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Abstract: We study the effect of mandatory IFRS adoption in Europe in 2005 on conditional conservatism. We capture conditional conservatism with a modified version of the Khan and Watts (2009) measure (C_Score) that also controls for potential shifts in unconditional conservatism and cost of capital. From a sample of 13,711 firm-year observations drawn from 16 European countries spanning the 2000-2010 period, we document an overall decline in the degree of conditional conservatism after the adoption of IFRS. We show that the decline in conditional conservatism is less pronounced for countries with high quality audit environments and strong enforcement of compliance with accounting standards using the Brown et al. (2014) index. As asset impairment tests are a key mechanism ensuring conditional conservatism in the IFRS framework, we further examine these. We show that firms booking an asset impairment present a smaller decline in the degree of conditional conservatism relative to firms that do not. We also demonstrate that firms that do not book an asset impairment when evidence suggests the probable need to do so experience a more pronounced reduction in conditional conservatism. We argue that IFRS are conceptually conditionally conservative but that inappropriate application of conditional conservatism principles is likely to prevent financial reporting from reaching the level of conservatism targeted by the IASB. Key words: Conditional Conservatism, IFRS, Europe, Enforcement, Impairment, Goodwill, Intangibles JAL: M41, M48, G38
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Impact of Mandatory IFRS Adoption on Conditional
Conservatism in Europe
Paul André*, Andrei Filip and Luc Paugam
ESSEC Business School
Forthcoming Journal of Business Finance & Accounting
Acknowledgements:
We are grateful for the valuable comments received from Mary Barth, Gilles Hilary, Wayne
Landsman, Steven Monahan, and other workshop participants of the joint ESSEC-INSEAD
research seminar and the Catholic University of Leuven seminar. The authors would also like
to thank the participants of the 32
nd
French Accounting Association Conference – Montpellier
2011, the 6
th
Accounting and Management Information Systems Conference – Bucharest 2011,
the 10
th
International Conference on Governance – Montreal 2011, the Financial Reporting and
Business Communication Conference – Bristol 2011, the EUFIN Conference, Bamberg 2011,
the Accounting and Auditing Convention Cluj-Napoca 2011 and the European Accounting
Association Conference, Ljubljana 2012, for their helpful comments and suggestions. Paul
André and Andrei Filip thank the Autorité des Normes Comptables for financial support. Paul
André also thanks the ESSEC KPMG Financial Reporting Centre.
*Corresponding author:
Paul André
Professor of Accounting
Director ESSEC KPMG Financial Reporting Centre
ESSEC Business School
Cergy-Pontoise 95021 CEDEX
France
andre@essec.fr
The Effect of Mandatory IFRS Adoption on
Conditional Conservatism in Europe
Abstract: We study the effect of mandatory IFRS adoption in Europe in 2005 on conditional
conservatism. We capture conditional conservatism with a modified version of the Khan and
Watts (2009) measure (C_Score) that also controls for potential shifts in unconditional
conservatism and cost of capital. From a sample of 13,711 firm-year observations drawn from
16 European countries spanning the 2000-2010 period, we document an overall decline in the
degree of conditional conservatism after the adoption of IFRS. We show that the decline in
conditional conservatism is less pronounced for countries with high quality audit environments
and strong enforcement of compliance with accounting standards using the Brown et al. (2014)
index. As asset impairment tests are a key mechanism ensuring conditional conservatism in the
IFRS framework, we further examine these. We show that firms booking an asset impairment
present a smaller decline in the degree of conditional conservatism relative to firms that do not.
We also demonstrate that firms that do not book an asset impairment when evidence suggests
the probable need to do so experience a more pronounced reduction in conditional
conservatism. We argue that IFRS are conceptually conditionally conservative but that
inappropriate application of conditional conservatism principles is likely to prevent financial
reporting from reaching the level of conservatism targeted by the IASB.
Key words: Conditional Conservatism, IFRS, Europe, Enforcement, Impairment, Goodwill,
Intangibles
JAL: M41, M48, G38
2
1. INTRODUCTION
The mandatory adoption of International Financial Reporting Standards (IFRS) by a large
number of European listed firms in 2005 resulted in a major accounting change. Domestic
GAAP, shaped by local institutions and regulations and embedded into national economies and
cultures, were abandoned for a single set of principle-based accounting standards. One of the
major intended purposes of the adoption of IFRS was to enhance financial reporting through
the requirements of a set of ‘high quality standards’. We examine if the adoption of IFRS
resulted in an improvement of financial reporting quality, in particular in the degree of
conditional conservatism of financial reporting.
Conditional conservatism is the greater aggressiveness in the recognition of bad news
than in the recognition of good news and is considered a key qualitative characteristic of
financial reporting (Watts, 2003a; Francis et al., 2004; Ecker et al., 2006; Ball et al., 2008;
Dechow et al., 2010; Kothari et al., 2010). This form of news-dependent prudence ensures that
potential economic losses are reported in earnings in a timely fashion, whereas the recognition
of potential economic gains is delayed. Conditional conservatism is distinguished from
unconditional conservatism, also known as ex ante or news-independent prudence, consisting
in systematically understating the book value of net assets relatively to their economic value,
independent from any news (Pope and Walker, 2003; Beaver and Ryan, 2005).
The effect of the adoption of IFRS on conditional conservatism is a priori unclear. Indeed,
it is often argued by observers (like the press) that IFRS are ‘less prudent’ than national GAAP
for two main reasons. First, the term ‘prudence’ has been removed from the conceptual
framework (IASB, 2010). Second, IFRS allow various fair value options that would be
imprudent per se. Regarding the first argument and according to the IASB, prudence conflicts
with the quality of neutrality and the Board explained in 2008 that “[t]he exercise of prudence
does not allow for deliberate understatement of assets or income or overstatement of liabilities
or expenses. […] Introducing bias in understatement of assets (or overstatement of liabilities)
in one period frequently leads to overstating financial performance in later periods a result
that cannot be described as prudent” (IASB, 2008, § BC2.21). The form of ‘prudence’ that the
Board intended to eliminate from the conceptual framework (and financial reporting) can be
clearly related to unconditional conservatism, not to conditional conservatism. It is also clear
that the Board describes the negative relation between unconditional conservatism and
conditional conservatism which is also discussed in the literature (e.g., Pope and Walker, 2003;
3
Beaver and Ryan, 2005).
1
Regarding the second argument, fair value for financial assets does
not significantly affect many industries other than the financial sector, and if firms decide to
follow the fair value option, both unrealized gains (good news) and unrealized losses (bad news)
are recognized in earnings (or other comprehensive income). Fair value cannot be considered
less conditionally conservative than amortized cost.
2
Conversely, IFRS do include various mechanisms ensuring the application of conditional
conservatism, such as the recognition of probable liabilities vs. the non-recognition of
contingent assets (IAS 37), the lower of cost or net realizable values for inventories (IAS 2), or
impairment for financial assets and long-lived assets (IAS 39 and IAS 36), to name a few (see
Barker and McGeachin, 2014). For instance, directly translating the idea of conditional
conservatism, IAS 36 § 1 states “The objective of this standard is to prescribe the procedures
that an entity applies to ensure that its assets are carried at no more than their recoverable
amount. […] If this is the case, the asset is described as impaired and the standard requires the
entity to recognise an impairment loss [in earnings].”
IFRS introduced relatively more stringent
and systematic impairment-testing rules relying on fair value estimates than local GAAP. This
is particularly the case for intangible assets with an indefinite useful life among which goodwill.
Goodwill is tested for impairment systematically once a year but was amortized under domestic
GAAP prior to the adoption of IFRS over periods ranging from 5 to 20 years (see Nobes and
Parker, 2010).
3
Therefore, from a conceptual perspective, IFRS can be considered conditionally
conservative. Ceteris paribus, the adoption of IFRS should lead to an increase in the degree of
conditional conservatism. However, there is evidence that the considerable discretion permitted
by IFRS may have prevented financial reporting from reaching the level of conditional
conservatism targeted by the IASB. Christensen et al. (2008), examining voluntary adopters vs.
mandatory adopters in Germany, show that “the flexibility embedded in IFRS might render it
ineffective in restricting earnings management of firms with low incentives to comply.”
Similarly, there are particular concerns about a potential inappropriate application and
1
The new chairman of the IASB, Hans Hoogervorst, reiterated the argument according to which IFRS include
various mechanisms ensuring prudence of financial reporting (Hoogervorst, 2012).
2
Under IAS 16, optional revaluations of property, plant and equipment are recorded as a gain in other
comprehensive income (OCI). Subsequent negative fair value adjustments are first recorded as a loss in OCI (as a
reversal of the previously booked gains), and then as a loss in earnings. Under IAS 40, both gains and losses of
investment properties are included in earnings under the fair value option. Under IAS 39, both gains and losses on
financial instruments designated at fair value affect earnings while only significant loss (impairment) affect
earnings for financial instruments measured at cost.
3
For instance, under local GAAP goodwill was usually amortized over 20 years in the UK, 15 years in Germany,
less than 20 years in France, 5 years in Italy, and between 5 and 10 years in Spain.
4
enforcement of impairment tests which can arguably be considered as IFRS’ main mechanism
ensuring conditional conservatism (e.g., Kim et al., 2013; Lawrence et al., 2013;
Roychowdhury and Martin, 2013). Lawrence et al. (2013) explain that conservatism results
(partly) from the requirement that “non-financial assets must be written down when their fair
value drop sufficiently below their carrying value, but generally cannot be written up when their
fair value rise above their carrying values” (p. 112). Impairment tests are particularly important
in the context of our study for three raisons. First, IFRS introduced more stringent impairment-
testing rules in particular for intangible assets with indefinite useful life such as goodwill.
Second, impairment tests need to be applied to a large proportion of balance sheet items (all
tangible and intangible fixed assets, including goodwill).
4
Third, they are relevant to firms in
the non-financial sectors.
However, the implementation of impairment tests (in particular for intangibles with
indefinite useful life) usually relies on valuation models, requires ‘significant judgment’ from
managers (Hilton and O'Brien, 2009; Petersen and Plenborg, 2010, 420), and is prone to
manipulation by managers because it relies on unverifiable fair value estimates (Hayn and
Hughes, 2006; Ramanna, 2008; Bens et al., 2011; Li and Sloan, 2011; Ramanna and Watts,
2012). Hans Hoogervorst, Chairman of the IASB, acknowledges his “concerns about goodwill
resulting from business combinations” and admits that “[g]iven its subjectivity, the treatment
of goodwill is vulnerable to manipulation of the balance sheet and the P&L” (Hoogervorst,
2012, 5). The European Securities and Market Authority (ESMA) recently expressed concerns
about insufficient impairment recognition by major listed European companies during the
financial crisis (see ESMA, 2013). Various professional reports by large auditors or other
consulting firms have also documented this lack of recognition of economic impairment for
several years.
5
Further studies have documented an incomplete and heterogeneous level of
compliance with disclosure requirements under IFRS 3 and IAS 36 (Amiraslani et al., 2013;
Glaum et al., 2013; Mazzi et al., 2014; Paugam and Ramond, 2014; Tsalavoutas et al., 2014).
Finally, the press recently echoed insufficient and untimely recognition of economic
4
According to IAS 36 § 2: Impairment testing procedures cover all assets but the following: inventories (IAS 2),
construction contracts’ assets (IAS 11), deferred tax assets (IAS 12), post-employment benefit assets (IAS 19),
financial instruments (IAS 39), investment property measured at fair value (IAS 40), biological assets measured
at fair value (IAS 41), specific assets that arise from insurance contracts (IFRS 4), and non-current assets held for
sale and discontinued operations (IFRS 5).
5
See Ernst & Young (2010) ‘Meeting today’s financial challenges – Impairment reporting: Improving stakeholder
confidence’ and Houlihan Lokey (2013) ‘The European Goodwill Impairment Study 2012-2013’
5
impairment for goodwill.
6
The effect of the adoption of IFRS in 2005 on conditional
conservatism in Europe remains therefore an empirical question and it is most likely dependent
on the capacity to enforce various conditional conservatism mechanisms, among which
impairment-testing principles for non-financial assets play a critical role.
