Does IFRS increase transparency and consequently increase investor protection?

Contents

Executive Summary

1 Introduction

2 Theoretical rationale: Earnings management
2.1 Techniques and effects
2.2 Reasons for use of earnings management

3 Empirical Evidence: earnings management and investor protection under IFRS
3.1 Prior adoption of IFRS
3.2 Voluntary adoption of IFRS
3.3 Mandatory adoption of IFRS

4 Summary and conclusion

Bibliography

List of abbreviations

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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.

2.1 Techniques and effects

According to Ortega and Grant (2003, p. 54) earnings management techniques can be categorised into four main classes:

1. Revenue recognition – premature recognition of sales in order to increase turnover of the actual period
2. Operating expenses timing – transfer of expenses from one period to another in order to decrease/increase costs of the actual period
3. Unrealistic assumptions to estimate liabilities – using aggressive/defensive assumptions regarding accruing liabilities (e.g. bad debts)
4. Real (operating) actions – management of earnings via regular business decisions (e.g. stimulate turnover and earnings through pricing or asset sales in periods of low regular revenues)

The first three techniques attempt to mask the company’s real performance through accounting techniques such as hidden reserves, improper earnings recognition or even create artificial entities. They create no real value and in the worst case is nothing more than fraud. In contrast, real activities are not attempting to hide the company’s real performance through accounting techniques. Rather, the management is taking real measures to stabilise the company’s performance in order to create real value for investors (Parfet, 2000).

2.2 Reasons for use of earnings management

According to Arya, Glover and Sunder (2003) there are two kinds of reasons for the use of earnings management:

- The selfless manager is better informed about the company’s economical and financial situation due to information asymmetry. Through earnings management, he aims to give investors a more accurate picture of the company situation, which is not falsified due to transient shocks. The aim is to prevent the investor from making wrong decisions caused by temporary effects.
- Contrarily, the manager seeking to find ways to manipulate the company’s performance and mislead investors follows personal goals (e.g. job security and compensation).

A survey of the CFO Magazine revealed that earnings management is widely used by managers. Over two thirds of CFOs indicated that they had been pressurised by senior management to use some sort of earnings management; from which more than half adhere to. Furthermore, nearly half of the CFOs were instructed to misrepresent the company’s financial and economical situation, of which 38% complied (Barr, 1998).

Burgstrahler and Dichev (1997) find that companies with decreased or slightly negative pre-managed earnings tend to manage their earnings in order to present a positive trend or result. Additionally to the previously mentioned rationale, managers use earnings management because higher earnings lead to lower transaction costs with stakeholders. For instance, increased earnings lead to significantly better terms for loans offered by lenders, due to either decreased risk in default or repayment delay. In the same vein, suppliers offer better terms, in an attempt to generate higher revenues in the future (Cornell & Sharipo, 1987 and Bowen et al., 1995 in Burgstrahler & Dichev, 1997, p. 122).

However, irrespective of the motivation, earnings management reduces the transparency for the investor and thereby reduces investor protection.

3 Empirical Evidence: earnings management and investor protection under IFRS

Since the mid 1990s, companies in the European Union were allowed to disclose their consolidated financial statements according to US-GAAP or IAS (predecessor of IFRS) (Sellhorn & Gornik-Tomaszewski, 2006).^[1] Since 2005, the disclosure of consolidated financial statements according to IFRS is mandatory for all listed companies in the European Union. Ball (2006) states that through the elimination of most differences in the standards and by requiring a uniform reporting format, transparency and international comparability of companies is significantly increased. Consequently, the IFRS adoption should minimise analysts’ adjustments needed in order to compare companies’ financial ratios, which leads to lower costs. Ball further claims that small investors particularly benefit from the increased comparability, because their limited resources prevent them from conducting the same adjustments.

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^[1] Note that individual accounts still have to be reported under country specific GAAP. Consequently, the disclosure according to IFRS does not affect taxes or dividends because it is only applied to the consolidated financial statement (Leuz & Verrecchia, 2000, p. 96).