Gauri Bhat*, Jeffrey L. Callen**, Dan Segal***Feb. 2014*Olin Business School, Washington University in St. Louis, One Brookings Drive, MO 63105, USA; bhat@**Rotman School of Management, University of Toronto, 105 St. George St., Toronto Ontario, Canada M5S 3E6; callen@rotman.utoronto.ca*** Arison School of Business, Interdisciplinary Center Herzliya, Israel 46510 and Singapore Management University, Singapore; dsegal@idc.ac.ilAcknowledgementsBhat gratefully acknowledges the Center for Research in Economics and Strategy (CRES) at the Olin Business School for financial support. Callen gratefully acknowledges the Humanities and Social Sciences Research Council of Canada for financial support. We wish to acknowledge the anonymous reviewer of this Journal for detailed and constructive comments. We wish to thank workshop participants at the University of Missouri-Columbia, University of Notre Dame, University of Waterloo, Washington University in St. Louis, and the Hebrew University of Jerusalem. We also wish to thank conference participants at the 2012 Winter Global Conference on Business and Finance, 2011 University of Minnesota Empirical Accounting Research Conference, 2011 Utah Winter Accounting Conference Program, and the 21st Annual Conference on Financial Economics & Accounting. We also with to acknowledge Richard Carrizosa the discussant at the 2011 Utah conference and Nicole Jenkins the discussant at the 21st Annual Conference on Financial Economics & AccountingAbstractThis study compares the pricing of credit risk information conveyed by accounting numbers under IFRS relative to local GAAP. We measure the price of credit risk by CDS spreads and focus on three fundamental accounting metrics that inform about credit risk: earnings, leverage and book value equity. Using a difference in differences methodology, we find that while earnings, book value and, to a lesser extent, leverage are significant determinants of credit risk pricing both prior to and after IFRS adoption, the adoption of IFRS did not change the credit risk informativeness of these accounting variables as reflected in CDS spreads. This conclusion is robust to controlling for institutional differences among countries as well as a battery of sensitivity analyses.Key words: Credit Default Swaps, Credit Risk, IFRSJEL Classification: M40, M41, G13, G20Data Availability: All data are publicly available.11. IntroductionThis study evaluates the impact of the adoption of International Financial Reporting Standards (IFRS) on the relevance of accounting information in pricing credit risk in the over-the-counter Credit Default Swap (CDS) market. IFRS uses a principle-based approach, emphasizes fair value accounting, and aims to promote uniformity and comparability across countries. We compare the information conveyed by accounting information in pricing credit risk under IFRS relative to local Generally Accepted Accounting Principles (GAAP) for countries that adopted IFRS. We focus on three fundamental accounting metrics that inform about credit risk: earnings, leverage and book value equity. We measure the credit risk relevance of each of these accounting metrics by reference to their estimated coefficients in a regression of CDS spreads on these metrics, controlling for other potential determinants of the spread.1 This approach is similar to measuring the value relevance of earnings for equity returns by an Earnings Response Coefficient where CDS spreads replace equity returns.The role of accounting information in the pricing of credit risk finds theoretical support in the Duffie and Lando (2001) model which explicitly acknowledges the relevance of noisy accounting information as a determinant in the pricing of credit risk. Callen, Livnat and Segal (2009) and Das, Hanouna and Sarin (2009) provide empirical evidence that accounting information has a role in CDS pricing incremental to market information, and other determinants of CDS spreads. Our study is guided by the above prior research that speaks to the importance of accounting information for credit markets and the empirical evidence that directly links accounting information to CDS pricing.The adoption of IFRS provides a unique research opportunity to examine the impact of financial statement information on the pricing of credit risk because the switch to IFRS for most firms was exogenously mandated by accounting regulators, mitigating1 In this paper, the term “credit risk relevance” refers to the relevance of accounting information in the pricing of credit risk.2the potential impact of confounding endogenous events.2 In addition, a relatively large number of firms had to switch to IFRS, thereby providing a reasonable sample size.Whether the credit informativeness of accounting information in the pricing of credit risk has changed under IFRS as compared to prior local GAAPs is unclear a priori. On the one hand, IFRS is principles based rather than rules based, and therefore encourages companies to adapt their reporting to better reflect the underlying substance of the transaction. Further, IFRS emphasizes greater use of fair value accounting than local GAAPs. Fair value information provides timely early warning signals of changes in current market expectations, which are particularly relevant for the analysis of credit risk (Linsmeier 2011). In addition, one set of standards across countries promotes uniformity and comparability and, hence, should allow for better assessment of credit risk especially in the case of cross-country debt.On the other hand, by allowing managers to have more judgment and