We address the following research questions: what is the effect of the adoption of IFRS
in 2005 on conditional conservatism? Can we relate a potential change of the degree of
conditional conservatism to institutional factors and/or inappropriate application/enforcement
of particular accounting mechanisms such as impairment tests?
We examine pre and post levels of conditional conservatism for a sample of European
firms that adopted IFRS in 2005, comprising 13,711 firm-year observations spanning from
2000 to 2010 drawn from 16 countries (Austria, Belgium, Denmark, Germany, Finland, France,
Great Britain, Greece, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden, and
Switzerland). Our sample period includes two major stock market crises, i.e., the burst of the
Internet bubble at the beginning of 2000s and the financial market crisis of 2008-2009, and
offers particularly interesting possibilities to investigate the effect of asset impairment on
conditional conservatism.
7
Various measures have been used to capture conditional
conservatism in the literature (see Ryan, 2006). In our main tests, we use an extension of the
Khan and Watts (2009) version of the Basu (1997) measure also known as the C_Score. Our
measure includes controls for the effects of shifts in unconditional conservatism and cost of
capital after the adoption of IFRS.
8
Next, we explore if the strength of enforcement led to a
change (or lack of a change) in the degree of conditional conservatism after the adoption of
IFRS in 2005 using a recent index measuring the quality of the auditing environment and the
strength of accounting enforcement activity (Brown et al., 2014).
We assess the role played by asset impairment testing in the change of the degree of
conditional conservatism in Europe. In particular, we examine the effect of impairment
recognition and impairment avoidance on the level of conditional conservatism after the
adoption of IFRS. The change in the level of conditional conservatism is likely to be affected
by the application of asset impairment testing rules. Specifically, we conduct two sets of tests.
6
See Tata Steel – Goodwill Hunting, May 14
th
, 2013 on the website of The Economist. Available at:
http://www.economist.com/news/business/21578082-what-corus-write-reveals-goodwill-hunting
7
We thank the participants at the 2014 JBFA capital markets conference for this suggestion.
8
Pope and Walker (1999) show that conditional conservatism is related to cost of capital and various studies
demonstrate that cost of capital was affected by the adoption of IFRS (e.g., Karamanou and Nishiotis, 2009; Li,
2010; Daske et al., 2013).
6
Our first set of tests focuses on the effect of impairment recognition on conditional
conservatism. We examine the level of conditional conservatism of (1) firms that recognize
asset impairment relative to all the other firms, (2) firms that recognize impairment of intangible
assets relative to other firms carrying intangible assets, and (3) firms that recognize impairment
of goodwill relative to other firms carrying goodwill. Our second set of tests focuses on the
effect of impairment avoidance on conditional conservatism. We examine the level of
conditional conservatism of (1) firms likely to carry impaired assets that do not recognize any
asset impairment relative to other firms, (2) firms likely to carry impaired assets that do not
recognize intangible asset impairment relative to other firms carrying intangibles, and (3) firms
likely to carry impaired assets that do not recognize goodwill impairment relative to other firms
carrying goodwill.
We focus the analysis not only on any asset impairment but on asset impairment of
intangible and goodwill separately for three reasons. First, IFRS require systematic annual
impairment testing for goodwill and other intangible assets with indefinite useful life. Second,
the valuation for such assets is prone to subjectivity as management frequently relies on
unverifiable ‘value-in-use’ estimates as opposed to ‘fair value less cost to sell’ to compute
recoverable value (Petersen and Plenborg, 2010). Third, the literature shows that impairment
tests for goodwill, which represents the bulk of recognized intangible assets, appear to be
manipulated (Hayn and Hughes, 2006; Ramanna, 2008; Hilton and O'Brien, 2009; Bens et al.,
2011; Li and Sloan, 2011; Ramanna and Watts, 2012; Roychowdhury and Martin, 2013).
We document the following results. First, we show that conditional conservatism has
decreased after the mandatory adoption of IFRS in Europe in 2005. This result holds across
several measures of conditional conservatism and different time periods. This confirms results
by Ahmed et al. (2013) who examine the effect of IFRS adoption on several proxies for
accounting quality and suggest a decrease in conditional conservatism after the adoption of
IFRS. Second, using the index developed by Brown et al. (2014), we show that the decrease in
conditional conservatism is less pronounced for high auditing quality/strong accounting
enforcement countries. The institutional environment appears to be particularly important to the
application of IFRS.
Third, we show that the decrease of conditional conservatism after the adoption of IFRS
is predictably related to asset impairment recognition and avoidance. Our first set of tests
indicates that firms that recognize asset impairments exhibit a smaller decrease in the level of
conditional conservatism relatively to non-impairers carrying the same asset type. Our second
7
set of tests shows that firms that do not recognize asset impairment although evidence suggests
that they carry impaired assets present a greater decline in the degree of conditional
conservatism than other firms. These results hold for impairments of any assets, of total
intangible assets and of goodwill. For the sub-sample of firms carrying goodwill, results even
show that the introduction of IFRS led to an increase in conditional conservatism after
controlling for the negative effect of non-impairers carrying economically impaired goodwill.
We identify one important accounting mechanism that explains some of the decrease in the
degree of conditional conservatism after the adoption of IFRS.
We make several contributions to the literature. First, we add to the current literature on
the intended and unintended consequences of accounting regulation on financial reporting
quality (Brüggemann et al., 2013). Second, focusing on a key dimension of accounting quality,
we demonstrate that although IFRS can be generally considered conditionally conservative, we
observe a decrease after the adoption of IFRS and present evidence of the importance of
institutional characteristics that are relevant for financial reporting. Third, we identify a
potential explanation: the deficiency in the application of the most important conditional
conservatism mechanism, namely impairment tests. We add to prior studies on the effects of
IFRS adoption (e.g., Barth et al., 2008; Christensen et al., 2008; Daske et al., 2008; Ahmed et
al., 2013).
The rest of this paper is organised as follows. In sections 2 and 3, we present a brief
review of the literature, discuss factors that might affect conditional conservatism following the
mandatory adoption of IFRS in Europe and review the related literature. In section 4, we
develop our hypotheses and in section 5 we present our empirical models and sample. In section
6 and 7 we discuss respectively our main results and sensitivity tests. We conclude with
implications of our research in section 8.
2. CONSERVATISM IN ACCOUNTING AND ADOPTION OF IFRS
Dickhaut et al. (2010), citing Littleton (1941), suggest that the principle of conservatism has
been around since the 15
th
century, pre-dating Pacioli’s treatise on accounting bookkeeping.
They argue that, by limiting the overstatement of net assets and income, conservatism
constrains actions that could harm one’s reputation in a multi-period world of exchanges based
on reciprocity.
Watts (2003a) offers four explanations for the demand for conservatism – defined as “the
differential verifiability required for recognition of profits vs. losses” (p. 207). First,
8
conservatism is an efficient contracting mechanism it contributes to maximize firm value
because it limits managerial opportunism and counters managerial bias. Indeed, conservatism
constrains opportunistic payments by management to itself (compensation) or to other parties
such as shareholders (dividends). Second, conservatism limits litigation costs which are more
likely when a firm overstates its earnings and net assets. Third, conservatism reduces the present
value of a firm’s taxes, because taxable income and reported earnings are generally related.
Fourth, conservatism can reduce the political costs to standard setters and regulators from
criticisms if firms overstate income or net assets. Watts (2003b) argues that empirical evidence
mostly supports contracting and litigation explanations of conservatism. Kothari et al. (2010)
further claim that conditional conservatism is a response to the demand for credible financial
information from shareholders and debt holders. Mora and Walker (2014) discuss the role of
conditional accounting conservatism in helping to reduce the moral hazard and adverse
selection problems that cause capital markets to be imperfect or incomplete.
The literature also makes a critical distinction between unconditional conservatism and
conditional conservatism (Pope and Walker, 2003; Beaver and Ryan, 2005). On the one hand,
unconditional conservatism – also known as ex ante or news-independent conservatism
consists in systematically understating the book value of net assets relatively to their economic
value. This accounting bias toward reporting low earnings and book values of stockholders
equity leads to higher (internally generated) un-booked goodwill and higher market-to-book
ratio. Unconditional conservatism is a primary source of unrecorded goodwill, which also
captures the present value of expected economic profits (e.g., rents, growth). Unconditional
conservatism mechanisms include: routinely over-expensing, routinely expensing early or
routinely deferring revenue recognition, independent of true economic income. Examples of
unconditional conservatism include: expensing most costs related to internally developed
intangibles; accelerated depreciation methods for property, plant, and equipment (usually
driven by tax payments minimization incentives); historical cost accounting for positive net
present value projects; systematic amortization of (purchased) goodwill. For instance, in
Germany, creditor protection has been considered as the main factor explaining why pre-IFRS
German firms “have engaged in unconditionally conservative practices such as charging future
operating expenses against current period income” (Ball et al., 2008, 194). In France, rules to
compute taxable income generated a strong incentive for accelerated depreciation methods. The
various fair value options, the capitalization of development costs, or the change from goodwill
9
amortization under domestic GAAP to impairment testing under IFRS are a few examples of
an attempt to reduce unconditional conservatism.
On the other hand, conditional conservatism (also known as ex post or news-dependent
conservatism) consists in writing down book values and decreasing income under suciently
adverse circumstances. Conversely, book value is not written up when circumstances are
favorable. Examples of conditional conservatism include asset impairments (for tangible and
intangible fixed assets, financial instruments), accounting for inventories at lower of cost or
market, and provisions.
Pope and Walker (2003) and Beaver and Ryan (2005) explain how the two forms of
conservatisms are negatively related: lower ex ante unconditional conservatism is a condition
for higher ex post conditional conservatism (see García Lara and Mora, 2004). Indeed, lower
book values lower the threshold triggering conditional conservatism mechanisms, and vice
versa. Unconditional conservatism “constitutes a form of ‘accounting slack’ that pre-empts the
application of conditional conservatism unless news is suciently bad to use up that slack”
(Beaver and Ryan, 2005, 270). Pope and Walker (2003, 2) also shed light on this relation:
Ceteris paribus, when the proportion of market value accounted for by recognized assets is
relatively high, a decrease in market value (bad news) is more likely to be attributable to assets
currently recognized on the balance sheet.” To exemplify this negative relation, taking the
extreme case where an investment is completely expensed (e.g., most internally generated
intangible assets) there is no possibility to book any impairment, even under extremely adverse
circumstances, because there is no asset to impair. To be able to isolate the effect of IFRS on
conditional conservatism, it is therefore critical to control for any changes in unconditional
conservatism surrounding the adoption of IFRS.
There is general acceptance among standard setters that unconditional conservatism, as a
deliberate understatement of asset values and earnings, is a form of ‘bad’ prudence (EFRAG et
al., 2013, § 11), while conditional conservatism has been recognized as a qualitative
characteristic of financial reporting for decades at national or supra national levels by standard
setters in Europe (EFRAG et al., 2013, § 1-2). Nevertheless, as noted by Holthausen (2009),
the quality of financial reporting within each country is shaped by many forces and accounting
standards are only one of them. Country-specific reporting incentives and institutional factors
affect the quality of financial statement information and accounting standards alone are unlikely
to mitigate these differences (Filip and Raffournier, 2013). Studies in the literature have
documented various levels of conditional conservatism within countries in international settings
10
(Ball et al., 2000; Ball et al., 2003; Watts, 2003a, 2003b; Garcia Lara et al., 2005; Gassen et al.,
2006; Ball et al., 2008; Barth et al., 2008). These different country-specific levels of conditional
conservatism are the result of an equilibrium in which accounting standards is one important
factor. The introduction of IFRS in 2005 resulted in a major change to this factor which most
likely resulted in firms responding differently influenced by other country-specific
institutional factors.
Up to recently, the IASB’s and FASB’s conceptual frameworks had a place for
conservatism or ‘prudence’, a dimension of reliability that is one of the four principal qualitative
characteristics of financial statements. To the surprise of many, the new chapter on qualitative
characteristics (Chapter 2) of both the IASB and FASB, adopted in 2010 but on the table since
the early 2000s does not include conservatism or ‘prudence’ as a desirable quality of financial
reporting (IASB, 2010). The IASB considers ‘faithful representation’ as a fundamental
qualitative characteristic of financial information which implies a focus on completeness,
neutrality, and freedom from errors. Examples of ‘neutrality’ under IFRS include greater use
of fair values, impairment testing rather than amortization, including the possibility to reverse
prior impairments for assets with finite useful life, and stricter rules on how and when to book
provisions.
