IFRS and Earnings Management
Aggregate accruals approach on Dutch listed companies
Erasmus School of Economics
Master Thesis
Abstract - Since the introduction of 2005, all listed European companies are obliged to
prepare their consolidated financial statements in accordance with IFRS. There are some
reasons to believe that this can be associated with a lower level of earnings management at
these companies. Based on results of prior research and the factors that are of specific
influence in the Netherlands, in this thesis is studied whether this is the case in the
Netherlands. Using the Modified Jones Model, 75 Dutch companies are investigated both 3
years before and 3years after the implementation of IFRS. Also, the possible influence of the
size of the company studied. Unfortunately the results provide not enough evidence that a
high quality standard as IFRS is associated with a lower level of earnings management, as is
the case with most comparable researches in this area, and that there is no difference in this
effect between small and large companies.
Author:
C.A. Ton (311975)
Supervisor:
A.H. van der Boom
Date:
07-07-2011
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Preface
This thesis is written in the final phase of the master's education in Accounting, Auditing and
Control. First of all, I would like to thank mister van der Boom, teacher at the Erasmus
University, for his help and supervision in the writing process. I appreciate what he did for me
and I am very grateful that he has helped me writing this thesis in such a nice and friendly but
also very professional way. He has always been very patient and nothing but helpful when I
had lost the way for a moment. I think that a good teacher can make a great difference in the
final result and in my case; this has worked out very well to me.
I would also like to thank the employees of the data team in the library of the Erasmus
University. Thanks to them I was able to collect all my data in a very efficient way. Their
patience and clear explanation of collecting data was very valuable to me. It would have been
very hard to finish this thesis without their help.
My parents are the following people I would like to thank. During all four years of my
education they financed and supported me and made sure I had all the facilities I needed. If it
was not for their support, I would not have been ready to join the labour market already at the
age of 21. Also accepting my bad mood when things did not work out the way I planned is
something I would like to thank them for.
My boyfriend Barry Bondt deserves special attention as well. His well developed experience
with Microsoft Office's Excel helped me in analyzing and restating my data far more quickly
than I would have been able to do on my own. The same special thanks to my sister Monique
Ton, who helped me with some crises in Microsoft Office's Word. Both programs are not my
very best talent as I was never interested much in such things and I am happy that they were
able to help me with these facility problems.
Last but not least I would like to thank my colleague Hilbert Elzen, who helped me with my
English writing when I asked for it.
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Content
Preface ..................................................................................................................................................... 2
1. Introduction ......................................................................................................................................... 5
1.1 Introducing the subject .................................................................................................................. 5
1.2 Research question & relevance ..................................................................................................... 7
1.3 Contribution to prior research ....................................................................................................... 9
1.4 Methodology ............................................................................................................................... 10
1.5 Structure of the thesis .................................................................................................................. 11
2. Research Approach ............................................................................................................................ 13
2.1 Introduction ................................................................................................................................. 13
2.2 General research approaches ....................................................................................................... 13
2.3 Earnings management specific approaches ................................................................................. 14
2.4 Summary ..................................................................................................................................... 18
3. Theoretical Framework ..................................................................................................................... 19
3.1 Introduction ................................................................................................................................. 19
3.2 Implementation of IFRS .............................................................................................................. 19
3.2.1 IFRS as a high quality standard ............................................................................................ 19
3.2.2 Fair value accounting ........................................................................................................... 20
3.2.3 General view of advantages and disadvantages of IFRS ...................................................... 21
3.3 Earnings management ................................................................................................................. 22
3.3.1 Types of earnings management ............................................................................................ 22
3.3.2 Incentives for earnings management .................................................................................... 23
3.3.3 Different directions of earnings management ...................................................................... 24
3.3.4 Methods of earnings management ........................................................................................ 24
3.4 Accruals Approach ...................................................................................................................... 25
3.4.1 Defining accruals .................................................................................................................. 26
3.4.2. Calculating accruals............................................................................................................. 26
3.4.3. Discretionary and nondiscretionary accruals ....................................................................... 27
3.4.4 Cross sectional and time series analysis ............................................................................... 33
3.5 Summary ..................................................................................................................................... 33
4. Prior literature study .......................................................................................................................... 36
4.1 Introduction ................................................................................................................................. 36
3
4.2 Influence of IFRS on earnings management ............................................................................... 36
4.2.1 No decrease in earnings management .................................................................................. 36
4.2.2 Decrease in earnings management ....................................................................................... 41
4.3 The Netherlands and specific factors........................................................................................... 42
4.4 Summary and concluding remarks .............................................................................................. 45
5. Hypotheses ........................................................................................................................................ 48
5.1 Hypotheses development ............................................................................................................. 48
5.2 Summary ..................................................................................................................................... 50
6. Research Design ................................................................................................................................ 51
6.1 Introduction ................................................................................................................................. 51
6.2 Research Model ........................................................................................................................... 51
6.3 Sample selection .......................................................................................................................... 55
6.4 Data attainability ......................................................................................................................... 57
6.5 Summary ..................................................................................................................................... 57
7. Empirical Research............................................................................................................................ 59
7.1 Empirical results .......................................................................................................................... 59
7.2 Summary ..................................................................................................................................... 66
8. Conclusion ......................................................................................................................................... 68
8.1 Summary ..................................................................................................................................... 68
8.2 Conclusion and answer to research question ............................................................................... 70
8.3 Limitations................................................................................................................................... 71
8.4 Recommendations for future research ......................................................................................... 73
References ............................................................................................................................................. 75
Appendix 1: Overview of reviewed literature about effect of IFRS on Earnings Management ........... 79
Appendix 2: Overview of general Earnings Management and IFRS literature ..................................... 81
Appendix 3: Companies in research sample ......................................................................................... 83
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1. Introduction
"IFRS leads to more earnings management" (translated: van Beest 2008), “The persistence of
earnings and earnings components after the adoption of IFRS” (Doukakis 2010), "Have IFRS
affected earnings management in the European Union?", (Callao, S. and Jarne, J.I. 2010),
"The effect of IFRS adoption and investor protection on earnings quality around the world"
(Dunston, Karim, and Houqe 2010). These are just some titles of articles published in
magazines in the accountancy world. It shows the enormous popularity of the subject earnings
management in relation to the introduction of IFRS. This is one of the reasons that this will be
the subject for this thesis. An elaborated explanation and more arguments for this choice can
be found in the rest of this chapter.
1.1 Introducing the subject
“The increasing internationalization of businesses and the capital market creates naturally the
need for harmonization of norms for the external reporting at regional and global level.”
(Klaassen and Hoogendoorn 2006, p. 45) This increasing need for harmonization in the rules
for financial reporting, made the European Union decide to introduce the IFRS: International
Financial Reporting Standards. “Starting in 2005, listed companies are required to report
consolidated financial statements prepared according to IFRS” (Ball 2006, p. 5), so all listed
companies in the EU are obliged to prepare their consolidated financial accounts in
accordance with these rules, in order to obtain comparability between several financial
statements. It is interesting to investigate the impact of this decision on the informative value
of financial statements, because the informative value of financial statements is very
important to the stakeholders of a company. Dependent on the accounting standard,
stakeholders that rely on the financial statements are assumed to include different parties. For
example, the Accounting Standards Board (ASB, 1999) in the UK states that only the
decisions of investors are important to take into account at financial accounting. But,
according to the International Accounting Standards Board (IASB, 1989), which has
developed the IFRS, stakeholders of a company include much more participants such
shareholders, but also customers or the bank that finances the company. Stakeholders largely
base their decisions on the financial statements of a company. Some examples of such
decisions include an investor that wants to know how profitable the shares of a company are
and banks want to know whether a company is able to repay its loans. Therefore, it is
important that the financial statements provide a true and fair view of the companies' position
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and performance. The impact of a new accounting standard in relation to the informative
value of financial statements is interesting for these stakeholders.
The informative value of financial statements is among other things dependent on whether the
presented earnings are manually managed by the managers of a company. There are a lot of
definitions of earnings management, one of them is from Healy and Wahlen (1999, p. 368)
“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”. In this definition it is important to notice that it is
about intentionally misleading or influencing financial numbers. One of the intentions a
manager is willing to manage earnings is when his bonus depends on the financial results of
the company, which is discussed together with the other intentions in chapter 3. In this case,
earnings management is seen as a bad phenomenon, since it might be clear that stakeholders
cannot fully rely on financial statements when they are managed in the interest of the
managers. "In general, it is assumed that earnings management has a negative impact on the
transparency and comparability of financial reporting." (Heemskerk and Van der Tas 2006, p.
571) This is what van Beest (2008) also recognizes; he states that earnings management is in
general seen as a negative phenomenon. He defines earnings management as the use or abuse
of accounting decisions to make the financial report look 'better' (van Beest 2008, p. 14). The
fact that earnings management is in general a negative thing is an important assumption for
this thesis. Earnings management is further explained in chapter 3.
Standard setters are always looking for ways to improve the accounting standards in order to
increase the informative value of financial statements of companies. The previous mentioned
obligation of listed companies to prepare their financial statements in conformity with IFRS is
one example of improving this informative value of financial statements. One of the main
issues of IFRS is uniformity in accounting rules and regulations which will make sure that
financial statements are more reliable and transparent, and therefore have a greater value to
stakeholders due to this higher quality (Tendeloo and Vanstraelen 2005, p. 161; Jeanjean and
Stolowy 2008, p481). Namely, as a result of the increased comparability, the costs of
comparing international financial reports decrease for investors. This increase in
comparability "puts pressure on managers to reduce earnings management" (Jeanjean and
Stolowy 2008, p. 384). According to van Beest (2008), IFRS is an accounting standard that is
of high quality, which should lead to an increase in the quality of the financial statements (van
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Beest 2008, p. 14). So it is actually assumed that the introduction of IFRS increases the
quality of financial reports. Following Ball (2006) and Dechow, Ge and Schrand (2010),
earnings management is one of the proxies that has an influence on the quality of financial
reporting. In the case earnings management is seen as bad, it is assumed that earnings that are
not managed are of higher quality than earnings that are managed. This is consistent
especially with the second of the following four requirements of Ball (2006, p. 9) of financial
reporting quality: "1) accurate depiction of economic reality, 2) low capacity for managerial
manipulation, 3) timeliness and 4) asymmetric timeliness".
1.2 Research question & relevance
Due to increasing globalization, the above described uniformity in accounting standards is
more and more needed; investors want to able to compare financial statements of national and
foreign companies. The question is, however, did the introduction of the obligation to prepare
financial statements in accordance with IFRS indeed increase the informative value of the
financial statements? More precisely; did the introduction of IFRS lead to a decrease in the
level of earnings management? And, what is also interesting: is there a difference in the
quality of the financial statements between small and large companies? The expectation exists
that there is a difference between small and large companies because of the political cost
theory (explained in chapter 3). Because of this expectation, general results of one sample of
companies are not very useful to stakeholders. Stakeholders want to know the effect of IFRS
on earnings management on their type of company and not in the effect in general. Therefore,
separating small from large companies increases the informative value of the results since
they will be more specific. This is what this thesis will be about and the main question of this
thesis is:
"To what extent did the introduction of IFRS in The Netherlands result in a reduction of
accruals based earnings management, in the period 2002-2007 for small and large
companies, listed on the Dutch stock exchange?”
As said before, an important assumption here is that earnings management is indeed bad.
Therefore a reduction in earnings management is one way of increasing the quality of
financial statements. Evidence for the fact that a higher quality standard can lead to a
reduction in earnings management can be found in Barth et al (2008), which will be discussed
7
later on in this article. In order to come to a straight answer for this question, the following
sub questions are developed which will be answered in the chapters 2 until 7:
1. Which research approach is the most appropriate one for this study?
2. What is the implication of the introduction of IFRS in 2005?
3. What are the methods of managing earnings?
4. How are accruals defined?
5. With which models can earnings management be measured?
6. What is the influence of IFRS on the level earnings management in other countries,
according to prior research?
7. What are specific factors in the Netherlands that can have an influence on the success
of IFRS?
8. What are the expectations regarding the influence of the mandatory implementation of
IFRS on the level of earnings management at Dutch listed companies?
9. What are the hypotheses for the research?
10. How does the research design look like?
11. What are the results of the research?
12. Which conclusions can be drawn from these results?
In chapter 5 specific hypotheses will be developed in order to come to a final answer at the
main question. The topic is very interesting, because a lot of time and effort is put in setting
new and improving current standards. It is important therefore, that these standards do indeed
reach their goal of improving the quality of the information in financial statements. Investors
benefit from knowing whether financial statements are transparent and whether they can fully
rely on them. Therefore, the influence of the obliged introduction of IFRS on earnings
management, and therefore on the informative value of the financial statements, will be
important knowledge for investors and other stakeholders. But also auditors of financial
statements need to know what differences in opportunities for earnings management arise
with the new regulations. This is because a higher level of earnings management results in a
higher risk for the auditors, since there is a greater chance that boundaries of materiality will
be exceeded.
Besides this, there are still countries that have not yet shifted to IFRS for financial reporting.
Examples of these countries are Mexico, Canada and Japan (www.ifrs.com). It could be very
interesting for standard setters, investors and other stakeholders in these countries, to know
8
the outcome of an investigation on the influence of IFRS on earnings management. The
direction and magnitude of the outcome can be a motivation to implement IFRS, or not.
Although the specific circumstances may be different in these countries, the outcome can still
be interesting for them, since it is possible to control for such factors in a research model.
1.3 Contribution to prior research
In this thesis the focus of the research will be on Dutch listed companies. This includes
companies listed on the AEX, AMX and AScX, but also companies that are not on one of
these indices. A distinction will be made between large and small companies. This research
contributes to prior research for two reasons.
First, until now no research has specifically studied the Netherlands. There are reasons to
believe that the results in the Netherlands might be different to the results in other (European)
countries due to some specific factors that are present. This research will contribute by
studying whether these specific factors really have influence on earnings management and
therefore contribute to the success of the implementation of IFRS. As will be discussed in
chapter 4, country specific factors are very important in the expected result that IFRS will
have when it is implemented. First of all, The Netherlands is a French Civil Law country (La
Porta et al 1998, p. 1118). A lot of previous research is done in Germany, which is a German
Civil Law country. The difference between German and French Civil law is not a clear,
general difference like the difference between 'code' and 'common' law. Like Merryman and
Perez-Perdomo (2007) state in their book: France and Germany are, among others, frequently
spoken of civil law countries, but they have their own legal systems with different rules,
procedures and institutions (Merryman and Perez-Perdomo 2007, p. 2).One relevant
difference between these two is the level of investor protection, which is the lowest in French
civil law countries and much higher in German Civil Law countries. The difference in legal
system can have an influence on the level of transparency in financial reporting, which will be
explained in chapter 4.
Another argument is that the standard that was in place before IFRS was implemented, the
Dutch GAAP, was already very much in line with IFRS, which was not the case in Germany
and other countries that were investigated like France and Switzerland. These and other
factors, discussed in paragraph 4.3, make the situation in the Netherlands unique.
Secondly, there has never been done such a research, not in the Netherlands nor somewhere
else, where specifically small and large companies are compared to each other. Almost every
research studies different industries in a company, expecting a difference in the level of
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earnings management between several industries. However, it is interesting to study whether
there is a difference between small and large companies, since the political cost theory
(explained in chapter 3) implies a different level of earnings management at small and large
companies. Because it is expected that the results are different for large and small companies,
general results of one sample of companies are not very useful to stakeholders. Stakeholders
want to know the effect of IFRS on earnings management on their type of company and not in
the effect in general. Therefore, separating small from large companies increases the
informative value of the results since they will be more specific. Stakeholders want to know
whether there really is a difference in this effect at small and large companies, in order to be
able to draw a more company specific conclusion about the informative value of the financial
statements after IFRS has been implemented.
So this thesis will contribute to prior literature, since the specific focus on the Netherlands
with its country specific circumstances and the new approach of comparing small and large
companies may provide interesting outcomes. The results might not provide a generalization
for other countries due to the specific circumstances.
1.4 Methodology
In order to do research, there are three main research approaches namely: market-based
research, positive research and normative research. The research of this thesis has a positive
approach, and more specifically the Positive Accounting Theory (PAT). The difference
between a positive theory and PAT is explained in chapter 2. In short, PAT is a theory that
"seeks to explain and predict managers' choices of accounting methods" (Deegan and
Unerman 2006, p. 252). The specific angle of incidence within the PAT will be the agency
theory. This is the most appropriate way of doing research for this subject, as will be
explained in chapter 2. In order to investigate whether the mandatory introduction of IFRS
was successful in providing a higher quality of financial statements, including a lower level of
earnings management, the financial numbers of Dutch companies will be used. The sample
size includes 75 companies, which were all listed during the period of 2002-2007. As chapter
4 and 5 explain more thoroughly, all data is obtained by the Thomson One Banker Database,
which is available at the Erasmus University Rotterdam. The relevant data is collected in a
data file. The Modified Jones Model (explained in chapter 3) is used for calculating the
relevant numbers with the collected data. After that, a regression analysis in SPSS is
performed to measure the possible relevant correlations of the accounting standard used,
Dutch GAAP versus IFRS, and the firm size, small or large, with the level of earnings
10
management. It is investigated whether the mandatory introduction of IFRS in 2005 has had a
positive, negative or even no influence on the level of earnings management at Dutch listed
companies.
1.5 Structure of the thesis
The rest of this thesis will be as follows. Chapter 2 discusses the appropriate research
approach for this research. This is important because the position taken is important
background knowledge for the discussion of prior research. Sub question one will be
answered in chapter 2.
