Submitted in part of fulfillment of the requirement for the Degree of Master of

Science in International Financial Management

The International Financial Reporting Standards impact on Earnings

Management: the case of FTSE 100

By

Vasileios Anastasopoulos

Faculty of Business, Economics and Law

University of Surrey

August 2012

Word count: 13475

© Vasileios Anastasopoulos

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Abstract

In 2005, all listed firms in the European Union (EU) were obliged to implement a new

accounting system that is equally applied for all firms, International Financial Reporting

Standards (IFRS). The IFRS is a new principles-based system that has many advantages

but also drawbacks that play a significant role in the accounting quality. This study

focuses on the impact of IFRS on accounting quality and more specifically, on Earnings

Management. Its basic purpose is to re-examine whether the IFRS/IAS adoption enables

managers to use specific Earnings Management techniques in order to decrease or

increase their financial results either in a legal or illegal way. The method that is used to

detect Earnings Management practice is estimating accruals (Total and Discretionary

Accruals). Applying this method we try to find whether the accruals have increased after

the year 2005 when the IFRS were adopted by firms. We considered a sample of listed

companies that have large capitalization and are considered to be among the best. They

are all listed in the FTSE 100 at the London Stock Exchange. We found evidence that the

level of Earnings Management has been increased after the IFRS introduction. In

particular, the accruals have been increased and we are able to confirm other authors that

found similar outcomes in their research. These findings might be due to the transition

from the Generally Accepted Accounting System (GAAP) to IFRS and occur only for the

first year after 2005, but might be due to some room for manipulation of earnings that

really allow firms to take advantage of it.

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Declaration of Originality

'I confirm that the submitted work is my own work and that I have clearly

identified and fully acknowledged all material that is entitled to be attributed

to others (whether published or unpublished) using the referencing system set

out in the programme handbook. I agree that the University may submit my

work to means of checking this, such as the plagiarism detection service

Turnitin® UK. I confirm that I understand that assessed work that has been

shown to have been plagiarised will be penalised.

Vasileios Anastasopoulos, 25 August 2012

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List of Tables

Table 1. Corresponding table of Databases definitions 35

Table 2.A Total Accruals Descriptive Statistics for all time periods 41

Table 2.B Total Accruals Descriptive Statistics for all time periods 42

Table 3. Total Accruals Quartiles for all time periods 43

Table 4. Statistical Characteristics of Parameters: a, b, c 45

Table 5. Statistical information for a, b and c parameters 45

Table 6. Discretionary Accruals Descriptive Statistics pre and post IFRS adoption 48

Table 7. Discretionary Accruals Quartiles pre and post IFRS adoption 51

Table 8. DA differences pre and post IFRS 52

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List of Figures

Figure 1. Time line of the event study 33

Figure 2. Actual, Fitted and Residual Graph 46

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List of Graphs

Graph 1. Revenue Growth for 2004, 2005, 2006 years 39

Graph 2. The Total Accruals distribution for the 2002-03 time period 40

Graph 3. The Total Accruals distribution for the 2003-04 time period 40

Graph 4. The Total Accruals distribution for the 2005-06 time period 41

Graph 5. Discretionary Accruals Frequency Histogram for 2003-2004 period 49

Graph 6. Discretionary Accruals Frequency Histogram for 2005-2006 period 50

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Table of Contents

Abstract 1

Declaration of Originality 2

List of Tables 3

List of Figures 4

List of Graphs 5

Table of Contents 6

Acknowledgements 8

Abbreviations 9

1. Introduction

1.1 Dissertation overview and Research objectives 10

1.2 Structure of the Dissertation 12

2. Literature Review

2.1 The International Financial Reporting Standards adoption 14

2.1.1 International Financial Reporting Standards 14

2.1.2 Motivation for Adopting IFRS 15

2.1.3 Disadvantages of IFRS 17

2.2 Earnings Management usage 18

2.2.1 Basic idea of Earnings Management 19

2.2.2 Motivation for Earnings Management 20

2.2.3 Earnings Management Techniques by Firms 22

2.2.4 Earnings Management Measurement 23

2.2.5 Theoretical Background of Discretionary Accruals models 25

2.2.6 Decreasing Earnings Management Phenomenon 27

2.3 Impact of IFRS on Financial Reports and Earnings Management 28

2.3.1 Earnings Management after IFRS adoption 28

2.3.2 Existing empirical studies 30

3. Methodology

3.1 Overview of Methodological approach 32

3.2 Sample and Data 34

3.3 Methods of Analysis 35

3.4 Research Ethics 38

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4. Analysis of findings

4.1 Descriptive statistics: Total accruals 39

4.1.1 The Distribution 40

4.1.2 Basic statistics 43

4.2 Non- Discretionary Accruals regression results 44

4.3 Descriptive statistics for Discretionary Accruals 48

4.4 Change in DA 51

4.5 Discussion of results 52

5. Conclusion

5.1 Summary of Findings 55

5.2 Limitations and further research opportunities 57

Reference List 59

Appendix A 66

Appendix B 72

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Acknowledgement

The writing of this thesis has been one of the most academic challenges that I had to face.

Without the support of some people, this thesis would be more difficult to complete. I

would like to thank my supervisor Dr Julinda Nuri for her advice and comments in order

to improve all the parts of the dissertation and those at IT service who helped me using the

Bloomberg database in Management School. Lastly, I would like to thank my Father,

Konstantinos and my Mother, Katerina for keeping me motivated from distance.

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Abbreviations

At – Total Assets

CEO – Chief Executive Officer

DA – Discretionary Accruals

EM – Earnings Management

GAAP – Generally Accepted Accounting Standards

IAS – International Accounting Standards

IASB - International Accounting Standards Board

IFRS – International Financial Reporting Standard

LSE – London Stock Exchange

NDA – Non Discretionary Accruals

OLS – Ordinary Least Squares

PPE – Property Plant and Equipment

TA – Total Accruals

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1 Introduction

1.1 Dissertation overview and Research objectives

The International Accounting Standards (IAS) that advanced to International Financial

Reporting Standards (IFRS) has created the basis for the synchronization of the different

accounting systems around the world. The new accounting system is an important step for

the improvement of international investments and the development of the economic

globalisation. In spite of the efforts for better synchronization of accounting systems

worldwide, there are still important differences in accounting systems. It is referred in the

bibliography that after the initiation of IFRS, important changes took place regarding the

financial reporting information of the companies.

