A considerable part of the literature investigates the impact of IFRS adoption on accounting quality by examining the possible effect on earnings management. Authors in the literature have been using various measures to proxy for accounting quality. These include proxies using value relevance based on regressions of stock returns on earnings and book values (Gassen and Sellhorn, 2006; Barth et al., 2008; Paananen and Lin, 2009; Osma and Pope, 2011), proxies using earnings management measures based on estimating the correlations between accruals and cash flows (Van Tendeloo and Vanstraelen, 2005; Paananen and Lin, 2009; Barth et al., 2008; Capkun et al., 2013; Ahmed et al., 2013), based on the variance of net income (Barth et al., 2008; Gassen and Sellhorn, 2008; Paananen and Lin, 2009; Ahmed et al., 2013), based on changes in cash flow and earnings (Gassen and Sellhorn, 2006; Capkun et al., 2013), proxies of conservatism estimated through a reverse regression of earnings on stock returns (Gassen and Sellhorn, 2006), proxies of earnings persistence based on regressions of earnings on lagged earnings (Gassen and Sellhorn, 2006) the variance of net income over cash flows (Barth et al., 2008; Capkun et al., 2013; Ahmed et al., 2013) the frequency of positive earnings (Barth et al., 2008; Capkun et al., 2013) proxies of timely loss recognition through a) the frequency of negative earnings (Barth et al., 2008; Paananen and Lin, 2009; Capkun et al., 2013) or b) binary variables for loss makers (Christensen et al., 2008; Ahmed et al., 2013).
Most of the above studies investigate if and how the adoption of IFRS is likely to be related to changes in the manipulation of earnings by company managers, while our research investigates whether and how the adoption of IFRS is likely to affect properties of the analysts’ earnings forecasts. Hence, it is crucial to study the existing academic literature and identify factors likely to affect accounting quality.
It can be suggested that such factors related to the manipulation of earnings are expected to be related to properties of their forecasts too. Such understanding will help us to build on the existing literature in order to construct the methodology and research design of our project. Also, we will be able to critically evaluate our findings and identify any common patterns with the existing studies.
A study, of accounting quality, by Barth et al. (2008) examined whether firms implementing IAS/IFRS were likely to have higher accounting quality compared to firms that reported under local standards. As they explained, on one hand IAS could limit the management’s discretion to exploit opportunities in managing earnings but on the other hand this under certain circumstances could limit the firm’s flexibility to report the closer to reality results. They also highlighted several areas in IAS that allowed managerial discretion. Their sample included companies that implemented IAS from 21 countries between 1994 and 2003 and employed the following accounting quality proxies:
- value relevance (regressions using stock returns as dependent variables and earnings and equity book value, net income for earnings as independent variables)
- earnings management (correlation between accruals and cash flows, variance of net income, variance of net income over cash flows, frequency of positive earnings)
- timely loss recognition (frequency of negative earnings)
Barth et al. (2008) used a method to match each firm adopting with another non- adopting firm, matched on country and size and compare accounting quality before and after IAS adoption. Their independent variables were turnover growth, market value, equity issuance, debt issuance, cash flow, ownership concentration, BIG5 auditor, and exchange listing details.
Their findings showed that firms using IAS had lower earnings management, higher value relevance and more timely recognition of losses compared to firms not using IAS. Also, Barth et al. (2008) showed that firms before IAS adoption did not have significantly better accounting quality than non-adopters. They also compared the accounting quality change (before and after IAS) for each group and argued that the accounting quality improvement is greater for IAS firms. A potential deficiency of this study is that the authors, although they used multiple countries, did not take into account factors that later studies (Van Tendeloo and Vanstraelen, 2005; Osma and Pope, 2011; Capkun et al. 2013) considered such as the legal and financial reporting enforcement level, investor protection regulation and the local GAAP-IAS differences.
