Earnings Quality under Rules- vs.

Principles-Based Accounting Standards: A Test of the Skinner Hypothesis

Erin Webster Daniel B. Thornton webstere@post.queensu.ca dbt@qsilver.queensu.ca Phone: (613) 533-6000 x 75461 Phone: (613) 533-6194 Queens University School of Business Kingston, Canada K7L 3N6

June 2004 The authors gratefully acknowledge financial support from the Social Sciences and Humanities Research Council of Canada (Grant No. 410-03-1046) and the Canadian Accounting Standards Board. They also appreciate receiving constructive suggestions and comments on previous versions of the paper from Duncan Green, Peter Martin, Katherine Schipper, Michael Welker, and participants at the 2004 CAAA Conference. Thanks for technical advice go to Richard Caruana, Carol Kavanaugh, Juergen Dingel, Jon Wittmer, and Anna Harhay.

Earnings Quality under Rules- vs. Principles-Based Accounting Standards: A Test of the Skinner Hypothesis

Abstract
We provide preliminary confirmation of Skinners (1995) hypothesis that Canadas relatively principles-based GAAP yield higher accrual quality than the USs relatively rules-based GAAP. These results stem from a comparison of the Dechow-Dichev (2002) measure of accrual quality for cross-listed Canadian firms reporting under both Canadian and US GAAP. However, we document lower accrual quality for Canadian firms reporting under US GAAP than for US firms, which are subject to stronger US oversight and greater litigation risk, reporting under US GAAP. The latter results are consistent with stronger US oversight compensating for inferior accrual quality associated with rules-based GAAP. Consistent with the positive effect of Canadas principles-based GAAP and the offsetting negative effect of Canadas weaker oversight, we find no overall difference in accrual quality between Canadian firms reporting under Canadian GAAP and US firms reporting under US GAAP. Consistent with Skinners writings, the results imply that it fallacious to attribute perceived deficiencies in Canadian financial reporting to the leeway allowed by principles-based GAAP without allowing for Canadas oversight, which is relatively weak due largely to the absence of a national securities regulator. If anything, over our 1990-2002 sample period, principles-based standards and the consequent role of professional judgment enhance the quality Canadian firms financial reporting.

Keywords: accounting standards; earnings quality; accrual quality; principles-based GAAP; rules-based GAAP. Data availability: The data used in this study are publicly available from the sources indicated. A list of sample firms is available from the authors.

I.

INTRODUCTION

We hypothesize and find that accrual quality, defined as the precision of firms working capital accruals mapping into past and future cash flows (Dechow and Dichev, 2002) depends jointly on a jurisdictions generally accepted accounting principles (a GAAP effect) and its regulatory/legal environment (an oversight effect). To test these hypotheses, we examine the accrual quality of firms in two jurisdictions, Canada and the United States, which differ along both dimensions. In our test of the GAAP effect, we confirm the Skinner hypothesis (Skinner, 1995) that Canadas relatively principles-based GAAP yield higher accrual quality than the United States relatively rules-based GAAP by examining accrual quality for a sample of Canadian firms cross-listed in the US. Cross-listed firms report under both Canadian and US GAAP (Bandyopadhyay et al., 1994, 2002). Hence, we can measure accrual quality under both GAAP for the same firms, holding the oversight effect constant. We then compare the accrual quality of what we call CC firms (Canadian firms reporting under Canadian GAAP) with that of CU firms (the same Canadian firms reporting under US GAAP). We hypothesize and find that CC firms have higher accrual quality than CU firms. In our test of the oversight effect, we confirm the hypothesis that the USs stronger oversight is associated with higher accrual quality than Canadas weaker oversight. To test this hypothesis, we attempt to hold the GAAP effect constant by comparing the accrual quality of a sample of CU firms (Canadian firms reporting under US GAAP but subject to Canadian oversight) with that of an industry/size-matched sample of what we call UU firms (US firms reporting under US GAAP and subject to

2 US oversight). We hypothesize and find that CU firms have lower accrual quality than UU firms. We also compare the accrual quality of larger samples of CC firms with that of industry/size-matched samples of UU firms. Since the GAAP effect and the oversight effect offset each other, we state and fail to reject the null hypothesis that there are no significant differences in accrual quality across any of these samples. These findings confirm our overall hypothesis that accrual quality depends jointly on the GAAP effect and the oversight effect and suggest that US oversight compensates for any shortcomings in US GAAP with respect to accrual quality. They also support the assertions that (a) policy makers who wish to compare the effectiveness of oversight across jurisdictions must control for the GAAP effect; and (b) accounting standard setters who wish to compare the effectiveness of principles- vs. rules-based GAAP must control for oversight. The article continues as follows. The next section reviews prior research motivating the study and underscores its contributions to the literature. Remaining sections develop the hypotheses, describe the research design, outline sample selection, and present empirical results. We conclude with a summary of the findings and suggestions for future research.

II. LITERATURE REVIEW AND MOTIVATION FOR THE STUDY

Skinner (1995) takes issue with a newspaper allegation that principles-based accounting standards provide Canadian accountants with undue leeway, resulting in misleading financial reporting:
The complaint, then, is that those responsible for financial reporting are playing games with the rules or they are not applying proper judgment

3
when there is room for judgment. The solution proposed by The Financial Post is to take away that room. But is there really a problem? Is it as simple as biased judgment? And if it is, will the proposed solution work? Hard evidence is lacking to answer these questions (Skinner, 1995: 14)

Our aim is to provide such evidence by comparing the accrual quality of Canadian companies reporting under a relatively principles-based accounting regime with that of US companies reporting under a more rules-based accounting regime. We focus on observations prior to the Enron debacle of 2002 for two reasons. First, the theory of accrual quality we rely on requires consistent time series data and there are reasons to believe that the financial reporting environments changed radically in both countries after Enron. Second, the pre-Enron environment is the one Skinner contemplated, so the data in that period are appropriate for testing the Skinner hypothesis.

