Earnings quality and the adoption of IFRS-based accounting standards Evidence from an emerging market Wan Adibah Wan Ismail and Khairul Anuar Kamarudin Faculty of Accountancy, Universiti Teknologi Mara, Segamat, Johor, Malaysia Tony van Zijl School of Accounting and Commercial Law, Victoria University of Wellington, Wellington, New Zealand, and Keitha Dunstan School of Business, Bond University, Gold Coast, Australia Abstract Purpose – This study aims to investigate the differences in earnings quality of Malaysian companies after the adoption of IFRS-based accounting standards named FRS. Design/methodology/approach – It is hypothesize that under the new set of accounting standards, the quality of earnings reported by these companies is relatively higher. Specifically, the study tests whether the level of earnings management is significantly lower after the adoption of IFRS, and reported earnings is more value relevant during the IFRS period. This study uses a large sample of 4,010 observations over a three-year period before and a three-year period after the adoption of the new set of accounting standards. Findings – The results show that IFRS adoption is associated with higher quality of reported earnings. It is found that earnings reported during the period after the adoption of IFRS is associated with lower earnings management and higher value relevant. Originality/value – The results of this study contribute additional evidence to the literature on earnings quality and the impact of IFRS adoption. As most of the existing studies on earnings quality and IFRS have been conducted on data from the U.S and European countries, this study fills a gap in the existing literature by studying the effect of adoption of IFRS on earnings quality in an emerging market. Keywords Earnings quality, Accounting standards, IFRS, Financial reporting, Malaysia Paper type Research paper Introduction Many countries have adopted international financial reporting standards (IFRS) as their primary standards for the preparation of corporate accounts. Despite this widespread adoption, little research has directly addressed the impact of IFRS adoption on the quality of financial reporting in an emerging market. Current studies seem to focus more on the effect of such adoption in European countries (Callao and Jarne, 2010; Callao et al., 2007; Chen et al., 2010; Daske and Gebhardt, 2006; Devalle et al., 2010; Ernstberger and Vogler, 2008; Gjerde et al., 2008; Iatridis and Rouvolis, 2010; Jermakowicz, 2004; Kaserer and Kingler, 2008; Paananen and Lin, 2009; Tsalavoutas and Evans, 2010; Van der Meulen et al., 2007; Van Tendeloo and Vanstraelen, 2005) and other developed countries such as Australia (Clarkson et al., 2011; Goodwin et al., 2008; Jeanjean and Stolowy, 2008). This is an important gap in the literature given the differences that exist between developed and developing countries. The current issue and full text archive of this journal is available at www.emeraldinsight.com/1321-7348.htm Asian Review of Accounting Vol. 21 No. 1, 2013 pp. 53-73 r Emerald Group Publishing Limited 1321-7348 DOI 10.1108/13217341311316940 53 IFRS-based accounting standards
Transcript
Earnings quality and theadoption of IFRS-basedaccounting standards
Evidence from an emerging marketWan Adibah Wan Ismail and Khairul Anuar Kamarudin
Faculty of Accountancy, Universiti Teknologi Mara, Segamat, Johor, Malaysia
Tony van ZijlSchool of Accounting and Commercial Law, Victoria University of Wellington,
Wellington, New Zealand, and
Keitha DunstanSchool of Business, Bond University, Gold Coast, Australia
Abstract
Purpose – This study aims to investigate the differences in earnings quality of Malaysian companiesafter the adoption of IFRS-based accounting standards named FRS.Design/methodology/approach – It is hypothesize that under the new set of accounting standards,the quality of earnings reported by these companies is relatively higher. Specifically, the study testswhether the level of earnings management is significantly lower after the adoption of IFRS, andreported earnings is more value relevant during the IFRS period. This study uses a large sample of4,010 observations over a three-year period before and a three-year period after the adoption of the newset of accounting standards.Findings – The results show that IFRS adoption is associated with higher quality of reportedearnings. It is found that earnings reported during the period after the adoption of IFRS is associatedwith lower earnings management and higher value relevant.Originality/value – The results of this study contribute additional evidence to the literature onearnings quality and the impact of IFRS adoption. As most of the existing studies on earningsquality and IFRS have been conducted on data from the U.S and European countries, this study fills agap in the existing literature by studying the effect of adoption of IFRS on earnings quality in anemerging market.
Keywords Earnings quality, Accounting standards, IFRS, Financial reporting, Malaysia
Paper type Research paper
IntroductionMany countries have adopted international financial reporting standards (IFRS) astheir primary standards for the preparation of corporate accounts. Despite thiswidespread adoption, little research has directly addressed the impact of IFRSadoption on the quality of financial reporting in an emerging market. Current studiesseem to focus more on the effect of such adoption in European countries (Callao andJarne, 2010; Callao et al., 2007; Chen et al., 2010; Daske and Gebhardt, 2006; Devalleet al., 2010; Ernstberger and Vogler, 2008; Gjerde et al., 2008; Iatridis and Rouvolis,2010; Jermakowicz, 2004; Kaserer and Kingler, 2008; Paananen and Lin, 2009;Tsalavoutas and Evans, 2010; Van der Meulen et al., 2007; Van Tendeloo andVanstraelen, 2005) and other developed countries such as Australia (Clarkson et al.,2011; Goodwin et al., 2008; Jeanjean and Stolowy, 2008). This is an important gap in theliterature given the differences that exist between developed and developing countries.
