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Is IFRS conditionally or unconditionally more conservative than local

GAAP? Evidence from Japan

Konosuke Shimamoto and Fumiko Takeda

Department of Technology Management for Innovation

University of Tokyo

7-3-1, Hongo, Bunkyo-ku, Tokyo 113-8656 Japan

E-mail: quahuh19910706@hotmail.co.jp (Shimamoto)

E-mail: takeda@tmi.t.u-tokyo.ac.jp (Takeda)

January 2018

Corresponding and presenting author.

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Is IFRS conditionally or unconditionally more conservative than local GAAP? Evidence from Japan

Abstract

This article examines whether there is a difference in the degree of conditional and unconditional conservatism between firms that adopted or plan to adopt IFRS and those that use Japanese Generally Accepted Accounting Principles (J-GAAP). Although some differences in accounting standards and accounting treatments related to conservatism exist between J-GAAP and IFRS, whether IFRS is less conservative is a priori unclear. However, our estimated proxies of conditional conservatism are larger for J-GAAP users, which have the similar corporate governance structure as IFRS adopters, than for IFRS adopters, while those of unconditional conservatism are not significantly different between the two parties.

JEL classification: M41; M48EFM classification: 710Keywords: Voluntary IFRS adoption; Conservatism

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Is IFRS conditionally or unconditionally more conservative than local GAAP? Evidence from Japan

1. IntroductionThe purpose of this study is to investigate whether there is any difference in

accounting conservatism between firms that voluntarily adopted or plan to adopt the International Financial Reporting Standards (IFRS) and those that continue to use the Japanese Generally Accepted Accounting Principles (J-GAAP). The “principle of conservatism,” which is listed as the sixth general principle of J-GAAP, stipulates that firms should make prudent accounting choices and estimates when future events would make negative effects on their financial conditions. In other words, firms should conduct account treatment based on careful judgment in preparation for foreseen future risks. Forexample, when it is unclear whether expenditures, such as R&D expenses, will lead to future economic benefits, they cannot be capitalized and are recorded as expenses for the period in which they occurred. Alternatively, for example, when an investment made by the firm cannot be expected to recover due to the decline in profitability, an impairment loss is recorded. However, even if the profitability is expected to improve later, in principle, this impairment cannot be reversed.

At the same time, the principle of conservatism does not allow overly conservative accounting choices and estimates. In other words, it stipulates that firms must not distort their true financial condition and business performance by conducting excessively conservative accounting treatment. Specifically, excessively conservative accounting practices, such as concealing profits, recording large expenses with considerably low occurrence probability, and accumulating secret reserves and consciously showing underestimated profits, are unacceptable. In other words, the principle of conservatism recognized by J-GAAP permits the selection of accounting practices that allow profits to be recorded conservatively, among the accepted methods of accounting choices and estimates.

In Japan, the voluntary adoption of the IFRS has been approved since 2010, and the number of firms adopting IFRS began to increase since 2013. In the International Accounting Standards (IAS) mandated by the International Accounting Standards Board (IASB), which was the organization that established the IFRS, neutrality is one of the characteristics of financial information and financial reporting (OB2, QC12, 14). In addition, the IASB does not include prudence, a similar concept of conservatism, in the characteristics of financial information and financial reporting. This is because this inclusion can lead to biased financial information and thus violate neutrality. For example,

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development cost items that are deemed necessary to create future economic benefits can be capitalized without recording expenses in the period they are incurred (IAS 38.57). Furthermore, regarding assets to which impairment accounting is applied, if they are exempt from impairment losses or show signs of possible recovery of profitability, the impairment can be reversed to the extent that the recoverable amount is measured and this recoverable amount exceeds the book value after impairment (IAS 36).

Although some differences in accounting standards and accounting treatments related to conservatism exist between J-GAAP and IFRS, whether IFRS is less conservative is a priori unclear. In recent years, studies on accounting conservatism have often been discussed under two categories: “conditional conservatism” and “unconditional conservatism” (Basu 1997; Watts 2003; Beaver and Ryan 2005). Conditional conservatism refers to an accounting practice that records expenses and losses earlier and overstated when firm value declines due to economic losses compared to the profits when firm value improves due to economic benefits. On the other hand, unconditional conservatism is an accounting process that proactively records expenses before firm value declines due to economic losses. The nature of these two types of conservatism is very different, and so do their impacts on financial reporting.

On the one hand, IFRS include conditional conservatism elements, such as recognition of profitable liabilities and non-recognition of contingent assets (IAS 37), the lower of cost or net realizable values for inventories (IAS 2), and impairment of financialassets and long-lived assets (IAS 39 and IAS 36). On the other hand, IFRS has stronger unconditional conservatism elements than J-GAAP for retirement benefits, as actuarial difference is not deferred under IFRS (IAS 19.122) while expenses are recorded over a period of time under J-GAAP.

Several prior studies that use European data report a decrease in conditional conservatism under IFRS (Zeghal et al. 2012; Ahmed et al. 2013; Andre et al. 2015; Piot et al. 2015). Nonetheless, to the best of our knowledge, almost no studies provide a comparative analysis of the IFRS and J-GAAP with respect to conservatism. Furthermore, while many studies discussing conservatism related to IFRS adoption in other countriessolely focus on conditional conservatism, only few studies analyze unconditional conservatism (Piot et al. 2015).

Therefore, in this research, we examine whether there is a difference in the degree of conditional and unconditional conservatism between firms that adopted or plan to adopt IFRS and those that use J-GAAP. While IFRS adoption is mandatory in Europe, it is voluntary in Japan. We consider the possibility that voluntary IFRS adoption may generate a self-selection bias attributable to firm-level reporting incentives. To reduce

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such potential self-selection bias, we employ a propensity score matching (PSM) approach and choose control firms that have similar probability of adopting IFRS but have continued using J-GAAP instead. Our estimated proxies of conditional conservatism are larger for J-GAAP users than for IFRS adopters, while those of unconditional conservatism are not significantly different between the two parties.