The Skinner Hypothesis

Skinner (1995), like Brown et al. (1993), motivates our study by arguing that financial reporting benefits from well-trained, ethical accountants applying sound professional judgment under principles-based GAAP:
The proposition that standards should be written to cover every possible reporting issue or combination of issues stems from a belief that professional judgment on presentation is not now being exercised fairly. But any such multiplication of rules will fail first, because it is not feasible to write rules covering every possible issue, and second, because the greater the number of detailed rules (downgrading the overall goal of fair presentation), the greater will be the ability of those so minded to dance among the rules drawing support for biased reporting conclusions (Skinner, 1995: 21).

Further motivation for the study comes from the US Sarbanes-Oxley Act of 2002, which requires an investigation the pros and cons of a principles-based accounting system. In response, FASB (2002) issued a document outlining the features of a principles-based approach to standard setting. More recently, the SEC (2003) released a staff study advocating principles-based standards that are objective-oriented and avoid scope

4 exceptions, bright-line but arbitrary distinctions, and excessive detail. Neither of those studies, however, provides any empirical evidence in favor of one system or the other or even considers how policy makers could glean such evidence. We argue below that the existing literature supports Skinners proposition that, all else being equal, sound professional judgment exercised in the context of principlesbased GAAP enhances financial reporting quality. To date, however, three factors have clouded the issues surrounding principles- vs. rules-based GAAP and precluded empirical testing. First, critics of Canadas principles-based GAAP almost invariably cite isolated, extreme examples of misleading financial reporting in Canada while ignoring similar US reporting failures (Standing Senate Committee, 2003, especially the testimony of L.S. Rosen). Thus, which country has higher reporting quality on average is an open issue. Second, only recently has an accepted empirical measure of accrual quality, an aspect of financial reporting quality, appeared in the academic literature (Dechow and Dichev, 2002). Finally, as far as we know, ours is the first study to employ a research design that not only uses this new measure but also controls for institutional features other than GAAP that are likely to spawn differences in accrual quality across jurisdictions. Without controlling for non-GAAP factors, one cannot test the Skinner hypothesis. In our test of the Skinner hypothesis, we perfectly control for non-GAAP factors, which compose the oversight effect, by comparing the accrual quality of CC vs. CU firms. To test the impact of oversight strength on accrual quality, we imperfectly control for the GAAP factor by using a quasi-experimental research design: We compare the accrual quality of CU firms with an industry/size-matched sample of UU firms.

Prior literature
Several definitions of earnings quality appear in extant literature: high quality earnings are persistent, accurately represent underlying economic transactions and events, or map precisely into future cash flows (McNichols, 2002; Francis et al., 2004). The Dechow-Dichev (2002, henceforth DD) model of accrual quality measures the extent to which accruals map into cash flow realizations. Lower estimation error implies higher accrual quality. DD derive the following expression for accruals at time t:
At = CFt t1 (CFt t +1 + CFt t 1 ) + CFt t+1 + tt+1 tt 1

(1)

where: At = current accruals recognized in period t.

CFts = cash from operations realized in period t, recognized in earnings in period s.

ts

= estimation error associated with accruals recognized in period s and cash flows realized in period t.

Their empirical version of this equation is: WCt = b0 + b1 CFOt-1 + b2 CFOt + b3 CFOt+1 + t The DD measure of accruals is changes in working capital (WC); the proxy for cash flows related to accruals is cash flow from operations (CFO). DD use the standard deviation of the residuals as a measure accrual quality, higher standard deviation implying lower accrual quality. This is consistent with accrual quality defined as the precision of accruals mapping into cash flow realizations. DD find that certain firm characteristics including length of operating cycle, volatility of sales and cash flow, and firm size contribute to differences in accrual quality across firms. One must therefore control for these firm-specific factors when examining (2)

6 differences in accrual quality for firms in different accounting regimes such as Canada and the US. To isolate accrual quality differences resulting from the use of Canadian vs. US GAAP, we use the same set of firm-year observations for cross-listed Canadian firms reporting under both types of GAAP. Thus, we match firm characteristics perfectly by construction in our CC vs. CU comparisons. In our CU vs. UU comparisons, we control for firm-specific factors by matching firms by industry and size.

III. HYPOTHESIS DEVELOPMENT

We hypothesize that differences between the accrual qualities of firms in any two regimes, such as the US and Canadian regimes, depend jointly on a GAAP factor and an oversight factor, which comprises several aspects of countries legal/regulatory environments. In the first part of this section, we argue that Canadian GAAP is more principles based than US GAAP and hypothesize that this GAAP factor results in higher accrual quality in Canada. In the second part, we argue that US oversight is stronger than Canadian oversight and hypothesize that this oversight factor results in higher accrual quality in the US. In Section IV, we describe in more detail our experimental design, which disentangles the effects of the GAAP factor and the oversight factor.

GAAP Hypothesis
Both anecdotal and empirical evidence suggest that Canadas accounting standards are more principles-based, whereas US standards are more rules-based. Key contributors to this difference in orientation are the relatively litigious US environment (Pacini et al., 2000; SEC, 2003) and accounting practitioners consequent demands for standards that they can apply mechanically to avoid lawsuits (Nelson et al., 2002). US auditors mitigate their liability by complying with detailed rules, clearly violated or not,

7 rather than applying standards that provide less detailed guidance but better reflect the substance of a transaction if applied conscientiously. The SEC staff study admits that rules-based standards can result in financial reporting that is not representationally faithful to the underlying economic substance of transactions and events (SEC, 2003, p. 5). In a legal context, Kaplow (1992) sees the sole distinction between rules and standards as the extent to which efforts to give content to the law are undertaken before or after individuals act. A rule gives content to the law ex ante; a standard gives content to the law ex post. A rule specifies permissible conduct, leaving only factual issues to professional judgment: e.g., The speed limit is 60 km/h. In contrast, a standard often specifies permissible conduct but leaves factual issues to be judged according to casespecific circumstances; e.g., Do not drive at an excessive speed, where excessive is not specified by the standard ex ante. That rules are necessarily more detailed than standards is a common misconception. The SEC staff study espouses this view as it advocates a moderate level of detail in principles-based, objectives-oriented standards:
if constructed with the optimal level of detail, such standards would provide users, as well as regulators and others who oversee or monitor the financial reporting process, with sufficient detail to better comprehend and properly gauge the results reported by management and attested to by the auditors (SEC, 2003, p. 6).

