Examining Earnings quality under IFRS and US GAAP

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Earnings quality is of considerable interest to participants in the financial reporting process, including standard setters, preparers, auditors, regulators, analysts and financial press commentators. It is also of interest to accounting educators and accounting researchers. As an evidence of this interest, we point to several analyses of earnings quality, including Dechow and Schrand (2004) and Schipper and Vincent (2003). These analyses vary in the benchmark construct that earnings is presumed to capture or describe and in the evidence on earnings quality that is presented or discussed.

Dechow and Schrand (2004) analyze earnings quality from a financial analysis perspective. They take the view that earnings are of high quality if they accurately attribute annuitizing-of-value with reporting a normalized, sustainable or representative earnings number that corresponds to permanent earnings and they describe such an earnings number as being of high quality because it has three attributes: it accurately reflects current performance, it indicates future performance, and it is a useful summary for assessing firm value. Our perspective complements the point of view of Dechow and Schrand: we associate earnings quality with precise information about a construct that earnings are intended to describe. In the context of Dechow and Schrand's discussion, this construct would be permanent earnings.

Schipper and Vincent (2003) however consider earnings quality both from a decision usefulness perspective (following the Financial Accounting Standards Board's (FASB) conceptual framework), and from a Hicksian income perspective (following the idea that accounting earnings should faithfully represent changes in wealth). Applying our perspective to their paper, the construct that is captured with precision by high quality earnings would be wealth changes. This would probably not correspond to the normalized or sustainable earnings number proposed by Dechow and Schrand. While Schipper and Vincent discuss some of the earnings quality measures, they do not consider the capital market consequences of earnings.

In general, the structural and organizational differences between IFRS and US-GAAP are in the literature mostly described as principle versus rules based. US-GAAP is described as rule based, because of the breadth of the rules compared to IFRS. In contrast with US-GAAP, IFRS is not a national set of standards. Also the IASB is not embedded in the national structure as is the case with the FASB (Helleman, 2006). Moreover, IFRS and US-GAAP have not the same recognition and measurement rules that affect the information content of the accounting numbers. Based on an agreement between the two authorities which develop IFRS and US-GAAP (the International Accounting Standards Board or IASB respectively the Financial Accounting Standards Board or FASB) both accounting standards include changes in order to meet each other. But still important differences continue to exist between US-GAAP and IFRS.

In this essay the following research question will be elaborated:

To what degree are there differences between earnings quality under IFRS and US-GAAP and how can these differences be explained?

In chapter 2 a theoretical review of earnings quality will be described. In chapters 3 and 4 we will elaborate the relation between earnings quality, IFRS and US-GAAP. In chapter 5 earnings attributes based on Francis et al. (2004) will be evaluated. Finally chapter 6 provides for concluding remarks and the discussion.

2. Earnings quality: a theoretical review

2.1 Earnings

Earnings are important to a firm for the reason that they are used as a summary measure of the performance of a firm by a large variety of users. When doing research on the quality of accounting information, it is first of all important how to determine this quality. In academic literature, quality of the accounting information is very often determined by the quality of the reported earnings. For this matter, researchers have made the quality of accounting information empirically operational by developing several attributes in order to determine the earning quality (Schipper and Vincent, 2003).

For two main reasons Schipper and Vincent (2003) relate earnings quality to decision-usefulness. Firstly the focus of the Financial Accounting Standards Board (FASB) is shifted from the stewardship function of accounting to decision-usefulness. FASB states that the idea of financial reporting is to offer useful information for business decision making. Secondly, 'decision usefulness is empirically tractable and is commonly used in accounting research'. Schipper and Vincent (2003) also relate earnings quality to an economics-based definition of earnings developed by Sir John Richard Hicks. The definition of Hicksian income is as follows:

'The amount that can be consumed (paid out as dividends) during a period, while leaving the firm equally well off at the beginning and the end of the period (Hicks, 1939).'

