- Email: [email protected]
Impact of IFRS on Earnings Management: Comparison of Pre-Post IFRS Era in Pakistan
Available online at www.sciencedirect.com
ScienceDirect Procedia - Social and Behavioral Sciences 230 (2016) 343 – 350
3rd International Conference on New Challenges in Management and Organization: Organization and Leadership, 2 May 2016, Dubai, UAE
Impact of IFRS on Earnings Management: Comparison of Pre-Post IFRS Era in Pakistan Maliha Baiga,*, Shuja Ali Khanb b
a Bahria University, Islamabad 44000, Pakistan Capital University of Science & Technology, Islamabad 44000, Pakistan
Abstract This paper investigates the impact of introduction of International Financial Reporting Standards on earnings management of Public limited companies in Pakistan as the purpose of the reporting standards is to make the financial statements of companies more transparent and comparable. The research undertaken, is based on sampling process involving 100 Companies, listed on Karachi Stock Exchange of Pakistan, to investigate the quality of accounting information enhanced in the context of preǦpost IAS/IFRS period i.e. 2001. The cutǦoff point is to evaluate the Earning management Score in absolute terms of Pakistani listed companies. This study relies upon the the crossǦsectional modified Jones model of by Kothari et al. (2005). With this approach, discretionary accruals are measured on the past estimates of an industry. In earning management the discretionary accruals represent the employment of earnings management. This is done after subtracting the portion of nonǦdiscretionary accruals from the total value of accruals. The global practice is converging towards transitioning from GAAP to domestic IFRS. With this, in many countries the use of earnings management has significantly decreased, but this is not the case in Pakistan due to two reasons; 1) Pakistan is using the IAS/IFRs based system since its inception 2) Due to 1) the data features are in a comparable form to check the effectiveness of IFRS. However, since the onset of 2001, a decreasing trend has been observed in the using of earnings management. It renders ineffective, the conclusion that the introduction of IFRS, during the period 2001 – 2009, led to less earnings management. © Published by by Elsevier Ltd.Ltd. This is an open access article under the CC BY-NC-ND license © 2016 2016The TheAuthors. Authors. Published Elsevier (http://creativecommons.org/licenses/by-nc-nd/4.0/). Peer-review under responsibility of the Ardabil Industrial Management Institute. Peer-review under responsibility of the Ardabil Industrial Management Institute
Keywords: IFRS; Earnings Management; Modified Jones Model; Pakistan
*Maliha Baig. Tel.: +9251-9263425; Fax: +92519260885 Email Address: [email protected]
1877-0428 © 2016 The Authors. Published by Elsevier Ltd. This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/). Peer-review under responsibility of the Ardabil Industrial Management Institute doi:10.1016/j.sbspro.2016.09.043
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Maliha Baig and Shuja Ali Khan / Procedia - Social and Behavioral Sciences 230 (2016) 343 – 350
1. Introduction 1.1 Background The world is at the end of convergence towards International Financial Reporting Standards (IFRS) which are high quality accounting standards for judging the transparency and comparability of financial statements in financial reporting process. All users of financial statements want a true and fair representation of information about companies in financial statements. However, under the crisis period, it is disputable whether companies present the true position to the users of financial statements to make economics decisions and for resources allocation. On the other hand the management of companies can make different accounting choices or structure business transactions to report according to intent rather than true and fair presentation. In past many big or well reputed companies in all over the world created sophisticated methods for accounting manipulations by abusing accounting and shaking the confidence of the investors and general public too, which hurt the economic activity around the world. One study ‘Do accounting standards matter’ points out that USA, which uses rule based accounting standards (GAAPS), could not make much difference to safeguard its companies like Enron, worldcom etc. In USA the level of Earnings management score is 2 points, out of 34 countries (1990-1999). The highest point in Austria is 28 points and in Pakistan the earning management score is 17.8 points. IFRS in financial reporting can be extended beyond the quality of financial information, out in the following terms: x To reduce the asymmetry and Earning management which can mitigate the agency problem x To reduce the cross-border listing requirements x To make the local GAAPS align to IFRS that is harmonization of local accounting standards x To make better economic decisions with the help of full disclosures in the financial reports x To maximize the firm value x To improve the predictive and confirmatory value of the information which is more relevant and reliable to the decision making process. 1.2 Problem Statement In Pakistan difference of opinions exists on whether IFRS adoption makes for more transparent and comparable financial statements or not and the positive or negative impact on earnings management. This has not been empirically tested before. 1.3 Research Basis Following research question forms the basis of research to study the impact of the introduction IFRS on earnings management: What is the trend of earnings management after adoption of IFRS and the level of earnings management observed prior to adoption of these standards, in Pakistan? The undertaken study will fulfill the following research objectives; x x x
To identify the practices of earnings management prior to IFRS adoption, among Pakistani companies listed in KSE (Karachi Stock Exchange). To explore whether EM trend of Pakistani companies after adoption of IFRS has changed. To compare the EM behavior of the KSE listed companies in Pakistan before and after adoption of IFRS
1.4 Significance of study x x x
To initiate a process of deliberation on IFRS with respect to earnings management practice in Pakistan To accumulate empirical evidence with reference to such trends that give rise to EM. To determine and share possible implications of EM practices in Pakistan, with policy formulators and research nets.
