When the rules change: influence of cultural characteristics
on earnings quality during IFRS adoption
Name: Robin Domburg Student number: 10641696
Thesis supervisor: dr. G. Georgakopoulos Date: June 24, 2018
Word count: 6044
MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam
Statement of Originality
This document is written by student Robin Domburg, who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Abstract
This paper examines the impact of cultural characteristics on earnings quality, measured by earnings discretion, and how this impact has changed with the adoption of IFRS in 2005. The analysis is conducted using a sample of firms from 27 countries, part of the European Union, over the period 2000-2009. The results indicate that earnings discretion is associated with the individualism dimension of national culture. This paper also finds evidence for the negative association between earnings discretions and uncertainty avoidance. However, not enough evidence is found to assume IFRS adoption has changed the impact of cultural characteristics on earnings discretion.
Contents
1 Introduction ... 5
2 Literature review and theory ... 7
2.1 Earnings, earnings quality and earnings management ... 7
2.2 Cultural characteristics and accounting choices ... 8
2.2.1 Uncertainty avoidance ... 9
2.2.2 Individualism ... 10
2.3 IFRS adoption ... 10
3 Hypothesis development ... 12
4 Research method and design ... 14
4.1 Dependent variable ... 14 4.2 Independent variables ... 14 4.2.1 Cultural factors ... 14 4.2.2 Control variables ... 14 4.3 Empirical models ... 15 4.4 Sample selection ... 15 5 Empirical results ... 17
6 Discussion and conclusions ... 22
1 Introduction
While the accounting profession is heavily regulated, managers have discretion in preparing the financial statements of their company. Given this discretion, those managers are able to implement their own reporting preferences and can thereby influence the quality of
information for various decision-makers.
Since the quality of earnings can influence the decisions that stakeholders make, it is important to know what factors have an effect on the earnings quality of a company.
According to Dechow et al. (2010, p.379), there are six categories of research of the determinants of earnings quality; firm characteristics, financial reporting practices, governance and controls, auditors, equity market incentives and external factors. Prior literature has addressed the relationship between most determinants and earnings quality, but little research has been done to determine the role of national culture on earnings quality.
Research has shown that the environment people live in has an important influence on the way that person behaves. Culture is a factor that determinates how that environment looks like, and could therefore alter the way somebody behaves and makes decisions. Taken these factors, it can be expected that the cultural characteristics of the people involved in the financial reporting decisions to have an influence on earnings quality. Therefore, the research question is: do cultural characteristics have an impact on earnings quality and is this impact influenced by the adoption of IFRS in 2005?
Research that has been done on the relationship between culture and reporting behavior has mainly focused on the deliberate manipulation of earnings, better known as earnings management as a proxy for earnings quality (Doupnik (2008); Han et al. (2010); Nabar & Thai (2007); Kanagaretnam (2011)). However, the articles have very mixed results. For example, Doupnik (2008) states a relationship between culture and earnings management in a totally different direction than Kanagaretnam (2011). Besides, little research has been done to examine the relationship between a change in reporting standards and the association between earnings quality and cultural characteristics. Because of these factors, this research can contribute to existing literature by providing additional evidence on the relationship between culture and earnings quality and to examine the influence of IFRS adoption.
The rest of this paper is organized as follows. The next section discusses prior literature on (1) earnings, earnings quality and earnings management, (2) cultural characteristics and accounting choices and (3) the impact of IFRS adoption. Section 3
presents the hypotheses. Section 4 describes the research method and the research design. In section 5 the empirical results are presented. In the last section, the findings are discussed and conclusions can be found.
2 Literature review and theory
In this section, the literature regarding earnings, earnings quality and earnings management are discussed and the association between these topics will be explained. Then the literature regarding cultural characteristics and accounting choices will be reviewed. The last paragraph includes a discussion relating the literature about the impact of IFRS adoption.
