The quality of financial reporting after the
mandatory adoption of IFRS:
The moderating effect of Corporate
Governance
Student: Naaznien Nafiesa Gatoen Gaffar
Student number: 10266836
Date: June 21, 2015
Word count: 14834
Supervisor: Dr. B. Qin
MSc Accountancy & Control, variant Accountancy
Amsterdam Business School
Faculty of Economics and Business
University of Amsterdam
Statement of Originality
This document is written by student Naaznien Nafiesa Gatoen Gaffar 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 study examines to what extend the quality of financial reporting changes after the mandatory adoption of IFRS and what the influence of corporate governance is on this change. From the study results that the quality of financial reporting did not change after the mandatory adoption due to the fact that there was no change in the degree of earnings management for the period after the mandatory adoption in comparison with the period before the mandatory adoption. Moreover, there is no evidence found that the proxies for corporate governance (e.g. the presence and the independence of the audit committee) had an influence on this effect.
Content
1.0 Introduction………...………2
2.0 Background and hypothesis development……….5
― § 2.1 Mixed evidence regarding the adoption of IFRS………..……….……5
o § 2.1.1 Voluntary adoption...5
o § 2.1.2 Mandatory adoption………6
― § 2.2 Difference in standards after the mandatory adoption.………10
o § 2.2.1 Agency theory………...10
o § 2.2.2 Agency theory in IFRS standards………...………11
― § 2.3 The moderating effect of corporate governance………..15
3.0 Methodology………..19 ― § 3.1 Sample……….19 ― § 3.2 Measurement of variables………19 o § 3.2.1 Dependent variable………...19 o § 3.2.2 Independent variable (CG)………...21 o § 3.2.3 Control variables………...22
― § 3.3 Multivariate Regression Model………...24
4.0 Descriptive statistics and results……….25
o § 4.1 Descriptive statistics………25
o § 4.2 Results Multivariate Analysis………..29
5.0 Discussion of results………...33
6.0 Conclusion………..35
Bibliography……….37
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1.0 Introduction
From a survey of the IFAC, carried out in 2007, it appeared that of the 143 leaders from 91 countries, 90% of those surveyed believed that the introduction of a single set of international standards, such as the International Financial Reporting Standards (IFRS), is essential for economic growth (AICPA IFRS Resources, 2011). Prior to 2005, most listed companies in Europe used their national accounting standards. Therefore, the mandatory adoption of IFRS on January 1, 2005 in Europe, was one of the biggest changes in the history of financial reporting, which led to much controversy. This was mainly about whether the mandatory adoption of IFRS would or would not lead to improving the quality of financial reporting. According to the European Regulation 1606/2002, the adoption was described as a positive change (Council Regulation, 2002), since it should mainly lead to an increase in the
reliability, the transparency and the relevance of financial reporting.
Additionally, Barth, Landsman & Lang (2008) investigate the quality of financial reporting by examining the degree of earnings management and the relevance of financial reporting after the voluntary adoption. From the research results that the degree of earnings management has decreased and the relevance has increased. Therefore, Barth et al. (2008) conclude that the quality of financial reporting has increased after the voluntary adoption. Further, Aussenegg, Inwinkl & Schneider (2008) share this opinion, since their research also indicates a decrease in the degree of earnings management after the voluntary adoption. Additionally, just as the previous studies, other studies also indicate an increase in the quality of financial reporting after the voluntary adoption (Márquez- Ramos, 2011; Covrig, Defond & Hung, 2007).
Now, ten years after the mandatory adoption, a lot of research has been done on the mandatory adoption of IFRS as well. While studies on the voluntary adoption report that the voluntary adoption has led to an increase in the quality of financial reporting due to for example a decrease in the degree of earnings management, the vast majority of the studies regarding the mandatory adoption (Capkun et al., 2008; Callao and Jarne, 2010; Capkun et al., 2012 and Ahmed et al., 2013) report a significant increase in earnings management and thus a decrease in the quality of financial reporting. An explanation for this increase in earnings management could be the increase in management discretion in certain standards following the mandatory adoption.
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However, according to Leuz (2010), the quality of financial reporting as a result of moving to a single set of accounting standards (e.g. IFRS) depends on managers’ reporting incentives which moreover is shaped by many factors, inter alia certain aspects of corporate governance. Subsequently, the study of La Porta et al. (2000) is in line with the rationale that characteristics of corporate governance have an influence on the quality of financial reporting and therefore this phenomenon will play a key role in this research. Moreover, it is essential to take this phenomenon into consideration, because although there are already many studies that have measured the quality of financial reporting after the mandatory adoption, studies that measure the effect of corporate governance on the quality of financial reporting as a result of the mandatory adoption of IFRS are limited. Therefore, the research question is: To what extend does the quality of financial reporting change after the mandatory adoption and what is the effect of corporate governance on this change?
It is essential to examine this phenomenon, because IFRS standards are constantly changed in order to make them effective for all countries, but it could be the case that certain aspects of corporate governance could also have an influence on the quality of financial reporting, as Leuz (2010) stated. Hence, it may be useful that standard setters should also take into account this phenomenon while evaluating the quality of financial reporting after the mandatory adoption of IFRS, in order to improve the standards when necessary.
Additionally, the quality of financial reporting will be measured by examining the degree of earnings management which will be based on the discretionary accruals. Hereby, the presence and the independence of an audit committee will be used as a proxy for corporate governance. Further, in this research, data from the United Kingdom will be used, since this country is representative due to the fact that IFRS has been mandatory adopted in the United Kingdom on January 1, 2005. Also, this country is suitable for conducting this research due to the data availability.
Moreover, the time frame that will be examined in this research is the period before the mandatory adoption of IFRS, which will be reflected by the years 2002-2004, and the period after the mandatory adoption, which will be reflected by the years 2006-2014. The year 2005 will be left out, due to the fact that the transition took place on January 1, 2005.
From the research resulted that the quality of financial reporting did not change after the mandatory adoption due to the fact that there is no evidence found for a change in the degree of earnings management. Furthermore, there is also no evidence found that the presence of the audit committee has an influence on this effect for both the period before, as well as after the mandatory adoption. Moreover, there is evidence found that the degree of
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earnings management decreases if the members of the audit committee are independent before the mandatory adoption. However, there is no evidence found for the presence of this effect after the mandatory adoption. Therefore, there can be concluded that the quality of financial reporting did not change after the mandatory adoption and that the chosen proxies for corporate governance had no influence on this effect.
Furthermore, it is essential that research is done on the quality of financial reporting, as the IASB has future plans to mandatory implement IFRS on January 1, 2018 in countries around the world. Also, studies on the quality of financial reporting in general are relevant from a societal point of view, knowing that investors mainly use financial reporting for
decision making. Further, this study contributes and extends literature on IFRS, since research on IFRS in relation with corporate governance is still limited.
In addition, chapter 2 describes several studies regarding the mandatory and voluntary adoption of IFRS. Subsequently, based on the agency theory, chapter 2 describes how some of the accounting changes following the mandatory adoption can affect the degree of earnings management. Moreover, in chapter 2 an explanation will be given on what the moderating effect of corporate governance on the quality of financial reporting will be. Furthermore, in chapter 3 the methodology will be described and in chapter 4 the results of the research will be provided. Subsequently, chapter 5 will provide a discussion of the founded results and in chapter 6, a conclusion of this research will be given.
