Earnings Management Behavior and Choice of Accounting Standards

WOLFGANG AUSSENEGG, PETRA INWINKL, RANKO JELIC AND GEORG SCHNEIDER

Jnkping International Business School Jnkping University JIBS Working Papers No. 2011-3

Earnings Management Behavior and Choice of Accounting Standards **

Wolfgang Aussenegg(a),, Petra Inwinkl(b), Ranko Jelic(c)*, and Georg Schneider(d)

(a)

Department of Finance and Corporate Control, Vienna University of Technology, Favoritenstrasse 9-11, A-

1040 Vienna, Austria, E-mail: waussen@pop.tuwien.ac.at, Phone: +43 1 58801 33082, Fax: +43 1 58801 33098
(b)

Department of Accounting and Finance, Jnkping University, Jnkping International Business School, P.O.

Box 1026, SE-551 11 Jnkping, Sweden, E-mail: petra.inwinkl@ihh.hj.se, Phone: +46 36-101818, Fax: +46 36-161069
(c)

Department of Accounting and Finance, University of Birmingham, Birmingham, B15 2TT, United Kingdom,

E-mail: r.jelic@bham.ac.uk, Phone: +44 (0) 121 414 5990, Fax: +44 (0) 121 414 6238
(d)

Department of Business Administration, University of Paderborn, Warburger Str. 100, 33098 Paderborn,

Germany, E-mail: Georg.Schneider@notes.uni-paderborn.de, Phone: +49 5251 60 2914; Fax: +49 5251 60 3546

This Draft: December 2010

* **

Corresponding author A former version of the paper has been distributed and presented under the title Earnings Management and Local vs International Accounting Standards of European Public Firms. We would like to thank Dan Admiran, Jeffery Abarbanell, Ray Ball, Wolfgang Ballwieser, Joachim Gassen, Jan Bouwens, Jeremiah Green, Wayne Landsman, Hansrudi Lenz, Auke Plantinga, Ivana Raonic, Thorsten Sellhorn, Susie Wang, participants of the 2009 Accounting Section VHB/International Association for Accounting Education and Research (IAAER) conference (Munich), the 2009 Midwest Finance Association Meeting (Chicago), the 2009 Financial Management Association European Meeting (Turin), the 2009 Atlantic City Global Conference on Business and Finance (Atlantic City), the 2009 European Accounting Association Meeting (Tampere), as well as seminar participants at the University of Birmingham, the University of Graz, the University of North Carolina at Chapel Hill (Kenan-Flagler Business School), the University of Paderborn, and the Vienna University of Technology for helpful comments and suggestions. We also thank Thomson Reuters for providing data.

Abstract
In this study we examine earnings management in public listed firms within 15 EU member states plus two non-EU members, namely Switzerland and Norway. In 10 of the countries included in our sample, provisions were made to allow firms to use international accounting standards (IAS/IFRS) well before they became mandatory in 2005. This presents us with an opportunity to compare the earnings management behavior of international accounting standards adopters with earnings management in firms using local standards (GAAPs). We also examine how the transition from local to international accounting standards affected earnings management in different groups of countries according to their legal tradition. Our results suggest that companies that opted for the international accounting standards managed earnings to lesser extent than firms choosing domestic accounting standards. The results are robust to potential endogeneity induced by the possibility of firms in certain countries to choose whether to adopt IAS/IFRS. We also documented that earnings management is generally less pronounced in Anglo-Saxon and Northern European countries than in the rest of Europe.

JEL classification: G14, G15, G38, M41 Keywords: Earnings Management, Accounting Standards, IAS/IFRS, Europe

1. Introduction
The ongoing discussion about the choice of accounting standards has intensified since the European Unions (EU) requirement for adoption of international accounting standards (i.e. IAS/IFRS) by European listed companies by 2005.1 Prior to 2005, companies that were admitted to trading on a regulated market in an EU member state used a variety of countryspecific Generally Accepted Accounting Principles (GAAPs) or international (IAS/IFRS or US-GAAP) accounting standards (see, e.g., Van Tendeloo and Vanstraelen, 2005). The domestic GAAPs were required to comply with the Seventh Council Directive from June 13th, 1983 (EU Directive on consolidated accounts).

The use of international accounting standards, as an alternative to their country-specific standards before 2005, was allowed in the following countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Luxemburg, Portugal, and Switzerland.2 This presents us with an opportunity to compare the earnings management behavior of IAS/IFRS adopters and firms using local GAAPs. We also examine how the transition from local to international accounting standards affected earnings management in different groups of countries according to their legal tradition. Our empirical analysis is based on 4 different proxies for earnings management in the sample that consists of around 20,000 firm-year observations, during 1995-2005. Our research contributes to the literature in several ways. First, we analyze whether different accounting standard regimes (in our case IAS/IRFS and local European GAAPs) have an influence on the level of earnings management. Different to other studies that examine the earnings management behavior of IAS/IFRS adopters in a single country, we examine a large international sample. This also provides us with opportunity to investigate to what extent potential earnings management differences are driven by country or regional differences.

Our results reveal lower earnings management in firms adopting IAS/IFRS compared to firms applying local GAAPs. At the first glance this result seems to be obvious. But one has to keep in mind that under IAS/IFRS managers tend to have more degrees of freedom to manage their earnings (if they chose to). On the other IAS/IFRS are associated with much more
1

Firms that have prepared their consolidated financial statements according to US-GAAP were allowed to continue until the end of the 2006 accounting year. From 2007, all companies that are listed on any of EU stock exchanges have to prepare consolidated accounts in accordance with IAS/IFRS. 2 See,www.iasplus.com./europe/0501ias-use-of-options.pdf, Delvaille et al. (2005), and Dick and Walton (2001).

disclosure requirements. Thus, the greater disclosure requirements seem to be more important than the larger degrees of freedom to manage earnings. Our results are robust to potential endogeneity induced by the possibility of firms in certain countries to choose whether to adopt IAS/IFRS. Second, we can document that earnings management is generally less pronounced in Anglo-Saxon and Northern European countries than in the rest of Europe. The earnings management differences are not only related to adoption of different accounting standards. The differences persist irrespective which accounting standards were used. For example, the earnings management levels in the UK and Ireland are much lower than in other European countries, especially those in Southern Europe (e.g. Italy, Spain, or Greece).

The remainder of the paper is organized as follows. In the next section, we explain the legal environment in Europe and discuss the properties of IAS/IFRS relative to local GAAPs. In Section 3 we review the relevant literature and motivate our hypothesis. We present our data and the methodology used to estimate earnings management in Section 4. Results of our univariate and multivariate analysis are presented and discussed in Section 5. Finally, in Section 6 we provide conclusion.

2. Local and International Standards across Europe

The two main EU accounting directives are the Fourth Council Directive of 25 July 1978 (hereafter EU Accounting Directive) and the Seventh Council Directive from June 13th, 1983 (EU Directive on consolidated accounts). The EU Accounting Directive was the first accounting-based directive adopted by the European Parliament and the Council of the European Union (Council) and can, therefore, be seen as initial point of the harmonization process within the EU, since it focuses on the coordination of national provisions of accounting. Before the adoption of this directive, meaningful comparisons of financial reports within Europe were difficult as Europe is the origin of many legal systems. The introduction of EU Directive on consolidated accounts, was driven by the economic need to draw up consolidated accounts so that financial information gives a true and fair view of a company's assets and liabilities, financial position and profit or loss. Both directives were subject of adoption by each member state, which means that the rules stated therein had to be transformed by each state in its national law. This implies that local GAAPs are on the one hand based on the same principles, but differ on the other hand from each other dependent on the national implementation in each country.