discretion, IFRS affords greater flexibility for manipulation of accounting information. Furthermore, any discretion accompanying a principles based approach is bound to be plagued by inconsistent interpretation and application, and potentially compromises comparability. As far as fair value accounting is concerned, in the absence of fairly liquid markets, fair values may not be meaningful, especially given that the determination of fair values (mark-to-model) is largely a matter of managerial judgment (Kothari, Ramanna and Skinner 2010).Furthermore, any effect of IFRS adoption is potentially contingent on country level institutional factors that complement accounting standards and shape financial reporting incentives (Ball 2006). Indeed, prior literature documents that institutional factors are associated with the quality of accounting information (e.g. Ahmed, Neel, and Wang 2012, Chen, Tang, Jiang and Lin 2010, Alford, Jones, Leftwich and Zmijewski 1993, Ali and Hwang 2000, Bartov and Goldberg 2001, Bushman and Piotroski 2006, Ball, Kothari and Robin 2000). Thus, we also examine the impact of variation in institutional factors on the relation between CDS spreads and our three accounting2 Our sample excludes firms that adopted IFRS voluntarily.3metrics, including the system of laws (code vs. common law – a proxy for quality of financial statement information), the quality of securities law enforcement, the extent of creditor rights protection, the pervasiveness of earnings management, the extent of differences between local GAAP and IFRS, and the country-level degree of conservatism as measured by differential timeliness.3While IFRS potentially affects financial reporting as a whole and some of the induced changes in financial reporting affect the quality of disclosures rather than the accounting numbers directly, we choose to study the impact of the adoption of IFRS on the credit risk relevance of three primary accounting variables, earnings, leverage and book value. We perform three distinct tests to examine the impact of IFRS on these three accounting metrics. First, we examine the association of earnings, leverage and book value with CDS spreads under both local GAAP (i.e. pre-IFRS) and IFRS, and test whether the adoption of IFRS changed their association. Second, we examine whether the association of earnings, leverage and book value with CDS spreads subsequent to the adoption of IFRS depend on the country level institutional factors indicated above. Third, we also test for the potential asymmetry (non-linearity) of CDS spreads with respect to the levels of earnings, leverage and book value equity in light of the evidence in Callen, Livnat and Segal (2009) of a non-linear relation between CDS spreads and profitability. We also test for asymmetry with respect to investment/speculative grade debt following Florou et al. (2012).Using a sample of 5,893 firm-quarters across 13 countries (with US firms as a control sample) and difference-in-differences approach, we show that our accounting metrics are informative in the pricing of credit risk in IFRS countries both before and after the adoption of IFRS, consistent with the findings in Callen, Livnat and Segal (2009) and Das, Hanouna, and Sarin (2009). However, there is no statistically significant difference in the association of these accounting numbers with CDS spreads between the pre and post adoption periods, indicating that IFRS adoption had no impact on the3 While differential timeliness (DT) is also related to country characteristics such as code vs. common law (Ball, Kothari and Robin 2000, Bushman and Piotroski 2006) and strength of securities law enforcement (Bushman and Piotroski 2006), we treat DT as an independent feature of the accounting system.4relevance of these accounting metrics in pricing credit risk. The results of our second set of tests which condition on institutional factors show that the credit risk relevance of accounting information in pricing CDS spreads depends on institutional factors. Specifically, earnings, leverage and book value are credit risk relevant in common law countries, and in countries with strong legal enforcement, strong creditor rights, low earnings management, low differences between local GAAP and IFRS, and countries with high differential timeliness. Nevertheless, the adoption of IFRS did not have any impact on the pricing of credit risk; namely, the relations just described hold both in the pre and post IFRS adoption periods.We should emphasize that the lack of evidence to support change in the credit risk relevance of these accounting variables does not mean that IFRS adoption failed to produce any beneficial effects, nor does our evidence necessarily contradict the current evidence referenced below regarding the impact of IFRS adoptions on debt markets and credit ratings. What the evidence does show is that IFRS adoption had no impact on the relevance of earnings, book values and leverage in pricing credit risk (in the CDS market), despite the relevance of these accounting metrics in pricing credit risk both before and after the adoption of IFRS.We contribute to the extant literature on IFRS by studying the impact of IFRS adoption on credit market pricing. The prior literature in this area focuses predominantly, but not exclusively, on equity market returns. However, the credit market is no less important than the equity market for several reasons. First, the informational needs of the equity market may differ from those of the credit market. Exclusive reliance on the equity market to quantify the pricing impact