Chapter 3 provides a theoretical framework for this research. It begins with discussing the
implications of the introduction of IFRS, as well as different views on the impact of this
implementation. After that, earnings management as a phenomenon is discussed. Several
definitions, incentives and methods for earnings management are discussed. Then, the term
accruals is explained. The difference between discretionary and nondiscretionary accruals is
explained, which is necessary to determine the existence of earnings management. When this
is clear, several models that distinguish discretionary from nondiscretionary accruals are
presented. Here, also the relationship between accruals and earnings management is defined.
In the conclusion of this chapter, sub questions 2, 3, 4 and 5 are answered.
Then, in chapter 4, the influence of the implementation of IFRS on earnings management will
be discussed. This will be done by an extensive review of existing literature on this topic.
Research on this subject is done in several countries, especially in Europe after the obliged
introduction of IFRS for listed companies. Both research on early adopters as well as research
on companies that followed IFRS after the obliged implementation are discussed. After that
paragraph, the country specific factors of the Netherlands that are relevant are discussed. The
conclusions of the prior researches will be summarized and compared with each other. The
chapter will end with a summary, including an answer to sub questions 6 and 7.
After that, chapter 5 presents the formulated hypotheses. Sub questions 8 and 9 are answered
in chapter 5.
Then in chapter 6 the research model is introduced. It is argued why this model is chosen. The
meaning of the variables of the models are explained and it is explained how the hypothesis
can be answered with these models. Also, the sample selection and the data attainability is
discussed. In the concluding paragraph, sub question 10 will be answered.
The results of the research will be showed and explained in chapter 7, which will be the
answer on sub question 11. All relevant outcomes will be discussed. Also an analysis of the
11
findings will take place. With this analysis, sub question 12 can and will be answered.
Chapter 8 will provide the conclusion. First a short summary of the important issues of the
thesis is given and then the main question will be answered. The thesis will end by
mentioning the limitations of this research, followed by some recommendations for further
research of this subject.
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2. Research Approach
2.1 Introduction
This chapter provides an overview of several approaches to do accounting research. After the
appropriate way of doing this research is chosen, the specific approaches to do earnings
management research are discussed. The eventual choice for a model for this research is
defended in paragraph 2.3
2.2 General research approaches
In order to do a research, it is important to choose which approach is going to be used. As
mentioned in the introduction, a research can be done from a market based, normative or
positive approach. Within these general research approaches, Deegan and Unerman (2006)
provide several specific approaches to do accounting research, such as the inductive
accounting theory, also known as market based research, normative accounting theory and
Positive Accounting Theory (PAT).
The first approach, market based research "explores the role in accounting and other financial
information in equity markets" (Deegan and Unerman 2006, p. 377). It is about examining the
reactions of the market on specific accounting procedures or information releases. The
observations that are done in real life then, serve as evidence which is generalized for a
specific theory. Thus from the market researches, several conclusions are drawn which are
used to develop a theory of what the reaction of the market should be in several situations.
The normative accounting theory serves as a prescription. As the name already suggests, such
theories prescribe what people or companies should do in certain circumstances. "Theories
that prescribe particular actions are called normative theories as they are based on the norms
(or values or beliefs) held by the researchers proposing the theories" (Deegan and Unerman
2006, p.10) A limitation of this type of research is that it is not based on practical
observations. Therefore, they cannot tell anything about the real practices.
The third and last approach is Positive Accounting Theory (PAT). Positive theories just
describe, explain and predict what is happening. It can be seen as the opposite of induction
theory, because it "begins with some assumption(s) and, through logical deduction, enables
some prediction(s) to be made about the way things will be". (Henderson, Peirson and Brown
1992, p. 326) In the special case of PAT it is about describing, explaining and predicting the
accounting behavior of managers. It is a more specific approach of doing positive research by
applying it to the accounting behavior of managers. Positive Accounting Theory is based on
13
empirical testing of existing theory. One of the limitations of this kind of research is that is
does not tell companies what to do, but just observe what is done right now.
The research of this thesis will use the third approach, the Positive Accounting Theory. The
argumentation for this is that there are existing models for measuring earnings management
and together with assumptions about the influence of the introduction of IFRS on earnings
management; it is tested whether the variable IFRS is associated with the level of earnings
management. Since earnings management is about describing, explaining and predicting the
accounting behavior of managers, the PAT is applicable here. The market based approach is
not applicable to this kind of research, because it will not be studied what the reaction of the
market on the adoption of IFRS is. Also the normative accounting theory is not applicable,
since there will be no advice on what companies should do. This research will just focus on
predicting the possible effect of IFRS on earnings management, which is why positive
accounting theory is the most applicable approach.
As mentioned by Deegan and Unerman: “Positive Accounting Theory focuses on the
relationships between the various individuals involved in providing resources to an
organization and how accounting is used to assist in the functioning of relationships” (Deegan
and Unerman 200, 207). An important assumption of the positive accounting theory is that
every individual acts in his own interest and that companies try to align the interests of agents
and principals, which is also known as the agency theory. In the specific case of this thesis,
managers of companies are the agents and the stakeholders are principals. When managers are
engaged in earnings management, it is assumed they indeed act in their own interest, resulting
in a conflict with the stakeholders. Accounting standards are then the mechanism that has to
make sure that managers do not act in their own interest, but in the interest of the stakeholder.
Therefore, the main assumption of the Positive Accounting Theory is valid for this research,
making this approach the best for researching the effect of new accounting standards on the
behavior of managers.
The next paragraph will discuss some specific approaches, used in the work field of earnings
management, after which the final approach for this research will be presented.
2.3 Earnings management specific approaches
There are basically three main approaches used in the current literature about earnings
management, namely; measuring aggregate accruals, measuring specific accruals and analyze
the distribution of earnings after management (McNichols 2000, p. 314).
14
The first approach, the aggregate accruals approach, is the one most used in research of
earnings management. More precisely: “The model of aggregate accruals proposed by Jones
(1991) is the most commonly used in the literature” (McNichols 2000, p.314).The aggregate
accruals approach tries to explain earnings management on behalf of separating discretionary
and non-discretionary accruals. The discretionary accruals are an indication for earnings
management. The term accruals, as well as the difference between discretionary and
nondiscretionary accruals, will be further explained in paragraph 3.4. When the aggregate
accruals approach is used, both total and specific accruals can be studied. The first takes into
account all accruals present at a company to estimate nondiscretionary accruals. For example
Healy uses this method, which is explained in paragraph 3.4.2. The second way is only take
into account some specifically defined accruals. As will also become clear in paragraph 3.4.2,
Jones and Dechow measure earnings management by studying only some accruals to estimate
the nondiscretionary accruals. Both methods within the aggregate accruals approach are
applicable for comparing different companies with different sizes, different operating
industries and other differences.
The second approach by McNichols, measuring specific accruals, also separates discretionary
from non-discretionary accruals in order to estimate earnings management. The difference
with the first approach is, however, that the focus in this kind of research is on one specific
industry, making use of industry specific accruals. In this way, firm specific circumstances for
earnings management are taken into account. For this kind of studies, the knowledge of
institutional arrangement is used to characterize the likely behavior of accruals for a specific
industry (McNichols 2000, p. 314). An advantage of this approach is that "by exploiting
information about specific accruals, potentially more powerful methods for detecting earnings
management can be developed" (McNichols 2000, p. 321). For both the aggregate accruals
and the specific accruals approach the Jones model, explained in chapter 3, is one of the many
models that can be used.
The third approach studies the distribution of earnings, after the management of earnings is
done. Burgstahler and Dichev (1997, see chapter 3) are one of the users of this approach in
order to investigate whether earnings are managed to meet targets, by measuring the nondiscretionary part of earnings and the interval around the earnings targets. The research done
by Jeanjean and Stolowy (2008, see chapter 3) is another example of the method of studying
the distribution of earnings. As will be explained in chapter 4, they study irregularities in
earnings distribution as an indication for earnings management.
15
The above approaches for studying earnings management all have their limitations. The main
limitation of the aggregate and specific accruals models is that accruals management is not the
only way of earnings management (see chapter 3). Therefore, a large part of earnings
management is not considered in these studies (Lippens 2010, p. 86). Besides, in the
aggregate accruals approach it is possible that results are distorted because the performances
of different industries are compared (Kothari, Leone and Wasley 2005).
This second limitation is the reason McNichols (2000) had the preference to use the approach
of specific accruals. However, a disadvantage of this approach is that the results are hard to
generalize because of the specific situation. McNichols (2000) also mentions the high costs as
a disadvantage of this approach, because a lot of institutional data and knowledge is needed.
The last, innovative approach for earnings management has as main disadvantage that is
seems implausible that small intervals around earnings targets are explained by the
nondiscretionary component of earnings (McNichols 2000, p. 336). Besides, since this
approach is not used a lot in prior research, there is little information about the strength of this
method.
Taking the pros and cons of the three approaches, the research in this thesis will make use of
the first approach, aggregate accruals. Since the research will focus on a group of companies
across several industries, before and after the event of introducing IFRS, a specific accrual
approach is not applicable. The sample will be too small to look at institutional factors
influencing the different behavior of accruals and will therefore not provide reliable
outcomes. As will become clear when the research model is presented, the sub-method within
the aggregate accruals approach of some accruals is used instead of the total accruals.
The reason that the method of making use the distribution of accruals is not chosen, is because
it is not used a lot in prior research. For example, the model of Jeanjean and Stolowy (2008),
which is explained in chapter 4, is quite new. Therefore, it is not sure whether this model
provides reliable outcomes. The current literature has not found any evidence on the
reliability of this model. A more important argument that the model of Jeanjean and Stolowy
is not used is that they do not have very strong incentives to use this model their selves.
"Given constraints on data availability, and consequently the difficulties of implementing the
methods based on accruals, in this paper we apply the third methodology and analyze the
distribution of earnings in the three countries" (Jeanjean and Stolowy 2008, p. 485). Their
reason not to use another model is that it is 'too difficult', which is not a very strong argument
to defend a research model. Therefore, following Jeanjean and Stolowy in using their model
16
for measuring earnings management would not be a very convincing choice, especially when
there is no evidence that this model provides reliable outcomes.
So, the aggregate accruals approach will be used in order to do the research. One of the many
models that use this approach is the Modified Jones Model by Dechow et al (1995). An
argument to choose for Modified Jones is that is the most accepted model in the existing
literature. Several researches concluded that only the Jones- and the Modified Jones model are
able to provide reliable estimates for earnings management. Dechow et al (1995) compared
several models that make use of the accruals approach, namely Healy, DeAngelo and Jones,
which will all be explained in chapter 3. In their own research, Dechow et al developed the
Modified Jones Model. In order to get a good comparison of the several models they made
use of practical data, namely "32 firms alleged by the Security Exchange Commission (SEC)
to have overstated earnings" (Dechow et al. 1995, p. 219). They studied which model showed
the existence of earnings management at the 32 companies of which the SEC said that
earnings management was apparent. Their findings were consistent with previous findings
that the Jones model provides the most powerful explanation, since this model indeed
provided the most significant indication for earnings management at these 32 companies,
compared with a sample of 1000 event-years. This counts for both the standard and the
Modified model of Jones.
Since the Modified Jones model is more extended than the standard model this is the best
method for this research, as will be explained in chapter 3. Although the model has faced a
lot of criticism, most of the commentary of this method is against the cross-sectional variant
of this type of model (Heemskerk and Van der Tas 2006), which will also be explained in
chapter 3. This research will not include a cross-sectional analysis, so a large part of the critic
is not relevant. Besides this, despite the limitations, the time series variant of the Jones Model
is used a lot in prior research and it is seen as an acceptable approach. It also enhances the
comparability of results to use this method. Research done in for example Germany also used
this method and the outcomes cannot be compared when a total different model is used.
Although the country specific factors are not the same, the results might be comparable when
they are critically reviewed. Therefore, this method will be used in this research.
17
2.4 Summary
This chapter explained the different approaches to do accounting research; market-based,
normative and positive accounting theory. Market based research is about observing things in
reality and bring this into a theory. Normative accounting theory is about prescribing what
people should do. Positive accounting theory is about describing or predicting what is
happening. In the special case of accounting, Positive Accounting Theory (PAT) describes,
explains and predicts the accounting behavior of managers.
Positive accounting research begins with some assumptions (see chapter 5) and theories and
then uses models to explain what happens in reality. Therefore, the positive accounting theory
is the most applicable approach for this research.
Within this theory, the agency is the most appropriate sub approach. An important assumption
of this theory is that individuals act in their self interest. As will be explained in chapter 3, self
interest of managers plays a role in whether a company is engaged in earnings management.
McNichols (2000) has set up three methods for studying earnings management; measuring
aggregate accruals, measuring specific accruals and analyze the distribution of earnings after
management. For this type of research, the aggregate accruals approach is the most
appropriate because of the characteristics of the data. This will be used studying only some
accruals instead of total accruals. Eventually, the time series variant of the Modified Jones
Model by Dechow (1995) is the specific model that will be used. This is the answer to sub
question 1: "Which research approach is the most appropriate one for this study?" It is the
Modified Jones Model by Dechow (1995), taking into account that this is a Positive
Accounting Theory. The specific accruals approach is not applicable for this research because
the purpose of this research is not to look at a specific industry and the approach of analyzing
the distributions of earnings, is not applicable because the insights and models are quite new
and therefore not very strong yet. This reduces the confidence in such models. Besides this,
the models are less elaborated in the source articles, which makes it hard to use them.
18
3. Theoretical Framework
3.1 Introduction
This chapter will provide the broad theoretical background that is needed for an understanding
of the research done later in this thesis. The items IFRS, earnings management and accruals
are thoroughly explained respectively, in order to come to a clear view of these subjects.
Together with the explanation of accruals, the accruals approach and the supporting model
that is used a lot in research of earnings management is discussed. Later on in this thesis, the
importance of this model becomes clear and it is used for this research as well. This broad
explanation of some terms and models is necessary for the specific prior literature study in
chapter 3. The chapter ends with a summary wherein sub questions 2,3,4 and 5 are answered.
3.2 Implementation of IFRS
3.2.1 IFRS as a high quality standard
An important aspect of this thesis is the introduction of IFRS in 2005. IFRS stands for
International Financial Reporting Standards and these standards are issued by the
International Accounting Standards Board (IASB). The IASB is a cooperation of national
accounting organizations. (Klaassen and Hoogendoorn 2006, p. 48) The conceptual
framework of the IASB covers almost all aspects of the annual report. Such a conceptual
framework is important, since it contributes to a consistent set of rules. (Klaassen and
Hoogendoorn 2006, p. 86) It is important to mention that IFRS are principles-based standards
instead of rules-based. (Carmona and Trombetta 2008, p. 456) The main difference between
these two approaches is that rules-based standards “includes specific criteria, ‘bright line’
thresholds, examples, scope restrictions, exceptions, subsequent precedence, implementation
guidelines etc” (Nelson 2003, p. 91) while ‘‘principles-based standards refer to fundamental
understandings that inform transactions and economic events (Carmona and Trombetta 2008,
p 456). So principles-based systems give a more general guideline of how an annual report
should be made up, which is applicable for IFRS. It is a system of financial reporting that is
based primarily on the fundamentals of accounting (van Beest 2011, p. 2-3). It makes use of
the professional judgment of the users of the guidelines. These users have to think about the
intention of the standard setter. This is not the case for rules based standards, where the users
just do what is stated in the rules instead of think themselves. The stated rules include very
extensive and precise elaborations concerning what is allowed or is not allowed (Alexander
and Jermakowicz 2006), where principles based standards leave more room for interpretation
for the users.
19
IFRS are introduced in order to increase the comparability of financial statements and also to
enhance the transparency of financial reports. Since IFRS is a high quality standard, financial
statements prepared in accordance with IFRS are assumed to be of higher quality. This is what
Barth et al (2008) recognizes: “A goal of the International Accounting Standards Committee
(IASC), and its successor body the International Accounting Standards Board (IASB), is to
develop an internationally acceptable set of high quality financial reporting standards.” (Barth
et al. 2008, p. 468) Taking this into account, together with the definition of Healy and Wahlen
(1999) that earnings management is seen as a bad thing that misleads stakeholders, the overall
expectation is that IFRS leads to a lower level of earnings management because of this higher
quality of standards. This assumption is strengthened by the conclusion of the research of
Barth et al (2008) that firms that apply the international accounting standards are, among
other things, less engaged in earnings smoothing and managing earnings towards a target.
(Barth et al 2008, p. 496-497) These positive consequences of the implementation of IFRS are
also recognized by Ball (2006), who discusses the pros and cons for investors of the
introduction of IFRS. He makes a distinction between indirect and direct advantages for
investors. These include more accurate, comprehensive and timely information, small
investors being able to compete with professional analysts due to better information and
eliminate the need to make adjustments in order to make financial statements of companies
more comparable. (Ball 2006, p. 11) These positive effects of the implementation of IFRS
mentioned by Ball imply that the rules and regulations of IFRS are better than the standards
used before. Heemskerk and van der Tas (2006) mention that one of the reasons to choose for
IFRS is that it makes financial reporting more transparent and comparable. This would
suggest that there is less room for managers to manage earnings, resulting in a better quality
of financial statements.
3.2.2 Fair value accounting
A very important aspect of IFRS is that many assets, liabilities, revenues and costs should be
recognized at their fair value, especially financial assets and liabilities (Laux and Leuz 2009,
p. 4). According to Klaassen and Hoogendoorn (2006, p. 94), fair value is defined by the
IASB as follows: “the amount for which an asset could be exchanged or a liability settled
between knowledgeable, willing parties in an arm’s length transaction.” This fair value is
directly one of the main disadvantages of IFRS that is mentioned by Ball (2006). In a lot of
cases this can be the market price of a specific asset for example, but when there is no market
for the asset, or the price is unknown, the fair value has to be estimated. The fact that this
20
estimation, or valuation, process is done by the management of the company makes it a very
subjective process, which may enhance the possibility of earnings management. Another
problem with fair value arises in the case of illiquid markets. For example, in the recent
financial crisis, banks sold a lot of (financial) assets because of an urgent need for liquidity
due to threat of bankruptcy. So in fact, there was a market price for these (financial) assets.
