are adjusted to effect this conservatism. Which ones are they? Are they adjusted within limits permitted by accounting standards, or are they manipulated outside the limits of GAAP? Are the adjustments disclosed or are they hidden? (There should be no reason to hide them, if financial institutions just want to have conservative balance sheets.)9 8
Capkun and Weiss (2008) find that distribution of assets to lenders before distributions to equity holders is the usual case. 9 Like many studies, Garcia Lara and Mora (2004) avoids the accounting. It uses handy sources of aggregated data. They assert (rather than show) that conservative
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Bushman and Piotroski (2005) study degrees of conservatism among countries as products of certain national characteristics, such as the wellworn “code vs. common” legal system. They do no analysis of accounting numbers, but infer conservatism by indirect means. Even if one could accept that accounting conservatism can be detected without dealing with accounting data, the fact is that in our sample of countries there are very few differences in the national characteristics that they include (see their appendix 2). We find no compelling reasons or evidence to support inter-country differences in conservatism. Since all countries following IFRS are bound by the same rules, the only way conservatism could differ among countries is for companies in some countries to pervert the standards by manipulating accruals, etc. We conclude that within our sample of homogeneous countries there is no reason to control for inter-country differences. 2.3. Different accounting standards Inter-country studies are fairly common in accounting research. What do researchers do, when they conduct international studies that use accounting from different sets of standards? Do they attempt to adjust for different accounting methods, or do they assume the numbers are comparable without adjustment? The “close enough” assumption is common across a range of studies. Pincus et al. (2002) explore an “accrual anomaly” using data from seven countries and four different accounting traditions: (1) the US, (2) associated Anglophone countries (UK, Canada, Australia), (3) continental Europe (Germany and France) and (4) Japan. The accrual measurement was created by subtracting cash flow from operations from net income. The net income measure, being net result of many different accounting differences (e.g., revenue recognition, expense capitalization, impairment methods), captures a majority of the differences among accounting principles. To act as though there are no differences, and treat net income as a uniform
accounting is being applied. See also Daske et al. (2007), who rest their design on alternative accounting policies within IFRS without mentioning which policies.
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measure among all seven countries, raises questions as to the strength of conclusions. Wysocki (2003) performs an analysis of “earnings quality,” and uses US data and data from 30 other countries. Although the research rests heavily on amounts of accruals, there is no discussion or adjustment for different methods of making accruals that may exist among 31 countries. Ball et al. (2006) use net income before extraordinary items in their tests. Because accounting for extraordinary items differs among countries’ GAAP (Stolowy and Lebas 2002, 229-30) an event in one country may be “above the line” while it would be below the line in another. The definition of what constitutes “extraordinary” differs even between IFRS and GAAP, to say nothing of the differences among countries’ GAAP. IAS 8 defines an extraordinary item as “income and expenses that arise from events or transactions that are clearly distinct from the ordinary activities of the enterprise and therefore are not expected to occur frequently or regularly” (para. 7). This is not the same as the “unusual and infrequent” test under US GAAP (APB 30), so the same events can be classified differently. This shows the problem of treating accounting numbers from different accounting standards as if they all measure the same thing in the same way. What do researchers do when they use data from a span where the standards are unstable (as we point to in our review of Ucieda Blanco and García Osma (2004) in section 2.1)? They seem not to recognize the instability in the time series. For example, Ball et al. (2006) perform tests using accounting data from 22 countries. Their time series is 1992-2003. This is a period when IASs were changing. The “Comparability and Improvement Project” of the IASC resulted in ten new standards in 1995. The IASC sought to obtain IOSCO approval of IAS; it did this by tightening the standards.10 The numbers that Ball et al. use preceding this program, e.g., 1992, would have far different measurement properties from those of 10
In 1995 the IOSCO accepted 14 IAS standards as adequate. The IASC began a process to make standards acceptable to IOSCO. With the issue of IAS 39 in 1999, IOSCO was satisfied with the 30 IASs (Flower and Ebbers 2002, 270). This change work was going on throughout the period used by Ball et al. (2006).
