the effect of mandatory ifrs adoption on real and accrual-based earnings management activities

J. Account. Public Policy xxx (2014) xxx–xxx

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J. Account. Public Policy

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The effect of mandatory IFRS adoption on realand accrual-based earnings managementactivities

http://dx.doi.org/10.1016/j.jaccpubpol.2014.08.0060278-4254/� 2014 Elsevier Inc. All rights reserved.

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Please cite this article in press as: Doukakis, L.C. The effect of mandatory IFRS adoption on real and accruaearnings management activities. J. Account. Public Policy (2014), http://dx.doi.org/10.1016/j.jaccpubpol.2014

Leonidas C. DoukakisHEC Lausanne, University of Lausanne, Switzerland

a b s t r a c t

This study examines the effect of mandatory adoption of Interna-tional Financial Reporting Standards (IFRS) on both accrual-basedand real earnings management. While prior literature has mainlyexamined the effects of IFRS adoption on accrual-based earningsmanagement, no study to date has focused on the impact of IFRSadoption on real earnings management. Using a sample of 15,206observations from 22 European countries between 2000 and2010, this study employs a control sample of voluntary adoptersand applies a differences-in-differences design to control for con-founding concurrent events. The results suggest that mandatoryIFRS adoption had no significant impact on either real or accrual-based earnings management practices. Additional analysis on asub-sample of firms with relatively strong earnings managementincentives supports a dominant role for firm-level reporting incen-tives over accounting standards in shaping financial reportingquality.

� 2014 Elsevier Inc. All rights reserved.

1. Introduction

The adoption of International Financial Reporting Standards (IFRS) is the most significantregulatory change in financial reporting worldwide in the last 30 years. Since 2005, all companieslisted on EU stock exchanges have been required to prepare their consolidated financial statements

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2 L.C. Doukakis / J. Account. Public Policy xxx (2014) xxx–xxx

in accordance with IFRS.1 IFRS adoption in the EU was part of a broader initiative (the FinancialServices Action Plan, or FSAP), launched in the late 1990s with the aim of improving capitalmarkets through increased financial disclosure, increased enforcement and improved governanceregimes.2

Regulators expect the IFRS to enhance the comparability of financial statements, improve corporatetransparency, and raise the quality of financial reporting (EC Regulation No. 1606/2002). Financialreporting quality should increase if the adoption of IFRS limits management’s opportunistic discretionin determining accounting amounts. If so, IFRS which are of higher quality than local GenerallyAccepted 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 doso. This suggests that IFRS may not be optimal for mandatory adopters and thus they may have no incen-tive to rigorously apply IFRS. If so, they may apply IFRS as they did their old national GAAPs with no sub-stantial change in their accounting practice. Prior literature underscores the potential role of firm-levelincentives as well as the role of institutional factors in determining accounting quality. Finally, the inher-ent flexibility allowed under principles-based standards together with lax enforcement of IFRS may evenlead to an increase in earnings management practices. These arguments suggest that the impact of man-datory IFRS adoption on earnings management is an open empirical issue that warrants furtherinvestigation.

Recent research has pointed to the importance of understanding how firms manage earningsthrough 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 manage-ment. This study aims to fill the gap in the IFRS and earnings management literature by examiningthe impact of mandatory IFRS adoption on earnings management and, more precisely, on bothaccrual-based and real earnings management. In this respect, this study allows for a broader andmore comprehensive understanding of the possible impact of IFRS adoption on earningsmanagement.

The study is based on a broad sample of 15,206 firm-year observations of available data from22 countries that mandatorily adopted IFRS in 2005. I use a differences-in-differences design toinvestigate changes in earnings management activities between the pre- versus post-mandatoryadoption periods for mandatory adopters relative to a control sample of voluntary adopters overthe same period. The results suggest that mandatory IFRS adoption had no significant impact onthe level of accrual-based and real earnings management. Additional analysis of firms with rela-tively strong earnings management incentives confirms the lack of significant impact on accrualand real earnings management and points to the important role that firm-level incentives playin shaping earnings management behavior.

This study contributes to the mandatory IFRS adoption and earnings management literature in sev-eral respects. First, this is the first study to provide a broad examination of the impact of mandatoryIFRS 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 specificallytest 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 fulllist 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 ActionPlan and the study carried out by the Economic and Monetary Affairs Division (2009) of the European Parliament for an assessmentof the 10 years of FSAP.

3 IFRS are more detailed, require more disclosures, allow fewer options and are broader in scope compared to many nationalaccounting standards.

4 In particular, DeFond (2010, p. 406) states that ‘‘an area of the earnings quality literature that seems relatively under-researched is so-called ‘real activities’ manipulation, or ‘transaction’ management . . . compared to the research that investigatesaccruals-based earnings management, research on activities management is scarce.’’ Examination of real earnings management iscritical, because while accrual-based earnings management activities have no direct cash flow consequences, real earningsmanagement does affect cash flows.

Please cite this article in press as: Doukakis, L.C. The effect of mandatory IFRS adoption on real and accrual-basedearnings management activities. J. Account. Public Policy (2014), http://dx.doi.org/10.1016/j.jaccpubpol.2014.08.006

http://www.iasplus.com/country/useias.htm


L.C. Doukakis / J. Account. Public Policy xxx (2014) xxx–xxx 3

regulatory change.5 The present study, therefore, allows for a more comprehensive understanding of theimpact of mandatory IFRS adoption on earnings management. Second, by employing a sub-sample offirms with relatively strong earnings management incentives, the present study complements priorempirical studies that point to the second-order role of standards and suggests the primary role offirm-level reporting incentives in affecting financial reporting quality. Finally, the study provides someindirect 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 assessingwhether mandatory IFRS adoption has accomplished its stated objective of improving accountingquality. The findings of the study do not imply that standards are irrelevant, but rather that other fac-tors also influence earnings management practices. Furthermore, although mandatory IFRS adoptiondoes not seem to materially affect earnings management, there are indications that concurrentregulatory changes (other legislative initiatives implemented under the FSAP) might play a role inenhancing 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 manda-tory IFRS adoption, and to investors and analysts who seek to understand the effects of mandatoryIFRS adoption on accounting numbers.