This measure of income matches with the change in net economic assets other than from transactions with owners. Schipper and Vincent (2003) define earnings quality as follows:

'The extent, which reported earnings faithfully represent Hicksian income. In this context, representational faithfulness means 'correspondence or agreement between a measure or description and the phenomenon that it purports to represent.' (FASB Concepts Statement No. 2, Par. 63).

However, the term earnings quality in itself has no established meaning and has been used with different interpretations; i.e. with the use of different earning metrics or attributes, each covering a different feature of the quality aspects of earnings. Because earnings can be decomposed into cash flows and accruals, several researchers use accruals quality to draw conclusions about the earnings quality (Dechow Dichev, 2002; Francis et al., 2004). Other researchers in turn interpret the quality of earnings when earnings are persistent (e.g. Penman and Zhang, 2002, Richardson, 2003). Mikhail et al. (2003) explain the quality of earnings in terms of the predictive ability of the earnings. They view earnings to be of high quality when a firms past earnings are strongly associated with its future earnings. Also there are researchers who view earnings to be of higher quality when earnings are value relevant, i.e. the earnings are strongly associated with the security price (Francis and Schipper, 1999). Ball and Shivakumar (2005) consider timely loss recognition as an important attribute of financial reporting quality.

2.2 Frameworks of earnings quality

Regarding the academic literature, an agreed definition or framework for determining the quality of reported earnings doesn't exist. As a consequence, researchers determine earnings quality in various ways, i.e. looking at different aspects of earnings in line with their view of what important aspects of earnings are. Francis et al conducted a research in 2004 where they discussed the most important and widely used earning attributes in order to come up with a summary of seven earning attributes.

Their research discusses seven earnings attributes used in prior research and are divided into two groups, the market- and accounting-based attributes, each describing a unique characteristic of earnings. Most literature on earnings quality investigates one or two earnings attributes, while Francis et al. provide a summary of seven attributes that are discussed in academic research. For this reason and also the fact that their research was widely referred to by other researchers in studying the earnings quality concept followed after the publication of their research, the summary of widely used attributes by Francis et al. will be used in order to extract a suitable framework in determining the earnings quality for IFRS and US-GAAP earnings.

The information content of earnings is dependent upon several earnings attributes. Francis et al. (2004) apply the following attributes: accruals quality, persistence, predictability, smoothness, value relevance, timeliness and conservatism. They conclude that firms with the least favorable values of the attributes experience larger cost of capital than those with the most favorable values. Their finding is explained by information risk. Firm-specific information risk is priced, and favorable earnings attributes reduce the information risk. All of the attributes investigated by Francis et al. (2004) are measures of earnings quality. However, no unique definition of earnings quality exists and earnings quality is a concept that can be measured along several dimensions.

Also the framework of Soderstrom and Sun (2007) will be evaluated. In this framework a model of determinants for accounting quality after the adoption of IFRS in the European Union is debated. The researchers highlight the importance of both institutional and firms factors that could influence accounting quality. Moreover, Soderstrom and Sun refer that empirical studies of determinants of accounting quality have a relevant importance, while all the countries of the European Union are going to have a group of consistent accounting rules, the future improvement of the accounting quality will depend on the change of the political and legal system from one country to the other and incentives of the financial report of each company.

Prior empirical research on quality differences between US-GAAP and IFRS is scarce and provides mixed results (Van der Meulen, Gaeremynck, Willekens, 2007). The existing literature on (the determinants of) earnings quality provides an interesting overview. In the next chapter we will elaborate upon the relation between IFRS and earnings quality based on existing theoretical research.

3. Earnings quality under IFRS and US-GAAP

3.1 Background information

The globalization and the more intensive international trade in the last decades led to the need for harmonization of accounting standards across countries. A big step in this harmonization process was the adoption in 2005 of the International Financial Reporting Standards (IFRS) by all listed companies in the European Union (Renders and Gaeremynck, 2007).

The implementation of International Financial Reporting Standards (IFRS) would enhance the comparability of the financial performance of companies across different countries (Jeanjean, Stolowy, 2008). Besides this it would enhance the quality of financial reporting (Daske, 2006).