An important reason that voluntary IAS/IFRS adoption in EU countries increased, especially in late 1990s, was that the standards became much improved over time. In 1987, in response to criticism of too much leeway for non-compliance and too many opportunities for earnings management under IAS/IFRS, the International Accounting Standards Committee (IASC)3, initiated a major effort to constrain accounting choice. By the same token the International Organization of Securities Commission (IOSCO) focused in the efforts of the IASC to provide acceptable IAS/IFRS for use in multinational securities offerings, since 1989. In 1998, a new set of core IAS/IFRS standards were introduced requiring full compliance by firms (instead of only partial compliance required prior to 1998). These core standards received conditional endorsement from IOSCO. Consequently, several EU countries allowed firms to voluntarily choose IAS/IFRS instead of their domestic GAAPs in late 1990s. For example, the following European member states allowed firms to use IAS/IFRS and US-GAAP as substitute for domestic accounting standards: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Luxemburg, and Portugal.4 Switzerland, non-EU member state, permitted listed companies to use IAS/IFRS on an unsolicited basis several years prior the enacted IAS/IFRS Regulation (EC) date. The adoption of IAS/IFRS in the above countries was allowed to the extent that they complied with the Fourth and Seventh Council Directives (Prather-Kinsey et al. 2008). Countries where early adoption was not allowed were UK, Ireland, Spain, Italy and Sweden. Norway, non-EU member state also did not permit early adoption of IAS/IFRS. The above differences between European countries regarding the adoption of IAS/IFRS disappeared on January 1st, 2005. From this date, firms governed by the law of a member state have to prepare their consolidated accounts in conformity with IAS/IFRS.5 For companies which already have applied another set of internationally accepted standards as the primary basis for their consolidated accounts, the provision provides a transition period for two years until 2007. This exemption was made for companies which are publicly traded both in the EU and on a regulated third country market as well as for companies, which had only publicly traded debt securities.
IASC was renamed to International Accounting Standards Board (IASB) in April 2001. Although the application decree has not been published in France prior to 2005, French firms were also allowed to adopt international standards for the preparation of their consolidated accounts. For example, larger French firms were able to use options that would allow them to converge towards international accounting standards (IAS) since 1986. There is also evidence to suggest that French companies exhibited certain degree of opportunism applying IFRS lite (basically not complying fully with IFRS) (Dick and Walton 2001). 5 The date was fixed in Article 4 of IAS/IFRS Regulation (EC). Complete title of the regulation is: Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards.
4 3

3. Literature Review
The majority of studies provide evidence that managers can and also do (at least in particular circumstances) manage their earnings. By developing a discretionary accrual model to measure earnings management, Jones (1991) showed that managers of U.S. firms tend to manage their earnings downwards during import relief investigations. Burgstahler and Dichev (1997) confirm the anecdotal evidence that managers use earnings management to avoid having to report earnings decreases or to report small losses. There is also ample of evidence for earnings management around equity issues and/or in relation to meeting various earnings targets (Teoh et al. 1998; Peasnell et al. 2000).

More recently, earnings management was examined in the context of accounting choice, using international data. Burgstahler et al. (2006), for example, document, for a set of European companies, lower earnings management levels for public traded firms compared to private (not traded) firms. Leuz et al. (2003) examine systematic differences in earnings management across 31 countries. They find that earnings management decreases in investor protection because strong protection limits insiders ability to acquire private control benefits, which reduces their incentives to mask firm performance and therefore they establish a link between corporate governance and the quality of reported earnings. Consistent with Leuz et al. (2003), Lara et al. (2005) show that in countries such as France and Germany managers have greater incentives to engage in earnings management. They suggest that the differences in earnings management may be the reason why previous studies (e.g. Raonic et al. 2004) failed to find significant differences between common-low (UK) and code-low based countries (Germany and France).

Nabar and Boonlert-U-Thai (2007) analyze the impact of investor protection and national culture on earnings management for a sample of 30 countries. They also report negative association of earnings management with protection of investors rights.6 They conclude that culture is an important determinant of accounting choice and should, therefore, be considered by standard setters regulating international financial reporting rules. The above results are consistent with findings of a recent Report from the Commission to the Council and the European Parliament concerning the IAS/IFRS Regulation (EC) on the application of IAS/IFRS
6

According to Nabar and Boonlert-U-Thai (2007) national culture (like uncertainty avoidance and masculinity) impacts managers earnings discretion but not earnings smoothing.

(April 24th, 2008) showing that the use of options in the IAS/IFRS Regulation (EC) by EU member states is not consistent.

Barth et al. (2008), show, that limiting alternatives in accounting systems can increase accounting quality as this will limit managers discretion in determining accounting amounts. The authors document for an international sample of 21 countries (327 firms, and 1,896 firmyear observations) that firms applying IAS/IFRS have higher accounting quality (i.e., less earnings management) than firms applying local GAAPs. They especially show that IAS/IFRS firms exhibit less earnings smoothing (i.e., less volatility of changes in net income over the volatility of changes in cash flow from operations).7 However, Van Tendeloo and Vanstraelen (2005) find that earnings management behaviour of German firms did not change with IAS/IFRS adoption.8 They conclude that the adoption of high quality accounting standards (like IAS/IFRS) is not sufficient for providing high quality information in a code (civil) law country with lower investor protection rights, as in Germany.

In this study we focus on public traded firms within 15 EU member states plus two non-EU members, namely Switzerland and Norway. As noted earlier, some countries made provisions allowing companies to use international accounting standards before 2005. This presents us with an opportunity to compare the earnings management level of IAS/IFRS adopters with companies using local GAAPs. We conjecture differences in earnings management between adopters and companies using local GAAPs. For example, IAS/IFRS require higher disclosure requirements than most European local GAAPs. More disclosure may increase the costs of (undetected) earnings management and therefore one might expect lower levels of earnings management during the transition from local GAAPs to IAS/IFRS. On the other hand, adopting a new standard might offer more degrees of freedom for auditors. For example, due to companies lack of experience auditors may be more willing to allow for broader interpretations of the standards. In addition, IAS/IFRS provides more forward looking information than most local GAAPs. While such information seems highly relevant it may suffer from low reliability. This may be especially true for valuations where managers have discretionary power. For example, IAS/IFRS allows for revaluation of property, plant and equipment (IAS 16) while German GAAPs only allows for historical costs. Other examples include the estimation
7 Overall, the evidence also suggest that adoption of IAS/IFRSs tend to move European firms closer to the quality provided by adoption of US-GAAP (Barth et al. , 2006; Daske et al.,2006; Leuz and Verrecchia, 2000). 8 It should be mentioned that this study only considers 636 firm-year observations relating to the period 19992001.

of fair values in cases, in which there is no market, and the determination of the recoverable amount in the course of an impairment test (IAS 36).

In line with Leuz et al. (2003) and Nabar and Boonlert-U-Thai (2007) we also conjecture that legal aspects, investor protection, and the cultural environment seem to be important determinants for the incentive of managers to manage earnings. Thus, we test the following hypotheses:

H1: Firms that adopt IAS/IFRS do not engage in significantly less or more earnings management compared to firms reporting under local GAAPs.

H2: The impact of IAS/IFRS adoption on earnings management will differ in countries with different legal traditions.

We also control for several firms characteristics such as: firms growth potential, firms size, cash flow position, financial leverage, return on assets (ROA), industry classification, and accounting years (i.e. time).

4. Data and Methodology 4.1. Sampling Process and Descriptive Statistics

Our database consists of all public traded firms available in Compustat Global (Version 2006) for EU15 member states plus Switzerland and Norway. The group of EU15 countries comprises (in alphabetic order) Austria, Belgium, Denmark, France, Finland, Germany, Greece, Ireland, Italy, Luxemburg, Netherlands, Portugal, Spain, Sweden, and U.K. Our investigation period starts with 1995 accounting year and ends with the last accounting year prior to the first year of mandatory IFRS adoption in 2005. The starting sample consists of 4,745 public traded companies with overall 47, 4505 firm-years (4,745 x 10 years).

Table 1 presents the distribution of these 4,745 firms across our 17 countries. The number of public traded companies is highest for the U.K. (1,590) and lowest for Luxemburg (26). Table 1 further presents the fraction of sample firms adopting IAS/IFRS for the total sample and each country, in different years (voluntary adoption countries are marked bold).

*** Insert Table 1 about here ***

We use the Compustat accounting standard code (CAS-code) to distinguish between firms reporting under IAS/IFRS and under local GAAPs. All firms with the CAS-code DI (Domestic standards generally in accordance with IASC guidelines) are classified as IAS/IFRS adopters in the corresponding fiscal year. Firms with the CAS-code DS (Domestic Standards) are classified as local GAAPs adopters. As Table 1 reveals, the voluntary adoption is especially pronounced in the three countries with German legal origin (Austria, Germany, and Switzerland), plus Luxemburg. For example, the fraction of public traded firms voluntarily adopting IAS/IFRS in 2001 is round 43% in Austria, 29% in Germany, 51% in Switzerland, and 42% in Luxemburg. On the other hand, Ireland, Netherlands, Norway, Spain, Sweden, and the U.K. did not allow a voluntary adoption prior to 2005.