But it might be clear that these forced selling prices are not a valid measure for the fair value
of these assets for other parties. "The basic idea is that banks may (have to) sell assets at a
price below the fundamental value and that the price from these (forced) sales becomes
relevant to other institutions that are required by fair value accounting to set their assets at
these value" (Laux and Leuz 2009, p. 826-834; Allen and Carletti 2008; Plantin et al 2008a).
For these reasons, the fair value aspect is seen as a disadvantage of IFRS, regarding the
informative value of financial statements, since it may lead to even more earnings
management instead of show a decrease. Other disadvantages mentioned by Ball are less
competition among several systems and incentives of preparers will remain local. (Ball 2006,
p. 25)
3.2.3 General view of advantages and disadvantages of IFRS
The conclusions of Ball are more or less the same as that of Bolt-Lee and Smith. They state in
their paper, which is about highlights in IFRS research, that “the benefit of U.S. investors
might not exceed costs”. (Bolt-Lee and Smith 2009, p. 50) The benefit of improved standards
and cost saving aspect of multinationals are admitted, but they are skeptical about the net
effect of the introduction of IFRS.
Heemskerk and Van Der Tas (2006) do also recognize the previous mentioned advantages and
disadvantages of the implementation of IFRS. They state that although the rules are very
stringent, the application of these rules comes with a lot of subjective measures. Therefore,
earnings management should be less possible when financial statements are prepared in
conformity with IFRS. However, at the same time, the subjective estimates which are needed
would lead to more possibilities of earnings management.
Soderstrom and Sun (2007) argue that it is not possible to give a general view of whether the
implementation of IFRS has a positive influence on the quality of financial reporting. Unlike
Ball (2006) and Bolt-Lee and Smith (2009), they do not give an overview of advantages and
disadvantages, but they state that it depends on the circumstances. According to Soderstrom
and Sun (2007) there are three important factors that determine the success of the
implementation of IFRS: (1) the quality of the standards; (2) a country’s legal and political
21
system; and (3) financial reporting incentives (Soderstrom and Sun 2007, p. 695). Jeanjean
and Stolowy (2008) recognize this as well. They state that "IFRS provides management with
discretion" and that "how far that discretion is used depends on firm specific characteristics
and national legal institutions" (Jeanjean and Stolowy 2008, p. 481).
Paragraph 4.3 will discuss some relevant country specific factors that are applicable for the
Netherlands.
3.3 Earnings management
3.3.1 Types of earnings management
Earnings management is a popular topic in the existing academic literature. Plenty of articles
are written about the definition, incentives and implications of earnings management. The
definition of earnings management described in section 1 is just one of many existing
definitions. But, as Paton (1922) states: "It is always difficult to frame a useful definition for a
broad subject. Precise definitions are likely to be inadequate at best, and often positively
misleading." (p. 3) Ronen and Yaari (2008) do also recognize this and that’s the reason they
introduced white, gray and black earnings management. The definitions of the three kinds of
earnings management are described as follows: "Beneficial (white) earnings management
enhances the transparency of reports, pernicious (black) earnings management involves
outright misrepresentation and fraud, the gray is manipulation of reports within the boundaries
of compliance with bright-line standards, which could either be opportunistic or efficiency
enhancing." (Ronen and Yaari 2008, p. 25) In fact, white earnings management is seen as
'good', since this enhances the quality of the financial statements. For example, income
smoothing can be a good form of earnings management. In this phenomenon, earnings are
managed in such a way that a stable trend can be presented, instead of strongly fluctuating
numbers each year. Investors like stability in that it reduces their risks. So when this is the
only intention why the earnings are managed, it can be seen as a good type of earnings
management, because the value of the information will increase. 'Gray' earnings management
can be good when used for efficiency but can be bad when used for opportunistic reason, so
this is the vaguest one of the three. Finally, black earnings management is really fraud. This is
'bad' earnings management since managers manage earnings just in order to get better
themselves. In this way, the only intention of the manager will be increasing their own wealth,
for example because their bonus will increase when presented earnings are higher. By this
type of earnings management, investors are not benefited since the results are not managed in
order to improve the information value of the financial statements. The black form of earnings
22
management is in line with the definition of earnings management of Healy and Wahlen
(1999). Although Ronen and Yaari do recognize that earnings management can be good (the
white or gray variant), they conclude with the definition of Healy and Wahlen for earnings
management, as stated in the introduction of this article. Following Ronen and Yaari (2008),
Leuz et al. (2003), Tendeloo and Vanstraelen (2005) and others this definition of earnings
management is the starting point of this thesis, which assumes that earnings management is a
bad thing.
3.3.2 Incentives for earnings management
Healy and Wahlen (1999) give three main incentives for earnings management: capital market
expectation and valuation, contracts written in terms of accounting numbers and antitrust or
other governmental regulation.
The first incentive, the capital market expectation and valuation, is about the influence of
earnings on the stock price. Managers can increase earnings, in order to increase the stock
price, for example to meet analysts' expectations. (Burgstahler and Eames, 1998) This can be
important for the managers, since they will be held responsible for the results of a company.
They therefore will think it is important to meet analysts' expectations, in order to avoid
disappointed investors.
The second incentive that explains earnings management according to Healy and Wahlen, the
contracts written in terms of accounting numbers, has to do with all the contracting
agreements a company has. In order to align the interests of managers and stakeholders, a lot
of contracts are in place. According to Watts and Zimmerman (1978) these contracts give rise
to an increase in possibilities for earnings management. An example is that companies that are
close to lending contracts manage earnings. Banks for example increase the interest rate when
the risk of their client becomes higher. This can be a reason to manage earnings by presenting
a better result in order to avoid an interest increase resulting in higher costs. Another, maybe
more familiar example is management compensation contracts. (Healy and Wahlen 1999, p.
376). When the compensation of a manager depends on the results of the company, there will
be an incentive to manage the earnings in a positive way. The reason for this is that the
manager will receive a personal benefit as a result of the numbers presented.
The third incentive for earnings management, the antitrust or other governmental regulation,
has to do with eventual intervention of the government or another institution, for example
when industrial regulations are violated. This is also known as the political cost theory.
(Deegan and Unerman 2006, p. 241) In order to avoid such intervention, management tries to
23
manage earnings in such a way that the intervention is not needed. An example of this
situation can be that a bank which is close to a minimum capital requirement recognizes
abnormal gains, which will lead to a better capital position. (Healy and Wahlen 1999, p. 378)
But also the government or lobby groups can put pressure on a company. According to
Deegan and Unerman (2006) especially large companies have to deal with such political
costs, since they attract more attention as they are more visible than small companies.
3.3.3 Different directions of earnings management
An article about earnings management, especially about avoiding losses, is written by
Burgstahler and Dichev. The main subject of their article is “how and why firms avoid
reporting earnings decreases and losses” (Burgstahler and Dichev 1997, p. 101). They use
descriptive statistics with data from 1977 until 1994 in order to get evidence on this
phenomenon. They find indeed that earnings are managed, specifically that losses are
managed away. This article provides two main reasons for managers to choose for earnings
management: “managers avoid reporting earnings decreases and losses to decrease the costs
imposed on the firm in transactions with stakeholders” and “an explanation based on prospect
theory, which postulates an aversion to absolute and relative losses” (Burgstahler and Dichev
1997, p. 124).
The incentives that this article mentions for earnings management are slightly different from
that of the article of Healy and Wahlen. This is because Burgstahler and Dichev focus on one
side of earnings management, managing earnings in case of losses, while Healy and Whalen
focus on the totality of earnings management, both in good and in bad times. This concludes
that earnings management can include both over- as well as undervalue earnings. This is
consistent with earlier mentioned findings, since the compensation contracts of managers
probably lead to overvalue earnings, while the political costs theory can lead to an undervalue
of earnings.
3.3.4 Methods of earnings management
There are two broad ways of managing earnings; real earnings management and accruals
management. The first measurement of earnings management, real earnings management,
means that the management chooses several economic activities in order to influence the
financial statements (Heemskerk and van der Tas 2006, p. 571-572). This type of earnings
management does affect cash flows. According to Roychowdhury (2006) real earnings
management is defined as: "management actions that deviate from normal business practices,
undertaken with the primary objective of meeting certain earnings thresholds."
24
(Roychowdhury 2006, p.336) An example of real earnings management is the reduction in
discretionary expenses, such as research and development costs, in order to increase the
reported income (Cohen, Dey and Lys 2007, p. 12). Another example is to sell products with a
high discount, in order to increase the sales volume in the short term. So, real earnings
management is about managing the real activities of the company. According to
Roychowdhury (2006, p. 338) real earnings management more has to do with production and
pricing decisions. Since this will be less visible for accountants and other third parties, this
method of earnings management is a lot harder to detect than, for example, accruals based
earnings management. In fact, it might be technical impossible in practice. Therefore, the
research of this thesis will focus on accruals based earnings management.
Accruals based earnings management, the second method for earnings management, is about
the discretion of management in the process of selecting accounting methods and in
estimating numbers. The term accruals and their measurement will be further explained in
paragraph 3.4. For now the following explanation will be sufficient. Accrual management is:
"manipulating accruals with no direct cash flow consequences". (Roychowdhury 2006, p.
336) Accruals appear on the balance sheet, and total accruals are calculated by taking together
several balance sheet items. Examples of balance sheet items that are included in total
accruals are prepaid costs or debtors. The reason that these accruals can be an indication for
earnings management is that the discretion of the management is needed for the recognition of
some items. Also the timing of these items are subject to management discretion, for example
the write-off of assets can be delayed (Roychowdhury 2006, p. 336), which can be an
indication for earnings management. For a better explanation of accruals and accruals based
earnings management, see paragraph 3.4
As mentioned in paragraph 2.3, McNichols (2000) sets out the different models which are
most used in research about measuring earnings management: aggregate accruals, specific
accruals and the distribution of earnings after the earnings management took place. For a
thorough understanding of these different methods, see chapter 2.
3.4 Accruals Approach
In order to understand the methods of prior research, a quick overview of the Modified Jones
Model, as introduced as the model for this research in chapter 2, is given. A more elaborated
explanation of this model will be given in chapter 5, where the research model for this
research is introduced. In chapter 4, where the previous literature on this subject will be
25
discussed, it is explained that some researches did not make use of the accruals approach, but
developed other methods to measure earnings management. However, in order to make the
research results comparable to the outcomes of other European countries research results, the
Modified Jones Model, which is explained below, is used. A second reason for this choice has
to do with limitations of the other models. A third reason is that this model provides the most
reliable results compared to other models making use of the accruals approach. This was
explained in chapter 2.
The reason the accruals approach and the Modified Jones Model is already explained here is
that this knowledge is needed for an understanding of the discussed prior literature in chapter
4. Prior research indicated that this model is the best for this research, as discussed in chapter
2. Since there are no clear indications that the other models used in prior research provide
better estimations, these models will not be elaborated very much.
3.4.1 Defining accruals
As said before, one way of measuring earnings management is making use of accruals. This is
one of the three research approaches McNichols (2000) describes, as was discussed in chapter
2. The accruals approach is based on the accruals principle, that explains the difference
between cash flowing in and out of the company on the one hand, and the recognition of
revenues and costs on the other hand. The total accruals are a calculation of several balance
sheet items that can give an indication for the existence of earnings management. Accruals
include temporary items on the balance sheet that arise because cash flows do not always hold
on to the timing and matching principles. According to Dechow (1994) a problem with these
accruals in accounting is that their recognition is partly subject to the discretion of the
management. "This discretion can be used by management to signal their private information
or to opportunistically manipulate earnings." (Dechow 1994, p. 5)
3.4.2. Calculating accruals
Total accruals is not a balance sheet item in itself. It is the sum of several balance sheet items.
There is not one right calculation to determine the total accruals, but there are more. Dechow
et al (1995), Healy (1985) and Jones (1991) total accruals (TA) all use the same formula for
calculating total accruals. This thesis will be consistent with these studies and will use the
same formula.
26
Total accruals are calculated as follows:
(1)
TA (t) = [CA (t) -CL (t) - CASH (t) + STD (t) - Dep (t) ] / A (t-1)
where:
CA = change in current assets
CL = change in current liabilities
CASH = change in cash and cash equivalents
STD = change in debt included in current liabilities
Dep = depreciation and amortisation
A = total assets
Using formula (1), the total accruals for a firm in year t can be calculated. In the following
paragraph, 3.4.3, several models for measuring earnings management are discussed such as
Healy, DeAngelo and Jones. Although their methods differ, they all share formula (1) for
calculating total accruals.
3.4.3. Discretionary and nondiscretionary accruals
When the accruals approach is used for research, it is important that discretionary accruals are
separated from non-discretionary accruals. “Discretionary accruals are defined as actual total
reported accruals less expected normal accruals” (Tendeloo and Vanstraelen 2005, p. 163). So,
the nondiscretionary accruals are being seen as accruals that come from the operational
activities of a company, and the rest of the accruals are discretionary. An important difference
between discretionary and nondiscretionary accruals is the involvement of management
discretion. A clear example is given by van Beest (2008). He states that an example of a
nondiscretionary accrual is that of the relationship between turnover and debtors. Sold
products that are not paid for yet, lead to a logical increase in debtors without a judgment of
the management necessary. So debtors are a nondiscretionary balance sheet item. But for
example the estimation of doubtful debtors does involve the judgment of management, which
makes such a balance sheet item a discretionary accrual. Therefore, discretionary accruals are
an indication of earnings management, since the influence of the management plays a role
here. The discretionary accruals are estimated by several models, which will be explained
below.
Healy
The first model for estimating the discretionary part of accruals is from Healy (1985).
27
According to Healy, the mean total accruals from an estimation period are a representation of
the measure of the nondiscretionary accruals in the event period. (Dechow et al. 1995, p. 197).
The formula is as follows:
T
NDA () =  TA (t) / T
t=1
where:
NDA = estimated non discretionary accruals
TA = total accruals
t = 1,2 ... T is a year subscript for the years included in the estimation period
 = a year subscript indicating a year in the event period
This model implies that the total accruals of the past estimate the present nondiscretionary
accruals. This has to do with the fact that over time the average level of earnings
management, resulting from the discretionary accruals, is assumed to be zero on average. One
year earnings will be managed upwards, the other year they will be managed downwards.
This will lead to an average level of earnings management of zero. Therefore, the average
total accruals of the past will only contain nondiscretionary accruals, which are assumed to be
constant over time. However, an important implication of Healy's model is that the estimation
period should be determined. In order to calculate the total accruals from a period in the past,
a certain period must be chosen. This can for example be the time that one manager was
employed at the company, but also one economic cycle can be chosen. Unfortunately, Healy
doesn't elaborate on his choice for an estimation period.
DeAngelo
DeAngelo (1986) provides another model to estimate the nondiscretionary accruals, which
can be seen as a special case of the Healy model, according to Dechow et al. (1995). The
formula is as follows:
NDA () = TA (-1)
Instead of taking the average of the total accruals in the past, DeAngelo only takes the total
accruals of last year as an estimation of the nondiscretionary accruals of this year. This
implies that DeAngelo assumes that there was no earnings management in the year before the
year of research.
28
An important implication for both the models of Healy and DeAngelo is that they assume that
the nondiscretionary accruals are constant over time and the discretionary accruals are around
zero on average in the estimation period. (Dechow et al. 1995, p. 198) However, in practice, it
is unlikely to assume to both these assumptions are valid since economic circumstances
cannot be taken into account in such researches. The outcomes are therefore not very strong,
so both models are not likely to provide an estimation of the nondiscretionary accruals
without error.
Jones
In 1991, Jones wrote a paper wherein she established a model to determine the
nondiscretionary accruals (NDA) at a company. In this model, she relaxes the assumption of
Healy and DeAngelo that nondiscretionary accruals are constant. Jones provided a new
model; "to control for changes in economic consequences". (Jones 1991, p. 211) Another
difference with Healy and DeAngelo is that Jones focuses on some specific accruals to
estimate nondiscretionary accruals instead of the total accruals, as will become clear when the
formulas are shown. Since this model will be used in the research done in this thesis, the
explanation is more extensive then it is for the other models. The chronological steps that
must be made are presented.
First, the total accruals are calculated with formula (1), as introduced on page 22 and
presented again below. For every firm in the sample, the total accruals must be calculated.
This can be done with information from a database, for example the Thomson One-Banker.
(1)
TA (i,t) = [CA (i,t) -CL (i,t) - CASH (i,t) + STD (i,t) - Dep (i,t) ] / A (i,t-1)
where:
CA = change in current assets
CL = change in current liabilities
CASH = change in cash and cash equivalents
STD = change in debt included in current liabilities
Dep = depreciation and amortisation
A = total assets
t = year index
i = firm index
29
The second step is to calculate regression coefficients, which are used later on. The following
formula is used in this step:
(2)
TA (i,t) / A (i, -1) = 1 [1/A (i, t-1)] + 2 [REV (i,t) / A (i, t-1)] + 3 [PPE (i,t)/A (i,
t-1)] + 
where:
TA = total accruals for firm i in year t
REV = change in revenue
PPE = gross property, plant and equipment for firm i in year t
A = total assets
 = error term
t = year index
i = firm index
According to Jones (1991) the total accruals "includes changes in working capital accounts,
such as accounts receivable, inventory and accounts payable" (Jones 1991, p. 211) In the same
formula, Property, Plant and Equipment and the change in revenues are variables, so that
nondiscretionary accruals change by changing conditions are taken into account. The alphas
are regression coefficients that are obtained by ordinary least squares (OLS). This is done by
filling in historic numbers for Total Accruals (as calculated by formula (1)), Revenue,
Property Plant and Equipment and Assets. The regression coefficients can be calculated.