We make the following contributions to the related literature. First, to the best of our knowledge, our paper is the first to provide a comparative analysis of IFRS and J-GAAP with respect to conservatism. Second, we provide evidence on unconditional conservatism under IFRS, which has been examined in few prior studies. One of them is the study by Piot et al. (2015), which shows that the Big 4 auditors are likely to increase the level of unconditional conservatism, resulting in a decrease in conditional conservatism under IFRS. In our study, for control firms we use J-GAAP users which have a similar probability of IFRS adoption, i.e., they have similar corporate governance structures, characterized by the use of the Big 4 auditor, proportion of shareholding by foreign firms, and leverage ratio, to IFRS adopters. After controlling for the governance structure, we document no significant difference in the degree of unconditional conservatism between IFRS adopters and J-GAAP users, but a larger degree of conditional conservatism under IFRS than under J-GAAP.

The remainder of this paper is organized as follows. Section 2 provides a background on conservatism and IFRS adoption in Japan. Section 3 reviews related literature, and Section 4 develops the hypotheses. Section 5 explains the methodology to test the hypotheses, and Section 6 explains the data. Section 7 discusses the empirical results, and Section 8 provides concluding remarks.

1. BackgroundVoluntary IFRS adoption in Japan

The International Accounting Standards Committee (IASC), which is the predecessor of the IASB, was established in 1973 and then reorganized as the IASB in 2001. IFRS adoption has advanced in many countries worldwide, since the EU made it mandatory for listed firms from 2005. In 2009, the roadmap for the Japanese version of IFRS was announced, and on May 13, 2010, Nihon Dempa Kogyo Co., Ltd. announced the first domestic application of IFRS to the financial results of the fiscal year ended in March 2010. Since then, the number of firms adopting IFRS has increased, and as of November 2017, 138 firms have adopted IFRS and 20 more have announced their decision to adopt it. The total market capitalization of firms that adopted IFRS and those that planned to adopt it at the end of January 2017 was about 133.93 trillion yen, which

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is equivalent to about 22.59% of the total market capitalization of firms listed on the Tokyo Exchange.

Conditional conservatismAs mentioned in Section 1, there are two types of conservatism: conditional

conservatism and unconditional conservatism. Conditional conservatism is the tendency to reflect bad news on profits more quickly than good news (Basu 1997). It is also defined as “the different verifiability” required for recognition of profits/gains versus losses/expenses when economic news occurs (Watts 2003). In other words, in the financial report of a firm with a high degree of conditional conservatism, smaller amounts of profits are recorded when the firm value improves, while larger amounts of expenses are recorded when the firm value declines; such expenses are recorded in a timely manner, a practice known as asymmetric timeliness.

Examples of accounting treatment of conditional conservatism include impairment accounting and lower-of-cost-or-market of inventory assets. Impairment is a procedure that reflects the decline in book value when the profitability of the assets held by a firmdeclines and the recovery of the investment amount cannot be expected, in which case the decline in book value is recognized in expenses as an impairment loss. However, under J-GAAP, in principle, the profits are not reversed for assets that have been impaired, even if after the impairment, the profitability improves and is expected to be worth more than the book value. In other words, if the profitability of assets deteriorates, it is recognized as an expense, whereas if the profitability of assets improves, it is not recognized as a profit. The same applies to the lower-of-cost-or-market of inventory assets, and only when the profitability declines is the book value lowered and the expensesrecognized.

Unconditional conservatismUnconditional conservatism refers to the preparation of preventive expenses/losses

before firm value declines (Beaver and Ryan 2005). This specific accounting treatment is classified into two types. When an asset is acquired, it may be recorded as an expense immediately or over a certain period into the future. An example of the former, is anintangible asset, such as R&D expenses, and that of the latter is an accelerated depreciation method, such as the declining-balance method, rather than the straight-line method, which is used for the amortization of tangible fixed assets at a rate that is higher than the expected depreciation rate. In addition, unconditional conservatism includes the accounting treatment that continuously delays the recognition of good news. Specifically,

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this treatment includes the process of applying the acquisition cost principle to the investment plan for which the present value is positive because the estimated future cash flow exceeds the investment amount. As a result of these accounting treatments, the book value of net assets tends to be underestimated compared to market prices. In firms withstrong unconditional conservatism, accounting profits are recorded lower than in thosewithout such strong conservatism, and so is the book value of net assets, resulting in the higher price-to-book ratio (PBR).

Conditional vs. unconditional conservatismAs discussed in Beaver and Ryan (2005), the two types of conservatism have an

inverse relationship with each other. That is, as unconditional conservatism is incorporated, conditional conservatism gets invalidated/suppressed. If bad news occurs at some point and the profitability of assets is expected to deteriorate, impairment is carried out; however, when amortizing assets in a situation of strong unconditional conservatism, the impairment amount will be small, because the book value before impairment is smaller than the book value amortized in a situation of no unconditional conservatism. That is, if amortizing under an accounting policy with a low degree of unconditional conservatism, the effect of conditional conservatism when the bad news occurs is significant. In addition, the two types of conservatism have quite different properties, and they do not change in correlation with each other. Therefore, when discussing the degree of conservatism, it is necessary to distinguish between conditional conservatism and unconditional conservatism.

Difference between J-GAAP and IFRSSome of the differences in accounting standards and accounting treatments related

to J-GAAP and the IFRS are related to conservatism. Regarding tangible fixed assets, under J-GAAP, even if the profitability of the assets that were impaired improves and value is recovered, impairment is not reversed. On the other hand, the IFRS allows firms to estimate the profitability of assets, to reverse the impairment by the amount exceeding the book value after impairment, and to record the reversal income (IAS 36.110). Likewise, for financial assets, J-GAAP does not allow firms to reverse the impairment of financial assets, except for trading securities, but these are reversed under the IFRS (IFRS 9.5.5.8). The same applies to the inventory. After devaluating the book value of the inventory in a temporary event, the amount devaluated is not reversed under J-GAAP, but it is reversed under IFRS if there is evidence that the net realizable value has been recovered due to the change in an economic situation (IAS 2.33). For this reason, for the

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three examples above, J-GAAP becomes a strong accounting treatment with conditional conservatism elements.

Goodwill arises when a firm acquires or merges with another firm entirely or with part of another firm’s business at a price higher than the book value. Under J-GAAP, goodwill is recorded as an expense and amortized using the straight-line method over the period of 5–20 years; however, it is not amortized under IFRS and is subject to an impairment test every term (IAS 38.107, 108). Therefore, J-GAAP has stronger unconditional conservatism elements.

