The influence of IFRS adoption and the Rule of Law on
earnings management:
Evidence from the EU-15
by Wouter Loijson1 supervisor: Dr. J.H. Von Eije
Master thesis Msc International Financial Management University of Groningen
Abstract
In this study the relationship between IFRS adoption, a country’s rule of law and earnings management is investigated, using a sample of 2,761 listed firms across the EU-15 countries during
the time period of 1998-2012. The results show that IFRS adoption in a country with a low rule of law leads to a decrease in the magnitude of earnings management, but it does not lead to a change in the direction of earnings management. Furthermore, increasing the rule of law without IFRS adoption does not change the magnitude or direction of earnings management. Most importantly,
the results also show that in a country with a strong rule of law, the marginal impact of IFRS adoption leads to an increase in the magnitude of earnings management and to an increase in net
income decreasing earnings management.
JEL classification: C22, G38, K20
Keywords: Earnings management, IFRS, rule of law
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1. Introduction
Earnings or ‘net income’ is the most important item on a firm’s financial statement. It shows a firm’s net profit or loss after deduction of all expenses, cost of goods sold and taxes. For investors, net income is of particular importance since it is used in ratio analyses such as Profitability and Market Value Ratio’s, in order to decide in which firm to invest. In this context, it is of importance that net income provides a faithful representation of a firm’s performance. In reality, however, the net income of a firm is not uncommonly subject to manipulation. Dichev et al. (2013) have conducted an
extensive survey among 169 CFOs of public companies, in which they found that: ‘in any given period, about 20% of firms manipulate earnings to misrepresent economic performance, and for such firms 10% of EPS is typically managed.’ The manipulation of earnings is often referred to as
‘Earnings Management’. Managers engage in earnings management through discretionary accounting choices. A relevant example of a discretionary accounting choice, is the mandatory use of fair value measurement of assets and liabilities under the IFRS regulations (IFRS 13). Besides IFRS 13, several other IFRS standards influence the possibility of engaging in earnings management practices. In 2005, the IFRS has, officially, been introduced across Europe as the mandatory accounting standard for the consolidated financial statements of listed companies. However, many firms have conformed to the rules of the European commission, by adopting the IFRS, in an earlier or later stage. The introduction of these accounting standards was the result of a cry for harmonization, due to a lack of transparency and comparability of financial statements across Europe. Even though the European Commission originally intended to improve transparency of financial statements with IFRS2, it is widely criticized whether this goal has been achieved. Moreover, several authors (Capkun et al., 2012; Paananen and Henghsiu, 2009) claim that the IFRS leaves more room for managerial interpretation of accounting choices, therefore creating a higher possibility of earnings being managed.
It is not only the accounting standards that have been identified by previous literature to affect the amount of earnings being managed. Many authors (Ball et al., 2000; Ball et al., 2003; Cai et al., 2008; JeanJean & Stolowy, 2008) agree that a set of high quality accounting standards is a minimum
requirement for less earnings management, but is not sufficient on itself. The amount of earnings being managed also depends on firm-specific incentives and a country’s institutional and legal environment. The institutional and legal environment in a country can enable or restrain managers from engaging in the manipulation of earnings. Previous research on the influence of a country’s legal environment has mainly focused on the quality of investor protection rights and its enforcement or on the legal origin of a country (Burgstahler et al., 2006; la Porta et al. 1997,1998, 2000; Leuz et al. 2003). In my research, I will link earnings management and IFRS to a relatively unexplored measure of a country’s institutional and legal environment: the rule of law. The rule of law in a country can be
3 described as the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence (Kaufmann et al., 2010). A country can have high quality regulations and accounting standards but still experience a high fraud rate if the rule of law is low.
As Jensen and Meckling (1976) already pointed out, the return of cash flows to investors should not be taken for granted. Insiders might use resources for their own benefit (La Porta et al., 2000), which may result in managing earnings in a certain direction. In a society with a high rule of law, the country’s legal institutions will be of high quality. However, following Han et al. (2010), it is likely that in a country with a high rule of law, managers will pursue their self-interest through unregulated opportunities once the obligation to act in accordance with the law is met.
As been stated before, the IFRS provides managers a high level of discretion in making accounting choices, often more than the pre-IFRS European GAAPs did. This provides managers with the opportunity to manage earnings through accounting discretion, if they have incentives to do so. Given this proposed relationships between IFRS and legal institutions on one hand and earnings
management on the other; and taken into account that Ahmed et al. (2013) state that managers are likely to use accounting discretion in order to gain private benefits, the main research question has been constructed as follows:
To what extent does the interaction between IFRS adoption and the strength of a country’s rule of law influence earnings management behavior?
In order to find an answer to the main research question, the following hypotheses have been constructed:
1a. To what extent does IFRS adoption influence the magnitude of earnings management? 1b. To what extent does IFRS adoption influence the direction of earnings management?
And:
2a. To what extent does the interaction between IFRS adoption and the strength of a country’s rule of law influence the magnitude of earnings management?
2b. To what extent does the interaction between IFRS adoption and the strength of a country’s rule of law influence the direction of earnings management?
4 IFRS and rule of law on earnings management, it is of importance to examine this influence on both the direction and the magnitude of earnings management.
In order to find an answer to the formulated questions, I will use data of a sample of 2761 firms across 15 European countries for a time period of 13 years, from 1998 to 2012 (1999 and 2001 are left out). The firms are all listed (primary listing) at one of the stock exchanges in the EU-15 countries. I will use a dummy variable for a firm’s use of IFRS and use a dynamic Rule of Law Index provided by the World Bank.
1.1. Contribution to the literature
Prior evidence on the relationship between earnings management and the use of IFRS is primarily confined to a short period of time. In this paper, I will firstly go beyond this limitation and examine a period of 13 years, running from 1998 until 2012. I will take time period of 7 years before the official introduction of the IFRS and 7 years after it. This approach makes it possible to distinguish between official introduction of the IFRS and the firm-level adoption and to disentangle such effects from the period of study, in particular from the ‘official’ introduction year.