In fact, Capkun et al. (2013) used a sample of 29 countries between 1994 and 2009 and their findings, consistent with Barth et al. (2008), indicated decreased earnings management for voluntary adopters. However, Capkun et al. (2013) argued that voluntary adopters switched to IFRS because they already had incentives for transparency and consequently higher quality financial statements. Similar to Christensen et al. (2008) they also supposed that a considerable proportion of mandatory IFRS adopters could have a higher likelihood of conducting earnings smoothing. On top of that, Capkun et al. (2013) suggested that IFRS underwent substantial changes by the IASB after 2005. Therefore, a substantial number of accounting standards changed and the use of a wider time frame could help to better assess the overall impact of IFRS adoption. They also argued that after the mandatory adoption by listed companies in all EU countries, IFRS allowed higher flexibility of accounting policy choices compared to national standards and had numerous ambiguous areas. In fact, the authors explained how IFRS after 2005 provided higher flexibility through intangible assets’ policies and overt (IFRS standards with allowed alternatives) and covert options (IFRS standards with vague criteria) (Nobes, 2006). They also explained that IFRS use fair value extensively and that permits management discretion for some assets, which could be related with earnings manipulation. In our research we investigate a) intangible assets and b) use of fair value measurement and these areas are likely to be associated with changes in earnings quality after IFRS adoption.
Similar to the other studies, Capkun et al. (2013) distinguished firms by incentives and classified them in three categories: mandatory IFRS adopters, voluntary adopters until 2004 and voluntary adopters from 2005 onwards. The authors employed widely used earnings management and timely recognition models from the literature. Capkun et al. (2013) stated that their findings were consistent with Barth et al. (2008) as they found that voluntary IFRS adopters were likely to have lower earnings management. Their results showed that all groups including voluntary IFRS adopters were likely to have higher earnings management in the post 2005 period due to the above changes in IFRS. In additional tests, the authors showed that in countries where the level of financial reporting enforcement was stronger post 2005 relative to period before, the increase in earnings management was less likely to occur.
Looking at the results of Capkun et al. (2013) it can be criticised that the choice to voluntarily adopt IFRS was not available in all the countries. Therefore, firms with high quality incentives in major economies, e.g. UK and France, were not allowed to switch to IFRS until the mandatory adoption by the EU. This is likely to bias the results of a study with a large number of countries such as Capkun et al. (2013). This is also likely to be the case with another study on earnings management by Ahmed et al. (2013).
In a study investigating the impact of IFRS adoption on accounting quality, Ahmed et al. (2013) compared mandatory adopters from 20 countries with non-adopting firms from 2002 to 2007. Ahmed et al. (2013) followed Barth et al. (2008) arguments and explained that the probable effect of IFRS adoption on accounting quality is ambiguous. On one hand IFRS adoption is likely to be related to improved accounting quality (due to the use of fair value that leads to more timely and accurate recognition), expected less managerial discretion and IFRS consideration as principles based (contrary to domestic standards that tend to have stricter rules). On the other hand, the authors explained that principles-based standards can impair accounting quality as sometimes they cannot be appropriate for the recognition of certain economic events or have vague application instructions (Barth et al. 2008; Nobes, 2006).
The authors followed a matching methodology and matched the firms on five factors: book to market ratio, size, accounting performance, industry and legal enforcement. Ahmed et al. (2013) employed three accounting quality proxies: earnings management, reporting aggressiveness and income smoothing. For earnings management, they used two logistic regression models and examined a) if company earnings are equal or higher to analysts’ forecasts and b) if firm earnings are at the positive earnings threshold between 0% and 1%. They employed linear fixed effects models and as dependent variables for income smoothing they used a) the correlation between accruals and cash flow, b) the volatility of earnings growth and c) the volatility of earnings over the volatility of cash flow growth. Also, they examined if the size of accruals increased and if timely loss recognition changed with IFRS adoption. Their findings are consistent with Capkun et al. (2013) as Ahmed et al. (2013) found a substantial increase in income smoothing and aggressive reporting of accruals, as well as a reduction in timeliness of loss recognition for mandatory IFRS adopters. It should be noted that the observed effects were found in high enforcement jurisdictions and were consistent with Nobes (2006) point about higher IFRS flexibility after 2005.
While Barth et al. (2008), Capkun et al. (2013) and Ahmed et al. (2013) used a sample from multiple countries, Gassen and Sellhorn (2006) focussed on one country and attempted to identify the motivation and impact of voluntary IFRS adoption by German companies between 1998 and 2004. The study’s findings showed that voluntary IAS/IFRS adopters had a higher proportion of foreign turnover, higher size, wider ownership base and higher likelihood of being listed on international stock markets. Subsequently, Gassen and Sellhorn (2006) examined the impact of voluntary IFRS adoption on earnings quality by using the following proxies: accrual quality (unexpected working capital accruals), earnings predictability (low earnings shocks), conservatism (reverse regression of earnings on returns), value relevance (proportion of stock returns explained by earnings information) and earnings persistence (regression of current earnings on lagged earnings). Their results showed that firms reporting under IFRS instead of German GAAP had higher earnings persistence and conservatism and lower earnings predictability.