9
However, as already explained above, the form of ‘prudence’ that the IASB
intended to eliminate from financial reporting is actually related to unconditional conservatism,
not conditional conservatism (see IASB, 2008, § BC2.21). From a conceptual perspective, the
IASB framework and IFRS promote conditional conservatism while limiting unconditional
conservatism. However, the actual degree of conditional and unconditional conservatism of
financial reporting depends of the application (enforcement) of these principles.
Pope and Walker (1999, 60) also demonstrate how cost of capital affects empirical
measures of conditional conservatism. In an analytical model, they assume market efficiency
(and no growth) so that stock prices are equal to (1/r) times permanent earnings, where r is the
cost of capital. Permanent earnings follow a random walk and reported earnings adjust
permanent earnings by applying a certain degree of conditional conservatism to good vs. bad
news (positive vs. negative shocks to previous permanent earnings). Under these assumptions,
Pope and Walker (1999) show that cost of capital affects the coefficients of good vs. bad news
of the Basu (1997) piecewise linear regression model, i.e., the responsiveness of earnings to
positive and negative returns. Several studies document that the adoption of IFRS in 2005 had
9
IAS 37 is said by many to curtail ‘cookie jar reserves or provisions’ quite prevalent in Continental Europe, (see
Walton, 2011) for a discussion.
11
an effect on firm cost of capital (e.g., Karamanou and Nishiotis, 2009; Li, 2010; Daske et al.,
2013). Therefore it is important to control for a potential change in cost of capital surrounding
the adoption of IFRS.
Lawrence et al. (2014) show that the lower persistence of losses relative to profits is not
only the result of accounting conservatism of financial reporting but also of curtailments.
Managers facing losses are more likely to divest some assets and engage in real activities to
improve firm performance, thus reducing the persistence of economic losses (Hayn, 1995). As
a result the Basu (1997) measure captures simultaneously the effects of conservatism and
curtailments.
10
3. LITERATURE REVIEW
While Watts (2003b) surveys conservatism in the US, we review time-series and cross-country
studies particularly concerning Europe.
11
Ball et al. (2000) examine the effects of international
institutional factors on the properties of accounting earnings. They find that accounting income
in common-law countries (the US, the UK, Australia, Canada) is significantly more timely than
in code-law countries (France, Germany, Japan) during the 1985-1995 period, due entirely to
quicker incorporation of economic losses (income conservatism). Ball et al. (2000) suggest that
UK income is less conservative than other common-law countries. However, Pope and Walker
(1999) analyse differences in the timeliness of income recognition between the US and the UK
during the 1979-1996 period and conclude that apparent differences in conservatism between
the US and the UK are sensitive to the definition of earnings, in particular to the inclusion or
the exclusion of extraordinary items in the UK. Because there is greater latitude in the
accounting for extraordinary items under UK GAAP, their results suggest that UK firms
recognize bad news faster than US firms but that they classify bad news differently. Giner and
Rees (2001), looking at a sample spanning from 1990 to 1998, find weak evidence that
asymmetric recognition is stronger in the UK (common law) than in France (code-civil law) or
Germany (code law). García Lara and Mora (2004) examine unconditional and conditional
conservatisms in eight European countries (the UK, Germany, France, Switzerland, the
Netherlands, Italy, Spain and Belgium) and show that conditional conservatism practices are
only marginally different between countries. However, they document that unconditional
10
However, after the adoption of IFRS there is a priori no reason to expect a significant change in real investment
decisions regarding curtailments that would dramatically affect the validity of the Basu-type measures in our
context.
11
See also Ryan (2006) for a survey of other types of conservatism studies.
12
conservatism is greater in continental Europe and that there is a negative association between
unconditional conservatism and conditional conservatism.
Raonic et al. (2004) further examine a sample of European firms from 1987-1999. They
conclude that conservatism and timeliness are present and increasing regardless of the legal
tradition while the importance of the equity markets jointly with the level of enforcement can
explain some differences. Bushman and Piotroski (2006) examine the joint effect of legal
system, securities law, political economy and tax regime on the level of asymmetric timeliness
in 38 countries over the period of 1992 to 2001. They find greater conservatism in countries
with high quality judicial systems after controlling for legal origin. Moreover, they find a
similar result for countries with strong public enforcement from securities law but no effect
from private enforcement aspects. They also show that managers adjust their financial reporting
to the level of involvement of the state. Common law countries with low state involvement
exhibit greater conservatism than civil law countries with greater state involvement. However,
they find mixed and inconclusive results as to the effect of financial architecture and tax regime.
Bushman et al. (2011) examine the effect of country-specific conditional conservatism on
capital allocation and find that investment responses to declining opportunities increase with
conservatism, but not for increasing investment opportunities.
Gassen et al. (2006) examine 23 developed equity markets over the 1990-2003 period and
show that cross-country differences in conditional conservatism are influenced by the effects
of other accounting properties, mostly income smoothing and to a lesser extent unconditional
conservatism. Gaio (2010) examines the relative importance of firm, industry and country
characteristics in 38 countries over a similar time window ranging from 1990 to 2003 in
explaining aggregate earnings quality based on many attributes including conservatism.
None of the above studies covers the period following the mandatory adoption of IFRS
by European countries in 2005. While there have been numerous country-specific and cross-
country studies on the effects of mandatory IFRS adoption on various dimensions of accounting
quality such as value relevance (e.g., Barth et al., 2008; Capkun et al., 2008; Filip, 2010;
Tsalavoutas et al., 2012) or earnings management (Barth et al., 2008) and other economic
consequences, for example on the cost of capital (e.g., Daske et al., 2008; Li, 2010), there are
only a couple of papers analysing the effects of IFRS on accounting conservatism.
Ahmed et al. (2013) examine the effect of the adoption of IFRS using data spanning 2002
to 2007 from 20 countries around the world on various measures of accounting quality, namely
income smoothing, reporting aggressiveness, and the likelihood to meet or beat earnings
13
benchmark. Ahmed et al. (2013), considering the methodological issues related to the Basu
(1997) measure, use the asymmetric timeliness measure “only to supplement [their] accruals
testing providing evidence on changes in aggressiveness of financial reporting after IFRS
adoption and to compare [their] findings with prior work that has used timeliness of loss
recognition measures” (p. 16).
12
The authors find a reduction in the timeliness of loss
recognition after the adoption of IFRS in countries with strong enforcement. Ahmed et al.
(2013) highlight that the increase discretion and flexibility permitted by IFRS could prevent
financial reporting quality to increase despite strong enforcement. Our study differs from
Ahmed et al. (2013) in several important respects. First, we control for the potential effect of
shifts in unconditional conservatism and cost of capital on conditional conservatism, whereas
Ahmed et al. (2013) use a control group mainly composed of US and Japanese firms. Second,
we attempt to identify an important mechanism explaining the decrease in conditional
conservatism, namely inappropriate enforcement of impairment test. Third, we use a more
recent index measuring the quality of the auditing environment and the strength of accounting
enforcement activity (Brown et al., 2014).
13
While our findings is consistent with the above cited study reporting a decrease in
conditional conservatism following the IFRS adoption, we contribute to the literature by
explaining this decrease of accounting conservatism, controlling for shifts of unconditional
conservatism and cost of capital, and attempt to identify one important channel of the decrease
in conditional conservatism. We also extend the period of study to include years until 2010 and
consider institutional factors that are relevant to financial reporting, namely the auditing quality
and the strength of accounting standards enforcement.
4. DEVELOPMENT OF HYPOTHESES
(i) Conservatism and mandatory IFRS adoption
We argue that the switch to IFRS, a set of principle-based accounting standards oriented toward
faithful representation of economic reality to inform capital providers, introduced accounting
procedures intended to increase conditional conservatism relatively to domestic GAAP.
However, the actual level of conditional conservatism of financial reporting reached after the
12
Patatoukas and Thomas (2011) argue that the Basu (1997) measure suffers from scale effects, whereas Ball et
al. (2013) demonstrate that the measure is affected by a correlated omitted variable issue that can be corrected with
‘standard’ estimation procedures such as the Khan and Watts (2009) version of the Basu (1997) measure.
13
Piot et al. (2010) examine conditional and unconditional conservatism around the IFRS voluntary and mandatory
adoption and study the role of Big 4 auditors.
14
adoption of IFRS in 2005 depends on many institutional factors shaping the incentives to apply
the principles introduced by IFRS. It is difficult to conjecture on the effect of the mandatory
adoption of IFRS given institutional factors present in each country which vary on many
dimensions. Therefore we state our main hypothesis in the alternative but non-directional form.
H1: The mandatory adoption of IFRS in 2005 led to a change in the degree of
conditional conservatism of financial reporting.
(ii) The role of institutional factors
As noted above, (Watts, 2003a) suggests four explanations for conservatism: contracting,
shareholder litigation, taxation and financial reporting standard and regulation. We look at
cross-country variation in conservatism with respect to institutional factors and examine
whether these factors influence the change in the degree of conditional conservatism. More
specifically, we examine differences in enforcement for at least two reasons. First, because
IFRS are principles-based, the role of enforcement mechanisms is central to the successful
implementation of IFRS, which heavily depends on an appropriate application. Second,
enforcement is also frequently studied in the literature, allowing direct comparison with other
studies (e.g., Ahmed et al., 2013).
Strong legal rules are a necessary condition to guarantee that the rights of shareholders
are protected, but not a sufficient one. Legal rules may remain ineffective without proper
enforcement (Burgstahler et al., 2006). Furthermore, a solid system of legal enforcement can
also substitute for weak rules because active and well-functioning courts can rescue investors
abused by managers (La Porta et al., 1998). The influence of law enforcement is supported by
numerous studies dealing with various aspects of accounting quality. Bushman and Piotroski
(2006) show that firms in countries with strong public law enforcement slow the recognition of
good news in reported earnings relative to firms in countries with weak public law enforcement.
Daske et al. (2008) document that the increase in liquidity and equity valuations following the
mandatory adoption of IFRS is restricted to countries with strict enforcement regimes.
Consistent with these findings, DeFond et al. (2007) report that high quality earnings combined
with strong law enforcement strengthen the market reactions to earnings announcements.
Brown et al. (2014) propose an index designed to capture institutional differences
between countries that are relevant for financial reporting, in particular the quality of the
auditing working environment and of the enforcement of compliance with accounting
standards. The index improves on previous measures such as those developed by La Porta et al.
15
(1998) or Leuz et al. (2003) of the quality of law enforcement that are less relevant to the context
of financial reporting covered in this study. We therefore rely on the index suggested by Brown
et al. (2014). The quality of the auditing and the strength of the enforcement of compliance with
accounting standards shape the incentives to apply conditional conservatism mechanisms under
IFRS. It is likely that it interacts with the application of IFRS in 2005, but given past empirical
results we state our second assumption in the alternative but unsigned form.
H2: The change in the degree of conditional conservatism of financial reporting
after the adoption of IFRS is associated with quality of the audit environment and
of the enforcement of compliance with accounting standards.
(iii) The effect of asset impairment on conditional conservatism after the adoption of IFRS
The implementation of conservatism mechanisms under IFRS is different from domestic GAAP
as it requires subjective judgment from managers. Impairment tests illustrate the higher level
of subjectivity required under IFRS. Impairment tests ensure that assets are not carried at more
than their economic value, also known as the recoverable value (IASB, 2004). IFRS require
that an impairment loss should be recognized in earnings whenever the recoverable amount is
below the carrying amount (IAS 36 § 59). The recoverable amount is the greater of ‘value-in-
use’ (present value of firm-specific expected future cash flows) or ‘fair value less costs to sell’
(computed with observable market data).
Lawrence et al. (2013) explain that conservatism results from various contracting
incentives but also from the requirement that “non-financial assets must be written down when
their fair value drop sufficiently below their carrying value, but generally cannot be written up
when their fair value rise above their carrying values” (p. 112). They notably highlight that
intangible assets affect the degree of conditional conservatism of financial reporting. They
argue that firms carrying intangible assets, in particular goodwill, should be more conservative
due to the absence of recoverability conditions, relatively to firms carrying more tangible fixed
assets. They conclude that goodwill impairments should lead to more conservatism of financial
reporting because they grant managers more subjectivity.