The accounting data used in our sample are from Compustat Global (Version 2006), updated in some cases using Reuters Xtra 3000.9 We are excluding financial companies (Compustat economic sector code: 5,000-5,999), as their financial statements significantly differ from those of other firms. We further exclude all firm-years with one or more missing accounting information necessary to compute all earnings management measures, including total assets (in year t, and year t-1), net profit, operating cash flow, revenue, PPE (plant, property and equipment), current assets, current liabilities, short term debt, income tax payable, depreciation & amortization, accounts receivable, inventory, other current assets, accounts payable, and other current liabilities. In addition it is worth mentioning that not all firms were listed during the entire ten year period (1995-2004). Some firm-year observations, therefore, are missing from our database. As Table 2 reveals, these exclusions reduce the number of firmyears in our sample to 21,397.

*** Insert Table 2 about here *** We excluded firm-years with either US-GAAP (1,023 firm-years) or other standards as indicated by the Compustat Accounting Standard codes DA, DD, DO, DR, and DT (68 firmyears). This further reduced the number of firm years to 20,306.The first accounting year of

This applies to some accounting variables for Swedish firms.

adopting a new accounting standard might be biased due to necessary adjustments. We therefore exclude the first year following the voluntary IAS/IFRS adoptions. This procedure reduces our sample by further 273 firm-years.

As indicated earlier, Netherlands, Norway, Sweden, and UK are among the countries that did not allow listed companies to voluntary adopt IAS/IFRS standards prior to 2005. Nevertheless, we observed a small number of firm-year observations that would indicate adoption of IAS/IFRS by the sample firms prior to 2005 (Netherlands: 36; Norway: 6; Sweden: 29; UK: 18). We, therefore, exclude those 89 firm-year observations. To further minimize the influence of data errors we deleted firm-year observations where the operating cash flow is reported as exactly zero and/or when total assets were below 1 Million. This truncation procedure reduces the number of available firm-years to final sample size of 19,807 (see Table 2).10

Table 3 presents the final number of firm-year observations for the total sample and each accounting year. We include accounting years that end in 2005 but start prior to the date of mandatory IFRS adoption within European Union countries (January 1st 2005), Thus, the year 2005 also contains a few firm-years. The fraction of voluntary IAS/IFRS and local GAAPs adopters varies across calendar years between about 7 and 14 percent. This fraction is higher compared to the overall fraction of IAS/IFRS firms presented in Table 1, indicating that, on average, Compustat provides more accounting information for firms that adopted IAS/IFRS than for firms reporting under local GAAPs. Furthermore, Table 3 also reveals that the number of voluntary IAS/IFRS adopters increased over the years from 48 in 1995 to 391 firms in 2004.

*** Insert Table 3 about here ***

Table 4 provides descriptive statistics for subsamples of firms with local GAAPs and the firms adopting IAS/IFRS. Panel A shows that IAS/IFRS firms are typically larger than local
10

To further mitigate the influence of outliers we winsorized important accounting items (discretionary total accruals, discretionary current accruals, their absolute values, ROA, revenue growth, net operating cash flow as a fraction of total assets in t-1, and the debt-equity ratio) at the 1st and 99th percentile.

10

GAAPs firms. Based on mean and median differences of total assets, revenue, shareholders equity, operating cash flow, and net income before extraordinary items, IAS/IFRS companies are about twice as large as local GAAPs firms. This difference is significant in all case. Panel B of Table 4 reveals that local GAAPs and IAS/IFRS firms tend to be quite similar concerning important accounting ratios. This especially applies to annual revenue growth (about 6 to 7%, based on median values), return on assets (ROA) (approximately 3 to 4%, based on median values), the debt/equity ratio (around 1.3 for median and 1.9 for mean values), and current assets scaled by lagged total assets (about 55-56%). Only current liabilities and net operating cash flows, both scaled by lagged total assets, are statistically significantly higher for local GAAPs firms (34% vs. 30% for current liabilities and 8.8% vs. 7.4% for net operating cash flow, both based on median values).

*** Insert Table 4 about here ***

5.2. Earnings Management Proxies

Since earnings management can not directly be observed, reported results in the literature are difficult to compare due to variety of proxies used to measure earnings management. Most frequently used earnings management proxies are discretionary accrual measures based on the modified Jones model (see e.g. Jones (1991), Dechow (1994), or Dechow et al. (1995)). In this study we use four discretionary accrual measures (EM1 to EM4). These are discretionary total accruals (DTAC), discretionary current accruals (DCAC), as well as the absolute values of DTAC and DCAC:

EM1:

DTAC TA t 1

(1)

EM2:

DCAC TA t 1

(2)

EM3:

DTAC TA t 1

(3)

11

EM4:

DCAC TA t 1

(4)

All measures are scaled by lagged total assets (TAt-1) to make them comparable among firms and over time. Discretionary accruals are estimated using the cross-sectional version of the modified Jones model, where total accruals (TAC) and current accruals (CAC) are separated into an expected and discretionary component:

TAC = E[TAC]+ DTAC CAC = E[CAC]+ DCAC

(5)

(6)

E[TAC] is the expected or nondiscretionary total accrual component and E[CAC] is the expected or nondiscretionary current accrual component. Total accruals are defined as, e.g., in Dechow et al. (1995) and Burgstahler et al. (2006) and computed as follows:

TAC = (TCA Cash) (TCL ST Debt) D & A exp ,

(7)

where TCA represent total current assets, TCL are total current liabilities, ST Debt is short term debt, D&Aexp are depreciation and amortization expenses, and is the shortcut for change.

Some studies reveal that managers (at least in the short-run) have more discretion on current accruals. We define and compute current accruals (CAC) in line with the procedure used in Teoh et al. (1998a, 1998b):

CAC = (AR + Inventory + OCA) (AP + TaxPay + OCL),

(8)

where AR represents accounts receivables, OCA are other current assets, AP represents accounts payable, TaxPay is Tax Payable, and OCL are other current liabilities. To estimate
12

discretionary accrual components we are using in a first step, in line with Teoh et al. (1998a, 1998b), a cross-sectional ordinary least square (OLS) regression to compute an expected or nondiscretionary accrual component.

Therefore, to estimate the expected total accruals of IAS/IFRS firm i, in country m, industry n, and year t, we estimate the following cross-sectional OLS regression using all local GAAPs firms j = 1, , J (in country m, industry n, and year t) as an estimation sample:

TAC j, t , m, n TA j, t 1, m, n

= 0

1 TA j, t 1, m, n

+ 1

Re v j, t , m, n TA j, t 1, m, n

+ 1

PPE j, t , m, n TA j, t 1, m, n

+ j, t , m, n ,

(9)

where TACj,t,m,n are the total accruals of local GAAPs firm j, in fiscal year t, country m, and industry n, and TAj,t-1,m,n are the corresponding lagged total assets of local GAAPs firm j in fiscal year t-1. Revj,t,m,n is the corresponding change in revenue, and PPEj,t,m,n are the plant, property and equipments of local GAAPs firm j.

By using the three dimensions (country, industry and year) to pool observations we control for country, industry, and time effects. Thus, we assume that accruals of a particular firmyear are not only influenced by earnings management, but are also affected by country and industry affiliation, as well as the corresponding year.

