Why It Doesn’t Make Sense to Force Financial Reporting Reform

As part of the attempt to equalize the flow of information between corporate managers and other insiders, and investors and other outsiders, the European Union and more than 100 other countries require or permit the adoption of harmonized International Financial Reporting Standards (IFRS), or a local version of them.

But accounting quality does not necessarily improve with adopting IFRS—at least unless a firm has an incentive to adopt them, according to research by Chicago Booth’s Hans B. Christensen, with Edward Lee, Martin Walker, and Cheng Zeng, all of Manchester Business School.

The researchers analyzed financial reporting improvements, or the lack of improvement, among more than 400 firms in Germany—a country that initially gave companies the option to adopt IFRS on a voluntary basis and subsequently mandated adoption. This setting let the researchers test whether accounting quality—earnings management, timely loss recognition, and value relevance (how well financial statements capture and summarize a firm’s worth)—actually improved when firms were forced to comply with higher-quality accounting standards.

Consistent with existing literature, the researchers find that voluntary adoption of IFRS was associated with decreased earnings management, increased timely loss recognition, and increased value relevance. But they also discover that these improvements were not found among so-called resister firms that chose not to voluntarily adopt IFRS but eventually were forced to by the mandate. The resister firms in the sample tended to have close relationships with banks and other insiders, and were not under much pressure to provide a lot of information to capital markets.

Currently regulators in the United States, Japan, India, Russia, Malaysia, and Colombia are considering mandating IFRS adoption, but that may not yield higher accounting quality among firms that have no incentives to adopt the new standards. The researchers find that financial reporting incentives influence accounting quality, despite the many potential benefits from international accounting harmonization under IFRS.