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2003, when their time series ends. In total, twenty-three of thirty-four standards were either published or underwent a major revision between the starting and ending date of their time series (Nobes and Parker 2004, 83). Although theirs was not a US GAAP-IFRS study, local GAAP was changing as countries tried to stay in alignment with IFRS. The more important point is that the research made no allowance for standards that were different among countries and were changing. Overlooking this type of major differences is likely to limit the significance of the reported research findings. 3. Institutions 3.1. The expansion of IFRS reporting Recently, the set of companies that uses IFRS has greatly expanded, and it is this expansion that makes our research both relevant and feasible (Ball 2006). All of the approximately 7,000 listed firms in the European Union are required to prepare financial statements under IFRS from 2005 onward. IFRS standards differ from US GAAP, which is one of the motives for our study; if accounting standards differ, then financial data and ratios based on those standards will differ, too. This is irrespective of any earnings manipulation. The International Accounting Standards Board (IASB) and the FASB have agreed in principle to harmonize accounting standards, and mechanisms in place are working to that goal currently. Although the IFRS and GAAP standards are already similar in most respects, many differences still remain (Deloitte 2007). Our study does what descriptive lists (Ernst & Young 2006, Deloitte 2007) do not: we report on their empirical importance. What are the dollar values that are associated with different policies and how frequently do they occur? Some differences may exist but not matter. Consider, as an illustration, accounting for joint ventures. The rules differ between IFRS and GAAP. However, instances of reporting differences may occur rarely, or they may be of insignificant amounts when they do happen. In this paper we isolate the most important observed dollar differences.
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3.2. Enforcement The importance of enforcement is that the numbers we observe depend as much on how closely companies follow standards as on what the standards say. Without good reason to expect that rules are executed as intended, we cannot have full confidence in the numbers even if they have been adjusted for differences in the accounting. LaPorta et al. (1998) stress that rules are only as effective as their enforcement. Many accounting studies incorporate the idea that in countries with good investor protection systems and sound enforcement, accounting quality is high, as these examples show. Describing Leuz et al. (2003), Lev (2003, 44) writes: “strong and wellenforced outsider rights mitigate earnings manipulations because insiders have a lower ability and fewer incentives to conceal and manipulate information.” Again from Lev (2003), describing Guenther and Young (2000) and Ball, Kothari and Robin (2000): “in countries where the economic and legal system effectively protects investors, reported earnings reflect underlying economic events better and in a more effective manner…” Bushman and Piotroski (2005) state: “…strong securities laws could increase litigation concerns, thereby encouraging the use of conservative accounting practices” (p.14). There is considerable debate about the reliability of LaPorta et al.’s classification scheme (see, for example, Lindahl and Schadéwitz 2008).11 The severity of the problem, whatever it is, does not affect our research design, since we have taken a sample of firms from northern European countries, all with a tradition of high accounting quality. We make no provision for different “quality of enforcement” among our sample firms. As we describe in section 4.1, our confidence in high quality is supported by our sample selection procedures.
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The weakness of La Porta et al. (1998) has been acknowledged by the same authors, who have prepared a revised analysis (Djankov et al. 2008).
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4. Sample Our research method is to compare a set of net income, shareholder equity, and cash flow reports prepared under IFRS that also show reconciliation to US GAAP. We study a homogeneous sample with traditions of high quality financial reporting. These are the countries that are best able to implement a new set of standards on their first attempt, and least likely to need to invoke the first-time exemptions allowed by IFRS 1. The sample we use is all the U.S.-listed companies from Finland, Sweden, Denmark, the Netherlands, Luxembourg, Belgium, Switzerland, and Germany covering years 2004 through 2006.12 We base the choice of countries on two criteria, financial reporting quality and legal tradition. 4.1. Tradition of accounting excellence A tradition of high quality accounting means reliable, transparent financial reporting. Fortunately, there are a number of rankings that reflect the overall quality of business practice. We assume that the higher the overall level of business ethics, the higher the level of financial reporting quality, either because there is an accounting measure contained in the ranking criteria, or because the quality of accounting and business practice is highly correlated. Table 1 chooses three well-regarded indexes. The eight countries in our sample are all near the top. The lowest ranking of any country on any ranking is the 82nd percentile. On this evidence we feel that this set of countries is very high in terms of quality. Table 2 shows the countries and number of firms in the sample. *************** insert tables 1 and 2 about here ***************
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These eight countries are not the only ones with high quality reporting. Henry et al. (2008) did not follow the same approach, as they used firms from throughout Europe. While their sample may offer greater generalizability, it may alternatively limit generalizability by including countries with very different accounting traditions; Hungary vs. the UK, for instance. We also limit our sample to these countries because of the work of hand-collecting and then scrutinizing the data.