With regard to R&D expenses, it is stipulated in J-GAAP that all must be recorded as expenses when incurred (accounting standards related to R&D expenses etc.), including software development costs that fall under R&D. However, while under IFRS,research expenses are recorded as expenses (IAS 38.54), it is stipulated that developmentexpenses are recognized as intangible assets only when certain requirements such as technical feasibility and the intent of the company to use or sell can all be provedand will be partially capitalized (IAS 38.57). Furthermore, under IFRS, in-process R&D resulting from other firms’ R&D activities is a potential asset that is brought to the firm based on its expected economic benefits, and such asset is capitalized accordingly. However, it is charged as an immediate expense under J-GAAP. Therefore, J-GAAP has stronger unconditional conservatism elements.

With respect to installment sales, in addition to the sales basis, the due date for coming basis and payment basis are recognized under J-GAAP, but neither of them are recognized under IFRS (IAS 18.11). Usually, collection of funds and collection of deadline are recognized after the delivery of goods. Thus, the recognition of revenue will be delayed under the due date coming basis and payment basis, compared to the sales basis, which recognizes revenue at the time of the delivery of goods. Therefore, J-GAAP, which accommodates both collection deadline and payment criteria, has stronger unconditional conservatism elements.

When accounting for retirement benefits, the actuarial difference is not deferred under IFRS (IAS 19.122). On the other hand, under J-GAAP, expenses are recorded over a period of time. As a result, for retirement benefits, IFRS has stronger unconditional conservatism elements.

Thus, whether IFRS is less conservative compared to J-GAAP is a priori unclear. On one hand, under IFRS, where importance is attached to neutrality in order to improve comparability, there are no differences in the handling of income and expenses when firm value improves and when it declines. On the other hand, IFRS can be considered more conservative, as discussed regarding retirement benefits. Andre et al. (2015) also argue

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that IFRS is conceptually conditionally conservative, but that inappropriate application tends to make financial reporting less conservative.

2. Literature review Since the mandatory IFRS adoption in Europe began in 2005, several studies have

been conducted on the impact of the adoption on financial information, including on conservatism. Earlier studies employ timely loss recognition as a proxy for conservatism. Using data from 21 countries around the world between 1994 and 2003, Barth et al. (2008) show that voluntary IAS adoption is associated with more timely loss recognition. Chua et al. (2012) study the case of Australia, where IFRS adoption is mandatory, and report similar results. By contrast, using data from 15 EU countries between 2002 and 2007, Zeghal et al. (2012) provide evidence to the contrary and prove that mandatory IFRS adoption is associated with less timely recognition. Using data from 20 countries around the world between 2002 and 2007, Ahmed et al. (2013), too, show the decrease in conditional conservatism for IFRS adopters based on the timeliness of loss recognition measure.

Elshandity and Hassanein (2014) investigate the impact of mandatory IFRS adoption and/or board of directors’ independence on accounting conservatism in FTSE 100 nonfinancial firms between 2002 and 2007. Using an accrual-based measure of conservatism, they show that conservatism decreased after IFRS adoption, while it increased with the independence of the directors.

Andre et al. (2015) examine the impact of mandatory IFRS adoption on conditional conservatism based on the measure of Khan and Watts (2009), using a sample of 2,274firms in 16 European countries between 2000 and 2010. They report an overall decline in the degree of conditional conservatism after IFRS adoption. They also document that the decline of conditional conservatism is mitigated in countries with high-quality audit environments and strong enforcement of compliance with accounting standards. In addition, they show that conditional conservatism is less mitigated for firms that book an asset impairment.

Kim (2016) analyzes the conditional conservatism of firms that adopted IFRS in Russia using the Basu (1997) model. Mandatory adoption in Russia began in 2012, although some firms were exempted from the adoption and others had already adopted IFRS even before the adoption became mandatory. Therefore, Kim (2016) compares three groups of firms: firms exempted from IFRS adoption (S1); those that adopted IFRS before the adoption became mandatory (S21); and those that adopted IFRS when the adoptionbecame mandatory (S22). The findings suggest that although there is no difference in

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conditional conservatism between the first two groups of firms, both groups have a lower degree of conditional conservatism than the third group of firms.

All of the previous studies mentioned above focus on conditional conservatism, and they have not analyzed the impact of IFRS adoption on unconditional conservatism. In contrast, Piot et al. (2015) investigate the effect of mandatory IFRS adoption on not only conditional conservatism but also unconditional conservatism in Europe. They analyze 2,973 European firms from 2001 to 2004 before the mandatory IFRS adoption and from 2005 to 2008 after the mandatory adoption. They report that the degree of conditional conservatism decreases after IFRS adoption, while that of unconditional conservatism increases after the adoption, and this tendency is remarkable for firms that are audited by a Big 4 audit firm.

To summarize, previous studies on the relationship between IFRS adoption and conservatism provide mixe results. To the best of our knowledge, no study has examined the impact of IFRS adoption on conservatism in Japan. To fill this gap, in this research, we aim to compare the degree of conservatism of Japanese firms that voluntarily (plan to) adopt the IFRS and those that adopt J-GAAP. While pursuing our research objectives, we refer to the four papers related to the effect of conservatism on Japanese firms (Shuto and Takada 2010; Nakano et al. 2014) and the impact of IFRS adoption of Japanese firms (Takeda and Watanabe 2016; Sato and Takeda 2017).

Shuto and Takada (2010) analyze the effect of conditional conservatism on the relationship between management and shareholders. They report that the degree of conditional conservatism is higher for firms with a low ratio of shareholding by management than for firms with a high ratio. Nakano et al. (2014) analyze the influence of conditional and unconditional conservatism on corporate investment levels, risk-taking, and shareholder value, and report that firms with a high degree of conditional conservatism undertake less and/or low-risk investments, while those with a high degree of unconditional conservatism undertake more and/or high-risk investments.

Takeda and Watanabe (2016) and Sato and Takeda (2017) examine the relationship between IFRS adoption and firm characteristics, in particular, corporate governance. The difference between the two studies lies in the fact that the former focuses only on external governance reflected by foreign shareholders’ ratio, leverage, and high audit quality, while the latter incorporates internal governance factors. However, both studies show a positive correlation between the probability of IFRS adoption and the governance system characterized by high foreign shareholders’ ratio, less leverage, and quality audit.

