Statement of the General Hypothesis

This section explains the development of three general hypotheses to respond to the principal research problem. More specific hypotheses for each perspective of accounting quality will be elaborated in particular chapters. This thesis defines accounting quality as earnings persistence, value relevance and earnings timeliness; this is consistent with a large number of prior studies. Accounting information is a proxy to represent unobservable underlying economic constructs. Information users demand useful economic constructs for their decision making or relevancy before considering what and how a proxy of economic constructs is

Chapter I Introduction

determined (Maines and Wahlen 2006). Maines and Wahlen (2006) suggest that accounting information relevance stimulates measurement and reporting reliability. However, they further argue that information reliability is an essential but not adequate characteristic for the efficient use of applicative information. Because of the different perspectives of reliability and relevancy, it is controversial to differentiate as to whether reliability or relevancy is more important.

According to the statement of the Chairman of the International Accounting Standards Committee of Foundation Trustees (IASC Foundation Annual report 2006, pg.4), IFRS convergence brings high quality standards to countries that adopt them. This statement implies that the adoption of IFRS should provide better quality accounting information. Although more than 100 countries around the world have adopted IFRS in their accounting systems,15 there are only a few research studies which examine the transition of accounting standards. As a principles-based accounting system, IFRS allows firms to use their discretion. However, Dechow and Schrand (2004, pg.102) suggest that IFRS encourages value relevance. Most prior studies investigate the improvement of accounting quality after IFRS-adoption through analysis of value relevance. The results of these studies, however, are mixed and inconclusive (i.e. Prather-Kinsey 2006; Barth et al. 2008).

In this study, I address whether accounting quality is enhanced when converging the domestic accounting system to international accounting standards. I employ Thai data for the analysis as it has adopted IFRS for several years and now these new accounting standards should be fully implemented. Analysing a single country minimises the variation of market environment (Leuz 2003). In addition, although they use the same set of accounting standards, accounting quality can be varied across countries due to the dispersion of domestic investors (Alford et al. 1993). Graham et al. (2000) find that the value relevance of Thai book values and

15

Chapter I Introduction

earnings declined during the financial crisis. However, Davis-Friday et al. (2006) report that the value relevance of earnings declined but the value relevance of book values increased during the financial crisis. Prior studies suggest that Thai accounting information is value-relevant and the value relevance of the Thai accounting summary measures reflects economic consequences. It is controversial whether IFRS brings a higher quality of earnings than domestic accounting standards due to country-specific factors (Barth et al. 2008). Nevertheless, based on Barth et al. (2008), I have an ex ante prediction that earnings quality is enhanced after the accounting system change. As a result, the first general hypothesis in an alternative form is as follows:

General hypothesis 1

Accounting quality is enhanced after IFRS adoption.

Prior research provides evidence of accounting quality in different accounting regimes (Alford et al. 1993; Ali and Hwang 2000). Existing studies suggest that accounting information in code law countries is less sensitive to economic income and loss, implying a lower accounting quality (Ball, Kothari and Robin 2000; Ball et al. 2003; Ball and Shivakumar 2008). For example, Ball et al. (2003) argue that code law system countries are more likely to employ tax-based accounting systems that have a low ability to capture economic outcomes. Burgstahler, Hail and Leuz (2006) show that the number of firms in countries using tax rules for financial reporting purposes engaged in earnings management is greater than that in countries which use GAAP-based income. As a result, earnings informativeness is lower for countries where firms have large book-tax conformity.

In terms of the relationship between book income and taxable income, Guenther, Maydew and Nutter (1997) argue that it is difficult for firms to employ different accounting methods to increase taxable income or tax deductions, without increasing revenues or expenses in financial statements. For example, the estimated expense of warranty claims can be expenses in financial reporting, but it

Chapter I Introduction

cannot be a tax deduction unless economic performance has occurred. The condition in references to economic performance is sufficient, but not necessary for financial statement purposes (Guenther et al. 1997). In addition, high book- tax conformity violates stock exchange rules and increases potential costs, i.e. high tax payment and information loss (Hanlon, Laplante and Shelvin 2005; Hanlon, Maydew and Shevlin 2008). Guenther et al. (1997) argue that the book- tax difference occurs because of the underlying different incentives between financial and tax accounting. Accounting conservatism attempts to detect firms which understate expenses or overstate revenues; on the other hand, tax rules detect understated revenue and overstated expense. Mills (1998) reports that Internal Revenue Service audit adjustments increase as book-tax differences increase. This implies that book income information reflects tax activity.

Due to the different law and tax policies, firms in the tax-based accounting system may employ accounting standards in different ways from firms in the GAAP- based accounting system. The adoption of IFRS in tax-based accounting environments versus a GAAP-based accounting system possibly affects accounting quality differently (Ali and Hwang 2000). In GAAP-based accounting income systems, at the level of a given firm’s performance, reported earnings can be varied through different accounting treatments used. The book-tax difference in GAAP-based accounting income system has twofold: i) assuming that all firms had used the same tax strategy, at the level of a given firm’s performance, book- tax differences in GAAP-based accounting income systems reflect the management’s intention of using accounting standards and ii) on the other hand, assuming that all firms had used the same accounting treatment, at the level of a given firm’s performance, the difference of book income and taxable income reflects the level of aggressiveness in tax activities. In tax-based accounting income system, at the level of a given firm’s performance and tax strategy, firms are more likely to use tax rules for reported earnings. However, it is possible that tax rules do not cover all accounting transactions; book-tax differences still exist.