Secondly, previous literature has mainly focused on the influence of investor protection (Leuz et al., 2003) on earnings management. In order to do so, proxies for investor protection have been used such as: board independence, enforcement of securities laws, protection of minority shareholders’ interest, and enforcement of accounting and auditing standards (Ball et al., 2000; Houqe et al., 2012; Leuz et al., 2003; Nabar & Boonlert-U-Thai, 2007). However, these measures are solely focused on the regulatory quality. In my research, I will use a broader environmental en legal proxy, namely the rule of law (Kaufmann et al., 2008). By using this proxy, I will show that the influence on earnings management goes beyond the traditional proxies of investor protection. Rule of law captures not only the regulatory aspect, it also captures the perceptions of citizens towards regulation and authority. Previous research has already linked the rule of law to economic growth (Haggard & Tiede, 2011). However, research about its influence on earnings management is still absent.
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1.2. Structure
The research will be structured as follows. In the next part, a literature review will be provided in which the most relevant previous literature and theories will be discussed. The subjects of this part will be on earnings management, IFRS and a country’s institutional and legal environment. Also, the hypotheses will be posited. In section three, the research design will be presented, in which the regression model will be discussed. Section four presents the main findings of this study. Lastly, the conclusion of the study, the limitations and recommendations for future research will be provided.
2. Literature review
This section consists of three parts. In the first part, the term earnings management and its
components will be discussed. In the second part, the IFRS accounting regulation will be explained. The last part will provide further explanation on the relevance of the institutional and legal
environment of a country.
2.1. Earnings management
Earnings management has been a widely discussed subject in the recent literature. However, there is not a generally accepted definition of this phenomenon. Dechow and Skinner (2000) have referred to the definition given by Schipper (1989): “… a purposeful intervention in the external financial
reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process)....” (p.92)
Another definition is given by Healy & Wahlen (1999) who look at the subject from the perspective of standard setters: “Earnings management occurs when managers use judgment in financial
reporting and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers” (p. 368)
6 between earnings management and fraud. The figure is derived from Dechow and Skinner (2000) and adjusted to the IFRS regulations.
[Put figure 1 here]
Managing earnings can be carried out through real cash flow choices or accounting choices. Figure 1 shows several options of ‘real’ cash flow choices, which have a direct influence on actual economic performance. Another example of a discretionary choice which affects real cash flows, is the setting of transfer prices (Thomas, 1971). Through transfer pricing systems, firms are able to increase or decrease the amount of earnings of a firm in certain time period. Even though real cash flow choices account for a substantial part of the earnings management practices, it is beyond the scope of this paper. The reason for this is that measurement of real discretionary cash flow choices is extremely difficult, if not impossible, since firms are not obligated to disclose information in this regard.
By using accounting choices managers can either increase or decrease net income in a given period of time, without influencing the actual economic performance of a firm. The specific direction of the manipulation of net income depends on the incentives managers have to engage in earnings management in a given period of time.
2.1.1. Incentives for earnings management
A major incentive for managers to participate in earnings management is managing credit ratings (Jung et al., 2013). Credit ratings have a significant influence on the cost of a firm’s future capital such as borrowings and bonds. Jung et al. (2013) state that both Moody’s and Standard & Poor’s have confirmed their use of earnings volatility as a factor in evaluating issuer’s credit risk. By smoothing earnings, managers may accomplish a less volatile earnings pattern and therefore gain a better credit rating. Moreover, Graham et al. (2005) have found that the majority of CFOs prefer smooth earnings over more volatile earnings, even when there is a constant cash flow volatility. The smoothing of earnings is related to both net income increasing and decreasing earnings management.
7 order to: (1) mask losses; (2) report an increase in seasonally adjusted quarterly earnings; and (3) meet analysts’ forecasts for quarterly earnings.
Several researchers have found small losses to be exceptionally rare compared to small profits. Also, a small decline in reported profit is unusually rare in comparison with a small increase in reported profit. (Burgstahler and Dichev, 1997; Degeorge et al., 1999). According to Beatty et al. (2002) the pressure in meeting analysts’ forecasts arises especially in publicly held firms, with a highly dispersed ownership structure. They argue that small investors are more likely to rely on simple heuristics than sophisticated private investors, such as banks. This makes public firms more likely to engage in managing earnings upwards in order to meet earnings targets or avoid losses.
According to Burgstahler et al. (2006), forces that also lead to more upwards earnings management in firms are managerial compensation contracts, debt covenants, particularly in public debt agreements, or political pressure. Altogether, Healy and Wahlen (1999) conclude that motivations for conducting in earnings management practices arise from: 1) Capital market expectations and valuation; 2) contracts that are written in terms of accounting numbers; and 3) anti-trust and other government regulations. These three motivations result in the following directions of earnings management: capital market expectations and valuation can cause both net income increasing or decreasing
behavior, the pressure of contracts result in net income increasing manipulations, while anti-trust and government regulations generally result in net income decreasing actions.
2.2. International Financial Reporting Standards
In 2002 the European Commission (EC) released formal regulations requiring all listed EU companies to prepare their consolidated accounts in accordance with one single set of accounting standards, namely International Accounting Standards (IAS). These regulations, becoming effective from the 1st of January 2005, resulted in a widespread convergence from local Generally Accepted Accounting Principles (GAAP) to IFRS, with over 7000 EU companies adopting IFRS (Bozos, Ratnaike & Alsharairi, 2014).
The EC’s motivation for a new single standardized set of accounting rules was to ensure a high level of transparency and comparability of financial reporting in order to stimulate the efficiency and cost-effectiveness of the European internal market. However, the question arises: to what extent is the transparency actually improved by the implementation of the IFRS?