Some researchers (e.g. Armstrong et al., 2007, Covrig et al., 2007, Barth et al., 1999) assume that IFRS reporting makes it less costly for investors to compare firms in different markets and different countries. Despite that Jeanjean and Stolowy (2008) conclude that creating uniform accounting standards is not sufficient to influence earnings quality. Keeping this in mind we continue with the elaboration of US-GAAP, starting with a definition:

'Generally accepted accounting principles (GAAP)' is a technical term that encompasses the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. It includes not only broad guidelines of general application, but also detailed practices and procedures. Those conventions, rules and procedures provide a standard by which to measure financial presentations (Auditing Standards Board, AU Section 411).

GAAP represent federal financial accounting standards and is significant to US firms. Overall it is very broad in its techniques, as it requires being slightly valid to many different types of industries. According to the fact that in many cases it is flexible and general, most businesses in the United States have to follow GAAP. Generally accepted accounting principles are wide-ranging but based on a small number of basic principles which are consistency, relevance, reliability and comparability. Consistency means all the information should be collected and presented the same in all periods. For example, a firm cannot change the method they account for inventory from one period to another beyond saying it in the financial statements and having a crucial motive for the change. Relevance means the information in financial statements should be suitable and should contribute to a person evaluating the statements to estimate the future financial state of a firm. Reliability means basically that the information in financial statements is reliable and confirmable by an independent party.

Comparability is one of the most significant GAAP categories. Through comparability, a corporation's financial statements and other documents can be associated to similar companies inside its industry. The significance of this principle cannot be overstated, while in case of lacking comparability, investors would not be capable to recognize differences between firms within an industry to benchmark how a business performance is compared to its peers.

3.2 Literature review

An interesting framework in the paper of Soderstrom and Sun (2007) describes determinants of accounting quality after the adoption of IFRS, namely legal and political systems, accounting standards and incentives of financial reporting.

Considering figure 1, the accounting standards are one of the determinants of accounting quality. If there is continuously improvement of the quality of IFRS standards the value relevance and reliability of the financial reporting under IFRS is expected to increase (Soderstrom and Sun, 2007). We assume this process will give a better reflection of reality and of earnings quality. However there are more determinants of accounting quality such as the legal and political system and incentives of financial reporting. The influence of legal and political systems is indirectly as well as directly. The indirect influence is through the political process of accounting standard setting in which users of accounting have significant influence on standard setters. Also legal systems concerning common law and code law influences accounting standards. Code law allows governments to primarily influence accounting standards by means of governmental priorities (Soderstrom and Sun, 2007).

Legal and political systems also influence accounting quality directly, through implementation of accounting standards and legal action against managers and auditors. There is also an indirect influence on accounting quality through incentives from financial market development, capital structures, ownership and tax systems (Soderstrom and Sun, 2007).

Firstly, the strength or weakness of the investor protection, as an example of financial market development. The demand for information results needs to reduce information asymmetry (Soderstrom and Sun, 2007). Secondly, an example regarding capital structures: in some countries financial reporting is less used to reduce information asymmetry. As a consequence the earnings quality in these countries is lower. Thirdly, La Porta et al. (1998) found that countries with stronger investor protection have a lower concentration of ownership and high incentives for qualitative financial reporting. Finally, a strong link between accounting standards and tax laws reduces the quality of accounting standards. High tax rates increases the incentive to show lower profits.

Interaction between these determinants and the effect on accounting quality is (partly) analyzed in the papers of Burgstahler et al. (2007) and Ding et al. (2007). Ding et al. provide evidence on the link between financial reporting standards and the economic, financial and government institutions in a country. Because the other determinants differ across countries also accounting quality will differ following IFRS adoption. Comprix et al. (2003) and Burgstahler et al. (2006) state that new disclosures and accrual measures are significantly related with less earnings management in the EU (Soderstrom and Sun, 2007). The study of Burgstahler et al. (2006) provides compelling evidence that the reporting incentives of firms, which are created by market forces and institutional factors, are important determinants of accounting quality.