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2.0 Theoretical background and hypothesis development
This chapter describes several studies regarding the mandatory and voluntary adoption of IFRS (§ 2.1). Subsequently, based on the agency theory, it describes how some of the accounting changes following the mandatory adoption can affect the degree of earnings management (§ 2.2). Additionally, it explains the moderating effect of corporate governance on the quality of financial reporting, which moreover is the novelty of this research (§ 2.3). Moreover, the hypotheses will be formulated in the relevant paragraphs.§ 2.1 Mixed evidence regarding the adoption of IFRS
This paragraph describes mixed evidence regarding the mandatory and voluntary adoption of IFRS.
§ 2.1.1 Voluntary adoption
In addition, Barth, Landsman & Lang (2008) investigate the quality of financial reporting after the voluntary adoption. Hereby, Barth et al. (2008) measure the quality by examining the degree of earnings management and the relevance. From the study results that the degree of earnings management has decreased and the relevance has increased which indicates an increase in the quality of financial reporting after the voluntary adoption. Moreover, Aussenegg, Inwinkl & Schneider (2008) also measure the quality of financial reporting by examining the degree of earnings management and concluded that the quality of financial reporting increased after the voluntary adoption due to the decrease in the degree of earnings management.
Furthermore, Márquez- Ramos (2011) investigates the quality of financial reporting by examining the comparability and transparency after the voluntary adoption. Hereby, Márquez- Ramos (2011) states that the comparability and transparency reinforce each other since both variables ensure that informational differences between countries are reduced which in turn has a positive effect on foreign investments. From the study results that the comparability and the transparency improved after the voluntary adoption and that this phenomenon can be explained by a significant increase in foreign investments and a decrease in the information-asymmetry between countries. Hence, Márquez- Ramos (2011) concludes that the quality of financial reporting increased after the voluntary adoption.
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Additionally, Covrig, Defond & Hung (2007) investigate to what extent foreign investors are drawn after the voluntary adoption. Hereby, from the study results that foreign investments increased after the adoption and that this effect is greater for firms where there was a poor information environment before the adoption. Further, according to Covrig et al. (2007), this result is in accordance with the assumption that international standards can be seen as a tool to provide more information to investors. Hence, Covrig et al. (2007) conclude that the quality of financial reporting improved after the voluntary adoption.
From the previous can be concluded that the quality of financial reporting increased after the voluntary adoption. This phenomenon can be explained by the study of Christensen, Lee & Walker (2008). From the study results that, the quality of financial reporting increases after the voluntary adoption and decreases after the mandatory adoption due to a decrease in the degree of earnings management after the voluntary adoption and an increase in the degree of earnings management after the mandatory adoption. From the previous, Christensen et al. (2008) conclude that the adoption of IFRS does not necessarily lead to a quality improvement of financial reporting, but actually depends on incentives of firms to adopt IFRS.
Hereby, Christensen et al. (2008) argue that, there will be a quality improvement in companies where there are incentives to implement IFRS and that companies where these incentives do not exist, and therefore wait until the mandatory adoption, will not experience a quality improvement. Moreover, the results from this study are acknowledged by several studies, since most studies examining the voluntary adoption of IFRS are associated with an improvement in quality (Barth et al., 2008; Aussenegg et al., 2008). Hence, Christensen et al. (2008) conclude that the increase in the quality of financial reporting after the voluntary adoption can be explained by the self-selection of companies that choose to adopt IFRS voluntarily.
§ 2.1.2 Mandatory adoption
Additionally, Devalle, Onali & Magarini (2010) investigate the quality of financial reporting by examining the relevance after the mandatory adoption. The research is conducted in five European countries, namely: Germany, Spain, Italy, France (code- law countries) and the United Kingdom (common- law country). Hereby, from the study of Devalle et al. (2010) results that the relevance decreased in Germany, Spain and Italy and increased in France and the United Kingdom. Hence, it can be concluded that, apart from that there are differences
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between common- law and code- law countries, there are also differences within common- law and code- law countries regarding the relevance of financial reporting.
Moreover, regardless of the fact that Capkun et al. (2010) use the same proxies and part of the same countries that Devalle et al. (2010) used in their research, the results of the studies are not consistent for the countries that were the same. From this, it can be concluded that the differences in relevance of financial reporting does not necessarily depend on the type of proxy and the type of land, but also on the companies in the sample since the same proxy is used for the same countries. Hence, the relevance of financial reporting is also dependent on company- specific factors.
Additionally, Morais & Curto (2009) also examine the relevance after the mandatory adoption. From the study results that the relevance of the market price is higher for countries that have mandatory adopted IFRS in relation to the countries that had earlier adopted IFRS voluntarily. Also, from the research of Morais & Curto (2009) results that the relevance is higher in countries where accounting and tax is less related to each other. In addition, the relevance is higher in countries where there was a lack of certain accounting issues under local standards. Furthermore, from the study it resulted that the relevance of accounting information is lower in countries with strict laws and regulations. Hence, Morais & Curto (2009) conclude that the relevance of accounting information increases after the mandatory adoption and that the relevance depends on country- specific factors.
Subsequently, the study of Lourenço & Curto (2009) supports the previously discussed assumption that the relevance of financial reporting depends on country- specific factors. In addition, the country specific factor in this study is the degree of investor protection in which Lourenço & Curto (2009) state that the relevance depends on this factor. Additionally, from the study results that there is a positive relation between the degree of investor protection and the relevance of financial reporting. Furthermore, Aharony, Barniv & Falk (2010) use the association with the preceding local standards as a country- specific factor. From the study results that, the relevance decreases as the former local standards are more similar to the IFRS standards. The opposite is true for the voluntary adoption. On the other hand, the study of Clarkson et al. (2011) concludes that there is no significant change regarding the relevance after the mandatory adoption.
Furthermore, Byard, Li & Yu (2011) investigate the information environment for financial analysts after the mandatory adoption. From the study results that an improvement in the information environment depends on the legal enforcement in a country and the incentives for
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transparency and thus is not necessarily a consequence of the change in the accounting standards after the mandatory adoption. Moreover, Palea (2007) argues that the information- asymmetry decreased after the mandatory adoption due to a decrease in the cost of capital. In addition, Palea (2007) concludes that the reduction in the information- asymmetry is caused due to the fact that there is more information issued under IFRS.
Further, from the study of Li (2010) also results that the cost of capital decreased after the mandatory adoption. In addition, the study also shows that this decrease was only
significant for companies with a strong law enforcement and that this decrease is caused by an increase in the comparability and an increase in information presented in the financial
statements. Hence, from the study of Li (2010), there can be concluded that the improvement in the information environment and the increase in the comparability after the mandatory adoption depends on the legal environment in a country and thus is not necessarily a consequence of the standards that the mandatory adoption entails.
