The effect of mandatory IFRS adoption on real and accrual-based earnings management activities

J. Account. Public Policy 33 (2014) 551–572

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J. Account. Public Policy journal homepage: www.elsevier.com/locate/jaccpubpol

The effect of mandatory IFRS adoption on real and accrual-based earnings management activities Leonidas C. Doukakis HEC Lausanne, University of Lausanne, Switzerland

a b s t r a c t This study examines the effect of mandatory adoption of International Financial Reporting Standards (IFRS) on both accrual-based and real earnings management. While prior literature has mainly examined the effects of IFRS adoption on accrual-based earnings management, no study to date has focused on the impact of IFRS adoption on real earnings management. Using a sample of 15,206 observations from 22 European countries between 2000 and 2010, this study employs a control sample of voluntary adopters and applies a differences-in-differences design to control for confounding concurrent events. The results suggest that mandatory IFRS adoption had no significant impact on either real or accrualbased earnings management practices. Additional analysis on a sub-sample of firms with relatively strong earnings management incentives supports a dominant role for firm-level reporting incentives over accounting standards in shaping financial reporting quality. Ó 2014 Elsevier Inc. All rights reserved.

1. Introduction The adoption of International Financial Reporting Standards (IFRS) is the most significant regulatory change in financial reporting worldwide in the last 30 years. Since 2005, all companies listed on EU stock exchanges have been required to prepare their consolidated financial statements E-mail address: [email protected] http://dx.doi.org/10.1016/j.jaccpubpol.2014.08.006 0278-4254/Ó 2014 Elsevier Inc. All rights reserved.

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in accordance with IFRS.1 IFRS adoption in the EU was part of a broader initiative (the Financial Services Action Plan, or FSAP), launched in the late 1990s with the aim of improving capital markets through increased financial disclosure, increased enforcement and improved governance regimes.2 Regulators expect the IFRS to enhance the comparability of financial statements, improve corporate transparency, and raise the quality of financial reporting (EC Regulation No. 1606/2002). Financial reporting quality should increase if the adoption of IFRS limits management’s opportunistic discretion in determining accounting amounts. If so, IFRS which are of higher quality than local Generally Accepted Accounting Principles (GAAP), would lead to a decrease in earnings management practices.3 However, mandatory adopters had the option to adopt IFRS in the years prior to 2005 but chose not to do so. This suggests that IFRS may not be optimal for mandatory adopters and thus they may have no incentive to rigorously apply IFRS. If so, they may apply IFRS as they did their old national GAAPs with no substantial change in their accounting practice. Prior literature underscores the potential role of firm-level incentives as well as the role of institutional factors in determining accounting quality. Finally, the inherent flexibility allowed under principles-based standards together with lax enforcement of IFRS may even lead to an increase in earnings management practices. These arguments suggest that the impact of mandatory IFRS adoption on earnings management is an open empirical issue that warrants further investigation. Recent research has pointed to the importance of understanding how firms manage earnings through real earnings management in addition to accrual-based activities (Cohen and Zarowin, 2010; Cohen et al., 2008; Gunny, 2010; Roychowdhury, 2006; Zang, 2012; Zhao et al., 2012).4 However, no study to date has focused on the impact of IFRS adoption on real earnings management. This study aims to fill the gap in the IFRS and earnings management literature by examining the impact of mandatory IFRS adoption on earnings management and, more precisely, on both accrual-based and real earnings management. In this respect, this study allows for a broader and more comprehensive understanding of the possible impact of IFRS adoption on earnings management. The study is based on a broad sample of 15,206 firm-year observations of available data from 22 countries that mandatorily adopted IFRS in 2005. I use a differences-in-differences design to investigate changes in earnings management activities between the pre- versus post-mandatory adoption periods for mandatory adopters relative to a control sample of voluntary adopters over the same period. The results suggest that mandatory IFRS adoption had no significant impact on the level of accrual-based and real earnings management. Additional analysis of firms with relatively strong earnings management incentives confirms the lack of significant impact on accrual and real earnings management and points to the important role that firm-level incentives play in shaping earnings management behavior. This study contributes to the mandatory IFRS adoption and earnings management literature in several respects. First, this is the first study to provide a broad examination of the impact of mandatory IFRS adoption on both accrual and real earnings management. Capkun et al. (2012) and Ahmed et al. (forthcoming) investigate the effects of IFRS adoption on earnings management but do not specifically test for real earnings management and thus provide only a partial picture of the impact of this

1 Numerous other countries have officially adopted or systematically harmonized their domestic standards with IFRS. For a full list of IFRS adoption by country, please refer to http://www.iasplus.com/country/useias.htm. 2 See Kalemli-Ozcan et al. (2011) and Byard et al. (2011b) for the objectives behind the creation of the Financial Services Action Plan and the study carried out by the Economic and Monetary Affairs Division (2009) of the European Parliament for an assessment of the 10 years of FSAP. 3 IFRS are more detailed, require more disclosures, allow fewer options and are broader in scope compared to many national accounting standards. 4 In particular, DeFond (2010, p. 406) states that ‘‘an area of the earnings quality literature that seems relatively underresearched is so-called ‘real activities’ manipulation, or ‘transaction’ management . . . compared to the research that investigates accruals-based earnings management, research on activities management is scarce.’’ Examination of real earnings management is critical, because while accrual-based earnings management activities have no direct cash flow consequences, real earnings management does affect cash flows.

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regulatory change.5 The present study, therefore, allows for a more comprehensive understanding of the impact of mandatory IFRS adoption on earnings management. Second, by employing a sub-sample of firms with relatively strong earnings management incentives, the present study complements prior empirical studies that point to the second-order role of standards and suggests the primary role of firm-level reporting incentives in affecting financial reporting quality. Finally, the study provides some indirect evidence for the role of reporting enforcement initiatives in improving financial reporting quality. The empirical findings have direct implications for standard-setters and policymakers in assessing whether mandatory IFRS adoption has accomplished its stated objective of improving accounting quality. The findings of the study do not imply that standards are irrelevant, but rather that other factors also influence earnings management practices. Furthermore, although mandatory IFRS adoption does not seem to materially affect earnings management, there are indications that concurrent regulatory changes (other legislative initiatives implemented under the FSAP) might play a role in enhancing the enforcement of financial reporting and in improving financial market regulation. Finally, the results are of interest to securities regulators from countries that are considering mandatory IFRS adoption, and to investors and analysts who seek to understand the effects of mandatory IFRS adoption on accounting numbers. The remainder of the paper is organized as follows. Section 2 reviews prior literature focusing on mandatory IFRS adoption and earnings management, and on real activities manipulation. Section 3 develops the empirical hypotheses, while Section 4 discusses the methodology. Section 5 describes the sample while Section 6 reports the empirical findings. Section 7 presents some robustness tests, and Section 8 concludes. 2. Literature review 2.1. IFRS and accrual-based earnings management literature Christensen et al. (2008) compare the extent of income smoothing in the pre- and post-adoption periods for voluntary and mandatory IFRS adopters in Germany and find that income smoothing decreased significantly under voluntary but not under mandatory IFRS adoption. They suggest that mandatory adopters might perceive fewer benefits from a shareholder-oriented set of accounting standards (i.e. IFRS) and thus avoid the costs of transferring to IFRS. On the other hand, Capkun et al. (2012) report an increase in earnings management from pre-2005 to post-2005 for early and late voluntary adopters in countries that allowed early IFRS adoption, and for mandatory adopters in countries that did not allow early IFRS adoption. Similarly, Ahmed et al. (forthcoming) provide evidence suggesting that after mandatory IFRS adoption, income smoothing and accrual aggressiveness increase while timeliness of loss recognition decreases. Quite surprisingly, the decline in accounting quality is more pronounced for countries with strong law enforcement. Capkun et al. (2012) argue that IFRS changed significantly from 2003 to 2005, allowing managers greater flexibility and discretion. They conclude that these changes explain the contradictory results of Barth et al. (2008) for voluntary and Christensen et al. (2008) and Ahmed et al. (forthcoming) for mandatory IFRS adopters. An improvement in accounting quality is documented by Chen et al. (2010), who find evidence of a decrease in earnings management toward a target, a decrease in absolute discretionary accruals, and a decrease in the standard deviation of unexplained accruals. On the other hand, they also find an increase in income smoothing and a decrease in the likelihood of recognizing large losses. 5 The present study differs from these investigations in several important respects. First, this study examines the impact of mandatory IFRS adoption on real and accrual earnings management, whereas Ahmed et al. (2013) study the effect of mandatory IFRS adoption on income smoothing, reporting aggressiveness, and accrual earnings management to meet or beat a target. Capkun et al. (2012) investigate self-selection and accounting standards changes as potential reasons for the conflicting results on income smoothing between voluntary and mandatory IFRS adopters. They suggest that the greater flexibility allowed by the changes in IFRS between 2003 and 2005 explains the contradictory results between voluntary and mandatory IFRS adopters. Second, Ahmed et al. (2013) examine only two years of post-adoption data, whereas the present study extends to 2010, enhancing the generalizability of the results. Third, Ahmed et al. (2013) employ a control sample of non-adopters whereas the present study uses voluntary adopters as a control. Voluntary adopters have the same institutional and governance characteristics and face the same changes in economic environment over the sample period, making them a more suitable control sample (Li, 2010).