2.2.1. IFRS and earnings management
8 As stated above, one of the reasons for the introduction of the IFRS is to stimulate transparency and comparability of financial statements in order to improve efficiency in capital markets. Capkun et al. (2008) and Ball (2006) argue that the IFRS is seen as a higher quality accounting standard than local GAAPs. They argue that firms use IFRS as an opportunity to construct a more transparent financial statement in order to attract cheaper capital from investors. Moreover, Beuselinck et al. (2010) found an increase in analysts’ information processing due to the IFRS. They state that the analysts who are following firms in more than one European country experience the largest post-IFRS improvement in private information precision. This increase in transparency will raise the chance of detection of earnings management. Once earnings management is detected, it is likely that investors will take disciplinary actions. Therefore, a more transparent financial statement should lower the possibility of managers engaging in earnings management.
However, other authors have casted their doubts about whether IFRS has actually resulted in more transparency and therefore less earnings management (Ahmed et al., 2013; Paananen and Henghsiu, 2009; Nobes, 2006). It can be stated that a change in earnings management, after IFRS adoption, is likely to arise from the change in accounting discretion and the possibility to exercise managerial judgment in order to gain private benefits (Ahmed et al.,2012; Capkun et al., 2013). Nobes (2006) states that the post-2005 IFRS standards provide firms with greater flexibility due to overt options; covert options, vague criteria and interpretations and measurement estimations in IFRS. Nobes (2006) identifies 18 overt options, 21 covert options and several vague criteria that provide managers with flexibility to exercise managerial judgment and engage in earnings management. These vague criteria commonly contain words like ‘foreseeable’, ‘probable’ and ‘expected’, which leave room for interpretation.
In an attempt to evaluate the extent to which the IFRS should lead to more/less earnings management, Capkun et al. (2013), use a list of 21 key points of IFRS regulation that may differ from local GAAP (Kee-Hong et al., 2008). They argue that 11 out of 21 standards may lead to an increase or decrease in earnings smoothing. Applying this list, shown in table 1, to the local GAAPs of only the EU-15, which will be the scope of this paper, it can be concluded that the mandatory introduction of IFRS in Europe should lead to an increase in earnings smoothing.
[Put table 1 here]
However, it must be noted that there are no weights assigned to any of the standards, which casts doubts about the true extent of influence they have on earnings management. Also, the list applies to earnings smoothing, which is only one of the many courses of earnings management.
9 and Jermakowicz (2006) argue, rule-based standards simply tell you what to do. This idea is the opposite of principle-based standards, which have no clear agreement on how it should be done but tell preparer and auditor how to decide what should be done (Alexander and Jermakowicz, 2006). This difference causes principle-based standards to be more difficult to enforce than rule-based standards (Ahmed, 2012). Hence, the IFRS should be more difficult to enforce than several local GAAPs.
Last but not least, the IASB has shown a clear preference towards fair value measurement of assets and liabilities (Hung and Subramanyam 2007; Schipper 2005; Whittington 2005). IFRS 13 defines fair value as follows: ‘The price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date’. Ball (2006) has
identified several problems which may be caused by fair value measurement:
1) Market liquidity for a certain asset may be low which can cause substantial uncertainty about the fair value of the asset and will cause a noise in financial statements.
2) In illiquid markets, trading by managers can influence traded as well as quoted prices. Therefore, managers can manipulate the fair value measurement of an asset.
3) When liquid market prices are not available, firms will report estimated market prices instead of actual arm’s length market prices. Fair value accounting will now become ‘mark to model’ accounting. Due to imperfect pricing models and imperfect estimates of model parameters, a ‘model noise’ will arise in financial statements.
4) Firms tend to have positively correlated positions in commodities and financial instruments. Not all firms can cash out at the same time, which has caused fair value measurement to be even more controversial during the financial crisis of 2008-2009 (Valencia et al., 2013). However, the fair value measurement errors during the crisis mainly occurred in the financial sector’s measurement of financial assets ( De Jager, 2014; Pozen, 2009). Even though the financial sector is beyond the scope of this paper, it gives a good indication of the problems that may arise when fair value measurement is not adequate anymore.
The above stated arguments show that setting the price of an asset at fair value is often open for interpretation. Managers can use own judgment in picking the model used for valuating an asset or setting a price (Ball, 2006). This preference for fair value measurement can be found in many IFRS standards3 and is likely to affect the amount of earnings being managed (Paananen and Henghsiu,
10 2009). If the amount of earnings being managed increases, it would mean that the introduction of the IFRS has an unintended negative effect. Given the aforementioned theories, the first hypothesis is constructed as follows:
H1a: The introduction of the IFRS has a positive influence on the magnitude of earnings management. Besides the magnitude of earnings management, this paper also focuses on the question whether earnings management in a particular direction finds place in the specified time period. As been stated in section 2.1.1. managerial incentives exist to manage earnings downwards in order to smooth earnings and manage capital market expectations. However, capital market expectations also put severe pressure on firms to meet earnings targets, avoid losses and meet analysts’ forecasts. Taken into account the influence of managerial compensation contracts and debt covenants it can be concluded that it is more likely for managers to manipulate earnings upwards than downwards. As stated above, the IFRS is expected to leave more room for these manipulations, which is why the following hypothesis is constructed:
H1b: The introduction of the IFRS has a positive influence on the direction of earnings management. Previous research has shown different results considering these issues. Paananen and Henghsiu (2009) have conducted a research among German firms. They found, contrary to the intention of the
European adoption of IFRS, an increase in earnings smoothing after the adoption of IFRS. Also, a decrease in timely loss recognition was reported, which points to more net income increasing manipulation. They state that this development is driven by the changes in accounting standards, which makes it more difficult for investors to base their investment choice on IFRS financial
reporting. Callao and Jarne (2010) used a sample of 11 European countries which is representative of the Anglo-Saxon and Continental European accounting system. They have also found an increase in the magnitude of absolute earnings management practices in the post-IFRS period as a result of the increased flexibility of the newly adopted accounting standards. Moreover, JeanJean and Stolowy (2008) examined the effects of the mandatory adoption of IFRS among countries such as France and the UK. They found an increase in earnings management among French firms (less timely loss recognition) and no significant change in earnings management among the UK firms.