These 1, 2 and 3 are estimates for the regression coefficient in the next formula.
Jones calculates total accruals with respect to revenue, which can lead to an estimate of
earnings management that is biased towards zero because this extracts the discretionary
component of accruals.
The third step is determining the nondiscretionary accruals. The following model is the
expectation model for the nondiscretionary accruals by Jones:
(3)
NDA (i,t) = a1 [1/A (i,t-1)] + a2 [REV (i,t) / A (i,t-1)] + a3 [PPE (i,t)/A (i,t-1)]
where:
NDA = nondiscretionary accruals
A = total assets
REV = change in revenue between  and -1
30
PPE = gross property, plant and equipment
a1, a2, a3 = regression coefficients
i = firm index
t = year index
Jones calculates the nondiscretionary accruals also from the past, but she corrects this for a
performance variable (the profit and loss account revenue) and a position variable (the
balance sheet item property, plant and equipment). As Dechow, Ge and Schrand (2010)
mention about these variables in the Jones model: "sales growth and investment in PPE are
reasonable and intuitive drivers of firm value" (Dechow, Ge and Schrand 2010, p. 358) and
therefore are good indicators for nondiscretionary accruals.The regression coefficients are
obtained by the formula (2). The 1, 2 and 3 are estimates for the a1, a2 and a3 in formula
(3).
The fourth step in this model is to calculate the discretionary part of the accruals. This can be
done by subtracting the nondiscretionary accruals, as obtained by formula (3), from the total
accruals, as obtained by formula (1).
As said before, the discretionary accruals are an indication for earnings management, so the
fifth step is to determine whether there is earnings management. Since this step depends on
the kind of research that is done, this is explained in chapter 5, where the research design for
this specific research is presented.
Dechow
Dechow et al. (1995) use the Jones model as a starting point and the make some adjustments
which results in The Modified Jones Model. They made an adjustment of the original model
in that the change in revenues is adjusted for the change in receivables in the event period.
Dechow et al. (1995, p. 199) estimate nondiscretionary accruals as:
NDA (i,t) = a1 [1/A (i,t-1)] + a2 [REV (i,t) - REC / A (i,t-1)] + a3 [PPE (i,t)/A (i,t-1)]
where:
REC = change in net receivables
Besides the extra variable, the change in net receivables, the modified model is the same as
the standard model. This extra variable is the result of a limitation that Jones recognized in her
standard model.(Jones 1991, footnote 31) "The original Jones model implicitly assumes that
31
discretion is not exercised over revenue in either the estimation period or the event period"
(Dechow et al 1995, p. 199). In the modified Jones model, the revenues are adjusted for the
receivables. The assumption that discretion is not used for revenues is relaxed. Therefore, the
level of earnings management can be better estimated with the modified model, since the
estimates of earnings management should no longer be biased towards zero in samples where
earnings management took place through revenues. (Dechow et al. 1995, p. 199)
Both the standard and the modified Jones model have been used in many investigations on
earnings management. Heemskerk and Van Der Tas (2006) explain why the Modified Jones
Model is a way of measuring earnings management: “The discretionary accruals are that part
of the total accruals that cannot be explained by operational factors and therefore come from
intentional adjustments by management” (Heemskerk and Van Der Tas 2006, p. 576)
According to an evaluation of several models of Dechow et al (1995) "a modified version of
the model developed by Jones (1991) provided the most powerful tests of earnings
management". This is already explained in chapter 2. Guay, Kothari and Watts (1996) take the
same position. They conclude in their article that among others, only the Jones and Modified
Jones Model are able to give reliable estimates of discretionary accruals. (Guay, Kothari and
Watts, 1996, p. 104)
Kothari
The last model to estimate nondiscretionary accruals is established by Kothari, Leone and
Wasley (2005). In their research, Kothari, Leone and Wasley add one constant variable to the
model of Jones. Nondiscretionary accruals are estimated as follows (Kothari, Leone and
Wasley 2005, p. 174):
NDA (i,t) = a1 [1/A (i,t-1)] + a2 REV (i,t) + a3 PPE (i,t) + a4 ROA (i,t)
where:
ROA = Return on assets
The reason they include the performance variable ROA is that they want to compare
performance-matched discretionary accruals with the traditional accruals approach methods
such as Jones and Modified Jones. When the ROA is included as a variable, the discretionary
accruals are matched to the performance of a company. Since there is little or no evidence that
this calculation of discretionary accruals provides strong outcomes, it will not be used in this
paper and therefore the explanation of this measurement method stops here.
32
3.4.4 Cross sectional and time series analysis
The Modified Jones model can both be used for a cross-sectional analysis, using a crosssectional variant of the model, and a time series analysis, using a time series variant of the
model. A cross-sectional analysis means that for one moment in time, a company is compared
to its industrial branch. It is possible to do a cross-sectional analysis for more years, but that
doesn't make it a time series analysis, because there is no event that requires a comparison of
the period before and after that event. The cross-sectional variant of the Modified Jones
Model faces a lot of critics. For example, McNichols states: "Researchers estimating
nondiscretionary accruals by industry, as the cross-sectional Jones model is often applied,
may well overstate the magnitude of nondiscretionary accruals and understate the magnitude
of discretionary accruals, because industry-level controls include the average level of
discretion exercised by the industry." (McNichols 2000, p. 324) As might be clear, this variant
of the model is not applicable for this research, since the research is not about the difference
between industries, but about the possible difference before and after the implementation of
IFRS.
A time series analysis means that the same group of (in this case) companies are compared
before and after some event (Heemskerk and Van der Tas 2006). So when the introduction of
IFRS in 2005 is the event, a time series analysis contains a sample of companies before the
introduction of IFRS and the same sample of companies after the introduction of IFRS. The
results before and after the introduction of IFRS are compared. It is important that the same
companies before and after the event are included, because one company can be more likely
to be engaged in earnings management than another company. Therefore, the possible
difference in results might be biased when the sample of the two periods is not the same. This
type of research is applicable for this study, since the same companies from the Dutch stock
exchange will be compared on the level of earnings management before and after 2005, when
IFRS was introduced.
3.5 Summary
Since 2005, all listed companies in the European Union are obliged to prepare their
consolidated financial statements in accordance with IFRS. One of the main reasons for such
universal rules is that it makes financial reporting more transparent and comparable. That's
why it is believed that the introduction of IFRS has led to a decrease in earnings management,
as defined before. Due to more and stricter rules, managers should have less influence on the
financial statements. However, not everyone agrees on this statement and therefore sub
33
question 2 "What is the implication of the introduction of IFRS in 2005?" cannot be answered
conclusive. On the one hand it is stated that the informative value of financial statement
should increase due to the implementation of a high quality standard like IFRS, but on the
other hand might the management get more freedom in measurement and estimation practices,
especially in the case of valuation assets and liabilities at fair value. Whether the overall effect
of IFRS on earnings management is positive or negative is hard to say and depends on the
country and the prior standard of that country.
The second topic of this paper is earnings management. In the introduction earnings
management is defined as: "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". Since this
definition presents earnings management as a bad thing, this definition will be used in this
thesis. This is important for the assumption of this research, since a higher quality standard
can only lead to a reduction of earnings management when earnings management is seen as a
bad thing that negatively influences the quality of a financial report.
The answer to sub question 3 "What are the methods of managing earnings?" is that earnings
can be managed trough managing the real activities of a company or by managing accruals.
The specific method for managing earnings that is important from now on is making use of
managerial discretion in the recognition of accruals.
Further on, accruals are defined as the sum of several balance sheet items. The answer to sub
question 4: "How are accruals defined?" is formula 1: TA (t) = [CA (t) -CL (t) - CASH
(t) + STD (t) - Dep (t) ] / A (t-1). Since the discretion of the management plays an important
role in the recognition of these items that form the accruals, it is important to separate
discretionary and nondiscretionary accruals in order to have an indication of earnings
management. Therefore, the answer to sub question 5: "With which models can earnings
management be measured?" is that the discretionary part of accruals is an indication for the
existence of earnings management, since these accruals do not arise out of operating activities
and are subject to the discretion of management. The models with which the discretionary
accruals can be measured include Healy (1985), DeAngelo (1986), Jones (1991), Dechow
(1995) and Kothari (1996).
34
Several methods of estimating the nondiscretionary accruals are discussed; Healy (1985),
DeAngelo (19856), Jones (1991) and Dechow (1995). For this research, it is important to
know that the Modified Jones Model by Dechow (1995) will be used to estimate the
nondiscretionary accruals because this model provides the most reliable results. Besides this it
is important to note that this research will perform a time series analysis. The same group of
Dutch listed companies will be compared before and after the introduction of IFRS.
35
4. Prior literature study
4.1 Introduction
Now both earnings management and the introduction of IFRS, as well as the accruals
approach are introduced the focus will be on what the influence of the obliged introduction of
IFRS has been on the level of earnings management at companies. This step narrows the
theoretical background which is used for the final research to the influence of IFRS on
earnings management. All other factors that are about earnings management in general and
IFRS are relaxed now. This chapter begins with an overview of prior literature that
investigated the influence of IFRS on the level of earnings management. The models that are
used, underlying assumptions and the results as well as the limitations of these researches are
discussed. After that, the next paragraph discusses the importance of country specific factors,
including overview of which are applicable for the Netherlands and might have an influence
on the expected results in the Netherlands. The results of both prior research and the specific
circumstances in the Netherlands are an important base for the formulation of the hypothesis.
This chapter will end with a summary, where sub questions 6, 7 and 8 are answered.
4.2 Influence of IFRS on earnings management
A lot of investigation on this subject is done, especially in Europe where the implementation
of IFRS is mandatory since 2005. The main objective of the researches is the comparison
between earnings management under national standards and under IFRS.
4.2.1 No decrease in earnings management
Tendeloo and Vanstraelen (2005) investigate whether earnings management has decreased at
voluntary adopters of IFRS in Germany. Germany is a code law country with low investor
protection, indicating a high level of earnings management according to prior research. (Leuz
et al, 2003) This is the reason they expect a decline in earnings management as a result of the
implementation of IFRS. A special situation arises in Germany, since under local law earnings
management can occur through the allowed hidden reserves. This reserves “can be created by
building up unjustified provisions, recognizing excessive depreciation of assets or setting
aside certain profits in tax-free reserves” (Tendeloo and Vanstraelen 2005, p. 161). Making
use of such reserves can facilitate managers in earnings management. To control for this
facility, Tendeloo and Vanstraelen (2005, p. 175) "include all the possible ways to manage
earnings". Besides short term accruals as debtors and prepaid cost, also several long term
accruals such as change in provisions are taken into account.
36
The focus of the research in this paper is on the early, voluntary implementers of IFRS,
because at the time they wrote their paper there was not enough evidence of companies that
had to deal with the obligation of reporting in accordance with IFRS. Their sample exists of
636 German listed companies, using data from 1999 until 2001. (Tendeloo and Vanstraelen
2005, p.155) They use the cross-sectional Jones model, another version of the models above.
This is the aggregate accruals approach. The three variables in their research are “(1) whether
the company has adopted IFRS or not, (2) whether the company is audited by a Big 4 audit
firm or not and (3) whether the company has a listing on the NASDAQ, the NYSE or the
LSE.” (Tendeloo and Vanstraelen 2005, p. 164) These variables are put into a regression
analysis. Their general conclusion is that the adoption of IFRS not necessary leads to a lower
level of earnings management. Instead, they find a significant increase in discretionary
accruals that are the indication for earnings management. However, this result is less
significant at firms that are audited by a Big 4 audit firm. They also mention that when they
control for the possibility of using hidden reserves, as discussed above, the effect of the
increase in earnings management no longer exists. In that case, there is no longer a difference
in earnings behavior under German GAAP and IFRS. This can be seen as a limitation of their
research. Another limitation arises with the fact that a lot of previous mentioned researches
have used the voluntary adopters. These companies are likely to be in favor of IFRS, because
otherwise they would not voluntary report in conformity with IFRS. This perceived benefit is
confirmed by Christensen, Lee and Walker (2008). They mention that voluntary adopters of
IFRS "perceive net benefits of doing so" and mandatory adopters voluntarily adopted IFRS
"perceive no net benefits of doing so". (Christensen, Lee and Walker 2008, p. 1) Taking this
into account, the results that earnings management did not decline is may be very
understandable, because these companies implement IFRS because they expect to benefit
from it. So a conclusion can be drawn that the samples of these researches are biased.
However, as will become clear below, voluntary adoption and the perceived benefit of this
adoption does not necessarily lead to an increase of earnings management.
Another limitation of this research that has to do with the early adoption is that the current
IFRS standards differ a lot from the original IFRS standards. According to Lippens (2010)
around the year of 2005 many old IAS standards are revised and new IFRS standards are
introduced. It is assumed that the quality of the standards is increased a lot since these
improvements.
37
A very clear conclusion about the difference between voluntary and mandatory adopters is
given by Christensen, Lee and Walker (2008). They follow Barth et al (2008) in their
methodology, which will be explained later in this section, to determine whether there is a
difference in the audit quality between firms that voluntary adopted IFRS and those that
waited until the mandatory adoption. One of their measures of audit quality is the level of
earnings management: the more earnings management, the lower the audit quality. Their
research is done in Germany, since Germany had a period of seven years (1998-2005) wherein
companies were allowed to prepare their financial statements in conformity with IFRS before
the mandatory adoption in 2005. Their sample includes 133 German firms that voluntary
adopted IFRS prior to 2005 en 177 German firms that did not implement IFRS before 2005.
The results of their regression analysis imply that voluntary adopters of IFRS show a lower
level of earnings management in the post-adoption period. On the other side, firms that did
not implement IFRS prior to 2005 seem to have no incentive to apply IFRS and this is
confirmed by the fact that they did not find a decrease in earnings management in the postadoption period for the mandatory adopters. These results are in contrast with the findings of
Tendeloo and Vanstraelen (2005) who found the opposite effect about voluntary adopters!
Christensen, Lee and Walker give the following reason for the difference between voluntary
and mandatory adopters: "In most countries accounting standards are identical for all listed
firms yet incentives are likely to vary." (Christensen, Lee and Walker 2008, p. 3)
Another research is done by the Dutch investigators Heemskerk and Van der Tas (2006). Just
like Tendeloo and Vanstraelen, they use an aggregate accruals approach in which they use the
Modified Jones Model to investigate the change in earnings management due to the
implementation of IFRS. They expect a decrease in earnings management due to the
implementation of IFRS because earnings management negatively influences the transparency
and comparability of financial reporting and improving those two elements is one of the
starting-points that standard setters want to achieve with the introduction of IFRS. The focus
in their research is also on the early adopters, since they wrote their article in 2006. Too little
data of mandatory adopters were available at that time. Eventually, their sample consists of
160 financial statements of German and Swiss companies (Heemskerk and Van der Tas 2006,
p. 575). A regression analysis including variables for firm size and operating sector gives the
conclusion that IFRS was not associated with a lower level of earnings management, neither
using discretionary accruals, nor using accruals in total. This is inconsistent with the findings
of Christensen, Lee and Walker (2008) who stated that earnings management did decline at
38
voluntary adopters of IFRS in Germany. A possible reason for this inconsistency can be that
the sample of Christensen, Lee and Walker included a lot more years of research. Their data
included seven years of voluntary adoption, but Heemskerk and Van der Tas do not mention a
specific number of years, so it is assumed that their data was only from 2006. Another reason
can be the fact that Heemskerk and Van der Tas included both German and Swiss companies.
Both time differences and country difference leads to another sample, which possibly leads to
the difference in outcomes.
The limitation of the research of Tendeloo and Vanstraelen does also count for this research.
Because of the focus on early adopters, the results might be biased since these companies are
likely to expect that they benefit from the introduction of IFRS.
As discussed before, accruals management is not the only way of earnings management.
Lippens (2010) recognizes this, and investigates not only the influence of IFRS on accruals
management, but also on real earnings management. He states that accruals based earnings
management is expected to decrease as a result of the mandatory introduction of IFRS,
because of the stricter rules and the lower level of tolerance against earnings management.
However, the incentives for earnings management will not be taken away. Therefore, he
expects that the level of real earnings management will increase as a substitute for accruals
based earnings management (Lippens 2010, p. 87). His argument for this statement is that
"earnings are thought to become more volatile, while previous research shows that
management likes to present a smooth earnings path". The timing of activities, an example of
real earnings management, can be used in this situation for making the earnings less volatile
again.
Just like the research described before, Lippens uses the Modified Jones Model to explain
accruals based earnings management. For the real earnings management he uses the abnormal
level of cash flows from operations and the abnormal level of production costs as proxies for
earnings management (Lippens 2010, p. 91). The normal level of cash flows from operations
is a function of the sales and the change in sales. The normal production costs are defined as
the costs of goods sold and the change in inventory. Both the abnormal level of cash flows
and production costs are calculated by taking the difference between the normal level and the
actual level.
Lippens' sample contains financial statements from listed companies from Belgium, Denmark,
Finland, Italy, Sweden and The Netherlands in the period 2000-2006. The country of origin is
one of the variables in his models. His conclusions are that both accruals based earnings
39
management as well as real earnings management has increased after the implementation of
IFRS. However, he did observe that the substitution effect indeed takes place. There is no
difference in outcome between the countries.