Additionally, the foregoing is consistent with the study of Yip & Young (2012) in which research is done on the comparability of financial reporting. In this study, Yip & Young (2012) conclude that the comparability of financial reporting is largely related to the laws and regulations in a country and thus is not necessarily related to the quality of the IFRS standards.
Moreover, an explanation that the previous studies regarding the mandatory adoption do not provide a clear conclusion might be related to the study of Soderstrom & Sun (2007). In this study, Soderstrom & Sun (2007) conclude that the mandatory adoption will not lead to an increase in comparability and thus the quality of financial reporting, as differences in the quality of financial reporting among countries will not disappear after the mandatory adoption.
According to Soderstrom & Sun (2007), this effect is caused by the fact that the quality of financial reporting depends on the legal and political system in the country where the company is located. Soderstrom & Sun (2007) also discuss different factors regarding the legal and political system of a country, and explain how these factors affect the quality of financial reporting. The figure below shows the relationships between the relevant factors and the quality of financial reporting.
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Figure 1: Determinants of accounting quality: From ‘’IFRS Adoption and Accounting
Quality: A Review,’’ by N.S. Soderstrom and K.J. Sun, 2007, European Accounting Review,
16, p. 688.
This figure argues that the mandatory adoption does not necessarily lead to an improvement in the quality of financial reporting and thus depends on various factors and conditions in the country where the company is located.
In addition, the study of Carmona & Trombetta (2008) argues that the mandatory adoption of IFRS will not lead to an increase in the comparability, since the IFRS standards are principle-based. This means that the standards specify a number of principles and that the respective auditors in a country may give their own interpretation to these principles when handling the standards. According to Carmona & Trombetta (2008), this allows the enforcement of these standards to differ per country, per company and even per auditor, since the interpretation of the principle-based IFRS standards are subject to the laws and regulations in a country, the type of business and the knowledge and skills of auditors.
Carmona & Trombetta (2008) explain this phenomenon due to the fact that the
principle-based standards provide no specific rules, criteria, constraints, certain jurisprudence and no guidance in the implementation of the standards. Due to the previous, the concerning auditors are forced to focus on their personal knowledge, skills and the laws and regulations in a country, when interpreting the standards.
Overall, from the previous studies it appears that the quality of financial reporting after the mandatory adoption depends on different factors, such as: the legal and political system in a country. Therefore, there is still a debate on whether the mandatory adoption would or would not lead to an increase in the quality of financial reporting.
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§ 2.2 Differences in standards after the mandatory adoption
This paragraph describes some of the major changes in standards after the mandatory adoption. More specifically, this paragraph describes that the degree of management discretion increases as a result of accounting changes following the mandatory adoption of IFRS, which in turn leaves room for earnings management (§ 2.2.2). Moreover, the incentives by managers to engage in earnings management can be explained by the agency theory (§ 2.2.1).
§ 2.2.1 Agency theory
The agency theory is a much discussed theory in the academic literature which is widely explained in the study of Eisenhardt (1989). This study defines the agency theory as follows:
“(…) agency theory is directed at the ubiquitous agency relationship, in which one party (the principal) delegates work to another (the agent), who performs that work. Agency theory attempts to describe this relationship using the metaphor of a contract.
Agency theory is concerned with resolving two problems that can occur in agency
relationships. The first is the agency problem that arises when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principal to verify what the agent is actually doing. The problem here is that the principal cannot verify that the agent has behaved appropriately. The second is the problem of risk sharing that arises when the principal and agent have different attitudes toward risk. The problem here is that the principal and the agent may prefer different actions because of the different risk preferences.”
Hence, according to Eisenhardt (1989), the agency problem occurs when cooperating parties have different goals and division of labour. Furthermore, it also emphasises the concept of incentives and self- interest in organizational thinking. Therefore, the incentives by managers (agents) to engage in earnings management can be explained by the agency theory.
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§ 2.2.2 Agency theory in IFRS standards
This paragraph describes how the concept of agency theory plays a key role in IFRS standards. In addition, this concept is reflected by the increase in management discretion in certain standards after the mandatory adoption. More specifically, one of the most discussed debate concerns the fact on whether the increase in management discretion in the new standards would lead to an increase in earnings management and therefore a decrease in the quality of financial reporting (Jeanjean & Stolowy, 2008).
In addition, the use of fair value accounting, accompanied with the mandatory adoption of IFRS, leaves room for management discretion in several standards. This management discretion arises due to the fact that the estimation of the fair value is subject to managers’ subjective judgement as well as valuation expertise on the firm’s future cash flows and economic and industrial conditions. An example of a standard were this phenomenon is dealt with is the goodwill impairment in IFRS 3.
Additionally, in 2004, the IASB revised IAS 36- Impairment of Assets and IAS 38- Intangible Assets and subsequently issued IFRS 3- Business Combinations. This standard requires that all business combinations should be reported under the purchase method and that goodwill should be impaired annually, instead of being amortised. Furthermore, according to IAS 36, all assets have to be annually tested for impairment if a triggering event occurs. To test for impairment, the acquired goodwill from the business combination should, from the date of acquisition, be allocated to each of the acquirer’s cash-generating units from which future economic benefits are expected. A cash generating unit to which goodwill has been allocated shall be tested for impairment annually, irrespective whether there is an indication that the unit may be impaired or not (IAS 38).
Furthermore, a recognition of an impairment loss is required if the carrying amount exceeds the recoverable amount. Hereby, the carrying amount is the amount on the balance sheet and the recoverable amount is the higher of the value in use (the net selling price) and the fair value less cost to sell. Below follows a graphical representation of the previous:
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Figure 1: Impairment test
Compare
Subsequently, the impairment loss should be allocated to respectively goodwill, intangible assets (without existing market) and to other assets of the unit on a pro rata basis which is based on the carrying amount of the unit (IAS 38).
Furthermore, the IASB issued IFRS 3 in order to reduce the differences in accounting for business combinations between IFRS and the U.S. GAAP (IAS 38). Another reason for the implementation of this standard was to increase the transparency in accounting for
business combinations in a way that the goodwill can be linked to economic benefits rendered in a particular accounting period, instead of consistent reduction in an asset with no logical reasoning behind it (amortization) (IFRS 3). Hence, IFRS 3 was supposed to increase the quality of financial reporting.
However, according to Beatty & Weber (2006), managers have substantial discretion in impairment decisions, specifically in determining the recoverable amount. This
phenomenon can be explained by the fact that the recoverable amount is based on managers’ subjective judgement, due to the fact that the recoverable amount is subject to expectations of the market and the company (e.g. future cash flows and earnings) (Carlin & Finch, 2010). Moreover, managers’ incentives also play a key role in impairment decisions, such as incentives to manage earnings in order to for example: meet debt covenant requirements, to engage in earnings smoothing, to ‘’take a big bath’’ or to maximize their compensation plan in order to attain higher bonuses (Beatty & Weber, 2006; Carlin & Finch, 2010).