The current issue and full text archive of this journal is available atwww.emeraldinsight.com/1321-7348.htm
Asian Review of AccountingVol. 21 No. 1, 2013
pp. 53-73r Emerald Group Publishing Limited
1321-7348DOI 10.1108/13217341311316940
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As mentioned by Hofstede and Hofstede (2004), developing countries are substantiallydifferent from developed markets in terms of the institutional, organisational andmarket aspects of the economy and society. Developing countries have weaker and lessmature capital markets (Gibson, 2003; Lins, 2003), limited regulatory enforcement(Berghe, 2002) and more concentrated ownership (Claessens et al., 2000; Shleiferand Vishny, 1997; Thillainathan, 1998); that arguably leads to greater informationasymmetry. In addition, accounting standards in developing markets are typicallydifferent from those of developed markets, which makes it harder for investors tojudge the true performance of a firm in a developing financial market and thus makerational investment decision (Rashid and Islam, 2008). Better accounting standardscould increase the quality of financial statements in these countries. Thus, the impactof the adoption of IFRS in developing countries could be more significant than isfound in developed markets.
In late 2004, the Malaysian accounting standard setting body (MalaysianAccounting Standard Board (MASB)) announced the adoption of IFRS forMalaysian companies, effective from 1 January 2006. The standards are namedfinancial reporting standards (FRS)[1]. The adoption of this new set of accountingstandards in Malaysia provides a setting to study the effect of IFRS-basedaccounting standards on the quality of earnings in a developing country. Theintroduction of IFRS in Malaysia is viewed as an advantage to the country due toexcellent reputation, good quality and high credibility of the standards. Accordingto Ball (2006):
IFRS promise more accurate, comprehensive and timely financial statement information,relative to the national standards they replace for public financial reporting in most of thecountries adopting them, Continental Europe included. To the extent that financial statementinformation is not known from other sources, this should lead to more-informed valuation inthe equity market, and hence lower risk to investors.
The major change in accounting in Malaysia as a consequence of the adoptionof IFRS is the use of fair value accounting. Among others, the extensive use offair value occurs in the standards related to share-based payments (FRS2),business combination (FRS3), property plant and equipment (FRS116), impairmentof assets (FRS136), intangible assets (FRS138) and investment properties (FRS140).The movement towards fair value accounting from historical-cost accounting isexpected to result in financial statements that are more relevant, timely, credibleand transparent.
Another attribute of IFRS is that it requires more extensive disclosure. For example,FRS136 on impairment of assets requires more disclosure on goodwill and otherintangibles, particularly in relation to allocation of goodwill to cash generating units,key assumptions used to measure recoverable amounts and impairment testing.Increased level of disclosure in corporate financial reports could affect the quality ofreported earnings. According to Levitt (1998), the disclosure systems that are foundedon high-quality standards give investors confidence in the credibility of financialreporting. If more disclosure is required, any attempt to manage earnings can moreeasily be detected and reduced by internal monitoring bodies (board of directors andauditors) in a company.
Given the emphasis on the use of fair value and greater disclosure requirementsprescribed under the new accounting standards, we conjecture the adoption of the newstandards would have a favourable impact on the quality of earnings reported by
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companies in Malaysia. To examine the effect of IFRS adoption on earnings quality, wetest whether the level of earnings management is significantly lower after the adoptionof IFRS, and reported earnings is more value relevant during the IFRS period. Ourstudy covers the two time periods, three years before adoption (MASB period) andthree years after the adoption (IFRS period). Since there was no other change in thecountry’s financial reporting environment during the period studied, we assumethat the potential country-level factor that could affect firm’s earnings quality duringthe period was the adoption of IFRS.
Our results show that earnings quality is higher after the adoption of the newIFRS-based accounting standards. First, we find that the absolute value ofabnormal accruals, which is the inverse measure of earnings quality, is significantlylower during the IFRS period. IFRS-based earnings quality outperformsMASB earnings quality holds after controlling for firm-specific factors such asfirm size, leverage, growth and profitability. Second, our results also show thatreported earnings are more value relevant during the IFRS period, as compared to theMASB period. This implies that the decision made by the Malaysian accountingstandard setting body to adopt IFRS resulted in significant benefits for thecountry’s financial reporting, in terms of less earnings management and more valuerelevant earnings.
This study makes several contributions. First, the results of this study contributeadditional evidence to the literature on earnings quality and the impact of IFRSadoption. As most of the existing studies on earnings quality and IFRS have beenconducted on data from the USA and European countries, this study fills a gap in theexisting literature by studying the effect of adoption of IFRS on earnings quality in anemerging market. Second, the results of this study can assist in understanding theimpact of the introduction of IFRS standards on the quality of financial reportingin Malaysia and identify issues that may assist regulators and standard setters inshaping future policy. In addition to that, similar to Zhou et al. (2009), our empiricalevidence, which suggests that the adoption of IFRS improves the quality of financialreporting, could encourage regulators and standard setters in other emerging marketsto move forward in adopting the standards.
Overview of Malaysia financial reporting environmentThe standards issued by the International Accounting Standards Board (IASB)have been the model for Malaysian accounting standards since 1978. Thecountry’s professional accounting body[2] at that time reviewed and adapted IAS[3]according to local needs. There was no regulatory mechanism to enforce compliancewith these standards until the Financial Reporting Act 1997 (FRA 1997) was enacted(Saleh et al., 2005).