The remainder of the paper is organized as follows. Section 2 reviews prior literature focusing onmandatory IFRS adoption and earnings management, and on real activities manipulation. Section 3develops the empirical hypotheses, while Section 4 discusses the methodology. Section 5 describesthe 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-adoptionperiods for voluntary and mandatory IFRS adopters in Germany and find that income smoothingdecreased significantly under voluntary but not under mandatory IFRS adoption. They suggest thatmandatory adopters might perceive fewer benefits from a shareholder-oriented set of accountingstandards (i.e. IFRS) and thus avoid the costs of transferring to IFRS. On the other hand, Capkunet al. (2012) report an increase in earnings management from pre-2005 to post-2005 for early and latevoluntary adopters in countries that allowed early IFRS adoption, and for mandatory adopters in coun-tries that did not allow early IFRS adoption. Similarly, Ahmed et al. (forthcoming) provide evidencesuggesting that after mandatory IFRS adoption, income smoothing and accrual aggressiveness increasewhile timeliness of loss recognition decreases. Quite surprisingly, the decline in accounting quality ismore pronounced for countries with strong law enforcement. Capkun et al. (2012) argue that IFRSchanged significantly from 2003 to 2005, allowing managers greater flexibility and discretion. Theyconclude that these changes explain the contradictory results of Barth et al. (2008) for voluntaryand 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 adecrease in earnings management toward a target, a decrease in absolute discretionary accruals, and adecrease in the standard deviation of unexplained accruals. On the other hand, they also find anincrease 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 ofmandatory IFRS adoption on real and accrual earnings management, whereas Ahmed et al. (2013) study the effect of mandatoryIFRS adoption on income smoothing, reporting aggressiveness, and accrual earnings management to meet or beat a target. Capkunet al. (2012) investigate self-selection and accounting standards changes as potential reasons for the conflicting results on incomesmoothing between voluntary and mandatory IFRS adopters. They suggest that the greater flexibility allowed by the changes inIFRS between 2003 and 2005 explains the contradictory results between voluntary and mandatory IFRS adopters. Second, Ahmedet al. (2013) examine only two years of post-adoption data, whereas the present study extends to 2010, enhancing thegeneralizability of the results. Third, Ahmed et al. (2013) employ a control sample of non-adopters whereas the present study usesvoluntary adopters as a control. Voluntary adopters have the same institutional and governance characteristics and face the samechanges in economic environment over the sample period, making them a more suitable control sample (Li, 2010).




Aussenegg et al. (2008), analyzing 17 European countries, observe that Central European firms thatapply IFRS experience less earnings management than firms that apply domestic standards. TheUnited Kingdom, Ireland, and Northern European countries, already characterized by lower earningsmanagement levels, exhibit no difference between IFRS and domestic GAAP.

Jeanjean and Stolowy (2008) investigate the effect of mandatory adoption of IFRS on earnings man-agement by examining 1146 firm-year observations from Australia, France, and the United Kingdomfrom 2005 to 2006. They report that earnings management in these countries did not decline aftermandatory adoption of IFRS, and even increased in France. They conclude that sharing rules is not asufficient condition to create a common business language, and that management incentives andnational institutional factors play an important role in framing financial reporting characteristics.Similarly, Paananen (2008) provides evidence consistent with a decrease in financial reporting qualityfollowing the adoption of IFRS in Sweden.

Overall, the findings on the effects of mandatory IFRS adoption on earnings management are mixedand focus on accrual-based earnings management. No study to date examines the impact of manda-tory IFRS adoption on real earnings management. In this respect, prior literature provides limited evi-dence on the impact of mandatory IFRS adoption on earnings management. This study intends to fill inthis gap by providing a broad and comprehensive examination of whether earnings managementchanged around mandatory IFRS adoption. In addition, the present study uses a larger sample, morecountries, and more years following adoption, providing stronger evidence regarding the overall levelof 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 tomanipulate 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 managersprefer real earnings management practices to accrual-based earnings management. Results of earlierstudies (Thomas and Zhang, 2002; Baber et al., 1991; Bens et al., 2002) indicate that managers overpro-duce to decrease cost of goods sold and cut research and development expenses and capital expendituresto meet specific earnings targets. Roychowdhury (2006) develops empirical measures to proxy for realearnings management and shows that managers avoid reporting losses by engaging in real activitiesmanagement. Zang (2012) examines the trade-off between accrual-based and real earnings manage-ment. She suggests that the real earnings management decision precedes the decision to manageearnings through accruals, and that the two earnings management strategies act as substitutes sinceaccrual-based and real manipulations are negatively correlated.

Findings of Gunny (2010) and Zhao et al. (2012) suggest that firm-years with abnormal real activ-ities intended to just meet earnings benchmarks have better subsequent performance. However, Zhaoet al. (2012) find that abnormal real activities in the absence of just meeting earnings targets are neg-atively associated with firms’ future performance. Cohen and Zarowin (2010) show that firms engagein real earnings management following a seasoned equity offering (SEO), and the decline in post-SEOperformance due to real earnings management is more severe than that due to accrual-based earningsmanagement. Finally, Cohen et al. (2008) show that since the passage of the Sarbanes-Oxley Actmanagers 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 bothpositive and negative potential effects on earnings management practices as well as reasons to expectnegligible 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 actionsthat deviate from normal business practices, undertaken with the primary objective of meeting certain earnings thresholds.’’




3.1. Disincentive argument

Regulators expect the use of IFRS to enhance the comparability of financial statements, improvecorporate 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 evaluateaccounting quality and to compare different accounting choices and assumptions among firms andacross countries. This result may act as a disincentive for managers to engage in accrual earnings man-agement 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 whichthe rules regarding certain accounting issues are missing in Domestic Accounting Standards but arecovered in IAS) is positively related to earnings management, IFRS adoption will result in lower levelsof earnings management. In addition, reduced reporting discretion (Ewert and Wagenhofer, 2005), incombination with higher disclosure requirements under IFRS, might narrow the room to exercisejudgment 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 opportunis-tically apply IFRS to achieve the desired reporting goals. Furthermore, firms with no incentives toadopt IFRS may respond to mandatory compliance with a ‘‘tick-box’’ mentality, rather than with sin-cere 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 stan-dards, 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 todiffer across firms as long as accounting standards offer some discretion and firms have differentreporting incentives (Leuz, 2006).

Moreover, the inherent flexibility allowed under principles-based standards (IFRS) could providegreater opportunity for earnings management relative to rules-based domestic standards.7 Nelson(2003) provides experimental and survey evidence suggesting that imprecise standards create difficultyfor auditors in constraining managers’ aggressive reporting behavior. Similarly, a single set of standardsmight not be as effective as nationally developed standards in accommodating differences in institu-tional characteristics (Ball et al., 2003; Ball, 2006; Jeanjean and Stolowy, 2008), and firms may have trou-ble communicating useful information to investors, leading them to choose aggressive reportingpractices.

3.3. Institutional features

Recent literature underlines the role of national institutional features and concludes that account-ing 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 complexinteraction of cultural, historical, economic, and institutional factors. According to Ball (2006), power-ful local economic and political forces determine how managers, auditors, courts, regulators and otherparties influence the implementation of rules. These forces have exerted a substantial influence onfinancial 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 practicesmay be limited relative to the effects of other forces, such as managers’ incentives, audit quality,ownership structure, corporate governance provisions, enforcement, regulation, and the litigationenvironment. 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.8 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 greatextent on the exercise of professional judgment or discretion rather than on the accounting standards per se.




