Will IFRS Adoption Affect Earnings Management and Improve the Liquidity and Competitiveness of Companies?

Will IFRS Adoption Affect Earnings Management and Improve the Liquidity and Competitiveness of Companies? Rene Craighead ACCT 715 Prof. Michael Miller June 23, 2013

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Abstract This paper outlines the effects of IFRS adoption in reference to earnings management, liquidity, and competitiveness. Widespread use of IFRS since 2005 provides an opportunity for investigation of these benefits. Excessive earnings management affects liquidity which in turn affects competitiveness. IFRS adoption has been shown to have little effect on earnings management in some companies while other companies have shown an improvement. More research needs to be done on the subject but overall improvement seems likely when higher quality accounting standards are in use.

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Contents
Introduction ..........................................................................................................................4

Literature Review.................................................................................................................6

Data Analysis .......................................................................................................................8

Conclusion .........................................................................................................................10

References ..........................................................................................................................12

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Introduction Not long ago the United States was one of the leading credit nations. That is no longer the case. Recent years of economic crisis have weakened its position as a global powerhouse. How many economic problems are related to earnings management? Did earnings management affect the liquidity and competitiveness of companies? Will IFRS adoption solve earnings management problems? Most of the major banks reported high earnings early 2009 during the worst part of the economic crisis. In his article Wells Fargo looks too good to be true Bloomberg News columnist Jonathan Weil explained how the bank got rid of billions of loan-loss provision the bank carried over from their buyout of Wachovia. After purchasing Wachovia and taking control of their reserves, Wells Fargo was able to start using those reserves to absorb their own losses. This enables the bank to reduce the appearance of losses. Banks are just one example of how earnings management may have affected the financial crisis. In difficult times, incentives could coerce management to do everything to lessen the effect of losses. It can be assumed, that if banks engage more aggressively in earnings management during economic turmoil, other companies do too. All the major players in the market bear some responsibility. The pressure to make the numbers has created a disturbing pattern: companies try to meet earnings projections in order to increase the value of stock options; analysts pursue feedback from companies to help cultivate and revise those expectations; and auditors are under pressure to retain clients. The problem is that accounting standards cannot address all possible situations. They must be flexible in their interpretation in order to account for all industries. If companies use too much discretion in reporting they present unrealistic earnings.

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Advocates of International Financial Reporting Standards (IFRS), state companies need to adopt a single set of accounting principles in order to create better markets. Mandatory IFRS adoption will help companies achieve comparability, transparency, decreased information costs, and reduced information asymmetry. All of this should increase the liquidity and competitiveness of companies. (Ball, 2006) While IFRS adoption can be beneficial the costs of transitioning can be high. Ball, in his 2006 article International Financial Accounting Standards (IFRS): Pros and cons for investors, noted the adoption of IFRS could add instability to financial statements. This instability could lead to both good and bad information; bad information is costly and usually comes from estimation error and managerial manipulation. Market liquidity can be an issue as it can lower confidence in fair value estimates and insert noise into the financial statements. Managers have the ability to influence stock prices and therefore can influence fair value. When fair value is not available estimates are used. These estimates are determined using fair value models. Because the parameters are set by management and subject to human error, model noise is created. (Ball, 2006)

As of January 1, 2005 European Union companies had to adopt IFRS. This decision was to enhance the competitiveness of the markets by forming a set of internationally recognized accounting standard. Results suggest IFRS improves accounting quality. It was also found mandatory adoption created substantial increases in market liquidity and value. (Epstein, 2009) US GAAP requires companies to list assets in order of liquidity starting with current assets and followed by noncurrent assets. Under IFRS order of liquidity is not specified. Firms

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can report assets and liabilities broadly, without separation of assets, if it is believed this is more relevant and reliable. Literature Review In one of the first large scale studies of firms adopting IFRS in a mandatory setting, Daske et al. (2008) conclude that market liquidity increases following adoption of IFRS. They also find evidence of a decrease in firms cost of capital and an increase in equity value occurring prior to the official adoption date. In a related study, the authors find benefits such as improved liquidity and lower cost of capital are more likely for firms that adopt IFRS (Daske et al., 2011). Beuselinck et al. (2009) investigated returns of IFRS adopters and determined that IFRS adoption exposed new information reducing revelations in the disclosure section. The value of information has been enhanced for IFRS reporters by reducing reporting lag, increasing analyst accuracy, and increasing investments. In a study done by Hung et al (2007) it was found IAS increased the importance of book value through net income. Landsman et al. (2011) consider the impact of the use of IFRS on share prices and trading (abnormal return volatility and trading volume). They conclude that the information content of earnings announcements has improved for IFRS reporters by reducing reporting lag, increasing analyst following and increasing foreign investment. They also find the IFRS effect depends on the level of enforcement in a country. Other studies explored the impact of IFRS for shareholders. The high quality and easily comparable standards prove to be a benefit during decision making. In relation to investors, studies provided evidence of various benefits that were linked to firms use of high quality, comparable standards. A study done by Armstrong et al (2010) reported an uptick in trading following the adoption of IFRS. This suggests investors expect IFRS adoption to be beneficial