An important issue that has been referred in the bibliography, numerous times, is that

managers have attempted to practice Earnings Management techniques so as to show a

different picture of the financial performance of the firms. In reality, the Earnings

Management is considered to be financial ‘‘numbers’’ manipulation that improves the

financial information homogeneity presented to the public.

The IFRS introduction in the European Union (EU) initially took place on the 1st of

January in 2005 and after that date. The adoption of IFRS included changes in the

accounting that was done in order to substitute the Generally Accepted Accounting

Standards (GAAP). The motivation for the IFRS adoption in Europe is linked to the

requirements of the international investments, accounting quality and economic

globalisation. The reporting quality that is provided by the firms is really doubtful for the

whole economic environment and as Barth et al (2008) mentioned, the IFRS adoption is

closely related to bad earnings quality or Earnings Management. Good quality of earnings

means transparent accounting information that lessens managerial discretion and do not

allow earning manipulation.

The discussion advanced so far is the structure of this dissertation as its objectives are

correlated to the IFRS introduction with management of earnings. Consequently, this

dissertation has come out due to the opportunities that IFRS has created for firms’

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managers. In general, however, accounting theory supports that financial reporting system

decreases information asymmetry by disclosing the proper information (Frankel and Li,

2004).

On the contrary, the Earnings Management importance is clear, as Burgstahler and Divhev

(1997) referred to Bank of America’s CEO Richard Rosenberg who stated that

“ Increasing earnings per share was our most important objective for the year”. This can

raise vital questions regarding to the managers who desire to perform Earnings

Management techniques.

The outcome of the debate proposed in this dissertation is to examine whether the

implementation of better accounting quality (like IFRS) can be associated with an illusion

of better financial performance. In particular, the aim of this dissertation is to assess the

impact that the IFRS introduction (2005-2006) had on the managers’ behaviour to practice

Earnings Management and influence the financial information quality, such as earnings.

The aims of this research are to find out the IFRS impact on management intention and

behaviour, taking into account Earnings Management. In other words, this dissertation

will seek to understand how, why and to what extent managers manipulate their earnings

by using the new applicable accounting rules.

The following research objectives are pursued:

-To discuss the theoretical framework of IFRS and what changes have been occurred in

financial statements.

-To analyse the Earnings Management concepts.

-To explore the changes brought by the IFRS implementation regarding the Earnings

Management, more specifically, regarding to the Discretionary and Total accruals.

Thus, to assess whether companies that report under IFRS can be related with superior

earnings quality we focus on data gathered from FTSE 100 of London Stock Exchange in

United Kingdom (UK). UK is a common law country with high investor protection rights.

For Earnings Management measurement, it is used Total Accruals and Discretionary

Accruals before and after IFRS adoption in order to examine their degree pre and post

2005. So, through a number of statistical procedures it will be evaluated if there are

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significant differences in Earnings Management. The outcomes from this thesis basically

come from the application of econometric regression that is based on two models existing

in the bibliography: Healy (1985) and Jones (1991) models. This research strategy was

adopted in order to determine the Total Accruals first, and Discretionary Accruals that can

easily be manipulated by the management. An increase in accruals might show us that a

worst information quality provided by the IFRS while a decrease means that IFRS related

to superior quality of accounting system.

1.2 Structure of the Dissertation

The present thesis will have two dimensions: theoretical and analytical. In the first part, I

identify those theories and ideas that I believe are the most valuable and interesting for the

research objectives. This will include a variety of journals, books, working papers and

reliable Internet sources which are related to the topic. In the second part of my thesis I

will attempt to explore the IFRS power on the Earnings Management. In other words, how

the implementation of a new accounting system has led financial managers to change their

points of view on how to manipulate earnings in order to meet their objectives and

projections. At this point, a number of data will be used to analyse the degree of

fluctuation. With all this in mind, the thesis can make numerous contributions to other

studies as it is considered the first to analyse firms from a great stock market index, like

FTSE 100.

Consequently, the remainder of this thesis has been divided into four chapters. Chapter 2

begins by laying out the theoretical dimensions of the research and focus on Earnings

Management literature and the implications of IFRS in Earnings Management. In

particular, it is devoted to explore the debate around IFRS initiation and the potential

impacts that this new accounting system has. Chapter 3 provides an overview of the

Methodological approach and Research design that it is going to be followed for the

purpose of the chapter 4 that provides us the analysis and discussion of the results from

our sample. Specifically, chapter 4 contains the findings from the empirical study. In this

chapter the outputs of the statistical work is also presented to confirm the discussion

provided subsequently. Finally, in 5th chapter findings are summarised, discussed and

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suggested new thoughts for our topic. It is also aimed to point out some of the limitations

of this dissertation.

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2 Literature Review

2.1 The International Financial Reporting Standards adoption

2.1.1 International Financial Reporting Standards

Over the past century, numerous legal accounting systems have been created, which make

the comparison of financial reports around the world difficult due to the fact that they

contain different economical and political issues. It is known that a lot of legal systems

have their origin in Europe: German, French, English and consequently there was a vast

diversity of accounting systems that were country-oriented accounting systems (Generally

Accepted Accounting Standards). Recognizing this, European Union members were the

frontrunners to harmonize their accounting systems and move toward better accounting

quality standards (Soderstrom and Sun, 2007). That is how International Accounting

Standards Board has been formed.

The International Accounting Standards Board (IASB) had an aim to develop universally

acceptable set of rules or principles that could apply to financial reporting of public

companies (IASB, 2012). This is a basic reason for the development of International

Accounting Standards (IAS), which is currently, renamed International Financial

Reporting Standards (from now on IFRS).

The dominant definition of IFRS is ‘’the transactional accounting rules that have been

adopted, or developed by the International Accounting Standard Board and which should

be followed in preparing the published financial statements of all companies’’ (McLaney

and Atrill,2010,p.714). These rules are trying to align the differences that exist between

countries’ multinational companies by creating a common “language”.