The expected or nondiscretionary total accrual component of IAS/IFRS firm i (in country m, industry n, and year t) is then defined as:

E[DTAC] i, t , m, n = a 0

1 TA i, t 1, m, n

+ a1

Re v i, t , m, n AR i, t , m, n TA i, t 1, m, n

+ a2

PPE i, t , m, n TA i, t 1, m, n

, (10)

where a0 is the estimated intercept, and a1 and a2 are the estimated slope coefficients for firm i in year t, country m, and industry n, based on the cross-sectional regression equation in (9). In line with Teoh et al. (1998a), we subtract the increase in accounting receivables from revenue

13

changes to allow for possible credit sale manipulations.11 The discretionary total accrual component DTACi,t,m,n for firm i in year t, country m, and industry n is then defined as:

DTACi, t , m, n =

TAC i, t , m, n TA i, t 1, m, n

E[DTAC]i, t , m, n

(11)

Discretionary current accruals (DCACi,t,m,n) for firm i in year t, country m, and industry n are computed in a similar way as for discretionary total accruals. In a first step expected current accruals, E[DCAC]j,t,m,n are estimated using a cross-sectional OLS regression with a sample of local GAAPs firms (j = 1, , J; estimation sample) for every year t, country m, and industry n:

CAC j, t , m, n TA j, t 1, m, n

= 0

1 TA j, t 1, m, n

+ 1

Re v j, t , m, n TA j, t 1, m, n

+ j, t , m, n

(12)

The expected or nondiscretionary current accrual component for firm i (in year t, country m, and industry n) is then computed as:

E[DCAC] i, t , m, n = b 0

1 TA i, t 1, m, n

+ b1

Re vi, t , m, n AR i, t , m, n TA i, t 1, m, n

(13)

where b0 is the estimated intercept, and b1 is the estimated slope coefficient using equation (12). The discretionary current accrual component DCACi,t,m,n for firm i in year t, country m, and industry n is then calculated as:

DCAC i, t , m, n =

CAC i, t , m, n TA i, t 1, m, n

E[DCAC]i, t , m, n

(14)

11

For example, more generous credit policy in year t can lead to higher revenues in that year. See Teoh et al. (1998c) for a robustness check of this measure relative to other measures.

14

To test our hypotheses, initially we estimate the following OLS model:

EMit = a0 + a1 ifrsit + a2 ln_TAit + a3 D/Eit + a4 rev_growthit + a5 nocfit +a6 roait + a7 atit+a8 beit +a9 chit +a10 deit +a11dnit +a12fiit +a13frit +a14irit +a15itit +a16luit +a17nlit +a18no it+a19spit + a20swit +a21ukit+ a22ind_basic_materialsit + a23ind_consumer_goodsit +a24ind_energyit+ a25ind_industrialsit +a26ind_information_techit +a27d_1996it +a28d_1997it +a29d_1998it +a30d_1999it +a31d_2000it +a32d_2001it +a33d_2002it +a34d_2003it +a35d_2004it +a36d_2005it +vit (15)

Dependent variables (EMit) are proxies for earnings management (EM1 to EM4). The following are categorical variables, taking value 1 if: firm adopts IAS/IFRS (Ifrs), Austrian firm (At), Belgian firm (Be), Swiss firm (Ch), German firm (De), Danish firm (Dn), Finish firm (Fi), French firm (Fr), firm from Luxemburg (Lu), Irish firm (Ir), Italian firm (It), Dutch firm (Nl), Norwegian firm (No), Spanish firm (Sp), Swedish firm (SW), British firm (UK), belong to different industries (basic, consumer, energy, industrials, information), and for relevant years (from d1996 to d2005). Additional variables are the logarithm of total assets in Mio EUR (ln_TA), the debt/equity ratio (D/E), defined as total liabilities divided by shareholder equity, revenue growth between years t-1 and t in percent (rev_growth), net operating cash flow scaled by total assets t-1 in percent (nocf), and net income scaled by total assets t-1 in percent (ROA).

In order to control for possibility that adoption of IAS/IFRS is not a random choice, we estimate the following simultaneous equations model:
ifrsit = bo + b1 numexit + b2 us_listing + uit

(16)

EMit = a0 + a1 ifrsit + a2 ln_TAit + a3 D/Eit + a4 rev_growthit + a5 nocfit +a6 roait + a7 atit+a8 beit +a9 chit +a10 deit +a11dnit +a12fiit +a13frit +a14irit +a15itit +a16luit +a17nlit +a18no it+a19spit + a20swit +a21ukit+ a22ind_basic_materialsit + a23ind_consumer_goodsit +a24ind_energyit+ a25ind_industrialsit +a26ind_information_techit +a27d_1996it +a28d_1997it +a29d_1998it +a30d_1999it +a31d_2000it +a32d_2001it +a33d_2002it +a34d_2003it +a35d_2004it +a36d_2005it +vit (17)

Where numexit and us_listing are the number of exchanges a firm is listed on and a categorical variable with value of one if the firm is listed on a U.S. exchange, and zero otherwise. In the above model we assuming that error terms, uit and vit, are independent and that the system is recursive. This allows us to estimate the system using 2 stage least square (2SLS) estimation, with IFRS as instrumented variable.

15

5. Empirical Results 5.1. Univariate Analysis

Figure 1 presents median values of EM1as a proxy for earnings management for the total sample of 19,807 firm-year observations, each year between 1995 and 2004, and the two subsamples: Local European GAAPs and international standards (IFRS). The graph reveals a downward trend in earnings management for both subsamples. For example, in the 1990s median EM1 tend to fluctuate around zero, while it tend to be negative during 2001-2004. In addition, Figure 1 shows that the median EM1 of firms voluntarily adopting international standards is more negative compared to local GAAPs adopters during 2001-2004.

*** Insert Figure 1 about here ***

A negative EM1 level is an indication that earnings of corresponding firms are lower than the expectation from the modified Jones model relative to the firms net operating cash flow. This reveals that in the sub-period 2001-2004 firms tend to engage more in earnings smoothing instead of managing their earnings upward (i.e. aggressive earnings management). One advantage of earnings smoothing is that managers easier can reach certain thresholds set by either analysts, institutional investors, or their own forecasts. Thus, Figure 1 shows that firms voluntarily adopting international standards (IFRS) tend to engage more in earnings smoothing compared to their local GAAPs counterparts during 2001-2004.

Table 5 displays mean and median values of all four earnings management measures (M1M4) for local GAAPs and international standard (IFRS) firms, as well as the corresponding mean and median differences for the total sample and five regions based on legal origin. Region 1 contains German legal origin countries (Austria (AT), Switzerland (CH), and Germany (DE)), Region 2 French legal origin countries in the France/Benelux area (Belgium (BE), France (FR), Luxemburg (LU), and the Netherlands (NE)), Region 3 contains French legal origin countries in southern Europe (Greece (GR), Italy (IT), and SP (Spain)), Region 4 Scandinavian legal origin countries (Denmark (DE), Finland (FI), Norway (NO), and Sweden (SW)), and Region 5 contains English legal origin countries (United Kingdom (UK), and Ireland (IR)). We are splitting the total sample in these sub-samples as the legal origin may have

16

an influence on the quality of accounting standards and thus also on the earnings management behavior (in line with Leuz et al., 2003) and Nabar and Boonlert-U-Thai, 2007).

*** Insert Table 5 about here ***

Discretionary total accruals (EM1, Panel A of Table 5) and discretionary current accruals (EM2, Panel B of Table 5) are lower for IAS/IFRS firms. This is the case for the total sample and nearly all five regions. An exception are mean EM1 in regions 2 and 3 (French legal origin countries) but the differences are not significant. Especially region 3 has a quite low number of firm-years based on only two Greece companies.

The observation of lower discretionary accruals for voluntary international standards adopters is most pronounced (and significant) in the sub-sample of German legal origin countries (region 1, see Panels A and B), where also the frequency of voluntary IAS/IFRS adoption is highest (1746 IFRS firm years against 2178 local GAAPs firm years).

Lower discretionary accruals, as reported in Panels A and B of Table 5, indicate lower earnings management in the form of less frequently managing earnings upward (relative to net operating cash flows). Panels C and D of Table 5 complement this results by showing that absolute discretionary accruals (especially EM3) tend to be higher for firms voluntarily adopting international standards compared to local GAAPs firms. Lower discretionary accruals and higher absolute discretionary accruals indicate that IAS/IFRS firms tend to manage their earnings downward relative to what is expected from the modified Jones model based on their net operating cash flow. Thus, voluntary adoption of international standards seems to be associated with more conservative earnings management behaviour in the sense of earnings smoothing.

This observation (lower discretionary accruals (Panels A and B) and higher absolute discretionary accruals (Panels C and D)) is most pronounced for region 1 with the German legal origin countries Austria, Germany, and Switzerland. Interestingly, in regions 2, 3, and 4 (French and Scandinavian legal origin) EM3 and EM4 tend to be significantly lower for IAS/IFRS firms. This also indicates that in these regions firms adopting international account-

17

ing standards tend to engage less in earnings management compared to their local GAAPs counterparts. The above results provide support to our hypothesis 2.

