Mandatory IFRS Adoption, Accounting Information, and Executive Compensation

The following post comes to us from Neslihan Ozkan of the School of Economics, Finance, and Management at the University of Bristol, Zvi Singer of Desautels Faculty of Management at McGill University, and Haifeng You of the Department of Accounting at Hong Kong University of Science and Technology.

In the paper, Mandatory IFRS Adoption and the Contractual Usefulness of Accounting Information in Executive Compensation, forthcoming in the Journal of Accounting Research, we investigate the contracting implications of the transition to IFRS. Specifically, we examine how the mandatory adoption of IFRS affects the contractual usefulness of accounting information in executive compensation, as reflected in pay-for-performance sensitivity (PPS) and relative performance evaluation (RPE). These tests allow us to infer whether compensation committees of European companies view IFRS as leading to increased earnings quality and comparability.

The mandatory adoption of International Financial Reporting Standards (IFRS) on January 1, 2005, by the European Union (EU) and several other countries (e.g., Australia; South Africa) marks major progress toward a single set of high-quality, globally accepted accounting standards (Daske et al., [2008]). IFRS is primarily aimed at enhancing earnings quality and achieving a high degree of comparability of financial statements (Regulation (EC) No. 1606/2002 of the European Parliament and of the Council). The extant research, however, has provided mixed evidence on whether mandatory IFRS adoption has achieved these goals (e.g., Barth et al., [2008], Ahmed et al. [2010], DeFond et al. [2011], Lang et al. [2010]).

We examine changes in the use of accounting information in executive compensation contracts in publicly listed companies from 15 countries in Continental Europe that mandatorily adopted IFRS in 2005. We posit that if the compensation committees of these companies perceive accounting earnings under IFRS as being of higher quality than the previously adopted local accounting standards, they will then place more weight on earnings in executive compensation contracts. We also posit that if compensation committees view accounting earnings as becoming more cross-country comparable, they will increase the use of foreign peers in accounting-based RPE when setting executive compensation.

We find evidence of increased use of earnings for PPS in the post-adoption period, which is primarily driven by countries with large differences between IFRS and the local accounting standards in place prior to the transition. We also find strong evidence of increased use of foreign peers in accounting-based RPE in the post-adoption period. Further analyses show larger increases in the use of RPE for firms with more foreign operations, and for those with fewer comparable domestic peers. We also show that the change in accounting-based RPE is not driven by the deepening economic integration in continental Europe, or by a global trend of compensation contract efficiency.

The overall results are consistent with mandatory IFRS adoption, leading to some improvement in the quality and a significant increase in the cross-country comparability of accounting earnings. Our paper highlights a major benefit of IFRS adoption; that is, the higher earnings quality and greater earnings comparability brought by the mandatory adoption of IFRS may facilitate executive compensation contracting.

The full paper is available for download here.

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