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Another factor to consider in the sampling plan is the widespread use of fair value accounting under IFRS.13 “Fair value” amounts can be derived from the same assets traded in active markets, or when those conditions do not apply to the asset, prices of similar assets. Failing to meet that condition, mathematical formulae may be applied (Ernst & Young 2005). Clearly, the market conditions in different areas of the globe can vary considerably. Because of market conditions, the determination of “fair value” in a highly industrialized country like Germany will not be the same as the value determined in, say, Papua New Guinea. And note that this difference arises under the most scrupulous, unmanipulated adherence to the standards. In our northern Europe sample, market conditions are similar, leading us to conclude that our sample is homogeneous in the application of fair value methods. 4.2. Legal tradition A number of accounting studies (e.g., Ball et al. 2000, Pincus et al. 2002, Garcia Lara and Mora 2004, and Ball et al. 2006) have built differential analysis around the distinction between civil law and common law. Though there is little supporting legal scholarship in these papers, they all claim that accounting is practiced differently in common law and civil law countries. Regardless of the merit of this claim, our sample consists of northern European countries, all of whose legal systems are classified as civil law (LaPorta et al. 1998). Differences between civil and common laws’ effects on financial reporting, unlikely in any case, would not affect our results. 5. Research methods We collect data by using every firm in our sample countries that reconciles IFRS to US GAAP, 2004 to 2006. We find them in annual reports on SEC Form 20-F, using the SEC’s official Edgar web site. The form is required for 13
The list of accounting items that rely on fair value is extensive: pension assets and liabilities, derivative financial instruments, certain other financial assets, financial liabilities held for trading, tangible and intangible fixed assets that have been acquired in a business combination, impaired or revalued assets, assets held for disposal, share-based payments, investment properties, provisions, and biological assets. (Ernst & Young 2005).
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all foreign private issuers in the U.S. These registrants either trade their shares in the U.S., or have registered certain types of American Depositary Rights. The 20-F form includes, as a note to the financial statements, the differences between net income and shareholders’ equity under IFRS and under U.S. GAAP. The presentation is a table that starts with IFRS income, then shows the reconciling amounts, and arrives at net income under GAAP. The reconciling amounts are also explained verbally. For our study, we read the verbal explanation to understand the nature of the difference. To understand the nature of the reconciling item entails much more than simply reading the label in the reconciling schedule, it also requires reading and analyzing the explanation in the accompanying footnote. The reconciling schedule includes notes explaining the line items and these footnotes often run to 10-15 pages or more. One problem with relying on the label to the reconciling item is that some line items include more than one difference. As an illustration, Deutsche Telekom lists “Mobil Communications Licenses.” Without reading the associated note, one would not realize that this includes two IFRS-GAAP differences, one for recording impairment and one for recording interest cost (expense vs. capitalize). In the same report is a line item called “Fixed Assets.” This item includes both an interest capitalization difference, and an exception allowed by IFRS 1 for “deemed cost” of the assets. Conversely, not all of the accounting differences are within the same labeled item. Also as illustrated in Deutsche Telekom, impairment differences are included in “Mobil Communications Licenses” as well as in “Accruals and other differences.” Some items are not, indeed, accounting differences. For example, “taxes” usually reports not differences in tax accounting, but the tax effect of the real accounting items that are reported “before tax.” Another problem is that some items are labeled as “other,” so one cannot possibly interpret them without reading further. There is information about GAAP-IFRS differences in the “bottom line”; that is, net income according to IFRS vs. net income according to GAAP.