2.1 Earnings, earnings quality and earnings management
According to previous literature, accounting earnings are a key component for valuing companies to investors. The main argument is that earnings announcements contain relevant information for the market in pricing debts and equities (Han et al., 2010). To make the reported earnings actually useful for external users of financial statements, the quality has to be at a decent level, since a low quality of input normally leads to a low quality of output. Dechow et al. (2010, p.344) begin their article about earnings quality by defining the term as ‘Higher quality earnings provide more information about the features of a firm’s financial performance that are relevant to a specific decision made by a specific decision-maker.’. Although this is a broad definition of earnings quality, it is clear that with a higher earnings quality stakeholders are better able to make more effective decisions. These decision-makers would therefore prefer a situation with high earnings quality. However, if circumstances exist in which preparers of the financial statement can benefit from reporting a lower quality of earnings, there is a chance that this objective will not be met.
Accounting is not a perfect science and allows for discretion in choosing how to treat events in the financial statements (Han et al., 2010 p.125). Examples of these events are depreciation rates, accruals for bad debts and asset write-offs. This discretion can help preparers of financial statements to include firm-specific characteristics, but might also give them the opportunity to manipulate the earnings number. A significant amount of literature provides evidence for the existence, determinants and consequences of earnings management. According to Walker (2013, p. 457) the empirical literature has identified three principal sets of motives that influences the earnings management choices for firms. Those motives include (1) achieving contractual terms or targets related to reported earnings, (2) to influence the information set used by external investors or information intermediaries used to form expectations of future cash flows or perceptions of firm risk and (3) to influence the information set of third parties with an interest in the financial strength of the firm. These parties could include competitors, customers, suppliers, workers, regulators, pressure groups
and politicians.
The contracting motive can take various forms, dependent on the incentives the preparers of the financial statements are subject to. The bonus of the CEO is in some cases linked to the return on assets (Healy, 1985) and in other cases the company prepares equity incentives for their CEO’s or CFO’s (Cheng & Warfield, 2005; Bergstresser & Philippon, 2006). In the case of a bonus that was linked to the ROA, Healy (1985) observed that directors manage earnings to game their bonus contracts, because the scheme provides incentives to do so. If earnings are just below the target, there is an incentive to manage earnings upwards, so the target would be reached. If earnings fell a long way under the target or a long way above it, an incentive is created to manage earnings downwards to increase the chance of reaching the target in the future (creating cookie-jar reserves). In the case of equity incentives, Cheng and Warfield (2005) found that firms with high equity incentives were more likely to beat analysts’ earnings benchmarks. Similar to those findings, Bergstresser and Philippon (2006) found that CEOs that were more incentivized by the company’s share price have higher levels of earnings management. Those CEOs appeared to be more aggressive in using discretionary components of earnings to affect their firms’ reported performance. Other motives for earnings management include influencing the information set used by investors or third parties. The idea is that managers use earnings management in order to manage share prices (upwards or downwards) or influence other information in order to change the behavior of other parties in regard to the company.
Managing earnings is not risk-free, besides the motives provided there might also be negative consequences of these actions. If the participants in the market notice that earnings are being managed they can penalize firms with low-quality earnings by adjusting their estimations. The results in this area of research are mixed. Ogneva (2012) finds that accounting quality is a priced risk factor. However, doubts have been raised about the reliability of the cost of capital estimates used in the literature (Easton, 2009; Lewellen, 2010). Walker (2013) concludes that the balance of the evidence is weakly in favor of the view that accounting quality is a priced risk factor.
2.2 Cultural characteristics and accounting choices
The environment, which also includes the culture, a person lives in can shape the way someone is and how he thinks. Hofstede (2001) argues that people carry ‘mental programs’ that are developed during a persons’ life. This may have an impact on the way people make
decisions, and more specifically for this study, decisions regarding the financial reporting of companies. Ge et al. (2011) document that accounting choices vary systematically across individual CFOs and that these differences may arise from differences in individual characteristics. Gray (1988) developed a model of culture, societal values and the accounting subculture, based on the work of Hofstede. In this model, it states that the value systems of attitudes of accountants may be expected to be related to and derived from societal values. Hofstede (2001) identifies five dimensions of culture:
1. Power distance: the extent to which less powerful members accept and expect that power is distributed unequally.
2. Uncertainty avoidance: the extent to which a culture programs its members to feel comfortable in unstructured situations.