This regulatory reform was in response to the rapid economic developmentand globalisation of commercial markets that had demanded the country upgradeits accounting practices (Fadzly and Ahmad, 2004). The Parliamentary Act sets outthe first formal accounting framework for Malaysia. It established two bodies, theMASB and the Financial Reporting Foundation (FRF)[4]. Under the FRA 1997,accounting standards issued by MASB have legal standing for both public andnon-listed companies.
The MASB, together with the FRF make up the new framework for financialreporting in Malaysia. This framework comprises an independent standard-settingstructure with representation from all relevant parties in the standard-setting process,
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including preparers, users, regulators and the accountancy profession. According toSection 7 of the FRA 1997, the functions of MASB includes:
(a) to issue new accounting standards as approved accounting standards; (b) to review, reviseor adopt existing accounting standards as approved accounting standards; (c) to issuestatements of principles for financial reporting; (d) to sponsor or undertake development ofpossible accounting standards; (e) to conduct such public consultation as may be necessaryin order to determine the contents of accounting concepts, principles and standards;(f) to develop a conceptual framework for the purpose of evaluating proposed accountingstandard; (g) to make such changes to the form and content of proposed accounting standardsas it considers necessary; and (h) to perform such other function as the Minister mayprescribe by order published in the Gazette.
The MASB has reviewed, revised and adopted existing accounting standards, andissued new standards as approved accounting standards named as MASB standards.At the end of 2004, the Board had produced a total of 97 technical pronouncements,comprising 33 standards, one interpretation bulletin, one foreword, two statementof principles (SOPs), two technical releases, one discussion paper, five draft SOPs and52 exposure drafts.
A number of regulatory bodies, including the Securities Commission, the CentralBank of Malaysia and the Companies Commission of Malaysia are responsible forenforcement of compliance with MASB standards. In the case of non-compliance withthe approved accounting standards, the regulators have the power to direct thecompany to take the necessary rectifying actions, or make announcements withrespect to the non-compliance. For publicly listed companies, there are also penaltiesfor such offence.
The country’s financial reporting system moved a step forward when MASBdecided to adopt IFRS. MASB announced its adoption of IFRS at the end of 2004. Asthe first step, MASB standards were renamed FRS in line with IFRS in 2005. Thechange of name from MASB standards to FRS in 2005 did not actually change thecontent of the standards. The adoption of IFRS was made effective from 1 January2006. Although the standards are named as FRS, they are virtually identical to theIFRS issued by the IASB. However, two standards, which are the IFRS 7, financialinstrument: disclosures and IFRS 8, operating segments, have not been adopted. FRSalso includes one Islamic accounting standard and four local standards, on topicswhich are not addressed in IFRS. The local standards are FRS2012004 PropertyDevelopment Activities, FRS2022004 General Insurance Business, FRS2032004 LifeInsurance Business and FRS2042004 Accounting for Aquaculture. Compliance withthese FRS is mandatory, as stated in the Financial Reporting Act 1997 (Section 26D).Thus, in this paper, we consider FRS as IFRS-based standards, and use the terminterchangeably. The IFRS-based standards adopted by the MASB were made effectivefrom 1 January 2006. Therefore, the earliest financial statements reported byMalaysian companies under the mandated FRS are dated 31 December 2006.
Note that similar to Barth et al. (2008), this current study examines the effect of IFRSadoption, which reflects the combined effect of the change in accounting standardsincluding its application, interpretation, enforcement, litigation and other features offinancial reporting system.
Association between earnings quality and accounting standardsStudies analysing managerial discretion in accounting regimes argue that the degree oflatitude in accounting standards plays some role in determining the quality of financial
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reports (e.g. Dye and Sunder, 2001; Goncharov and Zimmermann, 2006). Dye andSunder (2001) claim that:
Lax IASB standards allow firms more opportunity to manage their earnings, makingfinancial reports less useful to investors [y] Broad standards create more ambiguities andenhance chances that opportunistic, if not illegal, accounting treatments are blessed bygenerally accepted accounting principles.
Supporting Dye and Sunder’s argument, Goncharov and Zimmermann (2006) statethat:
The accounting standards provide different (amounts of) accounting choices, and thereforetheir application may results in earnings of different quality. As every accounting choice hasits costs and these costs increase with the frequency accounting choice is exercised, earningsmanagement is expected to be more widely spread under lax regimes that leave sufficientspace for making judgments.
The notion that different accounting standards are associated with different levels ofearnings quality is also evidenced in previous studies. By systematically modelling theeffects of tightening accounting standards, Ewert and Wagenhofer (2005) conclude thathigher earnings quality can be achieved by having stricter accounting standardsthat limit the number of accounting choices and prescribe clearer rules. In particular,their results confirm that tighter accounting standards increase earnings qualitymeasured by the variability of reported earnings and the association between reportedearnings and market price reactions.
Goncharov and Zimmermann (2006) investigate whether the level of earningsmanagement differs between consolidated accounts of German companies preparedunder three different accounting standards; German GAAP, IAS and US GAAP. Theirfindings show that the level of earnings management for firms that report their resultsunder US GAAP is significantly lower, while the level of earnings managementunder German GAAP and IAS is roughly equal. Based on the evidence, they concludethat the different accounting choices embedded in different accounting standardsinfluence the level of earnings management.