of IFRS ignores the fact that credit markets represent a significant source of financing for public firms. In particular, the CDS market, which is a subset of the overall credit market, is a multi- trillion-dollar market. The limited evidence in the literature supports the conjecture that the adoption of IFRS affected debt markets. Specifically, Beneish, Miller and Yohn (2012) find that IFRS adopting countries attract more debt investment, and have a lower extent of debt home bias. They also find that their result is contextual and is driven by adopting countries that have weaker investor protection and higher financial risk. They argue that their findings5indicate that IFRS adoption reduces the agency costs of debt in countries with less developed investor protection and greater financial risk, consistent with IFRS providing more transparent information. Christensen, Lee and Walker (2009) show that mandatory IFRS affects debt contracting. Their results suggest that as a result of the change to IFRS, the likelihood of debt covenant violations increases, requiring costly renegotiations between lenders and debtors. However, using the CDS market we find that adoption of IFRS did not change the credit risk informativeness of earnings, leverage, and book value of equity. Second, this paper provides evidence on the informativeness of accounting information in pricing credit risk using an international sample. While prior literature discusses the significance of accounting for U.S. credit markets, the empirical evidence on the relevance of accounting numbers for international CDS pricing is fairly limited. Third, using the mandatory adoption of IFRS, our study establishes the causal link between the relevance of accounting information and the prediction of credit default spreads.In what follows, Section 2 describes the advantages of using CDS as proxy for credit risk. Section 3 provides the literature review and develops the hypotheses. Section 4 describes the data. Sections 5 and 6 present the empirical results and sensitivity analyses, respectively. Section 7 concludes.2. CDS and the Pricing of Credit RiskThe extant research on IFRS adoption is concerned almost exclusively with equity markets (see for example Li 2010 and Daske, Hail, Leuz and Verdi 2013). But, as the financial crisis of 2008 has shown, debt markets are no less crucial than equity markets for the functioning of the financial system in general and the financing of public corporations in particular. Within the debt markets, we focus on the CDS market. In this6section we discuss the advantages of using the CDS market in comparison to the bond market and credit ratings to evaluate credit risk.2.1 CDS versus Bond MarketsThis study evaluates the impact of IFRS on the relevance of accounting information in pricing credit risk by reference to CDS spreads. The credit risk information conveyed by IFRS earnings could be evaluated instead through corporate bond yield spreads, as was done by Florou and Kosi (2013). Indeed, absent arbitrage opportunities, contractual features (such as embedded options, covenants, and guarantees), and market frictions, the CDS spread and the corporate bond yield spread—the difference between the bond yield and the risk-free rate—are necessarily identical for floating rate corporate debt (Duffie 1999). Nevertheless, it is precisely because of these latter factors—contractual features and market frictions—that CDS instruments offer many advantages over corporate bonds (and other debt instruments) for analyzing the determinants of credit risk pricing.First, the finance literature has shown that corporate bond spreads include factors unrelated to credit risk, such as systematic risk unrelated to default (Elton, Gruber, Agrawal and Mann 2001) and especially illiquidity (Longstaff, Mithal and Neis 2005).4 Huang and Huang (2002) conclude that less than 25 percent of the credit spread in corporate bonds is attributable to credit risk. Second, interest rate risk drives fixed-rate corporate bond yields for fixed rate debt quite independently of credit risk. Third, in contrast to CDS instruments, corporate bonds are replete with embedded options, guarantees, and covenants. Heterogeneity in these features potentially distorts the relationship between accounting numbers and credit risk in cross-sectional studies. Even more problematic is that they may generate a spurious relation between earnings and credit risk. For example, the positive relation between earnings and corporate bond prices could be driven by earnings-based covenants rather than by credit risk. With lower earnings, earnings-based covenants are more likely to be binding, increasing the4 These are relative statements. CDS markets also suffer from potential illiquidity—indeed we control forthe bid-ask spread in our empirical tests--but far less so than corporate bond markets.7probability of technical bankruptcy and concomitant expected transactions (renegotiation) costs, thereby leading to reduced bond prices. In contrast, except in rare cases, technical default is not a credit event in CDS contracts and thus has little impact on CDS spreads. Fourth, the available empirical evidence indicates that credit risk price discovery takes place first in the CDS market and only later in the bond and equity markets (Blanco, Brennan and Marsh 2005; Zhu 2006; Daniels and Jensen 2005; Berndt and Ostrovnaya 2008). The bond market’s lagged reaction potentially distorts empirical studies relating earnings to bond yields. Fifth, unlike corporate bond yield spreads, no benchmark risk-free rate