3. Individualism: the degree to which individuals are supposed to look after themselves 4. Masculinity: the distribution of emotional roles between the genders.
5. Long/short-term orientation: the extent to which a culture programs its members to accept delayed gratification of their needs.
The article of Gray (1988) describes that only the uncertainty avoidance and individualism dimension can be linked to the accounting values he identified and that these dimensions can act as a proxy for those values. Hope (2003) agrees with this statement and states that the uncertainty avoidance and individualism dimensions have the most straightforward implication on the way people make accounting decisions. The two dimensions will be explained in more detail below.
2.2.1 Uncertainty avoidance
Hofstede (1984, pp.83-84) describes the extent of uncertainty avoidance as follows: ‘Uncertainty avoidance is the degree to which the members of a society feel uncomfortable with uncertainty and ambiguity. This feeling leads them to beliefs promising certainty and to maintaining institutions protecting conformity. Strong uncertainty avoidance societies maintain rigid codes of belief and behavior and are intolerant towards deviant persons and ideas. Weak uncertainty avoidance societies maintain a more relaxed atmosphere in which practice counts more than principles and deviance is more easily tolerated. The fundamental issue addressed by this dimension is how a society reacts on the fact that time only runs one way and that the future is unknown: whether it tries to control the future or to let it happen.
Like power distance, uncertainty avoidance has consequences for the way people build their institutions and organizations.’
2.2.2 Individualism
‘Individualism stands for a preference for a loosely knit social framework in society wherein individuals are supposed to take care of themselves and their immediate families only. Its opposite, collectivism, stands for a preference for a tightly knit social framework in which individuals can expect their relatives, clan or other in-group to look after them in exchange for unquestioning loyalty (it will be clear that the word “collectivism” is not used here to describe any particular political system). The fundamental issue addressed by this dimension is the degree of interdependence a society maintains among individuals. It relates to people’s self-concept: “I” or “we”.’ (Hofstede, 1984, p.83).
2.3 IFRS adoption
In 2005 the European Union (EU) made it compulsory for all firms listed on the main European stock exchanges to use the International Financial Reporting Standards (IFRS). Also other jurisdictions, such as Hong Kong and Australia chose to adopt IFRS around the same period. The two most often stated objectives for the adoption are to (1) enhance reporting quality and (2) to improve the comparability of financial statements across countries (De George et al., 2016, p. 903).
The actual effects of mandatory adoption across countries are however a subject of debate among academics and practitioners. First of all, Dechow et al. (2010) mentioned that the promise of enhanced reporting quality is dependent on the definition and models used to measure the result. There is no measure for earnings quality superior to the other and the value of the new standards is context-dependent. Besides, the development of high quality accounting standards may not automatically be followed up by companies providing high quality financial reports. According to De George et al. (2016), reporting quality is only partly determined by the quality of the accounting rules and is also influenced by reporting incentives for managers and incentives faced by enforcers of the accounting rules, which include auditors, capital market and other regulators, courts, etc. The claim that the effects of IFRS adoption are context-dependent is illustrated by the research of Fox et al. (2013). They investigated the links between accounting numbers and legal, cultural and institutional factors through a comparison between Italy and the UK and found that the experiences of the various
stakeholders differed, due to the mentioned dimensions. Also Jeanjean and Stolowy (2008) point out that accounting standards have only a limited role on reporting quality. The underlying argument is that the application of accounting standards involves considerable judgement and the use of private information. Given that IFRS provide the preparers of the financial statements with discretion, the extent in which this discretion is used depends on firm-specific characteristics and the national legal institutions.
