IFRS Adoption, Political Connections, Family Firms and Earnings Quality: The Case of the GCC Region

Abstract

This thesis examines whether the adoption of the International Financial Reporting Standards (IFRS) plays a role in improving financial reporting quality, in the shape of earnings quality, in Gulf Cooperation Council (GCC) countries. This thesis also investigates the relationship between political connections, family firms and earnings quality in the same context. The vast majority of countries that have adopted the IFRS are emerging economies with weak institutional environments and weak accounting infrastructure, and critics have questioned the efficacy of IFRS adoption for improving financial reporting quality in these economies. It has been argued that change in the quality of financial reporting in a given context is a function of the presence of significant factors (e.g., socio-political and enforcement mechanisms) other than accounting standards. Motivated by this, this thesis descriptively explores the current state of IFRS implementation in the GCC region. Also, the thesis investigates quantitatively the association between the length of the IFRS experience (i.e., time since implementation) and earnings quality. Additionally, the GCC region has very distinctive cultural aspects that have evolved over time (e.g., high degree of uncertainty avoidance, large power distance and secrecy). The uniqueness of the region’s corporate environment stems particularly from the fact that businesses are predominantly controlled by families, and many businesses have overt political connections with ruling families. Empirically, prior evidence has shown that family-owned firms are characterised by higher earnings quality than non-family firms. Conversely, politically connected firms are characterised by lower earnings quality than non-connected firms. Given the significance of these two distinctive features in businesses in the GCC region, this thesis exploits this unique institutional setting and investigates how the relationship between family-owned firms and earnings quality is moderated by the presence of firm-level political connections. The relationship between IFRS adoption, political connections, family ownership and earnings quality is examined using a cross-country sample of 222 listed firms from Bahrain, Kuwait, Qatar and the United Arab Emirates (UAE) over the period 2012–2017. Level of IFRS compliance is measured by employing a self-constructed disclosure index using 24 applicable standards (seven IFRS and 17 International Accounting Standards [IAS]) with 219 disclosure items. The length of IFRS experience is measured by subtracting the adoption date from the end of each calendar year in the sample. Earnings quality is measured via two properties of earnings: persistence and accruals quality. Persistence is measured using two alternative proxies (earnings per share and return on assets) and accruals quality is measured using Dechow and Dichev’s (2002) model of accruals. The descriptive results provide evidence that the average level of compliance for the full sample over the sample period is 34.25%, suggesting that the level of overall compliance is low. This overall low level of compliance among sample countries can be attributed to the weak institutional environments of these countries (i.e., weak governance mechanisms, low financial reporting transparency and weak enforcement laws). Also, as a unique core cultural dimension in GCC countries’ societies, the propensity of secrecy can play a key role in lowering the level of compliance and disclosure practices, as it overrides IFRS/IAS requirements. Multivariate regression estimates based on two-way cluster-robust standard errors and random effects suggest that earnings persistence is decreasing in IFRS experience and discretionary accruals are increasing in IFRS experience in the GCC region over the period 2012-2017. The findings clearly show that reported earnings quality has declined following IFRS adoption in the GCC region over time. This is consistent with the critique that mere adoption of higher quality accounting standards does not improve financial reporting quality unless institutional weaknesses and managerial incentive problems are addressed. In addition, panel data estimations based on random effects suggest that family-owned firms exhibit higher earnings persistence (earnings per share) compared to non-family firms. Also, the two-way cluster-robust standard errors and random effects estimations provide evidence that family-owned firms exhibit higher accruals quality than non-family firms. Further, panel data estimations based on two-way cluster-robust standard errors and random effects suggest that politically connected firms exhibit higher earnings persistence and higher accruals quality than non-connected firms. However, the earnings quality of politically connected, family-owned firms is not significantly different from that of politically unconnected, family-owned firms in all models. Thus, the presence of board members that are politically connected with ruling families in the GCC region does not weaken the influence of family ownership on earnings quality. This thesis contributes to the literature in several ways. First, the GCC region is increasingly important in the global economy. Moreover, the literature on IFRS adoption, political connections, family firms and earnings quality in the Middle East is in its infancy. This thesis extends the literature on these topics by documenting recent evidence from the GCC region. Second, prior studies on IFRS adoption documented that IFRS adoption in the GCC region is de jure but not de facto. This thesis’s results provide new evidence that earnings quality has declined in IFRS experience in the GCC region. Third, this thesis contributes to the literature by exploiting the unique institutional setting of the GCC region, where political ties with ruling families are a precondition to business success and family ownership has emerged as the dominant form of business ownership. This setting allows us to examine how earnings quality is shaped in the simultaneous presence of family ownership and corporate–political connections. Finally, the results can be used as a reference by policymakers and governmental officials in other emerging economies that are in the process of implementing the IFRS. The regulatory bodies in these countries are subject to the danger that, unless there is a general awareness within the government and business communities regarding the role of enforcement mechanisms and other socio-political factors, IFRS implementation will be partial, particularly if managers have no motives or incentives to follow these standards.