needs to be specified for CDS spreads minimizing potential misspecification of the appropriate risk-free rate proxy (Houweling and Vorst 2005). Sixth, CDS rates are closely related to the par value of the reference bond, whereas corporate bond values (including their taxability characteristics) are affected by coupons. Heterogeneity in coupon rates potentially distorts the relationship between earnings and credit risk in cross-sectional studies. Finally, bond yield spreads are affected by tax differentials in bond pricing. Elton, Gruber, Agrawal and Mann (2001) document a tax premium of 29 to 73 percent of the corporate bond spread, depending on the rating.5,62.2 CDS versus Credit RatingsFlorou, Kosi and Pope (2012) show that IFRS adoption affects credit ratings. However, by focusing on credit ratings, their paper is conceptually different from ours. Unlike CDS and corporate bond yield spreads, credit ratings are not market prices. As is well-known, in addition to credit risk, credit ratings reflect rating agency incentives,5 Also, unlike equities, even the largest corporate bonds do not trade very often and bond prices are often not observable. Instead, published bond prices are often stale or simply interpolated.6 One may still be tempted to argue that since CDS instruments are derivatives whose price depend on the value of the underlying debt, the role of accounting information in determining the CDS spread is unclear because the prices and volatilities of the underlying financial instruments are observable. However, as shown by Duffie and Lando (2001), even noisy accounting information is relevant for the pricing of CDS because accounting provides information about the firm’s wealth and asset dynamics and, hence, about the probability of the occurrence of credit events such as bankruptcy.8rating agency competition, and the ability of rating agencies to predict credit risk well and in unbiased fashion (Becker and Milbourn 2011; Bolton, Freixas, and Shapiro 2012). That is not to say that credit ratings do not potentially convey information about credit risk pricing. Indeed, we control for credit ratings in our regressions below. Nevertheless, credit ratings are not market prices (or market quotes) and therefore it is unclear how effective or timely they are in measuring credit risk. It is telling that in some of the most egregious bankruptcy cases such as Enron and Worldcom, credit ratings did not even remotely predict the true credit risk of these firms. For example, credit ratings for Enron were positive and unchanged up to four days before bankruptcy whereas CDS spreads began to climb months before. Similarly, CDS rates began to climb for Worldcom well in advance of rating downgrades (Jorion and Zhang 2006). Furthermore, there is compelling evidence that CDS rates anticipate rating downgrades (Hull, Predescu and White 2004; Norden 2011) and that CDS spreads explain the cross-sectional variation in primary and secondary bond yields better than credit ratings (Chava, Ganduri and Ornthanolai, 2012).3. Hypotheses Development3.1 Earnings, Leverage, Book Value and CDS SpreadsOf the information provided by financial statements that relates to (the pricing of) credit risk, we focus our analysis on earnings, leverage and book value. Earnings and book values can be used by investors to estimate the reference entity’s economic performance and true asset (wealth) dynamics, important determinants of credit risk yields (Merton 1974; Duffie and Lando 2001). More specifically, increased profitability of the firm, as measured by current accounting earnings and book value, should reduce its credit risk since, with increased profitability, the reference entity is wealthier and less likely to default. Moreover, accounting studies have shown that current earnings are a good predictor of future earnings (Finger 1994; Nissim and Penman 2001), future cash flows (Dechow, Kothari and Watts 1998; Barth, Cram, and Nelson 2001) and firm equity performance (Dechow 1994). In other words, an increase (decrease) in earnings portends9an increase (decrease) in current and future operating and equity performance and, hence, a reduced (increased) probability of bankruptcy. Book value is a measure of minimal firm wealth (Watts 2003) and a measure of proximity to default, as firms generally do not declare bankruptcy until the accounting book value of equity is well below zero. Also, earnings and book value comprise a significant portion of the short-term change in firm assets (via clean surplus) and, therefore, provide information to investors about the firm’s asset and wealth dynamics, crucial variables in the estimation of credit risk (Duffie and Lando 2001).Consistent with the seminal study by Merton (1974), structural models imply that leverage is one of the main determinants of the likelihood and severity of default. In fact, earnings and leverage are the two variables which have been shown to provide financial distress information incremental to recent excess stock returns and stock volatility (Shumway 2001).Although Callen, Livnat and Segal (2009) and Das, Hanouna and Sarin (2009) show that accounting information is relevant for assessing credit risk in the CDS market, the findings in these studies are based primarily (but not exclusively) on U.S. reference entities employing U.S. GAAP. Given the relatively high quality accounting standards together with effective regulation and securities laws enforcement in the U.S., one cannot generalize these findings to an international setting where countries differed in their accounting standards