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through higher information quality and lower information asymmetry. Thus the adoption of IFRS has should promote more investing. Horton et al (2012) found IFRS adoption caused forecast accuracy to improve greatly. Atwood et al (2001) found that losses reported under IFRS were less than losses reported under U.S. GAAP. A study done by Epstein (2009) compared companies found IFRS adoption led to less earnings management, more suitable loss acknowledgment, and more relevance. IFRS adopters also demonstrated better accounting quality. Leuz (2003) found higher quality reporting and better disclosure which lessened the risk of estimation and reduced adverse selection issues. It was found that GAAP differences matter and there are economic costs associated with having different accounting rules throughout the world. (Bae, 2008) According to a study by Ding et al (2007) results for earnings management suggest that the differences between US GAAP and IFRS can have significant economic consequences. IFRS would lessen these accounting gaps, lowering cost and increasing competitiveness. When companies smooth over numbers in order to look more profitable it can be hard to get an accurate take on their real financial standing. It is misleading and often an industry wide practice and seems to be an accepted way of doing things. The problem lies in the inaccurate appearance given to investors and how heavily it affects market liquidity. Earnings management degrades the quality of earnings reports and disclosure in general. Existing accounting theory underscores a rm link between accounting disclosure quality and market liquidity. The study performed by Ascioglu et al (2012) presented empirical evidence linking earnings management to market-based measures of liquidity. Data Analysis

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In a study done by Grasso, The Effects of Earnings Management, 110 undergraduate and 132 graduate accounting students completed the survey as well as 116 IIA members and 623 IMA members. It was found Professionals, managers, and graduate and undergraduate accounting students surveyed after the highly publicized financial reporting scandals and the implementation of the Sarbanes-Oxley Act had significantly harsher judgments of earnings management practices than did managers and students surveyed prior to the scandals.

Three countries were selected for this study: Australia, France, And the UK. Australia voluntarily adopted IFRS in 2005 and France and the UK were mandated to adopt IFRS in 2005 also. The main goal was to see if IFRS decreased earnings management. A thresholds approach was used containing the following data: income before extraordinary items (IBEX), total assets, and sales. The sample was comprised of 1146 rms. (Stoloway, 2008) A study by Barth et al consists of 1,896 firm-year observations for 327 firms that adopted IAS between 1994 and 2003 for which DataStream data are available from 1990 through 2003. The results of their research indicate that firms adopting high quality international accounting standards engage less in earnings management, resulting in higher quality financial reporting. Five techniques of accounting hocus-pocus that summarized the most glaring abuses of the flexibility inherent to accrual accounting include: big bath charges, creative acquisition accounting, cookie jar reserves, materiality, and revenue recognition. Big Bath Charges: When a company is doing really bad and has no chance of meeting earning expectations, unscrupulous management would begin writing-

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off every expense and asset they could imagine. As a result, future expenses are reduced significantly and naturally earnings increase. To make it more difficult for companies to abuse of big bath charges, in 1998, the FASB adopted SFAS No. 144 on impairment losses and SFAS No. 146 on the timing of the recognition of restructuring obligations. Creative Acquisition Accounting: The allocation to expense of a greater portion of the price paid for another company in an acquisition in an effort to reduce acquisition-year earnings and boost future-year earnings. Since 1998 however, SFAS Nos. 141 and 142 have been adopted to provide guidelines on how the purchase price in a business acquisition should be allocated. Cookie Jar Reserves: an accounting practice in which a company uses generous reserves from good years against losses that might be incurred in bad years. Since 1998, the SEC has released Staff Accounting Bulletin (SAB) 101 outlining when deferring revenue is a permissible practice. Materiality: Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Auditors need to use more skepticism in the way they look at materiality. Revenue Recognition: Some companies will accelerate the recording of revenue in order to make the current period look better than it actually is. (Moniruzzaman, 2013)

