IFRS on earnings management

Journal of International Accounting, Auditing and Taxation 20 (2011) 61–72

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Journal of International Accounting, Auditing and Taxation

An analysis of the effect of mandatory adoption of IAS/IFRS on earnings management Daniel Zéghal ∗ , Sonda Chtourou, Yosra Mnif Sellami CGA-Accounting Research Centre, Telfer School of Management, University of Ottawa, 55 Laurier E. (7104), Ottawa, ON K1N 6N5, Canada

a r t i c l e

i n f o

Keywords: IAS/IFRS Mandatory adoption Earnings management Factors of enforcement

a b s t r a c t This paper examines whether mandatory adoption of international accounting standards, IAS/IFRS, by French companies is associated with lower earnings management. In addition, the impact of six factors that may be related to earnings management level are also considered: the independence and the efficiency of the board of directors, the separation of roles of CEO and Chairman of the board, the existence of an independent audit committee, the existence of block shareholders, the quality of the external audit and the listing on foreign financial markets. Based on a sample of 353 French listed groups relating to the period 2003–2006, our results show that the mandatory adoption of IAS/IFRS is associated with a reduction in the earnings management level. In addition, the independence and the efficiency of the board of directors, the existence of an independent audit committee, the existence of block shareholders, the quality of the external audit and the listing on foreign financial markets are important factors for enforcement of IAS/IFRS in France. Mandatory adoption of IAS/IFRS has decreased earnings management level for companies with good corporate governance and those that depend on foreign financial markets. © 2011 Elsevier Inc. All rights reserved.

1. Introduction On 19 July 2002, the European Parliament issued a regulation (1606/2002/EC) requiring all EU listed companies to prepare consolidated financial statements based on International Accounting Standards (IAS/IFRS) by 2005. Our paper examines whether mandatory adoption of IAS/IFRS is associated with lower earnings management. In particular, we question whether mandatory adoption of IAS/IFRS in France, a code-law country, is sufficient to override managers’ incentives to engage in earnings management. In fact, previous research provides evidence that earnings management magnitude is on average higher in code-law countries with low investor protection rights, compared to common-law countries with high investor protection rights (Leuz, Nanda, & Wysocki, 2003; Van Tendeloo & Vanstraelen, 2005). Previous literature has concentrated mainly on the voluntary adoption effect of IAS/IFRS by German companies on earnings management (Barth, Landsman, & Lang, 2008; Van Tendeloo & Vanstraelen, 2005). However, there is little research examining the mandatory adoption effect of IAS/IFRS on earnings management in French companies. We concentrate on France because, in contrast to Germany, it is an IAS/IFRS first-time adopter. This allows us to avoid the sample selection bias of prior studies on voluntary adoption of IAS/IFRS. In addition, France is a code-law country, with low investor protection rights and high magnitude of earnings management (Leuz et al., 2003). Therefore, mandatory adoption of IAS/IFRS should

∗ Corresponding author. Tel.: +1 613 562 5800x4769. E-mail addresses: [email protected] (D. Zéghal), [email protected] (S. Chtourou), [email protected] (Y.M. Sellami). 1061-9518/$ – see front matter © 2011 Elsevier Inc. All rights reserved. doi:10.1016/j.intaccaudtax.2011.06.001

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have a significant impact on earnings management. Furthermore, by focusing on France, we study a country which has made a major change from the stakeholder-oriented French GAAP to the shareholder-oriented IAS/IFRS. In fact, regulatory changes in France have raised numerous questions concerning the potential effects of mandatory adoption of IAS/IFRS in an accounting environment that is unaccustomed to the utilization of accounting standards of Anglo-American inspiration. The accounting system in France is characterized by regulatory rigidity and a legalistic outlook and differs significantly from the international accounting system that is marked by a conceptual framework that safeguards shareholder interests. The results of our study show that mandatory adoption of IAS/IFRS by French companies has decreased earnings management level. The results also show that the independence and effectiveness of the board of directors, the existence of an independent audit committee, the presence of block shareholders, the quality of the external audit and listing on foreign financial markets are important factors associated with enforcement of IAS/IFRS in France. Mandatory adoption of IAS/IFRS has decreased earnings management level for companies with good corporate governance and those that depend on foreign financial markets. The remainder of this paper is organized as follows. Section 2 provides theoretical background and hypotheses for the study. The research design is presented in Section 3. The results are discussed in Section 4. Finally, in Section 5, we summarize our results, discuss the implications and limitations of our analysis and give suggestions for further research. 2. Theoretical background and hypotheses 2.1. Effect of mandatory adoption of international accounting standards (IAS/IFRS) on earnings management A wide literature has addressed the issue of earnings management. Most research in this area has concentrated on the Anglo-American world. Fewer studies have focused on earnings-management in countries from the Euro-Continental accounting model. Previous research provides evidence that earnings management magnitude is on average higher in code-law countries with low investor protection rights, compared to common-law countries with high investor protection rights (Daske, Gebhardt, & McLeay, 2006; Han, Kang, Salter, & Yoo, 2010; Leuz et al., 2003). This paper examines whether mandatory adoption of IAS/IFRS in France, a code-law country, is sufficient to override managers’ incentives to engage in earnings management. Little research has examined the impact of voluntary adoption of international standards on earning management. Van Tendeloo and Vanstraelen (2005) find that voluntary adoption of IAS/IFRS cannot be associated with lower earnings management. However, Barth et al. (2008) and Christensen, Lee, and Walker (2008) found that voluntary adoption of IAS/IFRS is associated with lower earnings management. In our study, we test the following hypothesis: H1. Mandatory adoption of international accounting standards (IAS/IFRS) by French companies contributes to the reduction of earnings management. Earnings management was measured in our research by discretionary accruals estimated by the Kothari, Leone, and Wasley (2005) model. 2.2. Enforcement factors of international accounting standards (IAS/IFRS) Evidence supporting our first hypothesis could be attributed either to the high quality of IAS/IFRS or to the high enforcement of these standards. Indeed, the quality of financial statements prepared using IAS/IFRS depends on both the quality of these standards and their implementation (Van Tendeloo & Vanstraelen, 2005). Our research contributes to this debate by examining factors that have contributed to the enforcement of IAS/IFRS in France. Two categories of factors are examined: corporate governance factors and dependence on international markets. 2.2.1. Corporate governance factors A wide literature has addressed the issue of the impact of corporate governance mechanisms on earnings management (Bédard, Chtourou, & Courteau, 2004; Bozec, 2008; Jaggi & Leung, 2007; Jiraporn & Gleason, 2007; Peasnell, Pope, & Young, 2005; Xie, Davidson, & Dadalt, 2003). Corporate governance mechanisms are generally grouped into two types: internal and external. In our paper, we analyzed board of directors and shareholding structure as internal mechanisms, and audit as an external one. Board of directors: The board of directors is often considered as one of the most essential and important control mechanisms. However, board effectiveness depends on several characteristics that include independence of board members, board size, separation of the roles of CEO and board Chairman and existence of an independent audit committee. Independence of board members: according to agency theory, board effectiveness increases with the proportion of independent directors. Accordingly, corporate governance reports (Bouton, 2002; Cadbury, 1992; Viénot, 1995, 1999) recommend companies introduce independent directors to their board. Several previous studies have also argued that the presence of independent outside directors on the board improves its effectiveness and constitutes a constraint on fraud (Abbott, Parker,