The above mentioned discretionary accruals approach, used by Tendeloo and Vanstraelen
(2005), Heemskerk and van der Tas (2006) and Lippens (2010), is just one of three main
approaches. The other two are the specific accruals approach and study statistical properties of
earnings to identify thresholds. (Jeanjean and Stolowy 2008, p. 485) These three approaches
are already explained in chapter 2, with reference to McNichols. In their paper, Jeanjean and
Stolowy use the third method in order to investigate “whether companies managed their
earnings to avoid losses any less after the implementation of IFRS” (Jeanjean and Stolowy
2008, p. 485). As said in chapter 2, their reason for choosing the method of statistical
properties of earnings, is that they face constraints with respect to data availability and
difficulties with respect to the accruals approach. So instead they "analyze irregularities in
distributions as an indication of earnings management". (Jeanjean and Stolowy 2008, p. 481)
They use a statement of Glaum et al (2004) which explains why irregularities in distributions
are an indication of earnings management: "Such irregularities in distributions indicate that
companies avoid reporting net income below thresholds by managing it upwards. Without
earnings management, we would expect the distribution to be relatively smooth around the
thresholds." (Glaum et al. 2004, p. 50) Their data set includes financial statements from 2002
until 2006 from 1146 companies in Australia, France and the UK. The difference between this
investigation and that of Tendeloo and Vanstraelen and that of Heemskerk and Van der Tas is
that Jeanjean and Stolowy study first-time adopters. Early adoption was not possible in these
countries, so they all implemented IFRS in 2005. This is also the reason they have chosen
these countries. Another difference is that Jeanjean and Stolowy did not use the Modified
Jones Model in order to determine nondiscretionary accruals as an indication for earnings
management, but they study the distribution of earnings. For this, the variables Income Before
Extraordinary Items (IBEX), Total Assets and Sales are used and they perform a Wilcoxon
rank-sum test, which compares medians before and after the implementation of IFRS
(Jeanjean and Stolowy 2008, p. 488). It is not about the absolute value of these variables, but
about whether there is an asymmetry between the frequencies of reporting small losses and
the frequencies of reporting small profits. Their conclusion was that there is no significant
decline in earnings management as a consequence of the implementation of IFRS. Instead, in
France the level of earnings management did even increase. Although the method is different,
40
the outcome is in line with the research of Tendeloo and Vanstraelen (2005) and Heemskerk
and Van der Tas (2005). One major limitation of this research which Jeanjean and Stolowy
acknowledge their selves is that the databases contain financial information for 2004 under
local GAAP and for 2005 under IFRS. This is a problem, because they scale the IBEX of year
t by the ASSETS of year t-1. The numerator and denominator are not calculated under the
same standard, making the variable less valid. Although they recognize this limitation, they
still calculate it this way because of the non availability of data.
4.2.2 Decrease in earnings management
All researches discussed above, came to roughly the same conclusions; earnings management
did not decline as a result of the enforcement of IFRS. Although these results seem quite
severe, there are also some contradicting results found. For example, Cai, Courtenay and
Rahman (2008) did find a significant decrease in earnings management at countries where
IFRS has been adopted. They investigated companies in 32 countries during 2000 until 2006.
Their total sample consisted of 102.636 observations. They measure the magnitude of
accounting accruals. They argue that because of their sample size, other models for earnings
management are not suitable for their research. Their results show that both voluntary as well
as obliged adoption of IFRS can lead to a reduction of earnings management. An important
variable is, however, the level of enforcement of IFRS. "Strong enforcement is an effective
factor for reducing earnings management". (Cai, Courtenay and Rahman 2008, p. 19) They
also mention that country specific institutional factors (more specific: financial market, capital
market structure, ownership structure and the tax system) play a role in the outcomes, which
is in line with other researches. As Ball et al (2003) mentioned, the quality of financial
statements is "determined by the underlying economic and political factors influencing
managers’ and auditors’ incentives, and not by accounting standards per se" (Ball et al 2003,
p. 236). So a high quality standard like IFRS is not a guarantee for high quality financial
statements. However, a high quality standard is one of the conditions for high quality
reporting.
Another article that did find a reduction in earnings management as a result of the
implementation of IFRS was written by Barth, Landsman and Lang (2008). In their article,
they tried to find out whether the application of the International Accounting Standards has
led to a higher quality of financial reporting. They define the quality of financial reporting as
the level of earnings management, the loss recognition and the value relevance of the annual
reports. The focus here is only on the outcomes with respect to earnings management, due to
41
the irrelevance of the other aspects for this article. Their method differs from all other
methods discussed before. Through a regression analysis with variables such as size, growth,
change in liabilities and closely held shares they determine whether earnings management
occurs more or less under the international accounting standard, compared to non-US
domestic standards. There sample consists of “1,896 firm-year observations for 327 firms that
adopted IAS between 1994 and 2003 for which DataStream data are available from 1990
through 2003.” (Barth, Landsman and Lang (2008, p. 487) Companies from all over the world
are included. Note that their focus is on early adopters and not on mandatory adopters of
IFRS, since this is not possible taking into account the years of observation. The results of
their research indicate that firms adopting high quality international accounting standards
engage less in earnings management, resulting in higher quality financial reporting. This is
conformity with the findings of Christensen, Lee and Walker (2008) that early adopters show
a decline in earnings management. Again the limitation of the early adopters, which can lead
to biased outcomes, is valid for this research.
At this point, an important note is made. A major limitation of all of the above researches is
based on the assumption of Soderstrom and Sun (2007) that the influence of IFRS depends on
the circumstances of the country. This makes it hard to say whether IFRS in general
succeeded in reducing earnings management. In order to be able to define the research
hypothesis for the Netherlands, specific circumstances in the Netherlands that might influence
the success of IFRS are elaborated next.
4.3 The Netherlands and specific factors
As said before in section 2.2, country specific factors play an important role in whether the
implementation of IFRS is a success. The three main factors, derived from the article of
Soderstrom and Sun (2007) are (1) the quality of the standards that were used before IFRS,
(2) the country’s legal and political system and (3) the financial reporting incentives of
companies in that country.
In line with these factors, the specific situation in The Netherlands will be discussed in this
section in order to determine the expected results of this research.
To begin with the quality of the standards before the introduction of IFRS, the Dutch GAAP
was one of the national standards that were already very much in line with the standards of the
International Accounting Standards (IAS), which became the IFRS later. According to Haller
(2002) “The UK, Ireland and the Netherlands are the European countries of which the
42
national accounting approaches comply the most with IAS.” (p. 170) He also states that these
countries have expressed the intention of making their standards in compliance with the IAS.
This result implies that the quality of the standards in The Netherlands before IFRS was
introduced was high. Besides, according to Klaassen and Hoogendoorn (p. 43), The
Netherlands prefer a general guideline to detailed rules, so this implies that the accounting
standards in The Netherlands were already principles-based before IFRS was introduced. This
is confirmed by an article of Deloitte (2010, p. 6). It sets out the differences between Dutch
GAAP and IFRS and it is stated that Dutch GAAP includes “more principles-based standards
with more options and less application guidance”.
Since the opinions about the quality of IFRS (see section 2.2) are contradicting, it is hard to
say anything about the level of earnings management under Dutch GAAP and IFRS.
However, when it is stated that Dutch GAAP is in line with IFRS, it is expected that there is
no difference in earnings management between financial report presented under Dutch GAAP
and under IFRS.
The second factor that influences the success of IFRS is the country’s political and legal
system. One of the factors of the political and legal system is the level of investor protection
in a specific country. According to the results of Leuz, Nanda and Wysocki (2003, p.521):
"outside investor protection explains a substantial portion (39%) of the variation in earnings
management". This is valid for their sample, which includes companies from 31 countries.
This level of investor protection depends on the legal origin of a country (La Porta et al. 1998,
p.8). There are two main 'families' in this area; common law countries and code law
countries. Common law countries, for example the United States and England, form their law
“by judges who have to resolve specific disputes”(La Porta et al, 1998 p. 1119). This is a more
principle based system of law. Code law countries use “statutes and comprehensive codes as a
primary means of ordering legal material” (La Porta et al. 1998, p. 1118). Making rules and
enroll these in laws is more a rules based legal system. The code law system can be divided in
three subsystems: French, German and Scandinavian Civil Law. This is already explained in
chapter 1. According to La Porta et al. (2000) The Netherlands is a French Civil Law
Country. These types of countries have the lowest level of investor protection. This would
imply that the level of earnings management is higher in such countries, because it seems to
be not very important that investors are well informed. However, the introduction of the Code
Tabaksblat in 2003 did increase the investor protection in The Netherlands due to a higher
corporate governance level. The Code Tabaksblat has a 'comply or explain' policy, which
43
means that it is not obliged to comply the Code, but it is obliged to explain your reason when
you didn't comply. So when applied to this research, the level of investor protection in The
Netherlands will be high (since the data include only one year before and five years after the
Code Tabaksblat) which will imply a low level of earnings management. This is a valid
assumption in this research, following Leuz, Nanda and Wysocki (2003) who state: "strong
and well-enforced outsider rights limit insiders’ acquisition of private control benefits, and
consequently, mitigate insiders’ incentives to manage accounting earnings because they have
little to conceal from outsiders" (Leuz, Nanda and Wysocki 2003, p. 505)
Another factor included in the countries' political and legal system which is important for the
success of IFRS is the legal enforcement strength. In a research by La Porta et al (1998) it is
stated that French Civil Law countries have the lowest level of law enforcement (p. 1116).
However, the results of their research show that the Netherlands is an exception in this context
(p. 1142 and 1143). In these tables it is showed that according to the outcome of their
analysis, the legal enforcement level in the Netherlands is high. This is line with Burgstahler
et al. (2006) who point out that the Netherlands has a strong legal enforcement system. As
said before in section 2.3, not only the implementation of IFRS but even more the
enforcement of these rules are the success factors of IFRS (Cai, Courtenay and Rahman
2008). Since the Netherlands appear to be a strong law enforcement country, it is expected
that IFRS has been implemented successfully. The fact that countries with strong law
enforcement face lower levels of earnings management is in conformity with the findings of
Leuz et al (2003). The conclusion of their research was that there is a negative relationship
between earnings management and legal enforcement. It is therefore assumed that the
implementation of IFRS in the Netherlands has led to a reduction in earnings management,
because of the assumption that IFRS leads to a higher quality of financial reporting, including
a lower level of earnings management, and the assumption that the legal enforcement in The
Netherlands is high.
The third and last factor that influences the success of the implementation of IFRS is about
the financial reporting incentives of companies in The Netherlands. Due to the strong law
enforcement and investor protection described before, companies in The Netherlands are
expected to be willing to be transparent in their reporting in order to avoid litigation actions. It
is assumed that this transparency in reporting results in a low level of earnings management,
both under Dutch GAAP and IFRS.
44
Taking these 4 arguments above together, the findings are summarized below.
1) The level of earnings management in the reports prepared under Dutch GAAP and prepared
under IFRS will not differ much, since Dutch GAAP was already quite in line with IFRS;
2a) Due to the Code Tabaksblat, which implies better corporate governance and high investor
protection, Dutch companies are expected to not to be engaged in earnings management a lot;
2b) Due to the strong legal enforcements in the Netherlands, earnings management is
expected to be low at Dutch companies and
3) Dutch companies are expected to be willing to be transparent in their financial reporting
and therefore will engage less in earnings management.
Taking together into account these four arguments, the Netherlands is expected to be a
country where earnings management does not occur a lot, both under Dutch GAAP and IFRS.
Prior literature discussed in section 2.3 was not conclusive that there was a decline in earnings
management as a result of IFRS in the countries investigated. But, as said before, country
specific factors play a role in the success of IFRS, so the results of prior research are not
entirely useful for the Netherlands. Using the four arguments above, chapter 5 will formulate
the hypotheses that are will be used for the empirical part of this research.
4.4 Summary and concluding remarks
A short review of the conclusions of prior research is presented below. An overview of the
findings of prior literature can be found in Appendix 1.
Heemskerk and van der Tas (2006) and Tendeloo and Vanstraelen (2005) investigated whether
early adopters of IRFS have shown a decrease in earnings management. They both did this
with the aggregate accruals model, using the Modified Jones Model (Heemskerk and van der
Tas) and the cross-sectional variant of the Jones model (Tendeloo and Vanstraelen).
Heemskerk and van der Tas did their research in Germany, Tendeloo and Vanstraelen had a
sample of German and Swiss companies. Their conclusions were roughly the same. Earnings
management did not decrease as a result of the introduction of IFRS. In fact, Tendeloo and
Vanstraelen even found that earnings management has increased after the introduction of
IFRS. However, this effect was gone when they controlled for the fact that a company was
audited by a Big 4 audit company and when controlled for hidden reserves under German
GAAP.
Lippens (2010) made a distinction between accruals based earnings management and real
earnings management. He used the cross-sectional Jones Model and an estimation model from
45
Roychowdhury respectively in order to determine whether accruals based earnings
management has decreased, and real earnings management has increased as a result of IFRS.
His conclusions were consistent with those of Heemskerk and van der Tas and Tendeloo and
Vanstraelen: accruals based earnings management did not decrease after the implementation
of IFRS, but did even increase as well as real earnings management. However, he did find a
substitution effect from accruals based earnings management to real earnings management, by
doing some extra regression analyses. Finally, he mentioned that there is no difference in this
outcome between the six countries he investigated.
The fourth important research on this topic that is discussed is that of Jeanjean and Stolowy
(2008). They investigated whether the introduction of IFRS has led to a reduction in earnings
management, specifically to avoid losses. Their Wilcoxon rank-sum test resulted in the
conclusion that earnings management did not decrease as a result of the introduction of IFRS.
In France, one of the countries investigated, earnings management did even increase
according to their research.
The fifth research that was discussed is from Cai, Courtenay and Rahman (2008), which
found very contradicting results when compared with the researches discussed before. They
did find a decrease in earnings management when IFRS was adopted, but they mention that it
is important that there is a also strong enforcement instead of just adopting IFRS.
Finally, Barth, Landsman and Lang (2008) did a regression analysis and they also did find a
lower level of earnings management in countries where a high quality accounting standard,
such as IFRS, was implemented.
Some limitations that are mentioned must be taken into account. First of all, the effect of the
introduction of IFRS will largely depend on the circumstances of the country before and after
the implementation. In every research, this has to be taken into account.
Secondly, a lot of samples of previous literature include the voluntary adopters. These
companies are likely to be in favor of IFRS, otherwise they wouldn't implement it. This can
be a noise in the outcomes, since the sample is probably biased. Another problem with
voluntary adopters is that they face different standards than the mandatory adopters, since the
improvement process of the IASB around 2005.
To end this section, the answer sub question 6: "What is the influence of IFRS on the level
earnings management in other countries, regarding to prior research?" is given. Again, like
with question 2, there is not one conclusive answer. Previous research has found different
results, depending on the methods used and the countries investigated. It can be said that in
46
some circumstances IFRS succeeded in lowering the level of earnings management, but in
other countries this success is not found. The conclusion is that countries with a low quality
national GAAP and a very strong legal enforcement can benefit from the high quality of
IFRS, by a decreased level of earnings management.
Four specific factors of the Netherlands are mentioned in the last section: (1) the Dutch
GAAP was quite in line with IFRS, leading to the expectation that there will be no large
differences between financial reports under both standards, (2a) Dutch companies are
expected to be little engaged in earnings management due to the introduction of the Code
Tabaksblat which implies better corporate governance and investor protection, (2b) the legal
enforcement is strong in the Netherlands, leading to the expectation that the level of earnings
management will be low and (4) Dutch companies are willing to report their financial
statement in a transparent way, leading to less earnings management. These four factors are
the answer at sub question 7: "What are specific factors in the Netherlands that can have an
influence on the success of IFRS?"
Also sub question 8: "What are the expectations regarding the influence of the mandatory
implementation of IFRS on the level of earnings management at Dutch listed companies?"
can be answered. The expectation is that the level of earnings management will not decrease
as a result of the mandatory adoption of IFRS for Dutch listed companies. Due to the specific
circumstances in the Netherlands, the expectation is that the level of earnings management is
never been high, so therefore it will remain the same after the introduction of IFRS.
What is important from this chapter is that prior research is not conclusive about whether
IFRS was successful in decreasing the level of earnings management. The results depend at
least on 1) whether firm voluntary or mandatory adopts IFRS and 2) country specific factors.
These findings will be used for the formulation of the hypotheses in chapter 5.
47
5. Hypotheses
5.1 Hypotheses development
The main goal of implementing IFRS was making financial statements more reliable and
transparent. According to Soderstrom and Sun the "improvement is based upon the premise
that change to IFRS constitutes change to a GAAP that induces higher quality financial
reporting" (Soderstrom and Sun 2007, p. 676). As said in chapter 1, it is assumed that IFRS
leads to a higher quality reporting, including a lower level of earnings management. Prior
research has found a lot of evidence that earnings management has not decreased as a result of
IFRS. The reason that was given most for this phenomenon is that accounting in accordance
with IFRS is based on fair value measures. This subjectivity in estimating assets and revenues
gives managers more room for managing the earnings of the company. The researches that did
find a decrease in earnings management as a result of IFRS, focused on early adopters. As
mentioned by Christensen, Lee and Walker (2008) it is expected that voluntary adopters
indeed show a decrease in earnings management because of the incentives they seem to have
in favor of IFRS.
This research will focus on the mandatory adopters and leaves voluntary adopters out of the
sample, so it is not expected that a decrease in earnings management will be found. The
country specific factors of the Netherlands, including the high quality of Dutch GAAP, high
investor protection, strong legal enforcement and the willingness of companies to be
transparent, suggests that the level of earnings management in the Netherlands was already
low before IFRS was implemented. Based on the prior research findings and taking into
account the country specific factors of The Netherlands, the first hypothesis of this thesis is:
H1: "In Dutch listed companies, the level of earnings management has not changed as a
consequence of the mandatory introduction IFRS instead of Dutch GAAP"
This is strengthened by the statement of Heemskerk and Van der Tas (2006, p. 578), which is:
"It is assumed that countries with conservative accounting standards will face a larger impact
than countries as Great Britain and the Netherlands". This statement implies that the
Netherlands will not face a very large impact of the introduction of IFRS.