Contrary to the above mentioned papers, Zéghal et al. (2011) found a decrease in both the absolute and the signed earnings management among French firms after the mandatory adoption of IFRS. Moreover, Zéghal et al. (2012) also conducted a research among 15 European Union (EU) countries in which they found a decrease in the magnitude of earnings management. They also found a decrease in management towards earnings targets, which indicates less net income increasing earnings
11 accounting numbers. Surprisingly, they found the decrease in earnings management to be more pronounced for countries where the distance between IFRS and local GAAP are more important. Also, Aussenegg et al. (2008) have conducted a research among firms that are publicly traded on a European stock exchange in 17 European countries. They found a decrease among countries where firms have shown a high amount of earnings management in the pre-adoption period. However, no significant changes were found for countries (such as the UK, Ireland and Scandinavian countries) that showed a lower amount of earnings management in the pre-IFRS period.
Despite their differences, many researchers (Ball et al., 2000; Ball et al. 2003; Cai et al. 2008; JeanJean and Stolowy, 2008; Preiato et al., 2013) agree that accounting regulation on itself is not enough to guarantee high quality financial statements. Whether the implementation of IFRS results in an increase or decrease of earnings management also depends on other factors such as firm-specific incentives for earnings management and the institutional and legal environment of a firm.
2.3 Institutional and legal environment, IFRS & earnings management
The institutional and legal environment is a wide concept with no clear boundaries (JeanJean, 2012). It comprises, among others, investor protection, legal enforcement, rule of law, disclosure regulations, and judicial efficiency. In the following section the definition ‘institutional and legal environment’ will be explained at the hand of a country’s rule of law.
2.3.1. Rule of Law
The rule of law is a broad and wide concept which comprehends many aspects of a society. For achieving a high rule of law, more is needed than simply implementing regulations and enforcement mechanisms (Dawson, 2013). Carothers (2009) defines the road to achieving the rule of law as follows:
“…achieving the rule of law involves far more than getting judges trained, putting modern police equipment in place, and reprinting and distributing legal texts. It is a transformative process that changes how power is both exercised and distributed in a society… [and] also involves basic changes in how citizens relate to state authority and also to one another…” (p. 59-60)
As Carothers definition states, the rule of law captures both the side of a country’s authorities and the side of the citizens.
It is the responsibility of the authorities in a country to establish high quality regulation and establish the proper institutions needed in a country. However, this is only a minimum requirement for
12 Tamanaha (2007) has further clarified the ‘citizen’ aspect of the rule of law in his paper. He states that for the rule of law to exist, people must be committed to it and truly believe in it. They must take it for granted as an existing and necessary part of their political-legal system. This attitude towards the rule of law, is not a legal rule but a shared political ideal that amounts to a cultural believe (Tamanaha, 2007). Just as with any cultural believe, it is not subject to human control but it must grow in a society over time. Finally, Tamanaha states that this cultural believe is an essential element of the rule of law, and it is also the hardest to achieve.
Moreover, Kaufmann et al. (2010) have given the following definition of the rule of law, which will be used in my research:
“The extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence.” (p. 4)
The focus will be on the cultural believes element of the rule of law that influence managerial behavior. The above-mentioned theory brings up an important question: how does the rule of law, in combination with the IFRS, affect managerial behavior in regard to earnings management practices?
2.3.2. IFRS, rule of law and earnings management
Previous literature has given different interpretations of the meaning of the rule of law in the context of managerial behavior. One way to interpret the meaning of the rule of law is given by Dyreng et al. (2012). They have interpreted it in such a way that it represents the institutional and legal forces in a country that lead to a cultural believe of managers to engage in less earnings management. In their study, they examined the effect of rule of law on earnings management, but their focus is on whether the rule of law at the subsidiary level matters, holding constant the parent rule of law. The
consolidated financial statements of all the parent companies are subject to the U.S. GAAP and Securities and Exchange Commission (SEC) regulations. Dyreng et al. find a significant difference in earnings management at subsidiary-level. Firms with many subsidiaries located in countries with a high rule of law show less earnings management in foreign income than firms with many subsidiaries located in countries with a low rule of law.
13 A different interpretation of the meaning of the rule of law for managerial behavior can be derived from Salter and Niswander (1995) and Han et al. (2010). Salter & Niswander studied the influence of societal values on accounting systems. They conclude that in countries that are highly uncertainty avoidant, once the strict rules had been met, accountants felt free to measure items in a method that would benefit themselves. In other words, while the accountant is culturally inclined to reduce uncertainty, the accountant having met his obligation can seek through unregulated opportunities to meet their own objectives (Han et al., 2010). Also, Han et al. state that the IFRS has provided European countries with more opportunities for optimistic accounting choices than the pre-IFRS GAAPs, which in turn provides accountants with more possibilities to manipulate earnings in order to benefit themselves.
Using the same line of reasoning, it can be expected that once a manager has met his culturally inclined obligation to abide the rules and laws of a country, he will seek his way through unregulated opportunities in order to gain personal benefits. As been stated earlier, the IFRS has provided
managers with an accounting framework that leaves sufficient room for managerial discretion. In most European countries, the IFRS leaves more room for earnings management than the pre-IFRS local GAAPs (Han et al., 2010). In a country with a high rule of law, the social pressure to act in accordance with the law is strong. However, the IFRS provides unregulated opportunities to managers to act in their own benefit. Therefore, I argue that IFRS adoption in combination with a country’s rule of law, will lead to a higher amount of earnings management and posit the following hypothesis:
The joint effect of the IFRS and a strong rule of law has a positive influence on the magnitude of earnings management.