Using a broad sample, Barth et al. (2008) examine the accounting quality of firms in21 countries that adopted IAS between the year 1994 and 2003. The study comparesseveral accounting quality metrics between firms that apply IAS and a matchedsample of firms that do not. The results of the study shows that companies applyingIAS exhibit higher accounting quality in terms of less income smoothing, lessmanagement of earnings towards a target, more timely recognition of losses andhigher association of accounting information with share prices and returns. Inaddition, those firms also display an improvement in accounting quality between thepre- and post-IAS adoption periods.
A more recent study by Bova and Pereira (2012) investigates whether IFRScompliance improve a firm’s information environment in Kenya. The study argues thathigher-quality accounting standards, IFRS, lead to higher-quality financial reportingand transparency. This is because IFRS limits managerial discretion and imposesgreater disclosure requirements compared to domestic GAAP. The study found thatpublic, rather than private, firms exhibit greater compliance to IFRS and relates tohigher share turnover. The evidence signifies the importance of economic incentivesand capital market benefits in ensuring IFRS compliance in Kenya.
In line with the evidence shown in previous studies that different accountingstandards are associated with different levels of earnings quality, we conjecture that
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the adoption of IFRS-based accounting standards has an impact on the quality ofearnings reported by Malaysian companies. Due to the greater disclosure requirementsand greater emphasis on the use of fair value in the new standards, we posit thatearnings quality has significant positive association with the adoption of IFRS-basedaccounting standard in Malaysia. In other words, our study tests whether earningsquality after the introduction of IFRS-based accounting standards is higher than thequality of earnings before the introduction of the new standards. We measurehigher earnings quality as a lower level of earnings management and higher valuerelevance of earnings.
The extant literature on earnings management suggest that earnings managementexists due to the important roles and functions played by the reported earningsnumber. According to Vander Bauwhede (2001), managers may be inclined to manageearnings due to the existence of the firm’s explicit and implicit contracts, the firm’srelation with capital markets, the need for external financing, the politicaland regulatory environment or several other specific circumstances. For example,earnings numbers are normally included in management compensation and bonuscontracts, debts covenants and are relevant to management buyouts, proxy contest,valuation of initial public offerings, labour union negotiations and lobbying onaccounting standards and regulations.
Davidson et al. (1985) define earnings management as the process of takingdeliberate steps within the constraint of generally accepted accounting practiceto bring about a desired level of reported earnings. Similarly, Healy and Wahlen(1999) note that:
Earnings management occurs when managers use judgment in financial reporting and instructuring transactions to alter financial reports to either mislead some shareholders aboutthe underlying economic performance of the company, or to influence contractual outcomesthat depend on reported accounting numbers.
According to above definitions, it is clear that earnings management becomes possibledue to the discretion given to managers when preparing financial reports. However,it is limited to the boundaries permitted under a particular set of accounting standards.Thus, any changes to the extent of managerial discretion allowed under the accountingstandards may also change the amount of earnings management.
Zheng (2003) claims that the purpose of earnings management, as stated inHealy and Wahlen’s (1999) definition, indicates that managed earnings is of lowerquality than unmanaged earnings. The greater the departure of reported earningsfrom what it should be, the lower the quality of earnings. Consistently, previousstudies on earnings quality (e.g. Barth et al., 2008; Chen et al., 2007; Van Tendeloo andVanstraelen, 2008) often use the term “earning quality” to denote the absence ofearnings management. In addition, Levitt (1998) mentioned that when earningsmanagement is on the rise, the quality of financial reporting is on the decline. Given thechanges in disclosure requirement and the extent of managerial discretion allowedunder the IFRS-based accounting standard, we develop the following hypothesis:
H1. The extent of earnings management is lower after the adoption of IFRS-basedaccounting standards.
Earnings that are high in quality should also be more value relevant. In other words,high-quality earnings should have greater ability to explain market value of
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companies. A number of studies that examine the quality of financial reporting usevalue relevance of earnings to measure earnings quality (e.g. Cheng et al., 2007; Langet al., 2003, 2006; Leuz et al., 2003). These studies relate earnings directly to stock pricesor market returns. The association (the slope coefficient or the explanatory power ofthe model) between earnings and stock market performance suggests that earningsare both relevant and reliable to investors (Barth et al., 2001). In the existing studies,earnings are considered to be higher in quality if it is more value relevant. As claimedby Bao and Bao (2004):
Theoretically, if quality of earnings is improved, then the association between firm value andreported earnings should also be improved. If quality of earnings is impaired, then theassociation between firm value and reported earnings should also be impaired.
Based on these prior studies, our second hypothesis is as follows:
H2. The value relevance of earnings is higher after the adoption of IFRS-basedaccounting standards.
Our study is different from previous studies on earnings quality and IFRS. To the best ofour knowledge, this study is among the early empirical studies that examine the effect ofmandatory adoption of IFRS on earnings quality of companies over time in a developingcountry. Our study is closest to Paananen and Lin’s (2009) study that examined theadoption of IFRS in Germany. However, in Germany the adoption of IFRS was voluntaryfor two years before it was made compulsory. Thus, the initial year of IFRS adoption forcompanies in Germany varies according to whether they adopted early or not.
The common approach of existing studies that examine the impact of IFRSadoption on earnings quality is to compare the earnings quality of IFRS adopters andnon-IFRS adopters in a particular country during the period when companies weregiven the option of adopting IFRS or adhering to local GAAPs or other accountingstandards (Christensen et al., 2007; Van der Meulen et al., 2007; Van Tendeloo andVanstraelen, 2005; Zhou et al., 2009). According to Zhou et al. (2009), when the adoptionof accounting standards is voluntary, the results of the study could be subject to self-selection bias. This is evidenced in Paananen and Lin’s (2009) study where most of theearly adopters of IFRS were the companies that previously had higher quality offinancial reporting. Our study is free from the self-selection bias as we examine theeffect of IFRS in Malaysia where the adoption of IFRS was mandatory and there wasno prior period during which firms could voluntarily adopt IFRS. Therefore, the effectof adopting IFRS can be captured evenly for all companies in the sample as allcompanies are required to adopt IFRS starting from 1 January 2006.