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3. Hypotheses development Hypothesis on conditional conservatism

In Section 2, we explained the following items in which the IFRS is considered to have a lower degree of conditional conservatism than J-GAAP: tangible fixed assets; financial assets; and inventory. For these items, in accordance with the J-GAAP, expenses and losses are recorded against economic losses, although after profitability recovers, a return income is not recorded, and consequently, there is “a different verifiability”concerning the recognition of revenue/gains and expenses/losses when economic news occurs (Watts 2003). That is, conditional conservatism can be observed. On the other hand, under IFRS, neutrality is high as profitability recovers, as it is reflected in accounting. Therefore, we formulate the following hypothesis.

Hypothesis 1: Firms that announced IFRS adoption have a lower degree of conditional conservatism than those that apply J-GAAP.

Firms that announced IFRS adoption include both firms that have already reported an IFRS-based earnings summary and those that have not. We include the latter firms for the following reason. Although the IFRS-based earnings summary usually presents financial information one period earlier, financial information for that period is also required to comply with the IFRS, and so is the value on the balance sheet at the beginning of the first term. For example, if IFRS adoption is scheduled for the fiscal year ended March 31, 2017, the balance sheet in April 2015 should be IFRS-compliant financial information. In this situation, firms announce the adoption in any of the following three instances: at the time of reporting for the fiscal year ended March 31, 2017 (May 2017);before the settlement of accounts for the fiscal year ended March 31, 2017 (March 2017); and around the beginning of the fiscal year ended March 31, 2017 (April 2016). In any of the three cases, financial information at the beginning of the fiscal year ended March 31, 2015 complies with the IFRS, and therefore, the financial information of the period including the timing of the announcement of the adoption should also comply with the IFRS.

Hypothesis on unconditional conservatismIn Section 2, we also explained the following items in which the IFRS is considered

to have a lower degree of unconditional conservatism than J-GAAP: goodwill; R&D expenses; and installment sales. Under J-GAAP, goodwill and R&D expenses are

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recorded as expenses proactively as economic losses occur or before economic benefits can disappear, and unconditional conservatism can be observed. In some cases, under IFRS, such expenses are not recorded and unconditional conservatism is weaker than under J-GAAP. With regard to installment sales, it is expected that the degree of unconditional conservatism will become stronger as recognition of revenue may be delayed under J-GAAP. Based on the above point, we formulate the following hypothesis.

Hypothesis 2: Firms that announced IFRS adoption have a lower degree of unconditional conservatism than those that apply J-GAAP.

As discussed in Section 2, however, the two types of conservatism have an inverse relationship with each other. That is, as unconditional conservatism is incorporated, conditional conservatism gets invalidated/suppressed. This means that if our empirical results are consistent with Hypothesis 1 (or 2), they are unlikely to be consistent with Hypothesis 2 (1). Because J-GAAP has stronger elements of both conditional and unconditional conservatism than IFRS, whether our results are consistent with Hypothesis 1 or 2 is regarded as a practical and empirical question.

4. Research DesignThe degree of conservatism

To estimate the degree of conditional conservatism, we follow Shuto and Takada (2010), which is a modified version of Basu (1997) and Khan and Watts (2009). Specifically, we estimate the following equation:

𝑋 = 𝛽 + 𝛽 𝐷 + 𝑅 (𝜇 + 𝜇 𝑀 𝐾 + 𝜇 𝑀𝑇𝐵 + 𝜇 𝐿𝐸𝑉)+𝐷 𝑅 (𝜆 + 𝜆 𝑀 𝐾 + 𝜆 𝑀𝑇𝐵 + 𝜆 𝐿𝐸𝑉) + 𝜀

(1)

where X is the pre-tax net income divided by net assets; D is a dummy variable that takes the value of 1 if X is positive and 0 otherwise; R is the annual stock return; MK is the natural logarithm of market capitalization; MTB is the market to book ratio; and LEV is the interest-bearing debt ratio. Following Basu (1997), we calculate the stock return R between the three months after the beginning of the fiscal year and three months after the fiscal year-end. The reason for leaving the three months is to avoid the effect of annual earnings announcement on stock returns (Givoly and Palmon 1982; Easton and Harris 1991). The degree of conditional conservatism is proxied by a C_Score, which is calculated as follows:

C_Score = 𝜆 + 𝜆 𝑀 𝐾 + 𝜆 𝑀𝑇𝐵 + 𝜆 𝐿𝐸𝑉. (2)

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We then estimate the degree of unconditional conservatism following Beaver and Ryan (2000). Specifically, we estimate the following fixed-effect model:

𝐵𝑇𝑀 , = 𝛼 + 𝛼 + 𝛽 𝑅 . + 𝜀 . (3)

The degree of unconditional conservatism is captured by – 𝛼 .

Selection of control firmsTo investigate the effect of voluntary IFRS adoption on the degree of conservatism, we

compare the proxies of conditional and unconditional conservatism between firms that announce IFRS adoption (sample firms) and firms that do not (control firms). Specifically, we employ the propensity score matching to select control firms that have a similar probability of IFRS adoption as sample firms. The use of PSM is to mitigate potential self-selection bias attributable to firm-level reporting incentives, which are generated by voluntary IFRS adoption. We estimate the following probit model modified from Takeda and Watanabe (2016) and Sato and Takeda (2017), which shows a positive correlation between corporate governance and voluntary IFRS adoption:

𝑃(𝐼𝐹𝑅𝑆= 1) = 𝐹(𝛼+ 𝛽 𝐴𝑔𝑒+ 𝛽 𝑆𝑖𝑧𝑒+ 𝛽 𝐹𝑜𝑟𝑒𝑖𝑔𝑛𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠+ 𝛽 𝐵𝑖𝑔4+ 𝛽 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒+ 𝛽 𝑃ℎ𝑎𝑟𝑚𝑎𝑐𝑒𝑢𝑡𝑖𝑐𝑎𝑙𝑠+ 𝛽 𝐸𝑙𝑒𝑐𝑡𝑟𝑖𝑐_𝑎𝑝𝑝𝑙𝑖𝑎𝑚𝑐𝑒𝑠+ 𝛽 𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛_𝑐𝑜𝑚𝑚𝑢𝑛𝑖𝑐𝑎𝑡𝑖𝑜𝑛+ 𝛽 𝑊 ℎ𝑜𝑙𝑒𝑠𝑎𝑙𝑒_𝑡𝑟𝑎𝑑𝑒+ 𝛽 𝑇𝑟𝑎𝑛𝑠𝑝𝑜𝑟𝑡_𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡+ 𝛽 𝑆𝑒𝑟𝑣𝑖𝑐𝑒)