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Aussenegg et al. (2008), analyzing 17 European countries, observe that Central European firms that apply IFRS experience less earnings management than firms that apply domestic standards. The United Kingdom, Ireland, and Northern European countries, already characterized by lower earnings management levels, exhibit no difference between IFRS and domestic GAAP. Jeanjean and Stolowy (2008) investigate the effect of mandatory adoption of IFRS on earnings management by examining 1146 firm-year observations from Australia, France, and the United Kingdom from 2005 to 2006. They report that earnings management in these countries did not decline after mandatory adoption of IFRS, and even increased in France. They conclude that sharing rules is not a sufficient condition to create a common business language, and that management incentives and national institutional factors play an important role in framing financial reporting characteristics. Similarly, Paananen (2008) provides evidence consistent with a decrease in financial reporting quality following the adoption of IFRS in Sweden. Overall, the findings on the effects of mandatory IFRS adoption on earnings management are mixed and focus on accrual-based earnings management. No study to date examines the impact of mandatory IFRS adoption on real earnings management. In this respect, prior literature provides limited evidence on the impact of mandatory IFRS adoption on earnings management. This study intends to fill in this gap by providing a broad and comprehensive examination of whether earnings management changed around mandatory IFRS adoption. In addition, the present study uses a larger sample, more countries, and more years following adoption, providing stronger evidence regarding the overall level of earnings management after the introduction of IFRS. 2.2. Real earnings management literature In addition to accrual accounting choices, firms are likely to employ real operational activities to manipulate earnings figures (Healy and Wahlen, 1999; Dechow and Skinner, 2000; Graham et al., 2005).6 The investigation of Graham et al. (2005) provides survey evidence suggesting that managers prefer real earnings management practices to accrual-based earnings management. Results of earlier studies (Thomas and Zhang, 2002; Baber et al., 1991; Bens et al., 2002) indicate that managers overproduce to decrease cost of goods sold and cut research and development expenses and capital expenditures to meet specific earnings targets. Roychowdhury (2006) develops empirical measures to proxy for real earnings management and shows that managers avoid reporting losses by engaging in real activities management. Zang (2012) examines the trade-off between accrual-based and real earnings management. She suggests that the real earnings management decision precedes the decision to manage earnings through accruals, and that the two earnings management strategies act as substitutes since accrual-based and real manipulations are negatively correlated. Findings of Gunny (2010) and Zhao et al. (2012) suggest that firm-years with abnormal real activities intended to just meet earnings benchmarks have better subsequent performance. However, Zhao et al. (2012) find that abnormal real activities in the absence of just meeting earnings targets are negatively associated with firms’ future performance. Cohen and Zarowin (2010) show that firms engage in real earnings management following a seasoned equity offering (SEO), and the decline in post-SEO performance due to real earnings management is more severe than that due to accrual-based earnings management. Finally, Cohen et al. (2008) show that since the passage of the Sarbanes-Oxley Act managers have moved away from accrual-based toward real earnings management. 3. Hypotheses development Mandatory IFRS adoption has no clear ex ante effect on financial reporting. Arguments suggest both positive and negative potential effects on earnings management practices as well as reasons to expect negligible changes after mandatory IFRS adoption. 6 Accrual-based earnings management involves within-GAAP accounting choices that try to ‘‘mask’’ true economic performance (Dechow and Skinner, 2000, p240). In contrast, Roychowdhury (2006) defines real activities manipulation as ‘‘management actions that deviate from normal business practices, undertaken with the primary objective of meeting certain earnings thresholds.’’

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3.1. Disincentive argument Regulators expect the use of IFRS to enhance the comparability of financial statements, improve corporate transparency, and increase the quality of financial reporting (EC Regulation No. 1606/ 2002). Analysts, investors, and capital market authorities should be more able to monitor and evaluate accounting quality and to compare different accounting choices and assumptions among firms and across countries. This result may act as a disincentive for managers to engage in accrual earnings management practices and may put pressure on management to report truthfully. A related argument, based on the findings of Ding et al. (2007), suggests that since ‘‘absence’’ (i.e. the extent to which the rules regarding certain accounting issues are missing in Domestic Accounting Standards but are covered in IAS) is positively related to earnings management, IFRS adoption will result in lower levels of earnings management. In addition, reduced reporting discretion (Ewert and Wagenhofer, 2005), in combination with higher disclosure requirements under IFRS, might narrow the room to exercise judgment and reduce freedom to manage earnings. 3.2. Firm-level incentives argument On the other hand, if management has strong earnings management incentives, it may opportunistically apply IFRS to achieve the desired reporting goals. Furthermore, firms with no incentives to adopt IFRS may respond to mandatory compliance with a ‘‘tick-box’’ mentality, rather than with sincere efforts to adopt the new standards and improve their reporting quality (Daske et al., 2013; Christensen et al., 2008). Additionally, lax enforcement could result in limited compliance with standards, thereby restricting their effectiveness in enhancing accounting quality (Street and Gray, 2001; Ball et al., 2003). However, even with perfect enforcement, financial reporting behavior is expected to differ across firms as long as accounting standards offer some discretion and firms have different reporting incentives (Leuz, 2006). Moreover, the inherent flexibility allowed under principles-based standards (IFRS) could provide greater opportunity for earnings management relative to rules-based domestic standards.7 Nelson (2003) provides experimental and survey evidence suggesting that imprecise standards create difficulty for auditors in constraining managers’ aggressive reporting behavior. Similarly, a single set of standards might not be as effective as nationally developed standards in accommodating differences in institutional characteristics (Ball et al., 2003; Ball, 2006; Jeanjean and Stolowy, 2008), and firms may have trouble communicating useful information to investors, leading them to choose aggressive reporting practices. 3.3. Institutional features Recent literature underlines the role of national institutional features and concludes that accounting standards alone do not determine financial reporting quality (Ball et al., 2000, 2003; Leuz, 2003; Leuz et al., 2003; Burgstahler et al., 2006; Ding et al., 2007). In particular, Saudagaran and Meek (1997) and Papadaki (2005) emphasize that national accounting standards are the result of a complex interaction of cultural, historical, economic, and institutional factors. According to Ball (2006), powerful local economic and political forces determine how managers, auditors, courts, regulators and other parties influence the implementation of rules. These forces have exerted a substantial influence on financial reporting practice historically, and are unlikely to suddenly cease doing so, IFRS or no IFRS.8 Taken as a whole, the role of accounting standards in influencing earnings management practices may be limited relative to the effects of other forces, such as managers’ incentives, audit quality, ownership structure, corporate governance provisions, enforcement, regulation, and the litigation environment. Simply mandating IFRS may not be sufficient to ensure changes to financial reporting 7

Carmona and Trombetta (2008) argue that the principles-based notion of IFRS has enabled their worldwide application. Similarly, Kvaal and Nobes (2010) find that for 16 accounting policy issues in the largest five stock markets in Europe, pre-IFRS practice has continued after IFRS adoption. These findings imply that the application of accounting standards depends to a great extent on the exercise of professional judgment or discretion rather than on the accounting standards per se. 8

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behavior unless the underlying institutional and economic factors evolve as well (Holthausen, 2009). In this respect, the impact of mandatory IFRS adoption on earnings management remains an open empirical question and a subject of debate among academics and practitioners. The above arguments lead to the formation of the following hypothesis, stated in the null form. H1. Mandatory IFRS adoption is not associated with a change in accrual earnings management practices.