Model specificationEarnings management modelsWe examined the change in earnings quality after the adoption of FRS in Malaysia bylooking at the extent of earnings management and value relevance of earnings. Tomeasure the level of earnings management, we calculated the absolute value ofabnormal accruals using the Jones (1991) model, as modified by Dechow et al. (1995),by running the following regression, by year and industry based on the GeneralIndustry Classification Code:
where TACCRit is the total accruals for firm i in year t, ASSETSit�1 is total assets forfirm i in year t�1, DREVit is measured by revenues in year t less revenues in yeart�1 for firm i, DRECit is measured by receivables in year t less receivables in year t�1for firm i, PPEit is the gross property, plant and equipment for firm i in year t and eit isthe error term firm i in year t.
In regression (1), the total accruals (TACCRit)[5], change in revenue (DREVit),change in receivables (DRECit) and gross property, plant and equipment (PPEit) areeach scaled by previous year total assets (ASSETSit�1). We followed Kothari et al.(2005) who deflate the variables by total assets for the purpose of mitigatingheteroscedasticity of the residuals. In this model, normal accruals is estimated basedon the change in net revenue and PPE of firms in the same industry. The residualgenerated from this regression is the abnormal accruals of firms, that is the amountof accruals above or below the normal accruals. We used the absolute value of theresidual (ABACDEC) to measure the extent of earnings management, which is theextent of departure of total accrual from normal accrual (or the departure of reportedearnings from normal earnings). High absolute value of abnormal accrual indicateslow earnings quality.
To ensure robustness of the abnormal accrual estimation, we also calculate theabsolute value of abnormal accrual using the Kasznik (1999) model, which is avariation on the Dechow et al. (1995) model. Based on the evidence that cash flows fromoperations are negatively associated with total accruals, Kasznik (1999) added thechange in operating cash flows, to the Dechow et al. (1995) model. We use the followingmodel to estimate the absolute value of abnormal accruals, as based on the Kasznik(1999) model:
where DCFO is the change in cash flows from operation[6] for firm i in year t, and allother variables are as previously defined. We labelled the absolute value of abnormalaccrual estimated using Kasznik (1999) model as ABACKAS. We then estimate theOLS regression of Equation (3) to test our first hypothesis of whether the extent ofearnings management is lower after the adoption of FRS:
ABACi;t ¼ b0 þ b1LEVERAGEi;t þ b2SIZEi;t
þ b3PROFITABILITYi;t þ b4GROWTHi;t
þ b5IFRSi;t þ ei;t
ð3Þ
where ABACi, t is the absolute value of abnormal accrual for firm i in year t. ABACi, t
represents either ABACDECi, t which is the absolute abnormal accrual from theDechow et al. (1995) model or ABACKASit, which is the absolute value of abnormalaccrual from the Kasznik (1999) model. SIZEi, t is the natural logarithm of totalassets for firm i in year t, ROAi, t is the return on assets ratio for firm i in year t,LEVERAGEi, t is the total debt divided by total assets for firm i at the end of fiscalyear t, GROWTHi, t is the share price divided by book value per share for firm i at theend of fiscal year t and IFRSi, t is a dummy variable given a value of 1 if the financialstatement is prepared under FRS, 0 otherwise; for firm i in year t.
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In the above model, we include four control variables, firms size (SIZEi, t), profitability(ROAi, t), leverage (LEVERAGEi, t) and growth (GROWTHi, t), that could also influencethe extent of earnings management practices. According to Johnson et al. (2002), thesevariables can affect financial reporting quality in terms of the level of sophistication ofthe financial reporting system and in terms of management incentives to manipulateearnings. For example, larger and more mature companies are more likely to have moresophisticated financial reporting systems. Therefore, managers of these companies mayhave more opportunity to manipulate earnings. Also, it would be harder for an externalauditor to detect earnings manipulation in a more sophisticated accounting system.Other than that, previous studies on financial reporting quality have found certainconditions that may provide incentives for earnings manipulation, such as a firm’sfinancial condition (Burgstahler and Dichev, 1997; Dechow et al., 1996; Saleh and Ahmed,2005) and the tightness of debt constraints (Carlson and Bathala, 1997; DeFond andJiambalvo, 1994; Jaggi and Lee, 2002; Sweeney, 1994).