Next to the phenomenon of a reduction in earnings management in general, it is interesting
whether there is a difference between large and small companies. Since the risk of political
costs, or governmental intervention as mentioned in chapter 3, is one of the incentives for
48
earnings management, it makes sense to assume that different companies facing different
circumstances also have different levels of earnings management. This is confirmed by Han
and Want (1998). Using the example of companies in the oil industry, Han and Wang (1998)
mention that the situation wherein companies face different political visibility "is likely to
lead to different degrees of earnings management" (Han and Wang 1998, p. 104). The
difference in political visibility in their research is applied at crude petroleum and natural gas
versus petroleum refining, which face differences in the degree of consumer relations.
However, this difference in political visibility can also be valid for a difference between large
and small companies. Larger companies have more stakeholders and this makes the risk that
someone does not agree with the companies' actions, larger. Therefore, the risk of
governmental or legal intervention is also larger. This increases the political visibility of a
large firm, which can lead to a higher level of earnings management by lowering earnings in
order to lower political visibility. Assumed that large companies are in general more engaged
in earnings management and assumed that IFRS should increase the quality of financial
statements (see introduction), it can be expected that a decrease in the level of earnings
management as a result of the introduction of IFRS is apparent at large companies. However,
the country specific factors explained in chapter 4 and repeated in this chapter are also
applicable for large companies in the Netherlands. Therefore, it is expected that also large
companies are less engaged in earnings management than in other countries, making the
political cost theory less relevant. Therefore, the second hypothesis is:
H2: "There is no difference in the change in the level of earnings management as a
consequence of the mandatory introduction of IFRS between small and large Dutch listed
companies"
Another issue is that prior research has found evidence that companies that are audited by a
big 4 audit company engage less earnings management, as is discussed in chapter 4 (for
evidence; Tendeloo and Vanstraelen 2005). So this argument would suggest that the level of
earnings management was already low at larger firms, before IFRS was introduced. However,
the sample used in this research contains only listed companies. Since 66 companies out of
the sample of 75 companies are audited by a Big 4 audit company, the relationship between
earnings management and whether or not a Big 4 audit firm is hard to study in this case.
Therefore, this is not taken into account.
49
To conclude: due to the specific circumstances in The Netherlands, it is assumed that in
general the level of earnings management was already not very high before IFRS was
introduced. Therefore, it is likely to assume that there will be no decrease in earnings
management, such as stated in hypothesis 1. In general large companies are assumed to be
engaged more in earnings management because of the risk of political costs. Therefore, large
companies could show a decrease in the level of earnings management when IFRS is seen as a
financial information quality improving standard. However, this effect is assumed to be not
very strong in the Netherlands due to the overall low level of earnings management. So, it is
assumed that in the Netherlands there is no difference in the level of earnings management
between small and large companies.
The first hypothesis is a time-series research. The same group of companies before and after
the adoption of IFRS will be compared. One of the variables in the regression will contain the
size of the company, which is used to answer hypothesis two. The exact model will be
explained in chapter 6.
5.2 Summary
This chapter has provided the hypotheses development. With this chapter, sub question 9:
"What are the hypotheses for the research?" is answered. The hypotheses are as follows:
H1: "In Dutch listed companies, the level of earnings management has not changed as a
consequence of the mandatory introduction IFRS instead of Dutch GAAP"
H2: "There is no difference in the change in the level of earnings management as a
consequence of the mandatory introduction of IFRS between small and large Dutch listed
companies"
Because of the results of prior research and the specific circumstances in the Netherlands, it is
expected that the overall level of earnings management has not decreased since the
implementation of IFRS. The political cost theory assumes that larger companies are more
engaged in earnings management than smaller companies, assuming that it is possible that
IFRS is associated with a lower level of earnings management at large companies. However,
this will not be the case in the Netherlands because of the country specific factors that lead to
an overall low level of earnings management. Chapter 6 will continue with the research
design. The models will be explained in detail, including all the variables used and the steps
that are going to be taken are discussed. Also the sample selection and the attainability of the
data are discussed in chapter 6.
50
6. Research Design
6.1 Introduction
This chapter will outline the research design of this paper. As said before, the Modified Jones
Model will be used for this research. First these steps are presented, including the
corresponding formulas. This part of the chapter will show a lot of similarities with chapter 3.
After the research design is explained, the attainability of the data is discussed. The chapter
ends with a summary, including an answer to sub question 10.
6.2 Research Model
First of all, the total accruals of each company in the sample for each year must be calculated.
Formula (1) provides this calculation.
(1)
TA (i,t) = [CA (i,t) -CL (i,t) - CASH (i,t) + STD (i,t) - Dep (i,t) ] / A (i,t-1)
where:
CA = change in current assets
CL = change in current liabilities
CASH = change in cash and cash equivalents
STD = change in debt included in current liabilities
Dep = depreciation and amortisation
A = total assets
t = year index, range from 1997 until 2007
i = firm index, range from 1 to 75
All the variables of the formula are known, so the total accruals can be calculated. The year
index includes all years from 1997 until 2007. Both the historic period, which is 1997 until
2001 and is explained at step two of the research model, and the research period, which is
2002 until 2007, are included because for both the historic period and the research period the
total accruals must be calculated. The firm index has values from 1 to 75 because there are 75
companies in the sample, as will be discussed in paragraph 6.3.
When the total accruals are known, they can be filled in at formula (2), which is developed to
calculate regression coefficients.
51
So step 2 in the research design is about calculating 1, 2, and 3 with the following
formula:
(2)
TA (i,t) / A (i, t-1) = 1 [1/A (i, t-1)] + 2 [REV (i,t) -REC (i,t) / A (i, t-1)] +
3 [PPE (i,t)/A (i, t-1)] + 
where:
TA = total accruals for firm i in year t
REV = change in revenue
REC = change in net receivables
PPE = gross property, plant and equipment for firm i in year t
A = total assets
 = error term
t = year index, range from 1997 until 2001
i = firm index, range from 1 to 75
The three variables A, REV and PPE, will come from the annual reports of the companies
included in the sample. As explained in the theoretical part, the regression coefficients 1,
2, and 3 can be calculated using historical data for all variables. These regression
coefficients measure the degree to which the dependent variable changes as the independent
variable changes. For example, when the α is 0,1 it means that if the dependent variable
increases with 10, the dependent variable increases with 0,1 times 10. All firms will get a
number from 1 until 75, since there are 75 companies in the sample which will be explained
in paragraph 6.3, and this will represent the firm index (i). The year index (t) means the year
that is investigated, starting with 1997 and ending with year 2001. The reason that these years
represent the historic data is as follows. Jones (1991) used all available data prior to year t-1
as historic data to obtain the regression coefficients. The Thomson One Banker, the database
that is used for the research in this thesis, includes data back to 1970. However, looking at
these data, for a lot of the companies included in the sample the available data does not go
back any further than 1997. In order to obtain statistical valuable regression coefficients, it is
important that the historical data matches as much as possible with the data of the sample. So
the historic data that is used to obtain the regression coefficients includes 1997 up to and
including 2001. This step is important, because these coefficients will be used in the next
formula.
52
This calculations will be done with the statistic program SPSS. Besides calculating the
regression coefficients, the overall explaining power of the model as well as the significance
of the individual variables will be discussed on the basis of model outcomes of SPSS. Also,
the R², which means which part of the dependent variable is explained by the independent
variables, is explained. In other words, some tests will be done in order to determine the
reliability of the model and therefore, the reliability of the outcomes. This will all be
explained in chapter 7 when the results are presented.
The next step is calculating the nondiscretionary accruals, in order to be able determine the
discretionary accruals later. Since discretionary accruals do not arise out of operational
activities, they are an indication and therefore a measure of earnings management. The
following formula is used for calculating the nondiscretionary accruals:
(3) NDA (i,t) = a1 [1/A (i,t-1)] + a2 [REV (i,t) - REC / A (i,t-1)] + a3 [PPE (i,t)/A (i,t-1)]
NDA = nondiscretionary accruals
A = total assets
REV = change in revenue between  and -1
REC = change in net receivables between  and -1
PPE = gross property, plant and equipment
a1, a2, a3 = regression coefficients
t = year index, range from 2002 until 2007
i = firm index, range from 1 to 75
So, to conclude: with formula (2) is it possible to calculate 1, 2 and 3 which are good
estimates for a1, a2 and a3 in formula (3). Since the only unknown variable is NDA, the
nondiscretionary accruals can be calculated.
When the nondiscretionary accruals are determined with the model above, the fourth step is to
calculate the discretionary accruals by calculating the difference between the total accruals at
firm I for year T and the nondiscretionary accruals at firm I for year T.
The fifth step contains a regression analysis based on Heemskerk and van der Tas (2006).
With this step, the association between the accounting standard used and the size of the
company on the level of the discretionary accruals is determined.
53
The regression formula is as follows:
(4)
| [DA (i, t)] | = γ1 + γ2 (Standard) + γ3 (Size) + 
Where:
(5)
| [DA (i, t)] | = | [TA - NDA (i,t)] |
and where:
- | [ TA- NDAit} | = Absolute value of discretionary accruals, divided by total assets in the
previous year
- Standard =
The accounting standard used, {1 = Dutch GAAP and 2 = IFRS}
- Size =
The company size, based on sales revenue {1 = large and 2 = small}
-=
An error term
- γ1, γ2, γ3 =
Regression coefficients
-t=
Year index, range from 2002 until 2007
-i=
Firm index, range from 1 to 75
The variables 'standard', 'size' and 'discretionary accruals' are known and filled in. Heemskerk
and van der Tas (2006, p. 576) mention that accruals can be both positive and negative, so that
therefore the absolute value of the discretionary accruals should be taken. With a regression
formula it is possible to determine which factors do have a significant explaining value. In
this case, it is investigate whether the introduction of IFRS and the firm size have an influence
on the level of earnings management. The absolute value of accruals is determined in step 4.
The standard used will be Dutch GAAP before 2005 and IFRS after 2005. The company size
will be determined on the market capitalization, dividing the total sample in two groups of
large and small companies. With this final step the regression coefficients γ1, γ2 and γ3 are
calculated. This is the final outcome that is needed to answer the hypothesis. Since the data
sets include discretionary accruals, standard and size for every company for every year, the
regression coefficients can be calculated.
The regression coefficients γ1, γ2 and γ3will show whether the level of earnings management,
measured as discretionary accruals, is associated with the standard under which financial
reports are prepared or the size of the company. First of all, γ2 is the coefficient which
determines the influence of the accounting standard on the level of the discretionary accruals.
Second, γ3 indicates the influence of the company size on the level of the discretionary
54
accruals. When these coefficients are calculated, both the direction and the significance of the
coefficient are important. The direction of the coefficient can be positive or negative, meaning
that there is a positive or negative association between the dependent variable and the level of
the discretionary accruals respectively. The significance of the coefficients means whether the
variables standard and size indeed are significant positively or negatively associated with the
level of discretionary accruals. A more extensive explanation of interpreting these outcomes is
given in chapter 7 where the analysis takes place.
The 'standard' variable will be used to answer hypothesis 1, whether IFRS has led to a
different level of earnings management. It is expected that there is no significant explaining
value of this variable, since it is expected that the level of earnings management before and
after IFRS to be the same. The 'size' variable will be used to answer hypothesis 2, to see
whether there is a difference in the level of earnings management between large and small
companies. It is expected that size has a positive influence on the level of earnings
management, since the political cost theory, as discussed in chapter 3, is more applicable to
large companies.
6.3 Sample selection
Unlike a lot of previous researches, this research does not focus on early or voluntary adopters
of IFRS. This research will focus on the Dutch market after the obliged implementation of
IFRS in 2005. Both the companies in the 3 Dutch indexes (AEX, AMX and ASCX) and the
residual companies that are not in an index are used. It is important to notice that foreign
companies that are listed in Amsterdam are excluded from the sample, since the research
focuses on Dutch listed companies, not on companies that have a listing in the Netherlands.
For example, the American company Conversus Capital has a European listing in Amsterdam,
but that does not make it a Dutch listed company (http://www.conversus.com)
Currently, there are in total 164 listed companies in the Netherlands. However, not all these
funds are usable for this research. The following four requirements must be met; 1) the
company was listed during the whole period 2002-2007, 2) the company is not active in the
financial sector, 3) the primary accounting standard up to and including 2004 was Dutch
GAAP and 4) the company did not adopt IFRS voluntary prior to 2005.
The first requirement, listed during 2002 - 2007 is important since the sample for a time series
research should be exactly the same for the period before IFRS was introduced as the period
55
after IFRS was introduced, so all new or disappeared companies will be excluded from the
sample. For example, the Dutch company Spyker is excluded from the sample since it is
established in 2005. Therefore, a comparison of companies before 2005 excluding Spyker and
companies after 2005 including Spyker brings noise into the sample.
The second requirement, which is that the company should not operate in the financial sector,
has to do with prior research. An extensive explanation for this is given by Heemskerk en van
der Tas (2006) that concludes that the accruals of financial enterprises seriously differ from
the other enterprises.
The third requirement, which is that the primary accounting standard should be Dutch GAAP,
is important in order to exclude companies from the sample that reported under other
standards than Dutch GAAP prior to 2005. For example Philips prepared its financial
statements up to and including 2004 under US GAAP. Since the research focus on the
possible difference in earnings management under Dutch GAAP and IFRS, the results of this
kind of companies are irrelevant.
The fourth requirement, which is that the company did not voluntary apply IFRS prior to
2005, is important because of the difference in expected outcomes between voluntary and
mandatory adopters of IFRS. In chapter 4 is already explained that voluntary adopters seem to
benefit from IFRS and therefore might bias the results. Therefore, voluntary adopters of IFRS
should be excluded from the sample.
Taking into account these four requirements, the sample of this research contains of 75 Dutch
listed firms. An overview of these firms is given in appendix 3.
Besides this time series research, hypothesis two will look at differences between large and
small companies. For this research the 75 funds are divided in two groups using the market
capitalization of the enterprises. The market-capitalization is defined as the total number of
outstanding shares times the market share price. There are all different kinds of measuring
firm size, for example the numbers of employees (Heemskerk and van der Tas 2006) total
turnover. However, since the market capitalization is mostly used as the valuation of a
company, this measurement will be used to determine firm size. Hereby Kothari et al (2005)
are followed. Besides, a check proved that separating firms by total revenue or by market
capitalization practically leads to same distinction of large and small companies.
The distribution by market capitalization creates a first group of the 38 smallest companies
56
and a second group of the 37 largest companies. These groups will be compared to check
whether size of the company has influence on the expected reduction in amount of earnings
management after IFRS was implemented.
6.4 Data attainability
The sample of this research will contain listed companies in the Netherlands. From the 25
companies listed on the AEX till all the local listed companies are used, which is a total of 75
companies. The period of the research will be from 2002 till 2007. The companies that will be
used for this research are all listed and therefore obliged to publish their annual results. In the
annual reports of the companies all the necessary data will be stated. This will be aspects of
the balance sheet like total assets and PPE. Also the profit and loss account will be used to
look at revenue and net receivables in the current and past year. All this information is
available at the university library. The database Thomson One Banker is a very extensive
database which includes all kind of information about companies, such as annual and
quarterly reports, but also investigation reports. It contains annual reports from 12.000
companies out of 70 countries, back to 1970 until now. Therefore, the variables needed for
this research will all be available, since it are annual reports data from 2002 until 2007. Also
the historical data needed to obtain the regression coefficients, as explained in paragraph 6.2,
are available in this database.
6.5 Summary
This chapter provides a model for measuring the level of accruals based earnings management
before and after the implementation of IFRS in 2005. The answer to sub question 10: "How
does the research design look like?" can be given now. The research design includes 5 steps
and is based on the research design from the Modified Jones Model. The first step is to
calculate total accruals, hereby following Healy (1985), Jones (1991) and Dechow (1995) in
the formula. The second step is to fill in the total accruals in a formula wherein three
regression coefficients are calculated with data from 1997 until 2001. These regression
coefficients are used in step 3, where the nondiscretionary accruals are calculated. Step four
calculates the discretionary accruals by subtracting the nondiscretionary accruals from step 3
from the total accruals from step 1. The fifth and last step is about a regression analysis,
where it is studied whether there is an association between the standard under which financial
reports are prepared and the firm size, and the level of earnings management. Therefore, the
57
discretionary accruals from step 4 are needed. Both hypothesis 1 and 2 can be answered with
these results.
The sample for the research will include Dutch listed firms, which 1) were listed during 20022007, 2) are non-financial companies, 3) prepared their financial statements prior to 2005
under Dutch GAAP and 4) did not implement IFRS voluntary prior to 2005. Taking into
account these four requirements, the final sample includes 75 Dutch listed companies. The
data that is needed for this research is attainable, since all the information is stated in the
annual reports of these companies, which they are obliged to present since they are listed in
the Netherlands. Since these annual reports are presented, the data of all these reports is
available through several databases of the university. These databases will be used to obtain
the relevant data.
58
7. Empirical Research
7.1 Empirical results
All needed data is available at the Thomson One Banker at the Erasmus University
Rotterdam. For every company, the variables needed were obtained in this database for the
years 2002 until 2007. As discussed in chapter 6, the historical data needed to calculate the
regression coefficients contains 1997 up to and including 2001. Together with the research
data, this data is obtained from the Thomson One Banker. Since this data is not immediately
ready to use for the analysis, it has to be restated in a standard format. The statistical research
is done with the SPSS program.
As discussed in chapter 6, when the research design was introduced, the first step of the
analysis is calculating the total accruals. Using formula (1) of chapter 6, both for the history
(1997-2001) and for the research sample (2002-2007) the Total Accruals are calculated.