(4)

IFRS is an indicator variable, which takes the value of 1 if the firm announces voluntary IFRS adoption and 0 otherwise. Age is the natural logarithm of the number of years the firm has been in business. Size is the natural logarithm of total assets. The next three variables (Foreignshareholders, Big4, and Leverage) are related to external governance. Foreignshareholders is the ratio of foreign shareholders among total shareholders. Big4 is a dummy variable, which takes the value of 1 if the firm is audited by a Big 4 audit firm and 0 otherwise. Leverage is a debt-to-equity ratio that shows the relative importance of creditors and shareholders for financing. The remaining sixvariables are dummy variables for industries that have the largest number of IFRS

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adopters. Using the estimated coefficients ( k ; k=0, …, 11), we calculate the probability

of voluntary IFRS adoption. Based on the probability, we select control firms that have a closer probability to the sample firms but do not adopt IFRS.

Methodology to test hypothesesFirst, we conduct univariate analyses to compare the degree of conditional and

unconditional conservatism between the sample and control firms by using Welch’s t-test. Second, we conduct a regression analysis to test Hypotheses 1 and 2, based on the following model:

nsInteractiotireInventoryFassetIassetTassetIFRSsmConservati

k kRe6

54321 (5)

where Conservatism is the degree of conditional or unconditional conservatism, in other words C-Score or –𝛼. The next five variables represent accounting items. Tasset is the ratio of tangible fixed assets against total assets; Iasset is the ratio of intangible assets against total assets; Fasset is the ratio of financial assets against total assets; Inventory is the ratio of inventory assets against total assets; Retire is the ratio of retirement allowances against total assets; and Interactions are the interaction terms between IFRS and each financial item. Our target variable is IFRS, which is expected to show a negative value, if Hypothesis 1 or 2 holds.

5. DataOur sample consists of firms that announced IFRS adoption by the end of March

2016, which include both firms that have already adopted IFRS and those that do not. According to the Japan Exchange Group, 112 firms announced IFRS adoption by the end of March 2016. We exclude 24 firms whose financial or stock price data were not obtained for our analyses. Thus, our sample consists of 88 firms that have announced IFRS adoption. For robustness check, we create another sample that consists of only firms that release financial data based on IFRS. Among 75 firms that released IFRS-based financial statements, we exclude 12 firms that do not have 10-year stock price data. Thus, our second sample consists of 63 firms that have released IFRS-based financial statements.

We use financial data that covers the fiscal year including the announcement date. For example, if the firms announced IFRS adoption in February 2015 and the settlement date is the end of March, we collect data for the fiscal year ending in March 2015. However, if the settlement date is the end of December, we collect data for the fiscal year

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ending in December 2015. Table 1 presents the descriptive statistics for variables used to estimate conditional

conservatism. Panel A shows variables for Group A that consists of sample firms that announced IFRS adoption and their control firms. Panel B shows those for Group B that consists of sample firms that adopted IFRS and their control firms. Thus, the number of observation is 176 in Panel A and 126 in Panel B. Table 2 presents descriptive statistics for variables used to estimate unconditional conservatism. Following Beaver and Ryan (2000), we use data for four fiscal years. We eliminate firms that lack financial data for four consecutive fiscal years. Thus, the number of observations is 656 (=82 firms x 4years x 2) in Panel A and 480 (=60 firms x 4 years x 2) in Panel B. Tables 3 and 4 present the Pearson correlation matrices for variables used to estimate conditional and unconditional conservatism, respectively.

(Tables 1 to 4 here)

6. Empirical resultsControl firm selection

Panel A of Table 5 shows the estimation results of the probit model (4) for all listed firms. All variables are statistically significant at the 1% level. The coefficients of Age and Leverage are negative, while those of other variables are positive. In other words, firms that have a long business history, hire a Big 4 audit firm, have high foreign shareholders’ ratio, large market capitalization, and low leverage, are more likely to adopt IFRS voluntarily. Using the estimated coefficients, we calculate the probability of IFRS adoption for each firm, and select control firms that have a closer probability to sample firms.

(Table 5 here)Panel B presents the result of balancing test. Before the propensity score matching,

the means of Big4, Foreignshareholders, and Size are significantly larger at the 1% level for sample firms than for other listed firms. After the matching, the difference between means of the five variables for sample and control firms are not significantly different from zero. In other words, our control firms have similar corporate governance structure as sample firms.

Conditional conservatismPanel A of Table 6 presents the estimation results of equation (1) for Group A (firms

that announced IFRS adoption and their control firms), Group B (firms that adopted IFRS and their control firms), and Group C, which excludes four pairs of Group A firms that

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belong to the financial industry and constitutes those that have an extraordinary large BTM value greater than 10.

(Table 6 here)The coefficient of D*R is positive and insignificant for Groups A and C, while it is

positive and statistically significant at the 1% level for Group B. This means losses/expenses, which are recorded when the firm value declines, tend to be larger than profits/gains, which are recorded when the firm value increases.

The coefficient of D*R*MK is negative and insignifcaint for Groups A and C, while it is negative and statistically significant at the 1% level for Group B. This means that the degree of conditional conservatism tends to be large for firms that have small market capitalization or leverage. Small firms are less likely to be covered by analysts and pickedup by the news media less frequently than large firms. Thus, the negative coefficient of D*R*MK is consistent with the notion that firms in the poor information environment tend to employ conservative accounting, which reduces agency costs arising from asymmetric information between investors and managers (Watts 1993; Ball 2001).

The coefficient of D*R*LEV is negative and insignificant for Groups A and C, while it is negative and statistically significant at the 10% level for Group B. Highly leveraged firms are likely to be monitored by creditors who are considered to be more sensitive to risks than shareholders. The negative coefficient of D*R*LEV is consistent with the governance structure in which creditors are more influential than shareholders.