According to Kaplow, the degree of detail does not distinguish a rule from a standard; there can be simple rules and complex standards. Kaplows distinction between rules and standards implies a role for professional judgment and is clearly germane to the principles-vs.-rules debate in accounting. The SEC staff study, consistent with Brown et al. (1993), recognizes that a rules-based approach intentionally minimizes (even trivializes) accounting judgment by establishing

8 complicated, finely articulated rules that attempt to anticipate all possible application challenges. The study finds this approach problematic because standard setters cannot foresee all business situations requiring the application of accounting standards and detailed rules fail to take advantage of the company-specific knowledge of management, accountants, and auditors. Consistent with the SEC analysis, Kaplow concludes that standards are generally preferable to rules in complex environments since rules are either over- or underinclusive, limiting the range of permissible considerations, while standards allow for adjudicating what is permissible after action occurs. Standards are more costly to apply than rules because professionals need to interpret standards. Rules-based standards are more costly to create and cheaper to apply. Overall, however, Kaplow, like Skinner (1995) and Brown et al. (1993), posits that generally, the hard-to-quantify benefits of standards outweigh their higher application costs. In an accounting context, since users know the financial reporting effects of rulesbased standards ex ante, rules-based standards are subject to opportunistic use by management (Nelson et al., 2002). To the extent that accountants apply their professional judgment effectively, principles-based standards are superior to rules-based standards in situations where accountants cannot anticipate managerial opportunism, such as typical earnings management situations where principles allow for the ex post application of standards intended effect. Evidence that Canadas accounting is relatively principles based compared with US accounting comes from an examination of the CICA Assurance Handbook and the CICA Accounting Handbook, which are much less prescriptive than US AICPA assurance guidance and FASB accounting guidance. We identified 134 uses of the term

9 professional judgment in the current CICA Assurance Handbook. Among the more important ones are
5400.15 In forming his or her opinion whether the financial statements are presented fairly, in all material respects, in accordance with generally accepted accounting principles, the auditor should exercise professional judgment as to the appropriateness of the selection and application of principles to the particular circumstances of an entity and as to the overall effect on the financial statements of separate decisions made in their preparation.

and
5130.06: A materiality decision ultimately becomes a matter for the auditor's professional judgment. Materiality is not a fine line where one dollar less is not material or one dollar more is material. It represents a grey area between what is very likely not material and what is very likely material.

Both of these passages enjoin Canadian accountants to stand back and assess whether financial statement assertions faithfully reflect the substance of transactions and events affecting the entity. Similarly, in describing representational faithfulness the CICA Accounting Handbooks introductory section, Financial Statement Concepts, states
1000.21 The determination of the substance of a transaction or event will be a matter of professional judgment in the circumstances

The CICA, which set Canadian Accounting Standards until the Canadian Accounting Standards Board became independent in 2001, published both Gibbins and Masons (1988) Professional Judgment in Financial Reporting and a later staff study (CICA, 1995), Professional Judgment and the Auditor. Both studies stress the importance, in practice, of applying sound professional judgment in the context of principles-based standards. Reinforcing this ethos, Canadian auditors qualify only after passing a national Uniform Final Examination stressing the application of judgment and diagnostic skills in realistic case situations. The Canadian CA profession then requires an articling (apprenticeship) term before admission to membership and auditor certification. The apprenticeship term aims to develop auditors professional judgment in applying

10 accounting standards. In contrast, American CPA certification does not require accountants to meet uniform national entrance standards and the admissions examination is multiple-choice based. Some states have apprenticeship requirements of varying lengths; others have none. The requirement of CAs to article with a public accounting firm, which is not a consistent requirement for qualification of a CPA in the US, contributes significantly to auditor performance. Ferguson et al. (2000) find that audit students with articling experience outperform those with formal education alone in an experimental setting. More recently, Gibbins et al. (2004) find that chief financial officers (CFOs) exert less influence on their auditors in Canadas more principles-based environment than in the more rules-based US environment. Some key results of this study are as follows:
American and Canadian CFOs have different mindsets. American CFOs feel their auditors must show them rules saying why they can't use the accounting methods they prefer to use. CFOs of domestic Canadian companies feel the shoe is on the other foot: They think the onus is on them to justify their company's accounting to the auditor. CFOs of cross-listed Canadian firms are in the middle (Thornton, 2003).

Although both rules-based and principles-based standards have certain advantages in various contexts (SEC, 2003), we argue that on balance, the literature supports Skinners hypothesis that principles-based standards, properly applied by ethical accountants exercising sound professional judgment in Canada, produces higher accrual quality than rules-based standards applied by US CPAs. Thus, our first hypothesis, stated in alternative form, is H1a: All else being equal, accrual quality is higher under Canadian GAAP than US GAAP.