3 Hypothesis development
In this section, the hypotheses, which are based on the earlier explained research, are provided. The research question stated in the introduction of this thesis is whether cultural characteristics have an impact on earnings quality and if this impact is influenced by the adoption of IFRS. The first part of the research question will be answered by hypotheses 1 and two, while the last part will be examined using hypothesis 3.
On the case of the influence of individualism, Doupnik (2008, p.323) suggests that in high collectivism (low individualism) societies, employees expect organizations to look after them like a family and to defend their interests. A lower variability of earnings might therefore be viewed as a way to meet this expectation, and earnings smoothing would be more prevalent in societies with low levels of individualism. However, meeting expectations can in a lot of cases benefit individuals instead of the stakeholders of a firm as a collective group. Think about bonuses rewarded to executives when specific targets are met. Because of these considerations, the following hypothesis is stated:
Hypothesis 1: There will be a positive relationship between the individualism dimension of national culture and the magnitude of earnings management.
According to Doupnik (2008, p.322), smoother earnings can be seen as an attempt by management to control future reported earnings, and should therefore be more prevalent in societies with high levels of uncertainty avoidance. However, there is risk in adjusting earnings for the managers themselves. Besides, as described earlier in this thesis, weak uncertainty avoidance societies maintain a more relaxed atmosphere in which practice counts more than principles and deviance is more easily tolerated. Because of these arguments and the direction that is chosen in prior research (e.g. Kanagaretnam, 2011, p.871) the second hypothesis is stated as follows.
Hypothesis 2: There will be a negative relationship between the uncertainty avoidance dimension of national culture and the magnitude of earnings management.
With the implementation of IFRS different countries have the same reporting standards. This uniformity of reporting is expected to make the influence of country-specific characteristics, such as national culture, decrease. Therefore, the third hypothesis is:
Hypothesis 3: The influence of national culture on the magnitude of earnings management has decreased with the implementation of IFRS.
4 Research method and design
4.1 Dependent variable
Following Tucker & Zarowin (2006) and Han et al. (2010), the performance-controlled accruals model is used in order to obtain empirical measures of earnings discretion. Earnings discretion is a proxy for earnings management in this research, following prior literature. For all sample firms available the following model is estimated using ordinary least squares (OLS) at time t for each country, to identify the discretionary component for given country-year observations: 𝑇𝐴𝐶𝐶𝑡 𝑇𝐴𝑡−1 = 𝑎0( 1 𝑇𝐴𝑡−1) + 𝑎1( ∆𝑅𝐸𝑉𝑡 𝑇𝐴𝑡−1) + 𝑎2 ( 𝐺𝑃𝑃𝐸𝑡 𝑇𝐴𝑡−1) + 𝑎3 ( 𝑅𝑂𝐴𝑡 𝑇𝐴𝑡−1) + 𝜀𝑡
In this model TACCt is the total accruals in year t (measured by the difference between the change in assets, the change in liabilities and the change in cash), ∆REVt is the change of revenue in year t, GPPEt is the level of gross property, plant and equipment in year t and ROAt is the return on assets in year t. Every variable is deflated by the lagged book value of total assets. The absolute value of the residuals (|RES|) of the regressions is used as a proxy for discretionary accruals.
4.2 Independent variables
4.2.1 Cultural factors
The cultural values for the two variables are obtained from Hofstede (1980) and are assumed to be held constant over time. The cultural variables included are individualism (IND) and uncertainty avoidance (UA).
4.2.2 Control variables
Control variables that are associated with earnings discretion are included to test for other explanations, following the model of Han et al. (2010). The natural logarithm of market value of equity (LNSIZE) is included because large firms are more constraint in exercising discretion because they are in a larger extent monitored by third parties, under which the stock market. The natural logarithm of book-to-market ratio (LNBM) is included because risky firms tend to possess greater incentive to exercise discretion in reported earnings. Other control variables are the leverage ratio (LEV) and a dummy variable for firm-years with large
(shareholders’ equity increases by 10% or more) stock issuance (ISSUE), because firms that are likely to raise capital more often have incentives to manage earnings opportunistically. Since loss firms tend to use more discretionary accruals to be able to show better earnings numbers in future years, or create ‘cookie jar’ reserves to increase future earnings, a dummy variable for loss firms (LOSS) is included.
