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Trading Volume Reaction to the Earnings Reconciliation from IAS to U.S. GAAP
Lucy Huajing Chen and Heibatollah Sami
Trading Volume Reaction to the Earnings Reconciliation from IAS to U.S. GAAP
Lucy Huajing Chen and Heibatollah Sami
Executive Summary
We examine the short-term trading volume reactions to the earnings reconciliation from international accounting standards (IAS) to U.S. generally accepted accounting standards (GAAP) for foreign cross-listed firms in the United States. Our paper is motivated by the increased listing in the United States over the past decade and the current policy debate over the earnings reconciliation requirement. As of December 31, 2005, there were 1,236 foreign companies from 53 countries registered with the U.S. Securities and Exchange Commission (SEC). A foreign registrant is required to file a Form 20-F, analogous to a Form 10-K, within six months after the fiscal year end. In a Form 20-F, a foreign registrant can choose either IAS or foreign GAAP as its primary reporting standard and reconcile its earnings and shareholders’ equity to U.S. GAAP under item 17 or 18.
On the one hand, the current SEC requirements for reconciliation ensure that financial statements prepared by foreign issuers are comparable to those of domestic issuers and sufficiently transparent for investors to make informed decisions. On the other hand, the U.S. SEC is considering allowing foreign firms to report financial statements under IAS without further reconciliation to U.S. GAAP to facilitate cross-boarder listings. The Financial Accounting Standards Board (FASB) has worked closely with the International Accounting Standards Board (IASB) over several short-term and long-term projects toward convergence between two sets of standards since the Norwalk Agreement in October 2002. The Norwalk Agreement evolved from IASB’s and FASB’s long-term continuous commitment toward convergence of global accounting standards. Under the Norwalk Agreement, both parties agreed on the need for a set of common, high-quality accounting standards. Specifically, both IASB and FASB would (a) take on a short-term project to remove some differences between U.S. GAAP and international financial reporting standards (IFRS); (b) eliminate any differences remaining on January 1, 2005 through the cooperation on their future projects; (c) continue the joint projects currently undertaken; and (d) encourage their members to coordinate their activities.
In a speech in 2004, the SEC chief accountant, Donald T. Nicolaisen, was optimistic that the SEC would be able to remove current reconciliation requirements. However, Mr. Nicolaisen noticed that the timing of eliminating reconciliation depends on the IASB’s continuous commitment to high-quality accounting standards. Subsequently, the SEC announced in April 2007 that it would solicit comments on abolishing the reconciliation requirement by 2009 for foreign companies that are listed in the United States and use the IFRS to file financial statements. The SEC also went further to consider allowing U.S. domestic firms to choose between IFRS and U.S. GAAP in the future. Our research results provide timely input into this process by the SEC.
The empirical evidence on whether earnings reconciliation from IAS to United States GAAP for foreign firms listed in the U.S. provides useful information is indirect and mixed, most of which is based on the price or return analysis. A variety of prior research has focused on either the value-relevance of reconciliation information of earnings and book value from foreign GAAP to U.S. GAAP in the U.S. markets, or the comparison of IAS and U.S. GAAP in foreign capital markets. On the other hand, some researchers have directly investigated the market valuation of earnings and book value under IAS versus U.S. GAAP for cross-listed firms in the United States. Their results indicate that U.S. GAAP earnings reconciliation numbers are significantly value-relevant for the market-value model and the annual return model, but not so for the price-per-share model. Moreover, they do not find evidence that book value reconciliation is significantly associated with market value. Overall, prior price–return studies yield limited results on the value-relevance of accounting information prepared under U.S. GAAP compared with that prepared under other accounting standards, especially IAS.
In contrast to prior studies, we focus on the short-term trading volume response to the earnings reconciliation from IAS to United States GAAP for cross-listed firms in the U.S. Unlike price reaction, trading volume reaction is due to individual investors’ disagreements about future prices. Consequently, when investigating information content, price reaction and trading volume reaction may not yield identical results, even for the same event. Moreover, the volume-based response is more powerful than the price-based one in the event study, especially when the sample size is small. On the basis of these discussions, we believe that a trading volume study is more appropriate in our context, where the number of foreign firms using IAS is limited and the investors, on the basis of their prior expectations, may interpret the earnings reconciliation differently.
Our study contributes to the current literature in four ways. First, to the best of our knowledge, this paper provides the first empirical evidence on the trading volume reaction to earnings reconciliation from IAS to U.S. GAAP. Second, our short-term window study directly assesses the SEC’s concern about incremental information content rather than just the association as in the long-term studies. Third, we extend prior research to more recent years, from 1995 to 2004. The International Accounting Standards Committee’s (IASC’s) Comparability Project was implemented in 1995, the Core Standards Project was completed in 1998, and the IASB replaced the IASC in 2001. Thus, our sample should reflect the assessments of new international accounting standards, which are more relevant to the current SEC concern. Lastly, our paper supplements the line of trading volume research by studying the factors associated with Form 20-F instead of Form 10-K or Form 10-Q.
Our sample consists of non-U.S. firms that use IAS as their primary reporting standards and reconcile to United States, GAAP in either Form 20-Fs or annual reports, whichever are issued earlier. The results show that the earnings reconciliation adjustment is significantly and positively associated with the abnormal trading volume in the U.S. in a two-day event window. Also, we find limited evidence that book value reconciliation adjustment is significantly and positively associated with the same abnormal volume. In addition, the above results hold for various measures of abnormal trading volume and after the Core Standards Project in 1998. Moreover, the results are similar when various event windows are employed and are qualitatively the same across the choice of different volume metrics. Finally, our results are consistently stronger when we include in our models either earnings or book value reconciliation alone. Taken together, the results provide some evidence of whether the earnings reconciliation from IAS to U.S. GAAP provides useful information to U.S. market participants.
In some cases, it may be cheaper for U.S. investors to trade in the home country markets. Also, investors in the home country may use the reconciliation information in their trading decisions. To accommodate such possibilities, we investigate the trading volume reaction to the same information in the local markets. We find that both earnings and book value reconciliations are marginally associated with abnormal volume in the same two-day window. More importantly, the reaction is stronger when we expand the windows to three-day, five-day, and seven-day. The results after core standards and for different volume metrics exhibit a similarly stronger reaction for longer windows. Finally, our results are consistently stronger when we include in our models either earnings or book value reconciliation alone. Overall, these results suggest investors trading in the local markets react less intensively and somewhat slower than investors trading in U.S. markets.