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 openempirical question and a subject of debate among academics and practitioners. The above argumentslead 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 managementpractices.

3.4. Substitution argument

Examining the impact of mandatory IFRS adoption on accrual-based earnings management wouldprovide only a partial picture of the impact of this regulatory change. As Cohen et al. (2008) argue, evi-dence of a decline in one type of earnings management may lead to the conclusion that such activitieshave decreased in response to regulators or other events, when in fact a substitution of one earningsmanagement method for another has occurred. Cohen and Zarowin (2010) and Gunny (2010) provideseveral 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 andlitigation. Second, a firm’s business operations and prior years’ accruals manipulation may constrainflexibility to engage in accrual earnings management. Third, accrual accounting choices are subjectto 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 earningsmanagement, it may also have an impact on real earnings management. However, the real earnings man-agement decision precedes the decision to manage earnings through accruals (Zang, 2012), suggestingthat 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 IFRSadoption may conceivably have a direct effect on real earnings management through increased trans-parency.10 Hirst and Hopkins (1998) and Jo and Kim (2007) suggest that more transparent disclosureslead to greater detection of and lower incentives for earnings management. Even if real earningsmanagement is more difficult to detect, the increased level of disclosure under IFRS may enable capitalmarket authorities, analysts, and investors to more easily identify actions that deviate from normalbusiness practices.

3.6. Institutional ownership argument

Recent literature also provides evidence consistent with an increase in foreign institutional equityownership 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 presenceof sophisticated institutional investors as well as a higher analyst following may deter managers fromengaging in real earnings management. Bushee (1998) and Roychowdhury (2006) provide empiricalevidence suggesting that the presence of institutional investors creates disincentives for managersto engage in real earnings management.

9 Although real earnings management activities can be indistinguishable from optimal business decisions, and thus are lessvulnerable 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 businessenvironment. Recent literature documents capital market effects associated with IFRS adoption. For instance, IFRS adoption isexpected 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 foreigndirect 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).




3.7. Increased marginal benefit argument

Finally, tighter (i.e. fewer options, more disclosures, etc.) accounting standards can increaseaccounting quality measured by higher earnings variability and higher value relevance of reportedearnings figures. As a result, the marginal benefit of earnings management rises and managers mayincrease real earnings management, which is costly and directly reduces firm value (Ewert andWagenhofer, 2005). This line of reasoning suggests that mandatory IFRS adoption may have a directimpact (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 earningsmanagement.11 The flexibility afforded by accrual accounting makes the accrual component of earningsless 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 manage-ment 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 discre-tionary 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 evidenceindicating that the modified Jones model is more powerful at detecting earnings management thanthe original. To control for the possibility that revenue recognition is subject to manipulation by man-agement, Dechow et al. (1995) add the change in accounts receivable. This study uses the modifiedJones 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 parameterestimation.12 Thus, this approach partially controls for industry-wide changes in economic conditionsthat affect total accruals and allows the coefficients to vary across time.13

11 Theadditio

12 Prio2008).single ecountry

13 Thebut are

Pleaseearnin

TAit

Assetsit�1¼ b0

1Assetsit�1

þ b1DSalesit

Assetsit�1þ b2

GPPEit

Assetsit�1þ eit ð1Þ

where TAit = total accruals, calculated as firm i’s net income minus cash flows from operations inyear t taken from the statement of cash flows; Assetsit�1 = 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 andequipment for firm i in year t.

Second, the coefficient estimates from equation (1) are used to estimate the firm-specific non-discretionary accruals (NAit) for the sample firms.

NAit ¼ b̂01

Assetsit�1þ b̂1

ðDSalesit � DARitÞAssetsit�1

þ b̂2GPPEit

Assetsit�1ð2Þ

where NAit = non-discretionary accruals for firm i in year t; DARit = change in accounts receivable forfirm i from year t � 1 to year t. All other variables are as previously defined.

study uses the absolute value because the hypothesis does not predict any specific direction for earnings management. Inn, the absolute value captures accrual reversals following earnings management (Cohen et al., 2008).r literature uses at least eight observations to estimate discretionary accruals (Gaver et al., 1995; Klein, 2002; Cohen et al.,

The estimation per industry and year is also followed by Chen et al. (2010), where EU member countries are viewed as aconomic entity. However, results remain unchanged (although based on a smaller sample) if the estimation takes place per, industry, and year cluster.implicit assumption is that accruals of a particular firm-year are not only influenced by earnings management practices,also affected by industry and year effects.

cite this article in press as: Doukakis, L.C. The effect of mandatory IFRS adoption on real and accrual-basedgs management activities. J. Account. Public Policy (2014), http://dx.doi.org/10.1016/j.jaccpubpol.2014.08.006



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

14 For15 The

provide

Pleaseearnin

DAit ¼ ðTAit=Assetsit�1Þ � 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 levelsof productions costs, cash flows from operations, and discretionary expenses.14 Subsequent investiga-tions (Zang, 2012; Cohen et al., 2008; Cohen and Zarowin, 2010; Zhao et al., 2012) offer evidence of theconstruct 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 pricediscounts or more lenient credit terms. This will temporarily increase sales volumes, but these gainsare likely to disappear once the firm returns to the old pricing policy. These real economic decisionswill result in lower cash flows in the current period. Finally, managers can manipulate current earn-ings through decreases in discretionary expenses, such as those for advertising, research and develop-ment, and selling, general, and administrative expenses, resulting in higher current-period earnings. Inthis way, managers can also manipulate current-period cash flows at the expense of future cash flowsif the firm generally pays for such expenses in cash.

Following Dechow et al. (1998) and Roychowdhury (2006), I estimate the normal levels of produc-tion costs, cash flows from operations, and discretionary expenses using the following models.15 Themodels are estimated for each year and industry cluster with at least eight observations. Thus, thisapproach partially controls for industry-wide changes in economic conditions that affect the dependentvariables and allows the coefficients to vary across time.

PRODit

Assetsit�1¼ a0 þ b1

1Assetsit�1

þ b2Salesit

Assetsit�1þ b3

DSalesit

Assetsit�1þ b4

DSalesit�1


CFOit


1Assetsit�1

þ b2Salesit

Assetsit�1þ b3

DSalesit


DISXit


1Assetsit�1

þ b2Salesit�1


where PRODit = production costs, defined as the sum of cost of goods sold and the change in invento-ries from year t � 1 to year t; CFOit = cash flows from operations taken from the statement of cashflows; DISXit = discretionary expenses defined as selling, general and administrative expenses for yeart. All other variables are as previously defined.