Nevertheless, Callao and Jarne referred to Jeff (2007) support that among countries there

are factors such as cultural differences that obstruct global comparability. Problems that

related to cultural differences are: diverse financial and accounting culture, auditing and

regulatory culture. For this reason, it is imperative need for the firms to adopt a new

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global accounting system, IFRS. Strong incentives have been provided by the “ regime”

for upper level financial quality.

2.1.2 Motivation for Adopting IFRS

Several countries around the world have either adopted IFRS or are trying to adopt it

because of the potential benefits of doing so. Supporters of IFRS believe that this set of

rules can lead to reduced information costs as the trading system becomes global step by

step (Ramanna and Sletten, 2009). The expectation is: firms and institutions by using the

internationally acceptable accounting standard lead international investments to efficiency

and improvement. Similarly, others argue that by adopting IFRS will help investors taking

trustworthy investment decisions as there will be provided reduced confusion which

comes from different GAAP systems (Tandeloo and Vanstraelen, 2005).

There is a large volume of published studies describing that the adoption of IFRS has

numerous benefits, the most significant are: a) help investors make right and informed

investment decisions as it encourages international investment b) decrease costs that result

from the financial reporting c) savings allocation becomes more efficient globally (Street

et al., 1999).

Analyzing the corporate level, companies choose to follow IFRS in order to be compatible

with international standards. The change from local GAAP to IFRS seems to be a

commitment for the company to keep transparent financial reporting due to high financial

needs (Tandeloo and Vanstraelen, 2005). A considerable amount of findings show that

companies, which adopt IFRS, are listed companies in stock markets and have high

exports. Therefore, adopting IFRS appears to be a basic reason for investors to follow

attractive investments, not only domestically.

A different aspect has been viewed by Ramanna and Slatten (2009) who categorize the

benefits of IFRS adoption in two values: net political and net economic value of IFRS.

Further, they support that net economic value is based on the quality of local governance

institutions and local GAAP. IFRS supporters argue that as trade becomes more and more

globalized, the information costs and information asymmetry are reduced by the

standards. Whereas net political value based on political lobbying where leading countries

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can affect IFRS. A good example is the prevailing position of some developed European

countries in IFRS (Brackney and Witmer, 2005) that their lobby groups urge International

Accounting Standard Board to reconsider IFRS requirements.

Moreover, Ball (2005) cites the ‘’pros’’ and ‘’cons’’ side of IFRS adoption for the

investors. Particularly, the potential benefits for him include:

-IFRS assure more accurate and more informed financial statement information, which

lead to a better valuation and then lower risk to investors.

-IFRS reduce the differences in accounting standard internationally and the comparison in

financial information is more feasible.

-Reducing international differences by using international accounting standards assists to

a great extent in eliminating difficulties to cross-border acquisitions, which theoretically

may reward investors with increased takeover premium.

-Increased transparency makes the firm’s management to act more in favor of

shareholders. While high quality transparency leads to the contracting efficiency between

lenders and firms.

Most countries by adopting IFRS could improve their economic environment if the IFRS

is considered to be helpful for the accounting quality of its firms. Barth et al (2008)

referred to some reasons why IFRS implementation could enhance the quality of

accounting.

First of all, IFRS can lessen managers’ discretion by excluding many accounting

alternatives. This could prevent managers from using opportunistic Earnings Management

techniques and then advance the quality of accounting (Ewert and Wagenhofer, 2005).

Secondly, IFRS are considered to be principles based standards and might are hard to

avoid. For instance, whether the standards are principles based, it is probably more

difficult not to accept liability recognition through transaction structuring. Thirdly, IFRS

allow managers to use their judgment in using measurement methods. For example, the

use of fair value accounting may be better reflecting the fundamental economics than

local accounting standards of each country.

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Last but not least, the harmonization value of IFRS based on the network idea. To be more

specific, this is the case of a network-dependent product becoming more attractive as

more and more governments adopt it (Ramanna and Slatten, 2009). This is what occurs to

IFRS adoption phenomenon as more and more countries accept IFRS. In other words,

countries cannot be constant in the new processes and have to develop their accounting

systems in respect of the new global economy.

2.1.3 Disadvantages of IFRS

It would be mistake to say that accounting systems do not have some weaknesses because

faithful and loyal committees or organizations have designed them. Then, on the ‘’con’’

side:

Ball (2005) mentioned numerous problems related to fair value accounting which includes

issues about market liquidity and illiquid markets. The motives of managers, auditors,

courts, boards, analysts, shareholders and the rating agencies remain still local and do not

go beyond the firm’s country borders. Mainly, the disadvantages are not restricted only by

Ball’s arguments.

In addition, many researchers suppose that IFRS adoption may have ineffective rules and

restrict the reporting flexibility when companies report their financial statements. Further,

opponents support the idea that IFRS implementation may not be suitable for all countries

and hence may not improve reliability, transparency and value relevance among different

nations. For instance, important findings have been found and show that in countries

without mature pension systems, the pension accounting may be subject to Earnings

Management (Ball, 2006). Specialists can use numerous techniques and assumptions to

manipulate the financial information for the good of the management. However, using a

global accounting system makes less costly to recognize such techniques (Soderstrom and

Sun, 2007).

Additional difficulties have been argued by Leuz et al (2003): they strongly believe that if

developed countries do not accept the IFRS, the implementation of IFRS becomes costly

due to the benefits come from the previous GAAP (switching costs). On the other hand in

less developed countries, it is a remarkable opportunity when they develop international

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acceptable standards probably because it is an essential need for them to progress. One

major criticism of Leuz et al (2003) work is that they do not examine the cultural

differences between developing and developed countries. A lot of researchers have

considered the dissimilarities that exist in social, political and economic level. For

instance, a country like Nigeria may not be able to cope with basic needs of its citizens;

however, it is obliged to adopt IFRS probably in order to meet international needs of

multinational companies. One major criticism of this situation is that such countries

should be helped (by an International organization) to boost their economy first and

afterwards they may be able to use a new accounting system that can advance the

financial quality.

Finally, there are speculations that IFRS reduce accounting quality. Barth et al (2008) as

well, referred two reasons that IFRS implementation might diminish accounting quality.