In a recent paper of Aubert and Grudnitski (2010) several determinants of earnings quality related to IFRS adoption have been examined: value relevance, timeliness and accruals quality. This is examined by recognizing important differences in return on assets for firms under IFRS and under local, generally accepted accounting principles. However, more value relevance under IFRS than under local GAAP is not confirmed. Besides this, the timeliness of IFRS information was not confirmed strongly. On the contrary, for several countries there was significant evidence that IFRS produces higher accruals quality than local GAAP (based on samples of firms in Greece, Finland and Sweden). It seems that IFRS is 'in some cases better than local accounting regimes in the quality of accounting information it produces for financial markets' (Aubert and Grudnitski, 2010). In the next paragraphs we will provide additional theories about earnings quality under US-GAAP (earnings quality as a determinant of accounting quality).

Previous studies that evaluate the quality of standards across regimes can roughly be divided into two groups: those comparing US-GAAP with other local regimes, and those comparing IFRS with local regimes. Studies that resort under the first group typically have two common features. First, almost all studies are performed using a sample of US and non-US companies listed on the same US stock exchange. Reason is that US stock exchanges have the interesting feature they allow foreign filers to report under their local standards, provided there is a reconciliation of earnings and shareholders' equity with US-GAAP. Second, quality is most often measured by applying value relevance models, looking at the association between stock prices and accounting data.

In comparing UK and US-GAAP constructed earnings and earnings changes, Pope and Rees (1992), conclude that US-GAAP earnings adjustments add only marginally to the ability of earnings to explain returns. Comparing US-GAAP with multiple local GAAP systems, Amir et al. (1993) find that the 20F reconciliations made by non-US filers are reflected in stock prices and thus are valued by the market. By contrast, Chan and Seow (1996) find earnings based on local GAAP to have greater information content than US-GAAP.

Splitting up the group of foreign filers, Barth and Clinch (1996) document variations depending on the country of residence. For UK and Australian firms, the reconciliations are found to be valued more than for Canadian firms. Given that US-GAAP and Canadian GAAP are similar for many items, this finding suggests that the usefulness of reconciliations to US-GAAP decreases, as the foreign GAAP is more closely comparable to US-GAAP. Alford et al. (1993) reach similar conclusions when considering several European local GAAP systems. They conclude that earnings based on Danish, German, Italian, Singaporean and Swedish GAAP contain less information and are less timely than US-GAAP earnings, while earnings based on local GAAP of Australia, France, the Netherlands and the UK are relatively more informative and timely.

Overall, results about US stock exchanges seem to suggest that from an investor's perspective reconciliations add value. While all the above studies compare US-GAAP to other accounting regimes within a US stock exchange environment, Harris et al. (1994) is the only study that analyzes across exchanges. Similar to the US stock exchange studies, Harris et al. (1994) assess quality by looking at the association between prices and earnings. However these associations are not calculated for the entire sample, but for the German and US stock market separately. They find that the explanatory power of German earnings is comparable to US earnings, but the explanatory power of shareholder's equity in Germany is significantly lower than in the US. Following these findings, in chapter 4 earnings quality under IFRS and US-GAAP will be compared.

4. IFRS versus US-GAAP

4.1 Comparing earnings quality under IFRS and US-GAAP

The impact of accounting standards used in a specific country or market can be tested by two different approaches. The first approach looks at the quality of earnings before and after the introduction of a different standard. For example, local GAAP as the former standard and US-GAAP as the new standard. This approach is for instance used in the study of Jennings et al. (2004) in which they investigate if the adoption of IFRS increases the timeliness and value relevance of financial statements. Specifically, they examine whether IFRS earnings are timelier and more value relevant for countries with high tax alignments. Tax legislation effectively determines financial accounting standards in countries with high tax alignment. Firms in high tax aligned countries will try to underestimate their firm profits to minimize taxes, thereby reducing the extent to which the financial statements reflect the economic value of the firm. In literature it is often claimed that IFRS imposes a degree of freedom on how to apply the rules for determining the accounting data. The research of Jennings proves that high and low tax aligned countries (HIGH and LOW) will use the IFRS rules differently in specific accounting situations. They find IFRS earnings to be significantly more timely in HIGH countries, due primarily to quicker incorporation of economic losses under IFRS. They also find IFRS earnings and book values to be more value relevant than HIGH countries (Jennings, 2004).