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When rms inate reported nancial information by managing earnings, they generate income-increasing accruals that reverse over time. Firms with income-increasing accruals in prior years must, therefore, either deal with the consequences of the accrual reversals or commit fraud to offset the reversals. (Dechow et al., 1996) Lee et al. (1999) nd a positive relation between the likelihood of fraud in year t0, the rst fraud year, and a dummy variable measuring whether the rm had positive accruals in both year t1,the year prior to the rst fraud year, and year t0. Ascioglu et al conducted a study on market liquidity an earnings management which resulted in their analysis supporting the hypothesis that earnings management activities, both accounting based and real, are associated with impaired liquidity. Companies practicing earnings management actually have less available to pay off debts if immediately needed to then what the financial statements show. Conclusion Studies show earnings management affects liquidity by distorting the appearance of companies financial health. When revenue is recorded at managers discretion it can lead to companies looking better than they actually are. As seen in the 1990s, once investors get word targets are not being met, revenue is being restated, and companies arent as liquid as they first appeared, they lose confidence. This loss of confidence leads to stock sell offs and a slowdown of further investing causing a company to be less competitive in all markets. It would seem IFRS adoption does affect earnings management but more research needs to be done. This is why it is important to study the affect earnings management and IFRS adoption has on liquidity and competitiveness.

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References Ascioglu, A., Hedge, S., Krishnan, G., & Mcdermott, J. (Feb 2012). Earnings management and market liquidity. Review of Quantitative Finance & Accounting, 38(2). 257-274. Armstrong, C. S., Barth, M. E., Jagolinzer, A. D., & Riedl, E. J. (2010). Market reaction to the adoption of IFRS in Europe. Accounting Review, 85(1), 31-61. Atwood, T.J., Drake, M.S., Myers, J.N., & Myers, L.A. (2001). Do earnings reported under IFRS tell us more about future earnings and cash flows? Journal of Accounting and Public Policy

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Bae, K.,. Tan, H. & Welker, M.(2008). International GAAP differences: The impact on foreign analysts. The Accounting Review 83: 593-628. Ball, R. (2006). International Financial Accounting Standards (IFRS): Pros and cons for investors. Accounting and Business Research (Special Issue): 527. Barth, M.E., Landsman, W.R., & Lang M.H. (2008), International accounting standards and accounting quality, Journal of Accounting Research, vol. 46, June, 467-498. Beuselinck, C., Joos, P., Khurana, I., & Van der Meulen, S. (2010) Mandatory IFRS reporting and stock price informativeness. Discussion Paper Cente, June. Retrieved from
http://arno.uvt.nl/show.cgi?fid=107197

Daske, H., L. Hail, C. Leuz, and R. Verdi. (2008). Mandatory IFRS reporting around the world: early evidence on the economic consequences. Journal of Accounting Research, 46(5), 10851142. Daske, H., Hail, L., Leuz, C., & Verdi, R. S. (2011). Adopting a label: Heterogeneity in the economic consequences of IFRS adoptions. Journal of Accounting Research, 51(3):495547. Dechow, P., Sloan, R., & Sweeney, A. (1996). Causes and consequences of earnings manipulations: An analysis of rms subject to enforcement actions by the SEC. Contemporary Accounting Research, 13(1), 136. Ding, Y., Hope, O-K., Jeanjean, T., & Stolowy, H. (2007). Differences between domestic accounting standards and IAS: Measurement, determinants and implications. Journal of Accounting & Public Policy 26: 1-38. Epstein, B. (2009). The Economic Effects of IFRS Adoption. CPA Journal, 79(3), 26-31. Horton, J., Serafeim, G., & Serafeim, I. (2012). Does mandatory IFRS adoption improve the information environment? Contemporary Accounting Research. Hung, M. & Subramanyam, K. (2007). Financial statement effects of adopting international accounting standards: The case of Germany. Review of Accounting Studies 12: 623-57. Grasso, L.P., Tilley, P., & White, R.A., (2009. The ethics of earnings management: pPerceptions after Sarbanes-Oxley. Management Accounting Quarterly, 11(1), 46-69. Landsman, W. R., Maydew, E. L., & Thornock, J. R. (2011). The information content of annual earnings announcements and mandatory adoption of IFRS. Journal of Accounting and Economics, 53(1-2), 34-54. Lee, T. A., Ingram, R. W., & Howard, T. P. (1999). The difference between earnings and operating cash ow as an indicator of nancial reporting fraud. Contemporary Accounting Research, 16(4), 749786 Leuz, C. (2003). IAS versus US GAAP: Information asymmetry-based evidence from Germany's mew Market. Journal of Accounting Research 41: 445-72.

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Moniruzzaman, M., Rahman, M., & Sharif, J. (2013). Techniques, motives, and controls of earnings management. International Journal of Information Technology and Business Management, 11(1). 22-34 Stolowy, H. & Thomas, J. (2008). Do accounting standards matter? An exploratory analysis of earnings management before and after IFRS adoption. Journal of Accouting and Public Policy, 27(6). 480-494. Weil, J. (2009, April 16). Wells Fargos profit looks too good to be true. Bloomberg. Retrieved May 25, 2013 from http://www.bloomberg.com/apps/news?sid=a6sv0hG.nW7g&pid=newsarchive