3.4. Substitution argument Examining the impact of mandatory IFRS adoption on accrual-based earnings management would provide only a partial picture of the impact of this regulatory change. As Cohen et al. (2008) argue, evidence of a decline in one type of earnings management may lead to the conclusion that such activities have decreased in response to regulators or other events, when in fact a substitution of one earnings management method for another has occurred. Cohen and Zarowin (2010) and Gunny (2010) provide several arguments as to why a firm may want to engage in real versus accrual earnings management. First, ex post aggressive choices with respect to accruals are at higher risk of regulatory scrutiny and litigation. Second, a firm’s business operations and prior years’ accruals manipulation may constrain flexibility to engage in accrual earnings management. Third, accrual accounting choices are subject to auditor scrutiny, whereas real operating decisions are less subject to auditor scrutiny and review.9 In sum, if mandatory IFRS adoption has an impact, either positive or negative, on accrual-based earnings management, it may also have an impact on real earnings management. However, the real earnings management decision precedes the decision to manage earnings through accruals (Zang, 2012), suggesting that real earnings management can take place independent of manipulation through accruals. 3.5. Transparency argument As well as having an indirect effect on real earnings management through accruals, mandatory IFRS adoption may conceivably have a direct effect on real earnings management through increased transparency.10 Hirst and Hopkins (1998) and Jo and Kim (2007) suggest that more transparent disclosures lead to greater detection of and lower incentives for earnings management. Even if real earnings management is more difficult to detect, the increased level of disclosure under IFRS may enable capital market authorities, analysts, and investors to more easily identify actions that deviate from normal business practices. 3.6. Institutional ownership argument Recent literature also provides evidence consistent with an increase in foreign institutional equity ownership among companies using IFRS versus local GAAP (DeFond, 2010). Further, Tan et al. (2011) report an increase in the number of foreign analysts following mandatory IFRS adoption. The presence of sophisticated institutional investors as well as a higher analyst following may deter managers from engaging in real earnings management. Bushee (1998) and Roychowdhury (2006) provide empirical evidence suggesting that the presence of institutional investors creates disincentives for managers to engage in real earnings management.

9 Although real earnings management activities can be indistinguishable from optimal business decisions, and thus are less vulnerable to auditor and regulator scrutiny, the costs of such practices can be economically significant for the firm. 10 Soderstrom and Sun (2007) suggest that widespread adoption of IFRS will result in a fundamental change in the business environment. Recent literature documents capital market effects associated with IFRS adoption. For instance, IFRS adoption is expected to enhance capital market efficiency, increase international investment flows, improve resource allocation, and the like. More specifically, IFRS adoption results in increases in market liquidity, reduction in information asymmetry, increases in foreign direct investment, decreases in the cost of equity capital, and so on (Covrig et al., 2007; Daske et al., 2008; Christensen et al., 2007; Gordon et al., 2012).

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3.7. Increased marginal benefit argument Finally, tighter (i.e. fewer options, more disclosures, etc.) accounting standards can increase accounting quality measured by higher earnings variability and higher value relevance of reported earnings figures. As a result, the marginal benefit of earnings management rises and managers may increase real earnings management, which is costly and directly reduces firm value (Ewert and Wagenhofer, 2005). This line of reasoning suggests that mandatory IFRS adoption may have a direct impact (increase) on real earnings management. The above arguments form the basis for the second hypothesis, stated in the null form. H2. Mandatory IFRS adoption is not associated with a change in real earnings management practices.

4. Methodology 4.1. Accrual-based earnings management The present study uses absolute discretionary accruals (ABS_DA) as a proxy for accrual earnings management.11 The flexibility afforded by accrual accounting makes the accrual component of earnings less reliable than the cash flow component of earnings (Larcker et al., 2007). As prior literature suggests, any test of earnings management is a joint test of earnings management and the expected accruals model used (e.g., Dechow et al., 1995; Guay et al., 1996; Kasznik, 1999; Klein, 2002). The literature proposes several methods for separating total accruals into discretionary and non-discretionary components. The most frequently used models are the Jones (1991) model and the modified Jones model (Dechow et al., 1995). Dechow et al. (1995) present evidence indicating that the modified Jones model is more powerful at detecting earnings management than the original. To control for the possibility that revenue recognition is subject to manipulation by management, Dechow et al. (1995) add the change in accounts receivable. This study uses the modified Jones model to calculate discretionary accruals. The model is estimated for each year and industry (Datastream level -4) cluster with at least eight observations to ensure sufficient data for parameter estimation.12 Thus, this approach partially controls for industry-wide changes in economic conditions that affect total accruals and allows the coefficients to vary across time.13

TAit 1 DSalesit GPPEit ¼ b0 þ b1 þ b2 þ eit Assetsit1 Assetsit1 Assetsit1 Assetsit1

ð1Þ

where TAit = total accruals, calculated as firm i’s net income minus cash flows from operations in year t taken from the statement of cash flows; Assetsit1 = total assets for firm i in year t  1; DSalesit = change in sales for firm i from year t  1 to year t; GPPEit = gross property, plant and equipment for firm i in year t. Second, the coefficient estimates from equation (1) are used to estimate the firm-specific nondiscretionary accruals (NAit) for the sample firms.

^0 NAit ¼ b

1 ^1 ðDSalesit  DARit Þ þ b ^2 GPPEit þb Assetsit1 Assetsit1 Assetsit1

ð2Þ

where NAit = non-discretionary accruals for firm i in year t; DARit = change in accounts receivable for firm i from year t  1 to year t. All other variables are as previously defined. 11 The study uses the absolute value because the hypothesis does not predict any specific direction for earnings management. In addition, the absolute value captures accrual reversals following earnings management (Cohen et al., 2008). 12 Prior literature uses at least eight observations to estimate discretionary accruals (Gaver et al., 1995; Klein, 2002; Cohen et al., 2008). The estimation per industry and year is also followed by Chen et al. (2010), where EU member countries are viewed as a single economic entity. However, results remain unchanged (although based on a smaller sample) if the estimation takes place per country, industry, and year cluster. 13 The implicit assumption is that accruals of a particular firm-year are not only influenced by earnings management practices, but are also affected by industry and year effects.

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Third, discretionary accruals (DA) equal the difference between total accruals and the fitted nondiscretionary accruals, defined as

DAit ¼ ðTAit =Assetsit1 Þ  NAit

ð3Þ

where DAit = discretionary accruals for firm i in year t. 4.2. Real earnings management Prior studies develop proxies for real earnings management activities. Following Roychowdhury (2006), I consider three metrics to study the level of real earnings management: the abnormal levels of productions costs, cash flows from operations, and discretionary expenses.14 Subsequent investigations (Zang, 2012; Cohen et al., 2008; Cohen and Zarowin, 2010; Zhao et al., 2012) offer evidence of the construct validity of the proxies initially suggested by Roychowdhury (2006). Real earnings management can take place by managers boosting production more than necessary, spreading the fixed overhead costs over a larger number of units and lowering fixed costs per unit. Managers can also manipulate earnings by accelerating the timing of sales through increased price discounts or more lenient credit terms. This will temporarily increase sales volumes, but these gains are likely to disappear once the firm returns to the old pricing policy. These real economic decisions will result in lower cash flows in the current period. Finally, managers can manipulate current earnings through decreases in discretionary expenses, such as those for advertising, research and development, and selling, general, and administrative expenses, resulting in higher current-period earnings. In this way, managers can also manipulate current-period cash flows at the expense of future cash flows if the firm generally pays for such expenses in cash. Following Dechow et al. (1998) and Roychowdhury (2006), I estimate the normal levels of production costs, cash flows from operations, and discretionary expenses using the following models.15 The models are estimated for each year and industry cluster with at least eight observations. Thus, this approach partially controls for industry-wide changes in economic conditions that affect the dependent variables and allows the coefficients to vary across time.