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& Peters, 2004; Beasley, 1996) and to earnings management (Bédard et al., 2004; Jiraporn & Gleason, 2007; Peasnell et al., 2005; Xie et al., 2003). In our research, we test the following hypothesis: H2. Mandatory adoption of IAS/IFRS has a greater effect on reducing earnings management level when a company’s board consists of a large proportion of independent external directors. In other words, the probability of belonging to the group that managed earnings the least, after adopting IAS/IFRS, is positively related to the proportion of independent external directors on the board. Following previous studies (Abbott et al., 2004; Beasley, 1996; Bédard et al., 2004; Peasnell et al., 2005; Xie et al., 2003), we measured the independence of the board of directors (IND) by the percentage of independent external directors serving on the board. Board size: It is a characteristic that seems to have a significant influence on the board’s performance and efficiency. Results of research that has focused on the influence of board size on financial statement quality are mixed. Indeed, Beasley (1996) finds a positive and significant influence of board size on fraud. However, Xie et al. (2003) prove that size of the board constitutes an important constraint on earnings management. Given the small number of studies that have shown the influence of board size on financial statement quality, we cannot predict the sign of this relationship. In our research, we test the following hypothesis: H3. Mandatory adoption of IAS/IFRS has a greater effect on reducing the level of earnings management when the board of directors is of a certain size. In other words, the probability of belonging to a group that managed earnings the least, after adopting IAS/IFRS, relates to board size. In accordance with previous studies (Xie et al., 2003; Bédard et al., 2004), board size (SIZE.B) was measured by the number of directors serving in the board. Separation of roles of CEO and Chairman of the Board: according to Fama and Jensen (1983), separation between management and control in large companies reduces the agency costs. In France, the two reports of Viénot. 1995, 1999, recommend separation of decision-making and control. Indeed, several previous studies have shown that the combination of functions has a negative effect on financial statement quality (Beasley, 1996; Peasnell et al., 2005). In our research, we test the following hypothesis: H4. Mandatory adoption of IAS/IFRS has a greater effect on reducing the level of earnings management when there is a separation of the roles of CEO and Chairman of the Board. In other words, the probability of belonging to a group that managed earnings the least, after adopting IAS/IFRS, is positively related to the separation of the roles of CEO and Chairman of the Board (negatively related to the combination of the two functions). In accordance with previous studies (Beasley, 1996; Bédard et al., 2004; Peasnell et al., 2005; Xie et al., 2003), separation of the roles of CEO and Chairman of the Board (SEP) was measured by a dummy variable that takes the value 1 if there is a separation of function and 0 otherwise. Existence of an independent audit committee: since the early nineties, existence of an independent audit committee within the board has been recommended by several regulation and governance reports (Bouton, 2002; Cadbury, 1992; Financial Security Law in France, 2003; Sarbanes-Oxley, 2002; Viénot, 1995, 1999). Several empirical studies have shown that the existence of an independent audit committee enhances financial reporting quality and represents a good corporate governance mechanism. The results of these studies show that the presence of an independent audit committee exercises a constraint on fraud (Abbott et al., 2004; Beasley, 1996) and on earnings management (Bédard et al., 2004; Jaggi & Leung, 2007; Xie et al., 2003). In our research, we test the following hypothesis: H5. Mandatory adoption of IAS/IFRS has a greater effect on reducing the level of earnings management when there is an independent audit committee within the board of directors of the company. In other words, the probability of belonging to a group that managed earnings the least, after adopting IAS/IFRS, is positively related to the existence of an independent audit committee within the board. In accordance with recommendations of the Viénot reports (1995, 1999), we use only audit committees with at least three members, including two independent members. Audit committee (AUDIT.C) is a binary variable that takes the value 1 if an independent audit committee exists and 0 otherwise. This measure was also used by Xie et al. (2003). 2.2.1.1. Shareholding structure: the existence of block shareholders. Ownership concentration has become a guarantee of control management effectiveness. Big investors are a very important factor for good corporate governance. They include both individuals and institutions that hold a significant stake in the company. Several previous studies have explored the relationship between ownership structure and financial statement quality and have shown that the existence of block shareholders improves financial statement reliability (Bédard et al., 2004; Kim & Yi, 2006). In our research, we test the following hypothesis:

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H6. Mandatory adoption of IAS/IFRS has a greater effect on reducing the level of earnings management when there are big investors in the company. In other words, the probability of belonging to a group that managed earnings the least, after adopting IAS/IFRS, is positively related to the existence of block shareholders. In accordance with previous studies (Abbott et al., 2004; Beasley, 1996; Bédard et al., 2004), existence of block shareholders (BLOCK) was measured by the percentage of shareholders holding more than 5% of the capital. 2.2.1.2. Audit quality. The Big 4 audit firms are assumed to provide higher audit quality than other audit firms and they should do a better job in financial reporting enforcement (DeFond & Jiambalvo, 1994; Van Tendeloo & Vanstraelen, 2005). According to Ben Othman and Zéghal (2006), it is reported in the literature that a high quality audit frequently translates into lower earnings management. Several studies have shown that Big 4 auditors constitute a constraint on earnings management. On the other hand, Street and Gray (2002) showed that being audited by a Big 4 audit firm is positively related to compliance with IFRS, for both disclosure requirements and presentation and measurement requirements. Van Tendeloo and Vanstraelen (2005), showed that German companies that have voluntarily adopted IAS/IFRS engage more in earnings smoothing, but this effect is significantly reduced when they are audited by a Big 4 auditor. In our research, we test the following hypothesis: H7. Mandatory adoption of IAS/IFRS has a greater effect on reducing the level of earnings management when a company is audited by a Big 4 audit firm. In other words, the probability of belonging to a group that managed earnings the least, after adopting IAS/IFRS, is positively related to the quality of the external audit. The specific French accounting legislation (obligation for companies to appoint two auditors) must be taken into account when we measure the audit quality variable (BIG 4). Therefore, to measure this variable, we used a binary variable that takes the value 1 if the company is audited by at least one Big 4 firm and 0 otherwise. 2.2.2. Dependence on international markets According to Van Tendeloo and Vanstraelen (2005), firms with a foreign exchange listing are presumed to have greater incentives to report transparently because they are subject to restrictions imposed by different countries and are exposed to a higher litigation risk. Therefore, it can be expected that earnings quality is enhanced when a firm is listed on an international capital market (Ball, Robin, & Wu, 2003). In their study, Street and Gray (2002) showed that compliance with IAS/IFRS is greater for companies that are listed on the U.S. financial market and/or foreign financial markets. Leuz et al. (2003) have established a link between stock markets development and earnings management level. They found that lower levels of earnings management are found in countries where financial markets are more developed. Street and Gray (2002) and Ball et al. (2003) suggest that financial statement quality is enhanced when companies are listed on international financial markets. Ball et al. add that a more effective way of signalling high quality for firms in codelaw countries (including France) would be to list them in a high-transparency common-law country, exposing them to common-law penalties for low quality disclosure. In our research, we test the following hypothesis: H8. Mandatory adoption of IAS/IFRS has a greater effect on reducing the level of earnings management when a company is listed on foreign markets. In other words, the probability of belonging to the group that managed earnings the least, after adopting IAS/IFRS, is positively related to foreign markets listing. To measure the variable dependence on international financial markets (IFM), we used the number of company listings on foreign markets. 2.2.3. Control variables According to previous literature, company size and debt level are two important characteristics that may influence earnings management. 2.2.3.1. Company size. Company size may have ambiguous effects on earnings management. On the one hand, company size is often used as a proxy for political cost. The political cost hypothesis argues that large firms are more likely to prefer downwards earnings management, because of the possibilities of increasing government control when the companies are larger and more profitable (Watts & Zimmerman, 1990). Ben Othman and Zéghal (2006), show that firm size contributes substantially to managing earnings downwards for French firms. On the other hand, company size has often been used as an indicator of the importance of the company’s internal control systems (DeFond & Jiambalvo, 1994). In fact, some studies have found a positive relationship between company size and financial statement reliability (Bédard et al., 2004; McMullen, 1996). In addition, large firms usually produce more information of better quality than smaller companies and their activities are monitored more closely by financial analysts, which could limit the earnings management (Bozec, 2008). Therefore, in our research, we expect that the level of earnings management, after adopting IAS/IFRS, is linked to the company’s size.

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To measure the size, we used logarithm base 10 of total assets (L.TA) of the years studied. This measure was also used by Street and Gray (2002), Ben Othman and Zéghal (2006) and Bozec (2008). 2.2.3.2. Debt. Debt may also have an ambiguous effect on earnings management. On one hand, indebted firms may be encouraged to manage earnings to avoid, for example, violating certain covenants related to their debt contracts (DeFond & Jiambalvo, 1994). In addition, debt hypothesis predicts that highly leveraged firms are more likely to engage in earnings management upward to avoid violation of debt covenants (DeFond & Jiambalvo, 1994; Watts & Zimmerman, 1990). In a French context, Ben Othman and Zéghal (2006) show that bank loans contribute heavily to upward earnings management in order to avoid debt covenants violation. According to these authors, the French environment seems to give more credit to the debt hypothesis. These authors show that earnings management incentives for French firms are specifically linked to contractual debt costs. On the other hand, supervision by the creditors may also allow for better governance and thus contribute to the reduction of managers’ flexibility when it comes to managing earnings (Bozec, 2008). Therefore, in our study, we expect that the level of earnings management, after adopting IAS/IFRS, is related to the company’s debt levels. To measure debt level (DEBT), we used the ratio of total debt over total equity. DeFond and Jiambalvo (1994) and Ben Othman and Zéghal (2006), also used this measure. 3. Research design In this section, we first present the selection procedure for our sample for the verification of hypothesis H1. Next, we describe the estimating procedure for discretionary accruals. Finally, we present the selection process for the sub-sample used for the verification of our other research hypotheses. 3.1. Sample The sample is drawn from the 851 French-listed companies from data available in the annual reports and Worldscope, Stockproinfo and Diane databases. We have eliminated financial institutions (131) in view of the peculiarities of the financial industry, its specific regulation and because of the fundamental differences in their financial accounting relative to nonfinancial firms. Furthermore, we have excluded firms that were not required to adopt IFRS (102), companies without the necessary data to calculate accruals (168), and companies without a December 31 fiscal year-end (97). The final sample consists of 353 companies in six industries: Mining and construction (18), Manufacturing (141), Transport, communications electricity, gas and sanitary services (33), Wholesale trade (33), Retail trade (23) and Services (105). The demographics characteristics of the remaining sample are described in Table 1. 3.2. Estimation of discretionary accruals We focus on discretionary accruals as the proxy of earnings management. Previous researchers have proposed various models to measure discretionary accruals (Dechow, Sloan, & Sweeney, 1995; Jones, 1991; Kothari et al., 2005). In this study, we adopted Kothari et al. (2005) model to calculate discretionary accruals (DA) because this model has been widely used in most recent studies for discretionary accruals estimation. Discretionary accruals (DA) of the 353 French companies are estimated with Kothari et al. (2005) cross-sectional model. Discretionary accruals estimation requires the estimation of a cross-sectional regression for each industry (two-digit SIC codes), so we eliminate industries with fewer than ten firms. Specific regression estimates are made individually for each industry of our final sample using ordinary least squares (OLS) method. The Kothari et al. (2005) model is the following: TAijt = a0j + a1j (REVijt − ARijt ) + a2j PPEijt + a3j ROAijt + εijt