Value relevance modelsTo test our second hypothesis, we compare the value relevance of earnings during theperiod before and after the adoption of IFRS-based accounting standards in Malaysia.We employ two widely used models, which are the price-earnings model and thereturn-earnings model, to examine the value relevance of earnings during the twoperiods. We follow the price-earnings model as used by Ohlson (1995) and Burgstahlerand Dichev (1997), where prices are regressed on both earnings and the book valueof equity. According to Ohlson (1995), the value of firm’s equity can be expressedas a function of its earnings and book value, as follows:
Pi;t ¼ a0 þ a1EPSi;t þ a2BVPSi;t þ ei;t ð4Þ
where Pi, t is the price of a share of firm i three months after fiscal year-end t, EPSi, t isthe earnings per share of firm i during the year t, BVPSi, t is the book value per share offirm i at the end of year t and ei, t represents other value relevant information of firm ifor year t. The value relevance of earnings and book value is represented by thecoefficient of these variables. The coefficient of earnings depends on how well a firm’searnings can explain stock prices. According to Ohlson and Zhang (1998), the abilityof earnings to explain stock prices can be influenced by its ability to reflect futureearnings. They explain that the relative weight of earnings as compared to book valuemay vary depending on the permanence of earnings. However, the combined weightsof earnings and book value should remain unchanged, for different accountingmethods unless the accounting choice has an economic impact. Therefore, other thanlooking at the coefficient of earnings, we compare the R2 values of the model toexamine whether the joint coefficient of earnings and book value after the adoption ofIFRS are more value-relevant and have higher quality. Our approach is similar toCheng et al. (2007) and Van der Meulen et al. (2007), wherein higher R2 of the modelsignals higher value relevance of earnings and book value.
We further extend our analysis by running a regression on the following extendedmodel, which include IFRS adoption as a dummy variable, and its interaction withearnings and book value:
Pi;t ¼ a0 þ a1EPSi;t þ a2BVPSi;t þ a3EPSi;t�IFRS
þ a4BVPSi;t�IFRS þ ei;t
ð5Þ
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In this model, all variables are as previously defined. The coefficient of the interactionvariables EPS� IFRS, a3, indicates whether the adoption of IFRS has a significantinfluence on the value relevance of earnings.
To ensure the robustness of our result, we also performed further analysis of thevalue relevance of earnings using the return-earnings model introduced by Eastonand Harris (1991). The approach of using return earnings to examine the valuerelevance of earnings is widely used in existing studies (e.g. Gul, 2006; Gul et al., 2002;Loftus and Sin, 1997; Warfield and Wild, 1992; Warfield et al., 1995). The return-earnings model is as follows:
RETi;t ¼ a0 þ a1E=Pi;t�1 þ ei;t ð6Þ
where RETi, t is holding returns for a 12-month period before the financial year end forfirm i in year t, E/Pi, t�1 is the earnings per share at the financial year end divided bythe closing price 12 months previously for firm i in year t and all other variables are aspreviously defined. The regression is run separately, for the period before and after theadoption of IFRS. Similar to the value-relevance analysis using the price-earningsregression, the coefficient of E/Pt�1 and the R2 of the model are examined to comparethe ability of earnings to explain stock returns between the two periods. To testwhether there is any significant difference between the value relevance of earningsbefore and after IFRS adoption using the return-earnings model, we include interactionvariables and other control variables, as shown below:
where RISKi, t is the b for firm i in year t, GROWTHi, t equals the share price divided bybook value per share for firm i at the end of fiscal year t, TDTAi, t is the total debtdivided by total assets for firm i in year t and all other variables are as previouslydefined. The coefficient of the interaction variable of E/Pt�1� IFRS, a3, captures theinfluence of IFRS on the value-relevance of earnings.
Data and sample selectionOur data was collected from the Thompson One Banker database from 2002 to 2009.We identify each firm’s financial year end and extract the firm’s data for the period ofthree years before the adoption of IFRS and three years after the adoption of IFRS.Since the adoption of IFRS is made effective from 1 January 2006, the first annualreport prepared using the new standard is dated 31 December 2006. Thus, we classifyour data based on financial year end of each firm. For example, data from annualreports dated 31 December 2006 to 30 December 2007 are considered to be data for thefirst year of FRS adoption.
Following previous research on earnings management and value relevance ofearnings (Callao et al., 2007; Van Tendeloo and Vanstraelen, 2005; Vander Bauwhede,2001), we exclude all financial institutions and utility companies from our sample, thusensuring greater homogeneity of the firms included in the sample. We impose datarestriction on the sample, such as the availability of accounting variables and marketvariables. We end up having two separate samples to test our hypotheses in order to
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maximise our observations. For the first hypothesis, relating to analysis on the effectof FRS adoption on earnings management, most of the missing data is caused by theunavailability of cash flows from operations data, which is required to calculate totalaccruals. For this analysis, our sample comprises 4,010 firm-year observations as inTable I. For value relevance models, we exclude data with missing market prices. Tocontrol for potential outliers, we removed the 0.5 per cent top and bottom of eachvariables used in the study. The total number of observations for the value relevanceanalysis was 2,663.
Table I presents descriptive statistics for the main variables used in the study. Thetable shows that there is not much difference between the absolute value of abnormalaccruals calculated using Dechow et al.’s model (ABACDEC) and those calculatedusing the Kasznik model (ABACKAS). The mean and median of ABACDEC(ABACKAS) is 0.849 (0.618) and 0.076 (0.064), respectively. Table II reports thecorrelation matrix between the variables included in the regression. The correlationmatrix shows that the Pearson (Spearman) correlations between ABACDEC orABACKAS and the other variables used in the model are relatively small and do notexceed 0.285 (0.465).