PRODit 1 Salesit DSalesit DSalesit1 ¼ a0 þ b1 þ b2 þ b3 þ b4 þ eit Assetsit1 Assetsit1 Assetsit1 Assetsit1 Assetsit1

ð4Þ

CFOit 1 Salesit DSalesit ¼ a0 þ b1 þ b2 þ b3 þ eit Assetsit1 Assetsit1 Assetsit1 Assetsit1

ð5Þ

DISX it 1 Salesit1 ¼ a0 þ b1 þ b2 þ eit Assetsit1 Assetsit1 Assetsit1

ð6Þ

where PRODit = production costs, defined as the sum of cost of goods sold and the change in inventories from year t  1 to year t; CFOit = cash flows from operations taken from the statement of cash flows; DISXit = discretionary expenses defined as selling, general and administrative expenses for year t. All other variables are as previously defined. The abnormal production costs (ABN_PROD), cash flows from operations (ABN_CFO), and discretionary expenses (ABN_DISX) expected to capture real earnings management are computed as the difference between the actual values and the normal levels predicted by Eqs. (4), (5), and (6). Given sales levels, firms that manage earnings upwards are likely to have one or all of the following characteristics: unusually low cash flow from operations, unusually low discretionary expenses, or unusually high production costs (Cohen and Zarowin, 2010). 14

For a thorough discussion of the means available to conduct real earnings management, see Roychowdhury (2006). The Salest2 variable in model (4) is based on the restated financial statements that first-time mandatory adopters had to provide for the previous year. 15

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Consistent with Zang (2012) and Cohen and Zarowin (2010), I multiply ABN_CFO and ABN_DISX by minus one, so the higher the amount of ABN_CFO and ABN_DISX, the more likely the firm is to be engaging in sales manipulation through price discounts and cutting discretionary expenses.16 Following prior literature (Zang, 2012; Cohen et al., 2008; Cohen and Zarowin, 2010; Zhao et al., 2012), I combine the individual measures to compute a measure of total real earnings management (REAL). However, model (6) can be estimated for only 8669 observations of the test sample since not all firms separately report selling, general, and administrative expenses. To avoid reducing the sample by almost 35%, REAL equals the algebraic sum of the two individual measures (ABN_PROD, ABN_CFO).17 Excluding the abnormal discretionary expenses variable has the additional advantage of making clear the net effect on abnormal cash flows from operations. Price discounts, channel stuffing, and overproduction have a negative effect on contemporaneous abnormal CFO, whereas a reduction of discretionary expenditures has a positive effect (Cohen and Zarowin, 2010). The empirical results are based on both the aggregate real earnings management measure (REAL) and the individual real earnings management proxies (ABN_PROD, ABN_CFO and ABN_DISX). 4.3. Differences-in-differences design The study employs a control sample of voluntary IFRS adopters and uses a differences-in-differences design to investigate the impact of mandatory IFRS adoption on accrual and real earnings management.18 The benchmark sample controls for contemporaneous changes in the economic environment that have an impact on the earnings management behavior of firms and that are unrelated to mandatory IFRS adoption. The choice of a suitable control sample is of crucial importance to this type of study (Daske et al., 2008). In summarizing the substance of the differences-in-differences design, Meyer (1995, p. 155) states that ‘‘the design is most plausible when the untreated comparison group is very similar to the treatment group.’’ A control sample of voluntarily adopting firms from the same group of countries as the mandatory adopters sample has the incontestable advantage of similar institutional and governance characteristics. As Li (2010) suggests, the regulatory homogeneity across EU countries reduces the likelihood of identifying effects that are subject to unspecified cross-country differences. A possible disadvantage of this benchmark choice is that voluntary adopters may make efforts concurrent with the voluntary adoption to improve their governance, audit quality, ownership structure, and so on. In other words, in the pre-adoption period, voluntary IFRS adopters might be quite different from mandatory IFRS adopters. However, their inclusion as a control sample does not preclude finding an effect for mandatory adopters after mandatory IFRS adoption. Mandatory IFRS adoption does not imply a substantial change in voluntary adopters’ accounting practice. In contrast, if adoption has an effect on mandatory adopters, then benchmarking with voluntary adopters creates the ideal setting to capture this effect. According to Daske et al. (2008, p. 1086) ‘‘[M]any adopting countries make concurrent efforts to improve enforcement and governance regimes, which likely play into our findings.’’ However, enforcement and governance improvements that take place at country level are expected to affect mandatory and voluntary adopters quite similarly and as a result will be identified as a common, general trend effect.19 In the pre- and post-2005 period, the only incremental difference between the change for mandatory adopters and the change for voluntary adopters is the effect of mandatory IFRS adoption. A control sample of non-IFRS adopting countries could be another option, but such a choice suffers from a number of criticisms. First, non-IFRS adopting countries (e.g., Argentina, Brazil, Chile, India, Malaysia, Pakistan, Peru, and Thailand) have significantly different institutional (e.g., legal system and level of enforcement) and economic characteristics. These countries form a highly heterogeneous group that includes G8, developed, developing, and emerging countries (Hail and Leuz, 2007), 16 I do not multiply ABN_PROD by minus one since abnormally high production costs indicate overproduction to reduce cost of goods sold. 17 Empirical results remain unchanged if REAL is based on the algebraic sum of the three individual measures. 18 Prior literature also employs the differences-in-differences design to examine the impact of mandatory IFRS adoption on the cost of equity capital, on the analysts’ information environment, on the market liquidity, and so on (Daske et al., 2008; Li, 2010; Byard et al., 2011a). I am grateful to the two anonymous reviewers for suggesting this research design. 19 Prior literature provides no arguments that these country-level changes will be more or less pronounced for voluntary than for mandatory adopters. However, either effect could create difficulties in distinguishing between the impact of mandatory IFRS adoption and the concurrent impact of enforcement and governance improvements.

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rendering them as a group hardly comparable to a set of developed European countries. Second, over the sample period changes in economic environment, enforcement levels, auditing, and governance might not be similar to the changes undertaken in the test sample countries.20 In contrast, mandatory and voluntary IFRS adopters from EU countries experience contemporaneous and similar economic shocks (e.g., financial crisis) unrelated to the IFRS mandate.21 Third, many of these countries gradually migrated toward or even adopted IFRS over the sample period (e.g., Brazil, Chile, China, and Israel). To sum up, the choice of a control sample to examine the financial reporting consequences of mandatory IFRS adoption that simultaneously affects all firms in an economy is subject to debate. However, on the basis of the above arguments and following recent literature (Biddle et al. 2013; Byard et al., 2011a; DeFond et al., 2012; Li, 2010; Wang et al., 2008), the present study employs a control sample of voluntary IFRS adopters. 4.4. Model specification The study creates a binary indicator variable, MANDATORY, that takes the value of one for firms that did not apply IFRS until compliance became mandatory. This variable is expected to capture any difference between the test and the control sample prior to mandatory IFRS adoption. The second variable of interest, POST2005, is a binary variable that equals one for observations after 2005. This variable is expected to capture any changes in earnings management practices that are independent of the adoption of IFRS. The models also include an interaction term, MANDATORY*POST2005, that takes the value of one for mandatory adopters in the post-adoption period. This is the main variable of interest expected to capture any incremental change in earnings management for mandatory adopters compared to voluntary adopters following mandatory IFRS adoption.

ABS DA ¼ b0 þ b1 MANDATORY þ b2 POST2005 þ b3 MANDATORY  POST2005 þ b4 BIG4 þ b5 GROWTH þ b6 SIZE þ b7 LEVERAGE þ b8 ROE þ b9 OWNERSHIP þ b10 REAL þ et REAL ¼ b0 þ b1 MANDATORY þ b2 POST2005 þ b3 MANDATORY  POST2005 þ b4 BIG4 þ b5 GROWTH þ b6 SIZE þ b7 LEVERAGE þ b8 ROE þ b9 OWNERSHIP þ b10 ABS DA þ et Prior literature documents that earnings management practices are affected by factors such as auditor type, growth, firm size, financial leverage, ownership structure, and profitability (Becker et al., 1998; Bartov et al., 2001; Klein, 2002; Bowen et al., 2008). BIG4 is an indicator variable that equals one if a Big 4 auditor is hired and zero otherwise. This variable is included because prior literature suggests that the presence of a Big 4 auditor restricts accrual earnings management practices (Francis and Wang, 2008). GROWTH is the annual percentage change in sales and is included in the models to control for the impact of growth on earnings management. To maintain the appearance of sustainable growth, managers may use income-increasing accruals or real earnings management when growth slows (Summers and Sweeney, 1998). Similarly, growth companies might be more willing to engage in income-increasing earnings management to raise the value of their shares and attract more investors to meet their capital needs. Moreover, since growth firms might be riskier as investments, they may be more likely to engage in window-dressing activities. In addition, the natural logarithm of market value of equity (SIZE) is included to control for the effect of firm size on earnings management. Watts and Zimmerman (1978) suggest that larger firms may face greater political costs than smaller firms owing to greater analyst following and investor scrutiny. On the other hand, Lobo and Zhou (2006) suggest that larger firms may be more inclined to manage their earnings because the complexity of their operations makes detecting overstatement more difficult. 20 According to Christensen et al. (2012), some non-IFRS adopting countries undertook regulatory changes that coincided with the mandatory IFRS adoption period (Japan in 2005, Chile in 2009, the US in 2002, etc.). 21 The essence of the differences-in-differences approach is to account for unobserved differences between test and control firms and adjust observable changes for the test firms by concurrent changes that are also experienced by the control firms (Daske et al., 2008). If these concurrent changes are not experienced by the control firms (i.e., non-IFRS adopters), then they will be erroneously identified as IFRS effects.

