Accruals-based and Real Earnings Managementin relation to the introduction of IFRS
Results from French Civil Law countries
Erasmus School of Economics
Master Thesis
Abstract: In 2005, the use of the International Financial Reporting Standards (IFRS) became mandatory for all European listed companies. With a combination of stringent rules and subjectivity, the new accounting standards tried to decrease the use of earnings management. Earnings management can be performed by two methods: accruals-based and real activities. The main question of this thesis is about the influence the introduction of IFRS in 2005 on the use of the two methods for performing earnings management. With data of 95 companies from the French Civil law Countries The Netherlands, Belgium and France, and the use of the Modified Jones model (1995) and the model developed by Roychowdhury (2006) is tried to answer this main question. The results of the research show a significant increase of accruals-based and no significant difference in the use of real earnings management by the introduction of IFRS in 2005.
Preface
To complete the Master Accountancy, Auditing and Control, the master thesis has to be completed as final assignment. The thesis could not have been completed without the help and support of some persons I would like to thank in this section. First, I would like to thank my supervisor mister van der Boom for his help during the whole process of writing the thesis. His help and support contributed in many ways to this thesis.
My parents are the next persons I would like to thank. Their patience and support duringall years of education as well as during writing this thesis kept me encouraged to complete this study and finish this thesis.
Table of Content
1 Introduction of the thesisp 5 1.1 Introduction p 5 1.2 Research question and relevance p 7 1.3 Contribution to prior research p 9 1.4 Methodology p 9 1.5 Structure of the thesis p 10
2 Research Approachesp 11 2.1 Introduction p 11 2.2 General research approaches p 11 2.2.1 Positive Theories p 12 2.3 Earnings management specific approaches p 12 2.3.1 Accrual-based approach p 13 2.3.2 Real activities manipulation approach p 13 2.3.2.1 Manipulation of operating activities p 14 2.3.2.2 Manipulation of investing activities p 14 2.3.2.3 Manipulation of financing activities p 14 2.4 Summary p 15
3 Earnings Management and IFRSp 16
3.1 Introductionp 16
3.2 Earnings managementp 16
3.2.1 Definition of the term earnings managementp 16
3.2.2 Methods of Earnings Managementp 18
3.2.2.1 Accruals-based earnings managementp 18
3.2.2.2 Real earnings managementp 18
3.2.3 Incentivesp 19
3.2.4 Directions of earnings managementp 20
3.3 IFRSp 22
3.3.1 Introductionp 22
3.3.2 Advantages and Disadvantages of the mandatory use of IFRSp 22
3.4 Models for measuring the use of earnings managementp 24
3.4.1 Accruals Approachp 24
3.4.2 Accruals modelsp 24
3.4.2.1 Healy (1985)p 25
3.4.2.2 DeAngelo (1986)p 26
3.4.2.3 Jones Model (1991)p 26
3.4.2.4 Modified Jones Model (1995)p 27
3.4.2.5 Kothari et al (2005)p 28
3.4.3 Real activities Approachp 29
3.4.3.1 Real Activities Manipulationp 29
3.4.3.2 Real Activities Manipulation Modelsp 30
3.4.3.3 Roychowdhury (2006)p 30
3.4.3.4 Gunny (2010)p 32
3.5 Summaryp 35
4 Related researchesp 38
4.1 Introductionp 38
4.2 Earlier conducted researchesp 38
4.3 French Civil Law factorsp 44
4.4 Summaryp 47
5 Hypothesesp 50
5.1 Introductionp 50
5.2 Hypotheses developmentp 50
5.3 Summaryp 51
6 Research Designp 53
6.1 Introductionp 53
6.2 Models for detecting Earnings Managementp 55
6.2.1 Modified Jones Model (1995)p 55
6.2.2 Roychowdhury (2006)p 58
6.3 Multiple Regressionp 60
6.4Data samplep 63
6.5 Data attainabilityp 64
6.6 Summaryp 64
7 The Empirical Researchp 67
7.1 Introductionp 67
7.2 Total amount of earnings managementp 67
7.2.1 Accruals-based earnings management coefficientsp 67
7.2.2 Real earnings management coefficientsp 69
7.3 Multiple regressionsp 73
7.3.1 Total amount of earnings managementp 74
7.3.2 Accruals-based earnings managementp 77
7.3.3 Real earnings managementp 79
7.4 Summaryp 84
8 Summary, Conclusions and Analysisp 87
8.1Summary of previous chaptersp 87
8.2 Answer of the main questionp 88
8.3 Limitations of this researchp 90
8.4 Further researchp91
Referencesp 93
Appendices
