From the Income Statement Model to the Balance Sheet Model: an Empirical Analysis on the Impact on SMEs’ Earnings Quality

Financial accounting figures have always been a result of a pragmatic compromise between the income statement model (i.e., revenue/expense approach) and the balance sheet model (i.e., asset/liability approach) (Dichev, 2008). However, during the last decades, financial reporting standards have been gradually moving from the former approach to the latter (Jinnai, 2005), describing the asset/liability view as the only logical and conceptually sound basis of accounting (Sprouse, 1966; Storey and Storey, 1998; Bullen and Crook, 2005). In response to the clear position taken by regulators, national and international standard setters, several scholars have stressed theoretical and empirical drawbacks associated to the balance sheet model. Indeed, the alleged conceptual superiority of the balance sheet is unclear, while it contrasts with how most businesses operate and create value (advancing expense to generate revenue and earnings) (Dichev, 2008; Kvifte, 2008). At the same time, according to Dichev and Tang (2008), by worsening the revenue-expense matching process, the balance sheet model has lowered the earnings quality of US listed companies, causing a marked deterioration in the forward-looking informativeness of earnings. Notwithstanding the still ongoing debate on the supposed conceptual primacy of the balance sheet model over the income statement model and on the actual implications exercised by the former over the usefulness of earnings, the asset/liability approach has been increasing its influence shaping the financial statements not only of listed companies but also of the private ones. Indeed, a balance sheet model clearly influences the IFRS for SMEs. Moreover, as a part of the Responsible Business package with its “Think Small First” principle, the European Commission has recently replaced the IV and VII EU Directive with the new Accounting Directive 2013/34/EU. This Directive, that applies its provisions from 1st January 2016, seems to adopt a financial reporting model closer to the balance sheet one4. For this reason, our study aims to extend knowledge on the relationship between financial reporting models and earnings quality (EQ) by comparing EQ indexes collected on Voluntary Italian IAS/IFRS Adopters (VIA) and Italian GAAP Firms (IGF). Indeed, the IASB standards are strongly rooted on an asset/liability approach (He & Shan, 2015), whereas the Italian GAAPs are traditionally based on a revenue/expense model. After controlling for several variables that affect the quality of earnings, we find that firms adopting a balance sheet approach (VIA firms) are characterized by earnings of lower quality than firms whose financial statements refer to an income model (IGF). Our study contributes to the accounting literature in several ways. First, this paper collects new evidence on the relationship between the financial statements models (revenue/expense vs. asset/liability approach) and the quality of earnings. Second, to the best of our knowledge, this is the first study to investigate on the effects of financial statements models on the earnings quality of private companies. Indeed, more research in the private firm setting is needed and this study – by improving our understanding about factors affecting SMEs’ earnings quality – responds to those scholars asking for an improved research design for smaller or private firms (e.g., Sellhorn and Gornik-Tomaszewski, 2006; Nobes, 2010; Brüggemann, Hitz and Sellhorn, 2013). Finally, we contribute to the international debate on the accounting harmonization process and its effectiveness in achieving regulatory objectives. The paper is structured as follows. In section 2, we show our literature analysis and we develop our research hypothesis. The research methodology and the variables definitions with the statistical analyses are illustrated respectively in sections 3 and 4. Finally, in section 5, we illustrate the findings of the empirical analysis and, in section 6, the concluding remarks and the limitations of our study.