Next, we calculate C_Score, which shows the degree of conditional conservatism,based on the estimation results. The results are shown in Panel B. Thereafter, we compare the means of C_Score among Groups A to C based on Welch’s t-test. The average C-Scoreof the sample firms is significantly lower than that of the control firms at the 5% level forGroups A and B and at the 1% level for Group C. These results show that firms that announced IFRS adoption have a smaller degree of conditional conservatism than thosethat employ J-GAAP. As such, the results are consistent with Hypothesis 1 and the results of Kim (2016).

Unconditional conservatismPanel A of Table 7 presents the estimation results of equation (2) for Groups A and

B. We calculate the proxy of unconditional conservatism by multiplying the firm fixed effect 𝛼 by -1. We then compare the average −𝛼 between Group A and Group B by using the Welch’s t-test. The results are shown in Panel B, which shows no significant difference between the two groups. These results are neither consistent with Hypothesis 2 nor with Piot et al. (2015) that shows that the degree of unconditional conservatism is

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increased after IFRS adoption.(Table 7 here)

However, our results are reasonable considering the inverse relationship between conditional conservatism and unconditional conservatism as discussed in Section 2. That is, as unconditional conservatism is incorporated, conditional conservatism gets invalidated/suppressed. In other words, significant conditional conservatism implies that unconditional conservatism is unlikely to be incorporated. Thus, the degree of unconditional conservatism is not significantly different between firms that announced IFRS adoption and those that used J-GAAP.

J-GAAP allows firms to select the lower-of-cost-or-market for year-end inventory assets, the declining balance method for depreciation, and the collection method for installment sales, among others. However, many firms use the same methods allowed under IFRS. This is partly because excessive conservatism is considered to distort the truereports and thus prohibited by the principle of conservatism under J-GAAP. In addition, unlike IFRS, which requires overseas subsidiaries to release IFRS-based financial reporting, J-GAAP allows them to apply accounting standards used in their location. This difference leads to the situation in which overseas subsidiaries tend to apply IFRS or US GAAP.

Furthermore, the special case is applied for first-time adopters of IFRS (IFRS 1 Appendix C1), which are exempt from retroactive application of IFRS regarding business combinations conducted prior to the date of transition. Thus, even IFRS adopters are allowed to record the book value regarding goodwill, which is used under J-GAAP. Such firms include JT, Rakuten, DeNA, Takeda Pharmaceutical Company, M3. Dentsu, Hitachi, Konami, Kao, Taiyo Nikko Sanko, NEC, and Nitto Denko, among others.

For these reasons, users of J-GAAP are unlikely to conduct proactive accounting more frequently than IFRS adopters, resulting in no significant difference in the degree of unconditional accounting between them. Our results are not consistent with Piot et al. (2015), which shows that the degree of unconditional conservatism is increased after IFRS adoption.

Regression resultsSince our univariate analyses provide evidence consistent with Hypothesis 1, but not

with Hypothesis 2, we conduct a regression analysis to estimate the C-Score based on equation (5). Table 8 represents a comparison of variables between sample and control firms. Panels A and B show the statistics for Groups A and B, respectively. Sample firms tend to have smaller amounts of tangible fixed assets (Tasset) and financial assets (Fasset)

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than control firms, while they have larger amounts of intangible assets (Iasset). Because Tasset and Fasset are associated with the difference in conditional conservatism between IFRS and J-GAAP, this contrast seems to be consistent with Hypothesis 1. Table 9 represents Pearson correlation matrices among variables for Group A (Panel A) and Group B (Panel B).

(Tables 8 and 9 here)Table 10 represents the regression results to estimate the C-Score based on equation

(5). Models A and B are results using Group A, while Models C and D are results using Group B. We employ White’s heteroskedasticity-consistent standard errors & covariance for all models. The choice of interaction terms is based on the variance inflation factors,which are below 10 for all models. Our target variable, IFRS, has significant negative coefficients at the 1% level for all models. This result is consistent with Hypothesis 1.

(Table 10 here)In addition, Tasset and its interaction with IFRS have significantly negative and

positive coefficients respectively, for all models. These estimated coefficients seem to bea little surprising, since IFRS can be regarded to have less conservative elements, as it allows firms to reverse the impairment by the amount exceeding the book value after impairment, and to record the reversal income. However, as Andre et al. (2015) argue, IFRS may be considered to employ more stringent impairment testing rules than J-GAAP. However, whether accounting treatment of tangible fixed assets is more conservative under IFRS is not clear. The smaller amount of tangible fixed assets in sample firms are likely to reduce the overall degree of conservatism.

7. Concluding remarksIn the present study, we investigated whether there is a difference in the degree of

conditional conservatism and unconditional conservatism between firms that adopted or plan to adopt IFRS and those that use J-GAAP. Although some differences in accountingstandards and accounting treatments related to conservatism exist between the J-GAAP and IFRS, whether IFRS is less conservative is not a priori unclear. Our estimated proxies of conditional conservatism are larger for J-GAAP users than for IFRS adopters, while those of unconditional conservatism are not significantly different between the two parties.

We make the following contributions to the related literature. First, to the best of our knowledge, our paper is the first to provide a comparative analysis of IFRS and J-GAAP with respect to conservatism. Second, we provide evidence on unconditional conservatism under IFRS, which has been examined in few prior studies. One of them is

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the study by Piot et al. (2015), which shows that the Big 4 auditors are likely to increase the level of unconditional conservatism, resulting in a decrease in conditional conservatism under IFRS. In our study, for control firms we use J-GAAP users which have a similar probability of IFRS adoption, i.e., they have similar corporate governance structures, characterized by the use of the Big 4 auditor, proportion of shareholding by foreign firms, and leverage ratio, to IFRS adopters. After controlling for the governance structure, we document no significant difference in the degree of unconditional conservatism between IFRS adopters and J-GAAP users, but a larger degree of conditional conservatism under IFRS than under J-GAAP.

However, we also acknowledge the limitations of our study. Although the number of our sample firms that announced IFRS adoption is sufficient for statistical analysis, it still consists of only a small portion of all listed firms in Japan. We hope that this limitation will become less problematic as the cumulative number of Japanese firms adopting IFRS continues to increase.

