We examine the effectiveness of China’s IFRS adoption from the perspective of an important set of financial report users, foreign institutional investors. We find that foreign institutional investment does not increase after China’s IFRS adoption, and some evidence that it actually declines, particularly among firms with weaker incentives to credibly implement IFRS, or with greater ability to manipulate IFRS’s fair value provisions. We also find that the association between earnings and returns generally declines after IFRS adoption, consistent with reduced earnings quality. In addition, we find that foreign institutional investors’ returns decrease after China’s IFRS adoption. Finally, the decline in foreign institutional investment is greater among investors from countries with weak institutions that have also adopted IFRS. Taken together, our evidence suggests that the weak institutional infrastructure in China’s transitional economy impairs IFRS’s intended goal of attracting institutional investment through improved financial reporting quality. Further, financial information users’ home country institutions and IFRS adoption experience affect the effectiveness of IFRS adoption.
In an effort to improve financial reporting quality and attract foreign investment, China’s domestic capital markets now use International Financial Reporting Standards (IFRS) (MOF, 2006; IASB, 2006).1 Advocates of IFRS claim that it reduces information acquisition costs, thereby increasing investors’ willingness to invest across borders (e.g., SEC, 2008; Tweedie, 2008). IFRS, however, is modeled on developed economies with strong institutions, and little is known about the effects of IFRS adoption in large transitional economies such as China, where institutions are weak. Further, foreign institutional investors’ home country institutions and IFRS adoption experience may affect the ability of IFRS to attract foreign investment. The purpose of our study is to test whether China’s IFRS adoption has achieved its intended goal of attracting foreign institutional investment and whether foreign investors’ home country institutions and IFRS adoption experience influence the association between IFRS adoption and foreign institutional investment. The stated goal of the International Accounting Standards Board (IASB) in formulating IFRS is to create a single set of high quality accounting standards that ‘‘take into account the financial reporting needs of emerging economies” (IFRS, 2011). As a result, many developing countries have adopted or are planning to adopt IFRS in the near future. Consistent with this trend, China mandated IFRS adoption for all publicly traded firms beginning in 2007. A primary goal of China’s IFRS adoption is to attract greater foreign investment (MOF, 2006). Prior research has generally found positive capital market consequences following mandatory IFRS adoption (Daske et al., 2008; Li, 2010; Tan et al., 2011; DeFond et al., 2011). Much of this research, however, is based on evidence from the European Union (EU), where economic and legal institutions tend to be stronger than those in China. In settings where IFRS is unlikely to be credibly implemented, the benefits of IFRS adoption tend to be weak or non-existent, consistent with the notion that the effectiveness of high quality accounting standards depends critically on managers’ reporting incentives (Fan and Wong, 2002; Ball, 2006; Ball et al., 2003; Leuz, 2003). Characterized by poor investor protection, weak rule of law, and poor audit quality, China’s institutional setting creates weak incentives for managers to produce high quality financial statements (DeFond et al., 2000; Chen and Yuan, 2004; Wang et al., 2008; He et al., 2012). In addition, IFRS’s principlesbased standards and a greater use of fair value accounting provide more opportunities for Chinese managers to misreport (He et al., 2012). Therefore, we predict that IFRS adoption in China is unlikely to result in increased financial reporting quality that will attract greater foreign investment.