The abnormal production costs (ABN_PROD), cash flows from operations (ABN_CFO), and discretion-ary expenses (ABN_DISX) expected to capture real earnings management are computed as the differ-ence between the actual values and the normal levels predicted by Eqs. (4), (5), and (6). Given saleslevels, firms that manage earnings upwards are likely to have one or all of the following characteris-tics: unusually low cash flow from operations, unusually low discretionary expenses, or unusuallyhigh production costs (Cohen and Zarowin, 2010).

a thorough discussion of the means available to conduct real earnings management, see Roychowdhury (2006).Salest�2 variable in model (4) is based on the restated financial statements that first-time mandatory adopters had tofor the previous year.




Consistent with Zang (2012) and Cohen and Zarowin (2010), I multiply ABN_CFO and ABN_DISX byminus one, so the higher the amount of ABN_CFO and ABN_DISX, the more likely the firm is to be engagingin sales manipulation through price discounts and cutting discretionary expenses.16 Following prior lit-erature (Zang, 2012; Cohen et al., 2008; Cohen and Zarowin, 2010; Zhao et al., 2012), I combine the individ-ual measures to compute a measure of total real earnings management (REAL). However, model (6) can beestimated 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 ofthe two individual measures (ABN_PROD, ABN_CFO).17 Excluding the abnormal discretionary expenses var-iable 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 abnor-mal 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-differ-ences design to investigate the impact of mandatory IFRS adoption on accrual and real earnings man-agement.18 The benchmark sample controls for contemporaneous changes in the economic environmentthat have an impact on the earnings management behavior of firms and that are unrelated to mandatoryIFRS 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 verysimilar to the treatment group.’’ A control sample of voluntarily adopting firms from the same groupof countries as the mandatory adopters sample has the incontestable advantage of similar institutionaland governance characteristics. As Li (2010) suggests, the regulatory homogeneity across EU countriesreduces 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 con-current 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 differentfrom mandatory IFRS adopters. However, their inclusion as a control sample does not preclude finding aneffect for mandatory adopters after mandatory IFRS adoption. Mandatory IFRS adoption does not imply asubstantial change in voluntary adopters’ accounting practice. In contrast, if adoption has an effect onmandatory adopters, then benchmarking with voluntary adopters creates the ideal setting to capturethis effect. According to Daske et al. (2008, p. 1086) ‘‘[M]any adopting countries make concurrent effortsto 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 man-datory and voluntary adopters quite similarly and as a result will be identified as a common, generaltrend effect.19 In the pre- and post-2005 period, the only incremental difference between the change formandatory 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 suffersfrom 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 systemand level of enforcement) and economic characteristics. These countries form a highly heterogeneousgroup 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 ofgoods 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 formandatory adopters. However, either effect could create difficulties in distinguishing between the impact of mandatory IFRSadoption and the concurrent impact of enforcement and governance improvements.




rendering them as a group hardly comparable to a set of developed European countries. Second, overthe sample period changes in economic environment, enforcement levels, auditing, and governancemight not be similar to the changes undertaken in the test sample countries.20 In contrast, mandatoryand voluntary IFRS adopters from EU countries experience contemporaneous and similar economicshocks (e.g., financial crisis) unrelated to the IFRS mandate.21 Third, many of these countries graduallymigrated 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 man-datory IFRS adoption that simultaneously affects all firms in an economy is subject to debate. How-ever, on the basis of the above arguments and following recent literature (Biddle et al. 2013; Byardet al., 2011a; DeFond et al., 2012; Li, 2010; Wang et al., 2008), the present study employs a controlsample of voluntary IFRS adopters.

4.4. Model specification

The study creates a binary indicator variable, MANDATORY, that takes the value of one for firms thatdid not apply IFRS until compliance became mandatory. This variable is expected to capture any dif-ference between the test and the control sample prior to mandatory IFRS adoption. The second vari-able of interest, POST2005, is a binary variable that equals one for observations after 2005. Thisvariable is expected to capture any changes in earnings management practices that are independentof the adoption of IFRS. The models also include an interaction term, MANDATORY*POST2005, that takesthe value of one for mandatory adopters in the post-adoption period. This is the main variable of inter-est expected to capture any incremental change in earnings management for mandatory adopterscompared to voluntary adopters following mandatory IFRS adoption.

20 Accthe man

21 Theand adj2008). Iidentifi

Pleaseearnin

ABS DA ¼ b0 þ b1MANDATORY þ b2POST2005þ b3MANDATORY � POST2005þ b4BIG4

þ b5GROWTH þ b6SIZEþ b7LEVERAGEþ b8ROEþ b9OWNERSHIP þ b10REALþ et

REAL ¼ b0 þ b1MANDATORY þ b2POST2005þ b3MANDATORY � POST2005þ b4BIG4

þ b5GROWTH þ b6SIZEþ b7LEVERAGEþ b8ROEþ b9OWNERSHIP þ b10ABS DAþ et

Prior literature documents that earnings management practices are affected by factors such asauditor type, growth, firm size, financial leverage, ownership structure, and profitability (Beckeret al., 1998; Bartov et al., 2001; Klein, 2002; Bowen et al., 2008). BIG4 is an indicator variable thatequals one if a Big 4 auditor is hired and zero otherwise. This variable is included because prior liter-ature 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 themodels to control for the impact of growth on earnings management. To maintain the appearanceof sustainable growth, managers may use income-increasing accruals or real earnings managementwhen growth slows (Summers and Sweeney, 1998). Similarly, growth companies might be more will-ing to engage in income-increasing earnings management to raise the value of their shares and attractmore investors to meet their capital needs. Moreover, since growth firms might be riskier as invest-ments, 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 effectof firm size on earnings management. Watts and Zimmerman (1978) suggest that larger firms may facegreater political costs than smaller firms owing to greater analyst following and investor scrutiny. On theother hand, Lobo and Zhou (2006) suggest that larger firms may be more inclined to manage theirearnings because the complexity of their operations makes detecting overstatement more difficult.

ording to Christensen et al. (2012), some non-IFRS adopting countries undertook regulatory changes that coincided withdatory IFRS adoption period (Japan in 2005, Chile in 2009, the US in 2002, etc.).essence of the differences-in-differences approach is to account for unobserved differences between test and control firms

ust observable changes for the test firms by concurrent changes that are also experienced by the control firms (Daske et al.,f these concurrent changes are not experienced by the control firms (i.e., non-IFRS adopters), then they will be erroneouslyed as IFRS effects.