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LEVERAGE is included to pick up debt-contracting motivations for earnings management. A number of studies provide evidence suggesting that managers of highly leveraged firms have strong incentives to use income-increasing earnings management practices to avoid debt covenant violation (DeFond and Jiambalvo, 1994; Sweeney, 1994; Francis and Wang, 2008). I measure leverage as the ratio of total liabilities to last year’s total assets. Return on equity (ROE), calculated as net income divided by last year’s total shareholders’ equity, controls for the relationship between profitability and earnings management. Following prior studies (Bagnoli and Watts, 2000; Fan and Wong, 2002; Burgstahler et al., 2006; Klassen, 1997), I include OWNERSHIP to control for the role of ownership structure on earnings management. The variable OWNERSHIP is measured as the percentage of closely held shares. I include REAL (ABS_DA) since prior literature suggests that accrual earnings management and real earnings manipulation are substitute mechanisms of earnings management. Specifically, firms may follow an overall earnings management strategy and use a mix of real and accrual-based earnings management tools. Alternatively, they can choose between the two management techniques, using the technique that is less costly for them (Cohen et al., 2008). Finally, the models control for industry and country fixed effects.

5. Sample The initial sample consists of all publicly listed companies in EU member states that mandatorily adopted IFRS in 2005.22 The sample period extends from 2000 to 2010. The study excludes financial institutions as well as firm-years that lack the accounting information necessary to compute the variables used in the analysis. The study also excludes observations with negative book value of equity, with missing information on accounting standards followed, and with no available data for the auditors. Further exclusions are early (voluntary) and never (not consolidated) IFRS adopters as well as firms that follow a different set of standards (e.g., US GAAP). Finally, as explained above, the study imposes the criterion of at least eight observations per industry and year cluster to ensure sufficient data for the estimation of accrual and real earnings management proxies. Imposing these data availability requirements yields a final test sample of 13,295 firm-year observations (2021 unique firms), of which 6225 observations lie in the pre-adoption period and 7070 in the post-adoption period. All accounting data are obtained from Datastream/WorldScope. As already mentioned, this study focuses on mandatory IFRS adoption. A mandatory adopter is a firm that followed IFRS for the first time in 2005. In other words, to be included in the test sample, a firm had to follow local accounting standards during 2000–2004 and IFRS during 2005–2010.23 Years 2000–2004 constitute the pre-adoption period, and years 2006–2010 are the post-adoption period.24 Mandatory IFRS adopters published their last local GAAP financial statements for their fiscal year ending either on 12/31/2004 or during the year 2005 if their fiscal year ended before 12/31/2005. The first IFRS financial statements cover the fiscal year beginning in 2005 and ending either on 12/31/2005 or during 2006. That is to say, the sample also includes firms that follow local GAAP in the year 2005 as long as they have a year-end different from 12/31/2005 and switch to IFRS the following year. Next, to control for the impact of potentially confounding concurrent events, I augment the sample with voluntary IFRS adopters and impose sample selection criteria similar to those used for the mandatory adopters sample. The control sample consists of 1911 firm-year observations (337 unique firms), of which 797 observations lie in the pre-adoption period and 1114 in the post-adoption period.25 The control firms use only IFRS, whereas the test firms use local GAAP in the pre-adoption period and IFRS in the post-adoption period. Table 1 presents the distribution of the test and control samples by country. The overall sample includes 15,206 firm-year observations (2358 unique firms) from 22 countries with significant 22

The accounting standards classification is based on the WorldScope item WC07536. Note that the focus on mandatory adoption results in the exclusion of a large number of observations since many countries allowed early adoption and a significant number of firms voluntarily adopted IFRS. 24 The estimation of real earnings management proxy, ABN_PROD, requires two lags of data (under the same standards) for the sales variable. As a result, the year 2005 is excluded from the analysis. This exclusion also removes any adoption year effect. 25 For the sake of consistency with the mandatory adopters’ sample, the switch year for voluntary adopters is excluded from the analysis. 23

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Table 1 Sample composition by country. Country

Austria Belgium Cyprus Czech Republic Denmark Finland France Germany Greece Hungary Ireland Italy Lithuania Luxembourg Norway Poland Portugal Spain Sweden Switzerland The Netherlands United Kingdom Total

Panel A: mandatory IFRS adopters

Panel B: voluntary IFRS adopters

Frequency

%

Frequency

%

61 289 4 24 424 652 1603 1082 436 21 204 1105 4 12 571 373 223 391 1042 198 665 3911 13,295

0.46 2.17 0.03 0.18 3.19 4.90 12.06 8.14 3.28 0.16 1.53 8.31 0.03 0.09 4.29 2.81 1.68 2.94 7.84 1.49 5.00 29.42 100

163 49 – 28 63 37 – 884 4 58 – – – – – – 11 – 4 598 7 5 1911

8.53 2.56 – 1.47 3.30 1.94 – 46.25 0.21 3.04 – – – – – – 0.58 – 0.21 31.28 0.37 0.26 100

Table 1 shows the number and percentage of firm-year observations across countries for mandatory (Panel A) and voluntary (Panel B) IFRS adopters. The test sample includes 13,295 observations that mandatorily adopted IFRS in 2005, of which 6225 observations lie in the pre-adoption period and 7070 in the post-adoption period. The control sample includes 1911 observations that voluntarily adopted IFRS before 2004, of which 797 observations lie in the pre-adoption period and 1114 in the post-adoption period.

representation from the United Kingdom and France (Germany and Switzerland) for the test (control) sample. Table 2 presents descriptive statistics relating to variables used in the analysis, along with univariate comparisons across the pre- and post-IFRS adoption periods, to explore potential differences. For the test and control sample, the means of REAL, ABN_CFO, ABN_PROD and ABN_DISX are not significantly different across the pre- and post-IFRS adoption periods, whereas the mean of ABS_DA is significantly lower for both mandatory and voluntary IFRS adopters after 2005. Mandatory IFRS adopters differ significantly in size, ownership, auditor type, growth opportunities, and profitability across the pre- and post-IFRS adoption periods. Voluntary adopters differ significantly in size, leverage, profitability and ownership structure across the pre and post-IFRS periods. Consistent with prior evidence, voluntary IFRS adopters are larger, less profitable, and less leveraged. The above differences suggest the use of multivariate models to control for correlated factors that potentially influence the earnings management practices of the sample firms. All continuous variables are winsorized at the top and bottom 1% of their distributions to mitigate the influence of outliers. 6. Empirical findings 6.1. Accrual and real earnings management models Table 3 presents the empirical findings for the accrual and real earnings management models.26 Column (a) reports results where absolute discretionary accrual is included as a dependent variable, while columns (b)–(e) include the total and the individual real earnings management proxies as dependent variables. The differences-in-differences design allows assessment of the incremental effect, if any, 26 The t-statistics are based on robust standard errors that are clustered by firm. The models also control for country and industry fixed effects.

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L.C. Doukakis / J. Account. Public Policy 33 (2014) 551–572 Table 2 Descriptive statistics. Mandatory IFRS adopters Mean N

Voluntary IFRS adopters Mean

Pre-2005

Post-2005

ABS_DA

13,295

0.061

0.055

REAL

13,295

0.007

0.007

ABN_CFO

13,295

0.002

0.003

ABN_PROD

13,295

0.005

0.004

ABN_DISX

8669

0.002

0.000

BIG 4

13,295

0.829

0.806

GROWTH

13,295

0.104

0.083

SIZE

13,295

5.238

5.446

LEVERAGE

13,295

0.596

0.599

ROE

13,295

0.069

0.093

OWNERSHIP

13,295

41.165

43.326

Dif.