Roychowdhury and Martin (2013) also consider the importance of asset impairment in
understanding the degree of conditional conservatism of financial reporting. They argue that
“managers in firms with multiple unlisted units need to develop estimates for the fair value of
every unit, as well as the fair value of that unit’s recorded assets, in order to compute the fair
value of the unit’s goodwill as the difference between the two. These multiple fair value
16
assessments conceivably grant managers considerable discretion in the goodwill impairment
decisions; this can in turn lead to opportunistic behaviour, with the result that goodwill
impairments induce a lower sensitivity of earnings’ asymmetric timeliness to BTM” (p. 141).
The authors consider that the level of intangible assets on firms’ balance sheet could actually
be associated with lower levels of conditional conservatism.
Recoverable value for intangible assets is typically based on ‘value-in-use’ in the absence
of observable market data. The implementation of impairment tests usually rely on valuation
models and involves ‘significant judgment’ from managers (Hilton and O'Brien, 2009; Petersen
and Plenborg, 2010). Impairment tests are particularly illustrative of the greater flexibility,
complexity and subjectivity that was introduced by IFRS. Impairment tests rely on the
application of various valuation techniques such as discounted cash flows. Agency theory
predicts that unverifiable discretion can be used opportunistically by managers (Ramanna,
2008). Ramanna (2008), Li and Sloan (2011) and Ramanna and Watts (2012) demonstrate that
impairments tend to be manipulated by managers because the procedure relies on unverifiable
fair value estimates. Asset impairments tend to be delayed and/or avoided. Ceteris paribus,
lagged and delayed impairment lead to a reduction in the level of conditional conservatism.
There is anecdotal evidence that asset impairment rules are not properly enforced in
several European countries. The French securities regulator (“Autorité des Marchés
Financiers”), the counterpart of the US Securities and Exchange Commission, in a report issued
November 4, 2009 made several recommendations to urge companies to comply with the
requirements of IAS 36. In a report on financial reporting of the French CAC 40 (top 40
companies listed in Paris) issued in 2010, the audit firm PWC also noticed the disparity of IFRS
reporting practices in the French market. In Denmark, Petersen and Plenborg (2010, 420)
document inconsistencies with impairment principles. In Germany, responding to auditors’
difficulties to audit valuations, the profession issued and revised ‘valuation standards’ (IDW,
2005, 2008) in order, inter alia, to help auditors apply and verify financial reporting under IFRS
requiring valuation-based estimates. The type of assets most subject to subjectivity are
intangible assets with indefinite useful life (e.g., goodwill, some brands) for which impairment
tests are required to be done at least once a year and rely on unverifiable fair value estimates
that depend on future performance. If inappropriate enforcement of impairment tests drives the
change in conditional conservatism after the adoption of IFRS, firms recognizing asset
impairment, in particular of intangible assets, will present a smaller reduction of the level of
conditional conservatism than the other firms carrying the same asset type. Conversely, firms
17
carrying impaired assets but that do not recognize asset impairment should be associated with
a greater decline in the level of conditional conservatism than other firms. Therefore we state
our last hypotheses:
H3a: The recognition of asset impairment is associated with a smaller decline in
the degree of conditional conservatism of financial reporting after the adoption of
IFRS.
H3b: The avoidance of asset impairment among firms carrying impaired assets is
associated with a larger decline in the degree of conditional conservatism of
financial reporting after the adoption of IFRS.
5. EMPIRICAL MODEL, SAMPLING AND DATA COLLECTION
Consistent with prior research, the asymmetric treatment of losses and gains is captured by the
piecewise-linear regression of accounting earnings on stock returns, i.e., the Basu (1997) model:
NI
it
= α
1
+ α
2
BN
it
+ α
3
AR
it
+ α
4
BN
it
AR
it
+ ζ
it
(0)
where:
AR
it
= share return of firm i in year t, net of dividends and capital contributions
adjusted for firm i's country average return in year t;
NI
i
= net income of firm i in year t, scaled by beginning of the period market value
adjusted for firm i's country average net income in year t;
BN
it
= dummy variable equal to 1 if AR
it
is negative, and 0 otherwise.
Our sample period spans 2000-2010. This offers superior possibilities to examine the
effect of asset impairments on conditional conservatism because the European equity market
was affected by two major stock market crises: the burst of the high technology bubble in 2000-
2002 and the financial market crisis of 2008-2009. However, these important market-wide
shocks led stock prices to be driven more by macroeconomic information rather than by firm-
specific information and might affect the ability of unadjusted returns to capture firm-specific
news. For instance given that the net return of the Eurostoxx 600 index in 2008 was -43.1%, a
return of -5% should be considered as a relative good news for the firm although, if we use
unadjusted returns, BN = 1 in the basic Basu model. Therefore, we adjust firm returns for the
average return for each country-year and compute adjusted returns to control for
macroeconomic news and better measure the relation between share returns and firm-specific
information in earnings. This approach is also discussed in Basu (1997).
18
Coefficient α
3
on the market return measures the timeliness of gain recognition or the
responsiveness of earnings to good news, while the sum of α
3
+ α
4
measure the timeliness of
loss recognition or the responsiveness of earnings to bad news. As explained in Pope and
Walker (1999), the α
4
coefficient, i.e., the product of market return by the negative return
dummy measures incremental timeliness of loss recognition, the ratio (α
3
+ α
4
)/α
3
is the ratio
of bad news to good news. A positive and significant coefficient α
4
implies asymmetric timely
loss recognition and therefore conditional conservative accounting (Pope and Walker, 1999;
Ball et al., 2000).
(i) Research design
(a) Overall research design
Following recent literature, we adopt the Khan and Watts (2009) extension of the Basu (1997)
model which is a firm-specific version of the model. Khan and Watts (2009) argue that
conditional conservatism is influenced by three variables size, market-to-book ratio and
leverage that capture the four factors that drive conservatism identified in Watts (2003a)
(contracting, litigation, taxation, and regulation). The regression model (0) becomes:
NI
it
= α
1
+ α
2
BN
it
+ α
3
AR
it
+ α
4
BN
it
AR
it
+
+ α
5
SIZE
it
+ α
6
SIZE
it
BN
it
+ α
7
SIZE
it
AR
it
+ α
8
SIZE
it
BN
it
AR
it
+
+ α
9
MB
it
+ α
10
MB
it
BN
it
+ α
11
MB
it
AR
it
+ α
12
MB
it
BN
it
AR
it
+
+ α
13
LEV
it
+ α
14
LEV
it
BN
it
+ α
15
LEV
it
AR
it
+ α
16
LEV
it
BN
it
AR
it
+ ζ
it
(1)
where:
SIZE
it
= log of the market value of firm i at the end of the year t;
MB
it
= market-to-book ratio of equity of firm i at the end of the year t;
LEV
it
= leverage of firm i at the end of the year t, defined as total debt scaled by market
value;
All other variables are as defined above.
Next, C_Score, measuring earnings incremental response to bad news, can be computed
as:
C_Score
it
= α
4
+ α
8
SIZE
it
+ α
12
MB
it
+ α
16
LEV
it
(2)
We extend the Khan and Watts (2009) model to control for additional effects of shifts in
unconditional conservatism and cost of capital that are important in the IFRS adoption context.
19
Indeed, Pope and Walker (2003) and Beaver and Ryan (2005) explain that conditional and
unconditional conservatism are negatively related. Therefore it is necessary to control for
possible changes in the level of unconditional conservatism. In order to capture unconditional
conservatism, we use the residual of annual cross-sectional regressions of the market-to-book
ratio of equity to several variables that previous research (Roychowdhury and Watts, 2007; Piot
et al., 2011) has shown to be correlated to the dependent variable (i.e., market returns, level of
intangibles, net value of property plant and equipment, capital expenditures, change in sales,
return on equity, volatility, leverage and size).
14
Market-to-book ratio of equity is influenced
by two factors: (1) the unverifiable (un-booked) increases in value of separable assets in place
(true unconditional conservatism), and (2) the expected value of economic profits (e.g.,
synergies between assets in place, growth, rents) (Roychowdhury and Watts, 2007). Therefore,
we adjust market-to-book ratio for expected growth and take the residuals as a proxy for
unconditional conservatism.
Additionally, Pope and Walker (1999) show that conditional conservatism is also related
to the cost of capital. Various studies have demonstrated that cost of capital was affected by the
adoption of IFRS (Karamanou and Nishiotis, 2009; Li, 2010; Daske et al., 2013). To proxy for
cost of capital we use the firms’ beta coefficient for each firm-year observation. The regression
model (1), estimated by year, becomes:
NI
it
= α
1
+ α
2
BN
it
+ α
3
AR
it
+ α
4
BN
it
AR
it
+
+ α
5
SIZE
it
+ α
6
SIZE
it
BN
it
+ α
7
SIZE
it
AR
it
+ α
8
SIZE
it
BN
it
AR
it
+
+ α
9
MB
it
+ α
10
MB
it
BN
it
+ α
11
MB
it
AR
it
+ α
12
MB
it
BN
it
AR
it
+
+ α
13
LEV
it
+ α
14
LEV
it
BN
it
+ α
15
LEV
it
AR
it
+ α
16
LEV
it
BN
it
AR
it
+
+ α
17
BETA
it
+ α
18
BETA
it
BN
it
+ α
19
BETA
it
AR
it
+ α
20
BETA
it
BN
it
AR
it
+
+ α
21
UCC
it
+ α
22
UCC
it
BN
it
+ α
23
UCC
it
AR
it
+ α
24
UCC
it
BN
it
AR
it
+ ζ
it
(3)
where:
14
The regression used for each year to determine the level of unconditional conservatism is:
MB
it
= β
1
+ β
2
R
it
+ β
3
INTAN
it
+ β
4
PPEN
it
+ β
5
CAPEX
it
+ β
6
SALES
it
+ β
7
ROE
it
+ β
8
VOLAT
it
+ β
9
LEV
it
+
+ β
10
SIZE
it
+ς
where:
INTAN
it =
intangible assets (including goodwill) of firm i at the end of the year t, scaled by total assets;
PPEN
it
= net value of property plant and equipment of firm i at the end of the year t, scaled by total
assets;
CAPEX
it
= capital expenditures firm i at the end of the year t, scaled by total assets;
SALES
it
= percentage change in sales of firm i in year t;
ROE
it
= net income firm i in year t, scaled by equity;
VOLAT
it
= price volatility of the share of the firm i in year t;
All other variables are defined above.
20
BETA
it
= beta coefficient of firm i in year t;
UCC
it
= measure of unconditional conservatism of firm i in year t;
All other variables are as defined above.
Equation (3) is the expanded version of the Basu (1997) model and includes all control
variables that are likely to affect the degree of conditional conservatism. Next, C_Score
measuring earnings response to bad news after additional control for shifts in cost of capital
and unconditional conservatism, can be re-computed as:
C_Score
it
= α
4
+ α
8
SIZE
it
+ α
12
MB
it
+ α
16
LEV
it
+ α
24
BETA
it
+ α
28
UCC
it
(4)
To test H1 and examine the effect of the adoption of IFRS on conditional conservatism
we regress the C_Score on an IFRS dummy variable. As explained in Khan and Watts (2009,
p. 148), we include as control variables the determinants of C_Score because failing to do so
may lead to spurious correlations (see also Garcìa Lara et al., 2013).
C_Score
it
= α
1
+ α
1
IFRS + α
3
SIZE
it
+ α
4
MB
it
+ α
5
LEV
it
+ α
6
BETA
it
+ α
7
UCC
it
+ ζ
it
(5)
where:
IFRS = dummy variable equal to 1 for years after 2005, and 0 otherwise.
All other variables are as defined above.
The effect of the mandatory IFRS adoption on conditional conservatism (H1) is captured
by the coefficient α
1
. A significantly positive (negative) value of α
1
indicates that the earnings
response to bad news has increased (decreased) after the adoption of IFRS.
(b) The role of the auditing environment and the enforcement of accounting standards
To study the effect of public enforcement on conditional conservatism surrounding the
adoption of IFRS (H2), we use the audit and enforcement index developed by Brown et al.