Another example of a standard where the increase in management discretion plays a role is the treatment of research and development under IFRS. This standard states that the generation of assets is divided into two phases: the research phase and the development phase (IFRS- IAS 38). Since a company conducting research may be unable to demonstrate that the
compare
Recoverable amount Carrying amount
Value in use Fair value less cost to sell
If recoverable amount < carrying amount: impairment loss If recoverable amount > carrying amount: no impairment loss
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intangible asset in the research phase will generate future economic benefits, the research expenditures incurred to acquire the new (technical or scientific) knowledge, should be written off as incurred (Shah, Liang & Akbar, 2013). However, for the development phase, IFRS requires the development costs to be capitalized as intangible assets if, and only if, the following criteria are met (IFRS- IAS 38):
‘’(…)
(a) the technical feasibility of completing the intangible asset so that it will be available for use or sale.
(b) its intention to complete the intangible asset and use or sell it. (c) its ability to use or sell the intangible asset.
(d) how the intangible asset will generate probable future economic benefits. Among other things, the entity
can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself
or, if it is to be used internally, the usefulness of the intangible asset.
(e) the availability of adequate technical, financial and other resources to complete the development and to use
or sell the intangible asset.
(f) its ability to measure reliably the expenditure attributable to the intangible asset during its development.
(…)’’
As a result of this standard, management discretion increases due to the fact that managers decide whether these criteria are present or not (Shah, Liang & Akbar, 2013). According to the IASB, one of the objectives for the implementation of this standard was to increase the verifiability, which in turn should increase the quality of financial reporting. However, according to Shah, Liang & Akbar (2013), the verifiability of financial reporting may not be achieved, because there is a substantial degree of management discretion due to the fact that the managers’ judgement involved in determining whether the six criteria are met, is
subjective.
Furthermore, Barth & Landsman (2010) also criticize the use of fair value accounting in a way that it leads to more management discretion. Additionally, Barth & Landsman (2010) argue that if there are no observable prices on which to base fair value estimates, the estimates can lack decision usefulness, because management is given the opportunity to manipulate the estimates to meet their own objectives. Barth & Landsman (2010) also state that, even if prices are observable, fair value estimates based on observable prices will not reflect dimensions of asset values about which management has private information.
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In addition, another example of a standard that increases the management discretion after the mandatory adoption is the amendment from IAS 39 to IFRS 9 regarding the loan loss provisions. The incurred loss model under IAS 39, results in credit losses only being
recognized when a credit loss event occurred. However, under the expected loss model under IFRS 9, expected credit losses and changes in those expectations of credit losses would always be recognized (PWC). Consequently, more timely information would be provided about expected credit losses. However, the switch to the expected credit loss model also increases management discretion due to the fact that the estimations of the expected credit losses are subject to management’s judgement (Barth & Landsman, 2010).
Another reason for the increase in management discretion after the mandatory
adoption has to do with the fact that IFRS standards are principle- based. This means that the standards specify a number of principles and that an own interpretation can be given to these principles when handling the standards. According to Carmona & Trombetta (2008), this allows the enforcement of these standards to differ per country and even per company, since the interpretation of the principle-based IFRS standards are subject to the laws and regulations in a country, the type of business and individual knowledge and skills. Jeanjean & Stolowy (2008) support this assumption and state that the adoption of IFRS provides managers with substantial discretion due to the fact that the standards are subject to considerable judgement and private information.
However, the increase in management discretion may only lead to (agency) problems if managers have incentives to use this phenomenon in their own interest (agency theory), such as incentives to manage earnings in order to for example: meet debt covenant requirements, to engage in earnings smoothing, to ‘’take a big bath’’ or to maximize their compensation plan in order to attain higher bonuses (Beatty & Weber, 2006; Carlin & Finch 2010). This
phenomenon reflects the agency problem in which the’’ desires or goals’’ of the managers (agents) and the shareholders (principals) conflict (Jensen & Meckling, 1979): While the managers (agents) have incentives to manage earnings and act in their own interest, shareholders (principals) endeavour that the information in the financial report contains a proper representation of the current situation of the company (Ijiri & Jaedicke, 1966).
Furthermore, another agency problem has to do with the fact that it is difficult for the shareholders (principals) to monitor the managers (agents) and to verify if the managers (agents) behaved in the interest of the shareholders (principals) (Jensen & Meckling, 1979). The previous two agency problems, that arise as a result of the increase in management
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discretion after the mandatory adoption, is still under discussion. More specifically, one of the most discussed debate regarding the mandatory adoption, concerns the fact on whether the increase in management discretion in the new standards would lead to an increase in earnings management and therefore a decrease in the quality of financial reporting (Jeanjean &
Stolowy, 2008). Hence, this study also focuses on examining the degree of earnings
management, and thus the quality of financial reporting after the mandatory adoption (Ijiri & Jaedicke, 1966).
Moreover, from empirical results of studies regarding the mandatory adoption of IFRS in association with the degree of earnings management, it can be expected that, overall, the degree of earnings management increases after the mandatory adoption of IFRS (Appendix: table 1). This is consistent with the rationale that, based on the agency theory, the increase in management discretion after the mandatory adoption would lead to management incentives to engage in earnings management (Jeanjean & Stolowy, 2008). Therefore, hypothesis 1 is as follows:
Hypothesis 1: There is a positive relation between the level of earnings management and the mandatory adoption of IFRS.
§ 2.3 The Moderating effect of Corporate Governance
This paragraph describes how the concept of corporate governance could moderate the effect on the quality of financial reporting. More specifically, how corporate governance could moderate the effect in the expected positive relation between the level of earnings management and the mandatory adoption of IFRS.
As was discussed in the introduction, according to Leuz (2010), the quality of financial reporting as a result of moving to a single set of accounting standards (e.g. IFRS) depends on managers’ reporting incentives which moreover is shaped by many factors, inter alia certain aspects of corporate governance. Subsequently, the study of La Porta et al. (2000) is in line with the rationale that characteristics of corporate governance have an influence on the quality of financial reporting and therefore this phenomenon will play a key role in this research. Moreover, it is essential to take this phenomenon into consideration, because although there
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are already many studies that have measured the quality after the mandatory adoption, studies that measure the effect of corporate governance on the quality of financial reporting as a result of the mandatory adoption of IFRS are limited. Hence, the concept of corporate governance is the novelty of this research.
Further, it is essential to examine this phenomenon, because IFRS standards are constantly changed in order to make them effective for all countries, but it could be the case that certain aspects of corporate governance could also have an influence on the quality of financial reporting, as Leuz (2010) stated. Hence, it may be useful that standard setters should also take into account this phenomenon while evaluating the quality of financial reporting after the mandatory adoption of IFRS, in order to improve the standards when necessary.
Additionally, the previous paragraph (§ 2.2) explained that, based on the agency theory, the increase in management discretion after the mandatory adoption would lead to management incentives to engage in earnings management. According to Jensen & Meckling (1979), managers (agents) will not act in the interest of shareholders (principals) unless governance structures are implemented in the corporation to safeguard the interests of
shareholders. Here, the board of directors has an important function in a way that it acts in the interests of shareholders and monitors management. Herein, the relationship between the chairperson and the Chief Executive Officer (CEO) plays an important role (Tricker, 1984) due to the fact that the interests of shareholders will only be safeguarded if the chair of the board is not held by the CEO or if the interests of the CEO and the shareholders are aligned (e.g. suitable designed incentive compensation plan) (Williamson, 1985). Hence, according to Williamson (1985), good corporate governance (e.g. board independence) plays a key role in reducing the before mentioned agency problems (e.g. conflict of interest and monitoring role) (§ 2.2) and management incentives, and might therefore also affect the expected increase in earnings management after the mandatory adoption.