(1)

TAijt is the total accruals for company i in industry j in year t, computed as the difference between net income before extraordinary items and cash flow from operations; REVijt is the change in revenues for company i in industry j between year t and t − 1; ARijt is the change in accounts receivable for company i in industry j between year t and t − 1; PPEijt is the gross property, plant, and equipment for company i in industry j in year t; ROAijt is the return on assets for company i in industry j in year t. All variables are deflated by lagged total assets. Discretionary accruals (DA) are residuals obtained from the estimation of this model. Specifically, we took the following steps to calculate DA: - First, we estimate the coefficients (a0j, a1j, a2j and a3j) of the Kothari et al., 2005 model for each industry. - Second, using the estimated coefficients (â0j, â1j, â2j, â3j) from industry division regressions, we evaluate the nondiscretionary component of total accruals (NDA) for each company in our sample: ˆ + a1j ˆ (REVijt − ARijt ) + a2j ˆ PPEijt + a3j ˆ ROAijt NDAijt = a0j

(2)

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Table 1 Sample descriptive characteristics. Characteristics

Final sample (N = 353)

Total assets (in D millions) 4 468 Mean 15 602 Std. deviation 1 Minimum 169 195 Maximum Median 167 Sales (in D millions) 3 334 Mean 11 121 Std. deviation Minimum 2 Maximum 122 618 163 Median Net income (in D millions) 174 Mean 830 Std. deviation −574 Minimum Maximum 12 273 Median 5 Debt (in D millions): 2 979 Mean 11 518 Std. deviation Minimum 1 Maximum 149 055 Median 92 International financial markets: 2 Mean 2 Std. deviation 0 Minimum Maximum 15 Median 1 Size of the board 8 Mean 4 Std. deviation 3 Minimum 22 Maximum Median 7

Sectors of activity (Sic code) 10–17 (N = 18)

20–39 (N = 141)

40–49 (N = 33)

50–51 (N = 33)

52–59 (N = 23)

70–89 (N = 105)

12 586 26 039 23 104 752 860

3 836 11 889 5 83 563 190

14 419 35801 32 169 195 1 052

3 953 8 966 5 40 446 108

6 118 13 906 10 45 221 382

598 1 889 1 12 791 61

12 160 28 820 3 122 618 367

2 568 7 077 3 56 267 194

6 801 14 090 67 51 064 1 022

3 838 8 333 8 35 110 121

8 568 21 621 7 74 496 461

456 1 208 2 7 562 70

934 2 866 −32 12 273 56

139 457 −574 3 367 5

512 1 260 −129 5 709 35

106 279 −8 1 264 4

113 386 −11 1 810 4

20 60 −12 386 2

11 072 29 634 22 149 055 809

2 788 6 391 2 27 853 64

3 093 8 508 3 35 835 104

395 1 328 1 9 423 41

7 977 15 650 12 63 269 582

2 398 7 553 1 54 159 109.315

3 3 0 13 1

2 3 0 15 0

3 3 0 12 1

1 2 0 11 0

1 3.467 0 11 0

10 5 3 22 10

8 3 3 19 8

10 4 3 20 11

8 4 3 20 7

8 4 3 17 8

1 2 0 6 1 7 3 3 17 6

The sectors of activity are: 10–17: Mining and Construction. 40–49: Transport, communications electricity, gas and sanitary services. 20–39: Industry. 50–51: Wholesale Trade. 52–59: Retail Trade. 70–89: Services.

- Finally, the proxy for discretionary accruals consists of the accruals prediction error. The discretionary accruals proxy is obtained by calculating the difference between total accruals and estimated non-discretionary accruals: DAijt = TAijt − NDAijt

(3)

Therefore, ˆ + a1j(REV ˆ ˆ PPEijt + a3j ˆ ROAijt DAijt = TAijt − (a0j ijt − ARijt ) + a2j

(4)

In the following tests, for our final sample we compare earnings management in the pre-mandatory IFRS adoption period (2003–2004) and the post-mandatory IFRS adoption period (2005–2006). For these firms, we examine both directional values for discretionary accruals (DA) and their absolute values |DA|. Data for each of the sample firms was required for each year of our study period (2003–2006). 4. Results In this section, we will first present the empirical results relating to the main hypothesis of our research. Next we will present the results of our empirical model.