Appendix 1 – Literature reviewp 96
Appendix 2 – Companies used for this researchp 99
Appendix 3 – Results from SPSSp100
1 Introduction of the thesis
1.1 Introduction
It is the 7th of May 2010; all prime ministers of the European countries agreed on providing Greece an 80 billion euro loan to improve their economic situation. Overspending increased the national debt of Greeceand gotthe country in a bad economic situation. In order to help Greece with its debt, the International Monetary Foundation (IMF) supported Greece in November 2010 again with a loan of 30 billion euro and stated that Greece is increasing its economic stability by executing savings and reformations. During this process of reformations, the annual deficitin 2010 of Greece appeared to be even bigger than the European Communityexpected; a deficitexists of 10.5 percentage of Gross Domestic Product (GDP) instead of theexpected 9.6 percentage. As a consequence of this unexpected higher level,the total debt of Greece became 143 percentage of the GDP, which implied that their debt was bigger than the magnitude of their economy. When this news became public, European Commissioner Olli Rehn of the Monetary Policy claimed that this unexpected higher level of debt was not due to the detection of creative accounting.[1]This was signalled by Commissioner Rehn because values of the financial statements of Greece had been adjusted during their examination for being admitted to the Euro. With the help of Goldman Sachs, the reported national deficit was stated much lower than it truly was. By a financial construction provided by Goldman Sachs, a part of Greek debt was not titled as national debt of Greece but as a debt of various banks for the first fifteen years of the loan.[2]
With the use ofcreative accounting, in addition called earnings management, Greece adjusted its financial situation and so misled the other European countries during their application for the Euro. This manipulation of financial values and deception is considered black earnings management(Ronen and Yaari 2008, p25). The distinction of whether earnings management is white, grey or black as Ronen and Yaari (2008) distinguish earnings management, can be made by focussingon the motivation behind the use of it. Considering the example of Greece, the intention of Greece was to mislead the other countries in the European union in order to be admitted to the Euro, what is titledby Ronen and Yaari (2008) as black earnings management.In order to be able to make a distinction in earnings management Ronen and Yaari (2008) use the definition of Healy and Wahlen (1999) to judge about a situation:
‘Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers’ (Healy and Wahlen 1999, p368)
The important distinction made in the definition of Healy and Wahlen (1999) compared to other definitions of earnings management,is that earning management is used to mislead other stakeholders about the financial situation of the company. The example about Greece reveals the deception of the other countriesin the European Union by using earnings management. This example is about misleading countries; these countries are ‘stakeholders’ of Greece by having interest in the financial situation of Greece. A bad financial situation or maybe even bankruptcy may influence the financial situation of the other countries in the European Union. This example can be compared on micro-level by companies that have interest in a company with a bad financial situation. The same can be performing with the misleading of the countries in the European Union during the application of Greece to the Euro; managers may adjust the financial situation of a company in order to mislead their stakeholders.
In order to abandon or at least reduce to possibilities of managers to mislead the stakeholders, accounting standards are provided. These standards shouldensure stakeholders that the numbers provided in the financial statements present a trueand fairview of the financial situation of a company. One of the recent attempts of standard setters to provide this assurance is the introduction of theInternational Financial Reporting Standards (IFRS) in 2005 which became obligatory to adopt by all the stock exchange quoted companies in the European Union.