(2014). Therefore, equation (5) becomes:
C_Score
it
= α
1
+ α
1
IFRS + α
2
ENF
it
+ α
3
IFRS*ENF
it
+ α
4
MB
it
+ α
5
LEV
it
+
α
6
BETA
it
+ α
7
UCC
it
+ ζ
it
(6)
where:
ENF
it
= value of the Brown et al. (2014) audit and enforcement index in 2002 for firm
i’s country for firm-year observations before IFRS adoption and value of the index in
2008 for firm i’s country for firm-year observations after the adoption of IFRS;
21
All other variables are as defined above.
In model (6), α
1
captures the effect of the adoption of IFRS on conditional conservatism,
coefficient α
2
measures the effect of auditing quality/strength of accounting enforcement on the
degree of conditional conservatism before the adoption of IFRS, and α
3
captures the incremental
effect of auditing quality/strength of accounting enforcement after the adoption of IFRS (H2).
(c) The role of asset impairments
To examine if and how impairment testing affects the degree of conditional conservatism
after the adoption of IFRS (H3), we run two sets of tests. First, we introduce in model (5) a
dummy variable equal to 1 for firms that recognize asset impairments on various asset types.
Therefore model (5) becomes:
C_Score
it
= α
1
+ α
1
IFRS + α
2
DIMP
it
+ α
3
IFRS*DIMP
it
+ α
4
MB
it
+ α
5
LEV
it
+ α
6
BETA
it
+ α
7
UCC
it
+ ζ
it
(7)
where:
DIMP
it
= one of the following three variables:
DIMPA
it
= 1 if the firm books an impairment on any assets, and 0 otherwise;
DIMPINT
it
= 1 if the firm books an impairment on intangible assets, and 0 otherwise;
DIMPGW
it
= 1 if the firm books an impairment on goodwill, and 0 otherwise;
All other variables are already defined above.
To allow meaningful interpretations, we estimate the model on three different samples:
full sample if DIMP = DIMPA, sample of observations with positive lagged value of intangible
assets if DIMP = DIMPINT, and sample of observations with positive values of lagged goodwill
if DIMP = DIMPGW. The main coefficient of interest is the coefficient α
3
that captures the
difference in the change of the degree of conditional conservatism for firms that recognize asset
impairment after the adoption of IFRS relative to the other firms. A positive coefficient would
suggest that firms that recognize asset impairment experience a smaller decline in the degree of
conditional conservatism relative to the other firms, and vice versa. A smaller decline for those
firms would be consistent with inappropriate enforcement of impairment tests’ principles
because the lack of asset impairment from the rest of the observations would drive the overall
decline in conditional conservatism.
In our second set of tests, we focus on the effect of impairment avoidance on conditional
conservatism. We introduce in model (5) a dummy variable for firms that avoid booking asset
22
impairments although evidence suggests the probable need to do so. The market-to-book ratio
has been used in many empirical studies to identify firms carrying impaired assets (e.g., Beatty
and Weber, 2006; Hilton and O'Brien, 2009; Ramanna and Watts, 2012; Lawrence et al., 2013;
Roychowdhury and Martin, 2013; Chen et al., 2014).
15
We follow Ramanna and Watts (2012)
and use a market-to-book less than one for two consecutive years as an indicator of
economically impaired assets. The following model facilitates the estimation of the effect of
impairment avoidance on conditional conservatism:
C_Score
it
= α
1
+ α
1
IFRS + α
2
SUSPECT
it
+ α
3
IFRS*SUSPECT
it
+ α
4
MB
it
+
α
5
LEV
it
+ α
6
BETA
it
+ α
7
UCC
it
+ ζ
it
(8)
where:
SUSPECT
it
= one of the following three variables:
SUSPECTA
it
= 1 if the firm has a market-to-book below one for two consecutive years
and does not book any asset impairment, and 0 otherwise;
SUSPECTINT
it
= 1 if the firm has a market-to-book below one for two consecutive
years and does not book any intangible impairment, and 0 otherwise;
SUSPECTGW
it
= 1 if the firm has a market-to-book below one for two consecutive
years and does not book goodwill impairment, and 0 otherwise;
All other variables are already defined above.
To allow meaningful interpretations, we also estimate the model on three different
samples: full sample if SUSPECT = SUSPECTA, sample of observations with positive lagged
value of intangible assets if SUSPECT = SUSPECTINT, and sample of observations with
positive values of lagged goodwill if SUSPECT = SUSPECTGW. The main coefficient of
interest is the coefficient α
3
that captures the difference in the change of the degree of
conditional conservatism for firms that avoid asset impairments after the adoption of IFRS
although evidence suggests the need to book one. A negative coefficient would suggest that
firms that avoid asset impairments experience a greater decline in the degree of conditional
conservatism relative to the other firms, and vice versa. A greater decline for those firms relative
15
The SEC also considers that the MTB ratio is a relevant indicator of potential goodwill impairment. In a survey
about the usefulness of goodwill impairment test, KPMG (2014) also explains that although interviewees agreed
that a MTB less than one does not automatically warrant a goodwill impairment loss, it is an important indicator
that requires further assessment of a potential goodwill impairment.
23
to other firms would be consistent with inappropriate enforcement of impairment tests because
impairment avoidance would at least partially explain a decline of conditional conservatism.
In all models, standard errors are clustered at the firm level.
(ii) Sampling and data collection
Regulation No. 1606/2002 of the European Parliament requiring all public firms to prepare
consolidated financial statements on the basis of IFRS was issued in 2002, at a time when the
EU was composed of 15 member states. In 2004, ten other countries joined the EU, followed
by Romania and Bulgaria in 2007. To avoid ambiguity, our study focuses on the 15 “early” EU
member states. Because Norway and Switzerland issued similar accounting regulations, they
are also included in our sample. Luxembourg was dropped from the sample because of an
insufficient number of observations.
Panel A of Table 1 describes the sampling and data collection process. Our initial sample
comes from the Thomson Reuters database consisting of 8,153 active public firms from the 16
European countries. Because banks, insurance companies and other financial institutions
(WS.PrimarySICCode 6xxx) follow specific reporting regulations, they are deleted from the
sample (1,654 firms). As our study focuses on 2005 IFRS adopters, firms that followed
international accounting standards before 2005 (WS.AcctStandardsFollowed 02 or 23) and
firms that followed other than IFRS accounting standards after 2005 are deleted from the
sample. In order to reduce the possible risk of bias, all firms where this data is not available are
also deleted from the sample. This leads to a sample of 2,274 firms adopting IFRS in 2005
(2005 IFRS adopters).
INSERT TABLE 1 ABOUT HERE
Next, we collect the accounting and market data from the Thomson Reuters database
16
for the period 2000 to 2010, i.e., five years before and six years after the adoption of IFRS in
order to ensure a relatively balanced panel.
17
Data was not available for 10,848 firm-year
observations and another 455 observations were dropped from the sample due to negative
16
We also use Datastream in order to collect firms’ beta coefficients and the volatility index that are not available
in Worldscope.
17
Results are qualitatively similar if we drop observations from the 2005 adoption year.
24
equity or negative total assets. The final sample consists therefore of 13,711 firm-year
observations.
Panel B of Table 1 provides the distribution of the observations per country. As usual in
studies on European capital markets, most observations are from France (2,664) and Great
Britain (1,852), while the lowest number of observations is from Austria (90).
18
In order to
mitigate the effects of outliers on our inferences, we winsorize all continuous variables used in
our regressions at 1%. Panel C of Table 1 presents some descriptive statistics for the main
variables used in the empirical models. A few observations are noteworthy. The average
(median) market-to-book and beta are 2.263 (1.570) and 0.885 (0.810) respectively. Average
(median) leverage is 81.4% (34.1%). The average (median) level of total intangibles to total
assets is 17.1% (9.7%). The frequency of bad news (BN), i.e., negative abnormal returns is
0.586.
19
The frequency of any asset impairment is 32.7%, of an impairment of intangible assets
is 14.6%, and of an impairment of goodwill is 10.2 %. Panel C of Table 1 also shows that among
observations with a market-to-book below one for two consecutive years, 12.6% of
observations do not book any impairment (SUSPECTA), 16.8% do not book an impairment of
intangible assets (SUSPECTINT) and 17.3% do not book an impairment of goodwill
(SUSPECTGW).
Models (1), (2), (3) and (4) are estimated annually in order to allow coefficients to vary
each year. After estimating model (4), we compute C_Score with equation (5). C_Score is also
presented in Panel C of Table 1. The mean (median) C_Score is -0.091 (-0.093) and ranges
from -0.850 to 0.572.
6. EMPIRICAL FINDINGS
(i) Effect of mandatory IFRS adoption and the role of institutional factors on conditional
conservatism
In the Basu (1997) model of conservatism, quality accounting earnings are deemed to reflect
bad news more quickly than good news, while market returns capture both good news and bad
news simultaneously. The first column of Table 2 shows the association between C_Score and
factors explaining conservatism according to (Watts, 2003a). The second column of Table 2
reports the results of the regression from model (5) which examines the effect of IFRS on
18
The low number of observations in Italy for the pre-IFRS period is explained by the fact that the beta coefficient
is not available in Datastream for the years before 2004.
19
If stock returns were normally distributed BN would be equal to 0.50.
25
conditional conservatism for the overall sample (H1). The third column presents the estimation
results of model (6) which examines the effect of enforcement on the change in conditional
conservatism after the adoption of IFRS (H2).
INSERT TABLE 2 ABOUT HERE
The first column shows that conservatism is significantly positively associated with MB
and BETA and negatively associated with LEV and UCC (significant at less than 1%, two-
sided). With the exception of LEV, results are consistent with predictions and results from Khan
and Watts (2009). Firms with higher market-to-book ratio of equity have more growth options
relative to assets in place, growth options are positively related to agency costs, for which
conservatism is an efficient corporate governance response. We expand the Khan and Watts
(2009) measure with proxies for cost of capital and unconditional conservatism. Conservatism
is positively associated with firm’s beta, which is a proxy for systematic risk. Higher risk
(higher BETA) is likely to drive greater demand for conservatism. Conversely, C_Score is
negatively related with unconditional conservatism (UCC), this is consistent with the negative
association between unconditional and conditional conservatism explained in Pope and Walker
(2003) and Beaver and Ryan (2005).
The second column shows a negative association between IFRS and C_Score as
coefficient on IFRS is -0.031 (significant at less than 1%, two-sided). The decrease of the
asymmetric timeliness of earnings following the adoption of IFRS is relatively large; given that
the mean of the C_Score over the entire sample period is -0.091. This result indicates that a key
objective of IFRS, i.e., promoting high quality accounting standards, is not reached at least
regarding this important dimension of accounting quality.
We further examine the effect of institutional factors relevant for financial reporting on
the effect of IFRS adoption on the level of conditional conservatism (H2). Using the index
developed by Brown et al. (2014), we examine the importance of auditing quality and the
strength of the enforcement of compliance with accounting standards on conditional
conservatism. Estimation results of model (6) are presented in column (3). Results show that
the decrease in conditional conservatism is less pronounced in strong enforcement countries
(see the estimated coefficient on IFRS * ENF is positive and significant at less than 1%, two-
sided). The decrease in conditional conservatism is lower for countries with high auditing
26
quality and strong enforcement of compliance with accounting standards. This indicates the
importance of institutional setting in ensuring the enforcement of principle-based IFRS.
This result contrasts with the findings of Ahmed et al. (2013) who report a more
significant decrease in the timeliness of loss recognition for high enforcement countries. The
different results could come from two factors. First, Ahmed et al. (2013) use a traditional index
of law enforcement similar to La Porta et al. (1997) which is also used in various studies (e.g.,
Leuz et al., 2003). We use an index more directly related to financial reporting which might
better capture relevant dimensions of the institutional environment. Second, another possible
explanation is that Ahmed et al. (2013) consider only observations until 2007. The ability to
achieve better relative enforcement of IFRS in high auditing quality/strong enforcement
countries could have taken more than three years after IFRS adoption.
(ii) The role of impairment tests
The previously reported results show that the adoption of IFRS resulted in a decrease in
conditional conservatism. The effect of the adoption of IFRS in 2005 on conditional
conservatism in Europe is likely to be dependent on the capacity to apply various conditional
conservatism mechanisms, among which impairment testing for non-financial assets plays a
central role in the IFRS framework (Lawrence et al., 2013; Roychowdhury and Martin, 2013).