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Table 2 Earnings management: test of difference between the two groups (IFRS Group (05–06) and non-IFRS Group (03–04)). Variables

Non-IFRS group (03–04) mean (N)

IFRS group (05–06) mean (N)

t-test (sign bilateral)

Wilcoxon test (sign bilateral)

|DA| DA DA ≥ 0 DA < 0

0.07591 (N = 628) −0.04746 (N = 628) 0.05194 (N = 172) −.08496 (N = 456)

0.06032 (N = 628) −0.00986 (N = 628) 0.06190 (N = 256) −0.05924 (N = 372)

n/a n/a −1.362 (0.174) n/a

−3.763*** (0.000) −6.573*** (0.000) n/a −4.389*** (0.000)

|DA|: the absolute value of discretionary accruals. DA: the discretionary accruals. DA ≥ 0: the positive discretionary accruals. DA < 0: the negative discretionary accruals. n/a: not applicable. *** Significant at the 1% level.

4.1. Analysis of results relating to the main hypothesis Our main hypothesis to be tested is that mandatory adoption of IAS/IFRS by French companies contributes to the reduction of earnings management level. To test this hypothesis, we compared earnings management level between two periods: the period before mandatory adoption of IFRS (2003–2004), and the period after mandatory adoption of IFRS (2005–2006). Before beginning this analysis, it was important to check the normality of variables in order to choose the appropriate statistical tests. We used the Kolmogorov–Smirnov test to check the normality of variables in our study. The results of this test show that certain variables follow the normal law and others do not. Consequently we used the t-test of mean equality for those variables following the normal law and the Wilcoxon non-parametric test of mean equality for the remaining variables. It should be noted that for earnings management calculation, we eliminated 39 companies from our final sample. These are those companies that do not have complete data for the four years (2003–2006). This elimination is motivated by the desire to compare the same companies for both periods. The results of comparing the two periods (2003–2004) and (2005–2006) are presented in Table 2. Table 2 shows that all means of all variables of IFRS group for the period (2005–2006) are significantly smaller than for the non-IFRS group (2003–2004) except for the variable DA ≥ 0, which is not significant. The two groups are thus statistically different for the variables |DA|, DA and DA < 0. Therefore, earnings management is less important after the mandatory adoption of IAS/IFRS. Consequently, we can conclude that our main hypothesis H1 is verified: The mandatory adoption of IAS/IFRS by French companies has contributed to the reduction of earnings management level. However, the fact that we have found results that support this hypothesis could be due to IAS/IFRS quality as well as to the influence of specific factors that have participated in their implementation. Ball et al. (2003) argue that adopting high quality standards might be a necessary condition for high quality information, but not necessarily a sufficient one. Indeed, the quality of financial statements prepared after the adoption of IAS/IFRS depends on both the quality of these standards and their implementation (Leuz et al., 2003; Van Tendeloo & Vanstraelen, 2005). This research also contributes to this debate by examining the factors that have contributed to the implementation of IAS/IFRS in France. The results are presented in the next section. 4.2. Analysis of empirical model results Before proceeding to the verification of our research hypotheses using multivariate statistical tests, we present the results of univariate analysis. 4.2.1. Univariate analysis To analyze the factors that have contributed to the implementation of these standards, we focused on a subsample1 consisting of only 100 companies located at the extremities of discretionary accruals calculated for the year 2005 following the mandatory adoption of IAS/IFRS. The purpose of our univariate analysis is to compare characteristics of two groups: the group of companies that have managed their earnings the least following the mandatory adoption of IAS/IFRS (Group |DA| lowest) and the group of companies that have managed their earnings the most following the mandatory adoption of IAS/IFRS (Group |DA| highest). However, before performing this analysis, it is important to check the normality of the independent variables so as to choose the appropriate statistical tests. We used the Kolmogorov–Smirnov test to check the normality hypothesis for

1 Selection procedure of the subsample: we ranked our final sample consisting of 353 French companies in increasing order of the absolute value of discretionary accruals |DA| calculated for the year 2005 following the mandatory adoption of IAS/IFRS. We then chose the 50 French companies with the highest abnormal accruals and the 50 companies with the lowest abnormal accruals in order to ensure the maximum variability in our sample and to improve the power of our tests by mitigating the measurement error problem (Bédard et al., 2004).

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Table 3 Descriptive statistics and results of univariate analysis of the two groups (Group |DA| lowest and Group |DA| highest). Variables

Groups

Mean/proportion

Standard deviation

t-test

Wilcoxon test

2 test

IND

|DA| lowest |DA| highest

Mean = 0.20711 Mean = 0.02309

 = 0.239184  = 0.078579

n/a

Z = −5.085*** p = (0,000)

n/a

SIZE.B

|DA| lowest |DA| highest

Mean = 9.04 Mean = 6.44

 = 3.636  = 2.815

n/a

Z = −3.678*** p = (0,000)

n/a

SEP

|DA| lowest |DA| highest

Prop = 0.48 Prop = 0.30

n/a

n/a

n/a

2 = 4.840** p = (0,028)

AUDIT.C

|DA| lowest |DA| highest

Prop = 0.26 Prop = 0.02

n/a

n/a

n/a

2 = 51.840*** p = (0,000)

BLOCK

|DA| lowest |DA| highest

Mean = 57.8568 Mean = 56.9835

 = 24.92857  = 23.62564

t = 0.180 p = (0,858)

n/a

n/a

BIG 4

|DA| lowest |DA| highest

Prop = 0.88 Prop = 0.54

n/a

n/a

n/a

2 = 17.640*** p = (0,000)