Chapter I Introduction

In this thesis, I investigate accounting quality in Thai firms by partitioning firms according to the magnitude of book-tax differences between the pre- and post- adoption period. I use book-tax differences to distinguish firms’ incentives in two areas; the use of accruals and tax activity. All else being constant, the argument is that new accounting standards implemented in the Thai tax-based accounting system will enlarge the difference between book income and taxable income due to the increasing opportunity to use discretionary accruals (Dechow and Schrand 2004, pg.113-114). However, the larger book-tax difference during post-adoption periods may be generated by aggressive tax planning. When comparing between earnings manipulation and tax activity in Thai settings, there is a higher variation in engagement in managing accruals among firms because aggressive tax planning is limited by law enforcement and tax audit and adjustment (Mills 1998).

In addition, I employ book-tax differences to construct firm portfolios because: i) the study of accounting quality and accounting system transition has not investigated the change in patterns of book-tax differences when the accounting system has been changed, and ii) in a tax-based accounting income system, IFRS adoption results in larger book-tax differences, at an unchanged level of tax activity. The larger book-tax difference reflects either the implication of principles-based accounting or management’s incentives in the area of accruals, if tax activity is held constant. However, it should be noted that smaller book-tax differences in the post-adoption period are not free from management discretions. New principles-based accounting standards allow firms to have more opportunity to perform more accruals. It will be problematic if the management is likely to perform opportunistic or informative earnings management to increase, decrease or smooth reported earnings. For example, Tucker and Zarowin (2006) suggest that informative earnings management is observed through income smoothing.

Based all above arguments, the second general hypothesis in an alternative form is as follows:

Chapter I Introduction

General hypothesis 2

Accounting quality is varied according to the magnitude of book- tax differences.

Accounting quality is also influenced by the indirect parameter as aforementioned. Based on the general hypothesis 2, if the variation in accounting quality among firms is observed, this thesis proposes that a firm’s governance system is a potential factor inducing the variation in accounting quality. Therefore, this leads to the third general hypothesis stating in an alternative form.

General hypothesis 3

There is an association between accounting quality and firm governance systems, influencing the variation in accounting quality among firms.

It should be noted that the analysis is divided into three perspectives of accounting quality. More detailed explanations about the development of hypotheses for each perspective, including earnings persistence, value relevance and earnings timeliness, are introduced in chapter 4 (H.4.1 – 4.3), 5 (H.5.1 – 5.3) and 6 (H.6.1 – 6.2), respectively. It also should be noted that general hypotheses 1 and 2 are to respond to the principal research problem whereas general hypothesis 3 is to respond to the supporting research question.

A summary of all research questions and alternative hypotheses is presented as follows:

Principal research problem

“whether the quality of accounting information is altered in Thai accounting regime and capital market environments between pre- and post-adoption accounting standards.”

Chapter I Introduction

General hypothesis 1

Accounting quality is enhanced after IFRS adoption.16 Hypothesis 4.1 (H.4.1):

Earnings are of higher persistence after the adoption of IFRS in Thailand.

Hypothesis 5.1 (H.5.1):

The value relevance of accounting summary measures is enhanced after the adoption of IFRS in Thailand.

General hypothesis 2

Accounting quality is varied according to the magnitude of book-tax differences. Hypothesis 4.2 (H.4.2):

When comparing between pre- and post-adoption periods, earnings persistence is related to book-tax differences

Hypothesis 5.2 (H.5.2):

When comparing between pre- and post-adoption periods, the value relevance is related to book-tax differences.

Hypothesis 6.1 (H.6.1):

Earnings timeliness is more pronounced when Thai listed firms exhibit larger book-tax differences.

Supporting research question

“whether the firm governance system affects the accounting information quality in Thailand.”

16

It should be noted that general hypothesis 1 is applied to the analysis of earnings persistence and value relevance but not the timeliness of earnings. It is due to the fact that the earnings persistence and the earnings timeliness have an opposite perspective. In particular, the earnings timeliness will be less likely for firms with higher persistence of earnings relative to firms with lower persistence of earnings. Therefore, if the alternative hypothesis 4.1 is not rejected, the earnings timeliness will be less likely after the adoption of IFRS in Thailand.

Chapter I Introduction

General hypothesis 3

There is an association between accounting quality and firm governance systems, influencing the variation in accounting quality among firms.

Hypothesis 4.3 (H.4.3):

Earnings persistence varies according to the firm governance system in Thailand.

Hypothesis 5.3 (H.5.3):

The value relevance varies according to the firm governance system in Thailand.

Hypothesis 6.2 (H.6.2):

There is a positive association between firm-specific conservatism measures and book-tax differences in Thai settings.