Table 3 shows the estimation results of models (7) and (8). Panel A presents the difference
in earnings response to bad news for firms which book asset impairments relative to other firms
carrying similar assets. Panel B presents the difference in earnings response to bad news for
firms that do not book an asset impairment although evidence suggests the probable need to
book one relative to other firms carrying similar assets. The conjecture is that if the lack of asset
impairment drives the decrease of conditional conservatism after the adoption of IFRS, firms
that booked an asset impairment should present a smaller decline in conservatism relatively to
the other firms and firms that avoid booking impairments although evidence suggest they
should – should experience a greater decline in conditional conservatism.
INSERT TABLE 3 ABOUT HERE
Panel A of Table 3 shows that the decrease in conditional conservatism is less pronounced
for firms that booked an asset impairment after the adoption of IFRS relative to other firms that
27
carry similar assets. This result holds for impairment of any assets (see coefficient IFRS * DIMP
= 0.077 in column (1), significant at less than 1%, two-sided), impairment of intangible assets
(see coefficient IFRS * DIMP = 0.103 in column (2), significant at less than 1%, two-sided) or
impairment of goodwill (see coefficient IFRS * DIMP = 0.089 in column (3), significant at less
than 1%, two-sided). Results suggest that the decline in conditional conservatism is more
pronounced among firms that do not book asset impairments, consistent with our conjecture.
Panel B of Table 3 allows us to compare the difference in earnings response to bad news
for firms that are likely to have avoided booking an asset impairment. Results indicate that firms
avoiding to recognizing an impairment have a greater decline in the degree of conditional
conservatism of financial reporting than the other firms. This result holds for impairment of any
assets (see coefficient IFRS*SUSPECT = -0.100 in column (1), significant at less than 1%,
two-sided), intangible assets (see coefficient IFRS*SUSPECT = -0.108 in column (2),
significant at less than 1%, two-sided), and goodwill (see coefficient IFRS*SUSPECT = -0.098
in column (3), significant at less than 1%, two-sided). Results from column (3) of Panel B even
suggests that after adjusting for the negative effect of goodwill impairment avoidance on
C_Score, the introduction of IFRS led to an increase in conditional conservatism (see
coefficient IFRS = 0.013 in column (3), significant at less than 5%, two-sided).
These findings support our conjecture that, on average, impairments are potentially not
booked in a timely fashion (because there is too much flexibility and/or lack of enforcement)
thus reducing overall timely loss recognition of financial reporting. This is also consistent with
concerns expressed by the IFRS standard setter and the European market regulator
(Hoogervorst, 2012, 5; ESMA, 2013). We therefore identify one important accounting
mechanism that is associated with the decrease in the degree of conditional conservatism.
7. SENSITIVITY TESTS
(i) Using different measures of conditional conservatism
To corroborate our primary findings, we also rely on two other measures of conditional
conservatism. First, we transform the classic Basu (1997) model by adding another dummy
variable (IFRS) and its interaction effects with stock returns directly. This approach is inspired
by Ball and Shivakumar (2005) who modify the model to allow for differences between
subsamples. Therefore we estimate the following model:
NI
it
= α
1
+ α
2
BN
it
+ α
3
AR
it
+ α
4
BN
it
AR
it
+
28
+ α
5
IFRS
it
+ α
6
IFRS
it
BN
it
+ α
7
IFRS
it
AR
it
+ α
8
IFRS
it
BN
it
AR
it
+ ζ
it
(9)
In equation (9), the responsiveness of earnings to bad news before the IFRS adoption is
measured by the sum α
3
+ α
4
, while the responsiveness of earnings to bad news after IFRS
adoption is measured by the sum α
3
+ α
4
+ α
7
+ α
8
. An incremental timeliness of loss recognition
significantly higher for the post-IFRS period would imply a positive and significant coefficient
α
8.
A negative coefficient α
8
denotes less timely loss recognition after the IFRS adoption, i.e.,
less conservative accounting.
Second, we also complement the model developed by Basu (1997) with the Khan and
Watts (2009) firm-specific extension and add an IFRS dummy variable. We estimate the
following model:
NI
it
= α
1
+ α
2
BN
it
+ α
3
AR
it
+ α
4
BN
it
AR
it
+
+ α
5
IFRS
it
+ α
6
IFRS
it
BN
it
+ α
7
IFRS
it
AR
it
+ α
8
IFRS
it
BN
it
AR
it
+
+ α
9
SIZE
it
+ α
10
SIZE
it
BN
it
+ α
11
SIZE
it
AR
it
+ α
12
SIZE
it
BN
it
AR
it
+
+ α
13
MB
it
+ α
14
MB
it
BN
it
+ α
15
MB
it
AR
it
+ α
16
MB
it
BN
it
AR
it
+
+ α
17
LEV
it
+ α
18
LEV
it
BN
it
+ α
19
LEV
it
AR
it
+ α
20
LEV
it
BN
it
AR
it
+ ζ
it
(10)
Under this specification, conditional conservatism is measured as the sum of the
coefficients α
4
+ α
8
+ α
12
+ α
16
+ α
20
. Similar to model (9), the effect of the mandatory IFRS
adoption on conditional conservatism is captured by the coefficient α
8.
Estimated results of
models (9) and (10) are presented in Table 4.
INSERT TABLE 4 ABOUT HERE
Results show a reduction of the degree of earnings asymmetric response to good and bad
news after the adoption of IFRS in 2005. The modified Basu model and the extended Kahn and
Watts model show consistent results with findings reported above (see estimated coefficient
BN*AR*IFRS = -0.132, significant at less 1%, two sided in column (1) and estimated
coefficient BN*AR*IFRS = -0.125, significant at less than 1%, two-sided in column (2)).
29
(ii) The effect on the response of earnings to good news vs. bad news
As a robustness test, we also examine changes in earnings response to good news (G_Score)
20
and the changes in the difference of response to bad news vs. good news (C_Score – G_Score)
around the adoption of IFRS. Indeed, a different measure of conservatism is the difference in
the sensitivity to bad news and the sensitivity to good news which is discussed in Pope and
Walker (1999). Untabulated results show that the introduction of IFRS also led to a decrease in
earnings response to good news. However, the decrease in the earnings response to bad news
is significantly greater in absolute value than the decrease in the earnings response to good
news. This confirms previously reported findings of a decrease in conditional conservatism
after the mandatory adoption of IFRS.
(iii) Other robustness tests
We have conducted other (untabulated) sensitivity tests. Because most studies investigating the
effects of IFRS adoption use a narrower time window, we have re-estimated our main model
over a different time window. We obtain similar results by restricting the period under study to
2002-2007. Results are also qualitatively similar if observations in 2005, i.e., the first adoption
year of IFRS, are excluded.
To assess the sensitivity of our results for the effect of enforcement and auditing quality on the
level of conditional conservatism, we have also re-estimated model (6) using a different
measure of the strength of legal enforcement, namely the measure from (Leuz et al., 2003) and
we obtained qualitatively similar findings. In addition, our primary results of a decrease in
conditional conservatism are also unaffected by the use of raw returns instead of abnormal
returns.
8. CONCLUSION
The adoption of IFRS in Europe was to achieve better quality financial reporting. Since then,
numerous studies have looked at different pieces of the puzzle. We examine conditional
conservatism – an important qualitative characteristic of financial reporting – and document a
decrease after the adoption even though IFRS have reduced the level of unconditional
conservatism and put in place mechanisms to ensure conditional conservatism such as
20
G_Score
it
is computed after estimation of model (3) as G_Score
it
= α
3
+ α
7
SIZE
it
+ α
11
MB
it
+ α
15
LEV
it
+
α
23
BETA
it
+ α
27
UCC
it
30
impairment testing. In order to better understand this result, we examine if auditing quality and
the strength of enforcement of accounting standards is associated with this decrease. We
document that the decrease has been lower in high auditing quality/strong accounting standards
enforcement countries relatively to weak auditing quality/enforcement countries.
Next, we investigate which channels led to a decrease in conservatism of financial
reporting, i.e., the standards per se or the greater flexibility permitted by the standards and their
inappropriate application. We show that the decrease in conditional conservatism after the
adoption of IFRS is less pronounced for firms that recognize an asset impairment and more
pronounced for firms that do not book an asset impairment although evidence suggest they
probably should. The implementation of impairment tests (in particular for intangibles with
indefinite useful life) usually relies on valuation models, requires significant judgment from
managers, and is prone to manipulation because it relies on unverifiable fair value estimates.
The European Securities and Market Authority (ESMA) and the chairman of the IASB recently
expressed their concerns about accounting for goodwill and insufficient impairment recognition
(see Hoogervorst, 2012; ESMA, 2013). Further studies have documented an incomplete and
heterogeneous level of compliance with disclosure requirements under IFRS 3 and IAS 36
(Amiraslani et al., 2013; Glaum et al., 2013; Mazzi et al., 2014; Paugam and Ramond, 2014;
Tsalavoutas et al., 2014). The effect of the adoption of IFRS in 2005 on conditional
conservatism in Europe is likely dependent on the capacity to apply and enforce various
conditional conservatism mechanisms, among which impairment-testing principles for non-
financial assets play a critical role (Lawrence et al., 2013; Roychowdhury and Martin, 2013).
Inappropriate enforcement of impairment tests is a potential explanation. Untimely impairment
allows managers to defer the recognition of bad news in earnings and reduce the level of
conditional conservatism.
Overall, our results inform stakeholders about a potential negative effect of the greater
flexibility permitted by IFRS and/or lack of appropriate enforcement on a key dimension of
accounting quality. They have important implications for European regulators and standard
setters as they review the cost and benefits of IFRS. Our study also sheds light on the importance
of the institutional environment for achieving the targeted objective of improving financial
reporting quality.
31
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Ramanna, K., and R. Watts (2012), 'Evidence on the use of unverifiable estimates in required
goodwill impairment', Review of Accounting Studies, Vol. 17, pp. 749-780.
Raonic, I., S. McLeay, and I. Asimakopoulos (2004), 'The timeliness of income recognition by
European companies: An analysis of institutional and market complexity', Journal of
Business Finance & Accounting, Vol. 31, pp. 115-148.
Roychowdhury, S., and X. Martin (2013), 'Understanding discretion in conservatism: An
alternative viewpoint', Journal of Accounting & Economics, Vol. 56, pp. 134-146.
Roychowdhury, S., and R. L. Watts (2007), 'Asymmetric timeliness of earnings, market-to-
book and conservatism in financial reporting', Journal of Accounting & Economics, Vol.
44, pp. 2-31.
Ryan, S. G. (2006), 'Identifying conditional conservatism', European Accounting Review, Vol.
15, pp. 511-525.
Tsalavoutas, I., P. André, and L. Evans (2012), 'The transition to IFRS and the value relevance
of financial statements in greece', British Accounting Review, Vol. 44, pp. 262-277.
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convergence: Mandated disclosures and the financial statement effects of IFRS 3, IAS
36 and IAS 38', Research Report No. 134, ACCA, London, UK.
Walton, P. (2011), 'An executive guide to IFRS: Content, costs and benefits to business', John
Wiley & Sons.
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Watts, R. L. (2003a), 'Conservatism in accounting part i: Explanations and implications',
Accounting Horizons, Vol. 17, pp. 207-221.
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Accounting Horizons, Vol. 17, pp. 287-301.
36
Table 1. Sampling and data collection
Panel A: Sampling
Firms on Thomson from 16 European countries 8,153
(-) Firms with unavailable data 1,683
(-) Financial institutions 1,654
(-) Non 2005 IFRS adopters 2,542
(=) Firms included in the sample 2,274
(x11) Firm-years observations for 2000 to 2010 25,014
(-) Observations with unavailable data 10,848
(-) Observations with negative equity or negative total assets 455
(=) Final number of firm-years observations 13,711
Panel B: Distribution of the sample by period and country
Country Before After Pool
AUT 29
61 90
BEL 150
226 376
CHE 63
109 172
DEU 519
708 1,227
DNK 181
246 427
ESP 290
441 731
FIN 303
430 733
FRA 1,111
1,553 2,664
GBR 660
1,192 1,852
GRC 203
1,030 1,233
IRL 48
68 116
ITA 194
747 941
NLD 293
364 657
NOR 246
480 726
PRT 108
146 254
SWE 568
944 1,512
TOTAL 4,966
8,745 13,711
37
Panel C: Descriptive statistics
N Mean Std. Dev.