LEVERAGE is included to pick up debt-contracting motivations for earnings management. A number ofstudies provide evidence suggesting that managers of highly leveraged firms have strong incentivesto use income-increasing earnings management practices to avoid debt covenant violation (DeFondand Jiambalvo, 1994; Sweeney, 1994; Francis and Wang, 2008). I measure leverage as the ratio of totalliabilities to last year’s total assets. Return on equity (ROE), calculated as net income divided by last year’stotal 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. Thevariable 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 aresubstitute mechanisms of earnings management. Specifically, firms may follow an overall earningsmanagement strategy and use a mix of real and accrual-based earnings management tools. Alterna-tively, they can choose between the two management techniques, using the technique that is less costlyfor 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 mandatorilyadopted IFRS in 2005.22 The sample period extends from 2000 to 2010. The study excludes financialinstitutions as well as firm-years that lack the accounting information necessary to compute the vari-ables used in the analysis. The study also excludes observations with negative book value of equity, withmissing 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 thatfollow a different set of standards (e.g., US GAAP). Finally, as explained above, the study imposes thecriterion of at least eight observations per industry and year cluster to ensure sufficient data for the esti-mation of accrual and real earnings management proxies. Imposing these data availability requirementsyields a final test sample of 13,295 firm-year observations (2021 unique firms), of which 6225 observa-tions lie in the pre-adoption period and 7070 in the post-adoption period. All accounting data areobtained from Datastream/WorldScope.

As already mentioned, this study focuses on mandatory IFRS adoption. A mandatory adopter is afirm 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 Years2000–2004 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 endingeither on 12/31/2004 or during the year 2005 if their fiscal year ended before 12/31/2005. The first IFRSfinancial statements cover the fiscal year beginning in 2005 and ending either on 12/31/2005 or during2006. That is to say, the sample also includes firms that follow local GAAP in the year 2005 as long as theyhave 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 samplewith voluntary IFRS adopters and impose sample selection criteria similar to those used for the man-datory adopters sample. The control sample consists of 1911 firm-year observations (337 uniquefirms), of which 797 observations lie in the pre-adoption period and 1114 in the post-adoptionperiod.25 The control firms use only IFRS, whereas the test firms use local GAAP in the pre-adoption per-iod and IFRS in the post-adoption period.

Table 1 presents the distribution of the test and control samples by country. The overall sampleincludes 15,206 firm-year observations (2358 unique firms) from 22 countries with significant

22 The accounting standards classification is based on the WorldScope item WC07536.23 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.



Table 1Sample composition by country.

Country Panel A: mandatory IFRS adopters Panel B: voluntary IFRS adopters

Frequency % Frequency %

Austria 61 0.46 163 8.53Belgium 289 2.17 49 2.56Cyprus 4 0.03 – –Czech Republic 24 0.18 28 1.47Denmark 424 3.19 63 3.30Finland 652 4.90 37 1.94France 1603 12.06 – –Germany 1082 8.14 884 46.25Greece 436 3.28 4 0.21Hungary 21 0.16 58 3.04Ireland 204 1.53 – –Italy 1105 8.31 – –Lithuania 4 0.03 – –Luxembourg 12 0.09 – –Norway 571 4.29 – –Poland 373 2.81 – –Portugal 223 1.68 11 0.58Spain 391 2.94 – –Sweden 1042 7.84 4 0.21Switzerland 198 1.49 598 31.28The Netherlands 665 5.00 7 0.37United Kingdom 3911 29.42 5 0.26Total 13,295 100 1911 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 6225observations lie in the pre-adoption period and 7070 in the post-adoption period. The control sample includes 1911 obser-vations that voluntarily adopted IFRS before 2004, of which 797 observations lie in the pre-adoption period and 1114 in thepost-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 withunivariate comparisons across the pre- and post-IFRS adoption periods, to explore potential differ-ences. For the test and control sample, the means of REAL, ABN_CFO, ABN_PROD and ABN_DISX arenot significantly different across the pre- and post-IFRS adoption periods, whereas the mean of ABS_DAis significantly lower for both mandatory and voluntary IFRS adopters after 2005. Mandatory IFRSadopters differ significantly in size, ownership, auditor type, growth opportunities, and profitabilityacross the pre- and post-IFRS adoption periods. Voluntary adopters differ significantly in size, lever-age, profitability and ownership structure across the pre and post-IFRS periods. Consistent with priorevidence, voluntary IFRS adopters are larger, less profitable, and less leveraged. The above differencessuggest the use of multivariate models to control for correlated factors that potentially influence theearnings management practices of the sample firms. All continuous variables are winsorized at the topand 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 depen-dent 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 industryfixed effects.



Table 2Descriptive statistics.

Mandatory IFRS adopters Voluntary IFRS adoptersMean Mean

N Pre-2005 Post-2005 Dif. N Pre-2005 Post-2005 Dif.

ABS_DA 13,295 0.061 0.055 �0.006*** 1911 0.060 0.051 �0.009***

(0.000) (0.002)REAL 13,295 �0.007 �0.007 �0.000 1911 �0.015 �0.017 �0.002

(0.988) (0.857)ABN_CFO 13,295 �0.002 �0.003 �0.001 1911 �0.004 �0.005 �0.001

(0.565) (0.779)ABN_PROD 13,295 �0.005 �0.004 0.001 1911 �0.011 �0.012 �0.001

(0.892) (0.896)ABN_DISX 8669 �0.002 �0.000 0.002 1569 �0.007 �0.007 0.000

(0.671) (0.980)BIG 4 13,295 0.829 0.806 �0.023*** 1911 0.829 0.819 �0.010

(0.001) (0.579)GROWTH 13,295 0.104 0.083 �0.021*** 1911 0.082 0.087 0.005

(0.000) (0.703)SIZE 13,295 5.238 5.446 0.208*** 1911 5.575 5.977 0.402***

(0.000) (0.000)LEVERAGE 13,295 0.596 0.599 0.003 1911 0.546 0.569 0.023**

(0.400) (0.042)ROE 13,295 0.069 0.093 0.024*** 1911 0.031 0.094 0.063***

(0.000) (0.000)OWNERSHIP 13,295 41.165 43.326 2.161*** 1911 48.690 44.950 �3.740***

(0.000) (0.003)

Table 2 reports the firm-level descriptive statistics across the pre- and post-adoption periods and by voluntary and mandatoryadopters. The t-test tests the null hypothesis that the mean difference on the variable is zero. ABS_DA is the absolute value ofdiscretionary accruals; REAL is the algebraic sum of the ABN_PROD and ABN_CFO; ABN_PROD is the abnormal level of productioncosts; 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 percentagechange in sales; SIZE is the natural logarithm of the market value of equity; LEVERAGE is the total liabilities divided by last year’stotal 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 signifi-cantly negative sum of the coefficients (�0.006 + 0.002 = �0.004, p-value = 0.00) suggests a decrease inaccrual earnings management practices for mandatory IFRS adopters from the pre- to the post-IFRSadoption period. Voluntary IFRS adopters also experience a decrease in accrual earnings managementafter 2005 (�0.006, t-stat = �1.92). However, the insignificant coefficient of MANDATORY*POST2005indicates that mandatory IFRS adopters do not experience an incremental decrease in accrual earningsmanagement relative to voluntary adopters. Consistent with prior literature, the presence of a Big 4 audi-tor seems to restrict accrual earnings management practices. High growth, highly leveraged, smaller, lessprofitable, and less closely held firms engage in higher accrual-based earnings management (Bagnoli andWatts, 2000; Klein, 2002; Aussenegg et al., 2008; Cohen et al., 2008; Cohen and Zarowin, 2010). Finally, anegative and statistically significant coefficient is found for REAL, indicating that managers use accrualand 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 realearnings management. With respect to REAL as a dependent variable, the findings suggest thatmandatory IFRS adoption has no significant impact on real earnings management. The coefficienton MANDATORY*POST2005 is negative but statistically insignificant. Again, while the findings reflecta negative relationship between accrual and real earnings management, this substitution betweenaccrual and real earnings management is not related to mandatory IFRS adoption. Consistent withprior literature, the presence of a Big 4 auditor has no impact on real earnings management. Highly