In the second approach concerning the comparison on different accounting standards, the valuation model is run simultaneously on the two sets. This is possible when in one country or market two or more accounting standards are being used. This is for instance the case in the former German New Market, where firms had to report financial statements that are either IFRS or US-GAAP compliant. On one hand these firms have to comply to IFRS rules, consistent with the EU legislation. On the other hand, a proportion of the firms are listed on the US-Market as well, for which they have to report in compliance with US-GAAP. The following section will deal with prior research on the area of the comparison of US-GAAP and IFRS earnings using the second approach. Four studies applying this approach based on the comparison between IFRS and US-GAAP could be found in academic literature.

The first research was done by Harris and Muller in 1999. They investigated if earnings and book value on the US market prepared by foreign filers under IFRS are more value relevant than the earnings prepared by US firms using US-GAAP. To address these questions, Harris and Muller used a sample of foreign firms, for the period 1992-1996, listed in the US that prepared their home country financial statements using IFRS and provided reconciliations to US-GAAP through Form 20-F fillings. The purpose of this research was to provide evidence for the debate between the US SEC and NYSE on whether foreign firms should be allowed to list in the US by only using IFRS. They found that IFRS accounting data is more associated with price-per-share and security returns than US-GAAP accounting data, i.e. IFRS is more value relevant than US-GAAP accounting data (Harris and Muller, 1999).

In 2003 Leuz compared US-GAAP and IFRS in terms of information asymmetry and market liquidity, two key concepts in securities regulation. They used firms trading in Germany's New Market for the years 1999 and 2000. The firms had to choose between IFRS and US-GAAP in creating their financial statements, but faced the same regulatory environment. Their findings did not contain that US-GAAP is of higher quality as often claimed. Analyses of the dispersion of analysts' forecasts, IPO underpricing and firms' standard choices support these results. Therefore, at least for New Market firms and based on the researchers' quality valuation model, IFRS and US-GAAP appear to be comparable (Leuz, 2003).

The third study was performed in 2007 by Van der Meulen et al. In their study, they compared the quality of US-GAAP and IFRS using a sample consisting of German New Market firms for the period between 1997 through 1999. They found that the quality of US-GAAP and IFRS prepared financial statements is overall very comparable, based on several earning quality attributes such as accruals quality, value relevance, persistency and timeliness. However they found US-GAAP to be significantly more persistent than IFRS (Van der Meulen et al., 2007).

Finally, the study by Ndubizu (2006) compared the differences in value relevance of earnings prepared under US-GAAP Chile with IFRS in Peru. In their research, on data from 1992 through 2000, they observed that earnings contain value-relevant information for investors in the two accounting regimes. However, US-GAAP earnings are more value relevant than the IFRS earnings. They also found that US-GAAP losses in Chile are timelier than IFRS numbers in Peru. The higher timeliness is due to higher market sensitivity to economic losses (income conservatism) in Chile than in Peru. Therefore, the Chilean US-GAAP has higher quality accounting information than the Peruvian IFRS based on value relevant and timeliness measures (Ndubizu, 2006). In the following chapter we will provide an elaboration of earnings attributes used by Francis et al. (2004). This in order to extract a suitable framework in determining the earnings quality under IFRS and US-GAAP.

5. Earnings attributes

5.1 Accounting based earnings attributes

In the literature there are multiple earnings attributes. We follow Francis et al. (2004) and describe our implementation of their earnings attribute measures below. Francis et al. (2004) are interested in constructing firm-specific measures of earnings attributes.