Maliha Baig and Shuja Ali Khan / Procedia - Social and Behavioral Sciences 230 (2016) 343 – 350
x
To give a basic accounting framework related to EM to Institute of Chartered Accountants of Pakistan (ICAP) and International Accounting Standards Board (IASB).
1.5 Defining Earnings Management Whenever financial decisions are based on intentional judgment applied for transaction structuring and financial reporting with the sole purpose of meaningful deceit, concealment or data spinning, it gives rise to earnings management. This is done in order to mislead the investors and stakeholders and influence favorable outcomes from business contracts through manipulated accounting figures as per Healey and Wahlen (1999, p.368). 1.6 Motivations for Earnings Management There exist four motives for engaging in EM which are; x Window dressing by stretching accounting assumptions prior to fund raising, acquiring loans from banks or through initial public offerings (IPOs) x Internal management goals setting and meeting of financial targets ahead of financial closing. x Even out irregularities in financial reporting through undue recognition of income and expenses. x Meeting external expectations. 1.7 Other incentives of Earnings Management Incentives are found in management presenting asymmetrical information to the investors and stake holders which arises the Principal-Agent problem related to Agency Theory. According to Jensen and Meckling (1976, p.5) a contract involving the delegation of decision making powers and authority, exists between several people called principals who engage other persons namely the agents, concluding in opportunistic behavior by the latter. A theory called Positive Accounting Theory by Watts and Zimmerman, 1978 like the Agency theory focuses on the relationship between different individuals in a business set-up. It explains how the management uses accounting information and methodical techniques to manipulate management earnings. It uses three hypothesis namely; x Bonus plan hypothesis x Debt or Equity hypothesis x Political cost hypothesis Earning Management is used to either increase or decrease earnings. The company’s management can have different strategies for earning manipulation depending upon real economic scenarios as per Hoogendoom (2004, p.60). These are; Profit maximization/minimization, Loss maximization/minimization (Big Bath accounting strategy) &Leveling out technique called “income smoothing” According to Huang, Li, (2005), despite of the interest-related partnerships in business, enterprises such as shareholders, managers, creditors, employees and government have conflicts of interests among themselves. Shah, Butt and Hasan (2009) state that agency problems between managers, minority shareholders and owners or controlling family exist in the agency problem which are the main focus of researchers and analysts. According to Azofra, Castrillo and Delgado (2003), accounting selection and managerial judgment stem from decision making rights causing problems. Asymmetric information dissemination arising. Managers interests lie in perquisites and discretionarily running the management (Iturriaga and Saona, 2005). A conflict of interest concept was associated with managers and shareholders. After paying the stakeholders their promised money, they keep the remaining amount for themselves (Jensen and Meckling, 1976). Discretion is also used over implementation of accounting policies and exercising choices to mislead internal and external financial statement users (Xiong, 2006).
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Maliha Baig and Shuja Ali Khan / Procedia - Social and Behavioral Sciences 230 (2016) 343 – 350
Healy, (1999)
Identified four incentives of earning management : IPOs, financial liabilities, Rules/Regulations and senior executives compensations
Beneish, (2001)
Added additional motivation of insider trading
Stolowy & Breton, (2000)
Identified 3 objective of EM: 1) Political cost minimization, Capital cost minimization, Wealth maximization of managers
Deanglo (1998)
Identified EM in buy-out cases
Watts & Zimmerman, (2005)
Discussed three hypothesis of EM: 1) Political costs hypothesis, Debt-covenant hypothesis, Benefit plan hypothesis
Schipper, (1989)
Provided a conceptual frame work with informational perspective.
Ewert & Wagenhofer, (2005)
Identified two types of earnings management : 1) Real-Earnings Management (REM) Accounting-Earnings Management (AEM)
2. Methodology and Data Description Accrual model has been followed for most of the earlier researches. An accrual is the difference between Profit after tax and Cash flow from operating activities. It appears effective in measuring earnings management for a certain period. There are two types of accruals depending on the extent to which the company’s management can influence them; the Discretionary Accruals & the Non-Discretionary accruals. Both are indicators of earnings management however, positive discretionary accruals indicate EM. For the purpose of our study Modified Jones model, (1995) will be used. Impact of IFRS is examined for a particular level of earnings management. For this purpose a comparison is done by looking at the level of earnings management in pre and post IFRS adoption era in Pakistan. The research period is from 2002-2004 for pre IFRS era and 2005-208 for post IFRS era and then four years from 2008-2011 to record any anomalies in our results A sample of 100 Pakistani companies listed on Karachi stock exchange, is taken . Financial institutions and utility companies have been excluded from the research owing to the specific accounting requisites