Interesting is also the observation that the level of discretionary accruals of firms adopting local accounting standards is lowest in English legal origin countries (see Panels A and B of Table 5). This indicates that firms in these countries tend to have relatively conservative earnings management behaviour. Thus, the average Anglo-Saxon (UK and Ireland) firm tends to engage more in earnings smoothing than in aggressive earnings management (i.e. managing earnings upward relatively to the net operating cash flow level). This might be due to local accounting standards that are (before 2005) more in line with international standards (IAS/IFRS), compared to continental European countries. This result is in line with the rating on accounting standards provided by La Porta et al. (1998). In using 1990 annual reports, they construct an index based on the inclusion or omission of 90 accounting items in a firms financial statement. They document that English legal origin countries have the highest rated (local) accounting standards, whereas the corresponding rating of German and French legal origin countries is significantly lower. In a next step we analyze the median EM1 for each country.12 Figure 2 compares in this respect median EM1 for local GAAPs as well as IAS/IFRS firms. In nearly all of our countries earnings management, based on the EM1 level, is lower for IAS/IFRS firms. This is true for Germany, Switzerland, Belgium, France, Luxemburg, Greece, Denmark, and Finland.13 The more negative median EM1 of IAS/IFRS adopters indicate also on a country level that voluntary international accounting standard adopters engage less in aggressive (earnings increasing) earnings management but more in earnings smoothing. Based on median EM1 level differences, this effect is as Figure 2 reveals - most pronounced for Germany, Switzerland, Belgium, Luxemburg, Greece, and Denmark.14

*** Insert Figure 2 about here ***

We exclude in this analysis Portugal, as we do not have enough accounting information for this country. Only in Austria is the median DTACC level of voluntary IFRS adopters higher than for firms reporting under local GAAP. 14 It is important to note that the level of discretionary total accruals of local standard adopters in Luxemburg and Spain as well as for voluntary international standard adopters in Greece might be influenced by a low number of firm-year observations (8 for local GAAPs adopters in Luxemburg and Spain, and 12 for international standard adopters in Greece. Voluntary adoption of international accounting standards (IAS/IFRS) has not been allowed in the Netherlands, Norway, Sweden, Ireland, and the UK.
13

12

18

5.2. Multivariate Analysis

The results for our OLS models are presented in Table 6. The results for models with EM1 and EM2 with dependent variables are economically and statistically consistent. In both models, ifrs variable is negative and highly statistically significant suggesting negative association of IAS/IFRS adoption and earnings management. Variables for leverage (D/E) and net operating cash flow (nocf) are also negative and highly statistically significant. The control variables for industry classification tend to be more important in the regression with EM1 as dependent variable. Overall explanatory power of the models for EM1 and EM2 measured by adjusted R2 is 28% and 23%, respectively. The results for models with EM3 and EM4 are economically and statistically consistent but exhibit much lower explanatory power.

*** Insert Table 6 about here ***

The results for heteroscedasticity robust 2 stage least square (2SLS) estimation, with IFRS as instrumented variable are presented in Table 7. Based on Kleibergen-Paap LM statistics for underidentification and Kleibergen-Paap Wald F statistics for weak identification, we reject null hypothesis that our model is under or weekly identified. Thus, the results of our OLS model remain robust after we control for the bias induced by possibility that the adoption of IAS/IFRS in our sample may not be random. The results for different variables remain economically and statistically consistent. Notable, variables ifrs, D/E, and nocf remain negative and statistically significant. The statistically significance for ifrs in the model for EM1, however, dropped to 10% while in the regression EM2 incresed from 5% to 1%. The results for models with EM3 and EM4 are economically and statistically consistent with the results reported for corresponding OLS models. The notable difference, however, is that now revenue growth, net operating cash flow and ROA variables become statistically significant in the 2SLS model. Overall, the results of our multivariate models are economically and statistically consistent with the results of our univariate analysis in providing support for our hypothesis 1.

*** Insert Table 7 about here ***

19

7. Conclusion
In this study we examine earnings management in public listed firms within 15 EU member states plus two non-EU members, namely Switzerland and Norway. In 10 of the countries included in our sample, provisions were made to allow firms to use international accounting standards well before they became mandatory in 2005. This presented us with an opportunity to compare the earnings management of international accounting standards (IAS/IFRS) adopters with earnings management in firms using local standards (GAAPs). We also examine how the transition from local to international accounting standards affected earnings management in different groups of countries according to their legal tradition.

Our empirical analysis is based on 4 different proxies for earnings management in the sample that consists of around 20,000 firm-years, during 1995-2005. The results suggest that firms that opted for the international standards manage earnings to lesser extent than firms choosing domestic accounting standards. The results are robust to potential endogeneity induced by the possibility of firms in certain countries to choose whether to adopt IAS/IFRS. We also documented that earnings management is generally less pronounced in Anglo-Saxon and Northern European countries than in the rest of Europe. The earnings management differences are not only related to adoption of different accounting standards and they persist irrespective which accounting standards were used. For example, the level of discretionary accruals of firms adopting local accounting standards is lowest in English legal origin countries. This indicates that firms in these countries tend to have relatively conservative earnings management behaviour. Thus, the average Anglo-Saxon (UK and Ireland) firm tends to engage more in earnings smoothing than in aggressive earnings management.

20

References
Ball R., A. Robin, and J. S. Wu (2003), Incentives Versus Standards: Properties of Accounting Income in Four East Asian Countries, Journal of Accounting & Economics, Vol. 36, pp. 235-270.

Barth, M. E., W. R. Landsman, and M. H. Lang (2008), International Accounting Standards and Accounting Quality, Journal of Accounting Research, Vol. 46, pp. 467-498.

Barth, M. E., W. R. Landsman, M. Lang, and C. Williams (2006), Accounting Quality: International Accounting Standards and US GAAP, Working paper, Stanford University, University of North Carolina.

Biddle G. C., and G. Hilary 2006, Accounting Quality and Firm-Level Capital Investment, Journal of Accounting Review, Vol. 81, pp. 963-982.

Bradshaw M. T., and S. M. Gregory (2007), Will Harmonizing Accounting Standards Really Harmonize Accounting?, Evidence from Non-U.S. Firms Adopting U.S. GAAP, Working paper, Havard Business School.

Burgstahler D., L. Hail, and C. Leuz (2006), The Importance of Reporting Incentives: Earnings Management in European Private and Public Firms, Accounting Review, Vol. 81, pp. 983-1016.

Burgstahler D., and I. Dichev (1997), Earnings Management to Avoid Earnings Decreases and Losses, Journal of Accounting and Economics, Vol. 24, pp. 99-126.

Bushman R. M, and J. D. Piotroski (2006), Financial Reporting incentives for conservative accounting: The Influence of Legal and Political Institutions, Journal of Accounting and Economics, Vol. 42, pp. 107-148.

21

Daske H., G. Gebhardt, and S. McLeay (2006), Economic Benefits of Adopting IFRS or US GAAP - Have the Expected Cost of Equity Capital Really Decreased?, Journal of Business Finance and Accounting, Vol. 33, pp. 1-45.

Dechow P. (1994), Accounting earnings and cash flows as measures of firm performance. The role of accounting accruals, Journal of Accounting and Economics, Vol. 18, pp. 3-42.

Dechow, P., R. Sloan, and A. Sweeney, Detecting earnings management, Accounting Review (1995),Vol. 70, pp. 193225.

DeFond M. L., and M. Hung (2003), An empirical analysis of analysts cash flow forecasts, Journal of Accounting and Economics, Vol. 35, pp. 73-100.

Degeorge F., J. Patel, and R. Zeckhauser (1999), Earnings Management to Exceed Thresholds, Journal of Business, Vol. 72, pp. 1-33. Delvaille, P., G. Ebbers, and C. Saccon (2005), International financial reporting convergence: Evidence from three continental European countries. Accounting in Europe, Vol 2, pp. 137164. Dick W. and Walton P. J. (2001), Conformite aux norms comptables intenationales: comparison franco-allemande, Revue Francaise de Comptabilite, pp. 36-39.

Directive 2006/43/EC of the European Parliament and of the Council of 17 May 2006 on statutory audits of annual accounts and consolidated accounts, amending Council Directives 78/660/EEC and 83/349/EEC and repealing Council Directive 84/253/EEC, OJ L 157, 9.6.2006, p. 87.

Dobler M. (2008), Auswirkungen des Wechsels der Rechnungslegung von HGB zu IFRS, Betriebswirtschaftliche Forschung und Praxis, Vol. 60, pp. 259-275.

