P  a g e  II

P   II

Contents   

Executive  Summary  4

1  Introduction.  2

2  Theoretical rationale: Earnings management.  3

2.1  Techniques and effects.  4

2.2  Reasons for use of earnings management  4

3  Empirical Evidence: earnings management and investor protection under IFRS.  6

3.1  Prior adoption of IFRS.  6

3.2  Voluntary adoption of IFRS.  7

3.3  Mandatory adoption of IFRS  9

4  Summary and conclusion  11

Bibliography   13

Executive Summary

This paper strives to determine if IFRS increases investor protection through improvements in reporting transparency. Therefore, this paper focuses on the ability of IFRS to decrease earnings management, the main driver of investor protection. The theoretical rationale gives an overview of earnings management, revealing its popularity among management. However, irrespective of the motivation, earnings management reduces the transparency for the investor and thereby reduces investor protection.

The review of empirical evidence reveals that voluntary adoption of IFRS leads to a strong decrease in earnings management and an increase in disclosure quality of financial statements. Indeed, the voluntary adoption is biased because the first-time adopters are convinced that a higher transparency could be used to their own advantage. In contrast, the mandatory adoption is not free of ambiguity, but literature tends to conclude that the forced implementation of IFRS leads neither to a reduction of earnings management nor to a higher level of disclosure. Consequently, a mandatory IFRS adoption does not necessarily increase investor protection.

1 Introduction

More than 100 countries allow or require the disclosure of financial statements according to the International Financial Accounting Standards or are pursuing convergence with the International Accounting Standard Board (IASB, 2010). In 2007 the American SEC allowed foreign listed companies to disclose their financial statements according to IFRS without reconciliation (SEC, 2007a), thus increasing the importance and ascendancy of IFRS. Furthermore, the SEC has introduced the concept of allowing domestic companies to use IFRS and from 2014 onwards the total replacement of US-GAAP with IFRS (SEC, 2007b). Since then, other economically prominent countries such as China, India and Japan have adopted IFRS or the convergence process (Gerrit, 2008).

IFRS supporters claim that a single accounting standard would increase transparency and augment the comparability of companies among different countries. Consequently, the quality of financial reports would be improved (Jeanjean & Stolowy, 2008). Hence, it is suggested that higher transparency leads to increased investor protection. Since IFRS has not been in place for a long time, the pertinent question is if this standard can achieve such an ambitious task.

This literature review investigates if the adoption of IFRS really improves transparency and consequently augments investor protection. Therefore, it initially focuses on earnings management as the main reason for decreasing transparency and comparability and hence, main driver of shareholder protection. Part two explains the theoretical concept of earnings management, how it can decrease comparability and transparency and, why it is used. The final section, gives an overview about empirical studies investigating the ability of IFRS preventing earnings management and in consequence, augmenting investor protection. The literature can be divided into voluntary and mandatory IFRS adoption.

2 Theoretical rationale: Earnings management

As a principles-based framework, IFRS does not provide explicit guidelines. Rather it relies on professional judgements, which requires a profound understanding of the company’s transactions and economic events from the financial statements’ preparer. Therefore, IFRS allows for flexibility in company’s individual circumstances by allowing professional judgement. The aim is to provide users (e.g. investors) with a ‘true and fair’ view of the firm’s economical and financial situation (Carmona & Trombetta, 2008). Consequently, this puts the responsibility of accounting judgements to the company’s management and its auditors (Benston, Bromwich, & Wagenhofer, 2006, p. 185).

In the context of investor protection, earnings, as a measurement for company performance, plays a major role. The aim of investor protection is to guarantee and enforce the rights and claims of shareholders (e.g. dividend payments and voting rights) and other stakeholder such as creditors (e.g. receivables and distribution in case of bankruptcy). Additionally, investor protection prevents expropriation of shareholders and stakeholders through company’s insiders (La Porta, Lopez-de-Silvanes, Shleifer, & Vishny, 2000). Earnings should give investors a clear picture about the company’s performance in order to allow them to evaluate their investment. Hence, earnings management contradicts this idea. Arthur Livitt, former chair of the SEC, described earnings management as ‘a grey area’ in which managers distort the accounting appliance. Consequently, disclosed earnings rather reflect the managers’ desires than the company’s fundamental performance (Livitt, 1998).

There exists an ambiguity amongst academics as to the exact definition of earnings management (Beneish, 2001, p. 4). However, this assignment follows the widely accepted definition of Healy and Wahlen (1999, p. 368), which describes earnings management as the modification of a company’s economical performance by the management in order to lead astray stakeholders or to influence contractual outcomes.