First, as we already said in the pros side, IFRS could decrease accounting options but

these alternatives might be the most suitable for communicating the fundamental

economics of a business consequently making managers to use less appropriate

accounting methods. In this way, accounting quality becomes poor. Secondly, IFRS are

based on principles. So, this means that the new standards may lack of comprehensive

guidance and thus offer to managers greater flexibility for having opportunistic behavior.

(Langmead and Soroosh, 2009). For example, in some significant areas like multiples

deliverables recognition, the lack of appropriate guidance could lead to increase in

managers’ discretion. The discretion rise owing to lack of appropriate guidance is possible

to lead to more Earnings Management opportunities and inferior accounting quality.

2.2 Earnings Management usage

Earnings management meaning is not consistent in finance and accounting literature.

There are main complications concerning the discussion of that concept. We are trying,

though, to provide a clear perception of that definition building on our judgment.

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2.2.1 Basic idea of Earnings Management

Initially, the question should be issued is whether IFRS deter the use of Earning

Management techniques. This is a hard question to be answered as different researchers

have concluded to dissimilar outcomes. We can recognize that when looking at some

empirical studies that are referred at part 3 in literature review chapter. It would be ideal

now to approach the Earnings Management phenomenon.

The issue of Earnings Management (from now on EM) in accounting has been under

analysis owing to its sensitivity. This is because there is a tight relation between

accounting and financial information revealed by firms that can create occasionally

transparency problems.

Actually there is no agreement on the definition of EM because it has many avenues.

Healy and Wahlen (1998) assert that EM refers to firms’ managers who alter financial

reporting statement so as to deceive investors and so on about the real performance of the

company; another reason for doing that is to influence events whose outcome associated

with reported accounting numbers. However, EM is regarded as being a specific

procedure in the companies’ financial reporting where managers intend to get some

private benefits (Schipper, 1989).

The definition of EM is not precise in the academic literature and authors make use of a

variety of terms to analyse the phenomenon. After having distinguished among many

related views of EM, I would choose that a common or basic definition of EM is:

‘’ the use of accounting practices within the limits available in a comprehensive basis of

accounting by management in order to achieve a desired result ‘’ (Callao and Jarne, 2010,

p.160).

Or

‘’Earnings Management is the active manipulation of accounting results for the purpose

of creating an altered impression of business performance ‘’ (Mulford and

Comiskey,2002, p.360).

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According to Yaping (2005) EM is the use of accounting standards in a wrong way for

manipulating purposes. In addition, Yaping referred to the definition by Brown (1999)

who stated that EM is the procedure of specific steps within the limits of accounting in

order to show the desired earnings and not the real performance. Therefore the approach

of definition based on accounting and management perspective. However, irrespective of

the approach all definitions focus on the management’s judgment and preference over

exploiting accounting methods in order to make financial performance of firm be under

management expectations and desires. It can be considered that EM includes creative

accounting essentials and some researchers condescend EM to be creative accounting and

fraud.

Nevertheless, EM has not been considered as an illegal action but has not been discussed

as legal. Dechow and Skinner (2000) mentioned that EM is classified in three parts:

earnings management, the legal use of accounting discretion and accounting fraud. The

basic difference between these three practices is the motive behind the action. In other

words, EM considered as legitimate because managers have not immoral intentions as

they do with the ‘’deceitful’’ accounting. One question that needs to be asked, however, is

whether EM has also a good aspect and intends to alter unfair financial results to avoid

shareholders’ and even stakeholders fear. But no matter what the managers’ purposes are,

what indeed counts is the investors’ protection.

2.2.2 Motivation for Earnings Management

Capkun et al (2010) referred to Lev (1999) emphasizes that accounting earnings are

considered to be the main financial information that should be viewed in financial

statements as positive earnings news might react favorably stock market (Kothari, 2001).

Hence, investors need to have standard accounting information so as to evaluate the

corporation’s performance. Obviously, this information should be based on the liquidity

and profitability of the firm.

Tandeloo and Vanstraelen (2005) mention that EM is in someway affected by economic

and other factors that exist in countries. In particular, managers exploit legal abnormalities

of countries’ laws. Common law countries such as England, Australia and North America

have accounting systems designed to meet investors’ needs because of the strong

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protection of investors. In these countries, accounting standards derive from the need of

investors for financial information. But countries that follow code law (for instance:

Germany, France and Russia) and their capital market are not very ‘’vivid’’ as they adapt

to tax and dividend regulations (Ball et al, 2000). Commercial law and courts institute

accounting standards in code law countries. Thence, EM becomes dominant in the last

case where Leuz et al (2003) examined.

As we will mention later, a mechanism that is used to temporarily inflate or reduce

reported earnings is the use of accruals by CEOs. These executives appear to use

Discretionary Accruals to manage their companies’ reported performance when they

exercise options and trade profitably many firms’ stocks (Bergstresser and Philippon,

2005). In addition, Bergstresser and Philippon referred to Healy (1985) who states that

there is evidence that the accrual mechanisms are linked to the managers’ motives in their

bonus contracts. It is obvious that managers’ engagement in EM goes beyond

compensation in manipulating earnings and includes issues such as self-fulfillment.

Furthermore, the question that arises is whether firms manage their earnings for stock

market purposes. Healy and Wahlen (1998) referred to DeAngelo (1988) examine that

earnings information plays important role in valuations in management buyouts and

suppose that the management of buyouts firms are motivated to lessen earnings. This

makes sense because the acquirer always tries to buyout another firm as “cheap” as

possible since big earnings are a way to create value.

Additionally, a large body of studies examined whether in equity offer periods, managers

attempt to smooth earnings. The findings illustrate that prior to equity offers, initial public

offers (see Teoh, Wong and Rao, 1998) and financial acquisition (Erickson and Wang,

1998), managers use positive unexpected accruals in their reporting. Further studies of

EM have assessed whether managers manipulate earnings in order to meet financial

analysts’ expectations (Healy and Wahlen, 1998).

Lastly, previous findings imply that management is willing enough to sacrifice real

corporate value by making use of transactional strategy so as to manipulate earnings

(Graham et al, 2005). This has led to tighter accounting standards as well as use of laws

such as the Sarbanes Oxley Act in order to reduce managers’ incentives to use discretion

in accrual manipulation (Graham et al, 2005).