Entwistle G., and F. Phillips (2003), Relevance, reliability and the earnings quality debate, Issues in Accounting Education, Vol. 18, pp. 79-92.

22

Ewert R., and A. Wagenhofer (2005), Economic Effects of Tightening Accounting Standards to Restrict Earnings Management, Accounting Review, Vol. 80, No. 4, pp. 1101-1124.

Fourth Council Directive 78/660/EEC of 25 July 1978 based on Article 54 (3) (g) of the Treaty on the annual accounts of certain types of companies, 78/660/EEC, OJ L 222, 14.8.1978, p. 11.

Glaum M., K. Lichtblau, and J. Lindemann (2004), The Extent of Earnings Management in the U.S. and Germany, Journal of International Accounting Research, Vol. 3, pp. 45-77.

Hung M., and K. R. Subramanyam (2007), Financial statement effects of adopting International Accounting Standards: the case of Germany, Review of Accounting Studies, Vol. 12, pp. 623-657.

Jones, J. J. (1991), Earnings Management During Relief Investigations, Journal of Accounting Research, Vol. 20, pp. 193-228.

Joos P., and M. Lang (1994), The effects of accounting diversity: Evidence from the European community, Journal of Accounting Research, Vol. 29, pp. 141-168.

La Porta, R., F.L. De Silanes, A. Shleifer, F., and R. Vishny, (1998), Law and Finance, Journal of Political Economy, Vol. 106, pp. 1113-1155.

La Porta R., A. Shleifer, F. Lopez-de-Silanes, and R. Vishny, (2000), Investor Protection and Corporate Governance, Journal of Financial Economics, Vol. 58, pp. 3-27.

Land J., and M. H. Lang (2002), Empirical Evidence on the Evolution of International Earnings, Accounting Review, Vol. 77, pp. 115-133.

Lang M., J. S. Raedy, and W. Wilson (2006), Earnings Management and Cross listing: Are Reconciled Earnings Comparable to US Earnings? Journal of Accounting and Economics, Vol. 42, pp. 255-283.

23

Lara, J.M.G, B.G. Osma, and A.Mora, (2005), The effect of earnings management on the asymmetric timeliness of earnings, Journal of Business Finance and Accounting, Vol. 32, pp. 691-726.

Leuz C., D. Nanda, and P. D. Wysocki (2003), Earnings Management and Investor Protection: an International Comparison, Journal of Financial Economics, Vol. 69, pp. 505-527.

Leuz C., and R. E. Verrecchia (2000), The Economic Consequences of Increased Disclosure, Journal of Accounting Research, Supplement: Studies on Accounting Information and the Economics of the Firm, Vol. 38, pp. 91-124.

Myers, J., L. Myers, and D. Skinner (2006), Earnings momentum and earnings management, Working Paper, University of Chicago.

Nabar S., and K. K. Boonlert-U-Thai (2007), Earnings Management, Investor Protection, and National Culture, Journal of International Accounting Research, Vol. 6, pp. 35-54. Peasnell, K.V., P.F. Pope, and S. Young (2000), Accrual management to meet earnings targets: UK evidence pre- and post-Cadbury, British Accounting Review, Vol. 32, pp. 415-445.

Prather-Kinsey, J, E.K. Jermakowitz and T. Vongphanith (2008), Capital market consequences of European firmsmandatory adoption of IFRS, Working Paper.

Raonic, I., S.J. Mcleay and I. Asimakopoulos (2004), The timeliness of income recognition by European companies: An analysis of institutional and market complexity, Journal of Business Finance and Accounting, Vol.31, pp.115-148.

Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards, OJ L 243, 11.9.2002, p. 1.

Schipper K., and L. Vincent (2003), Earnings Quality, Accounting Horizons, Vol. 17, pp. 97110.

24

Seventh Council Directive of 13 June 1983 based on the Article 54 (3) (g) of the Treaty on consolidated accounts (83/349/EEC), OJ L 193, 18.7.1983, p. 1.

Soderstrom N. S., and K. J. Sun (2007), IFRS Adoption and Accounting Quality: A Review, European Accounting Review, Vol. 16, pp. 675-702.

Teoh H. S., I. Welch, and T. J. Wong (1998a), Earnings Management and the Long-Run Market Performance of Initial Public Offerings, Journal of Finance, Vol. 53, pp. 1935-1974.

Teoh H. S., I. Welch, and T. J. Wong (1998b), Earnings management and the underperformance of seasoned equity offerings, Journal of Financial Economics, Vol. 50, pp. 63-99.

Teoh H. S., T. J. Wong, and G. R. Rao (1998c), Are earnings during Initial public Offerings opportunistic? Review of Accounting Studies, Vol. 3, pp. 175-208.

Van Tendeloo, B., and A. Vanstraelen (2005), Earnings Management under German GAAP versus IFRS, European Accounting Review, Vol. 14, pp. 155-180.

Wagenhofer A., and H. Dcker (2007), Die Messung von Earnings - Qualitt, Journal fr Betriebswirtschaft, Vol. 57, pp. 263297.

25

Table 1: Fraction of Sample Firms with Voluntary Adoption of IAS/IFRS

This table provides the percentage fraction of firms adopting IAS/IFRS in each of sample countries and each calendar year. Firms in Austria, Belgium, Denmark, Finland, France, Germany, Greece, Luxemburg, Portugal, and Switzerland were allowed voluntary adoption, and were marked in bold. Country Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxemburg Netherlands Norway Portugal Spain Sweden Switzerland UK Total # Firms 77 191 166 115 599 701 77 60 244 26 174 135 35 130 260 237 1,590 4,745 1995 0.0 1.0 1.2 1.7 4.8 0.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 15.6 0.0 1.7 1996 1.3 2.1 1.2 2.6 4.8 1.3 0.0 0.0 0.0 7.7 0.0 0.0 2.9 0.0 0.0 21.9 0.0 2.3 1997 6.5 2.1 1.8 2.6 5.3 3.6 1.3 0.0 0.0 7.7 0.0 0.0 2.9 0.0 0.0 26.2 0.0 3.1 1998 11.7 2.6 2.4 4.3 5.3 10.0 1.3 0.0 0.0 7.7 0.0 0.0 0.0 0.0 0.0 29.1 0.0 4.4 1999 20.8 3.1 4.8 6.1 5.7 22.4 1.3 0.0 0.0 30.8 0.0 0.0 0.0 0.0 0.0 42.2 0.0 7.3 2000 33.8 3.7 5.4 7.0 5.7 26.7 1.3 0.0 0.0 38.5 0.0 0.0 2.9 0.0 0.0 49.4 0.0 8.7 2001 42.9 5.8 4.8 6.1 5.3 29.2 5.2 0.0 0.0 42.3 0.0 0.0 2.9 0.0 0.0 50.6 0.0 9.5 2002 46.8 6.3 6.0 6.1 5.5 30.1 6.5 0.0 0.0 38.5 0.0 0.0 2.9 0.0 0.0 50.6 0.0 9.8 2003 54.5 7.9 9.0 7.0 5.2 31.1 6.5 0.0 0.0 42.3 0.0 0.0 2.9 0.0 0.0 51.9 0.0 10.4 2004 55.8 11.0 11.4 12.2 5.8 37.4 7.8 0.0 0.0 42.3 0.0 0.0 2.9 0.0 0.0 52.7 0.0 11.8

26

Table 2: Sample Selection Process

This table provides an overview of our sample selection process. The starting sample consists of 4,745 public traded companies (EU15 countries plus Switzerland and Norway) identified in the Compustat Global (version 2006) during 1995- 2004. Number of firm-years Starting sample We excluded financial companies (Compustat economic sector code: 5,0005,999), as their financial statements significantly differ from those of other firms. We are further excluding all firm-years with one or more missing accounting information (necessary data for each firm-year are: Total assets (in year t, and year t-1), net profit, operating cash flow, accruals and discretionary accruals (revenue, plant, property and equipment (PPE), current assets and liabilities, short term debt, income tax payable, depreciation & amortization), current and discretionary current accruals (accounts receivable, inventory, other current assets, accounts payable, other current liabilities)). It is worth mentioning that not all firms are listed during the entire sample period, which further reduced the number of firmyear observations. Remaining data We excluded firm-years with either US-GAAP (1,023) or other standards (Compustat Accounting Standard codes DA, DD, DO, DR, and DT) (68 firm years). Remaining data We excluded the first fiscal year after voluntary adoption of IAS/IFRS, due to potential contaminations (e.g. adjustments). Remaining data Netherlands, Norway, Sweden, and UK are among the countries that did not allow listed companies to voluntary adopt IAS/IFRS standards prior to 2005. Nevertheless, we observed a small number of IAS/IFRS firm years prior to 2005 (Netherlands: 36; Norway: 6; Sweden: 29; UK: 18); We, therefore, excluded 89 firm- years. Remaining data We exclude firm-year observations where the operating cash flow is exactly zero and/or when total assets are below 1 Million. Final sample 47,450

-26,053

21,397

-1,091

20,306 - 273

20,033

-89

19,944

-137 19,807

27

Table 3: Number of Firm-Year Observations

This table presents the final number of firm-year observations for the total sample and in each year. We include firm-year observations that end in 2005 but start prior to the data of mandatory IFRS adoption on January 1st 2005. Thus, the year 2005 also contains several firm-years.