Therefore, the remainder of this paragraph will describe the relationship between corporate governance and earnings management to examine the moderating effect of corporate governance on the quality of financial reporting. While the previous paragraph explained that, based on the agency theory, the increase in management discretion after the mandatory adoption would lead to management incentives to engage in earnings management, this paragraph argues that management incentives to engage in earnings management can be influenced by characteristics of corporate governance. This is moreover also in line with the study of Leuz (2010), which states that manager’s incentives are shaped by many factors, inter alia the corporate governance structure.
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In addition, according to Beasley (1996), corporate governance factors, such as the percentage of outside board members leads to a reduction in fraudulent financial reporting and the degree of managing earnings. Furthermore, the study of Xie et al. (2003) indicates that a higher degree of board independence is associated with a lower degree of earnings management. Subsequently, Xie et al. (2003) also conclude that the presence of active board and audit committee members reduce the level of discretionary current accruals which in turn reduce the level of earnings management.
Furthermore, the study of Cornett, Marcus & Tehranian (2008) conclude that institutional ownership of shares and the presence of independent outside directors on the board deter the use of discretionary accruals, which in turn reduce earnings management. Further, the study of Klein (2002) states that board characteristics, such as audit committee independence and board independence reduce the degree of abnormal accruals and therefore the degree of earnings management.
Moreover, according to Bédard, Chtourou & Courteau (2004), there is a negative relationship between income increasing earnings management and a larger proportion of outside board members, a compulsory supervision of the financial statement and the external audit, and a committee which consists solely of independent members that meet more than twice a year. Further, Bédard et al. (2004) also conclude that there is a negative relationship between the experience of board members and both income increasing as income decreasing earnings management.
Additionally, Carcello, Hollingsworth, Klein & Neil (2006) share the opinion of Bédard et al. (2004) in that there is a negative relation between the expertise of committee members and the degree of earnings management. Subsequently, Carcello et al. (2006) conclude that the financial expertise of the committee members in combination with the independence of committee members, are most effective in reducing earnings management.
The previous studies show that several characteristics of corporate governance reduce the effect of earnings management. This is consistent with the previously discussed rationale that a good corporate governance structure (e.g. board independence) reduces management incentives and thus the degree of earnings management after the mandatory adoption (Williamson, 1985). Furthermore, according to Xie (2003), the audit committee has a more direct role in controlling earnings management. Also, Bhuiyan et al. (2013) states that audit committee members will play a significant role in preventing earnings management, and that
18
an audit committee comprising a large proportion of independent directors will ensure effective monitoring. Therefore, the hypothesis regarding the moderating effect of corporate governance on earnings management is as follows:
Hypothesis 2: The presence of independent audit committee members reduces the expected positive relation between the level of earnings management and the mandatory adoption of IFRS.
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3.0 Methodology
This chapter describes the research methodology, including the sample, the measurement of the variables and the multivariate regression model used in this research.
§ 3.1 Sample
The final sample consists of 8329 observations from 1953 firms in the United Kingdom (Appendix: Table 3a). The United Kingdom is a representative country, since IFRS has been mandatory adopted here on January 1, 2005. Also, this country is suitable for conducting this research due to the data availability. Moreover, all data regarding the variables are collected from Datastream (Appendix: table 2).
The time frame that will be examined in this research is the period before the mandatory adoption of IFRS, which will be reflected by the years 2002-2004, and the period after the mandatory adoption, which will be reflected by the years 2006-2014. Due to the fact that there were a lot of missing values regarding the corporate governance data in Datastream, a longer time frame has been used for the period after the mandatory adoption. The year 2005 will be left out, due to the fact that the transition took place on January 1, 2005. In addition, this phenomenon will be presented as a dummy variable: IFRS, and will have a value of 0 before the mandatory adoption and a value of 1 after the mandatory adoption.
§ 3.2 Measurement of variables
This paragraph describes how the dependent variable, the independent and control variables are measured.
§ 3.2.1 Dependent variable
The quality of financial reporting will be measured by examining the degree of earnings management. In addition, various studies assume that the degree to which earnings management is possible, is an appropriate measure of the reliability of financial reporting (Peasnell, Pope & Young, 2000; Doyle, Ge and McVay, 2007). Hereby, studies indicate that a decrease in earnings management, indicates an increase in the reliability and thus an increase in the quality of financial reporting.
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Additionally, the discretionary accruals (dependent variable) will be used as a proxy for measuring the degree of earnings management. Hereby, an increase in the discretionary accruals indicates an increase in the degree of earnings management. Furthermore, according to Dechow, Sloan and Sweeney (1995), the Modified Jones Model provides the most
powerful tests of earnings management.
Therefore, the Modified Jones Model will be used for measuring the discretionary accruals, which consists of the following formulas.
The first formula calculates the non- discretionary accruals, scaled by lagged total assets, and is as follows (Bartov, Gul & Tsui, 2000):
NDAt = α1 ( 1 At−1) + α2 ( ∆REVt − ∆RECt At−1 ) + α3 ( PPEt At−1) or NDAt = α1 ( 1 At−1) + α2 ( REVt – REVt−1 At−1 - RECt – RECt−1 At−1 ) + α3 ( PPEt At−1)
, wherein the abbreviations mean the following:
Variables Description
NDAt Non-discretionary accruals in year t scaled
by lagged total assets
∆REVt Revenues in year t less revenue in year t -1
∆RECt Net receivables in year t less receivables in
year t -1
PPEt Gross property plant and equipment at the
end of year t
A t-1 Total asset at t-1
α1, α2,α3 Firm-specific parameters
The following formula is used to obtain the estimates of the firms-specific parameters (Bartov, Gul & Tsui, 2000):
TAt = a1 ( 1 At−1) + a2 ( REVt – REVt−1 At−1 ) + a3 ( PPEt At−1) + et
21 , wherein the abbreviations mean the following:
Variable Description
TAt Total accruals in year t scaled by lagged total
assets
a1, a2, and a3 OLS estimates of α1, α2, and α3
et The residual, which represents the
firm-specific discretionary portion of total accruals
Note that the DA is the absolute value of the residual (et) from the Modified Jones Model.
In addition the discretionary accruals (DAt) will be calculated by subtracting the
non-discretionary accruals (NDAt) from the total accruals (TAt):
DAt = TAt - NDAt
§ 3.2.2 Independent variable (CG)
According to Vance (1983), the audit committee, the nomination committee and the
compensation committee all have significant influence on corporate activities. Furthermore, Klein (2003) argues that the audit committee influences the performance of the firm, which in turn makes it likely that the structure of board committees and their composition will impact management’s willingness to manage earnings. Subsequently, according to Xie (2003), the executive committee only plays an indirect role while the audit committee has a more direct role in controlling earnings management.