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2.2.3 Earnings Management Techniques by Firms

Chapman and Steenburgh (2010) referring to Degeorge et al (1999) speculate that EM

behavior can be classified in two ‘’groups’’: misreporting earnings management that is

discretionary accounting and direct earnings management in which the timing of sales and

expenditures is used for the financing decisions. Therefore in the first group aspects of

financial reporting where EM can be affected include estimations of the economic life of

long-term assets, losses from bad debts and asset losses that associated with the managers’

choice of accounting techniques. In the second group, there are subjects that involve

expenditure shifting between periods or selling an asset that is illustrated as undervalued

in the balance sheet (Spohr, 2005). It should be mentioned that the techniques are not

restricted only to those two categories though.

When we focus on EM techniques, we usually first look at accruals which are accounting

components of earnings. In specific, they are considered as the part of sales or expenses

that are real cash collections and payments. So, if we assume that cash is difficult to be

manipulated, accruals show the way to managers on practicing EM. As we already

mentioned, timing is important, for instance, insiders can speed up the reporting of next

years revenues or delay the reporting of current costs to hide poor current performance

(Leuz et al, 2001). Moreover, accruals are balance sheet components of earnings that are

not appeared in current cash flow (Bergstresser and Philippon, 2004). Another technique

that insiders use is not to show strong current firm performance in order to keep ‘’funds’’

for the future. The results of the previous mentioned can be enhanced by Burgstahler and

Dichev (1997) who show that North American managers practice accounting discretion to

avoid small losses reporting.

McNichols (2000) classify his research design in three basic categories: specific accruals,

aggregate accruals and the distribution of earnings after management. These three

methods which depend on the managers’ choice are commonly used in the EM literature.

A strong point though is that these financial decisions are considered to be within the

borders of the general acceptable accounting standards, thus, making the practice of EM

seem legal.

The most important finding is that accruals that can be managed are the discretionary

ones. For that reason, they are used to mitigate earnings and manipulate the financial

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statements. The Discretionary Accruals are difficult to be detected and become a well-

matched tool for managers whether they need to meet their accounting aims. Generally

speaking, high values of Discretionary Accruals are correlated to EM use.

2.2.4 Earnings Management Measurement

The E.M measurement is an important factor for the accounting research of this

phenomenon. In order for the researcher to recognize if earnings have been managed,

he/she needs first to estimate earnings before the EM practice, which is hard enough to do

so (Healy and Wahlen, 1998). Generally, EM measurement is done via earnings

distribution, ratio of return on assets (ROA) and largely via accruals (Yaping, 2005).

According to Healy(1985) and Jones(1991) if a researcher attempts to estimate Total

accruals, he has to typically use the following formula:

TAi,t = (ΔCAi,t – ΔCLi,t – ΔCashi,t + ΔSTDi,t – Depi,t)/Ai,t-1

We will discuss about the formulas that it is going to be used in the methodology part.

According to Healy and Wahlen (1998) a very common approach is to detect the

motivations of managers to manage earnings and to estimate if these accruals are related

to their motives. Alternatively, taking into consideration the unexpected accruals that

cannot be explained as part of total accruals. It should be mentioned that information

asymmetry makes the idea of unexpected accruals an assumption and not a standard

method. However, accruals analysis is just a method of the issue of EM and is not proved

that is the most accurate.

Goel and Thakor (2003) measure EM with the use of earnings distribution. If there are

consistent smooth earnings distribution over accounting periods is a sign of earnings

management. This however contains problematic issues because earnings distribution

does not necessarily mean EM. As an alternative method of EM measurement, is the

Return On Assets ratio using histograms and graphs of frequency for that ratio. The

researcher in order to evaluate the measurement tries to detect possible abnormalities in its

distribution. In specific, if any irregularity happens, a space will appear between the

frequencies that approach zero value. Again, this variable is not an essential cause of EM

but it is based on assumptions (Yaping, 2005).

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Burgstahler et al (2005) discussed about four alternatives that take into consideration a

range of EM activities. These are when firms tend to avoid small losses, the smoothness

of earnings, the Total Accruals and the correlation of accounting accruals and cash flows.

Furthermore, Leuz et al (2003) using the existing EM literature developed four measures

that are similar to Burgstahler’s alternatives:

-Mitigate the variability by modifying the accruals: the measure that is used is a ratio of

country’s median standard deviation of operating earnings (firm-level) divided by the

standard deviation of operating cash flow (of the firms). Low values show that managers

use accounting discretion in purpose.

-Relation between cash flow from operations and accruals: For instance, managers can

speed up the future incomes reporting or delay of current costs in order to conceal bad

performance. Alternatively, they may misreport the current profitability in order to have

reserves for future reporting. The method that is used to quantify the earnings smoothing

is correlation between changes in accounting accruals and operating cash flow.

-Managers may use their reporting discretion to misstate firm’s performance

Measure: The median absolute value of country’s firms’ accrual divided by firms’

operating cash flow absolute value. It should be mentioned that Discretionary Accruals

are used to increase the financial reports’ information ability.

-Managers avoid small losses. Therefore, using accounting discretion manage earnings.

In other words, for them is more likely to change small losses to earnings than big losses.

What is used as a measure is the ratio of small reported profits to small reported losses.

Small losses means that their range is [-0.01, 0.00).

Likewise, Barth (2008) lists five measures of EM: first, the annual changes in the net

income. Secondly the volatility in net income scaled by the liquidity change. Third the

likelihood of reporting small earnings and fourth reporting large negative earnings. As a

fifth measure the correlation between residual cash flow and residual accruals.

However there is the acknowledgement that the whole techniques, which try to indicate

EM, cannot give precise and flawless measures of the topic.

Finally, it would be useful to classify the estimation approaches that have been published

by the most important authors:

25

a. Healy (1985), makes use of total accruals as Discretionary Accrual proxy. While

DeAngelo (1986) uses the change in Total Accruals between time periods.

b. Jones (1991), regresses total accruals on changes (delta) in revenues and PPE

(property, plant and equipment).

c. McNichols and Wilson (1988) use as a proxy the residual provision for bad debt.