of the former and diverse line of businesses of the latter. To collect all necessary data, website of State Bank of Pakistan. Non-discretionary accruals are “Those that arise out of normal transactions of the firm belonging to the current period given the performance levels, strategy, industrial practices, and other economic factors.” Discretionary accruals are “Those that arise out of accounting transactions and treatments deliberately chosen for earnings management. Most studies employ approach used in the Jones model called the aggregate accruals approach. Some academicians question the validity of the proxy of discretionary accruals used to determine EM (e.g., McNichols and Wilson, 1988, p. 12; Wilson, 1996, pp. 172, 177; Bernard and Skinner, 1996, pp. 315±320) however, the larger faction of the studies use this approach, suggesting it to be widely acknowledged as an appropriate proxy. 2.1. Data Description Secondary financial data has been used for this paper obtained from a publication of State Bank of Pakistan; “Balance Sheet Analysis of Joint Stock Companies listed on the Karachi Stock Exchange (2002 to 2008 and 2008 to 2011)”. A panel data sample of 100 KSE listed companies is taken for research study through convenient sampling technique because it covers major sectors including Textiles, Spinning, Chemicals and Engineering. Furthermore
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random sampling is used for analytical purpose. The convenient sampling technique covers major sectors; Spinning, textile, Chemical, Cement, Sugar and Engineering. 2.2. Methodology This research will use the Positive Accounting Theory approach by Watts and Zimmerman, (1976). It will be tested whether the introduction of independent variable IFRS has an impact on the level of earnings management, the dependent variable. Modified Jones model will be used to determine the level of discretionary accruals (Alijifri, 2007). Modified Jones Model: Total Accruals = Net Profit after tax-Cash flow from operating activities
(1)
TACt/TAt-1=a0+b1 (1/TAt-1) +b2 (¨REVt-¨RECt)/TAt-1+b3 (PPEt/TAt-1)+et (Aljifri, 2007). Where TACit is the total accruals in year t; TAt-1 is the total assets in year t; ¨REVt is the change in revenues from year t-1, ¨RECt is the change in receivables from year t-1, PPEt is the gross property, plant and equipment in year t and et is the regression error terms Following multiple regression equation was used for Non Discretionary Accruals. Non Discretionary Accruals = a0 +b (1/Total Assetst-1) +c ((¨ Revenue t - ¨ Receivables t)/ Total Assets t-1) +d (PPEt/TotalAssetst-1) + error term (Discretionary accrual)
(2)
2.3. Hypothesis Formulation In order to observe the impact of IFRS adoption on EM in the companies listed on Karachi Stock Exchange (KSE), the following hypotheses were formulated. Hypothesis 1: Ho1: Earnings Management are not associated with IFRS adoption. Ha1: Earnings Management are associated with IFRS adoption. Hypothesis 2: Ho1: Earnings Management are not associated with Discretionary accruals. Ha1: Earnings Management are associated with Discretionary accruals. There are two approaches to detect EM; Cross sectional approach & Time series approach x The cross-sectional method utilizes average values for the company’s industry. Therefore there is less stringent data requirement for analysis. Assumption# 1: All Firms are affected equally in one period, Assumption# 2: Testing and estimating period is the same. 2.4. Graphical Analysis The intercept is a constant value for a particular company in an industry. R2 values are expected to differ for a data set leading to under or overstatement of Discretionary accruals causing type-I error in prediction which harms the reliability of results. Contradiction was observed in results after research was done with different approaches on mainly six sectors of Pakistani companies to validate the dataset and detect any structural problems in it if any. For that purpose regression in the capacity of modified Jones model was run and very contradicting results in ܴଶ were presented. Pakistan is a country without local GAAPs like U.K or U.S.
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Seleection of Jones Model as per maximum m R2 vallue.
50% % 45% % 40% % 35% % 30% % 25% % 20% % 15% % 10% % 5% % 0% %
% R SQUARE-CEM S MENT SECTOR R -PAKISTAN NI LISTED CO OMPANIES UN NDER D DIFFERENT D DATA SET AS SSUMPTIONS S
45% 34%
27%
34%
2%
12%
3%
2001Ͳ2010 0
2001Ͳ20077
2004Ͳ2007 7
2001Ͳ2004 4
2001Ͳ20044
2001Ͳ200 04
2001Ͳ20004
PREͲPOST
PREͲPOSTT
POSTͲIFRSS
PREͲIFRS
PREͲIFRSS
PREͲIFRSS
PREͲIFRSS
FULLTENYEA ARS FULLSIXYEA ARS POSTͲIFRSͲDA ATA DATASET DATASET
CASEͲ1
CASEͲ2
PREͲIFRSͲDA ATA
CASEͲ3
PREͲIFRSͲDA ATAͲ PREͲIFRSͲDA ATAͲ PREͲIFRSͲDA ATAͲ ESTIMATIO ON ESTIMATIO ON ESTIMATIO ON PERIOD PERIODͲWIITH PERIODͲBIGFIRM NEWVARIA ABLE ELIMINATION SIZESALEES CASEͲ4
CASEͲ5
CASEͲ6
Fig.1. (a) Cement Seector R2 compariison A decreasing treend can be obseerved in the Earrnings Managem ment at the onseet of post IFRS era in a companny of Cemeent sector, show wing an overall decreasing accceptance toward ds earnings mannagement. This could be due too the majorrly important acccounting scand dals at the start of millennium. Furthermore, m many regulatory y interventions, such as thhose concerning g corporate go overnance, migh ht place a restrictive influennce over some levels of acccruals depenndent earnings management. m W When companiess find alternativ ve pathways forr manipulation, the trend of EM M increases in the mid of the year 2007 till 2011. Thereefore other expllanatory variablees need to be ad dded to detect thhese findings.