Local GAAPs Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Total # Firm-years 453 652 1,082 1,405 1,674 2,091 2,271 2,344 2,385 2,443 782 17,582

IAS/IFRS # Firm-years 48 55 84 117 167 285 323 335 362 391 58 2,225

Total # Firm-years 501 707 1,166 1,522 1,841 2,376 2,594 2,679 2,747 2,834 840 19,807

28

Table 4: Descriptive Statistics and Univariate Analysis

This table presents means and medians for sample firms characteristics (Panel A) and accounting ratios (Panel B) in subsamples that adopted local and IAS/IFRS standards. TA is total assets, CA is current assets, TL is total liabilities, CL is current liabilities, CF is cash flow, and Net Income is net income before extraordinary items, ROA is Return on Assets. Test statistics are based on a standard two sample t-test (mean differences) and a Wilcoxon signed rank test (median differences); corresponding p-values in brackets.

Panel A: Accounting Items in Million EUR (2004 prices) Mean Variable TA Test st. p-value Revenue Test st. p-value Shareholder Equity Test st. p-value Net Operating CF Test st. p-value Net Income Test st. p-value # of firm years 17,582 2,225 53.00 148.65 174.14 328.19 601.67 1,199.23 1,502.30 3,207.99 Local GAAPs 1,815.44 IAS/IFRS 4,085.84 Difference (Local IAS) -2,270.40 -7.68 (0.000) -1705.69 -7.96 (0.000) -597.55 -7.29 (0.000) -154.05 6.28 (0.000) -95.65 -6.69 (0.000) 17,582 2,225 4.14 6.14 10.13 17.75 54.62 99.00 155.21 256.93 141.39 236.34 Local GAAPs Median IAS/IFRS Difference (Local IAS) -94.95 -13.65 (0.000) -101.72 -11.61 (0.000) -44.38 -15.76 (0.000) -7.62 -7.61 (0.000) -2.00 -4.22 (0.000)

29

Panel B: Accounting Ratios (in %) Mean Variable Revenue growth p.a. Test st. p-value ROA Test st. p-value Net Operating CF/TAt-1 Test st. p-value TL/Shareholder Equity Test st. p-value TL/TA Test st. p-value CL/TA Test st. p-value CA/TA Test st. p-value # of firm years 17,582 2,225 55.32 55.10 36.64 32.88 58.27 56.54 1.98 1.93 6.99 5.04 0.48 -0.15 Local GAAPs 18.98 IAS/IFRS 18.10 Difference (Local IAS) 0.88 0.68 (0.495) 0.63 1.7 (0.074) 1.95 5.06 (0.000) 0.06 0.83 (0.408) 1.73 2.96 (0.003) 3.77 9.06 (0.000) 0.22 0.49 (0.621) 17,582 225 56.83 55.57 34.01 30.45 57.94 57.93 1.30 1.33 8.78 7.45 3.83 2.91 7.24 6.19 Median Local GAAPs IAS/IFRS Difference (Local IAS) 1.05 1.82 (0.069) 0.92 6.97 (0.000) 1.33 7.83 (0.000) -0.03 -1.08 (0.279) 0.02 0.82 (0.413) 3.56 8.38 (0.000) 1.26 1.68 (0.094)

30

Figure 1: Discretionary Total Accruals in Total Sample, 1995-2004

This figure presents median discretionary total accruals scaled by Total Assets t-1 (EM1), for the total sample (17 countries and 19,807 firm-year observations). Dashed line represents sample firms using international accounting standards (IAS/IFRS) whilst full boded line represents sample firms using local GAAPs (Local).

Median EM1 (%) 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Local IFRS

31

Table 5 Earnings Management by Region

This table presents the mean and median value of four earnings management measures (Panel A: EM1; Panel B: EM2; Panel C: EM3; and Panel D: EM4 and the corresponding differences between local accounting standards (Local) and international accounting standards (IFRS) for five regions and the total sample. Region 1 contains German legal origin countries (Austria (AT), Switzerland (CH), and Germany (DE)), Region 2 contains French legal origin countries in the France/Benelux area (Belgium (BE), France (FR), Luxemburg (LU), and the Netherlands (NE)), Region 3 contains countries in southern Europe (Greece (GR), Italy (IT), and SP (Spain)), Region 4 contains Scandinavian legal origin countries (Denmark (DE), Finland (FI), Norway (NO), and Sweden (SW)), and Region 5 contains English legal origin countries (United Kingdom (UK), and Ireland (IR)). Countries, within regions, that were allowed to voluntarily adopt IAS/IFRS standards are in bold. Portugal is excluded, as we do not have enough accounting information. All earnings management measures are scaled by total assets t-1 and are presented in percentage terms. Differences in the earnings management are calculated as Local minus IFRS. Test statistics are based on a standard two sample t-test (mean differences) and a Wilcoxon signed rank test (median differences). ***, significance at 1%; **, significance at 5%; significance at 10%.

Panel A: EM1
Mean Local Region 1: AT, CH, DE Region 2: BE, FR, LU, NL Region 3: GR, IT, SP Region 4: DN, FI, NO, SW Region 5: UK, IR Total Sample 0.78 -0.32 -0.27 -0.45 -0.81 -0.42 -1.12 0.70** IFRS -1.31 -0.13 1.54 -1.75 Difference 2.09*** -0.19 -1.81 1.31 Local 0.40 -0.36 -0.18 -0.57 -0.70 -0.44 -0.99 0.55*** Median IFRS -1.03 -0.80 -0.55 -1.17 Difference 1.43*** 0.43 0.37 0.60 # of firm years Local 2178 3583 1103 3089 7629 17582 2225 IFRS 1746 372 12 95

Panel B: EM2
Mean Local Region 1: AT, CH, DE Region 2: BE, FR, LU, NL Region 3: GR, IT, SP Region 4: DN, FI, NO, SW Region 5: UK, IR Total Sample 0.94 0.27 0.50 0.37 0.25 0.38 0.34 0.04 IFRS 0.48 0.17 -0.55 -1.43 Difference 0.46 0.09 1.05 1.80** Local 0.30 0.03 0.45 0.02 -0.05 0.07 -0.23 0.30* Median IFRS -0.20 -0.24 -0.76 -0.89 Difference 0.50** 0.28 1.21 0.91 # of firm years Local 2178 3583 1103 3089 7629 17582 2225 IFRS 1746 372 12 95

32

Table 5 (continued)

Panel C: EM3
Mean Local Region 1: AT, CH, DE Region 2: BE, FR, LU, NL Region 3: GR, IT, SP Region 4: DN, FI, NO, SW Region 5: UK, IR Total Sample 7.44 7.55 6.31 7.32 9.06 8.07 9.14 -1.07*** IFRS 10.10 5.76 4.81 5.38 Difference -2.66*** 1.79*** 1.50 1.94*** Local 4.77 4.75 4.10 4.81 5.47 5.01 5.08 -0.07** Median IFRS 5.78 3.70 3.11 3.66 Difference -1.01*** 1.05*** 0.99 1.15** # of firm years Local 2178 3583 1103 3089 7629 17582 2225 IFRS 1746 372 12 95

Panel D: EM4
Mean Local Region 1: AT, CH, DE Region 2: BE, FR, LU, NL Region 3: GR, IT, SP Region 4: DN, FI, NO, SW Region 5: UK, IR Total Sample 6.82 6.79 5.94 6.84 7.98 7.26 7.93 -0.67*** IFRS 8.83 4.70 4.67 4.60 Difference -2.01*** 2.09*** 1.27 2.24*** Local 4.23 4.14 3.84 4.26 4.37 4.26 4.04 0.22 Median IFRS 4.52 3.13 1.42 2.73 Difference -0.29*** 1.01*** 2.42 1.53*** # of firm years Local 2178 3583 1103 3089 7629 17582 2225 IFRS 1746 372 12 95

33

Figure 2: Discretionary Total Accruals per Country

This figure presents median discretionary total accruals scaled by Total Assets t-1 (EM1), for each country during 1995- 2004. We present EM1, as a proxy for earnings management, under local (Local) and international (IAS/IFRS) accounting standards. Portugal is excluded, due to lack of relevant accounting information.