The IFRS were introduced to strengthen uniformity in accounting rules and regulations in order to make the financial statements of companies more comparable and transparent. These aims of IFRS should create more value for stakeholders by being better informed about the financial situation of a company. These aims should be achieved by IFRS with the use of fair-value as most important principle(EC No 1606/2002, p243/2).
Despite the introduction of these new standards, managers will still have incentives to use earnings management; to achieve a personal and/or company target. To accomplish this target, earnings management can be executed by using the method of adjusting accruals or real activities[3].In previous researches about the use of earnings management, generally only the accruals-based method is used to detect the use of earnings management. But Graham et al. (2005) suggest that firms switched to managing earnings by using real activities, possibly because this method, although more costly, is likely harder to detect. This statement is strengthened by the following sentences of Graham et al. (2005):
‘We find strong evidence that managers take real economic actions to maintain accounting appearances. In particular, 80% of survey participants report that they would decrease discretionary spending on R&D, advertising, and maintenance (…) to meet an earnings target. More than half (55.3%) state that they would delay starting a new project to meet earnings target, even if such delay entailed a small sacrifice in value (…).’(Graham et al. 2005, pp. 32-35)
This possible switch by using more real activities for earnings management relative to accruals-based earnings management is the origin of this research. First the influence of IFRS on the total amount of the use of earnings management will be checked, before the possible substitution between the two methods for managing the earnings will be investigated.
1.2 Research question and relevance
One of the goals of IFRS, as signalled in the introduction,is creating more transparency and reliability of the financial statementswhich should have an effect on the (less) use of earnings management. IFRS changed the regulations by combining rigid rules with subjective valuations in the valuation of assets and liabilities for the composition of the financial statements.
Although IFRS have the objective to create a fair and true view of the financial situation, managers will still search for possibilities to show a better financial position of a company; for their own or company’s interest. According to Graham et al. (2005), real activities are used to manage earnings, while only the accruals-based method generally was used to detect the use of earnings management. In this thesis, the influence of the introduction of IFRS in 2005 on the use of the two methods for detecting earnings management is investigated. With the data from three French Civil law countriesThe Netherlands, Belgium and France, the possible influence of the introduction of IFRS is investigated. The specific use of three French Civil law countries might have influence on the results of the research by the characteristics of this type of law. The characteristics of the different types of laws and the possible influence of the characteristics of the French Civil law on the outcome will be commented in section 4.3.
The introduction of IFRS, the use of two methods for detecting earnings management and the use of data from French Civil law countries; all these aspects provide the following main question of this thesis:
Does a relation existsbetweenthe introduction of IFRS in 2005 and the choice of method of the use of earnings management, accruals-based or real activities manipulation, in the French Civil law countries The Netherlands, Belgiumand France?
The answering of the main question will be supported by first answering the following sub-questions of the thesis:
1What general and specific research approachesare most appropriate for this thesis?
2What are the definition and the purpose of the International Financial Reporting Standards (IFRS)?
3What is the influence of IFRS on the valuation of assets and liabilities in the financial statements?
4What is the content of the term earnings management?
5In which way is the use of earnings management detected and measured?
6What do prior literature and researches communicated about the relationship of IFRS and the use of earnings management?
7Which specific factors of French Civil law countriesmay influence the use of earnings management and the transition to IFRS?
8What hypotheses are formulated for this thesis?
9In which way is the empirical part of the research designed?
10What is the result of the empirical research?
11What is the conclusion of this research?
The possible influence of the new accounting standards on the use of the different methods of earnings management is what makes this research interesting. Has the introduction of IFRS decreased the use of earnings management and what is its influence on the use of the two main methods for managing the earnings? These possible changes in the use of earnings management can be used to create a better understanding on in which way managers determine when and in which way earnings are managed. The focus on French Civil law countries will present more insight on the possible influence of the characteristics of this type of countries on the total amount of the use of earnings management and the choice of method for performing earnings management.
