Examining earnings quality within the financial reporting process

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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 evidence of this interest, we point to several analyses of earnings quality, including Dechow and Schrand (2004), Scipper and Vincent (2003), and the 2002 special issue of The Accounting Review devoted to research on earnings quality. 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 annuitizing-of-value attribute with reporting a normalized, sustainable ore 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 summery for assessing firm value. Our perspective complements that taken by Dechow and Schrand in that we associate earnings quality with precise information about a construct that earnings is intended to describe. In the context of Dechow and Schrand's discussion, this construct would be permanent earnings.

In constant, Scipper and Vincent (2003) consider earnings quality both from a decision usefulness perspective, following the Financial Accounting Standards Board's (FASB) conceptual framework, and from a Hichsian 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 Scipper and Vincent discuss some of the earnings quality measures, they do not consider the capital market consequences of earnings.

Finally, the American Accounting Association conference on Quality of Earrings resulted in a special issue of The Accounting Review (2002) that contains six papers and related discussions that consider earnings quality from a balance sheet perspective, from an international perspective, from an analyst expertise perspective, and from an earnings management perspective.

Our essay complements these papers and some others by relating the quality of reported earnings under IFRS and US-GAAP. In general, the structural and organizational differences between IFRS and US-GAAP are in the literature mostly described as principle versus rule 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 another. But still important differences continue to exist between US-GAAP and IFRS.

Earnings quality under US-GAAP

The phrase ''generally accepted accounting principles'' 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)

For many decades, until the changes being wrought by the new Codification being to be felt, GAAP has been created be the promulgation of standards and interpretations by the bodies granted statutory and professional authority to make such rules. The FASB and AICPA both long adhered to rigorous due process when creating new guidance in category A and category B GAAP. The goal was and will continue to be, to involve constituents who would be affected by the newly issued guidance so that the standards created will result in information that reports economic activity as objectively as possible without attempting to influence behavior in any particular direction. Ultimately, however, the guidance is the judgment of the FASB of the AICPA, based on research, public input, and deliberation. The FASB's due process procedures are described role in the future. Due process, however, will remain as a guiding principle in the overall development of GAAP.

On July 1, 2009, the FASB Accounting Standards Codification became the single official foundation of authoritative, nongovernmental US generally accepted accounting principles (GAAP). It superseded all extant FASB, AICPA, EITF, and related literature. After this date, only one level of authoritative GAAP existed, excluding the supervision issued by the Securities and Exchange Commission (SEC). In effected, therefore, the formally five levels US-GAAP hierarchy was compressed to tow levels. The Codification did no change GAAP, but rather introduced a new structure, one that is organized into an easily accessible, under-friendly online research system. The codification reorganizes the large number of discrete US-GAAP announcements into roughly 90 accounting topics, and shows all topics using a constant structure.

Generally accepted accounting principles (GAAP) are the basis of financial accounting and represent federal financial accounting standards. GAAP is significant to US firms. GAAP is overall very broad in its techniques, as it requires being slightly valid to many different types of industries. GAAP exist as principle-based or exact technical requests. According to the fact that in many cases it is flexible and general, most businesses in the United States have to follow GAAP principles. Generally accepted accounting principles are wide-ranging but based on a small number of basic principles that must be supported by all GAAP rules, these principles are consistency, relevance, reliability, and comparability. Consistency is 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 crusial motive for the change. Relevance is the information presented in financial statements should be suitable and contribute a person evaluating the statements to do educated estimates according the future financial state of a firm. Reliability means basically that the information exist in financial statements is reliable and confirmable by an independent party. Basically a firm must approve that if an independent auditor were to base their reports of the similar information that they would come up with the same results. Moreover the generally accepted accounting principle also means that the firm is representing a clear view of what really happening with their business. Comparability is one of the most significant GAAP categories and one of the main causes having something similar to GAAP is needed. By make sure 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, as without comparability investors sould be not capable to recognize differences between firms within an industry to benchmark how a business performance is compared to its peers. Generally accepted accounting principles guarantees that all firms are on the same level playing field and that the existing information is consistent, relevant, reliable, and comparable. Even if US-GAAP is only exist in the U.S., and other countries have their own type of GAAP that are related in purpose, even if not always in design.

Previous studies that evaluate the quality of standards across regimes can roughly be divided into two groups: those comparing US-GAAP versus 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. These associations are however 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.


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]

However, the term earning 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 earning quality. [Dechow Dichev, 2002; Francis et al., 2004]. Other researchers in turn interpret the quality of earnings when earnings are persistent [e.g. Penman, 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. Other researchers 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]

Regarding the academic literature on accounting information quality, no agreed upon definition or framework for determining the quality of reported earnings exists. As a consequence, researchers determine earning quality in various ways, i.e. looking at different aspects of earning in line with their view of what are important aspects of earnings. This report tries to give a general overview on the earning quality of IFRS and US-GAAP and will cover several earning attributes which in turn may give a general view on the quality of the reported earnings. 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 earning 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 earning quality investigates one or two earning 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 earning 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 earning quality for IFRS and US-GAAP earnings.

Similarities and Differences of IFRS and US-GAAP

IFRS and US-GAAP follow similar conventions on many tax issues. Table 1 summarizes many of the key similarities and differences between IFRS and US-GAAP. Though both frameworks require a provision for deferred taxes, there are differences in the methodologies.Source: IFRS: IAS 1, IAS 12, and IFRS 3

Comparison of 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. More specifically, this approach first determines the quality of the financial information of the former standard (e.g. local GAAP). After the introduction of the new standard (e.g. US-GAAP) quality of the financial information is measured again. This approach is for instance used in the study of Jennings (2004).

In their study 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 in specific accounting situations. The research of Jennings proves that as a consequence high and low tax aligned countries will use the IFRS rules differently in specific accounting situations. Countries with high respectively low tax alignment are referred to as HIGH and LOW countries. 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]

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.

The second approach is also used in this report where the sample is based on a group of firms listed on the DJ Eurostoxx 50 as discussed in chapter two. Firms listed on the DJ Eurostoxx 50 have to comply on one hand to IFRS rules, consistent with the EU legislation. On the other hand, a large proportion of firms on the DJ Eurostoxx are listed on the US-Market as well, for which the firms have to report in compliance with US-GAAP, consistent with SEC requirements. 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 found on the comparison of US-GAAP and IFRS was done by Harris and Muller in 1999, where they investigate 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 use a sample of foreign firms, for the period 1992-1996, listed in the US that prepare their home country financial statements using IFRS and provide 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 2002 Leuz compares US-GAAP and IFRS in terms of information asymmetry and market liquidity - two key constructs in securities regulation. They use firms trading in Germany's New Market for the years 1999 and 2000. The firms must choose between IFRS and US-GAAP in preparing their financial statements, but face the same regulatory environment. Their findings do not indicate that US-GAAP is of higher quality as frequently claimed. Analyses of the dispersion of analysts' forecasts, IPO underpricing and firms' standard choices support these findings. Thus, at least for New Market firms and based on the researchers' quality valuation model, IFRS and US-GAAP appear to be comparable. [Leuz, 2002]

The third study was performed in 2006 by Van der Meulen et al. In their study, they compare the quality of US-GAAP and IFRS using a sample consisting of German new market firms for the period between 1997 through 1999. They find that the quality of US-GAAP prepared financial statements and IFRS information is overall very comparable, based on several earning quality attributes such as accrual quality, value relevance, persistency and timeliness. They found US-GAAP to be significantly more persistent than IFRS. [Van der Meulen et al., 2006]

Finally, the study by Ndubizu (2006) compares 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 on they observe 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 find 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]