Importing Accounting Quality: The Case of Foreign Reverse Mergers

Abstract

The recent influx of foreign companies to the U.S. capital markets via reverse mergers, transactions that bypass the scrutiny given to IPOs, has raised concerns about the quality of financial reporting by the resulting firms. Using an array of proxies for reporting quality, we find that the reporting quality of these reverse merger (RM) firms, regardless of country of origin, is lower than that of their domestic industry peers and foreign cross-listed companies. However, the evidence is less conclusive regarding the alleged inferior quality of foreign RM firms relative to that of RM firms originating in the U.S. We also find that important determinants of the inferior reporting quality of RM firms are their lower audit quality and weaker external monitoring by the investing public. With few exceptions, investors appear to recognize this quality differential by tempering their reaction to accounting information reported by RM firms, and discounting these firms’ equity values relative to their non-RM industry peers. The findings have implications for investors, market regulators and auditors. They are also relevant for the discussion on the costs and benefits of harmonizing accounting standards and for the debate on the desirability of capital market stimuli in the form of relaxed reporting and disclosure rules.