N

Pre-2005

Post-2005

0.006*** (0.000) 0.000 (0.988) 0.001 (0.565) 0.001 (0.892) 0.002 (0.671) 0.023*** (0.001) 0.021*** (0.000) 0.208*** (0.000) 0.003 (0.400) 0.024*** (0.000) 2.161*** (0.000)

1911

0.060

0.051

1911

0.015

0.017

1911

0.004

0.005

1911

0.011

0.012

1569

0.007

0.007

1911

0.829

0.819

1911

0.082

0.087

1911

5.575

5.977

1911

0.546

0.569

1911

0.031

0.094

1911

48.690

44.950

Dif. 0.009*** (0.002) 0.002 (0.857) 0.001 (0.779) 0.001 (0.896) 0.000 (0.980) 0.010 (0.579) 0.005 (0.703) 0.402*** (0.000) 0.023** (0.042) 0.063*** (0.000) 3.740*** (0.003)

Table 2 reports the firm-level descriptive statistics across the pre- and post-adoption periods and by voluntary and mandatory adopters. The t-test tests the null hypothesis that the mean difference on the variable is zero. ABS_DA is the absolute value of discretionary accruals; REAL is the algebraic sum of the ABN_PROD and ABN_CFO; ABN_PROD is the abnormal level of production costs; ABN_CFO is the abnormal level of cash flows from operations; ABN_DISX is the abnormal level of discretionary expenses; BIG 4 is an indicator variable that equals one if a Big 4 auditor is hired, and zero otherwise; GROWTH is the annual percentage change in sales; SIZE is the natural logarithm of the market value of equity; LEVERAGE is the total liabilities divided by last year’s total assets; ROE is the net income divided by last year’s total equity. OWNERSHIP is the percentage of closely held shares. ** Significance at the 0.05 level. *** Significance at the 0.01 level.

of mandatory IFRS adoption on mandatory adopters relative to that on voluntary adopters. The significantly negative sum of the coefficients (0.006 + 0.002 = 0.004, p-value = 0.00) suggests a decrease in accrual earnings management practices for mandatory IFRS adopters from the pre- to the post-IFRS adoption period. Voluntary IFRS adopters also experience a decrease in accrual earnings management after 2005 (0.006, t-stat = 1.92). However, the insignificant coefficient of MANDATORY*POST2005 indicates that mandatory IFRS adopters do not experience an incremental decrease in accrual earnings management relative to voluntary adopters. Consistent with prior literature, the presence of a Big 4 auditor seems to restrict accrual earnings management practices. High growth, highly leveraged, smaller, less profitable, and less closely held firms engage in higher accrual-based earnings management (Bagnoli and Watts, 2000; Klein, 2002; Aussenegg et al., 2008; Cohen et al., 2008; Cohen and Zarowin, 2010). Finally, a negative and statistically significant coefficient is found for REAL, indicating that managers use accrual and real earnings management techniques as substitute mechanisms for earnings management (Graham et al., 2005; Zang, 2012; Cohen et al., 2008). Columns (b)–(e) of Table 3 report the results for the impact of mandatory IFRS adoption on real earnings management. With respect to REAL as a dependent variable, the findings suggest that mandatory IFRS adoption has no significant impact on real earnings management. The coefficient on MANDATORY*POST2005 is negative but statistically insignificant. Again, while the findings reflect a negative relationship between accrual and real earnings management, this substitution between accrual and real earnings management is not related to mandatory IFRS adoption. Consistent with prior literature, the presence of a Big 4 auditor has no impact on real earnings management. Highly

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Table 3 First-level analysis of mandatory IFRS adoption on accrual and real earnings management.

(1) MANDATORY (2) POST2005 (3) MANDATORY⁄POST2005 Test of (2) + (3) = 0 [p-value] BIG4 GROWTH

SIZE LEVERAGE ROE OWNERSHIP REAL

(a) ABS_DA

(b) REAL

(c) ABN_CFO

(d) ABN_PROD

(e) ABN_DISX

0.003 (1.10) 0.006* (1.92) 0.002 (0.62) 0.004*** [0.00] 0.007*** (3.40) 0.020*** 0.007 (8.60) 0.005*** (12.18) 0.016*** (5.55) 0.038*** (9.80) 0.000** (2.05) 0.008** (2.44)

0.032*** (2.61) 0.016 (1.41) 0.012 (0.95) 0.004 [0.45] 0.004 (0.34)

0.002 (0.59) 0.007* (1.80) 0.004 (0.91) 0.003* [0.05] 0.003 (1.12)

0.035*** (3.32) 0.009 (0.94) 0.008 (0.80) 0.001 [0.91] 0.001 (0.08)

0.036*** (2.98) 0.003 (0.30) 0.009 (0.75) 0.006 [0.26] 0.018* (1.82)

0.012*** (0.87) 0.012*** (5.26) 0.167*** (11.11) 0.257*** (16.80) 0.000 (1.08)

0.006 (3.63) 0.005*** (7.18) 0.058*** (12.75) 0.133*** (25.44) 0.000 (0.95)

0.067*** (0.85) 0.007*** (3.85) 0.110*** (8.84) 0.126*** (10.14) 0.000 (1.59)

(9.40) 0.003 (1.49) 0.011 (0.91) 0.005 (0.39) 0.000 (0.22)

0.124** (2.43) 0.001 (0.06) Included 12.1% 15,206

0.080*** (3.44) 0.005 (0.70) Included 19.7% 15,206

0.041 (1.07) 0.004 (0.21) Included 6.7% 15,206

0.019 (0.54) 0.054*** (2.58) Included 3.5% 10,238

ABS_DA Intercept Country and industry fixed effects R2 adjusted N

0.070*** (16.09) Included 9.8% 15,206

Table 3 reports the results of the primary analysis examining the impact of mandatory IFRS adoption on accrual and real earnings management. The t-statistics are based on robust standard errors clustered by firm. The table also reports p-values from Wald tests assessing the statistical significance of the sum of two coefficients. MANDATORY is an indicator variable that equals one for firms that did not apply IFRS until it became mandatory; POST2005 is a binary variable that equals one for observations after 2005; MANDATORY⁄POST2005 is an interaction term that equals one for mandatory adopters in the postadoption period. All other variables are defined as in Table 2. * Significance at the 0.10 level. ** Significance at the 0.05 level. *** Significance at the 0.01 level.

leveraged, less profitable, and smaller firms seem to engage more intensively in real earnings management practices. Similar results (columns c to e) emerge for the individual real earnings management proxies (ABN_CFO, ABN_PROD, ABN_DISX), except for ABN_CFO, where an increase (at 10%) for mandatory IFRS adopters is found.27 Overall, the results in Table 3 provide some evidence of a decrease in accrual-based earnings management between the pre- and the post-mandatory IFRS adoption periods and no significant impact on real earnings management. However, the decrease in accrual-based earnings management for mandatory adopters is not significantly different from the concurrent decrease for voluntary adopters, suggesting that this finding cannot be solely attributed to mandatory IFRS adoption. This finding is consistent with Wang et al. (2008), who find an improvement in the analyst forecast characteristics and the information content of earnings announcements for mandatory adopters but not incremental to that for voluntary adopters. Daske et al. (2008) point out that the liquidity improvement for 27 However, the increase in sales manipulation disappears when I separately examine high and low law enforcement regimes (subsequent analysis).

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voluntary adopters after the IFRS mandate could be attributed to network effects that result from increased comparability. Although spillover or network effects could be present in capital market effects (valuation, liquidity, cost of capital, analyst forecasts, etc.), it seems to be more difficult to attribute network effects to earnings management practices. For voluntary adopters, mandatory IFRS adoption does not imply a substantial change in their accounting practice. Although one cannot rule out a role for mandatory IFRS adoption, concurrent changes in the enforcement and regulation environment around mandatory IFRS adoption (e.g., FSAP) may play a role in the decrease in accruals earnings management for both mandatory and voluntary adopters.28 Prior literature suggests that the impact of mandatory IFRS adoption may depend not only on the quality of the accounting standards, but also on the country’s legal and institutional characteristics (Ball et al., 2003; Daske et al., 2008; Li, 2010; Shima and Gordon, 2011; Ahmed et al., forthcoming). To explore the role of legal enforcement, I use the rule of law variable for 2005 (Kaufmann et al., 2007). Higher values of rule of law indicate a stronger enforcement environment. Following prior literature (Daske et al., 2008; Byard et al., 2011a; Li, 2010), I consider a country to have high (low) legal enforcement if the country’s score for 2005 is above (below) the median of the total sample. I then repeat the previous analysis separately for high and low law enforcement countries. Table 4 presents the empirical findings for this second level of analysis. Results show that mandatory adopters domiciled in low law enforcement countries experience a decrease in accrual-based earnings management (0.004, p-value = 0.00). However, the decrease is not incremental to that of the voluntary adopters (0.004, t-stat = 0.57). All control variables are consistent with the previous analysis. As in the primary analysis, mandatory IFRS adoption has no significant impact on real earnings management for either high or low law enforcement countries. This finding also holds for the individual real earnings management proxies (untabulated). Again, consistent with prior literature, the negative coefficient on ABS_DA suggests a substitution effect between accrual and real earnings management practices. However, it seems to be a firm-level effect that is independent of mandatory IFRS adoption. In other words, firms seem to substitute accrual with real earnings management practices when they face limited accounting flexibility. However, this limited accounting flexibility seems to be associated with prior accrual manipulation and not with mandatory IFRS adoption. Although the decrease in accrual-based earnings management for low law enforcement countries seems to be counter-intuitive (Daske et al., 2008; Li, 2010), a number of prior studies report similar results. Biddle et al. (2013) provide evidence consistent with an increase in capital investment efficiency following mandatory IFRS adoption only for countries with weak legal and regulatory environments. Similarly, Schleicher et al. (2010) find that IFRS reduces the investment–cash flow sensitivity of insider economies more than that of outsider economies. Finally, Christensen et al. (2012) provide evidence inconsistent with the interpretation that IFRS adoption has positive capital-market effects as long as it is introduced in countries with high levels of enforcement and strong institutions. Their results point to the role of concurrent enforcement changes in the EU. However, these results are not totally inconsistent with a role for the accounting standards. In particular, Ding et al. (2007) conclude that the ‘‘absence’’ (i.e., the extent to which the rules regarding certain accounting issues are missing in Domestic Accounting Standards but are covered in IAS) creates an opportunity for more earnings management. Countries that rank high in terms of the ‘‘absence’’ score belong to the low law enforcement group (e.g. Greece, Portugal, Spain, Italy, Belgium, and France), whereas countries that rank quite low in terms of the ‘‘absence’’ belong to the high law enforcement group (e.g., Germany, Sweden, the Netherlands, and Norway). This result might suggest that low law enforcement countries with a high level of ‘‘absence’’ under local GAAP engaging significantly in accrual earnings management experience a decrease in accrual-based earnings management