Moreover, a properly functioning audit committee may be able to reduce or eliminate earnings management. According to Bhuiyan et al. (2013), it is therefore expected that audit committee members will play a significant role in preventing earnings management, and that an audit committee comprising a large proportion of independent directors will ensure
effective monitoring. Hence, it is expected that the β for the presence and the independence of the audit committee members will be negative. Moreover, this is also congruent with the recommendations of Levitt’s Blue Ribbon Panel (Xie, et al., 2003). Therefore, the proxy that will be used to take into account the moderating effect of corporate governance is the
presence of the audit committee (AUD) and the independence of the members of the audit committee (AUDIN). These proxies are covered in the moderator variable in the multivariate regression model, which is called: CG.
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§ 3.2.3 Control variables
The control variables that will be taken into account are: leverage (LEV), return on assets (ROA), size (SIZE) and growth (GROWTH).
Leverage (LEV)
Additionally, leverage is used as a control variable due to the fact that firms with a high level of leverage are associated with greater debt-holder and shareholder conflicts (Watts, 2003). Furthermore, leverage reflects a firms’ business risk in terms of external financing. Therefore, according to Bradbury, Mak & Tan (2006), it is expected that there is a positive relation between the level of leverage and the discretionary accruals due to the fact that the
discretionary accruals might be used to manage external financing in order to show a rosier asset structure and firm performance. Also, the possibility of being unable to meet debt contract requirement is one of the main incentives to manage earnings in the accounting literature (Defond & Jiambalvo, 1994; Sweeney, 1994). Hence, it is expected that the β for leverage will be positive. Additionally, leverage is the total debt divided by the total assets.
Return on assets (ROA)
The second control variable is the return on assets, which indicates a firm’s performance in a way that it reflects how efficiently the assets are being utilised. Hereby, higher return on assets indicates better firm performance in a way that the firms’ assets are efficiently utilised. Hence, in contrast to leverage, there is no need, and thus no incentives, to use discretionary accruals in order to show a rosier asset structure and firm performance when the return on assets are already high. Therefore, according to Bhuiyan et al. (2013), it is expected that there is a negative relation between the return on assets and the discretionary accruals. Hence, it is expected that the β for return on assets will be negative. Additionally, the return on assets is the revenues divided by the total assets.
23
Firm size (SIZE)
The third control variable is firm size. It is expected that there is a positive relation between a firms’ size and the discretionary accruals. Hence, it is expected that the β for firm size will be positive. This can be explained by the fact that larger firms have more incentives to manage earnings due to the fact that these firms receive more public attention than smaller firms (Watts & Zimmerman, 1990). Further, according to the framework of the agency theory, it is easier for larger firms to manage earnings due to the fact that there is a greater distance between managers, shareholders and the external users of financial information (Callao & Jarne, 2010). Additionally, the firms’ size is represented as the natural logarithm of the firms’ total assets.
Growth (GROWTH)
The fourth control variable is the growth of the firm. It is expected that there is a positive relation between the firms’ growth and the discretionary accruals. Hence, it is expected that the β for firm growth will be positive. According to Lakonishok, Shleifer & Vishny (1994), this can be explained by the fact that managers of growth firms may have more incentives to manage earnings due to the fact that investors may have optimistic expectations on the growth firms which may result in disastrous consequences for firms if these expectations are not met (Skinner & Sloan, 2002). Additionally, the firms’ growth is represented as the change in revenues.
Hence, the following abbreviations hold:
Variables Description
CG Corporate Governance, which is reflected by
the presence of the audit committee (AUD) and the independence of the members of the audit committee (AUDIN). The CG variable will have a value of 0, when the two proxies are present and a value of 1 when these proxies are not present.
AUD This reflects the presence of an audit
committee.
AUDIN This reflects if the members of the audit
committee are independent.
IFRS This dummy variable will have a value of 0
before the mandatory adoption and a value of 1 after the mandatory adoption
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Variables Description
LEV Leverage, which is the long-term debt
divided by the total assets
ROA Return on assets, which are the total assets
divided by total revenues
SIZE Firms’ size, which are the total assets of a
firm
GROWTH Firms’ growth, which are the change in total
revenues of the firm
§ 3.3 Multivariate Regression Model
Considering all the above explanatory variables, the general multivariate regression model is as follows:
To measure the change in earnings management, the discretionary accruals (DA) will be measured for the period before the mandatory adoption (2002-2004), and for the period after the mandatory adoption (2006-2014). Hereby, the following model will be used:
DA = β0 + β1 IFRS + β2 CG + β3 IFRS×CG + β4 LEV + β5 ROA + β6 SIZE + Β7 GROWTH + ɛ
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4.0 Descriptive statistics and results
This chapter contains information regarding the descriptive statistics of the sample, both before and after the mandatory adoption (§ 4.1). Subsequently, the results of the multivariate analysis will be described (§ 4.2).
§ 4.1 Descriptive statistics
The tables 1a, 1b and 1c give an overview of the descriptive statistics of the discretionary accruals, the independent variables and the control variables for respectively the samples before, after and for the full sample. Moreover, all continuous variables are winsorized at the 1st and the 99th percentile. From the tables, it results that the full sample consists of 8329 observations, of which 2059 observations (24.7%) consists of data before the mandatory adoption and the remaining 6720 observations (75.3%) consists of data after the mandatory adoption. Furthermore, an extensive calculation of the final samples is given in the appendix (Appendix: Tables 3a, 3b and 3c). Moreover, the tables 4a, 4b and 4c in the appendix presents the number of observations per year.
Also, table 1c shows that in total, there are only 1805 observations (21.7%) of which there is data regarding the presence of the audit committee and 1750 observations (21%) of which there is data regarding the independence of the audit committee. This lack of data can be explained by the fact that not all companies are willing to release certain aspects of their corporate governance system. Moreover, this research controlled for industry effects by requiring a minimum of 10 observations for each two-digit SIC code (Jones, Krishnan & Melendrez, 2008) (Appendix: Tables 5a, 5b and 5c).
Furthermore, from the 1805 observations of which there is data regarding the presence of the audit committee, 273 observations (15.1%) consists of data before the mandatory adoption, and the remaining 1532 observations (84.9%) consists of data after the mandatory adoption. Subsequently, from the 1750 observations of which there is data regarding the independence of the audit committee, 227 observations (13%) consists of data before the mandatory adoption, and the remaining 1523 observations (87%) consists of data after the mandatory adoption.