prior to IFRS adoption, and differ subsequently in securities law enforcement, creditor rights protection, quality of financial information, and extent of earnings management. These considerations lead to our first hypothesis:H1a: CDS spreads are uncorrelated with accounting numbers (earnings, leverage and book value) both pre- and post-IFRS adoption for firms in countries adopting IFRS.Prior research suggests that underlying economic and political institutions influence the incentives of the managers and auditors responsible for financial statement preparation (e.g., Ball, Robin and Wu 2003). Therefore, we gauge the credit risk informativeness of accounting information controlling for the following institutional10factors: origin of the legal system, level of legal enforcement, level of investor rights protection, level of earnings management, degree of conditional conservatism, and a measure which quantifies differences between local GAAP and IFRS.Political influence on accounting standard setting in code law countries prior to IFRS promoted the use of accounting metrics in dividing profits among various stakeholders such as governments, shareholders, banks, and labor unions (Ball, Kothari and Robin 2000). As a result, accounting information in code law countries was less related to the economic performance of the firm and, therefore, less informative about credit risk than accounting information in common law countries.7Similarly, enforcement of the legal system also affects accounting quality directly, through enforcement of accounting standards and litigation against managers and auditors. Thus, accounting information in countries with high legal enforcement may be more reflective of credit risk than accounting information in countries with low legal enforcement pre and post IFRS adoption.Creditor Rights protection (CR) is defined as the extent to which creditors are protected when the borrowing firm faces financial difficulties, in particular the ability of creditors to repossess collateral or take over the firm in case of bankruptcy. CR is the result of various laws and legal mechanisms at the country level so that there is large variation in CR across countries (La Porta et al. 1998). Differences in the extent of CR may affect the relation between accounting information and CDS because CR affects the riskiness of debt and the recovery rate in case of bankruptcy. It is plausible that investors have more incentive to use accounting information to assess credit risk and protect their interests ex-ante if a country’s law is not creditor friendly.Earnings management generally distorts the informativeness of financial reports. We focus on distributional properties of reported accounting numbers across countries7 Code-law accounting affords managers more latitude in timing income recognition, thereby obfuscating the economic performance of the firm. In particular, one of the main accounting incentives of the various stakeholders is to reduce the volatility of net income, thereby creating a strong incentive to smooth earnings (Ball, Kothari and Robin 2000). This can be accomplished, for example, by firms creating earnings reserves in good years through excessive impairment charges and provisions, and using these reserves in bad years. These are promoted by the government’s stakeholder policy.11and across time as captured by the Leuz, Nanda and Wysocki (2003) measure of earnings management at the country level. We focus on this measure because past literature has identified the existence of earnings management as weakening the link between accounting performance and the true economic performance of the firm. Thus, one would expect accounting information in countries with high earnings management to be less informative about the pricing of credit risk than in countries with low earnings management.We use the difference between local GAAP and IFRS at the country level to identify countries which are likely to be affected the most from the transition to IFRS. If the difference between the local GAAP and IFRS is large, informativeness of accounting numbers should be different than if the difference is small.Conditional conservatism should be of particular importance to CDS investors (and bondholders) who are far more concerned with earnings decreases than earnings increases (Callen, Livnat and Segal 2009). As emphasized by Watts (2003), conditional conservative accounting is demanded by debt holders because it reduces management’s ability to artificially increase earnings and asset values. Specifically, when future negative cash flow shocks are anticipated, conservative accounting requires the firm to recognize future losses immediately in income, resulting in a concomitant reduction in asset values. Hence, the degree of conditional conservatism has a direct impact on the informativeness of accounting information. The more conditionally conservative the firm, the more likely is the firm’s accounting to act as a trip wire regarding anticipated future negative cash flow shocks that may reduce the firm’s ability to pay back its debt. Thus, one should expect ex ante that the more conservative the country, the more informative is accounting information for the pricing of credit risk and, hence, the more negative the relation between earnings and CDS spreads.These considerations lead to our next hypothesis:H1b: The relation between CDS spreads and accounting numbers (earnings, leverage, book value), both pre- and post-IFRS adoption depends on country-wide institutional differences such as code law versus common law, legal12。