4.3 Empirical models
In this research, the following regression is estimated:
|𝑅𝐸𝑆| = 𝛼0+ 𝛼1𝐼𝑁𝐷 + 𝛼2𝑈𝐴 + 𝛼3𝐿𝑁𝑆𝐼𝑍𝐸 + 𝛼4𝐿𝑁𝐵𝑀 + 𝑎5𝐿𝐸𝑉 + 𝛼6𝐼𝑆𝑆𝑈𝐸 + 𝛼7𝐿𝑂𝑆𝑆 + 𝜀
|RES| is earnings discretion measured by the absolute value of the residuals in the accruals estimation, described in the dependent variable section. The absolute value is taken because positive as well negative residuals can be related to earnings discretion. Large negative residuals might distort the regression results; IND is the individualism score from Hofstede (1980); UA is the uncertainty avoidance score from Hofstede (1980); LNSIZE is the natural logarithm of market value of equity; LNBM is the natural logarithm of book-to-market ratio; LEV is the leverage ratio; ISSUE is an indicator variable for equity issuance and LOSS is an indicator variable for loss firms.
4.4 Sample selection
The sample used in this study consists of 13,617 firm-year observations (4,827 distinct firms) for the period from 2000 to 2009 in 27 countries in the European Union. Data is extracted from Compustat Global. Only the firm-years that meet the following criteria are selected:
Firm is located in a country part of the European Union;
Non-financial firm;
Necessary financial variables are available;
Consistency of currency codes between adjacent years;
Book value of equity is positive;
Country-level variables are available; and
Each country-year combination has at least 10 observations to ensure a reasonable size for the measurement of discretionary accruals.
To mitigate the effects of outliers, |RES|, LNSIZE, LNBM and LEV are winsorized at the 1st and 99th percentiles of the pooled distribution. The other variables are categorical in nature (dummy or indicator variables) and do not exhibit extreme observations.
5 Empirical results
Descriptive statistics for the sample, Pearson correlations and OLS regressions for the key variables for hypotheses one and two are reported in the different panels in Table 1.
Panel A of Table 1 shows that |RES| has a mean of 0.1059, which is comparable to values reported in prior studies (Han et al., 2010). The means of individualism (IND) and uncertainty avoidance (UA) are 75.3407 and 57.8997, respectively.
Panel B of Table 1 presents the Pearson correlations among selected variables. Absolute discretionary accruals (|RES|) is significantly positively related to IND (0.0651, p<0.01) and significantly negatively related to UA (-0.1004, p<0.01). The first correlation finding supports Hypothesis 1 that, on average, individualism encourages earnings discretion through an increasing magnitude of discretionary accruals. The second correlation finding supports Hypothesis 2 that uncertainty avoidance inhibits excessive usage of earnings discretion. In addition, |RES| is significantly (p<0.01) negatively associated with book-to-market ratio (LNBM) and firm size (LNSIZE), and is significantly (p<0.01) positively associated with stock issuance (ISSUE) and loss firms (LOSS). The leverage (LEV) is negatively associated with |RES| but is only significant at a 10% level.
Panel C of Table 1 provides a test of the ability of cultural factors to explain the magnitude of earnings discretion. More specifically, it is tested whether individualism (IND) and uncertainty avoidance (UA) constrain or promote the usage of earnings discretion, measured by the absolute value of discretionary accruals. The result shows that both the coefficients on IND and the coefficients on UA are significantly negative, with both a value of -0.0005 at the 1% confidence level. The negative coefficient of individualism is in contrast with the positive association found in the Pearson correlation and is therefore inconsistent with the assumption that more highly individualistic countries have a greater magnitude of discretionary accruals. Because the findings are significant, the null in Hypothesis 1 can be rejected but, because of the contradictory results, there is not enough evidence for an alternative hypothesis. The negative coefficient of uncertainty avoidance is, however, consistent with the findings in the Pearson correlation. This allows to rejects the null in Hypothesis 2, in favor of the alternative that there will be a negative relationship between the level of uncertainty avoidance and the magnitude of earnings discretion.