Accrual quality

Francis et. al. (2004) use the accrual quality measure proposed in Dechow and Dichev (2002). Discretionary current accruals in a period are expected to relate to lagged, contemporaneous and leading cash receipts and disbursements. The discretionary part of current accruals is estimated as the residual (s, j, t, ε) from the following cross-sectional regression:

ACC s,j,t = φ0,s + φ1,s CFOj,t+1 + φ2,s CFOj,t + φ3,s CFOj,t-1 + εs,j,t (1)

where ACC s,j,t is firm j's total accruals calculated as net income less cash flows from operations in year t under standard s, and CFOj,t, represents the cash flows from operations of company j in year t. All variables are divided by the firm's market value at time t.

Based on the above regressions, we define accrual quality as the standard deviation of the estimated residuals for each accounting standard, IFRS and US-GAAP. Our measure differs from Francis et al. (2004) in three respects. First, we note that the dependent variable employed in Dechow and Dichev (2002) is Working Capital or the firm's total current accruals measured as (ΔCA - ΔCL - ΔCash + ΔSTDEBT), where CA is current assets, CL is current liabilities and STDEBT is debt in current liabilities. In contrast, we use total accruals because measures of working capital are not uniformly reported under both IFRS and US- GAAP. This difference is driven, in part by the difference in accounting standards, since IFRS defines, but under IAS 1 does not require, separate listing of current assets (IASB 2008). Second, to use a uniform scalar in our analyses, we scale by total market capitalization while Francis et al. (2004) scale by the book value of total assets. Two different asset measures (IFRS and US-GAAP) exist for each of our sample firms. Third, we estimate cross-sectional regression for each accounting standard, s=IFRS, US-GAAP, whereas Francis et al. estimate a time-series regression for each firm. Parallel to Dechow and Dichev (2002), the standard deviation of the residuals from equation (1), accrual qualities σ = (ε^s,j,t) , is our measure of accrual quality for accounting standard s= IFRS, US-GAAP.

Earnings persistence and predictability

Persistence is associated with earnings quality because transitory earnings components are supposed to have been smoothed (e.g., see Penman and Zhang (2002). Our measures of earnings persistence and earnings predictability are based on the relation between current and past earnings as follows:

NIs,j,t = φo,s + φ1,s NIs,j,t-1 + vs,j,t (2)

Where NIs,j,t is firm j's net income in year t under standard s. Variables are divided by the firm's market value at time t-1.

The estimated coefficient, φ1,s measures earnings persistence. The larger (smaller) values of persistence relate the more (less) persistent earnings. The standard deviation of the residuals from the equation is interpreted as earnings predictability. Large (small) values of predictability suggest less (more) predictable earnings. Francis et. al. (2004) estimate this as a time-series regression for each firm and find firm-specific measures of earnings persistence that vary across firms in their sample.

Cash persistence and predictability

Given that both standards purport to create measures of income that better predict future cash flows, we generate measures of cash flow persistence and predictability similar to earnings persistence and predictability.

CFOs,j,t = φο,s + φ1,s CFOs,j,t-1 + φ2,s ACCs,j,t-1 + vs,j,t (3)

where CFOs,j,t is firm j's net income in year t under standard s, where s is IFRS or US- GAAP. All variables are divided by the firm's market value at time t -1.

The regression assesses the ability of accruals (under the different standards) to aid in the prediction of current cash flows, controlling for past cash flows. Similar to the earnings-based measures, the estimated coefficient, φ^1,s , represents cash flow persistence and the standard deviation of the residuals from the equation is interpreted as cash flow predictability.

Earnings smoothness

Several prior papers (including Trueman and Titman (1988) and Tucker and Zarowin (2006)) suggest that smoothness is a desirable earnings attribute. Following Leuz, Nanda, and Wysocki (2003) and Francis et al. (2004), we measure earnings smoothness relative to that of cash flow from operations. Smoothness is defined as the ratio of the standard deviation of income before extraordinary items to the standard deviation of cash flows from operations. The measure of smoothness is computed as the ratio of the standard deviation of all company's net income under either IFRS or US-GAAP divided by beginning market values over the standard deviation of all company's cash flows from operations divided by beginning market values, that is, smoothnesss = σ(NI) / σ(CFO).