IFM

|DA| lowest |DA| highest

Mean = 3.68 Mean = 0.94

 = 3.519  = 1.531

n/a

Z = −4.815*** p = (0,000)

n/a

L.TA

|DA| lowest |DA| highest

Mean = 2.78436 Mean = 1.71951

 = 0.965593  = 0.712591

n/a

Z = −5.336*** p = (0,000)

n/a

DEBT

|DA| lowest |DA| highest

Mean = 86.24633 Mean = 55.53890

 = 120.646504  = 343.163101

t = 0.597 p = (0,552)

n/a

n/a

|DA| lowest: is the group of companies that managed their results the least (N = 50). |DA| highest: is the group of companies that managed their results the most (N = 50). N: number of companies in the group. IND: The independence of the Board of Directors. SIZE.B: The size of the Board of Directors. SEP: The separation of the roles of CEO and Chairman of the Board. n/a: not applicable. AUDIT.C: The existence of an audit committee. BLOCK: The existence of block shareholders. BIG 4: The quality of external audit. IFM: The number of listings on international financial markets. L.TA: The size of the company. DEBT: The level of debt. ** Significant at the 5% level. *** Significant at the 1% level.

independent variables in our study. The results of this test show that the variables existence of block shareholders (BLOCK) and debt (DEBT) follow a normal pattern. Therefore, for these variables we used the t-test of equality of means of two independent samples. In contrast, the variables independence of board of directors (IND), board size (SIZE.B), number of listings on international financial markets (IFM) and company size (L.TA), do not follow a normal pattern. For these cases, we present the results of the non-parametric test of Wilcoxon. For discrete variables, separation of the roles of CEO and board Chairman (SEP), the existence of an audit committee (AUDIT.C) and external audit quality (BIG 4), we present the results of the independence test of Chi-2. Descriptive statistics and results of the univariate analysis of the two groups (group of companies that have managed their earnings the least (Group, |DA| lowest) and group of companies that have managed them the most (Group, |DA| highest)) are presented in Table 3. The Wilcoxon non-parametric test allows us to verify the null hypothesis of mean equality of companies that have managed earnings the least (Group |DA| lowest) and companies which have managed them the most (Group |DA| highest). The results show important differences between the two groups with respect to the percentage of independent outside directors serving on the board (IND), the size of the board (SIZE.B), the number of listings on international financial markets (IFM) and the size of the company (L.TA). For all these variables, the t-test is significant at the level of 1%. On the other hand, the t-test shows that the variables existence of block voters (BLOCK) and debt (DEBT) are not significant. For discrete variables, separation of the roles of CEO and Chairman (SEP), existence of an independent audit committee (AUDIT.C) and external audit quality (BIG 4), the 2 test is significant at the 5%, 1% and 10% levels, respectively. Therefore, for those companies with separation of the roles of CEO and Chairman, with an independent audit committee within the board and that are audited by at least one Big 4 firm, a greater number are found in the group that managed their earnings the least than in the group that managed their earnings the most. The results of univariate analysis support the hypothesis that we have previously developed. In other words, companies that have managed their earnings the least, following mandatory adoption of IAS/IFRS, show the following characteristics:

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• • • • • • •

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have a higher percentage of independent outside directors serving on the board; have a large board of directors; are more likely to have a separation of the roles of CEO and Chairman of the board; are more likely to have an independent audit committee within the board; are more likely audited by at least one Big 4 firm; have the higher number of listings on international financial markets; are larger than those who managed their earnings the most. In the next section, we present the results of the multivariate analysis, along with the results of our empirical model.

4.2.2. Multivariate analysis and verification of research hypotheses In this section, we present our research model, then we check for the absence of multicollinearity and finally we present the main results. 4.2.2.1. Research model. According to our theoretical framework and to the hypotheses that we have defined, the conceptual model of earnings management could be expressed as follows: Earnings management following mandatory adoption of IAS/IFRS = f {(1) characteristics of corporate governance, (2) characteristics of dependence on international markets and (3) control variables}. The dependent variable of our research is dichotomous and takes the value 1 if the company belongs to the group that managed their earnings the least following mandatory adoption of IAS/IFRS and 0 otherwise. The logistic regression model is therefore appropriate in our analysis. The logistic analysis is not conditioned by the normal distribution of error terms, or by homoscedasticity. It does not require linearity between the dependent variable and independent variables. The following logistic regression model is tested in our study: P(belonging to group |DA| lowest) = ˇ0 + ˇ1 IND + ˇ2 SIZE.B + ˇ3 SEP + ˇ4 AUDIT.C + ˇ5 BLOCK + ˇ6 BIG 4 + ˇ7 IFM + ˇ8 L.TA + ˇ9 DEBT + ε

(5)

With: group |DA| lowest is the group of companies which managed their earnings the least following mandatory adoption of IAS/IFRS. P (belonging to group |DA| lowest) is the dependent variable of our research. It is a binary variable that takes the value 1 if a company belongs to the group which managed their earnings the least and 0 otherwise. IND is the percentage of independent outside directors serving on the board. SIZE.B is the number of directors serving on the board. SEP is a binary variable that takes the value 1 if there is a separation of the roles of CEO and Chairman and 0 otherwise. AUDIT.C is a binary variable that takes the value 1 if an independent audit committee exists and 0 otherwise. BLOCK is the percentage of shareholders holding more than 5% of the capital. BIG 4 is a binary variable that takes the value 1 if the company is audited by at least one Big 4 audit firm and 0 otherwise. IFM is the number of a company’s listings on international financial markets. L.TA is the company’s size as measured by the logarithm base 10 of the total assets. DEBT is the debt ratio measured by total debt to total equity. Applying logistic regression requires the absence of multicollinearity between independent variables. To identify potential problems of multicollinearity among the nine independent variables, we established a correlation matrix. In addition, we calculated the Variance Inflation Factor (VIF), which also tests for the presence of collinearity between the explanatory variables. The results of this analysis show that all the correlation coefficients are below 0.8 which is the limit at which we begin to have a serious problem of multicollinearity. For VIF, we note that the highest VIF is equal to 3.079. Consequently VIF are below 10 which is the limit at which we begin to have a serious problem of multicollinearity. Therefore, we can deduce the absence of any multicollinearity problems. 4.2.3. Results of the logistic regression The model of logistic regression allows us to calculate the coefficients ˇ with an iterative algorithm, based on the method of maximum likelihood. The 2 test verifies the following null hypothesis: H0 : ˇ1 = ˇ2 = ˇ3 = ˇ4 = ˇ5 = ˇ6 = ˇ7 = ˇ8 = ˇ9 = 0. Table 4 presents the results of the model of logistic regression used to test our previously established research hypotheses. From Table 4, we can conclude that the model tested is generally significant. Indeed, the Chi-square test has a value of 59.182 and is significant (p = 0.000). Then we reject the null hypothesis stating that all coefficients are zero. The Nagelkerke R2 indicates that 59.6% of the probability of belonging to the group that managed their earnings the least, following the adoption of IFRS, is explained by the nine variables in the model. Regarding the explanatory variables, Table 4 shows that the percentage of independent outside directors (IND) had a positive and very significant influence in the reduction in the level of earnings management. It also appears that the existence of block shareholders (BLOCK), the external audit quality (BIG 4), the number of listings on international financial markets (IFM) and company size (L.TA) have a significant and positive influence on reducing the level of earnings management. Characteristics of the board: according to the hypothesis H2, Table 4 shows a positive and very significant influence of the percentage of independent outside directors serving on the board (IND) on reducing the earnings management level.