As been stated in section 2.1.1., most capital market forces provide incentives for managers to manipulate earnings upwards. It is therefore expected that the IFRS has a positive impact on the direction of earnings management. Once the IFRS is introduced in a country with a high rule of law, it is expected that these earnings will be managed upwards even more. This is due to the fact that the managerial discretion provided by the IFRS and the likelihood of managers manipulating earnings in a country with a high rule of law, once the cultural obligation to act in accordance with the law is met, will enhance each other’s effects.
Therefore, the following hypothesis is constructed:
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2.3.3. Rule of law variable
As been stated before, the Rule of Law variable consists of both subjective and objective measures. The difference between this objectivity and subjectivity has been an on-going point of controversy (Haggard and Tiede, 2011). Some authors argue that measures of rule of law should be limited to objective indicators because of the risk of bias in subjective measures (Glaeser et al., 2004). However, this would ignore an important feature of the concept: the cultural believe to abide by the law.
Without this feature, a country’s regulation can be of high quality but still not have the intended effects. It is therefore of importance to capture the law-abidingness of a country’s citizens in order to measure the full extent to which regulations are useful.
I use the measure provided by the World Bank and Kaufmann et al. (2008, 2010), the ‘Rule of Law Index’ (ROL). The measure measures the general legal institutions of a country, the enforcement of the legislation and the citizens’ perception of these issues. As JeanJean (2012) state, country-specific institutions change over time. Strangely enough several authors recognize the important role of changing institutions in countries, but use indices that measure a single year (Leuz et al., 2003; Houqe et al., 2012), or only a limited amount of years (Preiato et al., 2013). To account for the change in institutional and legal environment, I will use the index of ‘Rule of Law’ from the time period of 1998-2012. Table 3 provides a complete list of all the variables taken into account by the World Bank and Kaufmann et al. (2010) while developing the Rule of Law variable.
[Put table 2 here]
The individual source data has been rescaled by the World Bank in order to make the data run from 0 to 1. Although nominally in the same 0-1 units, this rescaled data is not necessarily comparable across sources. For example, one data source might use a 0-10 scale but in practice most scores are clustered between 6 and 10, while another data source might also use a 0-10 scale but have responses spread out over the entire range (Kaufmann et al., 2010). After rescaling, the Unobserved Components Model (UCM) was used by Kaufmann et al. to construct a weighted average of the individual indicators for each source and make the data comparable. The composite measures of governance generated by the UCM are normally distributed and have a mean of zero, standard deviation of one, and run from approximately -2.5 to 2.5. Higher values correspond to better governance.
15 management and legal environment are conducted (Chen et al. 2010). However, Kaufmann et al. (2010) states that between 1998 and 2008 9% of the countries investigated in his research, experienced a significant change in rule of law (10% significance level). By taking a larger time period (1998-2012) this will most likely be more significant, which makes the use of this evolving index even more relevant.
3. Research design
In this section, the accounting accrual method and the regression analysis are discussed. Lastly, information about the control variables and the sample selection is provided.
3.2. Accrual accounting method
It is of importance to shortly explain the accrual accounting method which is to be used according to IAS 1.27, which requires that an entity prepares its financial statements, except for cash flow
information, using the accrual basis of accounting. According to this method, economic events are recognized at the time in which the transaction occurs rather than at the point at which the cash flow occurs. By matching the revenues and expenses at the time in which the transaction takes place rather than the time in which the cash flow occurs, a better view is generated of the current financial
condition of the firm. This method allows certain future cash flows to be recognized in order to give an accurate view of a firm’s performance.
3.2.1. Detecting earnings management: Discretionary accruals
Mohanram (2003), defines accruals as the difference between Net Income and Cash from Operations. At first glance, a high level of accruals is likely to have occurred from inflated earnings due to managing earnings. However, as many researchers agree (Dechow et al., 1995, Jones, 1991; Van Tendeloo & Vanstraelen, 2005; Zéghal et al. 2011), absolute accruals are not completely due to earnings management. High accruals could also be the result of a growth in sales, which might result in an increase in accounts receivable, or an investment in gross plant, property and equipment (PPE), which results in an increase in depreciation (Mohanram, 2003).
Therefore, previous research has differentiated discretionary accruals from non-discretionary accruals (Van Tendeloo & Vanstraelen, 2005; Dechow et al., 1995, Jones, 1991; Zéghal et al. 2011). Non-discretionary accruals are defined as the accruals resulting from normal operations on which the manager cannot exert influence (Mohanram, 2003). These accruals occur naturally in a firm, without pointing to the possibility of earnings management. Examples are accruals arising from depreciation, deferred income taxes, losses/gains arising from a minority interests in subsidiaries or a
16 (1)
(2)
(3)
(4) can only be practiced because accounting standards leave room for managerial discretion. Therefore, the focus of this research will be on the discretionary accruals, in order to measure earnings
management.
Zeghal et al. (2012) and Hribar & Nichols (2007) state that if the focus is on the magnitude of earnings management rather than the direction, it is better to measure the absolute value of
discretionary accruals to assess the level of earnings management. A higher level, corresponds to a lower level of earnings management. Therefore, the absolute value of accruals will be used in my research to examine the effects on the mangitude. Following Francis & Wang (2008), Houqe et al. (2012), and Hribar & Nichols (2007) signed discretionary accruals are used rather than absolute discretionary accruals in order to capture the direction of earnings management. Therefore, the signed accruals will be used in order to investigate the direction of earnings management.
