1. Introduction. 1.1 Motivation and scope
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1 1. Introduction 1.1 Motivation and scope IASB standardsetting International Financial Reporting Standards (IFRS) are on the way to become the globally predominating accounting regime. Today, more than 120 jurisdictions around the world permit or require IFRS financial statements for domestic listed firms (AICPA, 2011). Most major economies that have not yet introduced IFRS have established time lines to converge with or adopt IFRS in the near future either on a voluntary or a mandatory basis. IFRS are expected to bring along several benefits to companies stakeholders and especially to their investors. The major argument for the IFRS adoption by the European Union (EU) in 2005 was the expectation that IFRS will help to eliminate cross-border financing barriers by ensuring that the financial statements of firms provide more reliable, transparent, and comparable information (European Commission, 2002). The IFRS Foundation states its objectives to develop, in the public interest, a single set of high quality, understandable, and enforceable global accounting standards that require high quality, transparent, and comparable information in financial statements and other financial reporting to help participants in the world s capital markets and other users make economic decisions. (IFRS Foundation, 2010, par. 2a) Recently, the chairman of the International Accounting Standards Board (IASB) stated his high expectations regarding the application of IFRS: 1
2 Global accounting standards will enhance the drive towards the free trade of capital internationally. By adopting a globally accepted set of standards, all companies large and small are able to attract capital from a larger pool of investors, driving down the cost of capital, and facilitating cross-border mergers and acquisitions activity and strategic investments. (Tweedie, 2011) The convergence between the IASB and the Financial Accounting Standards Board (FASB) is of particular importance for the global acceptance of the IFRS. Based on the Memorandum of Understanding (FASB and IASB, 2002), the two boards coordinated their efforts and conducted several joint standard setting projects. The elaboration of the financial reporting rules around the world is observed on highest diplomacy level. For instance, the leaders of the Group of 20 (G20) countries confirmed their willingness to get favored accounting standards in the foreseeable future: We call on our international accounting bodies to redouble their efforts to achieve a single set of high quality, global accounting standards within the context of their independent standard setting process, and complete their convergence project by June The IASB s institutional framework should further enhance the involvement of various stakeholders. (G20, 2009, par. 14) In June 2011, the US Securities and Exchange Commission (SEC) staff published a work plan for the consideration of IFRS incorporation into the financial reporting system for United States (US) firms. The proposed condorsement - procedure (SEC, 2011) is controversially debated. The first purpose of this Doctoral Thesis is to shed light on the economic consequences of the IASB standard setting process. The IFRS are broadly discussed in practice and theory, however, it is an open question whether the expected benefits of IFRS changes have actually materialized and whether the standard setting efforts of the IASB are beneficial from an investor perspective. 2
3 The first paper of this Doctoral Thesis ( Do IASB s Standard Setting Pronouncements Meet Investors Demands around the World? ) evaluates investor reactions to specific milestones in the IASB s due process. The empirical findings provide evidence that investors take notice of the standard setting activities of the IASB. However, there are no positive overall market reactions to the IASB standard setting pronouncement around the world. These results suggest that investors do not expect that the benefits of new standards outweigh the respective cost. Further, standard setting pronouncements which tend to increase options and choices as well as fair value accounting are associated with more negative market reactions than other pronouncements. Enforcement of financial reporting standards The second part of this Doctoral Thesis deals with different aspects of establishing enforcement mechanisms in Germany. While the development, implementation, and adoption of accounting principles and their consequences are well discussed in current accounting literature, considerably less is known about the impact of the application of these standards. Accounting researchers conclude that accounting standards by their own do not determine financial reporting outcomes. Besides other forces, the overall level of enforcement is identified as one driver of financial reporting quality. Several studies suggest that even nuances in how securities laws are applied and enforced can lead to considerable differences in observed outcomes. In the context of the rapidly occurring adoption of IFRS around the world, this is also an issue of great urgency. Even if there is a uniform set of financial reporting standards around the world, several expected benefits will not be fully realized unless the underlying institutional and economic factors evolve to become sufficiently similar. The chairman of the IASB notices: In Britain everything is permitted unless it is prohibited. In Germany it is the opposite, everything is prohibited unless it is permitted. In the Netherlands everything is prohibited even if it is permitted. And in France, of course, everything is permitted especially if it is prohibited. (Tweedie, 2009) 3