E comparison n of Pre-post IFR RS Fig.2. Sugar Sector EM
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2.5. Tabular Analysis After inception of IASs/IFRS, the accounting governing bodies in Pakistan such as ICAP and SECP are enforcing their practice without contradicting the companies’ ordinance, 1984. Therefore any impact of EM is not directly observable. Hence, non-discretionary accruals will be separated from total accruals to check the phenomenon of earnings management in Pakistan. Using an Į of 0.05, we have F0.05; (2.58) = 3.156 for the cement sector. Since the test statistic is much smaller than the critical value, we accept the null hypothesis and conclude that there is a significant similarity in the population means of pre IFRS and post IFRS EM. The p-value for 3.156 is 0.84>0.05, so the test statistic is not significant at this level to accept our hypothesis. The t statistic value <1.96 for post IFRS showing presence of EM after 2004 and on this account too we cannot reject the null hypothesis and conclude that IFRS adoption had no significant negative impact on earnings management.
Table 1. Regression Statistics of CEMENT SECTOR Multiple R R Square Adjusted-R Square Standard Error
0.034602 0.001197 -0.03326 0.066949
Observations
60
ANOVA Significance F
df
SS
MS
F
Regression Residual
2 58
0.00031 0.25996
0.00015 0.00448
0.03348
Total
60
0.26027
Coefficients
Standard Error
t Stat
P-value
Lower 95%
Upper 95%
Intercept
-0.00235
0.01222
-0.19187
0.84851
-0.02681
0.0221
D(Pre-Post)IFRS
0.004558
0.01728
0.26367
0.79296
-0.03004
0.03916
3.156
5.1. Limitations and Conclusions Every research is bogged down in one way or another by limitations. Future research can be built on these. This study encountered several limitations. Firstly, the focus is only on the impact of IFRS for the observed intensity of earnings management. Consequently, only an aspect can be studied over which a conclusion will be drawn. IFRS impact the way losses are recognized in financial statements depending upon disclosure requirements and the degree of relevance to financial data (Barth et al., 2008). The empirical study is based on modified Jones model for discretionary accrual (DA) measurement. Although it produces verifiable results not every occurrence of DA is due to earnings management (McNichols, 2000). EM is not always captured through accrual models (Heemskerk and Van der Tas, 2006, p.578). The cross sectional approach used in this investigation assumes that all companies within an industry ought to have identical accruals. This limitation exists because companies are structurally, characteristically and size wise
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different. Cross sectional approach is better than time series approach (Bartov et al, 2001), however by producing good quality statements for the user, it is difficult to infer that there is earnings management in the company. 5.2. Recommendations Reducing earnings management is a matter of building trust with the stake holders, through building a strong reputation of a company and bringing profit generation on a stable footing. At the time of financial crises this trend is especially observable, therefore more research needs to be done on EM during the crises years for any significant changes. Longer sample period, cross country global analysis for better comparison and high quality models would be a welcomed approach for detecting accounting information manipulation. Institutional factors cannot be ignored and larger public awareness would have an impact in post IFRS era. Since no significant changes were found in this study it can be suggested that companies could be well prepared in advance for this change and might have looked for alternative methods of EM in the pre-IFRS era to remain undetectable in post IFRS era. Cash flows from operations can give an insight into the financial potential of the company as margin of difference with Net Income should be minimal. Hence, introducing CFO in our model would be one major factor of predictive research. References Ball, R., S.P. Kothari, & Robin. A. 2000. The effect of international institutional factors on properties of accounting earnings. Journal of Accounting and Economics, 29: 1 – 51. Barth, M.E., Landsman, W.R., & Lang, M. H. 2008. International Accounting Standards and Accounting Quality. Journal of Accounting Research , 46: 467 – 498. DeAngelo, L. E. 1986. Accounting numbers as market valuation substitutes: A study of management buyouts of public stockholders. The Accounting Review 61: 400 – 420. Goncharov, I. & Zimmermann, J. 2006. Do Accounting Standards Influence the Level of Earnings Management? Evidence from Germany. SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=386521 Healy, P. M. 1985. The impact of bonus schemes on the selection of accounting principles. Journal of Accounting and Economics 7: 85 – 107. Healy, P. M., & Wahlen, J. M. 1999. A Review of the Earnings Management Literature and Its Implications for Standard Setting. Accounting Horizons 13: 365 – 383 Heemskerk, M., & L.G. van der Tas. 2006. Veranderingen in resultaatsturing als gevolg van de invoering van IFRS. Maandblad voor Accountancy en Bedrijfseconomie 80: 571 – 579. Jones, J.J. 1991. Earnings Management During Import Relief Investigations. Journal of Accounting Research 29: 193 – 228. Klaassen, J., & Hoogendoorn, M.N. 2004. Externe Verslaggeving. Stenfert Kroese Groningen. Kothari, S. P., Leone, A.J., & Wasley. C. E. 2005. Performance matched discretionary accrual measures. Journal of Accounting and Economics 39: 163 – 197. Schipper, K. 2003. Principle-based accounting standards. Accounting Horizons (March): 61 – 77. Stolowy, H. & Breton, G. 2004. Accounts Manipulation: A literature review and Proposed Conceptual Framework. Review of Accounting & Finance 3: 5 – 66. Tendeloo, B. Van., & Vanstraelen. A. 2005. Earnings management under German GAAP and IFRS. The European Accounting Review 17: 281 – 308. Beneish, M. D. 1997. Detecting GAAP violations: Implications for assessing earnings management among firms with extreme financial performance. Journal of Accounting and Public Policy 16 (3): 271-309. Watts, R.L. & Zimmerman, J. L. 1978. Towards a Positive Theory of the Determination of Accounting Standards. The Accounting Review 53: 112 – 134. Watts, R.L., & Zimmerman, J. L. 1990. Positive accounting theory: a ten year perspective. The Accounting Review 65: 131 – 156.