Beaver and Engel (1996) estimate the residual from a regression of loan losses on charge

offs.

d. Burgstahler and Dichev (1997) test whether the annual earnings frequency are

more or less than zero earnings. Whereas, Degeorge et al (1991) find quarterly earnings

frequency and test if it is more or less than zero earnings and last quarterly earnings.

2.2.5 Theoretical Background of Discretionary Accruals models

After looking at the EM measurement it would be valuable to describe the most important

Discretionary-accruals models that are used in detecting any EM practice from managers.

Below, we discuss five Discretionary Accruals models:

a. The DeAngelo model (1986). In order for researchers to find the Discretionary

Accruals they have first to estimate the Non Discretionary Accruals. Using last time

period Total Accruals divided by lagged total assets:

NDAt= TAt-1/At-2

The magnitude of Discretionary Accruals can be found if we subtract NDAt from TAt/At-1.

b. The Healy model (1985). In order to find Non-Discretionary Accruals we have to

use the Total Accruals average divided by lagged Total Assets. Therefore, the model is:

NDAt = 1/nΣτ(TA/Aτ-1)

The magnitude of Discretionary Accruals is found if we subtract NDAt from TA in the

year t (divided by At-1).

26

c. The Jones model (1991) finds also the NDA first. The model is:

NDAt = a1(1/At-1) +a2(ΔRev/At-1) + a3(PPEt/At-1)

Where: NDA is the Non-Discretionary Accruals, ΔRev is change in revenue between year

t and t-1, PPEt is property plant and equipment while At-1 is total assets and a, b, c

coefficients that are used in finding Total Accruals.

d. The modified Jones model is an advanced model of the Jones one. This model is

trying to eliminate errors of Discretionary Accruals where managers use discretion for

revenue recognition. The model is:

NDAt = a1 (1/At-1) +a2 [(ΔRev-Δrec)/At-1) + a3 (PPEt/At-1)

The only adding is ΔRev, which is the net receivables change between t and t-1. It is

common that Jones and Modified Jones model suppose that Non-Discretionary Accruals

are constant over time.

e. The industry Model suppose that Non-Discretionary Accruals are constant as well.

In reality the Industry model suppose that the determinants of NDA is common across

firms in the same industry.

NDAt = β1 + β2 median (TAt/At-1)

Where NDA is calculated as in Jones Model and β1, β2 coefficients by using OLS

method.

All the previously mentioned methods have been widely used by researchers in order to

detect EM practice by managers. Numerous papers include these models as a method of

finding pre and post effects of an economic event and how this can detect the EM degree.

27

2.2.6 Decreasing Earnings Management Phenomenon

The management of the firm is influenced and supervised by the structure of corporate

governance. According to Dechow et al (1995) the governance structure has the proper

mechanisms and functions which related to financial reporting and can ensure

transparency and obedience to compulsory reporting requirements as well as keep the

financial statements’ credibility in a high level.

Theoretically, law code and accounting rules if properly imposed, have the strength to

reduce the aptitude of managers to use EM practices though (Leuz et al, 2003). Again,

according to Gore et al (2001) the major supervisors or auditors are those who can

monitor properly and check EM activities. Additionally, as it has been shown, obligatory

audits can ensure precise financial reporting. In reality, the Audit Committee should be

considered independent so as to provide vital quality to fulfill its supervision role

(Chtourou and Bedard, 2001). Krishnan (2003) argues that large ‘accounting’ firms not

only have the proper resources and knowledge to identify and detect EM, but also because

of their reputation and large clientele they need to protect themselves.

Besides the Audit committee, corporations can create an internal audit body to increase

the usage of internal governance framework that already exists. The new body can provide

firms with consulting warranty service, which in turn can improve the corporate

governance, control and risk management effectiveness (Davidson et al, 2005).

Another issue that arises is whether corporate governance practices have any effect on

utility of EM. For example, Chtourou and Beddard (2001) examine whether the members

of the board (managers) hold any certificate in accounting and they support that CEO

should have essential financial or accounting literacy.

In addition, an important factor that can play role in EM shrinking is auditing firms.

Numerous studies have revealed that Big 4 auditors create many obstacles on EM

(DeFond and Jiambalvo, 1991). Nevertheless, Maijoor and Vanstraelen (2002) find that

these limits initiated by Big 4 auditors on EM is not the same for all countries around the

world. In addition, Street and Gray (2002) believe that when a large auditor audits a

company is positively related to IFRS obedience. In respect of this, it is issued whether

28

IFRS implementation has stronger impact on earnings quality of the company when

audited by a Big 4 firm.

In terms of EM, the European Union obliged all listed companies to implement IFRS so as

to improve accurate reporting with efficient standards across the region.

2.3 Impact of IFRS on Financial Reports and Earnings Management

Arguments suggest that IFRS adoption may lead to actual advantages on the subject of

accounting quality but it is said that the IFRS transition is the most significant factor that

determine the accounting quality and EM. This is true because other factors (such as legal

or political systems) will continue to be different among countries (Soderstrom and Sun,

2007).

2.3.1 Earnings Management after IFRS adoption

The IFRSs implementation can reduce information asymmetry and mitigate the difference

in communication among insiders and outsiders (Bushman and Smith, 2001). This may

make managers be more reluctant to use EM techniques.

First of all, to assess the earnings quality we need to concentrate on IAS 1 (Presentation of

Financial Statements) objective that is to prepare the appropriate financial information in

order to meet the needs of individuals who are not in a position to have reports in their

hands (Alfredson et al, 2009). Specifically, paragraph 9 and 7 of IAS 1 underline that

financial statements are designed to provide the proper financial position of the firm by

using a range of components: a statement of financial position, changes in equity and cash

flows. These are the tools that IFRS “uses” so as to make the firms show transparent

financial reporting.

One question that needs to be asked is what does ‘’fair presentation’’ mean and is stated in

paragraph 15 of IAS 1? Fair presentation means that the transactions, events and

conditions related to the definitions and recognition of income, expenses and assets

29

contribute to achieve fair presentation under a faithful representation (Alfredson et al,

2009). All this helps users of the statements to make objective and unbiased economic

decisions. Consequently, fair presentation is supposed to be the way that is stated in IFRS

principles in order to increase accounting quality.