Gassen and Sellhorn (2006) found that firms reporting under IFRS had higher stock price volatility, higher stock turnover and higher bid-ask spread. Gassen and Sellhorn (2006) stated that their proxies were not likely to fully assess accounting quality as they did not take into account the firms’ disclosure. On top of that, they stated that their model did not contain all explanatory variables and that their proxies for earnings quality and information asymmetry were likely to be biased and noisy. On another study focussing on IFRS and accounting quality, Christensen at al. (2008) investigated the impact of incentives before and after IFRS adoption by examining two proxies for accounting quality, timely loss recognition and earnings management. Their sample spanned from 1998 to 2005 and, similarly to Gassen and Sellhorn (2006), is comprised only of German firms, where a considerable number of companies adopted IFRS voluntarily. To test the existence of earnings management, Christensen et al. (2008) looked at the residuals of pooled regressions using changes in cash flow and earnings as dependent variables. To examine the timeliness of loss recognition, the authors used a logistic regression, where the dependent variable took binary values representing GAAP or IFRS and the main independent variable was a binary variable that equalled one when a profitability ratio was below -20%. The empirical results showed that firms that voluntarily adopted IFRS had reduced earnings management and greater timeliness of loss recognition. The findings showed that mandatory IFRS adopters did not have any improvements in accounting quality. The authors further explained that firm incentives play a greater role compared to the quality of accounting standards.
In this paper, the observed accounting quality improvements for voluntary adopters were likely to be associated with less insider activities and more incentives for higher quality reporting. However, the sample firms were all located in Germany and it should be noted that voluntary adopters changed their accounting standards to IFRS across a broad time frame, while mandatory adopters adopted in one year, 2005. Hence, it can be suggested that the data for mandatory adopters in Christensen et al. (2008) is likely to be unbalanced, as accounting quality for mandatory adopters is investigated only in one financial year.
In our study, we examine the impact of IFRS adoption on earnings quality and use similar samples of German voluntary and mandatory adopters to identify any differences in financial reporting due to firm incentives. The extended time frame in our sample aims to test the persistence of differences in earnings quality for the above two groups.
Another study using samples of German companies by Van Tendeloo and Vanstraelen (2005) preceded Gassen and Sellhorn (2006) and Christensen et al., (2008) and examined whether earnings management in Germany decreased following voluntary IFRS adoption. The authors suggested that past studies have shown that companies in countries with a code law legal system like Germany were likely to have lower accounting quality and higher earnings management. The authors described the traditions and practices of the German accounting system and stated that German firms tend to mitigate the earnings variability during both good and bad financial periods. To achieve this objective, they conduct earnings management through unrealistic depreciation and impairment of assets, use of tax-free reserves and
maintenance of hidden reserves (Van Tendeloo and Vanstraelen, 2005). This is relevant to our research project, as goodwill impairment under IFRS could be
used for earnings smoothing. We investigate if goodwill impairment could consequently affect the analysts’ earnings forecast errors.
Van Tendeloo and Vanstraelen (2005) aimed to examine if voluntary adopters had lower earnings management due to either the higher quality of IFRS or the firm incentives for higher financial information quality. The authors further investigated the consequences of having a Big 4 auditor and/or a cross listing in a major foreign market. From 1999 to 2001 they compared companies reporting under German GAAP and companies that voluntarily adopted IFRS/IAS. The authors used linear regressions with discretionary accruals as their dependent variable (Van Tendeloo and Vanstraelen, 2005). Their results showed that IFRS/IAS adopters were not associated with lower earnings management. In fact, the authors suggested that earnings smoothing actually increased as firms that did not have the option to manage earnings via hidden reserves (although the authors acknowledged that they were not able to capture all of them) did use discretionary accruals for this purpose.