Median EM 1 (%) Median DTAC (%)

1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0
A us G tria er Sw ma itz ny er la Be nd lg iu m Fr an Lu xe ce Ne mbu t h rg er la nd G s re ec e Ita ly Sp D ain en m a Fi rk nn la N nd or w a Sw y ed e Ire n la nd U K
Local IFRS

34

Table 6 OLS Model for Determinants of Earnings Management

This table presents heteroscedasticity robust ordinary least square (OLS) estimates for the effect of IAS/IFRS adoption on earnings management. Dependent variables are proxies for earnings management (EM1, EM2, EM3, and EM4). The following are categorical variables, taking value 1 if: firm adopts IAS/IFRS (Ifrs), Austrian firm (At), Belgian firm (Be), Swiss firm (Ch), German firm (De), Danish firm (Dn), Finish firm (Fi), French firm (Fr), firm from Luxemburg (Lu), Irish firm (Ir), Italian firm (It), Dutch firm (Nl), Norwegian firm (No), Spanish firm (Sp), Swedish firm (SW), British firm (UK), belong to different industries (basic, consumer, energy, industrials, information), and for relevant years (from d1996 to d2005). Additional variables are the logarithm of total assets in Mill EUR (ln_TA), the debt/equity ratio (D/E), defined as total liabilities divided by shareholder equity, revenue growth between years t-1 and t in percent (rev_growth), net operating cash flow scaled by total assets t-1 in percent (nocf), and net income scaled by total assets t-1 in percent (ROA). ***, significance at 1%; **, significance at 5%; significance at 10%.

Ifrs ln_TA D/E rev_growth nocf ROA At Be Ch De Dn Fi Fr Ir It Lu Nl No Sp Sw Uk Ind_basic_materials Ind_consumer_goods Ind_energy Ind_industrials Ind_information_tech d_1996 d_1997 d_1998 d_1999 d_2000 d_2001 d_2002 d_2003 d_2004 d_2005 _cons R2_adjusted F N

EM1 -1.1286*** -0.001 -0.087*** 0.007** -0.478*** 0.496*** 0.389 -0.473 -1.259* -0.255 -1.268* -1.261* -0.678 0.206 -1.278* -0.028 -1.712** -1.586** -2.051* -1.841** -0.226 -0.973** -1.602*** -1.053 -1.576*** -2.411*** 0.397 -0.245 0.329 -0.392 -0.221 -0.221 -0.376 -1.019*** -1.105*** -0.904 5.503*** 0.281 58.93***

EM2 -0.638** 0.177*** -0.084*** -0.003 -0.442*** 0.367*** 0.874 0.084 -0.469 0.625 -0.109 -0.282 -0.240 1.185 -0.086 0.371 -0.383 -1.454* -0.809 -0.536 0.945 0.952** 0.645 0.728 0.672 0.939** 0.391 0.200 0.696* 0.856** 0.819** 0.519 0.228 -0.039 -0.345 0.457 1.275 0.232 44.47*** 19,807

EM3 -4.225 2.247 -0.083 0.467 -0.564 -0.603 -0.063 0.273 -0.335 -0.908 -2.469 -2.506 -2.583 -3.871 -6.817 -13.228 -0.248 -6.963 -10.100 -11.358 5.141 2.121 2.268 -7.023 13.751 -2.488 2.379 1.660 1.596 0.518 -4.992 21.678 1.728 2.831 0.979 -2.267 -11.157 0.007 6.21

EM4 -3.630 1.894 -0.057 0.409 -0.616** -0.477 0.028 0.658 -0.549 -0.561 -1.791 -2.013 -2.279 -3.592 -5.588 -12.691 -0.538 -5.767 -8.072 -9.809 4.716 2.138 1.789 -6.413 12.269 -2.494 2.383 1.403 1.419 0.767 -5.564 18.686 0.225 1.532 0.460 -2.779 -7.906 0.006 7.09

35

Table 7 2SLS Model for Determinants of Earnings Management

This table reports results for heteroscedasticity robust 2 stage least square (2SLS) estimation, with IFRS as instrumented variable. Dependent variables are proxies for earnings management (EM1, EM2, EM3, and EM4). The following are categorical variables, taking value 1 if: firm adopts IAS/IFRS (Ifrs), Austrian firm (At), Belgian firm (Be), Swiss firm (Ch), German firm (De), Danish firm (Dn), Finish firm (Fi), French firm (Fr), firm from Luxemburg (Lu), Irish firm (Ir), Italian firm (It), Dutch firm (Nl), Norwegian firm (No), Spanish firm (Sp), Swedish firm (SW), British firm (UK), belong to different industries (basic, consumer, energy, industrials, information), and for relevant years (from d1996 to d2005). Additional variables are the logarithm of total assets in Mio EUR (ln_TA), the debt/equity ratio (D/E), defined as total liabilities divided by shareholder equity, revenue growth between years t-1 and t in percent (rev_growth), net operating cash flow scaled by total assets t-1 in percent (NOCF), and net income scaled by total assets t-1 in percent (ROA). Kleibergen Paap (K-P) rk LM statistics for underidentification. Kleibergen Paap (K-P) Wald F statistics (K-P) is heteroscedasticity robust version of Cragg-Donald Wald F statistics for weak instruments test. Wald chi2 statistics is for the significance of the model. ***, significance at 1%; **, significance at 5%; significance at 10%.

Ifrs ln_TA D/E rev_growth nocf ROA At Be Ch De Dn Fi Fr Ir It Lu Nl No Sp Sw Uk Ind_basic_materials Ind_consumer_goods Ind_energy Ind_industrials Ind_information_tech d_1996 d_1997 d_1998 d_1999 d_2000 d_2001 d_2002 d_2003 d_2004 d_2005 _cons R2_adjusted F K-P lm K-P Wald F N

EM1 -4.442* 0.051 -0.102*** 0.007** -0.479*** 0.495*** 2.075 -0.184 0.256 0.768 -1.216 -1.234 -0.578 0.033 -1.493** 2.319 -1.896** -1.765** -2.441* -2.043*** -0.400 -0.945** -1.513*** -1.015 1.484*** 2.111*** 0.372 -0.297 0.285 -0.396 -0.517 -0.135 -0.265 -0.878** -0.939** -0.746 5.270*** 0.277 58.57 ***

EM2 EM3 -7.750*** -83.388 0.294*** 3.680 -0.117*** -0.463 -0.002 0.475*** -0.445*** -0.609** 0.365*** -0.633** 4.673*** 42.454 0.736 7.616 2.947** 37.767 2.931*** 24.852 0.009 -0.989 -0.221 -1.686 -0.014 0.040 0.793 -8.065 -0.569 -12.195 5.659** 45.446 -0.798 -1.626 -1.858** -10.553 -1.690 -20.242 -0.992 -14-536 0.552 1.145 1.017** 3.368 0.846** 4.845 0.814 -6.186 0.879** 16.407 1.617*** 5.146 0.335 1.928 0.083 0.227 0.599 0.344 0.847** 0.316 0.944** -3.703 0.713* 23.898 0.480 4.637 0.278 6.538 0.030 5.349 0.811 1.771 0.748 -18.084 0.207 0.005 44.38*** 3.65*** 116.054 *** 60.498 *** 19,807

EM4 -77.098 3.224 -0.410 0.417*** -0.657*** -0.504** 39.370 7.473 34.813 23.346 -0.417 -1.253 0.156 -7.485 -10.578 41.763 -1.817 -9.099 -17.484 -12.758 1.008 3.295 4.181 -5.636 14.734 4.591 1.964 0.073 0.257 0.580 -4.367 20.745 2.925 4.972 4.516 0.969 -14.335 0.005 3.58***

36