Transfer of knowledge: Do trade surpluses foster quality in accounting practices?

We study the association of persistent trade surpluses and earning management behavior in developing countries that sign trade agreements with developed countries, i.e., whether a coupling of nations via trade agreements results in a spillover of increased quality in accounting practices. Specifically, we assess financial reporting quality in Mexico in the years following NAFTA (as measured by earnings management). Under NAFTA, Mexico experienced persistent trade surpluses and adopted stricter regulatory standards. Using publicly listed Mexican firms, we find that the quality of earnings decreased under Mexican GAAP but improved and stabilized under IFRS. Our findings do not change when we control for the size of the trade surpluses, alternative measures of abnormal accruals, various growth measures, research and development intensity, and various measures of distress. Not only has Mexico experienced a growth in their economy under NAFTA but also an increase in earnings quality due to the transfer of accounting knowledge.