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Table 1: Descriptive statistics for conditional conservatismPanel A: Descriptive statistics for Group A

Panel B: Descriptive statistics for Group B

X R MK MTB LEV Mean 0.119 0.166 5.431 1.784 0.546 Median 0.119 0.139 5.493 1.315 0.303 Maximum 0.644 2.838 7.224 17.743 6.647 Minimum -1.332 -0.794 3.346 0.017 0.000 Std. Dev. 0.145 0.458 0.811 2.231 0.860 Skewness -5.641 1.727 -0.256 5.247 4.137 Kurtosis 59.841 10.094 2.441 34.376 26.219 Sum 21.0098 29.2889 955.8706 313.9511 96.0724

Observations 176 176 176 176 176

X R MK MTB LEV Mean 0.136 0.236 5.547 1.943 0.625 Median 0.126 0.213 5.604 1.305 0.310 Maximum 0.644 1.760 7.303 17.743 6.647 Minimum -0.390 -0.651 3.738 0.370 0.000 Std. Dev. 0.107 0.366 0.788 2.512 1.011 Skewness -0.039 0.963 -0.099 4.824 3.536 Kurtosis 10.998 5.616 2.200 28.387 18.656 Sum 17.1269 29.7714 698.9122 244.8043 78.8019

Observations 126 126 126 126 126

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Table 2: Descriptive statistics for unconditional conservatismPanel A: Descriptive statistics for Group A

Panel B: Descriptive statistics for Group B

BTM R t R t-1 R t-2 R t-3 R t-4 R t-5 R t-6

Mean 0.974 0.191 0.170 0.134 0.078 0.011 -0.012 -0.007 Median 0.867 0.112 0.081 0.037 -0.029 -0.089 -0.098 -0.071 Maximum 4.749 3.107 3.107 3.365 3.365 3.365 3.365 2.225 Minimum 0.056 -0.667 -0.698 -0.808 -0.808 -0.808 -0.808 -1.160 Std. Dev. 0.602 0.405 0.441 0.470 0.490 0.493 0.460 0.421 Skewness 2.114 1.838 2.152 2.202 2.201 2.092 1.909 1.283 Kurtosis 10.879 10.406 11.908 12.751 12.343 11.171 10.450 6.422

Observations 656 656 656 656 656 656 656 656

BTM R t R t-1 R t-2 R t-3 R t-4 R t-5 R t-6

Mean 0.945 0.192 0.143 0.134 0.056 0.005 -0.007 0.011 Median 0.863 0.110 0.066 0.051 -0.047 -0.097 -0.087 -0.046 Maximum 4.969 2.516 2.655 3.365 3.365 3.365 3.365 2.112 Minimum 0.056 -0.667 -0.698 -0.808 -0.808 -0.808 -1.160 -1.160 Std. Dev. 0.590 0.384 0.406 0.456 0.479 0.490 0.459 0.418 Skewness 2.259 1.507 1.671 1.879 1.946 1.990 1.913 1.065 Kurtosis 13.136 7.818 8.843 11.219 10.997 10.882 11.581 5.464

Observations 480 480 480 480 480 480 480 479

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Table 3: Pearson correlation matrices for conditional conservatismPanel A: Pearson correlation matrix for Group A

Panel B: Pearson correlation matrix for Group B

X R MK MTB LEVX 1.000R 0.142 1.000MK 0.173 0.114 1.000MTB 0.213 0.102 0.056 1.000LEV -0.042 -0.027 0.045 -0.027 1.000

X R MK MTB LEVX 1.000R 0.178 1.000MK 0.276 0.006 1.000MTB 0.328 -0.017 0.058 1.000LEV -0.078 -0.085 0.064 0.014 1.000

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Table 4: Pearson correlation matrices for unconditional conservatismPanel A: Pearson correlation matrix for Group A

Panel B: Pearson correlation matrix for Group B

BTM R t R t-1 R t-2 R t-3 R t-4 R t-5 R t-6

BTM 1.000R t -0.203 1.000R t-1 -0.178 0.027 1.000R t-2 -0.039 -0.099 -0.009 1.000R t-3 -0.009 0.059 -0.042 -0.083 1.000R t-4 -0.065 0.038 0.086 -0.051 -0.095 1.000R t-5 -0.053 -0.044 0.097 -0.003 -0.079 -0.097 1.000R t-6 0.009 -0.215 -0.161 0.155 -0.113 -0.154 -0.076 1.000

BTM R t R t-1 R t-2 R t-3 R t-4 R t-5 R t-6

BTM 1.000R t -0.273 1.000R t-1 -0.147 -0.059 1.000R t-2 -0.056 -0.086 -0.165 1.000R t-3 -0.032 0.071 -0.039 -0.221 1.000R t-4 -0.083 0.082 0.072 -0.079 -0.201 1.000R t-5 -0.080 -0.079 0.074 0.005 -0.124 -0.149 1.000R t-6 0.009 -0.121 -0.254 0.135 -0.141 -0.200 -0.090 1.000

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Table 5: Results of propensity score matchingPanel A: Estimation results of equation (4)

Note: *** indicates statistical significance at the 1% level.

Panel B: Results of balancing test

Note: *** indicates statistical significance at the 1% level.

Variable Coefficient

C -4.585 -24.317 ***Age -0.119 -4.097 ***Big4 0.208 3.082 ***Foreignshareholders 0.014 8.149 ***Size 0.242 15.694 ***Leverage -0.586 -4.977 ***Pharmaceuticals 1.079 10.048 ***Electric appliances 0.691 10.834 ***Information communication 0.484 5.784 ***Wholesale trade 0.411 5.133 ***Transport equipment 0.751 8.890 ***Service 0.575 6.975 ***

Total obs. 16,825Obs with Dep=1 590McFadden R-squared 0.229Akaike info criterion 0.236LR statistic 1,171.267 ***

z-Statistic

Variables Mean (A) Mean (B) Mean (C) Mean Mean t-statAge 3.738 3.760 3.788 -0.021 -0.267 -0.050 -0.429Big4 0.934 0.732 0.895 0.202 8.281 *** 0.039 1.003Foreignshareholders 27.244 8.827 28.970 18.417 12.146 *** -1.726 -0.748Size 12.943 10.744 13.054 2.199 11.473 *** -0.111 -0.375Leverage 0.497 0.516 0.515 -0.020 -0.998 -0.018 -0.602

(A) - (C)t-stat

Sample firms Other firms Control firms (A) - (B)

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Table 6: Analysis of conditional conservatismPanel A: Estimation results of equation (1)

Note: *** and * indicate statistical significance at the 1% and 10% levels, respectively.