Empirical resultsTable III presents the results of the ordinary least square regressions used to test therelationship between earnings quality, measured by the absence of earningsmanagement and IFRS adoption. The regressions based on model (3), include otherdeterminants of earnings management practices such as the firm’s size (SIZE),
Notes: ABACDEC and ABACKAS are the absolute value of abnormal accruals estimated usingDechow et al. (1995) model and Kasznik (1999) model, respectively; SIZE is the natural logarithm oftotal assets; PROFITABILITY is the return on assets ratio. GROWTH equals to the share pricedivided by book value per share at the end of fiscal year; LEVERAGE is total long-term debt divide bytotal assets at fiscal year end; P is closing price per share at the financial year end; BVPS is the bookvalue per share; EPS is earnings per share; RET is holding returns for a 12-month period before thefinancial year end; E/Pt�1 is earnings per share at the financial year end divided by the closing price12 months previously; TDTA is total debt to total assets. RISK is measured by firm’s b
profitability (PROFITABILITY), growth (GROWTH) and leverage (LEVERAGE) ascontrols. Panel A of the table reports the results from estimating the model using theabsolute value of abnormal accrual based on Dechow et al. (1995).
The table shows that the coefficient on the dummy variable IFRS, b1, is significantat the 1 per cent level with a t-statistic of �28.353. This result suggests that theadoption of IFRS-based accounting standards is significantly associated with lowerlevel of earnings management. In other words, the extent of reported earnings’departure from normal earnings is lower after the adoption of the new standard,suggesting that earnings quality is higher after the adoption of IFRS. Panel B ofTable III reveals that a similar association between IFRS adoption and earningsmanagement is observed as before, suggesting that the inference is robust to the use ofalternative estimation for the absolute value of abnormal accruals. Consistently, thecoefficient of the dummy variable IFRS, b1, shows a significant negative associationwith the absolute value of abnormal accruals using the Kasznik (1999) model(ABACKAS) at 1 per cent level with a t-statistics of �28.477.
Our analyses of the value relevance of earnings are presented in Tables IV and V.Table IV shows the results using the price-earnings model. Differences between MASBand IFRS-based earnings, with regard to value relevance, are reflected in thedifferences in model (4)’s coefficient for EPS, a1 and R2 between the pre-IFRS sampleand the post-IFRS sample. Further, to determine whether the difference betweenthe value relevance of earnings during the two periods is significant, we refer tothe results from estimation of model (5). The coefficient of the interaction variableEPS� IFRS, a3, indicates whether there is a significant difference in the valuerelevance of earning between the two periods.
As shown in Table IV, the coefficient of EPS from the price-earnings regressionbefore and after IFRS adoption is 4.139 and 5.199, respectively. Both coefficients aresignificant at 1 per cent level with a t-value of 19.039 (pre-IFRS) and 20.660 (post-IFRS).These results suggest that earnings reported during the IFRS period has greater valuerelevance compared to earnings reported in pre-IFRS period. Similarly, the R2 showsthat the joint coefficient of earnings and book value during the IFRS period is relativelyhigher, 41.4 per cent for the pre-IFRS period and 47.5 per cent for the post-IFRS period.Thus, it seems that IFRS-based earnings explain more of the variation in share values.The higher value relevance of earnings during the post-IFRS period is confirmed byfurther analysis using model (5). The result shows that the interaction variable,EPS� IFRS is positively significant at 1 per cent level with t-statistics 3.214.
Examination of the value relevance of earnings during the two different periodsusing return-earnings regressions, as in models (6) and (7), produces qualitativelysimilar results. The results are shown in Table V. We found that the ability of earningsin explaining returns is relatively higher during the period of IFRS adoption. Thecoefficient of E/Pt�1 during the period before and after IFRS adoption is 0.995 and2.104, and both are significant at 1 per cent level with t-statistics of 6.463 and 16.489,respectively. Consistently, the interaction variable, E/Pt�1� IFRS is positivelysignificant at 1 per cent level with t-statistics of 6.058. Our examination of the valuerelevance of earnings using return-earnings regression suggests that the main findingof this study is not sensitive to model specification issues.
Summary and conclusionIn this study, we examine the impact of IFRS adoption on the quality of reportedearnings. We focused on two attributes of higher quality of earnings, lower level of
66
ARA21,1
Poo
led
sam
ple
(bas
icm
odel
)P
re-I
FR
S(b
asic
mod
el)
Pos
t-IF
RS
(bas
icm
odel
)P
oole
dsa
mp
le(e
xte
nd
edm
odel
)V
aria
ble
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ffic
ien
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val
ue
Coe
ffic
ien
tt-
val
ue
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ffic
ien
tt-
val
ue
Coe
ffic
ien
tt-
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ue
Con
stan
t0.
486*
**12
.038
0.57
4***
12.3
240.
353*
**4.
724
0.57
4***
11.3
61E
PS
4.71
5***
29.6
064.
139*
**19
.039
5.19
9***
20.6
604.
139*
**17
.550
BV
PS
0.34
0***
16.9
240.
343*
**15
.779
0.34
4***
8.20
10.
343*
**14
.545
IFR
S�
0.22
1**
�2.
593
EP
S�
IFR
S1.
060*
**3.
214
BV
PS�
IFR
S0.
001
0.03
2A
dju
sted
R2
0.44
60.
414
0.47
50.
449
F-s
tati
stic
s1,
071.
788*
**53
0.05
8***
528.