5.2 Market-based earnings attributes

Timeliness and conservatism

Watts (2003a, 2003b) argues that conservatism in earnings is a desirable property. Kim and Kross (2005) suggest that increasing accounting conservatism plays a role in the greater ability of earnings to predict future cash flows. The FASB/IASB conceptual framework project report lists one of the objectives of financial reporting as meeting capital providers' interest in assessing "the entities ability to generate net cash inflows" (FASB-IASB 2008). Following Basu (1997), Pope and Walker (1999), Givoly and Hayn (2000) and Francis et. al. (2004), among others, we use the following regression to obtain measures of timeliness and conservatism.

NIs.j,t = αo,s + α1,s NEGj,t + β1,s RETj,t + β2,s NEGj,t * RETj,t + ωs,j,t (4)

where NEGj,t, is an indicator variable equal to one if RETj,t , is negative, and zero otherwise. NIs,j,t is divided by the firm's market value at time t -1.

Similar to other earnings attributes, the above equation is estimated separately for each standard, s. Larger values of timeliness (conservatism) imply more timely (conservative) earnings.


The final earnings attribute we examine is value relevance. We measure relevance as the adjusted R-squared from the following regression:

RETj,t = γo,s + γ1,s NIs,j,t + γ2,s ΔNIs,j,t + es,j,t (5)

Large (small) values of relevance suggest less (more) value relevant earnings. Levels and changes of net income, NIs,j,t and ΔNIs,j,t are scaled by the firm's market value at time the end of the prior period.

Incremental value relevance

Incremental value relevance tests consider the simultaneous effect on the income statement and on the balance sheet. Adoption of a new standard has a current year effect on the income statement and, possibly, a cumulative effect on the balance sheet. The effect on the balance sheet is the cumulative year effect from previous years as well as the cumulative prospective effect of asset revaluations, among others.

One analytical starting point for value relevance studies is the Edwards-Bell-Ohlson argument that, under clean surplus accounting, market prices are based on book value and earnings. It follows immediately that cumulative dividends are based on levels of earnings and changes in earnings relative to the previous year. This holds true for any set of accounting standards, whether US-GAAP or IFRS. However, all firms in our sample disclose two sets of earnings and book value of equity. In this setting, it is reasonable to think of investors employing a two stage heuristic. First, investors estimate market value under both US-GAAP and IFRS separately. Second, investors weigh the two value estimates according to their assessment of various metrics regarding earnings attributes. Prior studies on value relevance report regressions of stock returns on unexpected cash flows and unexpected accruals. Because of the argument in the previous paragraph, our initial value relevance tests include levels of cash flows and levels of accruals and changes of cash flows and changes of accruals..

Prior accounting studies, including Rayburn (1986), report that accounting accruals have incremental information content above and beyond cash flows from operations in the US. An accrual model provides insights beyond an (earnings) model, in that each accrual measure is incrementally informative to operating cash flows. While the earnings relevance regression can show that each earnings measure is significantly related to returns, one could not rule out the possibility that operating cash flows could be driving results. To investigate this hypothesis in our sample, we regress stock returns on both cash flows and accruals under each accounting standard:

RETj,t =γ0,s + γ1,s CFOj,t + γ2,s ΔCFOj,t +γ3,s ACCs,j,t +γ4,s ΔACCs,j,t +es,j,t (6)

where RETj,t , is firm j's 12-month return ending the month the current year's, t, Form 20-F is filed with the SEC.

Large (small) values of relevance suggest more (less) value relevant earnings. Earnings under accounting standard, s, have incremental information content over cash flows from operations under the null hypothesis that γ3,s = γ4,s= 0 .