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Table 1a: Descriptive statistics before IFRS (2002-2004)
Variable N St. Dev. mean 25% 50% 75%
DA 2059 0.1065 0.0848 0.0189 0.0472 0.1029 AUD 273 0.1584 0.9744 1.0000 1.0000 1.0000 AUDIN 227 0.1733 0.9692 1.0000 1.0000 1.0000 LEV 2059 0.2728 0.2667 0.0820 0.2034 0.3564 ROA 2059 0.9106 1.0505 0.3544 0.8832 1.4546 SIZE 2059 2.2619 11.1649 9.6185 11.0769 12.5907 GROWTH 2059 1.0951 0.2042 -0.0630 0.0442 0.1942
Table 1b: Descriptive statistics after IFRS (2006-2014)
Variable N St. Dev. mean 25% 50% 75%
DA 6720 0.0903 0.0802 0.0228 0.0508 0.1025 AUD 1532 0.0764 0.9941 1.0000 1.0000 1.0000 AUDIN 1523 0.2568 0.9291 1.0000 1.0000 1.0000 LEV 6720 0.2431 0.2504 0.0783 0.1933 0.3425 ROA 6720 0.8289 0.9076 0.3211 0.7241 1.2279 SIZE 6720 2.3856 11.6069 9.8614 11.4602 13.2620 GROWTH 6720 1.2389 0.2317 -0.0546 0.0645 0.2225
Table 1c: Descriptive statistics full sample (2002-2014)
Variable N St. Dev. mean 25% 50% 75%
DA 8329 0.0941 0.0813 0.0218 0.0501 0.1023 IFRS 8329 0.4314 0.7528 1.0000 1.0000 1.0000 AUD 1805 0.0938 0.9911 1.0000 1.0000 1.0000 AUDIN 1750 0.2479 0.9343 1.0000 1.0000 1.0000 LEV 8329 0.2508 0.2544 0.0790 0.1961 0.3463 ROA 8329 0.8520 0.9429 0.3281 0.7606 1.2886 SIZE 8329 2.3632 11.4976 9.8125 11.3498 13.1291 GROWTH 8329 1.2049 0.2249 -0.0566 0.0589 0.2156
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Furthermore, the tables 2a and 2b give an overview of the Pearson correlations in which the bold correlation coefficients are significant at a significance level of 1%, 5 % or 10%.
Table 2a: Pearson correlation before IFRS (2002-2004)
DA AUD AUDIN LEV ROA SIZE GROWTH
DA 1.0000 AUD -0.0402 1.0000 0.5087 AUDIN -0.0507 -0.0206 1.0000 0.4468 0.7571 LEV 0.1339*** 0.1104* 0.0966 1.0000 0.0000 0.0687 0.1470 ROA 0.1286*** -0.0610 0.0562 -0.0528** 1.0000 0.0000 0.3154 0.3997 0.0165 SIZE -0.3518*** 0.1232** -0.0198 -0.0975*** -0.1695** 1.0000 0.0000 0.0420 0.7665 0.0000 0.0000 GROWTH 0.1701*** -0.0423 0.0155 -0.0322 -0.0372* -0.0836*** 1.0000 0.0000 0.4860 0.8158 0.1441 0.0912 0.0001
* = significant at 10% ** = significant at 5% *** = significant at 1%
Table 2b: Pearson correlation after IFRS (2006-2014)
DA AUD AUDIN LEV ROA SIZE GROWTH
DA 1.0000 AUD 0.0191 1.0000 0.4553 AUDIN 0.0077 -0.0071 1.0000 0.7638 0.7824 LEV 0.1066*** 0.0412 -0.0994*** 1.0000 0.0000 0.1069 0.0001 ROA -0.0032* 0.0653** 0.0355 -0.1066*** 1.0000 0.0798 0.0105 0.1663 0.0000 SIZE -0.2822*** 0.0264 0.0883*** 0.0060 -0.2182*** 1.0000 0.0000 0.3019 0.0006 0.6345 0.0000 GROWTH 0.084*** 0.0102 0.0072 0.0075 -0.0442*** -0.0542*** 1.0000 0.0000 0.6889 0.7787 0.5517 0.0005 0.0000 *
= significant at 10% ** = significant at 5% *** = significant at 1%
Table 2a shows that, before the mandatory adoption, all the control variables are significant and are, except for the size, positively related to the discretionary accruals. The positive
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correlation of the control variable leverage is in line with prior literature due to the fact that the possibility of being unable to meet debt contract requirements is one of the main
incentives to manage earnings in the accounting literature (Defond & Jiambalvo, 1994). Furthermore, the positive correlation between the growth and the discretionary accruals is in line with the rationale that managers of growth firms may have more incentives to manage earnings due to the fact that investors may have optimistic expectations on the growth firms which may result in disastrous consequences for firms if these expectations are not met (Lakonishok, Shleifer & Vishny, 1994; Skinner & Sloan, 2002).
However, the positive correlation between the return on assets and the discretionary accruals, and the negative correlation between firms’ size and the discretionary accruals are not in line with prior literature. In fact, prior literature stated that there is no need, and thus no incentives, to use discretionary accruals in order to show a rosier asset structure and firm performance when the return on assets are already high (Bhuiyan et al. 2013). Furthermore, Watts & Zimmerman (1990) argued that there is a positive correlation between the firms’ size and the discretionary accruals since larger firms have more incentives to manage earnings due to the fact that these firms receive more public attention than smaller firms.
Subsequently, like before the mandatory adoption, table 2b shows that, all the control variables are significant after the mandatory adoption as well. Further, like before the
mandatory adoption, leverage and growth are positively correlated with the discretionary accruals, which moreover is in line with prior literature (Defond & Jiambalvo, 1994; Skinner & Sloan). Also, like before the mandatory adoption, there is a negative correlation between the firms’ size and the discretionary accruals, which moreover is not in line with the rationale that larger firms have more incentives to manage earnings due to the fact that these firms receive more public attention than smaller firms (Watts & Zimmerman, 1990).
Furthermore, there is a positive correlation between the return on assets and the discretionary accruals which moreover is in line with the rationale that there is no need, and thus no incentives, to use discretionary accruals in order to show a rosier asset structure and firm performance when the return on assets are already high (Bhuiyan et al. 2013). However, this positive correlation was not present before the mandatory adoption. In fact, before the mandatory adoption, there was a negative correlation between the return on assets and the discretionary accruals.
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§ 4.2 Results Multivariate Analysis
In this paragraph the results of the multivariate analysis will be explained. The tables 3a and 3b give an overview of the results before and after the mandatory adoption, respectively.
Table 3a: Regression before IFRS (2002-2004)
DA Coef. Std. Err. t P>|t| [95% Conf. Interval] AUD -0.0178 0.0190 -0.94 0.3480 -0.0552 0.0196 AUDIN -0.0238 0.0125 -1.90 0.058* -0.0484 0.0008 LEV -0.0040 0.0136 -0.29 0.7710 -0.0307 0.0228 ROA 0.0080 0.0036 2.24 0.026** 0.0010 0.0151 SIZE -0.0027 0.0018 -1.52 0.1300 -0.0061 0.0008 GROWTH 0.0149 0.0112 1.33 0.1840 -0.0072 0.0370
* = significant at 10% ** = significant at 5% *** = significant at 1%
Table 3b: Regression after IFRS (2006-2014)
DA Coef. Std. Err t P>|t| [95% Conf. Interval] AUD 0.0362 0.0364 1.00 0.3190 -0.0351 0.1075 AUDIN -0.0014 0.0037 -0.39 0.6950 -0.0086 0.0058 LEV -0.0067 0.0050 -1.32 0.1860 -0.0166 0.0032 ROA -0.0055 0.0016 -3.52 0.000*** -0.0085 -0.0024 SIZE -0.0034 0.0007 -4.66 0.000*** -0.0049 -0.0020 GROWTH 0.0039 0.0019 2.04 0.041** 0.0002 0.0076
* = significant at 10% ** = significant at 5% *** = significant at 1%
The tables 3a and 3b show that there is a negative relation between the presence of the audit committee and the discretionary accruals for the period before the mandatory adoption, while this relationship is positive for the period after the mandatory adoption. However, no conclusion can be drawn from these results, since the p-values are not significant.