4 The following papers dealing with the impact of the enforcement level directly respond to a suggestion of Holthausen (2009) to analyze the impact of external enforcement reforms on reporting outcomes and capital market properties. The German government stated in 2004: Corporate scandals in the past caused by earnings manipulations have undermined the trust of investors in capital markets. It is an urgent target of the Federal Government to restore and to encourage the trust of investors in the accuracy of financial reports and thus in capital markets. (Deutscher Bundestag, 2004) The second paper ( Why do German Firms Produce Erroneous Accounting? ) discusses drivers of the IFRS accounting quality in Germany. The German Financial Reporting Enforcement Panel (DPR Deutsche Prüfstelle für Rechnungslegung) primarily attributes detected materially erroneous financial reports to the enormous scope and highly complex nature of IFRS, which overwhelms companies (DPR, 2009). The empirical findings indicate that opportunistic motives are conducive to erroneous accounting, while governance quality increases the probability that firms prepare compliant financial statements. However, the results suggest that material errors in mandated IFRS financial statements cannot be attributed to firms being unable to cope with IFRS. Especially the latter aspect is important for the IASB, other standard setters, regulators, and enforcers. The third paper ( Enforcement of Accounting Standards in Europe: Capital Market Based Evidence for the Two-tier Mechanism in Germany ) contributes to the understanding of capital-market based sanction-mechanisms in civil law countries such as Germany. A key assumption for the effectiveness of the currently introduced German enforcement procedures is that firms are deterred from publishing erroneous financial reports as they fear sufficiently negative market reactions if the firm has to announce this circumstance in the course of the enforcement mechanism ( name and shame ). Indeed, such negative market reactions occur. More in detail, the findings suggest that capital market 4
5 participants perceive the detailed description of the detected accounting errors published within the error announcements as well as the (un-)willingness of the firm to cooperate with the enforcement institutions. The fourth and fifth paper of this Doctoral Thesis ( Economic Consequences of Accounting Enforcement Reforms: The Case of Germany and Reforms to the Enforcement of IFRS and the Cost of Equity and Debt Capital ) investigate economic consequences of recent reforms to the enforcement in Germany. Results suggest a desirable impact of these reforms on the accounting policy as well as on important capital market properties of firms that fall under the new enforcement regime. Findings provide further evidence that these enforcement reforms leveled the playing field in the enforcement of financial reporting. Reliability of sustainability information Besides classical information provided in financial statements, sustainability information are published in a more or less standardized form commonly seen as important for the evaluation of current and future performance. In this context, sustainability is a term which is frequently used by companies to describe their economical, social, and environmental orientation. In the so-called Brundtland Report, the United Nations (UN) World Commission on Environment and Development describes sustainability as a development that meets the needs of the present without compromising the ability of future generations to meet their own needs. (UN, 1987) It seems to be worthwhile from an ethical perspective but also from the view of the homo oeconomicus to consider and support firms sustainability orientation. The sixth paper ( Market Reactions to Increased Reliability of Sustainability Information ) evaluates whether investors consider the reliability of companies sustainability information when determining companies market value. As theoretically predicted, findings support that the reliability of sustainability information is important from an investor s perspective. More specifically, the findings suggest that investors of firms carrying higher information and 5
