Does the Adoption of International Financial Reporting Standards Restrain Earnings Management? Evidence from an Emerging Market

Abstract

INTRODUCTION The issue of earnings management has always been a concern for the integrity of published accounting reports. Evidence from the academic literature has shown that the practice of earnings management is extensively practiced by publicly listed firms (Barth et al., 2005; Burgstahler and Dichev, 1997). In recent years, primarily due to revelations of corporate scandals resulting from fraudulent financial reporting, both the popular press and accounting regulatory agencies have been focusing on earnings management, which may be regularly engaged in by public firms. In emerging markets, earnings management is more universally practiced because of relatively weak legal enforcement capabilities (e.g., Jian and Wong, 2004). Not surprisingly, earnings management has recently been an extensively researched topic in the emerging market literature. Prior studies examine accounting accruals (Aharony et al., 2000), non-operating earnings (Chen and Yuan, 2004), and related party transactions (Jian and Wang, 2004) to detect earnings manipulations by public companies in emerging markets. However, there is relatively little empirical evidence on whether the adoption of international financial reporting standards (IFRS, formerly known as IAS) has been instrumental in the improvement of the quality of accounting information, including any reduction in the level of earnings management. In this study, we investigate whether adopting IFRS is associated with less earnings management and more timely loss recognition. We use a pooled time-series cross-sectional sample to examine whether firms adopting IFRS are less likely to smooth earnings, less likely to manage earnings upwards to avoid reporting losses, and more likely to recognize losses in a timely fashion, compared with non-adopting firms. Our results indicate that adopting firms are less likely to smooth earnings to achieve earnings management than their non-adopting counterparts. However, we did not find that adopting firms evidence lower tolerance of losses or more timely loss recognition than non-adopting firms. Our study contributes to the literature in several ways. First, the empirical evidence provided in this paper suggesting that the adoption of accounting standards appears to improve financial reporting could prompt regulators to push for such adoption by public firms in emerging markets. This conclusion is especially relevant now that Chinese accounting standards are undergoing substantial changes. Second, the findings of this paper would help investors understand earnings management issues in China. Finally, the findings also suggest that the influence of IFRS on the quality of reported accounting information may be limited if it provides more accounting choices to managers without a concurrent stricter enforcement mechanism. The remainder of our paper is organized as follows. We present a summary of the evolution of accounting standards in China and develop our testable hypotheses regarding the impact of IFRS on earnings management in background and hypotheses development sections. This is followed by the presentation of our research design and sample selection in research methods and sample selection sections. We report our results in results section and the conclusions and limitations of our study in conclusion and limitation section. BACKGROUND-EVOLUTION OF CHINESE ACCOUNTING STANDARDS In the process of transforming itself from a centrally planned economy to a market oriented economy, China realized early the importance of a sound financial infrastructure. The earlier accounting standards and regulations were to provide information to various levels of government for planning and control purposes (Rask et al., 1998; Xiang, 1998). Accordingly, the financial performance measurements reported were not suitable for the financial reporting objectives in a market oriented economy. During China's progress toward a market oriented economy, it has experienced rapid growth of its economy, international trade and securities markets, which, in turn, demanded new objectives for financial reporting. …

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