3.2.2. Accrual model
Following Francis & Wang (2008) and Houqe et al. (2012) I use the linear expectation model, adapted from DeFond & Park (2001), that uses its own prior accruals in calculating the expectation
benchmark. The expected accruals will be based on a company’s prior year’s ratio of depreciation expense to Gross Property, Plant and Equipment, and on its prior year ratio of current accruals to sales (Francis & Wang, 2008). Using data from Datastream, predicted non-discretionary accruals are calculated as follows:
Non-discretionary accruals =
∗ ∗
Where, as Loftus & Sin (1997) state:
Current accruals= ∆( − ℎ ℎ ) −
∆( − ℎ − )
In order to calculate the total accruals, the following formula is used:
Total accruals
=
–
Finally the discretionary accruals are calculated using the following formula:
-17 (5) The discretionary accruals (DACCR) is used to measure the amount of discretionary accounting
choices used by managers, in order to increase or decrease income. A positive value of DACCR is interpreted as income increasing manipulations, while a negative value of DACCR is interpreted as income decreasing manipulations. Also, the absolute value of the discretionary accruals (ABDA) is used. By taking ABDA, it is possible to measure the magnitude of earnings management, regardless of its sign.
The model in equation (5) tests whether signed discretionary accruals (DACCR) are affected by the mandatory introduction of the IFRS and the country’s rule of law. In addition, I will change the dependent variable DACCR in equation (5) to the absolute value of discretionary accruals (ABDA) in order to test whether the independent variables affect the magnitude of discretionary accruals. In the regression analyses several control variables are also included. These control variables have been identified by previous literature as firm-specific factors that may affect discretionary accruals (Francis & Wang, 2008; Burgstahler et al., 2006; Barth et al. 2008; Zéghal et al., 2012; Houqe et al., 2012).
= + + + ∗ + + + ∆
+ + + +
= discretionary accruals scaled by lagged total assets for firm i in year t.
= dummy variable that takes the value of 1 if the firm uses IFRS as their accounting standard, 0 if otherwise.
= Rule of Law Index
∗ = Interaction between IFRS and Rule of Law Index
= natural logarithm of total assets in thousands of € for firm i in year t. 4
= total long-term debt /total assets for firm i in year t.
= sales growth rate, defined as sales in year t minus sales in year t-1, scaled by sales in year t-1.
= operating cash flows for firm i in year t scaled by lagged total assets.
∆ = PPE growth rate, defined as PPE in year t minus PPE in year t-1, scaled by PPE in year t-1.
= dummy variable that takes the value of 1 if the firm has reported a loss in the year t-1, 0
if otherwise. = error term.
18 Equation (5) is estimated as a cross-section fixed effects model. This allows the intercept to vary across firms, but is assumed to be the same over time. For the coefficient covariance method I use the White cross section (diagonal) method to estimate t-statisitcs and p-values that are robust to
heteroskedasticity.
3.3. Control variables
The control variables are included to control for firm-specific characteristics which might influence the amount of accruals, as identified by previous literature (Becker et al., 1998; Francis & Wang, 2008; Houqe et al., 2012). Francis & Wang state that larger firms tend to have less accruals. Therefore, size has been included as a control variable. Both growth in sales and PPE are drivers of non-discretionary accruals. However, if the relationship is non-linear, growth in sales and PPE will influence discretionary accruals, which is why both sales growth and PPE growth are included in the model (Houqe et al., 2012). The variable for leverage controls for financial distress and the likelihood of bankruptcy. Klein (2002) has identified leverage to be positively related to discretionary accruals. Moreover, a higher leverage means a higher likelihood of breaking debt covenants, which leads to a higher incentive for engaging in earnings management (Francis & Wang, 2008; Watts and
Zimmerman, 1986). Also, firms that reported a loss in year t-1 have incentives to not report a loss in year t-1, which could also be an incentive to manage earnings upwards. Francis & Wang (2008) and Zéghal et al. (2012) state that a well-documented inverse relationship exists between cash flows and accruals, therefore the control variable CFO will be necessary.
3.3.1. Sample selection
From the Datastream database, financial statement data from 1996-2012 for the EU-15 countries are obtained. In order to calculate discretionary accruals for year t, data is needed for three consecutive years. Following prior research (Leuz et al., 2003; Van Tendeloo and Vanstraelen, 2005; Zéghal et al., 2012) I exclude Financial Institutions with SIC codes 6000-6999, due to the fundamental differences in their accounting practices compared with non-financial firms. Next, data for the years 1999 and 2001 is excluded, since the Rule of Law Index is not available for those years. Furthermore, firms with error codes are eliminated. Also, firms with missing variables are excluded. Missing
observations (data that states ‘not available’) are then filtered out. Finally, observations that fall in the top or bottom 1 percent of discretionary accruals are excluded (Francis & Wang, 2008; Houqe et al., 2012). After the screening process, 22,228 observations from 2761 firms remain. The sample
19 [Put tables 3 and 4 here]
Table 5 shows the correlations between the variables included in the regression. The IFRS variable and the interaction variable IFRS*ROL show a high correlation of 0.91. By including both variables in the regression at the same time, the chance of a type-II error will be increased (Brooks, 2008).
However, the multicollinearity is ignored, since both variables show significant estimates, when including them in the regression analysis at the same time.
[Put table 5 here]
4. Empirical results
This section includes the main findings of the study. Moreover, the robustness of the results will be extensively discussed.
4.1. Descriptive statistics
Table 6 summarizes the descriptive statistics for the data sample. The mean of absolute discretionary accruals is 0.080 and the median is 0.048. The mean of signed discretionary accruals scaled by lagged total assets is -0.019, while the median is -0.010. 43,6 percent of the companies had positive
discretionary accruals, while 56,4% had negative discretionary accruals. This is surprising, since previous literature has identified more incentives for net income increasing manipulations than for net income decreasing.
[Put table 6 here]
The average firm size, measured by the natural logarithm of total assets, is 12.504 and shows high variation with a standard deviation of 2.274. Growth of sales is on average 14.17% and growth of PPE 31.21%. Leverage ratio is 14.16% and cash flows from operations 7.25%. Firms declared on average 25.41% of the time a loss in year t-1.