Min P25% Median P75% Max
AR
it
13,711 -0.002
0.521
-1.021
-0.301
-0.076
0.183
2.311
NI
it
13,711 -0.001
0.307
-1.179
-0.065
0.010
0.073
1.731
SIZE
it
13,711 18.934
2.111
10.911
17.394
18.707
20.321
24.485
MB
it
13,711 2.263
2.337
0.016
0.923
1.570
2.687
15.400
LEV
it
13,711 0.814
1.436
0.000
0.089
0.341
0.876
9.541
BETA
it
13,711 0.885
0.596
-0.308
0.460
0.810
1.232
2.818
UCC
it
13,711 -0.014
1.908
-2.785
-1.030
-0.431
0.376
9.626
PPE
it
13,711 0.260
0.212
0.003
0.082
0.212
0.384
0.856
INTAN
it
13,711 0.171
0.198
0.000
0.019
0.097
0.260
0.907
CAPEX
it
13,711 0.048
0.050
0.000
0.015
0.034
0.062
0.288
SALES
it
13,711 0.128
0.437
-0.683
-0.041
0.060
0.188
2.919
ROE
it
13,711 0.020
0.526
-3.187
-0.001
0.088
0.172
2.102
VOLAT
it
13,711 0.435
0.228
0.138
0.280
0.377
0.529
1.377
C_Score
it
13,711 -0.091
0.228
-0.850
-0.209
-0.093
0.034
0.572
BN
it
13,711 0.585
0.493
0.000
0.000
1.000
1.000
1.000
DIMPTOTAL
it
13,711 0.327
0.469
0.000
0.000
0.000
1.000
1.000
DIMPINTAN
it
13,711 0.146
0.353
0.000
0.000
0.000
0.000
1.000
DIMPGW
it
13,711 0.102
0.302
0.000
0.000
0.000
0.000
1.000
SUSPECTA
it
13,711 0.126
0.332
0.000
0.000
0.000
0.000
1.000
SUSPECTINT
it
13,711 0.168
0.374
0.000
0.000
0.000
0.000
1.000
SUSPECTGW
it
13,711 0.173
0.379
0.000
0.000
0.000
0.000
1.000
where:
AR
it
= share return of firm i in year t, net of dividends and capital contributions adjusted for firm i’s
country average share return in year t;
NI
it
= net income of firm i in year t, scaled by beginning of the period market value adjusted for the
average net income for firm i’s country in year t;
SIZE
it
= log of the market value of firm i at the end of the year t;
MB
it
= market-to-book ratio of firm i at the end of the year t;
LEV
it
= leverage of firm i at the end of the year t, defined as total debt divided by market value of equity;
BETA
it
= beta coefficient of firm i in year t;
UCC
it
= measure of the level unconditional conservatism of firm i in year t;
PPE
it
= net value of property plant and equipment of firm i at the end of the year t, scaled by total assets;
INTAN
it
= intangible assets (including goodwill) of firm i at the end of the year t, scaled by total assets;
CAPEX
it
=
capital expenditures of firm i in year t, scaled by total assets;
SALES
it
= percentage change in sales of firm i in year t;
ROE
it
= net income of firm i in year t, scaled by equity;
VOLAT
it
= price volatility of the share of the firm i in year t;
C_Score
it
= conditional conservatism score based on the adjusted Khan and Watts model;
BN
it
= 1 if AR is negative and zero otherwise;
DIMPTOTAL
it
= dummy variable equal to 1 if the firm books an impairment during the year t, and 0 otherwise.
DIMPINTAN
it
= dummy variable equal to 1 if the level of intangibles of firm i at the end of year t-1 is positive
and the intangibles have been impaired during the year t, and 0 otherwise;
DIMPGW
it
=
dummy variable equal to 1 if the goodwill of firm i at the end of the year t-1 is positive and the
goodwill has been impaired during the year t, and 0 otherwise;
SUSPECTA
it
= dummy variable equal to 1 if the firm has a market-to-book < 1 for two consecutive years and
does not book any impairment during year t, and 0 otherwise;
SUSPECTINT
it
= dummy variable equal to 1 if the firm has a market-to-book < 1 for two consecutive years, has
intangible assets at the beginning of the year and does not book impairment of intangible assets
during year t, and 0 otherwise;
38
SUSPECTGW
it
= dummy variable equal to 1 if the firm has a market-to-book < 1 for two consecutive years, has
goodwill at the beginning of the year and does not book impairment of goodwill during year t, and
0 otherwise;
All continuous variables are winsorized at 1%.
39
Table 2. The effect of IFRS on conditional conservatism and the role of enforcement
(1) (2) (3)
Intercept -0.096
***
-0.084
***
-0.029
(-6.36)
(-5.48)
(-1.61)
IFRS -0.031
***
-0.128
***
(-7.69)
(-10.33)
ENF -0.002
***
(-4.90)
IFRS * ENF 0.003
***
(7.31)
SIZE -0.001
-0.001
-0.001
(-1.02)
(-0.54)
(-1.05)
MB 0.016
***
0.015
***
0.016
***
(5.43)
(5.04)
(5.35)
LEV -0.026
***
-0.026
***
-0.025
***
(-10.11)
(-10.23)
(-10.11)
BETA 0.008
***
0.010
***
0.010
***
(2.61)
(3.32)
(3.47)
UCC -0.062
***
-0.061
***
-0.062
***
(-18.39)
(-18.06)
(-18.35)
Number of observations 13,711
13,711
13,711
Number of clusters 1,727
1,727
1,727
Adj. R² 0.1876
0.1919
0.1953
OLS regression of C_Score. Sample consists of European mandatory adopters of IFRS in 2005 from 16 countries
(Austria, Belgium, Denmark, Finland, France, Germany, Great Britain, Greece, Ireland, Italy, Netherlands,
Norway, Portugal, Spain, Sweden, and Switzerland). Sample period spans 2000-2010.
where:
C_Score
it
= conditional conservatism score based on the adjusted Khan and Watts model;
IFRS
it
= dummy variable equal to 1 if the year is superior or equal to 2005 and 0 otherwise;
ENF
it
= value of the Brown et al. (2014) audit and enforcement index in 2002 for firm i’s country before
IFRS adoption and value of the index in 2008 for firm i’s country after adoption of IFRS;
SIZE
it
= log of the market value of firm i at the end of the year t;
MB
it
= market-to-book ratio of firm i at the end of the year t;
LEV
it
= leverage of firm i at the end of the year t, defined as total debt scaled by market value;
BETA
it
= beta coefficient of firm i in year t;
UCC
it
= measure of unconditional conservatism for firm i in year t.
All continuous variables are winsorized at 1%. Standard errors adjusted for clustering at firm level. t-statistics
into brackets. *, **, *** indicates statistically significant at 0.10, 0.05 and 0.01 respectively.
40
Table 3. The importance of asset impairments after the adoption of IFRS
Panel A. Effect of impairment recognition on conditional conservatism
Any
Impairment
Impairment of
intangibles
Impairment of
goodwill
(1) (2) (3)
Intercept -0.072
*** -0.103
***
-0.086
***
(-4.47)
(-6.18)
(-4.93)
IFRS -0.048
*** -0.023
***
-0.011
**
(-10.72)
(-5.09)
(-2.32)
DIMP -0.066
*** -0.087
***
-0.082
***
(-8.10)
(-6.67)
(-6.66)
IFRS * DIMP 0.077
*** 0.103
***
0.089
***
(8.46)
(7.25)
(6.62)
SIZE 0.000
0.000
-0.001
(-0.46)
( (-0.29)
(-1.10)
MB 0.014
*** 0.017
***
0.016
***
(4.95)
(5.41)
(4.44)
LEV -0.026
*** -0.022
***
-0.025
***
(-10.03)
(-8.21)
(-8.59)
BETA 0.010
*** 0.008
** 0.009
**
(3.34)
(2.40)
(2.60)
UCC -0.060
*** -0.065
***
-0.065
***
(-17.99)
(-18.31)
(-16.50)
Number of observations 13,711
11,605
9,700
Number of clusters 1,727
1,596
1,377
Adj. R² 0.1967
0.2005
0.203
OLS regression of C_Score. Sample consists of European mandatory adopters of IFRS in 2005 from 16 countries
(Austria, Belgium, Denmark, Finland, France, Germany, Great Britain, Greece, Ireland, Italy, Netherlands,
Norway, Portugal, Spain, Sweden, and Switzerland). The sample period spans 2000-2010. Column (1) presents
estimation results for all observations, column (2) presents estimation results for observations with positive lagged
intangible assets, and column (3) presents estimation results for observations with positive lagged goodwill.
where:
C_Score
it
= conditional conservatism score based on the adjusted Khan and Watts model;
IFRS
it
= dummy variable equal to 1 if the year is superior or equal to 2005, and 0 otherwise;
DIMP = dummy variable equal to 1 if the firm impairs any assets (column (1)), intangible assets
(column (2)) or goodwill (column (3)), and 0 otherwise;
SIZE
it
= log of the market value of firm i at the end of the year t;
MB
it
= market-to-book ratio of firm i at the end of the year t;
LEV
it
= leverage of firm i at the end of the year t, defined as total debt scaled by market value;
BETA
it
= beta coefficient of firm i in year t;
UCC
it
= measure of unconditional conservatism of firm i in year t.
All continuous variables are winsorized at 1%. t-statistics are computed with standard errors adjusted for clusters
at the firm level. *, **, *** indicates statistical significance at 0.10, 0.05 and 0.01 respectively (two-tail tests).
41
Panel B. Effect of impairment avoidance on conditional conservatism
Avoid Any
Impairment
Avoid Impairment
of Intangibles
Avoid Impairment of
G
(1) (2) (3)
Intercept -0.115
*** -0.142 ***
-0.124
***
(-7.36)
(-8.57) (-6.96)
IFRS -0.016
*** 0.005 0.013
**
(-3.83)
(1.02) (2.55)
SUSPECT 0.096
*** 0.097 ***
0.099
***
(10.06)
(9.60) (8.80)
IFRS * SUSPECT -0.100
*** -0.108 ***
-0.098
***
(-9.63)
(-9.78) (-8.26)
SIZE 0.000
0.000 -0.001
(0.07)
(0.28) (-0.63)
MB 0.017
*** 0.019 ***
0.018
***
(5.70)
(5.91) (4.94)
LEV -0.027
*** -0.024 ***
-0.027
***
(-10.39)
(-8.66) (-9.08)
BETA 0.013
*** 0.011 ***
0.012
***
(4.23)
(3.35) (3.47)
UCC -0.062
*** -0.066 ***
-0.066
***
(-18.43)
(-18.48) (-16.46)
Number of observations 13,711
11,605 9,700
Number of clusters 1,727
1,596 1,377
Adj. R² 0.2036
0.2062 0.2095
OLS regression of C_Score. Sample consists of European mandatory adopters of IFRS in 2005 from 16 countries
(Austria, Belgium, Denmark, Finland, France, Germany, Great Britain, Greece, Ireland, Italy, Netherlands,
Norway, Portugal, Spain, Sweden, and Switzerland). The sample period spans 2000-2010. Column (1) presents
estimation results for all observations, column (2) presents estimation results for observations with positive lagged
intangible assets, and column (3) presents estimation results for observations with positive lagged goodwill.
where:
C_Score
it
= conditional conservatism score based on the adjusted Khan and Watts model;
IFRS
it
= dummy variable equal to 1 if the year is superior or equal to 2005, and 0 otherwise;
SUSPECT = dummy variable equal to 1 if the firm has a market-to-book below 1 for two consecutive years
and does not impair: any assets (column 1), intangible assets (column 2) or goodwill (column 3),
and 0 otherwise;
SIZE
it
= log of the market value of firm i at the end of the year t;
MB
it
= market-to-book ratio of firm i at the end of the year t;
LEV
it
= leverage of firm i at the end of the year t, defined as total debt scaled by market value;
BETA
it
= beta coefficient of firm i in year t;
UCC
it
= measure of unconditional conservatism of firm i in year t.