28 In addition to the IFRS regulation, the Financial Services Action Plan (FSAP) brought a number of other legislative initiatives aiming to improve the capital markets by enhancing the enforcement and governance regimes (Transparency Directive, Prospectus Directive, Statutory Audit Recommendation, Market Abuse Directive, etc.). All of these directives were implemented over the 2004–2009 period. For example, the Transparency Directive was implemented in 2007 and established disclosure requirements on an ongoing basis, imposed the responsibility statement on the contents of the reports, and generally aimed to facilitate IFRS compliance (Hail and Leuz, 2007; Wang et al., 2008).

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Table 4 Second-level analysis of mandatory IFRS adoption on accrual and real earnings management. ABS_DA

(1) MANDATORY (2) POST2005 (3) MANDATORY⁄POST2005 Test of (2) + (3) = 0 [p-value] BIG4 GROWTH SIZE LEVERAGE ROE OWNERSHIP REAL

REAL

HIGH ENFORCEMENT

LOW ENFORCEMENT

HIGH ENFORCEMENT

LOW ENFORCEMENT

0.006* (1.68) 0.006* (1.82) 0.003 (0.90) 0.002 [0.21] 0.004 (1.39) 0.016*** (4.67) 0.005*** (8.97) 0.012** (2.50) 0.034*** (5.64) 0.000*** (2.67) 0.009* (1.70)

0.003 (0.61) 0.009 (1.19) 0.004 (0.57) 0.004*** [0.00] 0.008*** (3.26) 0.023*** (7.23) 0.004*** (8.31) 0.018*** (5.18) 0.041*** (8.09) 0.000 (0.57) 0.008* (1.94)

0.012 (0.76) 0.012 (1.03) 0.015 (1.04) 0.003 [0.75] 0.016 (0.93) 0.023** (2.04) 0.014*** (4.13) 0.145*** (6.66) 0.276*** (12.83) 0.000 (0.55)

0.086*** (2.78) 0.051 (1.30) 0.049 (1.24) 0.002 [0.79] 0.014 (0.90) 0.006 (0.52) 0.013*** (4.19) 0.172*** (8.28) 0.229*** (11.10) 0.000 (0.80)

0.136* (1.93) 0.057 (1.31) Included 12.9% 8,743

0.073*** (12.18) Included

0.068*** (9.42) Included

0.121* (1.70) 0.053* (1.71) Included

9.2% 6,463

10.6% 8,743

15.0% 6,463

ABS_DA Intercept Country and industry fixed effects R2 adjusted N

Table 4 reports the results of the second-level analysis examining the impact of mandatory IFRS adoption on accrual and real earnings management across high- and low- law enforcement regimes. The distinction between high and low law enforcement regimes is based on the Kaufmann et al. (2007) rule of law variable for the year 2005. I consider a country to have high (low) legal enforcement if the country’s score for 2005 is above (below) the median of the total sample. The t-statistics are based on robust standard errors clustered by firm. The table also reports p-values from Wald tests assessing the statistical significance of the sum of two coefficients. All variables are defined as in Table 2. * Significance at the 0.10 level. ** Significance at the 0.05 level. *** Significance at the 0.01 level.

following mandatory IFRS adoption. This effect is also consistent with the Leuz et al. (2003) ranking, in which low law enforcement countries score quite high in terms of earnings management. Similarly, Aussenegg et al. (2008) find that the United Kingdom, Ireland, and the northern European countries already characterized by lower earnings management levels exhibit no difference between IFRS and domestic GAAP. In other words, countries with better reporting behavior before mandatory IFRS adoption should experience smaller changes in their reporting behavior, whereas countries with weaker reporting practices before mandatory IFRS adoption might experience an improvement in their financial reporting quality. 6.2. Suspect firm-years analysis The above analysis is based on a generic set of firms that mandatorily adopted IFRS. However, these firms may or may not have strong incentives to manage earnings, either through accruals or through real earnings management. To increase the power of the tests to detect earnings management practices, I perform a cross-sectional analysis using a sub-sample of firms with relatively strong incentives

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to manage earnings.29 This type of analysis allows some preliminary conclusions with respect to the relative importance of firm-level incentives versus accounting standards in influencing firms’ level of earnings management.30 In other words, if accounting standards play a prominent role in determining financial reporting quality and IFRS limit management’s opportunistic discretion in determining accounting amounts, then a decrease in accrual earnings management should be apparent even for firms with strong earnings management incentives. If so, firms may switch to real earnings management practices. If, on the other hand, accrual earnings management remains unchanged for the suspect firm-years, accounting standards are not the primary factor that influences financial reporting quality. Prior studies suggest that firm-years with earnings right at or just above benchmarks are likely to manage earnings to meet these important thresholds (Burgstahler and Dichev, 1997; Degeorge et al., 1999; Bartov et al., 2002). I create a range of firm-years with strong firm-level incentives for earnings management.31 First, I focus on firm-years with small positive earnings (SPOS), defined as firm-years that report net income over lagged total assets higher than or equal to zero but less than 0.005. Second, I create a small positive earnings changes sample (SCHA) that includes firm-years with change in net income over lagged total assets higher than or equal to zero but less than 0.005.32 According to prior literature, both groups of firms are likely to manage their earnings to report income marginally above zero. Third, I focus on firms that have a seasoned equity offering (SEO), defined as firm-years that fall in the fourth quartile of the percentage change of common stock. Prior literature provides evidence consistent with upwards earnings manipulation prior to the stock issue. I then concentrate on highly leveraged firms (DEBT), defined as firm-years that fall in the fourth quartile of the ratio of total debt over lagged total assets. Highly leveraged firms have strong incentives to engage in both accrual and real earnings management to avoid debt covenant violation. Finally, newly listed (IPO) firms may face stronger earnings management incentives compared to more mature and well established firms in an attempt to survive and maintain a record of growth. This argument is consistent with the evidence that many firms are subject to SEC enforcement actions because of financial statement manipulation shortly after their initial public offerings (Beneish, 1997). The IPO sample includes observations falling into the first quartile of the differences between the current year and the year the firm first had its record on Datastream. Table 5 presents the empirical findings for the suspect firm-years analysis. Firms with strong earnings management incentives do not decrease the level of accrual earnings management in the postIFRS adoption period. For newly listed firms, the findings even suggest a significant increase in accrual earnings management. As far as real earnings management practices are concerned, the results suggest no significant impact following mandatory IFRS adoption. Another notable finding is the lack of a significant negative relationship (except for IPO) between accrual-based and real earnings management practices. These results provide some preliminary evidence on the important role of firm-level incentives in earnings management practices. In other words, the findings suggest that firms with strong incentives to meet certain earnings targets engage in either type of earnings management both before and after mandatory IFRS adoption.33

7. Robustness tests I conduct a series of robustness checks. First, Barton and Simko (2002), Ewert and Wagenhofer (2005), and Zang (2012) argue that firms with limited accruals management flexibility are more likely to use real earnings management. To proxy for limited accounting flexibility due to prior overuse of accruals, I use the lagged net operating assets scaled by lagged sales in the real earnings management 29

I am grateful to the reviewer for suggesting this type of analysis. Among others, Roychowdhury (2006), Cohen and Zarowin (2010), and Zang (2012) focus on suspect firm-years observations. The implicit assumption of this cross-sectional analysis is that the firm-level incentives remain constant across the pre- and post-IFRS adoption periods. 32 The results are robust to alternative cut-off points for SPOS and SCHA (e.g. 0.010, 0.020). 33 The role of accounting standards versus the role of firm-level incentives on earnings management activities is a timely and interesting research question that goes beyond the focus of this study. This study provides some preliminary evidence that should be interpreted with caution. Future research could explore this issue further. 30