TABLE 1 – Regression results models H1 & H2 Panel A – Descriptive statistics
Variable Observations Mean St. deviation Min Max
|RES| 13,344 0.1059 0.1017 0.0014 0.6405 IND 13,344 75.3407 15.4201 27 89 UA 13,344 57.8997 25.4748 23 100 LNBM 13,344 -0.3544 0.9089 -3.2292 3.3787 LNSIZE 13,344 4.8697 2.1913 0.0295 11.0732 LEV 13,344 0.5235 0.2052 0.0304 0.9548 ISSUE 13,344 0.1545 0.3614 0 1 LOSS 13,344 0.3096 0.4623 0 1
Panel B – Pearson correlations
|RES| IND UA LNBM LNSIZE LEV ISSUE LOSS
|RES| 1 IND 0.0651 1 UA -0.1004 -0.7653 1 LNBM -0.112 -0.1491 0.1223 1 LNSIZE -0.143 -0.0913 0.0597 -0.2684 1 LEV -0.0144** -0.1026 0.1533 -0.1143 0.1907 1 ISSUE 0.1407 0.0741 -0.0891 -0.0608 -0.0706 -0.0883 1 LOSS 0.0339 0.0616 -0.0906 0.1218 -0.3415 -0.0815 0.1574 1 In the Pearson correlations table, *,**,*** indicate significance of the coefficients at 5%, 10% and >10% confidence level, respectively. A value without a star indicates a significance of the coefficients at 1% confidence level.
Panel C - Multivariate tests with control variables
|RES|
Variable Coëfficiënt p-value
Intercept 0.1981 0.000 IND -0.0005 0.000 UA -0.0005 0.000 LNBM -0.0161 0.000 LNSIZE -0.0088 0.000 LEV 0.0121 0.008 ISSUE 0.0340 0.000 LOSS -0.0082 0.000 Adj. R-squared 0.0658 Observations 13,344
OLS regressions are performed with the absolute level of residual accruals as dependent variable. *,**,*** indicate significance of the coefficients at 5%, 10% and >10% confidence level,
respectively. A value without a star indicates a significance of the coefficients at 1% confidence level.
Descriptive statistics for the sample, Pearson correlations and OLS regressions for the key variables for hypothesis three are reported in the different panels in Table 2.
Panel A of Table 2 shows that |RES| has a mean of 0.1340 in pre-IFRS years and a mean of 0.0641 in the years after IFRS implementation. This difference (almost 0.07) might indicate that the magnitude of discretionary accruals has declined since IFRS adoption. This is, however, out of the scope of this study. The means of individualism (IND) are 79.02 (2000-2004) and 72.45 (2005-2009) and the means of uncertainty avoidance (UA) are 54.01 (2000-2004) and 60.96 (2005-2009).
Panel B of Table 2 presents the Pearson correlations among selected variables. In the pre-IFRS years, absolute discretionary accruals (|RES|) is both significantly positively related to IND (0.0499, p<0.01) as to UA (0.0792, p<0.01). In the years after IFRS implementation, |RES| is significantly positively related to individualism (0.0690, p<0.01) and significantly negatively related to uncertainty avoidance (-0.0964, p<0.01). The positive correlation findings related to individualism are in line with the Pearson correlations of the total sample. However, the correlation is stronger in the years after IFRS implementation (increase of 0.0191), which is not in line with Hypothesis 3 that states that the influence of national culture on the magnitude of earnings management has decreased with the implementation of IFRS. The correlation findings related to uncertainty avoidance are also not in support of the hypothesis. Not only is the correlation stronger, but also the direction of the correlation has changed from positive to negative. In addition, in the period 2000-2004, |RES| is significantly (p<0.01) positively associated with book-to-market ratio (LNBM), firm size (LNSIZE), stock issuance (ISSUE) and loss firms (LOSS). In the period 2005-2009, |RES| is significantly (p<0.01) positively associated with stock issuance (ISSUE) and significantly (p<0.01) negatively associated with book-to-market-ratio (LNBM) and firm size (LNSIZE).