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Table 4 Results of the logistic regressions 1 and 2: group |DA| lowest and group |DA| highest. Variables

IND SIZE.B SEP AUDIT.C BLOCK BIG4 IFM L.TA DEBT Constant (ˇ0 )

Regression 1

Regression 2 (additional analysis)

Sign provided

ˇ coef

Wald

Significance threshold (p)

Sign provided

ˇ coef

Wald

Significance threshold (p)

+ ? + + + + + ? ?

8.293 −0.092 0.419 −2.255 0.040 1.670 0.388 0.983 0.001 −6.393

7.749 0.622 0.436 2.014 5.606 5.759 3.764 3.373 0.291 13.383

0.005*** 0.430 0.509 0.156 0.018** 0.016** 0.052* 0.066* 0.590 0.000***

n/a ? + + + + n/a n/a ?

n/a 0.168 0.544 2.233 0.018 1.416 n/a n/a 0.001 −3.826

n/a 4.459 1.198 3.994 2.752 6.130 n/a n/a 0.652 12.649

n/a 0.035** 0.274 0.046** 0.097* 0.013** n/a n/a 0.590 0.000***

Number of companies = 100. Regression1: Chi-square (2 ) = 59.182 with P = 0.000 Nagelkerke R2 = 59.6%. Regression 2: Chi-square (2 ) = 33.137 with P = 0.000 Nagelkerke R2 = 37.6%. * Significant at the 10% level. ** Significant at the 5% level. *** Significant at the 1% level. n/a: not applicable.

According to this table, the coefficient of this variable is positive (8.293) and significant at the 1% level (p = 0.005). Mandatory adoption of IAS/IFRS has had a greater effect on reducing the earnings management level of companies whose board of directors is composed of a significant proportion of independent outside directors. Therefore, board independence is an important factor for the implementation of IAS/IFRS in France. As opposed to this, hypotheses H3, H4 and H5, board size (SIZE.B), the roles separation of CEO and Chairman (SEP) and the existence of an independent audit committee (AUDIT.C) are variables that do not appear to have any significant effect on reducing the level of earnings management, although univariate analysis showed a positive and significant influence of these variables. These results are not consistent with prior studies especially for the variable existence of independent audit committee whose influence on earnings management level is generally verified (Beasley, 1996; Bédard et al., 2004; Jaggi & Leung, 2007; Xie et al., 2003). The possible explanation for these results is that the effect of these variables (board size, role separation of CEO and Chairman and existence of an independent audit committee) may be absorbed by other variables of the model which are significant. According to Multicollinearity test between independent variables, the audit committee variable (AUDIT.C) is strongly correlated with the variable percentage of independent outside directors (IND) with a correlation coefficient equal to 0.726. In addition, it should be noted that the variables company size (L.TA) and number of listings on international financial markets (IFM) are highly correlated with all variables in our model. To test this hypothesis, we repeated the logistic regression by eliminating these three variables (see regression 2 in Table 4). The results of this analysis show that the variables board size (SIZE.B) and existence of an independent audit committee (AUDIT.C) become significant. The results for other explanatory variables remain unchanged. This additional analysis allows us to confirm the effect of two additional variables on reducing the level of earnings management: board size and the existence of an independent audit committee within the board. Shareholding structure: according to the hypothesis H6, Table 4 shows a positive and significant influence of the existence of block shareholders (BLOCK) on reducing earnings management. According to this table, the coefficient on this variable is positive (0.040) and significant at the 5% level (p = 0.018). Mandatory adoption of IAS/IFRS has had a greater effect on reducing earnings management in companies where there are block shareholders. Investors are therefore an important factor in corporate governance and the enforcement of IAS/IFRS in France. Quality of external audit: according to the hypothesis H7, Table 4 shows a positive and significant influence of external audit quality (BIG 4) on reducing earnings management. According to this table, the coefficient of this variable is positive (1.670) and significant at the 5% level (p = 0.016). The mandatory adoption of IAS/IFRS has had a greater effect on reducing earnings management in companies that are audited by at least one Big 4 audit firm. The Big 4 audit firms are therefore an important factor for the implementation of IAS/IFRS in France. Indeed, the major international audit firms are best positioned to fully implement international standards and to ensure an improvement in financial statement reliability because of the high level of knowledge and experience of these firms in the field of international accounting. Dependence on international financial markets: according to the hypothesis H8, Table 4 shows a positive and significant influence of the number of listings on international financial markets (IFM) on reducing earnings management. According to this table, the coefficient on this variable is positive (0.388) and significant at the 10% level (p = 0.052). Mandatory adoption of IAS/IFRS has had a greater effect on reducing earnings management in companies that are listed on multiple foreign markets. French companies, which are listed in several places, have a higher number of foreign investors demanding higher