[Put table 7 here]
20
4.2. Main results
The results of the panel fixed cross-section regression analysis are presented in Table 8. The two regression models for absolute and signed discretionary accruals have an adjusted R² of respectively 26.3% and 12.7%.
The results of the regression model on the absolute discretionary accruals (ABDA) show a negative and significant (p<0.05) coefficient for IFRS. This is surprising since it was expected that the introduction of the IFRS would have a positive influence on the amount of earnings management. It can be stated that the extra room for earnings manipulations which is provided by the IFRS has not led to the expected increase in the magnitude of earnings management in an environment with a weak rule of law. As a matter of fact, it has led to a decrease in the magnitude of earnings management. Furthermore, the rule of law variable has a positive coefficient and is insignificant in regard to the absolute discretionary accruals (ABDA). It can therefore not be stated that the improving the rule of law without adopting the IFRS will lead to an increase in the magnitude of earnings management. However, the coefficient on the interaction of IFRS adoption and the Rule of Law variable
(IFRS*ROL) is positive and marginally significant (p<0.10). This result means that marginal impact of IFRS adoption on the magnitude of earnings management as the rule of law increases is positive. In regard to ABDA, the coefficients for the control variables are all significant (p<0.01), except for the CFO coefficient. The coefficients for SIZE and ΔPPE show a negative sign, while the coefficients for
GROWTH, LEV, LAGLOSS and CFO show a positive sign. The signs of the coefficients for SIZE, GROWTH, LEV and LAGLOSS are the same as expected. The sign of CFO is against my expectations.
The fact that ΔPPE has a significant negative influence on the magnitude of earnings management shows that the growth of Gross PPE is non-linear for the firms in the sample. If this relationship was linear, it would have only affected the non-discretionary accruals and not the discretionary accruals.
[Put table 8 here]
The results of the regression model on signed discretionary accruals (DACCR) show that the
21 In regard to the model on DACCR, the only control variables that show a significant coefficient at a 5% significance level are ΔPPE, LAGLOSS and CFO, while SIZE has a marginally significant coefficient (p<0.10). The GROWTH and LEV coefficients show no significant influence. GROWTH,
LEV, LAGLOSS and CFO are the control variables with a negative coefficient, while SIZE and ΔPPE
have positive coefficients.
4.3. Robustness
In order to test the robustness of the results, two countries are left out of the sample. Using the papers of Kee-Hong (2008) and Capkun et al. (2012), Austria and Germany are identified as the only European countries for which it is expected that the introduction of the IFRS has led to less earnings smoothing behavior by companies. Therefore, the regression model is re-estimated leaving Austria and Germany out of the analysis. The results are shown in table 9. The results of regression model for the absolute accruals (ABDA) are largely similar to the results of the model containing the complete sample. The signs of all coefficients are the same, while only the IFRS coefficient shows a different significance level. The IFRS coefficient is no longer significant at a 5% level. However, it is still marginally significant (p<0.10).
[Put table 9 here]
The results of the model for DACCR show more deviation from the results of the model containing the complete sample. The signs of all coefficients are the same. However, the coefficient of the interaction variable IFRS*ROL is no longer significant. Also, the coefficients for IFRS*ROL and SIZE are no longer marginally significant. Finally, the coefficient for CFO has gone from significant at a 5% level to marginally significant (p<0.10). The loss of significance shows that that coefficients
IFRS*ROL,SIZE and CFO in the original model for DACCR, are not robust against the exclusion of a
part of the sample.
5. Conclusion and future research
This study shows that adoption of the IFRS in a country with a weak rule of law leads to a decrease in the magnitude of earnings management. Against my expectations, the extra possibilities to engage in earnings management, provided by the IFRS, do not lead to an increase in the manipulations of earnings management. Managers do not take advantage of standards, such as the fair value measurement standard, in order to gain private benefits. This suggests that the introduction of the IFRS did not have unintended negative effects in regard to the magnitude of earnings management, in fact it has improved the amount of earnings management.
22 of earnings management as the rule of law is strengthened. This result highlights the theory that, in a country with a strong rule of law, managers will use unregulated opportunities to gain private benefits, once the social expectations to act in accordance with the law have been met. As been stated before, in a country with a strong rule of law, it is a minimum requirement that high quality regulation is
implemented together with the right legal institutions. It is also of importance that the cultural believe to act in accordance with the law exists. This study has shown that, in a society with a strong rule of law, once managers have met the obligation to prepare the financial statements in accordance with the regulations, they will seek opportunities to meet private goals through the unregulated opportunities provided by the IFRS.
Moreover, the study shows that adopting the IFRS in a country with a weak rule of law does not affect the direction of earnings management. Furthermore, increasing the rule of law in a country, without adopting the IFRS, does not change the direction of earnings management either. However, earnings management will be directed more towards decreasing net income when IFRS is adopted where a country’s rule of law is strong. However, the influence of the interaction between IFRS and the rule of law on the direction of earnings management has shown not to be robust against excluding a subsample. It can therefore be concluded that, although evidence is presented about the influence of the joint effect of IFRS and the rule of law on the direction of earnings management, the influence is not uniform across Europe. Therefore, I propose future research to focus on a single country or a small group of a countries. While investigating the IFRS, I recommend that future research focuses more on the differences between the local GAAP and the IFRS. Focusing on a smaller sample will enable researchers to get a deeper view on the differences between the accounting standards and therefore get a better view on the influence of the IFRS.
Regarding the rule of law, this research has been among the first to link this subject to earnings management. The groundwork has been laid for further research to investigate the influence of the rule of law on earnings management. This will be particularly relevant in several years, when a longer period for the Rule of law Index will be available and the change of the legal and institutional
environment over time will be more significant.
