Earnings management in Europe post IFRS: do cultural influences persist?
| Verfasser | Gray, Sidney J. |
| Posten | RESEARCH ARTICLE - International Financial Reporting Standards - Report |
Abstract We investigate the extent to which the mandatory adoption of International Financial Reporting Standards (IFRS) has restricted the previously documented association between national culture and international differences in earnings management practices. We analyze the earnings management behavior of publicly listed firms in 14 member countries of the European Union during the period 2000-2010. Our findings show that the tendency to engage in earnings management continues post IFRS and that cultural factors remain influential in explaining differences in the magnitude of earnings management behavior across countries.
Keywords Culture * Earnings management * Accounting standards * IFRS
1 Introduction
Earnings information is vital for decision-making by the users of financial statements. In addition to various firm-level factors, a number of studies have explored the impact of institutional factors at the country-level related to the quality of earnings such as the adoption of International Financial Reporting Standards (IFRS), legal investor protection and national culture (e.g., Leuz et al. 2003; Barth et al. 2008). Gray (1988) argues that national culture, as a key informal institutional factor (North 1990, 1994, 2005), also influences accounting measurement practices thus impacting earnings quality differentially across countries. While the earlier study by Han et al. (2010) documents an association between national culture and international differences in earnings management, it is not clear whether this relation persists under a single GAAP environment. Thus, the focus of our study is to examine the extent to which the mandatory adoption of uniform high quality accounting standards, IFRS in the European Union influences the impact of national culture on earnings management.
Earnings management, i.e., exercising earnings discretion in an opportunistic manner, is a matter of serious concern to shareholders, creditors, standard setters and regulators in global capital markets (e.g., Healy and Wahlen 1999; Leuz et al. 2003; Defond 2010). In the context of IFRS, Barth et al. (2008) report that the adoption of high quality reporting standards, IFRS, restricts earnings management in various jurisdictions. Their findings suggest that even though highly principles-based standards allow a considerable amount of accounting discretion to managers, they lead to less opportunistic reporting behaviors, presumably due to the fact that the standards do not permit certain accounting alternatives that have the potential of distorting corporate performance and hence could be used to manage earnings.
However, it is not entirely obvious that the adoption of IFRS necessarily leads to improved and harmonized reporting practices in all jurisdictions. For example, Bradshaw and Miller (2008) claim that harmonizing standards may not always result in a harmonization of accounting practices as compared to standards. Similarly, Sunder (2009) maintains that applying a single set of principles-based standards to companies in a worldwide context will not necessarily make financial statements more comparable and help financial statement users to make better decisions. Thus, it might be overly optimistic to assume that a single-set of high quality standards will harmonize accounting practices around the world and curb earnings management behavior given the persistence of international differences in institutional frameworks.
IFRS is a set of principles-based accounting standards that limits alternative accounting treatments. The idea is to have managers exercise their best judgment in choosing among a limited set of alternatives to measure and report the underlying economic situation. However, managers may potentially use any flexibility and discretion available under principles-based standards to manipulate earnings by deliberately choosing an accounting method that does not necessarily reflect the underlying economic situation in order to achieve personal goals, such as promotion, receiving bonuses, and so on.
Effective 2005, listed companies in the EU were required to use IFRS in their consolidated financial statements. The EU provides an ideal research setting to test the impact of IFRS as it has unique advantages not found in previous studies. For example, the EU has had a more or less unified legal system impacting accounting as each member state must adopt EU regulations directly and/or incorporate EU directives into local law. The EU securities markets are fairly homogeneous in the sense that laws, regulations and standards governing investment, securities and company activities are similar across national borders. Moreover, the EU has a single commercial market thus many aspects of the economic system and regulations governing business transactions (e.g. banking) are relatively homogeneous compared to the rest of the world. At the same time, each member state appears to have maintained its distinct culture and tradition during the harmonization process. Thus the EU has remained a culturally diversified, but a politically, legally and financially integrated economy. (1) This research setting thus minimizes the impact of changes in formal institutional factors, apart from the adoption of IFRS, and enables us to single out the effects of national culture on earnings management in the post-IFRS era.
As opposed to a more rules-based system that often contains substantial detailed guidance with bright-line tests, IFRS provides limited interpretive and implementation instruction, thus theoretically increasing the need to apply professional judgment (Agoglia et al. 2011). As prior research has demonstrated that people tend to respond in accordance with cultural prescriptions under conditions of uncertainty and ambiguity, culture can play an important role in people's judgment and behavior in a new or innovative situation (Meglino et al. 1989; Ravlin et al. 2000). So the question is whether the adoption of IFRS would in fact have provided more or less opportunities and incentives to manage earnings and respond to cultural influences. In other words, to the extent that such principles-based standards allow managers to exercise judgment, is culture likely to be a persistent influence on financial reporting practices subsequent to the adoption of IFRS?
Prior studies document evidence that management contracts, compensation systems, performance evaluation and some institutional factors explain earnings management incentives and practices. Prior studies also show how cross-national differences in societal values (culture) affect capital markets and accounting practices (Chui et al. 2002; Hope 2003; Doupnik and Tsakumis, 2004). Most recently, Han et al. (2010) hypothesize and document an association between national culture and earnings management in an international context.
Our research applies Gray's (1988) model, as extended by Doupnik and Tsakumis (2004), and used by Han et al. (2010), in order to consider the impact of differences in culture across a number of European countries on the extent to which managers exercise discretion in measuring accounting earnings in the post IFRS period.
We use a sample of 15,258 firm-year observations of firms in the EU during the period 2000-2010 to examine how cultural values are related to a proxy for earnings management both in the pre- and post-IFRS periods. We confirm in our sample the relationship between the individualism and uncertainty avoidance dimensions of national culture and earnings management and, importantly, find that national culture significantly influences managers' reporting decisions in the post IFRS adoption period. This suggests that firms that report using a set of principles-based accounting standards such as IFRS are able to continue to engage in culture-driven earnings management. We also document that more extensive national disclosure regulations reduce the effect of IFRS on the culture-earnings management relationship, consistent with the view that transparency can reduce managers' reporting bias (e.g., Fischer and Verrecchia 2000).
Our study extends the literature in at least two ways, and has some broad implications for standard setters and regulators. First, our findings suggest that international accounting differences persist even after the adoption of uniform high quality principles-based reporting standards. This finding is consistent with the views expressed by Bradshaw and Miller (2008) and Sunder (2009), and implies that the adoption of a set of uniform reporting standards might not necessarily lead to accounting harmonization and that existing differences in informal institutional factors i.e. cultural values, across countries can continue to create accounting differences.
Second, our evidence suggests that extensive national disclosure regulations can constrain culture-driven earnings management. While a set of principles-based reporting standards might continue to enable managers, consistent with their cultural orientations, to exercise their potential for discretionary reporting in a more opportunistic manner, more transparent disclosure requirements about firm management and ownership (e.g., the disclosure of sensitive managerial compensation and insider ownership information), can increase managers' accountability and would appear to discourage opportunistic earnings management behavior.
The remainder of this paper is organized as follows. The next section reviews the previous literature and develops hypotheses. Section 3 discusses research methodology. The empirical findings are presented in Sects. 4 and 5 provides conclusions.
2 Literature Review and Hypothesis Development
2.1 Studies on Earnings Quality
The prior literature claims that accounting earnings contain information content that users regard as relevant in their investment decisions (Ball and Brown 1968; Kothari 2001; Francis et al. 2004). However, managers have incentives...
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