Recall that in chapter 6 is explained why 1997 up to and including 2001 is used as the historic
period, namely because Jones used all available years prior to the research period. In this case
the data was only available back to 1997, and the last year prior to the research period is 2001,
making 1997 until 2001 the historic period. In order to make the results comparable, all
outcomes are scaled by the total assets of the corresponding company.
These total accruals are needed for step 2, where the regression coefficients are determined by
doing an ordinary least square regression. Recall the formula of calculating the regression
coefficients:
(2) TA (i,t) / A (i, t-1) = 1 [1/A (i, t-1)] + 2 [REV (i,t) -REC (i,t) / A (i, t-1)] +
3 [PPE (i,t)/A (i, t-1)] + 
where:
TA = total accruals for firm i in year t
REV = change in revenue
REC = change in net receivables
PPE = gross property, plant and equipment for firm i in year t
A = total assets
 = error term
i = firm index
t = year index
59
Before a regression analysis can be performed, it is important that the assumptions for a
multiple regression are fulfilled. Some important assumptions for a multiple regression
analysis are mentioned below. (de Vocht 2009, p. 199)
First of all, all variables should be numeric. This means that all variables can only have a
number as a value. Since all the variables in formula 2 are numeric, this assumption is met.
Another important assumption is that the independent variables do not measure the same. In
statistic terms this means that there is no multicollinearity. Since all three variables include
specific parts of the financial numbers of a company and no variable includes the same
financials as another variable, this assumption is also met. So the two most important
assumptions for a multiple regression analysis are met for formula (2) and the regression
analysis can be performed.
The data of 1997 until 2001 are used to calculate 1, 2 and 3. Before these are given, some
other tests need to be done in order to determine the reliability of the results. The first test is a
correlation test and the results are presented in table 1.
Table 1: Model Summary
Model
1
R
.230a
R Square
.053
Adjusted R Square
Std. Error of the Estimate
.045
.20844
a. Predictors: (Constant), [1/A(i, t-1)], [REV (i,t) - REC (i,t) / A (i, t-1)], [PPE (i,t) / A (i, t-1)]
This model summary is the first output of SPSS. In this model summary, the multiple R² is
important; it explains the correlation between the independent variables and the dependent
variable. In this model, the R² is 0.053 which means that approximately 5 percent of the total
accruals, the dependent variable, is explained by the combined effect of the three independent
variables Assets, Revenue-Receivables and Property Plant Equipment.
The second test that needs to be done is determining whether the overall model is significant.
In other words, it tells whether in general, the independent variables are able to predict
together the dependent variable. The ANOVA table, which is the second output table of SPSS,
states whether this is the case. The table below is the ANOVA table for this regression
analysis.
60
Table 2: ANOVAb
Model
1
Sum of Squares
Regression
Residual
df
Mean Square
.900
3
.300
16.119
371
.043
F
Sig.
6.906
.000a
Total
17.019
374
a. Predictors: (Constant), [1/A(i, t-1)], [REV (i,t) - REC (i,t) / A (i, t-1)], [PPE (i,t) / A (i, t-1)]
b. Dependent Variable: TA (i,t) / A (i, t-1)
The ANOVA test is a variance test and this table provides outcomes that tell whether the
model is significant. The F-value is the part of the explained variance divided by the part of
the unexplained variance of the model. The number of degrees of freedom (df) of the
regression is the same as the number of the independent variables, which is 3. The number of
the degrees of freedom of the residual is the total number of cases minus de df of the
regression minus 1. The total number of cases is 75 companies, for 5 historic years which is
375. So the number of df of the residual is 375-3-1 = 371.
The table shows that this model as a whole has a significant explaining power, since the
significance is 0.000. This significance is called the P-value and it means that if the
hypothesis is true, the chance is 0.000 that the results are a coincidence. In other words, the
smaller the P-value, the stronger the evidence is that there is an association between the
independent and the dependent variable which is not coincidental. The P-value has to be
compared with a specified level of significance, in order to determine whether the data is
statistically significant. For a result to be significant, the P-value of the test has to be smaller
than the significance level. In existing literature, the significance level that is mostly used is 5
percent. This means that "the data give evidence against the hypothesis so strong that it would
happen no more than 5% of the time that the hypothesis is rejected when the hypothesis is
true" (Moore et al. 2003, p. 388). Since there is no reason to assume that a 5% significance
level is not applicable here, this level will be used for determining the significance of the
regression results in this research. In this case the P-value of 0.000 is smaller than 0.05 so the
model is statistically significant.
Now the model as a whole is said to be significant, the next step is to see which individual
variables have a significant explaining power. The three independent variables of this model
are the total assets, the revenue minus the receivables and the gross property, plant and
equipment. The following table presents the final regression formula.
61
Table 3: Coefficientsa
Model
Standardized
Unstandardized Coefficients
B
1
Coefficients
Std. Error
(Constant)
.000
.019
1/A (i, t-1)
.019
.162
[ΔREV (i,t)-
.042
-.056
Beta
t
Sig.
-.019
.985
.006
.116
.908
.013
.169
3.219
.001
.021
-.141
-2.670
.008
ΔREC (i, t)]
/A (i, t-1)
PPE (i,t) / A
(i, t-1)
a. Dependent Variable: TA (i,t) / A (i, t-1)
The B in the table is the regression coefficient for all three variables, so this is the part that the
dependent variable changes as a result of a change in the independent variable. In short this
table shows that 1 is 0.019, 2 is 0.042 and 3 is -0.056. For example, this means that when
the variable [ΔREV (i,t)-ΔREC (i, t)] /A (i, t-1) increases with 1, the dependent variable TA
(i,t) / A (i, t-1) increases with 0.042. Both the total assets and the revenue minus the
receivables have a positive influence on the total accruals, while the gross property, plant and
equipment has a negative influence on the level of the total accruals. However, while the
overall model was said to be significant, not all individual variables are. As is shown in table
three, the variable 1/A (i, t-1) is not significant since the value of 0.908 is larger than 0.05.
The other two independent variables are significant, since 0.001 and 0.008 are both smaller
than 0.05. Although one variable is not significant, it is important not to exclude it from the
model. According to de Vocht (2009, p. 202): "all variables should be included in the
regression formula, also the ones that are not significant because the parameters of the
significant variables are corrected for these effects."
So all three regression coefficients are filled in formula (3) of chapter 6, the only unknown
variable remains the dependent variable nondiscretionary accruals. With a simple calculation
program, the nondiscretionary accruals can be determined for every company and each year.
The fourth step is subtracting the nondiscretionary accruals from the total accruals, for every
firm and every year. The outcome is the discretionary accruals variable, still scaled by assets,
62
which is the dependent variable of the regression analysis. Recall the regression formula,
needed for the analysis:
| [DA (i, t)] | = γ1 + γ2 (Standard) + γ3 (Size) + 
(4)
Where:
(5)
| [DA (i, t)] | = | [TA - NDA (i,t)] |
and where:
- | [ TA- NDAit} | = Absolute value of discretionary accruals, divided by total assets in the
previous year
- Standard =
The accounting standard used, {1 = Dutch GAAP and 2 = IFRS}
- Size =
The company size, based on sales revenue {1 = Large and 2 = Small}
-=
An error term
- γ1, γ2, γ3 =
Regression coefficients
-i=
Firm index
-t=
Year index
Filling in the dependent variable discretionary accruals (which is TA-NDA), the accounting
standard and the firm size, the regression coefficients can be calculated. For this regression
formula, the same assumptions as explained before have to be met. Since both the variables
standard and size are not numeric, they have to be restated in order to fulfil assumption 1. In
the explanation below, the restatement of these variables is explained.
The second assumption, that there is no multicollinearity, is also met here. Since the size of a
company does not change as a result of a new accounting standard, it might be clear that these
two variables do not measure the same thing. Now the regression analysis can be performed.
As with the first regression analysis, first the model summary is given in order to determine
the correlation between the independent variables and the dependent variable.
Table 4: Model Summary
Model
R
R Square
Adjusted R Square
Std. Error of the Estimate
1
.109a
.012
.007
.48629
a. Predictors: (Constant), Size, Standard
63
The R² for this model is only 0.012 which means that approximately 1 percent of the
discretionary accruals is explained by the independent variables accounting standard under
which the financial report is made and the company size. This means that the explaining
power of this model is unfortunately practically zero. There were no significant outliers in the
data that could bring noise to the results, so that is not the reason that the models' R² is so low.
The next step is to determine the significance of the whole model. The table is presented in
the ANOVA below.
Table 5: ANOVAb
Model
1
Sum of Squares
Regression
df
Mean Square
1.270
2
.635
Residual
105.704
447
.236
Total
106.975
449
F
Sig.
2.686
.069a
a. Predictors: (Constant), Size, Standard
b. Dependent Variable: Discretionary Accruals
Again, the F-value is the number of the explained variance divided by the number of the
unexplained variance. The number of the degrees of freedom of the regression is 2, since there
are two independent variables. The number of the degrees of freedom of the residual is 447,
since the data includes 75 companies, over 6 years which is 450 sets of data. Subtracting the 2
degrees of freedom for the regression and again subtracting 1 leaves 447 df for the residual.
The significance of the model is 0.069, which means that the model as a whole does not have
significant explaining power since 0.069 is larger than 0.05. This is an important thing to keep
in mind when the results are discussed.
The last step is again determine the significance of the individual independent variables,
which is been done with the results of the following table.
Table 6: Coefficientsa
Model
Standardized
Unstandardized Coefficients
B
1
(Constant)
Std. Error
-.077
.099
Standard
.039
.046
Size
.099
.046
Coefficients
Beta
t
Sig.
-.773
.440
.040
.844
.399
.101
2.159
.031
a. Dependent Variable: TA – NDA (i, t)
64
The constant variable has a value of -0.077. The regression coefficient for accounting
standard 0.039 and for company size it is 0.099. Both variables will be explained more
extensive below.
Starting with the independent variable accounting standard, there are two options to deal with:
Dutch GAAP before 2005 and IFRS from 2005 and further. Since a regression analysis cannot
be done with such qualitative variables, as said before one assumption is that all variables are
numeric, numeric values have to be assigned to these possibilities. There are two values that
these variables can have: 1 or 2. The automatic recode function of SPSS has given the
following values to the qualitative variable standard: when the variable is 1, it means that the
accounting standard used for preparing financial statements, and so the value of the variables,
is Dutch GAAP. When the variable has the value 2, the accounting standard refers to IFRS.
The total accruals calculated for 2002 up to and including 2004 are based on the regulations
of Dutch GAAP. Therefore, all data from these years have 1 as value for the variable standard.
The total accruals from 2005 until 2007 are calculated with data based on IFRS rules and
regulations. Therefore, these years have 2 as value for accounting standard. The regression
coefficient for accounting standard, when the dependent variable is Discretionary Accruals, is
0.039. It is a positive coefficient, meaning that value 2: IFRS, is associated with a higher level
of discretionary accruals. But, besides this coefficient being very low, it is not significant
since the corresponding P-value is 0.399, which is large than 0.05. Hypothesis 1: "In Dutch
listed companies, the level of earnings management has not changed as a consequence of the
mandatory introduction of IFRS instead of Dutch GAAP" is therefore not rejected. It can be
concluded that the change accounting standard is related to another level of earnings
management when measured as the discretionary part of accruals.
Second, for the independent variable size there are also two possibilities, namely a firm is
either large or small. Since these are again qualitative variables, they have to be recoded into
numeric values as well. The possible values given by the automatic recode in SPPS are: 1 or
2. The same story holds as for the standard variable, when it 1 is one it means that it is a large
firm and when the value is 2 it means that it is a small firm. As explained in chapter 6, the
market capitalization is used to determine whether a firm belongs to the group of large firms
or whether it is a rather small firm. It is important to note here that there is no difference
between the years in firm size. A firm is said to be large or small for the whole sample period,
since these differences between the several years are negligent.
65
The regression coefficient for this variable is 0.099 which is positive. However, since the
lower value of 1 is assigned to large companies and the higher value of 2 is assigned to small
companies, this implies that the smaller a firm is, the higher the level of discretionary accruals
will be. This result is quite surprising, since it is expected that larger firms are engaged more
in earnings management because of the political cost theory explained in chapter 3.
The corresponding P-value is 0.031. This means that although the model as a whole was said
not to be significant, this variable is significant at the 5 percent level since the value is lower
than 0.05. Although the coefficient is very low (not even 1 percent of the level of
discretionary accruals is explained by firm size) it seems that the firm size is likely to have a
very small influence on the level of discretionary accruals. Namely, smaller firms are more
engaged in earnings management than larger firms. However, since the overall level of
earnings management has not changed as a result of the introduction of IFRS, the difference
in the level of earnings management between small and large companies has also stayed the
same. So therefore hypothesis 2: "There is no difference in the change in the level of earnings
management as a consequence of the mandatory introduction of IFRS between small and
large Dutch listed companies" can also not be rejected.
7.2 Summary
This chapter provided the statistical results of the empirical research. First of all, the
regression coefficients for the formula calculating the total accruals are determined. These
regression coefficients determine the degree of change in the dependent variable when the
independent variable changes. With the historical data of 1997 up to and including 2001 these
regression coefficients were calculated. These were needed to calculate the nondiscretionary
accruals for all 75 firms in the sample, during 2002 until 2007. The calculated regression
coefficients are good estimates for the coefficients in this formula. The results of this
regression were that the model has significant explaining power as a whole, but that only the
revenue minus the receivables and the gross property, plant and equipment are the significant
variables in estimating the total accruals.
When the nondiscretionary accruals are calculated with a simple calculation program, the
nondiscretionary accruals are subtracted from the total accruals, being the dependent variable
discretionary accruals in the last regression model. With this regression model the explaining
power of the accounting standard used and the firm size are calculated in SPSS. The model
has less significant explaining power than the first regression formula, since the ANOVA test
provided a significance of 0.069. This implies that the regression is not significant at the 5
66
percent level. However, this does not mean that both variables do not have significant
influence on the dependent variable. The discretionary accruals are for 3,9 percent dependent
on the accounting standard used (the coefficient being 0.039). This implies a small increase in
earnings management, defined by the discretionary accruals, when IFRS was introduced since
IFRS got the higher numeric value in the recode process. Since the corresponding P-value is
0.399 this is not significant at the 5 percent level.
The other variable, the size of the firm, has a coefficient of only 0.099. Since the higher
numeric value of size is assigned to small firms, this result implies that small firms are a little
more engaged in earnings management. This is a very low percentage and, but it is significant
at the 5 per cent level, since the P-value is 0.031. So although the model has not significant
explaining power on it self, the firm size does have a significant influence on the level of
earnings management, even if it is a very small influence. All outcomes above are the answer
to sub question 11: "What are the results of the research".
To conclude, the answer to sub question 12: "Which conclusions can be drawn from these
results" is that both hypothesis cannot be rejected. First of all, the accounting standard used
does not seem to have a significant impact on the level of the discretionary accruals. The Pvalue of the regression coefficient for the variable accounting standard was 0.399 which is
larger than 0.05, making the results not significant.
Secondly, the results show that small companies are in general more engaged in earnings
management then large companies. There is a significant relation that states that the smaller
the firm, the higher the level of earnings management. However, since the new accounting
standard IFRS does not have an influence on the overall level of earnings management, the
difference in the level of earnings management between small and large companies stayed the
same after the introduction of IFRS. Therefore, hypothesis 2 cannot be rejected.
67
8. Conclusion
8.1 Summary
In 2005, the European Union introduced the high quality International Financial Reporting
Standards (IFRS). All listed companies are obliged to prepare their consolidated financial
reports in accordance with these standards. The introduction of IFRS is the first important
subject of this thesis, the phenomenon earnings management is the second. The definition of
earnings management that is used in this thesis is from Healy and Wahlen (1999): "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". The two main methods of earnings management are real
earnings management, wherein real activities of the company are managed, and accruals
based earnings management, which is about discretion of management in the process of
selecting accounting methods and estimating numbers. In this thesis the focus was on accruals
based earnings management, simply because real earnings management is very hard, if not
impossible, to measure in reality.
It was assumed for two reasons that the level of earnings management should decrease as a
consequence of the implementation of IFRS. First of all, the pressure on managers increases,
since the widely used standards increase comparability between companies. This increased
comparability should lower managers' incentives to intentionally mislead stakeholders.
Second, a high quality accounting standard should increase the quality of the financial
statements prepared in conformity with these statements. Since earnings management is one
of the proxies that lower the quality of financial statements, earnings management is assumed
to decrease as a consequence of the implementation of IFRS.
However, the expectation that earnings management will decrease is not the only view.
Because the new accounting standards include fair value estimations for a lot of assets and
liabilities, opponents mention that subjectivity in estimating those fair values can lead to an
increase of earnings management as a result of the introduction of IFRS, which is especially
the case in estimating fair values for assets or liabilities with no known market price, for
example in illiquid markets.
The empirical research in this thesis investigated what the effect of the implementation of
IFRS was on Dutch listed companies. The research question was as follows: "To what extent
did the introduction of IFRS in The Netherlands result in a reduction of accruals based
68
earnings management, in the period 2002-2007 for small and large companies, listed on the
Dutch stock exchange?" Trough answering twelve sub questions in the chapters 2 until 7, this
research question can be answered in the conclusion in paragraph 8.2.
Since the focus of the research was to describe, explain and predict what happens in reality,
the positive approach of doing research was applied. More specifically, the Positive
Accounting Theory (PAT) is used as research approach. An important assumption of PAT is
that individuals act in their own interest. In this case, managers influence the financial
numbers of a company so that they are better off, ignoring the consequences for their
stakeholders.