809*
**43
4.73
9***
n2,
663
1,49
71,
166
2,66
3B
asic
mod
el:P
i,t¼a 0þa 1
EP
Si,
tþa 2
BV
PS
i,tþe i,
t
Ex
ten
ded
mod
el:P
i,t¼a 0þa 1
EP
Si,
tþa 2
BV
PS
i,tþa 3
EP
Si,
t�
IFR
Si,
tþa 4
BV
PS
i,t�
IFR
Si,
tþe i,
t
Note
s:
Pis
the
clos
ing
pri
ceof
ash
are
offi
rmi
atth
efi
nan
cial
year
-en
d;E
PS
isth
eea
rnin
gs
per
shar
eof
firm
du
rin
gth
eye
ar;B
VP
Sis
the
boo
kv
alu
ep
ersh
are
atth
een
dof
the
yea
r;IF
RS
isa
du
mm
yv
aria
ble
giv
ena
val
ue
of1
ifth
efi
nan
cial
stat
emen
tis
pre
par
edu
nd
erF
RS
,0ot
her
wis
e.**
*,**
sig
nif
ican
ceat
0.05
and
0.10
lev
els,
resp
ecti
vel
y(t
wo-
tail
edte
st)
Table IV.OLS regressions on value
relevance of earningsusing price-earnings
models
67
IFRS-basedaccountingstandards
Pre
-IF
RS
Pos
t-IF
RS
Ex
ten
ded
mod
elV
aria
ble
Coe
ffic
ien
tt-
val
ue
Coe
ffic
ien
tt-
val
ue
Coe
ffic
ien
tt-
val
ue
Con
stan
t0.
106*
**3.
607
0.06
7**
2.19
20.
071*
**2.
841
E/P
t�1
0.99
5***
6.46
32.
104*
**16
.489
0.24
21.
135
IFR
S�
0.04
4�
1.16
9E
/Pt�
1�
IFR
S1.
086*
**6.
058
E/P
t�1�
RIS
K1.
249*
**10
.871
E/P
t�1�
GR
OW
TH
0.45
5***
8.07
3E
/Pt�
1�
TD
TA
�0.
042*
**�
8.57
8A
dju
sted
R2
0.03
00.
190
0.19
0F
-sta
tist
ics
41.7
76**
*27
1.89
5***
86.5
27**
*n
1,49
71,
166
2,66
3B
asic
mod
el:R
ET
i,t¼a 0þa 1
E/P
i,t�
1þe i,
t
Ex
ten
ded
mod
el:R
ET
i,t¼a 0þa 1
E/P
i,t�
1þa 2
IFR
Si,
tþa 3
E/P
i,t�
1�
IFR
Si,
tþa 4
E/P
i,t�
1�
RIS
Ki,
tþa 5
E/P
i,t�
1�
GR
OW
TH
i,tþa 6
E/P
i,t�
1�
TD
TA
i,tþe i,
t
Note
s:
RE
Tis
hol
din
gre
turn
sfo
ra
12-m
onth
per
iod
bef
ore
the
fin
anci
aly
ear
end
;E/P
t�1
isth
eea
rnin
gs
per
shar
eat
the
fin
anci
alye
aren
dd
ivid
edb
yth
ecl
osin
gp
rice
12m
onth
sp
rev
iou
sly
;IF
RS
isa
du
mm
yv
aria
ble
giv
ena
val
ue
of1
ifth
efi
nan
cial
stat
emen
tis
pre
par
edu
nd
erF
RS
,0
oth
erw
ise;
RIS
Kis
mea
sure
db
yfi
rm’sb;
GR
OW
TH
equ
als
toth
esh
are
pri
ced
ivid
edb
yb
ook
val
ue
per
shar
eat
the
end
offi
scal
year
;T
DT
Ais
tota
ld
ebt
toto
tal
asse
ts.
***,
**si
gn
ific
ance
at0.
05an
d0.
10le
vel
s,re
spec
tiv
ely
(tw
o-ta
iled
test
)
Table V.OLS regressions on valuerelevance of earningsusing return-earningsmodels
68
ARA21,1
earnings management practice and higher value relevance of earnings. Our resultsconfirm that IFRS adoption is associated with higher quality of reported earnings.Specifically, we found that earnings reported during the period after the adoption ofIFRS is associated with lower earnings management. Using both price-earnings andreturn-earnings models, our findings also show that earnings reported during theperiod after IFRS adoption is more value relevant.
Our results are based on Malaysian data, where some IFRS standards are yet to beimplemented. However, the results are of significant benefit for local standard settersas well as for other emerging countries that have similar capital market andinstitutional characteristics. More research could be conducted in other environmentsso that the impact of IFRS adoption in different environments can be revealed. Otherthan that, the consistent change in the level of earnings management and the valuerelevance of earnings during the period before and after the adoption of IFRS inMalaysia suggest that there is a possibility that investors can more accurately valueshares when there is a lower level of earnings management. Future research caninvestigate this issue further. Furthermore, additional studies can also consider otherattributes of earnings quality such as earnings conservatism, predictability,comparability, persistence and timeliness.
Notes
1. In this paper, we use the term FRS, IFRS-based and IFRS interchangeably.
2. The Malaysian Institute of Certified Public Accountants.
3. The standards issued by the International Accounting Standards Committee, thepredecessor body to the IASB were called International Accounting Standards (IAS). TheIASB adopted these standards and the full set of old and new standards is commonlyreferred to as IFRS.
4. FRF is a trustee body who watch over MASB’s performance, financial and fundingarrangements. It acts as a sounding board for the MASB. For instance, the FRF would be thefirst to review MASB’s technical pronouncements before it goes out to the public.
5. Total accruals are calculated by deducting the cash flows from operations (CFO) fromnet income.
6. CFO is obtained from the statement of cash flow.
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Corresponding authorWan Adibah Wan Ismail can be contacted at: [email protected]
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