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information quality especially following the mandatory adoption of IAS/IFRS. Therefore, the listing on several foreign markets is an important factor for the implementation of IAS/IFRS in France. Control variables: regarding the variable company size (L.TA), Table 4 shows a significant and positive influence of this variable on reducing earnings management. According to this table, the coefficient on this variable is positive (0.983) and significant at the 10% level (p = 0.066). Therefore, the mandatory adoption of IAS/IFRS has had a greater effect on reducing earnings management in large companies. This result is not surprising since large companies usually have better internal control systems. In addition, large firms usually produce more and better quality information than small firms and their activities are monitored more closely by financial analysts, which limit earnings management. Moreover, Bédard et al. (2004) in their study found that the larger the company is, the less chance it has of belonging to manipulator groups. Regarding the variable debt level (DEBT), Table 4 shows that it is not significant. In conclusion, from our multivariate analyses, we can conclude that the independence and effectiveness of the board, the existence of an independent audit committee, the existence of block shareholders, the external audit quality, quotation on foreign financial markets and company size are important factors for the implementation of IAS/IFRS in France. 5. Conclusion and research contributions The purpose of this study was to examine whether mandatory adoption of IAS/IFRS by French companies is associated with lower earnings management. Our study also analyzed the factors that have contributed to the enforcement of IAS/IFRS in France. Generally, we find that mandatory adoption of IAS/IFRS by French companies has reduced the use of discretionary accruals. Our results also show that the independence and effectiveness of the board of directors, an independent audit committee, the existence of block shareholders, the quality of external audit and listing on foreign financial markets are important factors for the implementation of IAS/IFRS in France. Mandatory adoption of IAS/IFRS has decreased earnings management level for companies with good corporate governance and those that depend on foreign financial markets. Our paper contributes to the prior literature examining the adoption of IAS/IFRS in several ways. First, we present evidence on the effects of mandatory adoption of IAS/IFRS in France, a member of the EU. By focusing on France, we study a country which has undergone a major change from following the stakeholder-oriented French GAAP to the shareholder-oriented IAS/IFRS. Previous studies (Barth et al., 2008; Van Tendeloo & Vanstraelen, 2005) presented the potential effects of voluntarily adopting IAS/IFRS. These studies were based in Germany with stakeholder-oriented accounting systems but the sample selection bias prevented these studies from coming to any firm conclusions. Analysis of mandatory adoption effect of IAS/IFRS in France has allowed us to avoid this bias, since the compulsory nature of the change across all French companies has removed any sample selection bias. Second, unlike these previous studies and in accordance with Van Tendeloo and Vanstraelen (2005), our paper analyzed the factors that have contributed to the implementation of IAS/IFRS. In fact, the convergence of accounting practices requires effective implementation and enforcement of accounting standards (Ball et al., 2003; Burgstahler, Hail, & Leuz, 2006). Besides the factors considered by Van Tendeloo and Vanstraelen (2005), our paper contributes to the corporate governance literature by examining the role of corporate governance mechanisms in the implementation of IAS/IFRS. Importantly, the findings show that corporate governance factors play a significant role in the enforcement of IAS/IFRS. Finally, our results contribute to the current debate on whether high quality standards are sufficient and effective in countries with weak investor protection rights. In fact, France is a code-law country, with low investor protection rights and a high level of earnings management. Our findings indicate that mandatory adoption of IAS/IFRS by French companies is associated with lower earnings management. Our results should be of interest to all parties seeking to evaluate the costs and benefits of mandatory adoption of IAS/IFRS, as they suggest a reduction of earnings management level and consequently some improvements in the quality of accounting information. In highlighting the presence of improvement in financial reporting quality, these findings are potentially useful for a number of organizations and decision makers, including governments, accounting standards setters, financial markets regulators, international institutions and investors, preparers and users of accounting information. Furthermore, our results should be useful for regulatory and supervisory authorities (particularly French regulatory authorities), investors, financial analysts and practitioners since the study provides insight into the factors involved in the implementation of IAS/IFRS. In fact, because of the relatively newer environment of the introduction of IFRS in France, our findings suggest that a stronger enforcement mechanism for the implementation of IFRS must be instituted to ensure its positive impact on the quality of accounting information. Our study provides specific enforcement mechanisms that can contribute to the successful implementation of IFRS in the EU and that may be useful in future studies. These mechanisms are likely also of interest to managers of publicly traded French firms, which must consider these factors in order to higher their financial reporting quality. Our results also may help French standard setters to improve the process of reinforcement of IAS/IFRS for all French companies. In addition, our research may be relevant to international regulators and institutions involved in the process (European Commission, IASB, securities markets). The results provide examples of how firms required to apply IFRS have approached the process in a continental European accounting system characterized by regulatory rigidity and a legalistic outlook. They contribute to our understanding of the dynamics of the process of adopting international standards in environments in which economic, cultural and business conditions are different from those of Anglo-American countries.

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Further, we expect our results to be of great interest to academics involved in guiding and researching progress with international accounting harmonization. They may also help the IASB in its efforts to promote the worldwide adoption of international standards. They are potentially useful for many countries including those that have not yet made the decision to move towards IFRS. In fact, the empirical evidence provided in this paper suggesting that the adoption of IAS/IFRS appears to improve financial reporting could prompt regulators to push for such adoption by public firms in other countries. In recent years, Brazil, Canada, China, and India have all committed to formal timelines for adoption of IFRS, and Japan has made 2011 its target for convergence to IFRS. However, our paper has some limitations. We used earnings management as a measure of the quality of financial statements. 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