It can be stated that IAS/IFRS accounting standards have initiated better use of fair value

presentation in certain accounts when compared to domestic GAAPs.

For instance, compared to domestic accounting standards, IAS 39 is considered to

increase the fair value of firms’ accounting components. Due to the unavailability of

liquid markets to provide market prices for fixed assets and other forms of financial

components (i.e. receivables), the use of mark-to-model measurements has greatly

increased firms’ discretion. According to Ball (2006), in the case of capital markets

illiquidity, greater discretion has been identified regarding fair value measurements. When

fair values are estimated using valuation models, managers can influence the estimations

through their choices of models and parameters. Thus opening door to greater

opportunistic EM.

An additional example is IAS 16 (PPE), as it enables firms to revalue certain long-lived

assets at fair value systematically, yet with direct consequences for depreciation, expenses

and earnings. Consequently, giving the opportunity to managers to manipulate their

earnings. The same holds for IAS 36 that requires asset impairment to fair value.

Likewise, Ball et al (2003) said that adopting high standards might not be necessarily to

attain high quality reporting. Further, he supports that if the costs of compliance with

IFRS are more than that of non-compliance then non-compliance will be dominant.

Therefore, penalties for non-compliance are doubtful because this condition may affect

the financial disclosure quality.

The suitability of IFRS worldwide and its impact on reporting standards is a significant

issue that has been argued not only in developed but also in developing countries. In the

developed world the argument is based on establishing high quality standards that can

reduce EM in countries without strong investor protection rights, like code law countries

(Tandeloo and Vanstraelen, 2005). In developing countries though, implementing IFRS is

a chance for them to follow a different way of thinking and assist the locals to invest with

more confidence.

30

Generally speaking, one of the IFRS adoption aims is to provide earnings quality to all

financial statements’ users and make the global financial environment well organised. No

matter what the real aims of IFRS are, I believe that many “spaces” have been created that

allow managers have opportunistic behavior.

2.3.2 Existing empirical studies

Several studies have made an attempt to illustrate that the adoption of IFRS has affected

the utility of EM. It would be useful to see a study that shows the firm’s income behavior

first. Therefore, among these are studies by Iatridis (2010) who investigated the impact of

IFRS implementation on important financial components of UK companies. He focused

on the UK GAAP-based financial numbers in 2004 and the IFRS restated financials that

reported in 2004. The findings show the adoption of IFRS has not decreased the measures

of profitability such as Earnings Per Share and Operating Profit.

To start with, among the studies that indicate the IFRS impact on EM is this by Tandeloo

and Vanstraelen (2005). It has already been referred that they use the magnitude of

absolute Discretionary Accruals and the correlation between reported accruals and cash

flow. Their results illustrate that Financial Reporting Standards did not lead firms to

reduce EM. On the contrary they show that as IFRS appeared, have increased the

management of Discretionary Accruals. Thence, they conclude that IFRS adoption does

not mean lower EM with the exception of some firms that have Big 4 auditor.

Another research by Goncharov and Zimmerman (2006) illustrated the same outcomes.

Their research was drawn by separating into Discretionary and Non-Discretionary

Accruals while using normal accruals as proxy for the Non-Discretionary Accruals which

might be affected by EM. They focus not only in German GAAP but in USA GAAP as

well. Their findings were that firms were more involved in EM when reporting under the

International Financial Reporting Standards.

More recent studies investigated by Jeanjean and Stolowy (2009) focused on UK,

Australia and France. These researchers made an attempt to discover whether firms in

these countries manage their earnings before and after IFRS introduction. The

methodology is focused not only in accruals but also in distribution of reported earnings

and particularly in income before extraordinary items and sales. Similar findings with the

31

Germany case have been found for France. They thus indicated that IFRS adoption did not

reduce EM, on the contrary it increased. Jeanjean and Stolowy (2009) claim that common

accounting language is not sufficient in management incentives and institutional factors,

which are both vital for the financial reporting quality.

Nevertheless, when examining the region of Europe, it can be noticed differences in

management behavior and how each country takes advantage of accounting changes. In

specific, Callao and Jarne (2010) considered opportunistic behaviour by managers in 11

countries. By analyzing long term and current Discretionary Accruals and determining the

correlation between accruals and corporate variables, the researchers conclude that the

majority of countries manipulate their earnings via the mentioned methods.

With consideration for the IFRS impact on developing countries, Zhou et al (2007)

investigated the impact of IFRS adoption on earnings mitigation. They simply used three

different types of income to show the frequency or variation pre and post adoption of IAS.

Similar to previous results, there was no evidence of declined EM. However there was

neither significant evidence of EM activity when adopt IAS.

Chrinstensen et al (2008) analysed a different case by comparing EM metrics of Early

adopters (from 1998 to 2004) with Late Adopters (2005). After examining 310 German

companies, they found that EM decisions decreased for the Early Adopters while

increased for those who adopted IFRS later. This is a different research and attributes the

difference in results to the need for potential incentives that Early Adopters firms have in

order to follow a high quality accounting standard.

Therefore, in the investigation of earnings management through IFRS adoption, it is valid

to explore the following fields:

- The IFRS impact on accounting performance.

- The volatility of earnings realizations and accruals magnitudes (after and pre IFRS

implementation).

- The manager’s behavior and intentions when such “event’’ changes take place.

32

3 Methodology

This section aims to discuss and analyse the construction of the methodological tools and

components that will be used in order to reach our research aims and objectives. The

section discusses concepts and issues that support this research project in a more effective

way and that make the reader understand how the presented result has been obtained.

Topics included are related to: strategy, data sampling and formulas, as well as methods of

data analysis.

3.1 Overview of Methodological approach

The main strategy that has been introduced to measure the IFRS effect on the EM

phenomenon are event studies. In reality an event study approach was chosen because it

allows us to find out the variation of the financial occurrence.

Economic researchers are often asked to evaluate the impacts of economic events on the

firms’ value. On the surface, a task like this is difficult, but using an event study makes

the construction of measures much easier. In fact, using data of financial markets, the

effect of a specific event can be measured by an event study regarding the firms’ value.