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Oversight hypothesis
Canada lacks what virtually every other industrialized nation possessesa national regulator of publicly traded companies (Brown, 2002). The Ontario Securities Commission, the largest and most active provincial securities commission, regulates Canadas largest securities exchange, the Toronto Stock Exchange (TSX). However, since each Canadian province has its own securities commission, reforms related to audit practice, corporate governance, and regulation of public company disclosures are difficult to harmonize and enforce nationwide because of lack of resources and inconsistent legal requirements. Thus, regulatory oversight of securities exchanges and firms that trade on those exchanges is much stronger in the US than in Canada. Thornton (2002) describes the SECs pervasive involvement in accounting issues, its proactive investigation of security market violations by its Division of Corporation Finance, and its continual challenging of registrants accounting and disclosure practices under its Full Disclosure program, which provides real-time feedback and restatement requirements to registrants. Unlike the Canadian provincial securities commissions, the SEC has long mandated that firms provide a Management Discussion and Analysis (MD&A) in their regulatory filings. The MD&A disciplines financial reporting by ensuring that senior managers review and interpret the numbers on financial statements in terms of company policy. During our sample period, MD&A requirements in Canada were virtually absent. For all of these reasons, Thornton (2002) concludes that US GAAP cannot be imported like US beef into Canada without the much stronger regulatory infrastructure in the US. The legal environments in Canada and the US differ substantially. Shareholders propensity to sue for financial statement misrepresentation exerts pressure on both

12 corporate managers and auditors to exercise care in making accruals, thereby limiting likely litigation losses stemming from allegations of misstated income or net assets. US securities laws and judicial interpretations create a far more litigious environment in the US than that in Canada (Baginski et al., 2002). Pacini et al. (2000) find that the scope of auditors liability to non-clients has been narrowing in both countries over the last decade. However, the US continues to have a far more litigious environment than Canada. Holding the GAAP factor constant, we argue that both stronger regulatory scrutiny and greater litigiousness induce managers and auditors to make higher quality accruals in the US compared with Canada. Thus, our second hypothesis, stated in alternate form is: H2a: All else being equal, Canadian oversight is associated with lower accrual quality than US oversight. We stress the importance of holding the GAAP factor constant in this hypothesis. We expect that under either rules- or principles-based GAAP, stronger oversight and the higher probability of litigation provide incentives for both company accountants and public accountants to make higher quality accruals. We can test the hypothesis that stronger oversight enhances accrual quality by comparing the accrual quality of CU firms with a matched sample of UU firms. To the extent that principles-based GAAP results in higher accrual quality than rules-based GAAP (H1), we hypothesize that the combination of Canadas principles-based GAAP and US oversight provides the highest accrual quality of all. Unfortunately, however, owing to the absence of UC firms (US companies reporting under Canadian GAAP), we are unable to test this hypothesis.

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Measurement and decomposition of Canada/US accrual quality differences

We measure the GAAP effect as the difference between the accrual quality for cross-listed Canadian firms reporting under Canadian GAAP (CC firms) with the accrual quality of the same firms reporting under US GAAP (CU firms): GAAP effect = CC accrual quality CU accrual quality Hypothesis H1a is that the GAAP effect is positive. We measure the oversight effect as the difference between the accrual quality of cross-listed Canadian firms reporting under US GAAP (CU firms) and the accrual quality of industry/size-matched samples of UU firms: Oversight effect = CU accrual quality UU accrual quality Hypothesis H2a is that the oversight effect is negative. Finally, we measure the total regime effect as Regime effect = GAAP effect + oversight effect = CC Accrual quality UU accrual quality Since we hypothesize that the GAAP and oversight effects have opposite signs, we state a third, regime hypothesis in null form: H30: There is no difference between the accrual quality of Canadian firms reporting under Canadian GAAP and the accrual quality of industry/sizematched samples of US firms reporting under US GAAP.

IV. RESEARCH DESIGN

Sample selection
Panel A of Table 1 summarizes sample selection. Canadian sample firms come from the 1990-2002 Compustat files. We identify those listed only in Canada and those

14 that cross-list. The Canadian sample is significantly smaller than the US sample. Starting with all firms listed on the Toronto Stock Exchange (TSX), we pare the sample to firms with complete data for assets, earnings, cash flow from operations (CFO), changes in accounts receivable, and changes in inventory. Consistent with DD, the last two requirements ensure sample firms have significant working capital accruals. We use CFO as reported in the Statement of Cash Flows rather than a balance sheet derivation of operating cash flow, consistent with Collins and Hribars (2002) recommendation. Requiring at least one year of past and future cash flows and earnings yields a sample of 646 Canadian firms and 5,180 firm-years. To estimate firm-specific regressions, we need at least six years of data. This requirement reduces the sample to 947 firm-year observations for 127 firms. Of these Canadian firms, nearly half are cross-listed on one of three major US exchanges: NYSE, AMEX, or NASDAQ.

Control Sample
To control for firm-specific characteristics such as size and industry volatility in comparing CU with UU firms, we assemble a matched control sample of US firms. DD predict and find that accrual quality varies systematically with firm characteristics such as volatility of operations or the length of operating cycle. Thus, we attempt to minimize firm-specific differences between the Canadian and US samples, so that we can infer that any difference between the total regime effect and the GAAP effect is due to the oversight effect and not idiosyncratic differences at the firm level. Panel B of Table 1 lists Canadian firms grouped by industry and summarizes results of matching US firms as closely as possible to the Canadian firms based on total operating revenue and SIC code. Panel C summarizes the construction of the CC/CU

15 subsamples: we eliminate from these subsamples 10 firms (most of whom made initial public offerings in the US during the sample period) lacking sufficient US GAAP timeseries data.

V. RESULTS
Data and descriptive statistics
Variables of interest are consistent with those identified by DD. Cash flow from operations is Compustat item 308. The change in working capital from year t1 to t (WC) is computed as CFO = AR + Inventory AP TP + Other Assets (net), where AR is accounts receivable, AP is accounts payable, and TP is taxes payable. Earnings after short-term accruals but before long-term accruals (Earn) is calculated as Earn = CFO + WC. Earnings is reported as Compustat item 123, Earnings before extraordinary items as reported on the cash flow statement. All variables are scaled by average total assets. Table 2 provides descriptive statistics and correlations for both the Canadian and US control samples. Descriptive information for variables of interest in Panel A is consistent with that reported by DD. Total accruals are negative, mainly due to depreciation, while working capital accruals are positive as scaled current earnings exceeds scaled cash flow from operations for both countries by 0.011. Mean earnings before extraordinary items is negative for both countries, whereas DD report a positive mean. This difference is likely due to the different sample periods. DDs sample was from 1987 to 1999 whereas our sample of 1990 to 2001 includes the post 9-11 period and recent economic downturn. In addition, our mean earnings is negative but median earnings is positive, indicating a few large losses are skewing the