When including hidden reserves, the level of earnings management was similar to the local GAAP firms. The authors also suggested that earnings management was likely to be decreased if the firm had a Big4 auditor. Therefore, Van Tendeloo and Vanstraelen (2005) suggested that the adoption of high quality accounting standards do not necessarily improve accounting quality when they are not complemented with strong audit and investor protection regulation (Nobes, 2006; Kvaal and Nobes, 2010).
In another study in Germany, Paananen and Lin (2009), similar to Christensen et al., (2008), differentiated the work from that of Van Tendeloo and Vanstraelen (2005) and Gassen and Sellhorn (2008) by looking to the IFRS effect on mandatory and voluntary adopters. The authors examined the IAS/IFRS effect on accounting quality by splitting their samples in three adopting periods: 2000-2002 IAS, 2003-2004 voluntary IFRS adoption and 2005-2006 mandatory IFRS adoption. The authors suggested that by dividing the sample periods they were able to assess the impact of IAS/IFRS improvements, as well as the company incentives for voluntary adoption and the effect of mandatory IFRS adoption. Paananen and Lin (2009) also stated that by studying only one country they were able to clear out all country factors such as enforcement level, legal system, level of market regulation etc.
Paananen and Lin’s (2009) used earnings quality measures such as value relevance, timely recognition and earnings smoothing. For their value relevance proxy they employed the Ohlson (1995) model with stock prices regressed on earnings and book value of equity. Regarding earnings smoothing, Paananen and Lin (2009) employed the change in cash flow, the correlation between accruals and cash flows, the earnings variability and a non-linear model with an IAS/IFRS indicator as the dependent variable. For timely recognition they used the non-linear model with a binary variable indicating firms with profitability ratio below -20% similarly to Gassen and Sellhorn (2006). The authors found results consistent with Van Tendeloo and Vanstraelen (2005) and argued that earnings quality is likely to deteriorate after mandatory IFRS adoption as a) earnings smoothing and earnings management increased and b) timely loss recognition and value relevance decreased. Thus, Paanenen and Lin (2009) explained that their results were robust after removing mandatory adopters.
They also argued that accounting quality deteriorated with IFRS after 2005 probably because of the revisions and the new standards. These inferences contradict Christensen et al. (2008) who found that earnings management decreased and therefore suggested that accounting quality improved after voluntary IFRS adoption. Osma and Pope (2011) examined earnings quality post mandatory IFRS adoption in a large sample with firms from 20 countries from 1999 to 2008. Similarly to other studies (Van Tendeloo and Vanstraelen, 2005; Capkun et al. 2013), Osma and Pope (2011) found that the level of enforcement and local GAAP-IFRS differences are
likely to influence the impact of IFRS adoption on earnings quality. They investigated the relationship between accounting quality and balance sheet
adjustments in the IFRS transition period. The authors suggested that during the transition period, IFRS granted flexibility to firms in certain areas and therefore provided them with earnings management opportunities. As they explained, IFRS adoption did not require restatements of asset and liability values from past M&A transactions or a write-back of goodwill that has been impaired. To proxy for abnormal adjustments they obtained the residuals from industry level regressions of firms’ transition adjustments to pre-defined local GAAP–IFRS differences (adjustments that were expected based on the differences between accounting standards). For accounting quality proxies, Osma and Pope (2011) followed the existing literature and used a) total accruals, b) the value relevance of earnings, c) the likelihood of a small reported profit and d) an asymmetric persistence of income model. Their findings did not reveal any improvement in earnings quality following IFRS adoption. In fact, they found an association between abnormal balance sheet adjustments and earnings quality, and argued that the accounting quality post IFRS adoption was significantly dependent on the differences between IFRS and local GAAP and the changes on transition. Consistent with the academic literature on IFRS, they showed that stronger enforcement was likely to be associated with lower abnormal balance sheet adjustments.
Although earnings management was not the primary research objective, the findings of a study by Ozkan et al. (2012) provided an interesting insight on the managers’ incentives and accounting quality. The authors examined the impact of IFRS adoption from an executive compensation perspective, using a broad sample from 15 European countries mandatorily adopting IFRS between 2002 and 2008. The rationale behind their research questions was that if companies’ executive compensation boards consider that IFRS adoption may improve earnings quality, then they would probably increase its use in pay for performance sensitivity (change in direct compensation for executives). The authors expected that IFRS adoption was likely to increase the