Furthermore, there is a negative relation between the independence of the audit committee and the discretionary accruals. This relationship is also present after the mandatory adoption. However, the p-value is only significant for the period before the mandatory adoption.
As aforementioned, from table 3a results that there is a negative relationship between the independence of the audit committee and the discretionary accruals. This effect indicates that as the members of the audit committee are more independent, the discretionary accruals and thus the degree of earnings management, will decrease before the mandatory adoption.
30
This is consistent with the rationale that an audit committee comprising a large proportion of independent directors will ensure effective monitoring and thus will play a significant role in preventing earnings management (Bhuiyan et al., 2013). However, after the mandatory adoption, there is no evidence for the presence of this effect (Table 3b).
Furthermore, table 3a shows that the return on assets are positively related with the discretionary accruals. This effect indicates that as the return on assets are higher, the discretionary accruals and thus the degree of earnings management will increase before the mandatory adoption. This effect is moreover not in line with the rationale that, there are no incentives to use discretionary accruals in order to show a rosier asset structure and firm performance when the return on assets are already high (Bhuiyan et al., 2013). However, table 3b shows that there is a negative relation between the return on assets and the discretionary accruals, which indicates that, as the return on assets are higher, the discretionary accruals and thus the degree of earnings management will decrease after the mandatory adoption. Hence, this effect is in line with the aforementioned rationale.
Further, from table 3b results that there is a negative relation between firms’ size and the discretionary accruals, which indicates that as the firms’ size is larger, the discretionary accruals and thus the degree of earnings management will decrease after the mandatory adoption. This effect is moreover not in line with the aforementioned rationale that larger firms have more incentives to manage earnings due to the fact that these firms receive more public attention than smaller firms (Watts & Zimmerman, 1990).
Also, from table 3b results that there is a positive relation between the firms’ growth and the discretionary accruals, which indicates that as the firms’ growth increases, the discretionary accruals and thus the degree of earnings management increases after the mandatory adoption. This effect is moreover in line with the aforementioned rationale that managers of growth firms may have more incentives to manage earnings due to the fact that investors may have optimistic expectations on the growth firms which may result in disastrous consequences for firms if these expectations are not met (Lakonishok, Shleifer & Vishny, 1994; Skinner & Sloan, 2002).
31 Table 3c: Regression full sample (2002-2014)
DA Coef. Std. Err. t P>|t| [95% Conf. Interval] IFRS 0.002966 0.002566 1.16 0.248 -0.00207 0.007999 AUD -0.00495 0.01803 -0.27 0.784 -0.04032 0.03041 AUDIN -0.00318 0.003491 -0.91 0.363 -0.01002 0.00367 LEV -0.007025 0.004715 -1.49 0.136 -0.016273 0.002223 ROA -0.003503 0.001426 -2.46 0.014** -0.006300 -0.000706 SIZE -0.003102 0.000678 -4.57 0.000*** -0.004432 -0.001772 GROWTH 0.004143 0.001843 2.25 0.025** 0.000529 0.007757
* = significant at 10% ** = significant at 5% *** = significant at 1%
Furthermore, from table 3c results that there is no evidence that the mandatory adoption of IFRS has an influence on the discretionary accruals. Additionally, there is also a t-test
performed to see if there is an increase or a decrease in the discretionary accruals, and thus the degree of earnings management after the mandatory adoption (table 4). In the t-test in table 4, 0 indicates the period before the mandatory adoption, and 1 indicates the period after the mandatory adoption. Furthermore, H0 indicates that there is no difference in the discretionary
accruals between the period before and after the mandatory adoption, whereas Ha indicates
that there is in fact a difference.
Subsequently, the results of the t-test show that there is no evidence that there is a change in the discretionary accruals in the sample after the mandatory adoption in comparison with the sample before the mandatory adoption. Hence, there is no evidence to assume that the degree of earnings management changed after the mandatory adoption, which is not consistent with hypothesis 1 that stated that there is a positive relation between the level of earnings management and the mandatory adoption of IFRS.
Table 4: T-test IFRS on discretionary accruals
Group Obs. Mean Std. Err. Std. Dev. [95% Conf. Interval]
0 2059 0.0833 0.0022 0.1021 0.0789 0.0877 1 6270 0.0806 0.0012 0.0913 0.0783 0.0828 Combined 8329 0.0813 0.0010 0.0941 0.0792 0.0833
Difference 0.0028 0.0024 -0.0019 0.0074
Diff= mean (0) –mean (1) H0: diff=0
Ha: diff < 0 Ha: diff != 0 Ha: diff > 0
32
Subsequently, taken into account that hypothesis 2 stated that the presence and the
independence of the audit committee reduces the expected positive relation between the level of earnings management and the mandatory adoption of IFRS, the results of the multivariate analysis are also not consistent with hypothesis 2 due to the fact that the results do not provide evidence for the expected positive relation between the level of earnings management and the mandatory adoption of IFRS (hypothesis 1).
Furthermore, from table 3a and 3b results that there is no evidence to assume that there is a relation between the presence of the audit committee and the discretionary accruals for both, before and after the mandatory adoption. This indicates that there is no evidence to assume that the presence of the audit committee has a moderating effect on the discretionary accruals and thus on the degree of earnings management. Moreover, from table 3a results that the independence of the audit committee members has a negative effect on the discretionary accruals. However, this effect is not present after the mandatory adoption. Hence, there is no evidence to assume that the presence and the independence of the audit committee has a moderating effect on the discretionary accruals and thus on the degree of earnings management.
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5.0 Discussion of results
In this chapter, the results of chapter 4 will be discussed and possible explanations will be given for the founded results.
Additionally, the results showed that there is no evidence to assume that there is a difference in the discretionary accruals and thus the degree of earnings management between the period before and after the mandatory adoption, which moreover is not consistent with hypothesis 1. An explanation for this result could be that there in fact was no difference between the period before and after the mandatory adoption. This can be supported by the study of Soderstrom and Sun (2010). They argue that the quality of financial reporting depends on the legal and political system in the country where the company is located. Soderstrom and Sun (2007) also discuss different factors related to the legal and political system of a country, and then explain how these factors affect the quality of financial reporting. The figure below, which moreover was also provided in § 2.1.2, shows the relationships between the relevant factors and the quality of financial reporting.
Figure 1: Determinants of accounting quality: From ‘’IFRS Adoption and Accounting
Quality: A Review,’’ by N.S. Soderstrom and K.J. Sun, 2007, European Accounting Review,
16, p. 688.
From this figure, it appears that the adoption does not necessarily lead to an improvement or a deterioration in the quality of financial reporting and thus depends on various factors and conditions in the country where the company is located, such as the laws and regulations in a country. Hence, a possible explanation why the results from chapter 4 are not consistent with