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

(a) (b) (c) (d) (e)ABS_DA REAL ABN_CFO ABN_PROD ABN_DISX

(1) MANDATORY �0.003 0.032*** �0.002 0.035*** 0.036***

(�1.10) (2.61) (�0.59) (3.32) (2.98)(2) POST2005 �0.006* 0.016 0.007* 0.009 0.003

(�1.92) (1.41) (1.80) (0.94) (0.30)(3) MANDATORY⁄POST2005 0.002 �0.012 �0.004 �0.008 �0.009

(0.62) (�0.95) (�0.91) (�0.80) (�0.75)Test of (2) + (3) = 0 [p-value] �0.004*** 0.004 0.003* 0.001 �0.006

[0.00] [0.45] [0.05] [0.91] [0.26]BIG4 �0.007*** �0.004 �0.003 �0.001 �0.018*

(�3.40) (�0.34) (�1.12) (�0.08) (�1.82)GROWTH 0.020***

0.007 0.012*** �0.006 �0.067***

(8.60) (0.87) (3.63) (�0.85) (�9.40)SIZE �0.005*** �0.012*** �0.005*** �0.007*** �0.003

(�12.18) (�5.26) (�7.18) (�3.85) (�1.49)LEVERAGE 0.016*** 0.167*** 0.058*** 0.110*** �0.011

(5.55) (11.11) (12.75) (8.84) (�0.91)ROE �0.038*** �0.257*** �0.133*** �0.126*** 0.005

(�9.80) (�16.80) (�25.44) (�10.14) (0.39)OWNERSHIP �0.000** 0.000 �0.000 0.000 0.000

(�2.05) (1.08) (�0.95) (1.59) (0.22)REAL �0.008**

(�2.44)ABS_DA �0.124** �0.080*** �0.041 �0.019

(�2.43) (�3.44) (�1.07) (�0.54)Intercept 0.070*** 0.001 0.005 �0.004 0.054***

(16.09) (0.06) (0.70) (�0.21) (2.58)Country and industry fixed effects Included Included Included Included IncludedR2 adjusted 9.8% 12.1% 19.7% 6.7% 3.5%N 15,206 15,206 15,206 15,206 10,238

Table 3 reports the results of the primary analysis examining the impact of mandatory IFRS adoption on accrual and realearnings management. The t-statistics are based on robust standard errors clustered by firm. The table also reports p-valuesfrom Wald tests assessing the statistical significance of the sum of two coefficients. MANDATORY is an indicator variable thatequals one for firms that did not apply IFRS until it became mandatory; POST2005 is a binary variable that equals one forobservations after 2005; MANDATORY⁄POST2005 is an interaction term that equals one for mandatory adopters in the post-adoption 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 manage-ment practices. Similar results (columns c to e) emerge for the individual real earnings managementproxies (ABN_CFO, ABN_PROD, ABN_DISX), except for ABN_CFO, where an increase (at 10%) for manda-tory IFRS adopters is found.27

Overall, the results in Table 3 provide some evidence of a decrease in accrual-based earnings man-agement between the pre- and the post-mandatory IFRS adoption periods and no significant impact onreal earnings management. However, the decrease in accrual-based earnings management for manda-tory 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 isconsistent with Wang et al. (2008), who find an improvement in the analyst forecast characteristicsand the information content of earnings announcements for mandatory adopters but not incrementalto 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).




voluntary adopters after the IFRS mandate could be attributed to network effects that result fromincreased comparability. Although spillover or network effects could be present in capital marketeffects (valuation, liquidity, cost of capital, analyst forecasts, etc.), it seems to be more difficult to attri-bute network effects to earnings management practices. For voluntary adopters, mandatory IFRSadoption does not imply a substantial change in their accounting practice. Although one cannot ruleout a role for mandatory IFRS adoption, concurrent changes in the enforcement and regulationenvironment around mandatory IFRS adoption (e.g., FSAP) may play a role in the decrease in accrualsearnings management for both mandatory and voluntary adopters.28

Prior literature suggests that the impact of mandatory IFRS adoption may depend not only on thequality 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 lit-erature (Daske et al., 2008; Byard et al., 2011a; Li, 2010), I consider a country to have high (low) legalenforcement if the country’s score for 2005 is above (below) the median of the total sample. I thenrepeat 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 manda-tory adopters domiciled in low law enforcement countries experience a decrease in accrual-basedearnings management (�0.004, p-value = 0.00). However, the decrease is not incremental to that ofthe voluntary adopters (0.004, t-stat = 0.57). All control variables are consistent with the previousanalysis.

As in the primary analysis, mandatory IFRS adoption has no significant impact on real earningsmanagement for either high or low law enforcement countries. This finding also holds for the individ-ual real earnings management proxies (untabulated). Again, consistent with prior literature, thenegative coefficient on ABS_DA suggests a substitution effect between accrual and real earnings man-agement practices. However, it seems to be a firm-level effect that is independent of mandatory IFRSadoption. In other words, firms seem to substitute accrual with real earnings management practiceswhen they face limited accounting flexibility. However, this limited accounting flexibility seems tobe associated with prior accrual manipulation and not with mandatory IFRS adoption.

Although the decrease in accrual-based earnings management for low law enforcement countriesseems to be counter-intuitive (Daske et al., 2008; Li, 2010), a number of prior studies report similarresults. Biddle et al. (2013) provide evidence consistent with an increase in capital investmentefficiency following mandatory IFRS adoption only for countries with weak legal and regulatory envi-ronments. Similarly, Schleicher et al. (2010) find that IFRS reduces the investment–cash flow sensitiv-ity 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-marketeffects 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. Inparticular, Ding et al. (2007) conclude that the ‘‘absence’’ (i.e., the extent to which the rules regardingcertain accounting issues are missing in Domestic Accounting Standards but are covered in IAS) cre-ates 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 lawenforcement group (e.g., Germany, Sweden, the Netherlands, and Norway). This result might suggestthat low law enforcement countries with a high level of ‘‘absence’’ under local GAAP engaging signif-icantly 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 initiativesaiming to improve the capital markets by enhancing the enforcement and governance regimes (Transparency Directive, ProspectusDirective, Statutory Audit Recommendation, Market Abuse Directive, etc.). All of these directives were implemented over the2004–2009 period. For example, the Transparency Directive was implemented in 2007 and established disclosure requirements onan ongoing basis, imposed the responsibility statement on the contents of the reports, and generally aimed to facilitate IFRScompliance (Hail and Leuz, 2007; Wang et al., 2008).