6 investment risks particularly demand more reliable sustainability information. Finally, the results provide evidence that this demand is even higher in times of economic uncertainties. The remainder of this Doctoral Thesis proceeds as follows. Section 1.2 summarizes the individual papers as well as publication details, before the sections 2 to 7 present six research papers in all detail. 1.2 Summary and publication details The Doctoral Thesis at hand is a cumulative work that consists of six individual papers in the context of IASB standard setting, enforcement of financial reporting standards, and reliability of sustainability information. In this section, each of the individual papers is briefly summarized and co-authors are named (no first-author assignments). Moreover, publication details are given. Please note that there are later versions of all papers available in the respective journals as indicated in the text or on scientific online platforms. Thus, please cite the current versions of the papers. 6
7 Paper 1: Do IASB s Standard Setting Pronouncements Meet Investors Demands around the World? This paper investigates whether the IASB standard setting pronouncements, i.e., the publications of specific milestones (discussion papers, exposure drafts, and final standards) in the IASB s due process meet the demands of investors. Specifically, we analyze abnormal return volatilities and cumulative abnormal returns of IFRS firms to the pronouncements. The major challenge of the IASB in the standard setting process is to evaluate whether the benefits of new standards outweigh the costs in order to gauge their efficiency. Using a sample of all IASB pronouncements from 2001 through 2009 we find that IASB standard setting pronouncements are considerably perceived by investors. However, there are no positive overall market reactions to IASB standard setting pronouncements of investors around the world. Yet, the market reactions vary cross-sectionally by jurisdiction, time period, and type of pronouncement. Further, we provide some evidence that standard setting pronouncements which tend to increase options and choices as well as fair value accounting are associated with more negative cumulative abnormal returns than other pronouncements. Co-author: Jürgen Ernstberger. JEL Classification: G14, M48, and M41. Keywords: IFRS, IASB, standard setting, due process, event study, and market reaction. Publication details: Conference paper. 7
8 Paper 2: Why do German Firms Produce Erroneous Accounting? Given voiced concerns with the alleged complexity of IFRS, this paper investigates determinants of material errors in mandated IFRS financial statements. For a matched sample of firms censured by the German enforcement mechanism for producing erroneous IFRS financial statements, we investigate the role of complexity and thus sources of unintentional accounting errors, and control for intentional factors. In line with the previous literature, we find that, as predicted, the presence of opportunistic motives is conducive to erroneous accounting, while governance quality increases the probability that firms prepare compliant financial statements. In contrast, we find no evidence that unintentional factors pertaining to financial reporting expertise and accounting resources shape reporting quality. The results of this paper are important for regulators and standard setters, as they suggest that material errors in mandated IFRS financial statements cannot be attributed to firms being unable to cope with the new and complex standards, but are due to earnings management incentives and weak controls. Co-authors: Jürgen Ernstberger and Jörg-Markus Hitz. JEL Classification: M41. Keywords: accounting quality, enforcement, IFRS, regulation, restatements, and Germany. Publication details: Revise and resubmit at an international journal. 8
9 Paper 3: Enforcement of Accounting Standards in Europe: Capital Market Based Evidence for the Two-tier Mechanism in Germany On the background of regulatory initiatives that mandate development of comparable enforcement systems in EU jurisdictions to ascertain consistent and faithful application of IFRS, this paper provides capital market based evidence on investor reactions for one specific institutional setup: the two-tier enforcement system in Germany. In operation since 2005, the German enforcement mechanism consists of a private body, the DPR, which investigates compliance of financial statements published by publicly traded firms, and, upon error findings, involves the German securities regulator BaFin, which on a second level enforces disclosure of these findings to create adverse disclosure. For a sample of all error findings published until the end of 2009, we address the potential effectiveness of this name and shame mechanism by investigating short- and long-window capital market reactions upon error announcements. Results on abnormal returns, abnormal trading volumes and abnormal bid-ask spreads indicate that these announcements represent new, negative information and suggest that, despite an enforcement environment that is categorized as weak in the extant literature, the activities of the DPR/BaFin are effective in penalizing infringing firms and thus provide potential deterrence. In detailed analyses, we find that the magnitude of abnormal return reactions is positively associated with the severity of the error(s) and with the threat of follow up litigation, while indication of unintentional error(s) appears to reduce the valuation discounts imposed by investors. Co-authors: Jürgen Ernstberger and Jörg-Markus Hitz. JEL classification: M 41. Keywords: enforcement, IFRS, accounting quality, restatements, regulation, and Germany. Publication details: European Accounting Review (forthcoming). 9