1.3 Contribution to prior research
The contribution of this thesis to prior research will be that the possible influence of IFRS on the use of earnings management and the method for executing this will be investigated, distinctive the check on real activities manipulation.Accruals-based earnings management has already been researched in other studies, while the use of real earnings management in scientific economic researches is relative new. Lippens (2010) has performed a research on the influence of the introduction of IFRS on the use of accruals-based and real earnings management. The main difference with this research is the data; Lippens uses data from 6 countries, while this thesis specifies on three French Civil law countries. The two methods of the use of earnings management in combination with specific factors like the strength of the legal system in French Civil law countries presentsmore insight on which factors might influence on the choices of managers to manage the earnings.
The focus on French Civil law countries presents a better view on what influence factors like the legal and the political system in the countries might have or did have on the implementation of IFRS and the use of different methodsfor managing the earnings. As will be commented in chapter 4, factors like being a ‘code’ or ‘common’ law country for example will possibly have their influence on the results. But this type of research in addition has its limitations; the results that are found will not be generalizable for other types of law countries.
1.4 Methodology
In order to execute the research, the positive approach is chosen. The different general research approaches that can be used for research are explained in more detail in chapter 2. The use of the positive approach can be specified with the use of the Positive Accounting Theory (PAT) for this research. The describing and predicting focus of this kind of research method was decisive in choosing for the PAT-approach. As a component of the PAT, the agency theory has its influence in this research by assuming that managers act with self-interest and that they do not always take into account what possible influence their actions might have on other stakeholders. Acting in self-interest can be one of the motivations for managers to use earnings management in its various ways.
Next to the determination of the general and specific approaches are used for this thesis, the methods for detecting accruals-based and real earnings management is determined. Earnings management by accruals will be measured by using the Modified Jones model (1995) and real earnings management by the model developed byRoychowdhury (2006). The process for deciding to choose for these models will be commented in sections 3.4.2 and 3.4.3.
These models will be used on a sample of 95 companies which contain listed companies from The Netherlands, Belgium and France that meet the established criteria. With the use of the Wharton Research Data Service (WRDS), the companies that meet the requirements are selected before the data of these companies is obtained from the Thomson One Banker database. With the data, the Modified Jones model (1995) and the model developed by Roychowdhury (2006) are executed. These indications of the use of earnings management will be used to check for the possible influence of the independent variables country, accounting standards and size on the dependent variables total amount of the used earnings management, accruals-based and real earnings management. In order to draw a conclusion about the use of earnings management in total and the possible substitution effect in the methods of executing earnings management due to the introduction of IFRS, the possible influence is checked by multiple regression.
1.5 Structure of the thesis
In order to get to an answer on the main-question of the thesis, each chapter provides an answer to one or more of the sub-questions that are listed in the introduction. In chapter 2, sub-question 2 about research approaches, both general and the term earnings management-specific are commented before sub-questions 3 and 4 are answered with the theoretical framework of the thesis; earnings management and IFRS described in chapter 3. To answer subs-questions 6 and 7, after the theoretical framework is provided, in chapter 4 prior researches and specific factors are reviewed. After the review of all the relevant literature in the first four chapters, the chapters 5-8 focus on the research design, the results of the research and the conclusions. Sub-question 8,which is about developing the hypotheses, is answered in chapter 5. Next, sub-question 9 about the design of the research will be answered in chapter 6. In chapter 7 the results of the empirical part of the research will be provided, which is the answer on sub-question 10 before sub-question 11 about the conclusion is answered in chapter 8.
2 Research Approaches
2.1 Introduction
Research in the field of accounting can be performed on many topics and each topic can be approached from different angles. By using a different approach and angle, different aspects of a topic will be investigated and highlighted. In this chapter, general- and earnings management specific-approaches will be presented to present an overview on what approaches can be chosen from and which approaches are chosen in this research.