ScienceDirect Procedia - Social and Behavioral Sciences 230 (2016) 343 – 350
3rd International Conference on New Challenges in Management and Organization: Organization and Leadership, 2 May 2016, Dubai, UAE
Impact of IFRS on Earnings Management: Comparison of Pre-Post IFRS Era in Pakistan Maliha Baiga,*, Shuja Ali Khanb b
a Bahria University, Islamabad 44000, Pakistan Capital University of Science & Technology, Islamabad 44000, Pakistan
Abstract This paper investigates the impact of introduction of International Financial Reporting Standards on earnings management of Public limited companies in Pakistan as the purpose of the reporting standards is to make the financial statements of companies more transparent and comparable. The research undertaken, is based on sampling process involving 100 Companies, listed on Karachi Stock Exchange of Pakistan, to investigate the quality of accounting information enhanced in the context of preǦpost IAS/IFRS period i.e. 2001. The cutǦoff point is to evaluate the Earning management Score in absolute terms of Pakistani listed companies. This study relies upon the the crossǦsectional modified Jones model of by Kothari et al. (2005). With this approach, discretionary accruals are measured on the past estimates of an industry. In earning management the discretionary accruals represent the employment of earnings management. This is done after subtracting the portion of nonǦdiscretionary accruals from the total value of accruals. The global practice is converging towards transitioning from GAAP to domestic IFRS. With this, in many countries the use of earnings management has significantly decreased, but this is not the case in Pakistan due to two reasons; 1) Pakistan is using the IAS/IFRs based system since its inception 2) Due to 1) the data features are in a comparable form to check the effectiveness of IFRS. However, since the onset of 2001, a decreasing trend has been observed in the using of earnings management. It renders ineffective, the conclusion that the introduction of IFRS, during the period 2001 – 2009, led to less earnings management. © Published by by Elsevier Ltd.Ltd. This is an open access article under the CC BY-NC-ND license © 2016 2016The TheAuthors. Authors. Published Elsevier (http://creativecommons.org/licenses/by-nc-nd/4.0/). Peer-review under responsibility of the Ardabil Industrial Management Institute. Peer-review under responsibility of the Ardabil Industrial Management Institute
Keywords: IFRS; Earnings Management; Modified Jones Model; Pakistan
*Maliha Baig. Tel.: +9251-9263425; Fax: +92519260885 Email Address: [email protected]
1877-0428 © 2016 The Authors. Published by Elsevier Ltd. This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/). Peer-review under responsibility of the Ardabil Industrial Management Institute doi:10.1016/j.sbspro.2016.09.043
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Maliha Baig and Shuja Ali Khan / Procedia - Social and Behavioral Sciences 230 (2016) 343 – 350
1. Introduction 1.1 Background The world is at the end of convergence towards International Financial Reporting Standards (IFRS) which are high quality accounting standards for judging the transparency and comparability of financial statements in financial reporting process. All users of financial statements want a true and fair representation of information about companies in financial statements. However, under the crisis period, it is disputable whether companies present the true position to the users of financial statements to make economics decisions and for resources allocation. On the other hand the management of companies can make different accounting choices or structure business transactions to report according to intent rather than true and fair presentation. In past many big or well reputed companies in all over the world created sophisticated methods for accounting manipulations by abusing accounting and shaking the confidence of the investors and general public too, which hurt the economic activity around the world. One study ‘Do accounting standards matter’ points out that USA, which uses rule based accounting standards (GAAPS), could not make much difference to safeguard its companies like Enron, worldcom etc. In USA the level of Earnings management score is 2 points, out of 34 countries (1990-1999). The highest point in Austria is 28 points and in Pakistan the earning management score is 17.8 points. IFRS in financial reporting can be extended beyond the quality of financial information, out in the following terms: x To reduce the asymmetry and Earning management which can mitigate the agency problem x To reduce the cross-border listing requirements x To make the local GAAPS align to IFRS that is harmonization of local accounting standards x To make better economic decisions with the help of full disclosures in the financial reports x To maximize the firm value x To improve the predictive and confirmatory value of the information which is more relevant and reliable to the decision making process. 1.2 Problem Statement In Pakistan difference of opinions exists on whether IFRS adoption makes for more transparent and comparable financial statements or not and the positive or negative impact on earnings management. This has not been empirically tested before. 1.3 Research Basis Following research question forms the basis of research to study the impact of the introduction IFRS on earnings management: What is the trend of earnings management after adoption of IFRS and the level of earnings management observed prior to adoption of these standards, in Pakistan? The undertaken study will fulfill the following research objectives; x x x
To identify the practices of earnings management prior to IFRS adoption, among Pakistani companies listed in KSE (Karachi Stock Exchange). To explore whether EM trend of Pakistani companies after adoption of IFRS has changed. To compare the EM behavior of the KSE listed companies in Pakistan before and after adoption of IFRS
1.4 Significance of study x x x
To initiate a process of deliberation on IFRS with respect to earnings management practice in Pakistan To accumulate empirical evidence with reference to such trends that give rise to EM. To determine and share possible implications of EM practices in Pakistan, with policy formulators and research nets.
Maliha Baig and Shuja Ali Khan / Procedia - Social and Behavioral Sciences 230 (2016) 343 – 350
x
To give a basic accounting framework related to EM to Institute of Chartered Accountants of Pakistan (ICAP) and International Accounting Standards Board (IASB).