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

ABS_DA REAL

HIGHENFORCEMENT

LOWENFORCEMENT

HIGHENFORCEMENT

LOWENFORCEMENT

(1) MANDATORY �0.006* �0.003 �0.012 0.086***

(�1.68) (�0.61) (�0.76) (2.78)(2) POST2005 �0.006* �0.009 0.012 0.051

(�1.82) (�1.19) (1.03) (1.30)(3) MANDATORY⁄POST2005 0.003 0.004 �0.015 �0.049

(0.90) (0.57) (�1.04) (�1.24)Test of (2) + (3) = 0 [p-value] �0.002 �0.004*** �0.003 0.002

[0.21] [0.00] [0.75] [0.79]BIG4 �0.004 �0.008*** 0.016 �0.014

(�1.39) (�3.26) (0.93) (�0.90)GROWTH 0.016*** 0.023*** 0.023** �0.006

(4.67) (7.23) (2.04) (�0.52)SIZE �0.005*** �0.004*** �0.014*** �0.013***

(�8.97) (�8.31) (�4.13) (�4.19)LEVERAGE 0.012** 0.018*** 0.145*** 0.172***

(2.50) (5.18) (6.66) (8.28)ROE �0.034*** �0.041*** �0.276*** �0.229***

(�5.64) (�8.09) (�12.83) (�11.10)OWNERSHIP �0.000*** �0.000 0.000 �0.000

(�2.67) (�0.57) (0.55) (�0.80)REAL �0.009* �0.008*

(�1.70) (�1.94)ABS_DA �0.121* �0.136*

(�1.70) (�1.93)Intercept 0.073*** 0.068*** �0.053* 0.057

(12.18) (9.42) (�1.71) (1.31)Country and industry fixed

effectsIncluded Included Included Included

R2 adjusted 9.2% 10.6% 15.0% 12.9%N 6,463 8,743 6,463 8,743

Table 4 reports the results of the second-level analysis examining the impact of mandatory IFRS adoption on accrual and realearnings management across high- and low- law enforcement regimes. The distinction between high and low law enforcementregimes 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 onrobust standard errors clustered by firm. The table also reports p-values from Wald tests assessing the statistical significance ofthe sum of two coefficients. All variables are defined as in Table 2.




following mandatory IFRS adoption. This effect is also consistent with the Leuz et al. (2003) ranking, inwhich 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 countriesalready characterized by lower earnings management levels exhibit no difference between IFRS anddomestic GAAP. In other words, countries with better reporting behavior before mandatory IFRS adop-tion should experience smaller changes in their reporting behavior, whereas countries with weakerreporting practices before mandatory IFRS adoption might experience an improvement in their finan-cial reporting quality.

6.2. Suspect firm-years analysis

The above analysis is based on a generic set of firms that mandatorily adopted IFRS. However, thesefirms may or may not have strong incentives to manage earnings, either through accruals or throughreal earnings management. To increase the power of the tests to detect earnings management prac-tices, I perform a cross-sectional analysis using a sub-sample of firms with relatively strong incentives




to manage earnings.29 This type of analysis allows some preliminary conclusions with respect to the rel-ative importance of firm-level incentives versus accounting standards in influencing firms’ level of earn-ings management.30 In other words, if accounting standards play a prominent role in determiningfinancial reporting quality and IFRS limit management’s opportunistic discretion in determiningaccounting amounts, then a decrease in accrual earnings management should be apparent even for firmswith strong earnings management incentives. If so, firms may switch to real earnings management prac-tices. 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 studiessuggest that firm-years with earnings right at or just above benchmarks are likely to manage earnings tomeet 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, Ifocus on firm-years with small positive earnings (SPOS), defined as firm-years that report net incomeover lagged total assets higher than or equal to zero but less than 0.005. Second, I create a small positiveearnings changes sample (SCHA) that includes firm-years with change in net income over lagged totalassets higher than or equal to zero but less than 0.005.32 According to prior literature, both groups offirms are likely to manage their earnings to report income marginally above zero. Third, I focus on firmsthat have a seasoned equity offering (SEO), defined as firm-years that fall in the fourth quartile of thepercentage change of common stock. Prior literature provides evidence consistent with upwards earn-ings manipulation prior to the stock issue. I then concentrate on highly leveraged firms (DEBT), definedas firm-years that fall in the fourth quartile of the ratio of total debt over lagged total assets. Highly lev-eraged firms have strong incentives to engage in both accrual and real earnings management to avoiddebt covenant violation. Finally, newly listed (IPO) firms may face stronger earnings management incen-tives compared to more mature and well established firms in an attempt to survive and maintain arecord of growth. This argument is consistent with the evidence that many firms are subject to SECenforcement actions because of financial statement manipulation shortly after their initial public offer-ings (Beneish, 1997). The IPO sample includes observations falling into the first quartile of the differencesbetween 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 earn-ings management incentives do not decrease the level of accrual earnings management in the post-IFRS adoption period. For newly listed firms, the findings even suggest a significant increase in accrualearnings management. As far as real earnings management practices are concerned, the results sug-gest no significant impact following mandatory IFRS adoption. Another notable finding is the lack ofa significant negative relationship (except for IPO) between accrual-based and real earnings manage-ment practices. These results provide some preliminary evidence on the important role of firm-levelincentives in earnings management practices. In other words, the findings suggest that firms withstrong incentives to meet certain earnings targets engage in either type of earnings management bothbefore 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 likelyto use real earnings management. To proxy for limited accounting flexibility due to prior overuse ofaccruals, 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.30 Among others, Roychowdhury (2006), Cohen and Zarowin (2010), and Zang (2012) focus on suspect firm-years observations.31 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 shouldbe interpreted with caution. Future research could explore this issue further.



Table 5Suspect-firm-years analysis.

