1. 11 Enforcement of Accounting Standards in Europe: Empirical Evidence for the Two-tier Mechanism in Germany INTACCT workshop Varna, March 2010 Jörg-Markus Hitz Göttingen University (Ex-ER Tilburg University)

2. 2 Agenda 1 Introduction 2 Institutional Background 3 Hypotheses 4 Sample selection and data collection 5 Results 6 Conclusion

3. 3 Introduction  Regulation EC No. 1606/2002 (“IFRS Regulation”) –Mandatory adoption of IFRS for listed firms in the EU –Mandate for EU member states to install enforcement mechanisms, implementation and coordination delegated to CESR  Quality of enforcement matters: –Academic research illustrates the crucial role of enforcement quality for (IFRS) accounting quality and capital markets effects (liquidity, cost of capital) (e.g. Daske et al, JAR 2008; Christensen and Walker, WP 2007; Beuselinck et al., WP 2009)  Attributes of high quality accounting enforcement remain unclear, particularly for heterogeneous governance / institutional environments throughout the EU  Germany: Introduction of two-tier enforcement mechanism in 2005: –Private institution: Deutsche Prüfstelle für Rechnungslegung (DPR) –Securities market regulator: Bundesamt für Finanzdienstleistungsaufsicht (BaFin)

4. Research Questions  What are the properties of firms censured by the German enforcement system for disclosure of errnoneous financial statements?  ‚Name and shame‘ – Is the adverse disclosure mechanism potentially effective in the German institutional setting?  What are the determinants of investor reactions upone release of DPR-induced error announcements? 4

5. European background 5  Regulation EC No. 1606/2002 (“IFRS Regulation”): Par. 16 requires member states `to take appropriate measures to ensure compliance with international accounting standards’  Coordination and supervisory role for CESR (Committee of European Securities Regulators): –“Standard No. 1 on Financial Information: Enforcement of Standards on Financial Information in Europe” (March 2003) –“Standard No 2 on Financial Information: Coordination of Enforcement Activities” (April 2004) –Review of Enforcement Practices (2007) –European Enforcers Coordination Sessions (EECS)

6. Two-tier enforcement system in Germany Deutsche Prüfstelle für Rechnungslegung (DPR): Investigates annual and interim financial reports of listed firms Firms are selected both based on random, risk-weighted sampling (proactive) and upon indication / information (reactive) Communicates informally witth firms under investigation Deutsche Prüfstelle für Rechnungslegung (DPR): Investigates annual and interim financial reports of listed firms Firms are selected both based on random, risk-weighted sampling (proactive) and upon indication / information (reactive) Communicates informally witth firms under investigation Tier 1 Bundesanstalt für Finanzdienstleistungsaufsicht (BAFIN): If required, BaFin forces firms to divulge information demanded by the DPR Conducts own investigations in rare circumstances Enforces disclosure of DPR error findings by censured firms Bundesanstalt für Finanzdienstleistungsaufsicht (BAFIN): If required, BaFin forces firms to divulge information demanded by the DPR Conducts own investigations in rare circumstances Enforces disclosure of DPR error findings by censured firms Tier 2 Objectives: Correction of erroneous financial reports Provide deterrence by adverse disclosure (‚name and shame‘) Objectives: Correction of erroneous financial reports Provide deterrence by adverse disclosure (‚name and shame‘) 6

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8. Hypotheses  Prior literature examines investor reactions (CARs, trading volume, liquidity) on the U.S. market: –SEC enforcement actions (Dechow et al., 1996; Nourayi, 1994; Beneish, 1999; Feroz et al., 1989; Karpoff et al., 2008) –Accounting restatements (Anderson and Yohn, 2002; Callen et al., 2006; GAO, 2002; Palmrose et al., 2004; Hribar and Jenkins, 2004; Richardson et al., 2002; Plumlee and Yohn, 2008)  No evidence so far for EU jurisdictions 8 Hypothesis 1: Investors react significantly upon the release of a DPR error announcement Hypothesis 1: Investors react significantly upon the release of a DPR error announcement Hypothesis 2: The size of the investor reaction is associated with the magnitude of the accounting errors and with the underlying motivation Hypothesis 2: The size of the investor reaction is associated with the magnitude of the accounting errors and with the underlying motivation

9. Enforcement Activities & Sample Selection 9

10. Error Findings 10

11. Characteristics of censured firms 11

12. Methodology: Measurement of investor reactions  Measures of investor reaction: –(Cumulative) abnormal return Abnormal return = Realized return – expected return Expected return based on estimation of the market model (150 prior trading days, CDAX-index as market index) –(Cumulative) abnormal trading volume Abnormal trading volume = actual trading volume – expected trading volume Expected trading volume: Average trading volume for the 150 trading days prior to the error announcement –(Cumulative) abnormal bid-ask spread Abnormal B/A spread= actual B/A spread – expected B/A spread Expected B/A spread: Average B/A spread for the 150 trading days prior to the error announcement  Event-study design: –Short term reactions around upon disclosure of the error announcements –Long-term reactions: Matched sample comparison 12

13. Short-term investor reactions (hypothesis 1) 13

14. Cumulative returns (long window): Censured firms versus control group 14 Sample firms Control sample

15. Determinants of market reactions (hypothesis 2) / 1 15

16. Determinants of market reactions (hypothesis 2) / 2 16

17. Conclusion  Enforcement quality represents an important factor in establishing compliance with IFRS in EU member states  Effectiveness of the ‚name and shame‘ mechanism in EU member states is an open question  This paper provides evidence for one particular institutional environment, Germany: –Significant investor reactions upon the disclosure of earnings announcements suggest potential effectiveness of the ‚name and shame‘ mechanism –No evidence that investors recognize the nature or degree of the erronoeus accounting  Issues and future research avenues: –Long-term effects of enforcement action: change in auditors, change in management –Long-term impact on IFRS compliance 17

18. Thank you for your attention! Questions, Suggestions? 18

19. Propensity Score Matching 19

20. Long-window investor reactions 20

21. Long-window reactions: Bid-ask-spreads 21

22. Long-window reactions: Relative trading volume 22