1.5 Defining Earnings Management Whenever financial decisions are based on intentional judgment applied for transaction structuring and financial reporting with the sole purpose of meaningful deceit, concealment or data spinning, it gives rise to earnings management. This is done in order to mislead the investors and stakeholders and influence favorable outcomes from business contracts through manipulated accounting figures as per Healey and Wahlen (1999, p.368). 1.6 Motivations for Earnings Management There exist four motives for engaging in EM which are; x Window dressing by stretching accounting assumptions prior to fund raising, acquiring loans from banks or through initial public offerings (IPOs) x Internal management goals setting and meeting of financial targets ahead of financial closing. x Even out irregularities in financial reporting through undue recognition of income and expenses. x Meeting external expectations. 1.7 Other incentives of Earnings Management Incentives are found in management presenting asymmetrical information to the investors and stake holders which arises the Principal-Agent problem related to Agency Theory. According to Jensen and Meckling (1976, p.5) a contract involving the delegation of decision making powers and authority, exists between several people called principals who engage other persons namely the agents, concluding in opportunistic behavior by the latter. A theory called Positive Accounting Theory by Watts and Zimmerman, 1978 like the Agency theory focuses on the relationship between different individuals in a business set-up. It explains how the management uses accounting information and methodical techniques to manipulate management earnings. It uses three hypothesis namely; x Bonus plan hypothesis x Debt or Equity hypothesis x Political cost hypothesis Earning Management is used to either increase or decrease earnings. The company’s management can have different strategies for earning manipulation depending upon real economic scenarios as per Hoogendoom (2004, p.60). These are; Profit maximization/minimization, Loss maximization/minimization (Big Bath accounting strategy) &Leveling out technique called “income smoothing” According to Huang, Li, (2005), despite of the interest-related partnerships in business, enterprises such as shareholders, managers, creditors, employees and government have conflicts of interests among themselves. Shah, Butt and Hasan (2009) state that agency problems between managers, minority shareholders and owners or controlling family exist in the agency problem which are the main focus of researchers and analysts. According to Azofra, Castrillo and Delgado (2003), accounting selection and managerial judgment stem from decision making rights causing problems. Asymmetric information dissemination arising. Managers interests lie in perquisites and discretionarily running the management (Iturriaga and Saona, 2005). A conflict of interest concept was associated with managers and shareholders. After paying the stakeholders their promised money, they keep the remaining amount for themselves (Jensen and Meckling, 1976). Discretion is also used over implementation of accounting policies and exercising choices to mislead internal and external financial statement users (Xiong, 2006).
345
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Maliha Baig and Shuja Ali Khan / Procedia - Social and Behavioral Sciences 230 (2016) 343 – 350
Healy, (1999)
Identified four incentives of earning management : IPOs, financial liabilities, Rules/Regulations and senior executives compensations
Beneish, (2001)
Added additional motivation of insider trading
Stolowy & Breton, (2000)
Identified 3 objective of EM: 1) Political cost minimization, Capital cost minimization, Wealth maximization of managers
Deanglo (1998)
Identified EM in buy-out cases
Watts & Zimmerman, (2005)
Discussed three hypothesis of EM: 1) Political costs hypothesis, Debt-covenant hypothesis, Benefit plan hypothesis
Schipper, (1989)
Provided a conceptual frame work with informational perspective.
Ewert & Wagenhofer, (2005)
Identified two types of earnings management : 1) Real-Earnings Management (REM) Accounting-Earnings Management (AEM)
2. Methodology and Data Description Accrual model has been followed for most of the earlier researches. An accrual is the difference between Profit after tax and Cash flow from operating activities. It appears effective in measuring earnings management for a certain period. There are two types of accruals depending on the extent to which the company’s management can influence them; the Discretionary Accruals & the Non-Discretionary accruals. Both are indicators of earnings management however, positive discretionary accruals indicate EM. For the purpose of our study Modified Jones model, (1995) will be used. Impact of IFRS is examined for a particular level of earnings management. For this purpose a comparison is done by looking at the level of earnings management in pre and post IFRS adoption era in Pakistan. The research period is from 2002-2004 for pre IFRS era and 2005-208 for post IFRS era and then four years from 2008-2011 to record any anomalies in our results A sample of 100 Pakistani companies listed on Karachi stock exchange, is taken . Financial institutions and utility companies have been excluded from the research owing to the specific accounting requisites of the former and diverse line of businesses of the latter. To collect all necessary data, website of State Bank of Pakistan. Non-discretionary accruals are “Those that arise out of normal transactions of the firm belonging to the current period given the performance levels, strategy, industrial practices, and other economic factors.” Discretionary accruals are “Those that arise out of accounting transactions and treatments deliberately chosen for earnings management. Most studies employ approach used in the Jones model called the aggregate accruals approach. Some academicians question the validity of the proxy of discretionary accruals used to determine EM (e.g., McNichols and Wilson, 1988, p. 12; Wilson, 1996, pp. 172, 177; Bernard and Skinner, 1996, pp. 315±320) however, the larger faction of the studies use this approach, suggesting it to be widely acknowledged as an appropriate proxy. 2.1. Data Description Secondary financial data has been used for this paper obtained from a publication of State Bank of Pakistan; “Balance Sheet Analysis of Joint Stock Companies listed on the Karachi Stock Exchange (2002 to 2008 and 2008 to 2011)”. A panel data sample of 100 KSE listed companies is taken for research study through convenient sampling technique because it covers major sectors including Textiles, Spinning, Chemicals and Engineering. Furthermore