SPOS SCHA SEO DEBT IPO

ABS_DA REAL ABS_DA REAL ABS_DA REAL ABS_DA REAL ABS_DA REAL

(1) MANDATORY �0.003 0.016 �0.005 0.049* �0.002 0.053*** 0.001 0.022 �0.007 0.044**

(�0.43) �0.55 (�1.11) �1.91 (�0.35) �2.79 �0.17 �1.19 (�1.44) �2.29(2) POST2005 0.005 �0.019 �0.005 0.042* �0.006 0.023 �0.001 �0.001 �0.017** �0.003

�0.5 (�0.43) (�0.88) �1.68 (�0.96) �1.27 (�0.23) (�0.05) (�2.56) (�0.11)(3) MANDATORY⁄POST2005 �0.01 �0.005 0.001 �0.04 0.003 �0.007 �0.001 �0.009 0.013* 0.003

(�0.90) (�0.11) �0.19 (�1.41) �0.39 (�0.34) (�0.21) (�0.45) �1.9 �0.11Test of (2) + (3) = 0 [p-value] �0.005 �0.024 �0.004 0.002 �0.004 0.016 �0.003 �0.01 �0.003 0

[0.24] [0.27] [0.12] [0.86] [0.15] [0.12] [0.19] [0.26] [0.25] [0.99]BIG4 �0.010** �0.008 �0.002 0.003 �0.013*** �0.012 �0.006 �0.008 �0.007* �0.02

(�2.11) (�0.27) (�0.58) �0.15 (�3.21) (�0.69) (�1.61) (�0.52) (�1.95) (�1.17)GROWTH 0.032*** �0.036 0.019** �0.023 0.024*** 0.004 0.012*** 0.007 0.020*** 0.027**

�2.84 (�0.85) �2.13 (�0.65) �6.55 �0.31 �3.28 �0.53 �5.54 �2.14SIZE �0.002** �0.01 �0.004*** �0.016*** �0.006*** �0.012*** �0.004*** �0.010*** �0.005*** �0.013***

(�2.25) (�1.50) (�6.04) (�3.27) (�7.32) (�3.65) (�7.43) (�3.68) (�6.47) (�3.10)LEVERAGE 0.020* 0.112** 0.024*** 0.245*** 0.022*** 0.100*** 0.058*** 0.052** 0.025*** 0.153***

�1.65 �2.04 �3.1 �6.68 �4.7 �5.09 �9.65 �2.36 �5.21 �6.75ROE 0.073 �1.459** �0.003 �0.437*** �0.031*** �0.225*** �0.012** �0.132*** �0.053*** �0.325***

�0.78 (�2.03) (�0.20) (�5.88) (�5.43) (�11.84) (�1.96) (�5.46) (�9.01) (�14.02)OWNERSHIP �0.000*** 0 0 0.001** 0 0 0 0.001** 0 0

(�3.12) �0.35 (�1.63) �2.06 (�0.28) (�0.93) (�1.39) �2.51 (�1.49) �0.33REAL �0.002 0.004 0.005 0.008 �0.020***

(�0.20) �0.48 �0.92 �1.11 (�3.86)ABS_DA �0.07 0.107 0.071 0.117 �0.290***

(�0.20) �0.48 �0.92 �1.12 (�3.80)Intercept 0.071*** 0.091 0.050*** �0.029 0.079*** 0.058* 0.032*** 0.049 0.075*** 0.017

�5.15 �1.31 �5.61 (�0.58) �8.89 �1.76 �3.76 �1.49 �9.44 �0.46Country and industry Included Included Included Included Included Included Included Included Included Included

Fixed effectsR2 adjusted 12.00% 5.70% 8.30% 19.20% 12.20% 11.90% 12.70% 8.20% 12.90% 16.40%N 467 1280 4016 3804 4454

Table 5 presents the results for the suspect firm�years analysis. SPOS sample includes observations with small positive earnings defined as 0 6 Net Incomet/Total Assetst�1 < 0.005; SCHAsample includes observations with small positive earnings changes defined as 0 6 (Net Incomet � Net Incomet�1)/Total Assetst�1 < 0.005; SEO sample includes observations falling in thefourth quartile of (Common Stockt � Common Stockt�1)/Common Stockt�1; DEBT sample includes observations falling in the fourth quartile of Total Debtt/Total Assetst�1; IPO sampleincludes 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 onrobust 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 inTable 2.



18L.C.D

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model. Consistent with prior literature, limited accounting flexibility is positively related to real earn-ings management practices.

Second, three countries – the United Kingdom, France, and Germany – seem to dominate the testand 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 voluntaryobservations.

Third, to account for the possibility that the empirical results are driven by the recent financial cri-sis, I exclude all observations after 2008. Finally, following Francis and Wang (2008) and Hribar andNichols (2007), I replace the absolute discretionary accruals (ABS_DA) with signed discretionary accru-als. In all cases, inferences remain unchanged.

8. Conclusion and discussion

This study examines the effect of mandatory IFRS adoption on earnings management using asample of European firms that mandatorily adopted IFRS in 2005. Prior literature has investigatedthe impact of mandatory IFRS adoption on accrual-based earnings management. However, recentliterature notes that to meet certain financial reporting goals, managers engage in real earnings man-agement. The present study contributes to the literature by investigating the impact of mandatoryIFRS adoption on both accrual and real earnings management, allowing for a more thorough and com-prehensive understanding on whether the mix of earnings management strategies has changed afterthe mandatory IFRS adoption.

The study employs a control sample of voluntary IFRS adopters and uses a differences-in-differencesdesign that controls for contemporaneous changes in the economic environment that may have animpact on the earnings management behavior of firms and that are unrelated to mandatory IFRS adop-tion. The empirical findings suggest that mandatory IFRS adoption had no significant impact on thelevel of accrual and real earnings management. Additional analysis on a range of suspect firm-yearsobservations with relatively strong earnings management incentives confirms the lack of a significantimpact on accrual and real earnings management and points to the important role that firm-levelincentives play in shaping earnings management behavior.

This study is subject to several caveats. First, although the main focus of the study is the impact ofmandatory IFRS adoption on real and accrual-based earnings management, managers might applyother earnings management techniques. For instance, Athanasakou et al. (2009) provide evidence sug-gesting that in the attempt to meet analyst forecasts firms in the United Kingdom are more likely toengage in classification shifting or expectations management than to manage accruals or real transac-tions. Second, the findings of the study should be interpreted with caution. The study fails to reject thenull hypothesis that mandatory IFRS adoption has no effect on accrual-based and real earnings man-agement. However, this finding does not rule out the existence of a difference in reality. Quite possiblythe insufficiency of evidence to reject the null hypothesis may be due to the sample used, the method-ology, the proxies for accrual-based and real earnings management, the time period, the empiricalsetting, and so on. Although the choice of a control sample consisting of voluntary adopters has manyadvantages (such as similar institutional characteristics, regulatory homogeneity, and similar eco-nomic shocks), the selection of a control sample is not infallible, and as prior literature suggests, resultsmay vary depending on the control sample used. Finally, the real earnings management identificationtechniques employed in this study may be subject to the same criticism as regression-based accrualearnings management techniques (e.g. lack of power, correlated omitted variables, misspecificationwhen applied to sample of firms with extreme financial performance, etc.). However, despite theirweaknesses, 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, SerainaAnagnostopoulou, Vasiliki Athanasakou, Michael Burkert, Vassilis Eftymiou, Dimitrios C. Ghicas (thesis




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

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