16 mean downwards. Descriptive statistics are similar for Canadian firms and their US matched firms, but Canadian firms are larger and less profitable. Pearson correlations provided in Panel B of Table 2 are also consistent with results reported by DD and with previous research. The correlation between Earn and CFO is significantly positive, and is slightly larger here than DDs 0.73. Also consistent with previous research is the positive correlation between Earn and WC, which is much higher for the US (0.88) than the Canadian sample (0.25). DD report a correlation of 0.33 for these variables, closer to our Canadian sample estimate. The correlation between CFO and WC is negative for our Canadian sample, consistent with DDs finding, yet is significantly positive for our US control sample. Also consistent with DDs previous findings is the statistically insignificant correlation between WC and CFOt+1. DD explain that the insignificant correlation between WC and CFOt+1, also found in our Canadian sample, results from the negative correlation between WCt and CFOt in concert with the positive correlation between CFOt and CFOt+1 , which effectively counteracts the expected positive relation between WC and CFOt+1. It is therefore reasonable that the US sample, with its positive correlation between WCt and CFOt (0.59), also has a statistically significant correlation between WC and CFOt+1.

Regression Analysis
Table 3 presents results of regressions of working capital accruals on past, present, and future cash flows from operations. Panels A, B, and C summarize firm-level regressions for all Canadian firms and the US firm control sample. We further partition the sample into a set of firms that trade only domestically on the TSX and a set of firms that cross-list on both the TSX and US exchanges. We use firm-level regressions to estimate sresid, the standard deviations of residuals from the DD model.

17 Results of firm-specific regressions are consistent with DD. Current changes in working capital are negatively associated with current cash flow from operations (mean regression coefficient 0.36) but positively related to past (0.19) and future (0.20) cash flow from operations. All mean regression coefficients differ significantly from zero. Coefficients on both the Canadian sample and the US control sample exceed those reported by DD. Mean (median) adjusted R2s of 0.36 (0.50) for the Canadian sample are lower than those DD found but still provide reasonable explanatory power. The US control sample has higher adjusted R2s, lower positive coefficients on the future cash flow variable and larger negative coefficients on current cash flow. Results in Panels B and C show that the models explanatory power is higher for domestically traded Canadian firms (adjusted R2 of 0.46) than cross-listed firms (adjusted R2 of 0.25). All coefficients in the partitioned sample are statistically significant except that of future cash flow from operations for the US control sample matched to domestic Canadian firms. Coefficients on the US firm-level regressions are comparable to those obtained from firm-level regressions on Canadian firms. Table 4 gives descriptive statistics for the standard deviation of the residuals from firm-level regressions of the DD model. A factor that could affect the results is that the SEC periodically reviews Canadian cross-listed firms filings, although with less zeal than it reviews US firms filings. Possibly, then, Canadian cross-listers are subject to some degree of US oversight. Our experimental design perfectly isolates the GAAP effect because our CC vs. CU comparison involves comparing accrual quality for the same set of firms under the two sets of GAAP. Thus, our test of the Skinner hypothesis is immune from this possibility. However, it could affect the interpretation of our comparison of accrual quality for CU vs. UU firms. If CU firms are subject to Canadian

18 oversight, any difference between CU accrual quality and UU accrual quality is due to stronger US oversight. If CU firms are subject to some degree of US oversight, however, the difference is difficult to interpret. To test for this possibility, in Panel A we compare the accrual quality of Canada-only listers (CC for pure Canadian firms) with that of Canadian cross listers (CC for cross listers) and find no differences for: (a) the full sample of 127 CC firms vs. 62 cross listed CC firms; (b) the full sample of 127 CC firms vs. 49 cross listed CC firms that have sufficient time series data to compute accrual quality under US GAAP; and (c) the 65 Canada-only listed CC firms vs. 49 cross listed CC firms that have sufficient time series data to compute accrual quality under US GAAP. These tests enhance our confidence that Canadian firms are subject to Canadian oversight whether they list in the US or not. Thus, we attribute any difference in CU accrual quality and UU accrual quality to the oversight effect.

Preliminary hypothesis tests

Panel B of Table 4 reports sresid for the subsample of Canadian firms reporting under both Canadian and US GAAP. Consistent with H1a, we find that the mean sresid for CC firms (.026) is significantly lower than the mean sresid for CU firms (.051). In the same panel, we report the mean sresid for the same 49 Canadian firms under US GAAP (CU firms) with the mean sresid of the industry/size-matched sample of US firms (UU firms). Consistent with H2a, we find that the mean sresid for UU firms (.029) is significantly lower than the mean sresid for CU firms (.051). Both differences are statistically significant at the .05 level. Panel C suggests that UU firms have slightly smaller mean sresid than CC firms. However, the difference is not statistically significant. These insignificant results hold for

19 the full Canadian sample of 127 firms, for the Canadian sample of 65 TSX-listed firms, and for the Canadian sample of 62 firms cross-listed on US exchanges. Thus, we fail to reject H30. Although the results of the above tests are all consistent with our hypotheses, we extend the analysis by performing (1) paired t-tests and (2) tests for differences between the two groups of sresid. The latter tests employ the normally distributed statistic, where a is sresid for Canadian firms and b is sresid for US firms. Under the null hypothesis of no difference in sresid, the mean of this statistic is 0.5.
a , a+b

H1a (GAAP Effect)

Panel A of Table 5 gives the results of the above two tests for the 49 CC firms that had sufficient US-GAAP time-series data and the same firms reporting under US GAAP (CU firms). Consistent with H1a, results of both tests are significant (p = .021 and p = .008 for tests 1 and 2, respectively), implying that CC accrual quality is higher than CU accrual quality. We note that three additional Canadian firms have sufficient CU data to perform these tests; however, they have extremely high sresid for the US GAAP data, so we exclude them from tests in both Table 4 and Table 5. When we include the three outliers, test results are even more significant.