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However the “bottom line” can mask large “line item” differences that offset each other. These line items are themselves subjects of accounting research. There is a veritable industry in studying “value relevance” of accounting line items. Because large data sets that are easily accessed by standard software do not exist to supply the US GAAP numbers for foreign issuers, this hitherto important topic has been ignored in the international literature. We attempt to give some idea of whether the accounting numbers are very different, because if they are, then presumably the measured “value relevance” differs according to which measure is used. Our method is to report the net income difference but not to stop there. We disaggregate the total into its components, and then look at both the relative and absolute importance of each item. To call attention to the most significant items, we look at only the five largest items for each company. In cases where there are fewer than five major items, we use them all. However, in any case we exclude an item less than 0.5% of IFRS net income. Our line-by-line analysis isolates the specific accounting standard that causes a difference. This allows us to identify offsetting effects that would not show up in the income-to-income comparison. As noted earlier in this section, this opens the window a bit on the topic of “value relevance.” If the chosen line item whose “value relevance” is under study is nearly the same under either IFRS or GAAP, then it would not be worth the trouble to put them on a common basis. Alternatively, large differences call for adjustment. Knowing the size of the difference could also be useful in future research on “earnings management” because some accruals are easier to manipulate than others. For example, depreciation is an accrual, but once the depreciation policy is set, it is not so easy to change it from year to year, whereas changing the assumed rate of return on pension plan assets is. Accounting researchers devote considerable ink to “earnings management” so it is important for them to know whether the accruals that differ between IFRS and GAAP are the ones subject to manipulation.
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As we have noted in sections 2.1 and 2.3, some previous research has compared US GAAP with local accounting. (Most of this work preceded the expanded use of IFRS.) However no research that we have found has compared cash flow statements. This may be a significant gap in what we know, since cash flow amounts may enter into research designs that compare American with non-American companies. Perhaps this omission is due to the truism that “cash is cash.” It is accordingly not subject to the same manipulations that earnings and balance sheet items are. However, it is usually “cash flow from operations” (CFO) that is used (e.g, Fama and French 1995). This quantity is subject to classification differences that exist between US GAAP and IFRS (Stolowy and Lebas 2002). Without measuring these differences we cannot know whether CFO under GAAP is “close enough” to CFO under IFRS that the differences can be ignored. We measure these differences. 6. Results We present four sets of findings. These first two sets of results address what Pownall and Schipper (1999) term “aggregate comparability,” and “line item comparability.” We first show the net income, “bottom line,” comparisons of IFRS with GAAP. Second, we heed Schipper (2007, 316): “The reliability of an aggregated number, such as net income, is likely to be a complicated function of the separate reliability of each of its components.” We show how the individual line items affect the sum. Next we compare the book value of equity, which accumulates all the current and previous income differences. Last, we compare the cash flow statement.
Although the total cash flow is simply the difference between
beginning and ending balances, the classification of cash flows can differ.14
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In some cases firms report three years of comparative information, 2003, 2004, and 2005. Three years are not required under IFRS, and since 2003 data are not complete for all firms, we leave them out of our analysis. 15 The span 2004-2006 is the lifetime of IFRS-GAAP for our sample firms. As of November 2007 the reconciliation requirement was lifted.
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We put the greatest stress on 2005, the first year of mandatory IFRS reporting. We present 2004 and 2006, and comment on noteworthy similarities and differences. 6.1. Income Analysis In this section we analyze the income differences from four perspectives. We report our “bottom line,” net income differences, then the line item differences, by frequency, by amount, and individual firm effects. 6.1.1. Net income vs. net income Panel A of table 3 reports the aggregate dollar effects of adjusting from IFRS to GAAP. It shows that in 2005 the mean is $2,180 million and the median is $521 million. 16 These companies are big, as expected since they are listed on American exchanges as well as in their home countries, and the net income is positively skewed.17 ************ insert table 3 about here ********** GAAP net income is lower than IFRS by 9.0% in 2005.18,19 The means are statistically different in 2005 and 2006 (p