Panel B: Comparison of C-Score

Note: *** and ** indicate statistical significance at the 1% and 5% levels, respectively.

Variable Coefficient Coefficient Coefficient

C 0.136 14.984 *** 0.150 15.121 *** 0.132 15.153 ***D -0.359 -8.642 *** -0.146 -1.665 * -0.356 -9.044 ***R -0.110 -0.898 -0.066 -0.455 -0.050 -0.390R*MK 0.020 0.897 0.003 0.099 0.013 0.554R*MTB 0.010 1.234 0.026 2.780 *** 0.001 0.118R*LEV -0.015 -0.430 0.006 0.214 -0.012 -0.239D*R 1.946 1.343 3.280 3.026 *** 1.916 1.399D*R*MK -0.175 -0.659 -0.526 -3.042 *** -0.173 -0.692D*R*MTB -0.045 -0.458 -0.005 -0.156 -0.032 -0.285D*R*LEV -0.248 -0.561 -0.238 -1.861 * -0.327 -1.092

Obs. 176 126 168Adjusted R-squared 0.443 0.377 0.478Akaike info criterion -1.553 -2.032 -1.668F-statistic 16.458 *** 9.420 *** 17.976 ***

t-Statistic t-Statistic t-StatisticGroup B Group CGroup A

C-Score No. C-Score No. C-Score No.

Sample average (A) 0.735 88 0.124 63 0.723 84

Control average (B) 0.829 88 0.290 63 0.818 84

(A) - (B) -0.094 -0.166 -0.095

(t-stat) 2.236 ** 1.906 ** 2.474 ***

Group A Group B Group C

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Table 7: Unconditional conservatismPanel A: Estimation results of equation (2)

Note: *** and ** indicate statistical significance at the 1% and 5% levels, respectively.

Panel B: Comparison of −𝛼

Note: ** indicates statistical significance at the 5% level.

Variable Coefficient Coefficient

BTM 1.112 70.365 *** 1.093 46.192 ***R t -0.306 -10.764 *** -0.404 -9.004 ***R t-1 -0.242 -8.292 *** -0.243 -5.048 ***R t-2 -0.182 -6.098 *** -0.188 -3.931 ***R t-3 -0.178 -5.237 *** -0.165 -3.226 ***R t-4 -0.148 -4.936 *** -0.151 -3.235 ***R t-5 -0.112 -4.083 *** -0.145 -3.408 ***R t-6 -0.068 -2.482 ** -0.106 -2.409 **

Cross-section fixed YES YESPeriod fixed YES YES

Obs. 704 504Adjusted R-squared 0.866 0.774Akaike info criterion 0.036 0.521F-statistic 25.489 *** 13.726 ***

t-Statistic t-StatisticGroup A Group B

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Table 8: Comparison of accounting items between sample and control firmsPanel A: Comparison for Group A

Note: *** and ** indicate statistical significance at the 1% and 5% levels, respectively.

Panel B: Comparison for Group B

Note: *** indicates statistical significance at the 1% level.

Sample average (A) 0.208 0.086 0.066 0.087 0.032Control average (B) 0.257 0.039 0.092 0.071 0.026

(A) - (B) -0.050 0.047 -0.026 0.016 0.006(t-stat) -2.192 ** 3.736 *** -2.118 ** 1.499 0.867

Tasset Iasset Fasset Inventory Retire

Sample average (A) 0.224 0.073 0.076 0.082 0.030Control average (B) 0.252 0.040 0.096 0.066 0.025

(A) - (B) -0.029 0.033 -0.020 0.016 0.006(t-stat) -1.232 2.685 *** -1.485 1.465 0.983

Iasset Fasset Inventory RetireTasset

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Table 9: Pearson correlation matrices for regression analysisPanel A: Pearson correlation matrix for Group A

Panel B: Pearson correlation matrix for Group B

IFRS Tasset Iasset Fasset Inventory RetireIFRS 1.000Tasset -0.164 1.000Iasset 0.272 -0.224 1.000Fasset -0.159 -0.089 -0.053 1.000Inventory 0.113 -0.053 -0.092 -0.121 1.000Retire 0.066 0.077 -0.021 -0.125 0.246 1.000

IFRS Tasset Iasset Fasset Inventory RetireIFRS 1.000Tasset -0.246 1.000Iasset 0.304 -0.244 1.000Fasset -0.205 -0.112 -0.092 1.000Inventory 0.148 -0.132 -0.111 -0.105 1.000Retire 0.057 0.033 -0.022 -0.130 0.340 1.000

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Table 10: Factors affecting C-Score

Note: ***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively.

Variable Coefficient Coefficient Coefficient Coefficient

C 0.936 10.231 *** 0.870 8.947 *** 0.464 3.160 *** 0.473 3.123 ***

IFRS -0.372 -3.497 *** -0.284 -2.775 *** -0.554 -3.382 *** -0.524 -3.159 ***

Tasset -0.341 -2.097 ** -0.347 -2.198 ** -0.549 -1.722 * -0.550 -1.744 *

Iasset -0.252 -0.813 0.209 0.774 0.309 0.504

Fasset -0.110 -0.467 -0.108 -0.462 -0.537 -1.252 -0.544 -1.278

Inventory 0.199 0.651 0.292 0.915 0.078 0.130

Retire -0.519 -0.531 1.092 1.107 0.623 0.969 0.563 0.859

Tasset x IFRS 1.053 3.494 *** 1.040 3.614 *** 1.577 2.818 *** 1.501 2.647 ***

Iasset x IFRS 0.603 1.393 -2.079 -1.423

Retire x IFRS 0.087 0.084

Obs. 176 176 126 126

Adjusted R-squared 0.073 0.085 0.483 0.483

Akaike info criterion 0.271 0.258 1.592 1.595 *

F-statistic 2.720 *** 3.033 *** 0.088 * 0.100

t-Statistict-Statistic t-Statistict-Statistic

Model A Model B Model C Model D