H2a (Oversight Effect)

Panel B of Table 5 compares CU firms with the industry/sized-matched sample of UU firms. Consistent with H2a, the two-sample paired t-test yields significant results (p = .046), implying that CU accrual quality is lower than UU accrual quality. The second test, which utilizes the novel statistic,
a , fails to support H2a. Thus, CU vs. UU results of a+b

20 the first test, while significant on balance, are less so than those of CC vs. CU; results of the second test are insignificant. The relative weakness of the H2 results likely stems, in part at least, from the imperfect matching of CU vs. UU firms compared with the perfect matching of CC vs. CU firms.

H30 (Regime effect)

Results for the regime effect appear in Table 6. Both tests fail to find significant results for accrual quality differences for CC and UU firms. To ensure that our failure to reject the null is not due to outliers, we repeat our tests for the full sample after excluding 25 firm-pairs (the top 15% of the sample) where sresid is above 0.06. Still we find no significant difference, with a t-statistic of 0.73. We repeat the paired t-test for matches with at least 10 years of data for Canadian firms, and again with at least 7 years of data. In both cases, we find no significant differences in accrual quality between CC and UU. Thus, none of our tests reject H30.

Summary of results
In summary, we find a significantly higher accrual quality for CC than CU firms. Thus, consistent with H1a, the GAAP effect (CC CU) is positive, favoring Canadas principles-based GAAP over the US rules-based GAAP. For the most appropriate statistical tests (paired t-tests), we find significantly lower accrual quality for CU than UU firms, favoring the stronger US oversight effect. Thus, consistent with H2a, the oversight effect (CU UU) is negative. Since these two effects are offsetting, we cannot predict whether the total regime effect (CC UU) is positive or negative and thus state H30 regarding the regime effect in null form. Indeed, we fail to reject H30: we detect no overall regime effect.

21

VI. CONCLUSIONS AND LIMITATIONS

Consistent with the Skinner hypothesis, we hypothesize and find strong evidence that accrual quality is higher for Canadian firms reporting under Canadian GAAP than for the same firms reporting under US GAAP. We also document that accrual quality is lower for Canadian firms reporting under US GAAP than for US firms, subject to stronger US oversight, reporting under US GAAP. Consistent with the offsetting nature of these two determinants of accrual quality, we hypothesize and find no significant difference in accrual quality between Canadian firms using Canadian GAAP and US firms using US GAAP. A limitation of the study is data availability with respect to Canadian firms. Only about 1,100 firms trade on the TSX during the period examined, and only about 10% of them meet our data requirements. Because the accrual quality model requires firm-level, time-series regression analysis, restrictive data requirements result in few Canadian firms meeting selection criteria. Using a longer sample period would not be practicable since cash flow statement data are unavailable pre-1987. A second limitation relates to the Dechow-Dichev accrual quality model used in this study. The model is among the first to measure accrual quality and, as such, may contain as-yet undetermined misspecifications. The models accrual quality measure considers only current accruals, ignoring longerterm accruals such as depreciation. It also ignores balance sheet information and the information in income statement line items and other required disaggregations. Despite its possible shortcomings, the results of the study underscore that improving financial reporting quality involves more than simply proclaiming changes in GAAP. Rather, GAAP interacts with oversight in any financial reporting regime. An open question is whether (hypothetically) principles-based GAAP, coupled with stronger,

22 US-style oversight, yields even higher financial reporting quality than that in Canada or the US. Our results are consistent with stronger oversight compensating for the shortcomings of rules-based GAAP. However, US GAAP and oversight evolved simultaneously. Possibly, US oversight would have been weaker had American policy makers relied more heavily on the accounting profession to exercise professional judgment. The strongest implication of the study is what Skinner (1995) would probably have welcomed most: Dont blame Canadian GAAP and Canadian accountants for perceived financial reporting shortcomings in Canada. If anything, they seem to enhance Canadian financial reporting quality.

23

VII. REFERENCES
Baginski, S., J. Hassell and M. Kimbrough. 2002. The effect of legal environment on voluntary disclosure: Evidence from management earnings forecasts issued in US and Canadian markets. The Accounting Review 77 (1), 25-50. Bandyopadhyay, S., J. Hanna and G. Richardson. 1994. Capital market effects of USCanada GAAP differences. Journal of Accounting Research 32, 262-277. Bandyopadhyay, S., A. Hilton, and G. Richardson. 2002. A re-examination of reconciling items between Canadian and United States GAAP. Managerial Finance 28, 37-56. Brown, D. Preventing Enron North: Improving Financial Reporting and Corporate Governance in Canada. Statement to the Conference Board's 2002 Business Outlook Briefings. March 7, 2002. Brown, G., R. Collins, and D. Thornton. 1993. Professional Judgment and Accounting Standards. Accounting, Organizations and Society 275-289. CICA. 1995. Professional Judgment and the Auditor. Toronto: Canadian Institute of Chartered Accountants. Collins, D. and P. Hribar. 2002. Errors in estimating accruals: Implications for empirical research. Journal of Accounting Research 40: 105-134. Dechow, P. and I. Dichev. 2002. The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review 77, 35-59. Ferguson, C., G. Richardson, and G. Wines. 2000. Audit education and training: The effect of formal studies and work experience. Accounting Horizons 24(2), 137-167. Financial Accounting Standards Board (FASB). 2002. Proposal: Principles-Based Approach to US Standard Setting. FASB, Norwalk, CT. Francis, J., R. LaFond, P. Olsson and K. Schipper. 2004. The market pricing of earnings quality. Working Paper, Duke University. Gibbins, M. and A. Mason. 1988. Professional Judgment in Financial Reporting. Toronto: Canadian Institute of Chartered Accountants. Kaplow, L. 1992. Rules versus standards: An economic analysis. Duke Law Journal 42, 557-629. Gibbins, M., S. McCracken, and S. Salterio. 2004. The auditor-client relationship behind financial reporting negotiation: interviews with matched pairs of audit partners and chief financial officers. Working paper, Queens University.