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random sampling is used for analytical purpose. The convenient sampling technique covers major sectors; Spinning, textile, Chemical, Cement, Sugar and Engineering. 2.2. Methodology This research will use the Positive Accounting Theory approach by Watts and Zimmerman, (1976). It will be tested whether the introduction of independent variable IFRS has an impact on the level of earnings management, the dependent variable. Modified Jones model will be used to determine the level of discretionary accruals (Alijifri, 2007). Modified Jones Model: Total Accruals = Net Profit after tax-Cash flow from operating activities
(1)
TACt/TAt-1=a0+b1 (1/TAt-1) +b2 (¨REVt-¨RECt)/TAt-1+b3 (PPEt/TAt-1)+et (Aljifri, 2007). Where TACit is the total accruals in year t; TAt-1 is the total assets in year t; ¨REVt is the change in revenues from year t-1, ¨RECt is the change in receivables from year t-1, PPEt is the gross property, plant and equipment in year t and et is the regression error terms Following multiple regression equation was used for Non Discretionary Accruals. Non Discretionary Accruals = a0 +b (1/Total Assetst-1) +c ((¨ Revenue t - ¨ Receivables t)/ Total Assets t-1) +d (PPEt/TotalAssetst-1) + error term (Discretionary accrual)
(2)
2.3. Hypothesis Formulation In order to observe the impact of IFRS adoption on EM in the companies listed on Karachi Stock Exchange (KSE), the following hypotheses were formulated. Hypothesis 1: Ho1: Earnings Management are not associated with IFRS adoption. Ha1: Earnings Management are associated with IFRS adoption. Hypothesis 2: Ho1: Earnings Management are not associated with Discretionary accruals. Ha1: Earnings Management are associated with Discretionary accruals. There are two approaches to detect EM; Cross sectional approach & Time series approach x The cross-sectional method utilizes average values for the company’s industry. Therefore there is less stringent data requirement for analysis. Assumption# 1: All Firms are affected equally in one period, Assumption# 2: Testing and estimating period is the same. 2.4. Graphical Analysis The intercept is a constant value for a particular company in an industry. R2 values are expected to differ for a data set leading to under or overstatement of Discretionary accruals causing type-I error in prediction which harms the reliability of results. Contradiction was observed in results after research was done with different approaches on mainly six sectors of Pakistani companies to validate the dataset and detect any structural problems in it if any. For that purpose regression in the capacity of modified Jones model was run and very contradicting results in ܴଶ were presented. Pakistan is a country without local GAAPs like U.K or U.S.
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Seleection of Jones Model as per maximum m R2 vallue.
50% % 45% % 40% % 35% % 30% % 25% % 20% % 15% % 10% % 5% % 0% %
% R SQUARE-CEM S MENT SECTOR R -PAKISTAN NI LISTED CO OMPANIES UN NDER D DIFFERENT D DATA SET AS SSUMPTIONS S
45% 34%
27%
34%
2%
12%
3%
2001Ͳ2010 0
2001Ͳ20077
2004Ͳ2007 7
2001Ͳ2004 4
2001Ͳ20044
2001Ͳ200 04
2001Ͳ20004
PREͲPOST
PREͲPOSTT
POSTͲIFRSS
PREͲIFRS
PREͲIFRSS
PREͲIFRSS
PREͲIFRSS
FULLTENYEA ARS FULLSIXYEA ARS POSTͲIFRSͲDA ATA DATASET DATASET
CASEͲ1
CASEͲ2
PREͲIFRSͲDA ATA
CASEͲ3
PREͲIFRSͲDA ATAͲ PREͲIFRSͲDA ATAͲ PREͲIFRSͲDA ATAͲ ESTIMATIO ON ESTIMATIO ON ESTIMATIO ON PERIOD PERIODͲWIITH PERIODͲBIGFIRM NEWVARIA ABLE ELIMINATION SIZESALEES CASEͲ4
CASEͲ5
CASEͲ6
Fig.1. (a) Cement Seector R2 compariison A decreasing treend can be obseerved in the Earrnings Managem ment at the onseet of post IFRS era in a companny of Cemeent sector, show wing an overall decreasing accceptance toward ds earnings mannagement. This could be due too the majorrly important acccounting scand dals at the start of millennium. Furthermore, m many regulatory y interventions, such as thhose concerning g corporate go overnance, migh ht place a restrictive influennce over some levels of acccruals depenndent earnings management. m W When companiess find alternativ ve pathways forr manipulation, the trend of EM M increases in the mid of the year 2007 till 2011. Thereefore other expllanatory variablees need to be ad dded to detect thhese findings.
E comparison n of Pre-post IFR RS Fig.2. Sugar Sector EM
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2.5. Tabular Analysis After inception of IASs/IFRS, the accounting governing bodies in Pakistan such as ICAP and SECP are enforcing their practice without contradicting the companies’ ordinance, 1984. Therefore any impact of EM is not directly observable. Hence, non-discretionary accruals will be separated from total accruals to check the phenomenon of earnings management in Pakistan. Using an Į of 0.05, we have F0.05; (2.58) = 3.156 for the cement sector. Since the test statistic is much smaller than the critical value, we accept the null hypothesis and conclude that there is a significant similarity in the population means of pre IFRS and post IFRS EM. The p-value for 3.156 is 0.84>0.05, so the test statistic is not significant at this level to accept our hypothesis. The t statistic value <1.96 for post IFRS showing presence of EM after 2004 and on this account too we cannot reject the null hypothesis and conclude that IFRS adoption had no significant negative impact on earnings management.
