The adoption of International Financial Reporting Standards (IFRS) has been effective in reducing earnings management in some countries. The authors find that the countries that benefit the most are those that had the greatest divergence from IFRS before adoption. The level of enforcement also affects how much the countries benefit; for example, lower-enforcement countries with low divergence do not benefit at all.
Convergence to International Financial Reporting Standards (IFRS) is intended to promote higher-quality reporting and make financial statements across the globe more comparable, with the expected result of lowering the cost of capital. The authors analyze the effects of IFRS adoption and country-level enforcement on earnings management.
The results indicate that the reduction in earnings management after IFRS adoption is greatest for countries with the most pre-adoption divergence from IFRS and with strong country-level enforcement. The next-highest impact is for highly divergent but low-enforcement countries. Countries with a low level of divergence do not significantly benefit from IFRS adoption.
How Is This Research Useful to Practitioners?
Adoption of IFRS is shown to reduce earnings management in two dimensions: first, where earnings management is measured by the degree of earnings smoothing—defined as variability in operating income scaled by the variability in cash flow from operations—and second, where earnings management is measured by the extent of managerial discretion measured in accruals as a proportion of cash flow from operations. The most notable decrease in earnings management is for countries with higher pre-adoption divergence from IFRS, irrespective of the enforcement strength in the country. It is likely that highly divergent countries have to make the most changes—not only in accounting standards but also in their accounting infrastructure (e.g., auditing and accounting professional requirements)—when adopting IFRS.
There has been a push for regulatory bodies to achieve full convergence between US GAAP and IFRS. The United States and Canada are the benchmark countries for this study because they have the lowest earnings management of the country groups studied. Both the United States and Canada are nonadopting countries with strong enforcement and low divergence from IFRS. Perhaps the ongoing efforts for convergence (IFRS and US GAAP) are not adding significant value to the investment profession; low-divergence countries do not experience significant increases in earnings quality after IFRS adoption. The authors report that greater benefit (i.e., more reduction in earnings management) is achieved in countries that had greater local GAAP divergence from IFRS. Encouraging highly divergent countries to adopt IFRS might result in increased benefits for the investment community.
How Did the Authors Conduct This Research?
Past research has shown mixed results on the impact of IFRS adoption on earnings quality. The authors hypothesize that the benefit of IFRS adoption depends on the level of pre-adoption divergence from IFRS and on the extent of country enforcement of the standards.
Regression models are used to test the impact of IFRS adoption and country-level enforcement on earnings management. Twenty-one local accounting rules are compared with IFRS to measure the level of divergence. Enforcement strength is a composite measure that incorporates insider trading laws, judicial efficiency, rule of law, and shareholder protection indicators.
The sample consists of 128,292 firm-year observations across 31 countries for the fiscal years 2000–2009. The Pearson and Spearman correlation coefficients suggest that (1) the quality of accounting standards affects the quality of reported financial information, (2) countries with stronger enforcement have lower levels of earnings management, and (3) countries with more concentrated corporate ownership have higher levels of earnings management.
All models show significant reduction in earnings management after IFRS adoption for high-divergence countries. Trend charts of earnings management from 2000 to 2009—with countries grouped on the basis of IFRS adoption, high or low divergence from IFRS, and high or low level of enforcement—reveal that IFRS adoption results in better earnings quality. Countries with high pre-adoption divergence and a high level of enforcement benefit the most, followed by adopting countries with high divergence but low enforcement. Countries with low pre-adoption divergence do not significantly benefit from IFRS adoption, perhaps because they have fewer changes to make in the standards and in the country’s accounting infrastructure.
The authors suggest that IFRS adoption is a major event for those countries with greater pre-adoption divergence from IFRS. Further research might examine how countries change their infrastructure (such as auditing standards or corporate governance requirements) leading up to adoption of IFRS and how structural changes in the accounting profession have affected earnings quality as well as the country’s financial markets.