5.1. Limitations
24
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31
Appendices
Figure 1
The distinction between Fraud and Earnings Management
Accounting choices
‘Real’ cash flow choices
Within IFRS
“Conservative accounting”
Overly aggressive recognition of provisions or reserves Delaying sales, inflating transfer prices
Overvaluation of fair value of financial liabilities Undervaluation of fair value of financial assets
Accelerating R&D or advertising
expenditures Overstatement of restructuring charges and assets
write-offs
“ Neutral earnings”
Earnings that result from a neutral operation of the process
“Aggressive accounting”
Understatement of the provision for bad debts Postponing R&D or advertising
expenditures Overvaluation of fair value of financial assets.
Undervaluation of fair value of financial liabilities Drawing down provisions or reserves in an overly aggressive manner Accelerating sales, deflating transfer prices Violates IFRS “Fraudulent Accounting”
Recording sales before they are ‘realizable’ Recording fictitious sales
Backdating sales invoices
Table 1
Differences of local GAAP with IFRS and their effect on earnings smoothing
Panel A: IFRS standards and their effect on earnings smoothing
The IAS/IFRS standards have been identified by Kee-Hong et al. (2008). These standards are the most important standards that differ from local GAAPs. Under ‘Description of countries coded 1 in Panel B’, a description is provided about the Local GAAP of a country. For example, if the description states ‘do not require a primary statement of changes in equity’, a country that is marked with a 1 in Panel B for item 1, does not require a primary statement of changes in equity under its local GAAP, while such a statement is required under the IFRS.
The possible effects of these differences on earnings smoothing have been identified by Capkun et al. (2012). After every item, the effect on earnings smoothing is denoted.
Item IAS rules Description of countries coded 1 in Panel B
1
IAS 1.7 Do not require a primary statement of changes in equity NO EFFECT
2
IAS 12 Do not generally require deferred tax accounting + SMOOTHING
3
IAS 14 Require no or very limited segment reporting NO EFFECT
4
IAS 17 Require no or very limited capitalization of leases + SMOOTHING
5
IAS 19
Do not have rules for accounting for employee benefit obligations (other than defined contribution plans in some
cases) + SMOOTHING
6
IAS 19.52 Do not have rules for accounting for employee benefits other than pensions + SMOOTHING
7
IAS 2.36 Do not require disclosure of FIFO inventory cost when LIFO is used NO EFFECT
8
IAS 22.56/38.99 Do not require impairment testing of goodwill or other intangibles with lives in excess of 20 years - SMOOTHING 9
IAS 24 Have no or very limited disclosure requirements for related-party transactions NO EFFECT
10
IAS 32.18/23 Do not require that companies account for their financial instruments based on substance over form NO EFFECT 11
IAS 32.77 Do not require the disclosure of the fair value of financial assets and liabilities NO EFFECT
12
IAS 35 Do not have rules outlining the treatment of discontinued operations NO EFFECT
13
IAS 36
Do not have rules calling for impairment testing for long-term assets, or impairments are only recorded when
deemed permanent - SMOOTHING
14
IAS 37 Do not have specific rules dealing with provisions + SMOOTHING
15
IAS 37.14 Permit establishing provision when there is no obligation - SMOOTHING
16
IAS 37.45 Do not have rules calling for the discounting of provisions + SMOOTHING
17 IAS 38.42 Permit capitalization of research and development costs + SMOOTHING
18
IAS 38.51 Permit capitalization of some other internally generated intangibles (e.g., brands) - SMOOTHING
19
IAS 7 Do not require a statement of cash flows NO EFFECT
20
IAS 8.6 Permit a broader definition of extraordinary items NO EFFECT
33
Panel B: List of possible differences of local GAAP to IFRS by country
The item numbers represent the IFRS standards that may differ from local GAAPs and have an influence on earnings smoothing, as identified in Panel A (Kee-Hong et al., 2008). When a ‘1’ is denoted, an increase in earnings smoothing is expected, while a ‘-1’ means an expected decrease in earnings smoothing is expected (Capkun et al., 2012).
34 Table 2
List of the individual variables used to construct the Rule of Law Index, constructed by Kaufmann et al. (2010) and the World Bank.
Variable
Violent crime Organized crime
Fairness of judicial process Enforceability of contracts Speediness of judicial process Confiscation/expropriation
Intellectual property rights protection Private property protection
Business Cost of Crime and Violence Cost of Organized Crime
Reliability of Police Services Judicial Independence
Efficiency of Legal Framework for Challenging Regulations IPR protection
Property Rights Informal Sector
Confidence in the police force Confidence in judicial system
Have you had money property stolen from you or another household member? Have you been assaulted or mugged?
Property Rights
Independence of judiciary
Degree of security of goods and persons
Criminal organizations (drug trafficking, weapons, prostitution...) Degree of judicial independence vis-à-vis the State
Degree of enforcement of court orders Timeliness of judicial decisions
Equal treatment of foreigners before the law (compared to nationals) Practical ability of the administration to limit tax evasion
Efficiency of the legal means to protect property rights in the event of conflict between private stakeholders? Generally speaking, does the State exercise arbitrary pressure on private property (e.g. red tape...)?
Does the State pay compensation equal to the loss in cases of expropration (by law or fact) when the expropriation concerns land ownership?
Does the State pay compensation equal to the loss in cases of expropration (by law or fact) when the expropriation concerns production means?
Degree of observance of contractual terms between national private stakeholders
Degree of observance of contractual terms between national and foreign private stakeholders
In the past 3 years, has the State withdrawn from contracts without paying the corresponding compensation vis-à-vis national stakeholders?
In the past 3 years, has the State withdrawn from contracts without paying the corresponding compensation vis-à-vis foreign stakeholders?
Respect for intellectual property rights relating to… trade secrets and industrial patents Respect for intellectual property rights relating to… industrial counterfeiting
Does the State recognize formally the diversity of land tenure system? Law and Order