The specific approach for earnings management research that was used is studying aggregate
accruals. This is one of the three methods discussed in chapter 2. The most popular model for
doing this kind of research is the Jones Model. This model has a couple of modified versions,
among others one from Dechow et al (1995) which was used in this thesis. This research
model tried to estimate earnings management by the use of discretionary accruals. The theory
behind this model was as follows. Accruals are the difference between cash in- and outflows
on the one hand and the recognition of revenues and cost on the other hand. Some of these
accruals come from normal operational activities and are quite straightforward and objective,
the so called nondiscretionary accruals. However, another part of the accruals are subject to
management discretion, the discretionary accruals. This second part of accruals, the
discretionary accruals, is an indication for the presence of earnings management. The model
of Jones provides, among others, an estimation method for the discretionary part of accruals.
For an extensive explanation of the research model, see chapter 6. This model was used to
measure the level of discretionary accruals at Dutch listed companies both before and after the
introduction of IFRS in order to compare the levels of earnings management. Comparing a
sample of companies before and after a specific event, here the introduction of IFRS, had
several implications. First of all, the sample had to include exact the same companies in both
periods, in order to avoid biased results. Second, the companies all had to use the same
standard before they changed to IFRS. These and other factors made the sample decline from
originally 164 listed companies in The Netherlands to 75 companies. For these companies all
data was obtained for the whole period 2002-2007. Besides, these companies were divided in
two groups, based on their market capitalization. One group contained all large companies
and the other contained the remaining small companies, where both groups were about the
same size. Since it is possible that large and small group differ in the their level of
69
engagement in earnings management due to the political cost theory, as discussed in chapter3,
this separation made it able to study whether this difference really exists in The Netherlands.
8.2 Conclusion and answer to research question
Chapter 7 presented the results of the empirical research. The regression with the independent
variables 'standard' and 'size' was the final test of this study. It became clear that the
accounting standard used did not have a significant influence on the level of the discretionary
accruals, or on earnings management. For the variable firm size, there was a (little) significant
influence. Namely, the smaller the firm the higher the level of discretionary accruals, or in
other words, the smaller the level of earnings management. However, since there is no
difference in the level of earnings management observed as a consequence of the introduction
of IFRS, the difference between small and large companies has stayed the same. Therefore, it
could not be concluded that the implementation of IFRS had a different impact at large or
small companies.
With the above results, the research question of this thesis can be answered. This question
was: "To what extent did the introduction of IFRS in The Netherlands result in a reduction of
accruals based earnings management, in the period 2002-2007 for small and large companies,
listed on the Dutch stock exchange?" The answer to this question cannot be given, since it is
not possible to measure the cause of an eventual change in earnings management. When there
is a change in the level of earnings management, it might be due to the implementation of
IFRS, but there can also be another reason. The only thing that can be said is whether the
implementation of IFRS is associated with a lower level of earnings management compared to
another accounting standard. Prior research showed that there could be a relation between
IFRS and a lower level of earnings management, but it is impossible to state that IFRS really
caused this decrease in earnings management.
The results of this result do not prove that there is a relation between the implementation of
IFRS and a lower level of earnings management. There is no change at all in the level of
accruals based earnings management as a consequence of the introduction of IFRS. Therefore,
the introduction is to no extent associated with significant lower level of accruals based
earnings management. This result is in conformity with the results that Heemskerk and van
der Tas (2006) found in Germany and Switzerland and Jeanjean and Stolowy (2008) in
France, the United Kingdom and Australia. The results are also in line with the statement of
Christensen, Lee and Walker that only voluntary adopters of IFRS show a decrease in the
70
level of earnings management and that this effect is not expected to be present for companies
who mandatory shifted to IFRS.
Both for small and large companies, the level of discretionary accruals stayed the same when
the financial reports prepared after 2005 under IFRS are compared with the financial reports
prepared prior to 2005 under Dutch GAAP. Although there is small evidence that smaller
companies are in general more engaged in earnings management than larger companies, the
introduction of IFRS did not have different consequences for both types of companies. These
results are only valid for Dutch listed companies and only for the period 2002 until 2007.
To conclude, a short overview of comparable researches is given in order to compare the
results that this research provided.
Prior research Germany: no relation found between IFRS and earnings management
Prior research Switzerland: no relation found between IFRS and earnings management
Prior research United Kingdom: no relation found between IFRS and earnings management
Prior research Australia: no relation found between IFRS and earnings management
Prior research France: IFRS associated with higher level of earnings management
Prior research 327 European and other companies: IFRS associated with lower level of
earnings management, but only at voluntary adopters
Prior research 102.636 European and other companies: IFRS associated with lower level of
earnings management, but only when enforcement is high
Netherlands: no relation found between IFRS and earnings management.
8.3 Limitations
As with every research, a couple of limitations arise at this point. These will be discussed
below. First of all the outcome is not very up to date. The research is performed with data
from 2002 until 2007 and it is already 2011 by now. It is possible that the situation is quite
different now, since it is four years later. Maybe the financial crisis could have an influence,
or the fact that IFRS is more familiar than a couple of years ago. Unfortunately not any
conclusions about the situation in the current period can be drawn. However, in order to avoid
taking into account the financial crisis, the sample was not enlarged by including 2008, 2009
or even 2010.
A second limitation of this research is that it is hard to generalize the results for other
countries. Since The Netherlands face some specific factors, the results will not automatically
71
be the same in other countries. For example, according to La Porta et al (1998), The
Netherlands are a French Civil Law country but is an exception when the legal enforcement
level of French Civil Law countries is compared. Therefore, even to other French Civil Law
countries the results maybe are not valuable. However, as said before several times, the
general effect of the implementation of IFRS on earnings management can be compared with
the results of comparable research in other countries, for example when there is controlled for
specific factors.
Another limitation is also recognized by Lippens (2010). The focus in this research is only on
accruals based earnings management. However, this is not the only way of managing
earnings. As said before; real earnings management is another opportunity, but this is hardly
measurable in reality. Still, it could be possible that the conclusion about no change in the
level of earnings management is no longer valid when real earnings management has been
taken into account.
With respect to the research design, there is a fourth limitation and this is also recognized by
Jeanjean and Stolowy (2008) for their research. In the regression formula for estimating the
nondiscretionary accruals, all variables of year (t) are scaled by the total assets of year (t-1).
This gives a problem for the year 2005, since the main variables such as revenue and property,
plant and equipment are valued under IFRS methods, while the assets with which the
variables are scaled are valued under Dutch GAAP method. A consequence is that this
variable might be less valid when the numerator and the denominator of one number are
calculated under different rules, especially when the value differs a lot under both standards.
Another limitation with respect to the research design is showed in chapter 7, not all variables
of the first regression model are significant. The first variable [1/A (i, t-1)] is not a significant
variable in estimating the total accruals and therefore is will also be not significant when this
variable and its corresponding regression coefficient are used to calculate the nondiscretionary
accruals. This might make the whole model less useful for determining the nondiscretionary
accruals as a basis for calculating earnings management.
A final limitation of this study that has to do with the research design is that the Model
Summary of the second regression analysis shows that only 1 percent of the discretionary
accruals is explained by the accounting standard and the firm size. Although it might be clear
that there are other factors determining the level of earnings management, it would be better if
72
the percentage was something higher. Now the correlation between the independent and the
dependent variables is heading towards zero. This makes the results not very strong.
8.4 Recommendations for future research
In order draw more, and probably stronger, conclusions about the effect of the implementation
of IFRS on the level of earnings management and the overall quality of financial statements,
more research is needed. Taking the limitations of this research as a starting point, some
recommendations for future research are given.
First of all, since the data from this research is not very up to date, a new research can be done
with more current data. Although the financial crisis can influence the results, it might be
interesting to compare financial reports from prior to 2005 with financial reports of 2008,
2009 and maybe further. The reason the results might differ from those of 2005-2007 is that
both managers and users of financial statements will be more familiar with IFRS. Besides, the
accounting standards faced a lot of changes after the first implementation in 2005. It may be
that the standards are changed in such a way that there is indeed less room for earnings
management nowadays. Therefore, doing the research again with more recent data may
provide interesting outcomes.
Another possibility for future research is to study more countries, but with control variables
for country specific factors. For example, the legal system or the level of investor protection
should be labelled in such a way that several countries can be distinguished, for example by
including these factors as dummy variables in the regression models. This enables the
researcher to see whether there are differences in the success of the implementation of IFRS,
with respect to earnings management. Standard setters might use this information to change
rules and regulations, and maybe stakeholders can use the information by interpreting
financial statements.
Further, it might be interesting to study the same data with another research model. Because
of lack of proof that more recent models provide reliable outcomes, the rather old Jones
model is used as research model in this thesis. However, it can be good to use another model,
since another approach can provide other (better) results. So when there is more proof that
these models provides reliable estimates for earnings management, it is recommended to use
such a model for doing this research again.
73
Two other reasons to redo the research with another model is that not all variables are shown
to be significant and that only 1 percent of the discretionary accruals is explained by the
accounting standard and the firm size according to the last regression formula results.
Concerning the fourth limitation about the inconsistent calculation method of variables, there
is unfortunately no solution within the research model. However, all variables of 2004 can be
restated in the valuation methods of IFRS which makes the valuation method of both the
numerator and the denominator of these variables equal. Since all companies had to make
restatements of their financial report of 2004 as if it was prepared under IFRS, this
information should be available. A recommendation is to do this research again, but then use
the restated financial information of 2004 for the calculations for the variables of 2005 which
have to be scaled by the assets of 2004. This might result in more reliable outcomes, since in
this way both the numerator and denominator of the 2005 variables will be calculated under
the same accounting standard and with the same calculation method.
74
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Appendix 1: Overview of reviewed literature about effect of IFRS on Earnings
Management
AUTHOR
OBJECT STUDY
SAMPLE
METHODOLOGY
CONCLUSION
Heemskerk,
M.J.L. and
Tas, L.G.
Determine whether
earnings management at
firms, who have adopted
IFRS voluntary in an early
stage, has declined
160 German
and Swiss
companies,
early adapters
before 2005
Aggregate Accruals:
Modified Jones
Model (regression)
Earnings Management did not
decline by companies that
voluntary report in accordance
with IFRS
Christensen,
H.B., Lee, E.
and Walker,
M.
Determine whether
company incentives or
accounting standards are
leading for the audit
quality.
133 German
companies that
voluntarily
adopted IFRS,
177 German
companies that
did not.
Compare voluntary
with mandatory
adopters of IFRS,
using a regression
analysis
Earnings management did
decrease at companies that
voluntarily adopted IFRS, but
this result was not found at the
mandatory adopters of IFRS.
Tendeloo, B.
and
Vanstraelen, A.
Investigate whether
German companies, that
also early adopted IFRS,
engage less in earnings
management, while
controlling for other
differences in earnings
management incentives
636 German
listed
companies in
the period
1999-2001
Aggregate Accruals:
Cross-sectional Jones
Mode (regression)
More Earnings Management
when IFRS implemented.
Effect reduced when company
audited by Big 4 audit
company.
Making a distinction
between accruals based
earnings management and
real earnings management,
and investigate whether the
first declines and the
second increases as a result
of obliged introduction of
IFRS.
Listed
companies
from Belgium,
The
Netherlands,
Denmark,
Italy, Sweden
and Finland
during 20002006
1) Aggregate
accruals: Crosssectional Jones
Model (regression)
Whether the
implementation of IFRS led
to any less earnings
1146 France,
U.K. and
Australian
companies
Distribution of
earnings: Wilcoxon
rank-sum test with
IBEX, total assets
Lippens, M.
Jeanjean, T.
and Stolowy,
H.
When corrected for hidden
reserves, no difference in
earnings management under
IFRS compared with GAAP
Accruals based accounting and
real earnings management
both increased after
implementation of IRFS. No
difference between countries
2)Distribution of
earnings: (real EM)
Estimate model from
Roychowdhury
(regression)
Earnings management did not
decrease after implementation
of IFRS. In France is even an
increase in earnings
79
management to avoid losses during 20022006
and revenue
management measured.
Cai,L.
Courtenay, S.
and
Rahman, A.
Whether adoption and
enforcement of IFRS leads
to a reduction of earnings
management
102.636 firmyear
observations in
32 countries
during 20062006
Accruals approach:
Comparing mean
difference in
earnings
management and
Ordinary Least
Square Regressions
Earnings management did
decline at countries that have
adopted IFRS, with an
important role for the level of
enforcement.
Barth, M.E.,
Landsman,
W.R. and
Lang M.H.
Whether adopting a high
quality international
accounting standards leads
to a higher accounting
quality, among other things
resulting in a lower level of
earnings management
1896 firm year
observations
from 327
companies
during 19902003
Regression analysis:
comparing mean
ratios and
correlations and the
eventual impact of
variables
Countries that have
implemented high quality
international standards do
indeed generate higher quality
information, including a lower
level of earnings management
Dechow, P.M.,
Sloan, R.G.
and Sweeney
A.P.
Comparing several accruals
models in order to see
which model has the most
exploratory power
1000 randomly
selected firmyear
observations
and 32 firms
targeted by the
SEC
Modified Jones
Model
The modified model of Jones
provides the most powerful
test of earnings management
80
Appendix 2: Overview of general Earnings Management and IFRS literature
AUTHOR
OBJECT STUDY
SAMPLE
METHODOLOGY
CONCLUSION
Healy P.M.
and Wahlen
J.M.
Review of the academic
evidence on earnings
management and its
implications for accounting
standards setters and
regulators
n/a
Literature review
Earnings management
literature currently provides
only modest insights for
standard setters. Earnings
management occurs for
variety of reasons; market
perception, increase
management compensation
and avoidance of regulatory
intervention
McNichols
M.F.
Discussion of trade-offs
associated with three
research designs commonly
used in the earnings
management literature
n/a
Review on three
research designs:
based on aggregate
accruals, specific
accruals and
distribution of
earnings after
management
The trade-off depend on the
question addressed, the
objective of the research in a
given context, how earnings
are managed and the
incentives. There is no ‘best
approach’
Ball R.
Discussion on the pros and
cons for investors on the
implementation of the IFRS
standards
n/a
Literature review
At least some convergence of
standards seems desirable due
to globalization. Therefore
there are some notes of
attention and caution
Burgstahler
D. and
Eames M.
Show that managers avoid
reporting earnings lower
than analyst forecasts
25.951
observations
Jones model,
Matsumoto model
Managers do take actions to
avoid negative earnings
surprises, as distributions of
earnings surprises contains an
unusual high frequency of
positive and unusual low
frequency of negative
surprises
Burgstahler
D. and
Dichev I.
Providing evidence that
firms manage reported
earnings to avoid earnings
decreases and losses
Total number of
observations is
64.644
Statistical test
There is empirical evidence
that earnings decreases and
losses are frequently managed
away
Soderstrom
N. and Sun
K.J.
A review of the literature
on changing accounting
standards and the
determinants of accounting
quality following IFRS
n/a
Literature review,
also discussion on
methodological
issues
International accounting
literature has generally found
a positive impact of IFRS.
Quality depends on: quality of
standards, country’s legal and
political system and financial
81
adoption.
reporting incentives
Bolt-lee C.
and Smith
L.M.
Highlight previous IFRS
research
n/a
Literature review
There are pros and cons for
the transition of US GAAP to
IFRS
Dechow,
P.M.
Investigate circumstances
where accruals are
predicted to improve
earnings ability to measure
firm performance
20,716 firmquarter
observations
from 1980 to
1989,
Regression analysis
and cross-sectional
variant of the Jones
model
Accounting accruals provide
a measure of short-term
performance that more
closely reflects expected
cashflows than do realized
cash flows. But, certain
accruals are less likely to
mitigate timing and matching
problems in realized cash
flows.
Regression analysis
High investor protection and
strong legal enforcement are
negatively related to earnings
management
28,647 firmyear
observations
from 1960 to
1989,
and 5,454 firmfour-year (non
overlapping)
observations
from 1964 to
1989.
Leuz, C.,
Nanda, D.
and Wysocki
P.D.
Investigate the relationship
between investor protection
and legal enforcement
strength and earnings
management
70.955 firmyear
observations in
31 countries
and 8616
companies
during 19901999
82
Appendix 3: Companies in research sample
Aalberts Industries NV
Hitt NM NV
Ordina NV
Accell Group NV
Holland Colours NV
Postnl NV
AFC Ajax NV
Hunter Douglas NV
Punch Graphix NV
Akzo Nobel NV
Hydratec Industries NV
Qurius NV
And International Publishers
ICT Automatisering NV
Randstad Holding NV
Arcadis NV
Imtech NV
Reed Elsevier NV
ASM International NV
Kendrion NV
Roodmicrotec NV
Ballast Nedam NV
Koninklijke Ahold NV
Roto Smeets Group NV
Batenburg Beheer NV
Koninklijke BAM Groep NV
Royal Boskalis Westminster NV
Beter Bed Holding NV
Koninklijke Brill NV
SBM Offshore NV
Brunel International NV
Koninklijke DSM
Simac Techniek NV
Corio NV
Koninklijke Porceleyne Fles NV
Sligro Food Group NV
Crown Van Gelder NV
Koninklijke Ten Cate NV
Stern Groep NV
CSM NV
Koninklijke Vopak NV
Telegraaf Media Groep
Ctac NM NV
Koninklijke Wegener NV
Tie Holding NV
Docdata NV
Koninklijke Wessanen NV
TKH Group NV
DPA Group NV
Macintosh Retail Group NV
Tom Tom
Eurocommercial NV
Mediq NV
Unilever NV
Exact Holding NV
Nederlands Apparanfabriek NV
Unit 4 NV
Fornix Biosciences NV
Nedsense Enterprises NV
USG People NV
Gamma Holding NV
Neways Electric International
Vastned Offices Industrial
Grontmij NV
Nieuwe Steen Investment
Vastned Retail NV
Heijmans NV
Nutreco NV
Vivenda Media Groep NV
Heineken NV
Oce NV
Wereldhave NV
HES-Beheer NV
Oranjewoud NV
Wolters Kluwer NV
83