Table 1. Regression Statistics of CEMENT SECTOR Multiple R R Square Adjusted-R Square Standard Error
0.034602 0.001197 -0.03326 0.066949
Observations
60
ANOVA Significance F
df
SS
MS
F
Regression Residual
2 58
0.00031 0.25996
0.00015 0.00448
0.03348
Total
60
0.26027
Coefficients
Standard Error
t Stat
P-value
Lower 95%
Upper 95%
Intercept
-0.00235
0.01222
-0.19187
0.84851
-0.02681
0.0221
D(Pre-Post)IFRS
0.004558
0.01728
0.26367
0.79296
-0.03004
0.03916
3.156
5.1. Limitations and Conclusions Every research is bogged down in one way or another by limitations. Future research can be built on these. This study encountered several limitations. Firstly, the focus is only on the impact of IFRS for the observed intensity of earnings management. Consequently, only an aspect can be studied over which a conclusion will be drawn. IFRS impact the way losses are recognized in financial statements depending upon disclosure requirements and the degree of relevance to financial data (Barth et al., 2008). The empirical study is based on modified Jones model for discretionary accrual (DA) measurement. Although it produces verifiable results not every occurrence of DA is due to earnings management (McNichols, 2000). EM is not always captured through accrual models (Heemskerk and Van der Tas, 2006, p.578). The cross sectional approach used in this investigation assumes that all companies within an industry ought to have identical accruals. This limitation exists because companies are structurally, characteristically and size wise
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different. Cross sectional approach is better than time series approach (Bartov et al, 2001), however by producing good quality statements for the user, it is difficult to infer that there is earnings management in the company. 5.2. Recommendations Reducing earnings management is a matter of building trust with the stake holders, through building a strong reputation of a company and bringing profit generation on a stable footing. At the time of financial crises this trend is especially observable, therefore more research needs to be done on EM during the crises years for any significant changes. Longer sample period, cross country global analysis for better comparison and high quality models would be a welcomed approach for detecting accounting information manipulation. Institutional factors cannot be ignored and larger public awareness would have an impact in post IFRS era. Since no significant changes were found in this study it can be suggested that companies could be well prepared in advance for this change and might have looked for alternative methods of EM in the pre-IFRS era to remain undetectable in post IFRS era. Cash flows from operations can give an insight into the financial potential of the company as margin of difference with Net Income should be minimal. Hence, introducing CFO in our model would be one major factor of predictive research. References Ball, R., S.P. Kothari, & Robin. A. 2000. The effect of international institutional factors on properties of accounting earnings. Journal of Accounting and Economics, 29: 1 – 51. Barth, M.E., Landsman, W.R., & Lang, M. H. 2008. International Accounting Standards and Accounting Quality. Journal of Accounting Research , 46: 467 – 498. DeAngelo, L. E. 1986. Accounting numbers as market valuation substitutes: A study of management buyouts of public stockholders. The Accounting Review 61: 400 – 420. Goncharov, I. & Zimmermann, J. 2006. Do Accounting Standards Influence the Level of Earnings Management? Evidence from Germany. SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=386521 Healy, P. M. 1985. The impact of bonus schemes on the selection of accounting principles. Journal of Accounting and Economics 7: 85 – 107. Healy, P. M., & Wahlen, J. M. 1999. A Review of the Earnings Management Literature and Its Implications for Standard Setting. Accounting Horizons 13: 365 – 383 Heemskerk, M., & L.G. van der Tas. 2006. Veranderingen in resultaatsturing als gevolg van de invoering van IFRS. Maandblad voor Accountancy en Bedrijfseconomie 80: 571 – 579. Jones, J.J. 1991. Earnings Management During Import Relief Investigations. Journal of Accounting Research 29: 193 – 228. Klaassen, J., & Hoogendoorn, M.N. 2004. Externe Verslaggeving. Stenfert Kroese Groningen. Kothari, S. P., Leone, A.J., & Wasley. C. E. 2005. Performance matched discretionary accrual measures. Journal of Accounting and Economics 39: 163 – 197. Schipper, K. 2003. Principle-based accounting standards. Accounting Horizons (March): 61 – 77. Stolowy, H. & Breton, G. 2004. Accounts Manipulation: A literature review and Proposed Conceptual Framework. Review of Accounting & Finance 3: 5 – 66. Tendeloo, B. Van., & Vanstraelen. A. 2005. Earnings management under German GAAP and IFRS. The European Accounting Review 17: 281 – 308. Beneish, M. D. 1997. Detecting GAAP violations: Implications for assessing earnings management among firms with extreme financial performance. Journal of Accounting and Public Policy 16 (3): 271-309. Watts, R.L. & Zimmerman, J. L. 1978. Towards a Positive Theory of the Determination of Accounting Standards. The Accounting Review 53: 112 – 134. Watts, R.L., & Zimmerman, J. L. 1990. Positive accounting theory: a ten year perspective. The Accounting Review 65: 131 – 156.