Panel C of Table 2 provides a test of the ability of cultural factors to explain the magnitude of earnings discretion in both periods. The result shows that in the pre-IFRS period both the coefficients on IND and the coefficients on UA are significantly negative, with values of -0.0006 and -0.0005, respectively, at the 1% confidence level. The results in the second period also show negative coefficients on individualism and uncertainty avoidance, both with values of -0.0002 at the 1% confidence level. Both coefficient levels have slightly decreased with IFRS implementation and are therefore in line with Hypothesis 3. However, the differences are still very small and are inconsistent with the Pearson correlations. Therefore, there is not enough evidence to reject the null in Hypothesis 3.
TABLE 2 – Regression results models H3 Panel A – Descriptive statistics
2000-2004 (pre-IFRS)
Variable Observations Mean St. deviation Min Max
|RES| 5,200 0.1340 0.1267 0.0018 0.8349 IND 5,200 79.0244 13.4536 27 89 UA 5,200 54.0071 24.5062 23 100 LNBM 5,200 -0.4145 0.8887 -3.2292 3.3787 LNSIZE 5,200 4.8579 2.1078 0.0400 11.0492 LEV 5,200 0.5297 0.2034 0.0305 0.9548 ISSUE 5,200 0.1442 0.3514 0 1 LOSS 5,200 0.3023 0.4593 0 1 2005-2009 (IFRS)
Variable Observations Mean St. deviation Min Max
|RES| 7,057 0.0641 0.0602 0.0007 0.3792 IND 7,057 72.4539 16.4151 27 89 UA 7,057 60.9606 25.8231 23 100 LNBM 7,057 -0.2630 0.9227 -3.2160 3.3117 LNSIZE 7,057 5.0675 2.2487 0.0295 11.0732 LEV 7,057 0.5285 0.2040 0.0304 0.9545 ISSUE 7,057 0.1502 0.3573 0 1 LOSS 7,057 0.3044 0.4602 0 1
Panel B – Pearson correlations 2000-2004 (pre-IFRS)
|RES| IND UA LNBM LNSIZE LEV ISSUE LOSS
|RES| 1 IND 0.0499 1 UA 0.0792 0.7955 1 LNBM 0.1125 0.1327 0.1029 1 LNSIZE 0.1447 0.0841 0.0719 0.2333 1 LEV 0.0184*** 0.1106 0.1767 0.1319 0.1868 1 ISSUE 0.1646 0.0259** 0.0426 0.0904 0.0558 0.0446 1 LOSS 0.0566 0.0941 0.0904 0.0983 0.3325 0.0808 0.129 1 2005-2009 (IFRS)
|RES| IND UA LNBM LNSIZE LEV ISSUE LOSS
|RES| 1 IND 0.0690 1 UA -0.0964 -0.745 1 LNBM -0.1217 -0.1262 0.1154 1 LNSIZE -0.1088 -0.0828 0.0485 -0.3401 1 LEV 0.0081*** -0.1188 0.1632 -0.1165 0.2013 1 ISSUE 0.1242 0.0914 -0.1039 -0.0188*** -0.0667 -0.1113 1 LOSS -0.0139*** 0.0509 -0.0897 0.1713 -0.3469 -0.0826 0.1684 1
Table 2 – continued
In the Pearson correlations table, *,**,*** indicate significance of the coefficients at 5%, 10% and >10% confidence level, respectively. A value without a star indicates a significance of the
coefficients at 1% confidence level.
