How the Financial Reporting Environment Affects Crash Risk

DEFOND, Mark | HUNG, Mingyi | LI, Siqi | LI, Yinghua

One of the greatest fears of investing in a company is that its stock prices may “crash” – in other words, the investment will suffer extreme negative stock returns. An important determinant of crash risk is the financial reporting environment in which a firm operates. This changed significantly in 2005 when dozens of countries mandated the adoption of International Financial Reporting Standards (IFRS), which in turn has provided researchers with a useful test bed for examining how the financial reporting environment affects firm-level crash risk.

The research team of Mark DeFond, Mingyi Hung, Siqi Li and Yinghua Li took the opportunity to analyze the effect of IFRS adoption on both non-financial and financial companies in order to compare the results, which they believed would show differences. Their expectation was that for non-financial firms, IFRS would affect crash risk primarily through increased reporting transparency as a result of additional disclosure and improved comparability -- existing research shows that greater transparency reduces managers’ ability to withhold bad news – and that the crash risk would decrease.

With regard to financial firms, the researchers expected IFRS adoption to affect crash risk through three channels, the net effect of which is difficult to predict. The first channel is through the same disclosures that lead to increased transparency for non-financial firms, though they expected the effect to be smaller for financial companies. The second is through the fair-value (defined as an amount at which an asset can be exchanged between knowledgeable and willing parties) consequences of implementing International Accounting Standard (IAS) 39; they expected this to be the major channel for financial firms, but could not predict whether it would increase or decrease crash risk because it would depend on the “fairness” of the fair value. The third is through changes in management risk-taking, which is also difficult to predict.

The team tested their expectations of the effects of mandatory IFRS adoption on a sample of 8,472 non-financial and 1,748 financial firms in 27 countries, focusing on two years before and after the 2005 adoption date.

They discovered a decrease in crash risk among non-financial firms after IFRS adoption, with the effect more pronounced among firms in poor-information environments and in countries with large and credible changes to local GAAP (generally accepted accounting principles). In contrast, for financial firms they found no change in crash risk post-adoption, on average. However, financial companies less affected by IFRS’s fair-value provisions experienced a decrease in crash risk, and banks with less restrictive banking regulations experience an increase in crash risk.

This research contributes to the literature by examining the effect of IFRS adoption on crash risk, a previously unexplored implication of IFRS adoption. The findings complement those of prior studies that examine the consequences of financial reporting regulation and add to the debate on fair-value accounting by examining how a shift from historical-based to fair-value-oriented standards affects crash risk. The results suggest that IFRS increases transparency, thereby broadly reducing crash risk among non-financial firms. Little evidence was found to indicate that fair-value accounting from IFRS increases crash risk for financial firms, contrary to concerns expressed by regulators. The authors caution, however, that their analysis of financial firms is preliminary and exploratory in nature.

HUNG, Mingyi

Head, Fung Term Professor of Accounting, Chair Professor