31

568

Table 5 Suspect-firm-years analysis. SPOS

(1) MANDATORY (2) POST2005 (3) MANDATORY⁄POST2005 Test of (2) + (3) = 0 [p-value]

GROWTH SIZE LEVERAGE ROE OWNERSHIP REAL

DEBT

IPO

ABS_DA

REAL

ABS_DA

REAL

ABS_DA

REAL

ABS_DA

REAL

ABS_DA

REAL

0.003 (0.43) 0.005 0.5 0.01 (0.90) 0.005 [0.24] 0.010** (2.11) 0.032*** 2.84 0.002** (2.25) 0.020* 1.65 0.073 0.78 0.000*** (3.12) 0.002 (0.20)

0.016 0.55 0.019 (0.43) 0.005 (0.11) 0.024 [0.27] 0.008 (0.27) 0.036 (0.85) 0.01 (1.50) 0.112** 2.04 1.459** (2.03) 0 0.35

0.005 (1.11) 0.005 (0.88) 0.001 0.19 0.004 [0.12] 0.002 (0.58) 0.019** 2.13 0.004*** (6.04) 0.024*** 3.1 0.003 (0.20) 0 (1.63) 0.004 0.48

0.049* 1.91 0.042* 1.68 0.04 (1.41) 0.002 [0.86] 0.003 0.15 0.023 (0.65) 0.016*** (3.27) 0.245*** 6.68 0.437*** (5.88) 0.001** 2.06

0.002 (0.35) 0.006 (0.96) 0.003 0.39 0.004 [0.15] 0.013*** (3.21) 0.024*** 6.55 0.006*** (7.32) 0.022*** 4.7 0.031*** (5.43) 0 (0.28) 0.005 0.92

0.053*** 2.79 0.023 1.27 0.007 (0.34) 0.016 [0.12] 0.012 (0.69) 0.004 0.31 0.012*** (3.65) 0.100*** 5.09 0.225*** (11.84) 0 (0.93)

0.001 0.17 0.001 (0.23) 0.001 (0.21) 0.003 [0.19] 0.006 (1.61) 0.012*** 3.28 0.004*** (7.43) 0.058*** 9.65 0.012** (1.96) 0 (1.39) 0.008 1.11

0.022 1.19 0.001 (0.05) 0.009 (0.45) 0.01 [0.26] 0.008 (0.52) 0.007 0.53 0.010*** (3.68) 0.052** 2.36 0.132*** (5.46) 0.001** 2.51

0.007 (1.44) 0.017** (2.56) 0.013* 1.9 0.003 [0.25] 0.007* (1.95) 0.020*** 5.54 0.005*** (6.47) 0.025*** 5.21 0.053*** (9.01) 0 (1.49) 0.020*** (3.86)

0.044** 2.29 0.003 (0.11) 0.003 0.11 0 [0.99] 0.02 (1.17) 0.027** 2.14 0.013*** (3.10) 0.153*** 6.75 0.325*** (14.02) 0 0.33

ABS_DA

Country and industry

0.071*** 5.15 Included

Fixed effects R2 adjusted N

12.00% 467

Intercept

SEO

0.07 (0.20) 0.091 1.31 Included 5.70%

0.050*** 5.61 Included 8.30% 1280

0.107 0.48 0.029 (0.58) Included 19.20%

0.079*** 8.89 Included 12.20% 4016

0.071 0.92 0.058* 1.76 Included 11.90%

0.032*** 3.76 Included 12.70% 3804

0.117 1.12 0.049 1.49 Included 8.20%

0.075*** 9.44 Included 12.90% 4454

0.290*** (3.80) 0.017 0.46 Included 16.40%

Table 5 presents the results for the suspect firmyears analysis. SPOS sample includes observations with small positive earnings defined as 0 6 Net Incomet/Total Assetst1 < 0.005; SCHA sample includes observations with small positive earnings changes defined as 0 6 (Net Incomet  Net Incomet1)/Total Assetst1 < 0.005; SEO sample includes observations falling in the fourth quartile of (Common Stockt  Common Stockt1)/Common Stockt1; DEBT sample includes observations falling in the fourth quartile of Total Debtt/Total Assetst1; IPO sample includes observations falling in the first quartile of the differences between the current year and the year that the firm had its first record on DataStream; The t-statistics are based on robust standard errors clustered by firm. The table also reports p-values from Wald tests assessing the statistical significance of the sum of two coefficients. All variables are defined as in Table 2. * Significance at the 0.10 level. ** Significance at the 0.05 level. *** Significance at the 0.01 level.

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BIG4

SCHA

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569

model. Consistent with prior literature, limited accounting flexibility is positively related to real earnings management practices. Second, three countries – the United Kingdom, France, and Germany – seem to dominate the test and control samples. I repeat the analysis after excluding observations from these countries. Similarly, I exclude mandatory countries with no pre-2005 observations (Cyprus, Lithuania, and Luxembourg), non-EU countries (Norway, Switzerland) and countries that have mandatory but no voluntary observations. Third, to account for the possibility that the empirical results are driven by the recent financial crisis, I exclude all observations after 2008. Finally, following Francis and Wang (2008) and Hribar and Nichols (2007), I replace the absolute discretionary accruals (ABS_DA) with signed discretionary accruals. In all cases, inferences remain unchanged. 8. Conclusion and discussion This study examines the effect of mandatory IFRS adoption on earnings management using a sample of European firms that mandatorily adopted IFRS in 2005. Prior literature has investigated the impact of mandatory IFRS adoption on accrual-based earnings management. However, recent literature notes that to meet certain financial reporting goals, managers engage in real earnings management. The present study contributes to the literature by investigating the impact of mandatory IFRS adoption on both accrual and real earnings management, allowing for a more thorough and comprehensive understanding on whether the mix of earnings management strategies has changed after the mandatory IFRS adoption. The study employs a control sample of voluntary IFRS adopters and uses a differences-in-differences design that controls for contemporaneous changes in the economic environment that may have an impact on the earnings management behavior of firms and that are unrelated to mandatory IFRS adoption. The empirical findings suggest that mandatory IFRS adoption had no significant impact on the level of accrual and real earnings management. Additional analysis on a range of suspect firm-years observations with relatively strong earnings management incentives confirms the lack of a significant impact on accrual and real earnings management and points to the important role that firm-level incentives play in shaping earnings management behavior. This study is subject to several caveats. First, although the main focus of the study is the impact of mandatory IFRS adoption on real and accrual-based earnings management, managers might apply other earnings management techniques. For instance, Athanasakou et al. (2009) provide evidence suggesting that in the attempt to meet analyst forecasts firms in the United Kingdom are more likely to engage in classification shifting or expectations management than to manage accruals or real transactions. Second, the findings of the study should be interpreted with caution. The study fails to reject the null hypothesis that mandatory IFRS adoption has no effect on accrual-based and real earnings management. However, this finding does not rule out the existence of a difference in reality. Quite possibly the insufficiency of evidence to reject the null hypothesis may be due to the sample used, the methodology, the proxies for accrual-based and real earnings management, the time period, the empirical setting, and so on. Although the choice of a control sample consisting of voluntary adopters has many advantages (such as similar institutional characteristics, regulatory homogeneity, and similar economic shocks), the selection of a control sample is not infallible, and as prior literature suggests, results may vary depending on the control sample used. Finally, the real earnings management identification techniques employed in this study may be subject to the same criticism as regression-based accrual earnings management techniques (e.g. lack of power, correlated omitted variables, misspecification when applied to sample of firms with extreme financial performance, etc.). However, despite their weaknesses, they seem to be a suitable methodology for examining this type of research question. Acknowledgments I appreciate helpful comments and suggestions from two anonymous reviewers, Seraina Anagnostopoulou, Vasiliki Athanasakou, Michael Burkert, Vassilis Eftymiou, Dimitrios C. Ghicas (thesis

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advisor), Frederic Imhof, Peter Kroos, Alexis H. Kunz, Afroditi Papadaki, Georgia Siougle, Karl Schuhmacher, David Veenman and Sander van Triest. I also thank seminar participants at Amsterdam Business School, HEC Lausanne and congress participants at the 34th EAA Annual Congress (2011) and the 7th Accounting Research Workshop (2011) for valuable comments. I am also thankful to Grigorios Anagnostopoulos for excellent research assistance.

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