Panel C - Multivariate tests with control variables
|RES|
2000-2004 (pre-IFRS) 2005-2009 (IFRS)
Variable Coëfficiënt p-value Coëfficiënt p-value
Intercept 0.2416 0.005 0.1075 0.002 IND -0.0006 0.000 -0.0002 0.000 UA -0.0005 0.000 -0.0002 0.000 LNBM -0.0193 0.000 -0.0104 0.000 LNSIZE -0.0103 0.000 -0.0051 0.000 LEV 0.0075*** 0.424 0.0137 0.000 ISSUE 0.0511 0.000 0.0202 0.000 LOSS -0.0020*** 0.611 -0.0099 0.000 Adj. R-squared 0.0662 0.0623 Observations 5,200 7,057
OLS regressions are performed with the absolute level of residual accruals as dependent variable. *,**,*** indicate significance of the coefficients at 5%, 10% and >10% confidence level,
6 Discussion and conclusions
This thesis conducts an examination to determine whether certain cultural characteristics of a country are able to explain the amount of earnings discretion used by companies and therefore the earnings quality provided by them, and if this influence has changed with the adoption of IFRS by countries part of the European Union (EU) in 2005. The main analysis is conducted using a sample of firms from 27 countries, part of the EU, over the period 2000-2009.
The first hypothesis is that there will be a positive relationship between the individualism dimension of national culture and the magnitude of earnings management. The results in this research show evidence that there is a relationship between individualism and earnings management. However, no clear evidence is found to determine the direction of the relationship. That there is no clear direction for the relationship is not a total surprise, given the different argumentations for earnings management. Meeting expectations by using earnings management can both serve to satisfy different stakeholders of the firm (incentive for members in a society with a low individualism/ high collectivism value) or to satisfy personal needs (incentive for members in a society with a high individualism/ low collectivism value). Because the rewards of serving personal needs (e.g. money/ status) are more direct than serving the group (e.g. appreciation) it was expected that this relationship would be stronger. The conflicting relationships that were found in the analysis could, however, be expected either.
The second hypothesis states that there will be a negative relationship between the uncertainty avoidance dimension of national culture and the magnitude of earnings management. The results in this research provide evidence for this relationship, given that all tests show the same (negative) association. The relationship makes sense for two main reasons. First, there is risk involved in using earnings management. The company as a whole or the preparers of the financial statements could personally be penalized for their behavior. Therefore, it is expected that companies in high uncertainty avoidance societies are in a lesser extent involved in earnings management. Second, weak uncertainty avoidance societies maintain a more relaxed atmosphere in which practice counts more than principles and deviance is more easily tolerated.
The third hypothesis is that the influence of national culture on the magnitude of earnings management has decreased with the implementation of IFRS. The results in this
research do not provide enough evidence to assume a relationship between the change of accounting standards and the association between the cultural values and earnings management. According to prior research, reporting quality is only partly determined by the quality of the accounting rules and is also influenced by reporting incentives for managers and incentives faced by enforcers of the accounting rules, which include auditors, capital market and other regulators, courts, etcetera (De George et al., 2016). This context-dependency provides an argument for the lack of clear evidence in this area.
This study is subject to the following limitations. First, Hofstede’s cultural characteristics are measured at the country level, whereas the tests to determine discretionary accruals are based on firm-level analysis. Besides, the cultural values are assumed to be constant over time. National culture tends to be relatively stable, but this may not necessarily hold in all environments. Second, the reported relations between national culture and earnings quality are observed associations and may not result from underlying causal relations. The results should therefore be taken with caution. Third, the sample size of this research is relatively small and the models are limited in their explanatory power. Despite these limitations, this research makes a contribution to the literature by identifying national cultural characteristics as a determinant of earnings quality and by determining whether a change of accounting standards has an influence on this relationship. Future research can explore the effects of national culture on accounting choices with measures that better reflect the components of culture, with more specific geographical areas and adjusted for possible changes in value. Additionally, future research can expand the findings by using a larger sample size and more extensive models, and providing more tests to prove causality instead of only associations between the used variables.
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