The Effect of IFRS Adoption on Real Earnings Management
Asian Tax Journal Vol. 16 No. 5 (2015), pp. 65-110
Abstract
This paper examines the effect of mandatory adoption of International Financial Reporting Standards (IFRS) on the real earnings management. This paper also examines whether firms substitute accrual-based earnings management and real earnings management once after the IFRS adoption becomes mandatory. Furthermore, additional analysis 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. Recent literature notes that to meet certain financial reporting goals, managers engage in real earnings management. While prior literature has mainly examined the effects of IFRS adoption on accrual-based earnings management, scarcely study to date has focused on the impact of IFRS adoption on real earnings management. Regulators expect the IFRS to enhance the comparability of financial statements, improve accounting transparency, and raise the quality of financial reporting. 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 Generally Accepted Accounting Principles (hereafter K-GAAP), would lead to a decrease 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. 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 real earnings management and accrual-based earnings management. In this respect, this study allows for a broader and more comprehensive understanding of the possible impact of IFRS adoption on real earnings management. In the regard, this study selected total 6,759 firm-year from 2008 to 2013 (pre-IFRS in 2008-2010 and post-IFRS in 2011-2013) as the samples, targeting non-financial companies of December 31 fiscal year-end listed on the KOSPI and KOSDAQ market. As in Roychowdhury (2006), this study uses the abnormal levels of cash flow from operation (ACFO), the abnormal level of production costs (APROD) and the abnormal level of discretionary expenses (ASGA) to capture the effects of real earnings management through all these three activities in a comprehensive measure, I construct an overall real earnings management proxy by summing ACFO, APROD, and ASGA. The empirical results are based on both the aggregate real earnings management measure and the individual real earnings management proxies. This study also uses the performance-adjusted model to calculate discretionary accruals (accrual-based earnings management) as described by Kothari et al. (2005). The empirical results of this study are as follows. First, in comparisons between pre- and post-IFRS adoptions, the average absolute value of real earnings management were significantly decreased after the adoption of IFRS. Besides, the average absolute value of discretionary accruals were significantly decreased after the adoption of IFRS. This results imply that the adoption of IFRS decreases opportunistic earnings management, there is evidence of an increase in earnings quality. Consequently, 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. Second, this paper do not find evidence that the switch from accrual-based to real earnings management activities. In other words, this paper find a decrease in real earnings management after the mandatory IFRS adoption, but rather a contemporaneous decrease in accrual-based earnings management. Finally, additional analysis on a range of suspect firm-years observations with relatively strong earnings management incentives confirms the lack of a significant impact on real earnings management and points to the important role that firm-level incentives play in shaping earnings management behavior. This study contributes to the literature by investigating the impact of mandatory IFRS adoption on both real earnings management and accrual-based 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. Therefore, empirical findings of this study may contribute to the extant literature by providing additional evidences that can be used for the understanding of the association between IFRS adoption and earnings quality. These practical implications may shed a light on the effect of change in accounting standard and accounting environment, which may benefit the standard-setters and policymakers for their decision on accounting standards. Thus, these findings are very useful and provide a lot of important implications to regulators, standard-setters and investors that are interested in earnings quality after the adoption of IFRS. Academics can also apply the discussion in this paper for related researches.
Keywords
- IFRS
- Real earnings management
- Accrual-based earnings management
- Substitution effect
- Incentive to increase reported earnings
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