24 McNichols, M. 2002. Discussion of The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review 77, 61-69. Nelson, M, J. Elliott, and R. Tarpley. 2002. Evidence from auditors about managers and auditors earnings management decisions. The Accounting Review 77 (Supp.), 175-202. Pacini, C., M.J. Martin, and L. Hamilton. 2000. At the interface of law and accounting: an examination of a trend toward a reduction in the scope of auditor liability to third parties in the common law countries. American Business Law Journal 37, 171-235. SEC. 2003. Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System Submitted to Committee on Banking, Housing, and Urban Affairs of the United States Senate and Committee on Financial Services of the United States House of Representatives Office of the Chief Accountant Office of Economic Analysis. Washington, DC: United States Securities and Exchange Commission. Skinner, R. (1995) Judgment in Jeopardy, CA Magazine (November), pp. 14-21. Standing Senate Committee on Banking, Trade and Commerce. June 2003. Navigating through The Perfect Storm: Safeguards to restore investor confidence. Thornton, D. 2002. Financial Reporting Quality: Implications of Accounting Research (Qualit de linformation financire: incidences de la recherche comptable). Testimony to the Senate Standing Committee on Banking, Trade and Commerce, Study on the State of the Domestic and International Financial System. May 29, 2002. __________. 2003. The GAAPs in their logic. Financial Post (September 25), p. FP 15.

TABLE 1 Sample Firm-Years, 19902001 Panel A: Canadian sample Firms traded on TSX with available cash from operations, earnings, and changes in accounts receivable and inventory and total assets reported in the statement of cash flows Firms with both lead and lag values of cash from operations and earnings Firms with 6 or more annual observations Firms traded only in Canada Cross-listed firms Total Firm-years available for the firms used in the remaining analysis

719 646

65 62 127 947

Panel B: Industry Composition: Canadian firms and matched US firms Canadian Industry Metal mining Chemicals and allied products Electronic and electric equipment Oil and gas extraction Primary metal industries Paper and allied products Transportation equipment Food and kindred products Wholesale trade-durable goods Business services Other firms 22 11 10 7 7 6 6 5 5 5 43 127 Number of US firms matched to 75% of Revenue to 4-digit SIC 20 5 11 8 10 5 7 4 7 4 6 4 6 5 5 2 5 5 5 4 38 30 120 76

Panel C: Subsample of cross-listed Canadian firms matched to US GAAP firm-years Cross-listed firms Firms with insufficient US data Available cross-listed firms Firm-year observations 62 10 52 380

24

TABLE 2 Descriptive Statistics and Pearson Correlation Matrix for Selected Variables 947 Canadian (1055 US) Firm-Year Observations 1990 to 2001 Panel A: Descriptive Statistics Mean Cash flow from operations (CFO) US matched sample Change in working capital (WC) US matched sample Earnings before long-term accruals (Earn) US matched sample Earnings before extraordinary items (Prof) US matched sample Accruals (Prof-CFO) US matched sample Total assets (in millions - CDN$) Matched US sample (in CDN$) 0.041 0.057 0.011 0.011 0.052 0.068 -0.029 -0.019 -0.070 -0.076 3,599 2,748 Standard Deviation 0.167 0.185 0.088 0.095 0.171 0.184 0.210 0.235 0.163 0.166 17,879 7,003 Lower Quartile 0.000 0.019 -0.016 -0.017 0.017 0.042 -0.042 -0.014 -0.104 -0.107 72 83 Median 0.066 0.084 0.005 0.009 0.078 0.095 0.022 0.034 -0.051 -0.057 380 511 Upper Quartile 0.119 0.138 0.034 0.040 0.130 0.152 0.062 0.084 -0.003 -0.014 2,610 2,149

25

TABLE 2 (continued) Panel B: Pearson Correlations Earnt Proft US firms Earnt US firms CFOt US firms WCt US firms CFOt+1 US firms CFOt-1 US firms Earnt+1 US firms
* Significant at the 0.0005 level. Variable definitions: Cash flow from operations (CFO) Change in working capital (WC) Earnings before long-term accruals (Earn) Earnings before extraordinary items (Prof) Accruals All variables are scaled by average total assets. = = = = = item 308 from the Compustat Statement of Cash Flows; AR + Inventory AP TP + Other Assets (net), where AR is accounts receivable, AP is accounts payable, and TP is taxes payable CFO + WC; Compustat item 123; and Prof CFO.

CFOt
* *

WCt
* * * *

CFOt+1
* * * * * *

CFOt-1
* * * * * *

Earnt+1
* * * * * *

Accrualst
* * * * * *

0.818
0.964

0.692
0.869

0.252
0.849

0.501
0.452

0.456
0.271

0.508
0.298

0.590
0.891

* * * * * * * *

0.878
0.904

0.245
0.879

0.639
0.509

0.603
0.279

0.631
0.349

0.134
0.799

-0.249
0.590

0.648
0.439

0.648
0.439

0.603
0.279

-0.174
0.551

0.623
0.123 *

-0.055
0.072

0.048
0.131 * * * * * * *

0.623
0.892

0.531
0.290

0.873
0.925

-0.033
0.109 *

0.484
0.165

-0.089
0.085

0.026
0.086

26

TABLE 3 Summary Statistics from Firm-Specific Regressions of the Change in Working Capital on Past, Current, and Future Cash Flow from Operations, 1990 to 2001 Regression model: WCt = b0 + b1CFOt-1 + b2CFOt + b3CFOt+1 + t Intercept b1 b2 b3 Adjusted R2

Panel A: 127 Canadian (127 matched US) firms Means (t-statistics) Canadian firms Matched US firms Lower quartile Canadian firms Matched US firms Median Canadian firms Matched US firms Upper quartile Canadian firms Matched US firms -0.009 (-0.61) 0.024 (2.30) 0.186 (3.01) 0.190 (5.29) -0.355 (-6.69) -0.464 (-12.75) 0.203 (4.31) 0.118 (2.88) 0.357 0.425