10 Paper 4: Economic Consequences of Accounting Enforcement Reforms: The Case of Germany This study investigates recent reforms of financial reporting enforcement in Germany. The objective of these reforms was to promote a consistent and faithful application of accounting standards. Conducting multivariate analyses, we find a significant decrease in earnings management, a significant increase in stock liquidity, as well as limited evidence for an increase in market valuation for the companies that fall under the new enforcement regime. We document that companies that are characterized by an overall low level of enforcement through other internal and external mechanisms are particularly affected by these reforms. In our analyses, we carefully control for effects of the mandatory IFRS adoption in Europe as well as for various other effects arising from the application of different accounting principles. Our results hold for different research designs, incl., a difference-in-differences approach and a matched sample approach. We conclude that the enforcement reforms in Germany have leveled the playing field in the enforcement of financial reporting and have enhanced the trust in financial reports of the affected companies. Co-authors: Jürgen Ernstberger and Oliver Vogler. JEL classification: M 41 and M 48. Keywords: enforcement; regulation; IFRS; earnings management; stock liquidity; market valuation. Publication details: European Accounting Review (forthcoming). 10
11 Paper 5: Reforms to the Enforcement of IFRS and the Cost of Equity and Debt Capital This paper investigates the impact of recent reforms to the enforcement of IFRS financial reporting in Germany to the cost of equity and debt capital. The objective of these governmental reforms was to promote a more consistent and faithful application of financial reporting standards by publicly traded firms and for IFRS financial statements in particular. As a major regulatory chance a twotier external enforcement mechanism combining private and public financial reporting oversight was established. Beside this, the scope of the auditors oversight was restructured and new auditor independence rules were enacted. First, I evaluate if the reforms to the enforcement of IFRS have lowered the cost of equity and debt capital finding weak evidence for such an impact. Second, I perform a path-analysis using the increase in earnings quality and trust in information prepared by firms which are caused by the reforms to the enforcement of IFRS as a link to the cost of equity and debt capital. In this case, I find considerable evidence for the effectiveness of these reforms on the cost of equity and debt capital. Further, I document that the increase in earnings quality is a link which is equally important for equity and debt holders whereas the increase in trust in the information provided by IFRS reporting firms has a considerably higher impact for equity than for debt holders. JEL classification: M 41 and M 48. Keywords: enforcement, IFRS, governance reforms, cost of equity capital, cost of debt capital, and path analysis. Publication details: Conference paper. 11
12 Paper 6: Market Reactions to Increased Reliability of Sustainability Information This paper investigates whether investors consider the reliability of companies sustainability information when determining the companies market value. Specifically, we examine market reactions (in terms of abnormal returns) to events that increase the reliability of companies sustainability information but do not provide markets with additional sustainability information. Controlling for competing effects, we regard companies additions to an internationally important sustainability index as such events and consider possible determinants for market reactions. Our results suggest that first, investors take into account the reliability of sustainability information when determining the market value of a company and second, the benefits of increased reliability of sustainability information vary cross-sectionally. More specifically, companies that carry higher risks for investors (e.g., higher systematic investment risk, higher financial leverage, higher levels of opportunistic management behavior, and so on) react more strongly to an increase in the reliability of sustainability information. Finally, we show that the benefits of an increase in the reliability of sustainability information are higher in times of economic uncertainty (e.g., during economic downturns and generally high stock price volatilities). Co-authors: Julia Lackmann and Jürgen Ernstberger. JEL classification: M14, M41, and M48. Keywords: sustainability, corporate social responsibility, CSR, reliability, market reactions, and event study. Publication details: Journal of Business Ethics (forthcoming). 12
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