All continuous variables are winsorized at 1%. t-statistics are computed with standard errors adjusted for clusters
at the firm level. *, **, *** indicates statistical significance at 0.10, 0.05 and 0.01 respectively (two-tail tests).
42
Table 4. Robustness tests: alternative measures of conditional conservatism (Basu and
Kahn and Watts models)
(1) (2)
Intercept 0.050
***
-0.066
(4.36)
(-0.93)
BN -0.006
-0.067
(-0.46)
(-0.76)
AR 0.017
-0.048
(0.59)
(-0.33)
BN * AR 0.257
***
0.777 ***
(6.82)
(3.73)
IFRS -0.016
-0.013
(-1.33)
(-1.14)
BN * IFRS -0.015
-0.018
(-0.95)
(-1.18)
AR * IFRS 0.030
0.014
(0.91)
(0.48)
BN * AR * IFRS -0.132
***
-0.125 ***
(-2.62)
(-2.63)
SIZE 0.007 **
(1.99)
BN * SIZE 0.003
(0.75)
AR * SIZE 0.005
(0.62)
BN * AR * SIZE -0.034 ***
(-3.11)
MB -0.012 ***
(-4.37)
BN * MB -0.001
(-0.31)
AR * MB -0.008 *
(-1.89)
BN * AR * MB 0.000
(0.03)
LEV 0.007
(0.47)
BN * LEV -0.013
(-0.95)
AR * LEV 0.050 ***
(2.97)
BN * AR * LEV -0.010
(-0.49)
Number of observations 13,711
13,711
Number of clusters 1,727
1,727
Adj. R² 0.0402
0.0905
OLS regression of NI. In column 1, we transform the classic Basu (1997) model by adding another dummy variable
(IFRS) and its interaction effects with stock returns directly. This approach is inspired by Ball and Shivakumar
43
(2005) who modify the model to allow for differences between subsamples. In column 2, we complement the
model developed by Basu (1997) with the Khan and Watts (2009) firm-specific extension and add an IFRS dummy
variable
Sample consists of European mandatory adopters of IFRS in 2005 from 16 countries (Austria, Belgium,
Denmark, Finland, France, Germany, Great Britain, Greece, Ireland, Italy, Netherlands, Norway, Portugal, Spain,
Sweden, and Switzerland). The sample period spans 2000-2010.
AR
it
= share return of firm i in year t, net of dividends and capital contributions adjusted for firm i’s
country average share return in year t;
NI
it
= net income of firm i in year t, scaled by beginning of the period market value minus average net
income for firm i’s country in year t;
SIZE
it
= log of the market value of firm i at the end of the year t;
MB
it
= market-to-book ratio of firm i at the end of the year t;
LEV
it
= leverage of firm i at the end of the year t, defined as total debt divided by market value of equity/
All continuous variables are winsorized at 1%. t-statistics are computed with standard errors adjusted for clusters
at the firm level. *, **, *** indicates statistical significance at 0.10, 0.05 and 0.01 respectively (two-tail tests).
... The International Accounting Standards Board (IASB) argues that conservatism should not be one of the financial reporting characteristics since using conservatism against uncertainty will reduce the future orientation of financial information and relevance of information for decision making purposes. Andre, Filip, and Paugam, 2015;Zeghal and Lahmar (2016) and Cerqueira and Pereira (2020) find that those European firms that adopt the IFRS have reduced accounting conservatism. Since 2016, the Capital Market Authority (CMA) in Oman observed a reduction in litigation risks against preparers and auditors due to preparers being expected to comply with IFRS standards while auditors are expected to meet the International Auditing Standards requirements. ...
... In the GAAP environment, Chen et al. (2014) and Heflin, Hsu, and Jin (2015) find that firms with more conservative accounting generate less persistent earnings than firms with less conservative accounting as accounting conservatism reduces GAAP earnings persistence. In the IFRS environment, such as Oman, prior studies (Zeghal and Lahmar, 2016;Andre et al. (2015); Preiato, Brown, and Tarca, 2015) reported that using of accounting conservatism is reduced because of IFRS indicating that accounting conservatism become less attractive and important and therefore the effect of it on earnings persistence is not expected. Also, Cerqueira and Pereira (2020) and Astuti (2020) assert that because IFRS adopts fair value accounting, accounting conservatism is reduced and omitted from the conceptual framework of IASB as the firms did not use it in financial reporting. ...
... However, both Gajevszky (2014), and Salehi et al. (2018) conclude that there is a negative relationship between accounting conservatism and earnings quality due to preparers being motivated by earnings management for their own personal gains and returns. On the other hand, the result of AC is in line with some prior studies with respect to earnings persistence (e.g., Zeghal and Lahmar, 2016;Andre et al., 2015;Preiato et al., 2015) who find that using of AC in the environment of IFRS is reduced because it has effect of neutrality of financial statements and therefore it is expected that AC does not have impact on earnings persistence. With respect to association with value relevance, the result conflicts with Hejranijamil et al. (2020) and Brown et al. (2006) who find negative association between them. ...
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This paper examines the impact of accounting conservatism and auditing conservatism on earnings quality. Four proxies were used to measure earnings quality; persistence, accrual quality, value relevance and earnings smoothness. We use the published annual reports of all the listed firms in the Muscat Securities Market (MSM) for the 6-year period from 2012-2017 to assess the interplay between accounting conservatism, auditing conservatism and earnings quality. The result reveals a positive and significant effect of auditing conservatism on earnings quality but no significant effect of accounting conservatism on earnings quality in terms earnings smoothness. This implies users tend to rely on auditors’ reports when assessing earnings quality. Our results are robust to the inclusion of four control variables; size of the firm, risk, audit firm size and industry type, the use of an additional analysis of one special case of auditing conservatism and earnings quality, and tests of potential relationship between auditing conservatism. The findings have implications to regulators when formulating standards and guidelines, auditors in the course of an audit, investors in reviewing the financial statements, and preparers when preparing their financial reports. The study recommends that Omani stockholders as well as international stockholders rely heavily on auditing conservatism which means that stockholders are prepared to receive modified audit reports.
... The literature identifies two levels in the application of accounting prudence: ex-ante prudence or unconditional conservatism, and ex-post prudence or conditional conservatism (Beaver and Ryan, 2005;André et al., 2015). The first form of prudence (unconditional conservatism) is not dependent on the events that affect the company's activity, manifesting itself, as a rule, in the accounting choices made by the company at the initial recognition of assets or liabilities: useful life of fixed assets, depreciation methods, criteria for capitalizing some expenses, choosing the evaluation method. ...
... To these we can add: -the correct application of prudence The indicators we analyse in this study -depreciation, impairment and provision expenses, that we call prudence expenses -are mainly related to conditional prudence, except for depreciation, which corresponds to accounting options (depreciation period and depreciation method, in particular) specific to unconditional prudence. André et al. (2015) notes that the application of IFRS in Europe since 2005 has led to an overall decrease in the effects of conditional prudence for a sample of firms from 16 European countries. However, in the case of Romania, from the individual financial statements of listed companies that have applied IFRS since 2012, it results that the immediate effects (related to 2011) seem to indicate a more prudent accounting in IFRS than in RAS, taking into account the effects on the net income (Istrate, 2014). ...
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Conservatism is one of the basic principles in accounting and financial reporting. Developments in international accounting standardization seem to lead to a decrease of the role of this principle in the development and application of accounting standards. The use, in Romania, of two financial reporting frameworks makes various categories of companies approach prudence in somewhat divergent ways. In the literature, it is sometimes criticized that the use of prudence leads to earnings management, in the sense of the reduction or of the smoothing of the net income. We analyse data provided by Romanian companies listed on the regulated market of the Bucharest Stock Exchange, in the period 2007-2019, but also data of companies listed on the alternative market AeRo of the same stock exchange, to calculate the share of expenses reported in the profit and loss account and related to the recognition of depreciations, impairments and provisions. The results show that companies on the regulated market have higher shares of prudence expenses in sales and that this situation can be explained by the standards currently applied (IFRS), but also by the fact that large companies are more exposed to external control, from the part of more exigent investors or auditors. The increase in leverage is associated with a decrease in the share of prudence expenses, as is the use of local auditors; moreover, the modified opinions are associated with significantly higher shares of prudential charges in sales.
... Watts (2003) explained that accounting conservatism is a mechanism that can be useful in the disclosure of fi nancial information which would subsequently be benefi cial in making decisions and in contracting. Utilizing conservatism accounting practice potentially decreases the tendency of managers to overestimate net asset value by reducing information asymmetry, and in coping with management's asymmetry disclosure incentives (Francis, Hasan, & Wu, 2013;Andre, Filip, & Paugam, 2015;Mora & Walker, 2015). As a result, management would instead receive credible information, including negative ones, in a timely manner (Basu, 1997;Watts, 2003). ...
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The objective of this study is to examine the relationship between chief executive officer (CEO) turnover and accounting conservatism, and the role family firms play in the relationship. The sample group used in the study consists of firms listed on the Stock Exchange of Thailand (SET) during the period of 2012 to 2017. Accounting conservatism was measured using the model introduced by Khan and Watts (2009) and the multiple regression approach was used to test the hypotheses. Results showed a negative relationship between CEO turnover and accounting conservatism. In addition, an interaction effect between family firms and CEO turnover was found to result in a higher degree of accounting conservatism in financial reports. Results revealed that the alignment effect of the interaction was higher than the entrenchment effect in family-owned firms. This study is the first to provide empirical evidence on the interaction of dual entrenchment mechanisms that results from the managerial horizon problem and family owned-firms, including their effects on conservative financial reports.
Thesis
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في العقود الأخيرة، شهد الاقتصاد تغيرات عالية السرعة وتقنيات جديدة جد متطورة، الأمر الذي استوجب على المحاسبة مواكبة هذه التغيرات، إذ أصبح الفكر المحاسبي يهتم بتسجيل الظواهر التي تتطلب التقييمات، التفسيرات، التقديرات والتوقعات، ويعتبر اتخاذ القرارات بناء على المعلومات المالية أحد التحديات الرئيسة التي تواجه الأفراد والمؤسسات والمنظمات والدول ذات العلاقة، وتفاقم الأمر حيث مر الاقتصاد العالمي بأزمة ثقة نتيجة الدور المتزايد لأساليب إدارة العديد من المؤسسات لبياناتها، باستعمال المستحقات المحاسبية بالدرجة الأولى. من هذا المنطلق، هدفت هذه الدراسة إلى إبراز دور هذه المستحقات في تفسير التدفقات النقدية والتنبؤ بها في المؤسسات الاقتصادية الجزائرية، اعتمادا على البيانات المالية للمؤسسات محل الدراسة والتي شملت 132 مؤسسة للفترة الممتدة من 2010-2020م، واستنادا على نموذج انحدار خطي مطبق على بيانات سلسلة زمنية مقطعية غير متوازنة بالاعتماد على برنامجي"10 EViews" و"SPSS 25" لإجراء الاختبارات الإحصائية. حسب نتائج الدراسة، فإن المستحقات المحاسبية تمثل مؤشر أفضل من التدفقات النقدية الجارية والأرباح المحاسبية في تفسير التدفقات النقدية والتنبؤ بها، وأن تقسيم المستحقات المحاسبية يساهم في زيادة القدرة على ذلك، إذ تعتبر المستحقات المحاسبية قصيرة الأجل أفضل من المستحقات المحاسبية طويلة الأجل، والمستحقات المحاسبية غير الاختيارية أكثر قدرة على تفسير التدفقات النقدية المستقبلية من المستحقات الاختيارية، كما أن لكل نوع من المستحقات المحاسبية محتوى إعلامي يختلف عن الأخر، وأن تغير المدينين وتغير الدائنين الأكثر قدرة على تفسير التدفقات النقدية والتنبؤ بها إلى جانب مخصصات الإهتلاك والمؤونات وتدني القيم، في حين أن كل من تغير الضرائب المؤجلة أصول، تغير الضرائب المؤجلة خصوم، وتغير المخزونات ليس لها دلالة إحصائية، ولا تساهم في تفسير التدفقات النقدية والتنبؤ بها للمؤسسات الاقتصادية الجزائرية.
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