Mandatory IFRS Adoption and the Usefulness of Accounting Information in Predicting Future Earnings and Cash Flows

Abstract

We examine whether the mandatory adoption of International Financial Reporting Standards (IFRS) has changed the usefulness of accounting information in predicting future earnings and cash flows out-of-sample. Using a sample of firms from European Union countries that mandatorily adopted IFRS in 2005, we find the out-of-sample earnings and cash flows forecasts become significantly more accurate after IFRS adoption. Improvements in earnings forecast accuracy vary with the strength of legal enforcement but not with the strength of securities regulation and differences between domestic accounting standards (DAS) and IFRS while improvements in cash flow forecast accuracy do not vary with institutional characteristics. Total accruals are useful in the prediction of earnings both before and after IFRS adoption and their usefulness does not vary with institutional characteristics. However, total accruals are useful in the prediction of cash flows only after IFRS adoption and their usefulness does not depend on institutional characteristics. Accrual components do not have incremental predictive ability over total accruals. Earnings are (not) more informative about future cash flows than cash flows alone in countries with weak (strong) enforcement/regulation and high (low) DAS differences from IFRS. Portfolios of stocks based on the out-of-sample forecasts generate higher hedge returns after IFRS adoption, which corroborates the detected forecast accuracy improvements. Overall, an important dimension of accounting quality, predictive ability of future earnings and cash flows, has improved after mandatory IFRS adoption.

Keywords: IFRS, out-of-sample prediction, earnings, cash flows

JEL Classification: M41, G15, G17, G18