The reconciliation difference between IFRS earnings and US-GAAP earnings can also be defined as the differences between IFRS accruals and US-GAAP accruals:

Diffj,t = NI US-GAAP, j, t - NI IFRS,j,t = ACC US-GAAP,j,t - ACC IFRS,j,t (7)

because cash flows from operations are assumed to be the same independent of the accounting standard. Estimating the following regression allows a test the null hypothesis that γ5,s = γ6,s = 0 which would imply that earnings prepared under accounting standard s have no incremental information content above and beyond earnings prepared under the other standard. These tests provide evidence of whether differences between IFRS and US-GAAP are informative.

RETj,t = γ0,s + γ1,s CFOj,t + γ2,s ΔCFOj,t + γ3,s ACCs,j,t + γ4,s ΔACCs,j,t + γ5,s Diffs,j,t + γ6,s Δdiffs,j,t + es,j,t (8)

6. Conclusion and discussion

6.1 Conclusion

The not fully convincing empirical evidence and the mixed results is the main reason for us to elaborate differences between earnings quality under IFRS and US-GAAP. It seems that IFRS is in some countries and circumstances better than local accounting regimes in the quality of accounting information. This also counts for US-GAAP, several researchers didn't find significant difference between US-GAAP and IFRS whereas other researchers stated that earnings quality under US-GAAP is significantly higher. This is based on one or several attributes (for example accrual quality, timeliness, value relevance, persistence).

Differences of earnings quality between IFRS and US-GAAP are among others related to principles-based standards (IFRS) and rules-based standards (US-GAAP). Also some differences can be explained by market-based earnings attributes (IFRS) and accounting-based attributes of earnings (US-GAAP). There are different ways to determine earnings quality but Francis et al. based their research in 2004 on market- and accounting-based attributes of earnings.

Harris and Muller (1999) state that IFRS is more value relevant than US-GAAP accounting data whereas Leuz (2003) find that IFRS and US-GAAP appear to be comparable. Van der Meulen et al. (2007) find that the quality of US-GAAP prepared financial statements and IFRS information is overall very comparable. They base this on several earnings quality attributes such as accrual quality, value relevance, persistency and timeliness. They also state US-GAAP to be significantly more persistent than IFRS. The research of Ndubizu (2006) concluded that the Chilean US-GAAP earnings has higher quality than the Peruvian IFRS earnings based on value relevance and timeliness measures. In the process of creating a framework important attributes of earnings quality have to be determined based on sound research (e.g. Soderstrom and Sun, 2007 / Francis et al. 2004). The elaboration of these frameworks provide a basis for the usage of measurable earnings attributes for future empirical research.

6.2 Discussion

Besides the different aspects of earnings, a clear view of researchers on the importance of attributes is also decisive for determining a sound theoretical framework. For this reason we think there will always be a degree of subjectivity which may lead to discussion.

There are also other aspects which can lead to discussion. When the effects of IFRS are studied across countries there raises a problem concerning omitted variables. For example, Bushman et al. (2004) state that pricing mechanisms and the information environment differ across firms and countries. There could also be differences while in some countries voluntary adoption of IFRS is possible and whereas in other countries voluntary adoption isn't possible (Aubert and Grudnitski, 2010).

Furthermore Aubert and Grudnitski expect that 'the association between the accounting numbers under IFRS and market outcomes will increase over time'. Eventually they expect that financial markets reach a comfort level in their reliance on information produced by IFRS. But in our opinion there is not a clear-cut answer on the question whether and/or when this will be realized. This offers researchers opportunities for monitoring and further research interesting research (Aubert and Grudnitski, 2010).

A recent development and contemporaneously a discussion topic is the so called convergence process of IFRS and US-GAAP. At this moment a debate is going on, which will proceed in the oncoming years. On one hand the essence of a uniform set of standards worldwide seems value-adding e.g. for enhancing comparability. On the other hand there are substantial differences in several areas which need to be lifted. This subject limits the future representativeness. Additionally the convergence process offers possibilities for fertile research which is, at this moment, out of the scope of this essay.