-0.021 -0.021

-0.050 -0.004

-0.688 -0.744

-0.058 -0.046

-0.006 0.164

0.011 0.022

0.077 0.140

-0.370 -0.466

0.137 0.108

0.500 0.529

0.040 0.056

0.291 0.365

-0.087 -0.187

0.366 0.343

0.844 0.788

Panel B: 65 Canadian TSX-listed (65 matched US) firms Means (t-statistics) Canadian firms Matched US firms -0.034 (-1.17) 0.025 (1.29) 0.251 (2.23) 0.200 (4.37) -0.275 (-3.07) -0.447 (-8.32) 0.273 (3.30) 0.112 (1.60) 0.459 0.451

Panel C: 62 Canadian cross-listed (62 matched US) firms Means (t-statistics) Canadian firms Matched US firms 0.017 (2.55) 0.023 (3.15) 0.117 (2.57) 0.180 (3.20) -0.438 (-8.26) -0.481 (-9.81) 0.129 (3.18) 0.125 (2.96) 0.250 0.397

The t-statistics in Panels A to C are determined based on the distribution of the 127 coefficients obtained from the firm-specific regressions requiring a minimum of six observations per firm. All variables are defined as in Table 2.

27

TABLE 4 Quality of Working Capital Accruals Measured by Standard Deviation of Residuals (sresid) 1990 to 2001 Standard Deviation Lower Quartile Upper Quartile

Mean

Median

Panel A: Tests for differences in mean sresid across subsamples of CC firms Full sample of 127 firms vs. 62 cross-listed firms Full sample of 127 firms vs. 49 cross-listed firms with sufficient US data 65 TSX-traded firms only vs. 49 cross-listed firms with sufficient US data t-statistic Significance 0.327 0.744 1.140 0.256 1.230 0.221

Panel B: 49 Canadian firms reporting under both Canadian (CC firms) and US GAAP (CU firms) compared with 49 matched US firms reporting under US GAAP (UU firms) outliers excluded CC CU Matched UU 0.026 0.051 0.029 0.031 0.072 0.028 0.007 0.012 0.010 0.016 0.022 0.020 0.036 0.076 0.037

Panel C: CC firms (Canadian firms reporting under Canadian GAAP) compared with UU firms (matched sample of US firms reporting under US GAAP) 127 CC firms 0.034 0.042 0.008 0.018 0.044 127 UU firms 0.030 0.037 0.010 0.020 0.034 65 TSX-listed CC firms 65 matched UU firms 62 Cross-listed CC firms 62 matched UU firms 0.036 0.033 0.032 0.027 0.047 0.045 0.037 0.026 0.007 0.011 0.011 0.009 0.018 0.021 0.019 0.019 0.049 0.034 0.041 0.036

The standard deviation of the residuals (sresid) is calculated based on the residuals from the following firm-specific regressions. All variables are scaled by average total assets: WCt = b0 + b1CFOt-1 + b2CFOt + b3CFOt+1 + t where: Cash flow from operations (CFO) Change in working capital (WC) Earnings before long-term accruals (Earn) = = item 308 from the Compustat Statement of Cash Flows; AR + Inventory AP TP + Other Assets (net), where AR is accounts receivable, AP is accounts payable, and TP is taxes payable CFO + WC.

28

TABLE 5 Panel A: Tests for GAAP Effect (H1a) Differences in sresid from Firm-Specific Regressions for 49 Canadian firms reporting under Canadian GAAP (CC) vs. US GAAP (CU), 1990 to 2001

n Two-sample paired T-tests Canadian cross-listed firms, CC vs. CU Test for a /(a+b) = 0.5 Canadian cross-listed firms (mean a /(a+b) is 0.403, median 0.439) 49 49

t-statistic

Significance

-2.392

0.021

-2.769

0.008

Panel B: Tests for Oversight Effect (H2a) Differences in sresid from Firm-Specific Regressions for 49 Canadian firms reporting under US GAAP (CU) vs. matched US firms (UU), 1990 to 2001

n Two-sample paired T-tests Canadian cross-listed firms, CU vs. UU Test for a /(a+b) = 0.5 Canadian cross-listed firms (mean a /(a+b) is 0.532 , median 0.559) 49 49

t-statistic

Significance

2.046

0.046

0.819

0.417

The standard deviation of the residuals (sresid) is calculated based on the residuals from the following firm-specific regressions: WCt = b0 + b1CFOt-1 + b2CFOt + b3CFOt+1 + t where: Cash flow from operations (CFO) = item 308 from the Compustat Statement of Cash Flows; Change in working capital (WC) = AR + Inventory AP TP + Other Assets (net), where AR is accounts receivable, AP is accounts payable, and TP is taxes payable Earnings before long-term accruals (Earn) = CFO + WC. a = sresid for Canadian firms b = sresid for US firms All variables are scaled by average total assets.

29

TABLE 6 Tests for Regime Effect (H30) Differences in sresid from Firm-Specific Regressions for Canadian Firms and Matched Samples of US firms, 1990 to 2001

n Canada and US two-sample paired T-tests Full sample of Canadian vs. Matched US firms TSX-traded Canadian vs. Matched US Cross-listed Canadian vs. Matched US Test for a /(a+b) = 0.5 Full sample (mean a /(a+b) is 0.492, median is 0.493) 127 127 65 62

t-statistic

Significance

0.923 0.409 0.980

0.358 0.684 0.331

-0.345

0.731

The standard deviation of the residuals (sresid) is calculated based on residuals from the firm-specific regressions WCt = b0 + b1CFOt-1 + b2CFOt + b3CFOt+1 + t where: CFO = Cash flow from operations (item 308 from the Compustat Statement of Cash Flows) WC = Change in working capital (AR + Inventory AP TP + Other Assets (net), where AR is accounts receivable, AP is accounts payable, and TP is taxes payable) Earn = Earnings before long-term accruals (CFO + WC.) a = sresid for Canadian firms b = sresid for US firms All variables are scaled by average total assets.