The event study approach is considered to be a useful tool that can help scientists evaluate

the impact of financial changes in firms’ policies. For instance, by this method, a

researcher determines whether there is an abnormal stock price effect related to an

unexpected event. Determining this, scientists can realise the significance of the event. It

is known that the event study method is used widely in finance or accounting research. It

always measures the firms’ control changes through time (McWilliams and Siegel, 1997).

Benston (1982) states that the event study is also very popular because it avoids the need

of the researcher to analyse accounting-based measures of profit that have been criticised

due to their lack of transparency for evaluating corporate performance. In our study, for

example, financial managers can make use of EM to manipulate the profits because of

their ability to select accounting procedures.

33

Nevertheless, once this method is extensively used to evaluate the impact of managerial

decision-making it would be essential to make sure that it has been applied properly. In

addition, it is imperative to report the results clearly and to assure the results interpretation

is suitable. It is well recognised that the analytical technique’s usefulness depends on a

range of strong hypothesis (Brown and Warner, 1980, 1985).

Some further disadvantages of the event study methodology are that: the design and

construction of the study are strongly linked to the outcome and many theories may have

been unjustifiably based on incorrect methods. Additionally, as already mentioned, the

methodology of event study depends heavily on assumptions. So, if the researcher violates

these assumptions, the results may be inaccurate and biased. Then, the final conclusion

may be problematic (Palgrave MacMillan, 2012).

It is meaningful to our readers, to select the right length of an event window that the study

takes place in. In this case, the event window used is considered to be categorized as

short run, as we try to capture the consequences of the IFRS application one year before

and one year after the disclosure of financial statements. We could include more sub-

periods prior and after the IFRS adoption but if the event period is too long, other events

or changes (that we cannot examine at the moment) occurring within this window may

impact on our study and reducing its reliability. Generally, problems related to this

approach are several. The problem that may arise is that by using too short event window

we may not capture the real effect of the event. However, a carefully chosen and right

length of event window can present the full consequences of the adoption. Another

problem that should be mentioned is that firms prior to 2005 may use different accounting

policies which mean that after the IFRS adoption, some firms may have more

opportunities than others to manipulate their numbers.

2003 2004 2005 2006

-Transition year- - IFRS adoption-

Figure 1. Timeline of the event study

34

The research covers the period from 2003-2006 (Figure 1) and it is divided into two sub-

periods: 2003-2004 and 2005-2006. However, the 2004-2005 period is not included as it

is the first time of the IFRS application in the UK and we want to capture the effect before

and after the ‘accounting event’ but we do extract descriptive statistics for that period to

observe what happens in the “ transition year”.

3.2 Sample and Data

Our sample consists of firms that are listed at the London Stock Exchange (LSE) and

particularly the FTSE100 on December 31, 2006. 19 firms (see Appendix A, Table D) are

excluded from the sample of 100 companies, due to them being part of the financial

industry. Additionally, six listed companies (see Appendix A, Table B) are excluded, that

have not used IFRS in the selected period and eight more firms (see Appendix A, Table C)

due to lack of data.

As previously mentioned the research covers the period from 2003 to 2006 and it is

divided into two sub-periods so as to assess the situation pre and post the implementation

of IFRS. Furthermore, it should not be omitted that, firms reported their annual results

under local GAAP for the period 2002-2004, while after 2005 all listed companies in the

United Kingdom implemented International Accounting Standards.

The companies were selected on the basis of their significant capitalisation and their

obligation to apply IFRS in year 2005 and 2006. The companies of FTSE100 represent the

largest UK companies (known as blue chips companies), the index represents

approximately 85% of the UK’s market capitalisation and is suitable as the basis for

investment products, such as funds, derivatives and exchange-traded funds. The FTSE 100

Index also accounts for 8% of the world’s equity market capitalisation (based on the FTSE

All-World Index as at 30 June 2011 (FTSE The Index Company, 2012).

An additional reason choosing this kind of firms is that such giant companies have the

strength and ‘’capabilities’’ to manipulate their financial results. Specifically, FTSE100

firms have more knowledge, experience and motivation to adopt EM techniques in the

interest of their managers or shareholders.

35

Secondary data have been collected from Amadeus and Bloomberg Database (the firms’

annual reports) to determine the results. The variables that have been selected are

measured differently from each individual database. The following table shows their

specific definitions in both databases.

Selected Variables Amadeus Bloomberg

-Current Assets (CA) Current assets Total Current Assets

-Current Liabilities (CL) Current liabilities Total Current Liabilities

-Cash Cash & cash equivalent Net Changes in Cash

-Long Term Debt (STD) Loans Long-Term Borrowings

-Depreciation (Dep) Depreciation

Depreciation &

Amortization

-Total Assets (A) Total Assets Total Assets

-Sales (Rev) Operating revenue

(turnover) Turnover

-Gross Property, Plant, Equipment

(PPE) Tangible Fixed Assets Net Fixed Assets

Table 1. Corresponding table of Databases definitions

3.3 Methods of Analysis

The estimation of discretionary accruals is the main aim of the methodology that should

be followed. As has been discussed in the literature review, accruals are components of

incomes and expenses in a firm that do not include real collections of money or payments

and can be calculated as a difference between earnings and operating cash flow (Callao

and Jarne, 2010). Different authors have measured EM in a variety of ways but our

method focused on specific models.

36

For the purpose of finding the Total Accruals, as previously indicated are using the Healy

Model (1985), which has been restated by Jones in 1991. Then, Total Accruals are

calculated as:

TAi,t = (ΔCAit – ΔCLi,t – ΔCashi,t + ΔSTDi,t – Depi,t)/Ai,t-1 (1)

where,

TAi,t symbolizes the total accruals of the company i and year t. The Δ (delta) represents

the change in the factors between the year t and t-1. As independent variables, the

following are included : ΔCAi,t,, the currents assets change of company i at year t. ΔCLi,t ,

the current liabilities change. ΔCashi,t , the cash and cash equivalent change. ΔSTDi,t , the

long-term debt change in current liabilities. Depi,t , expenses in depreciation and

amortization and finally Ai,t-1 represents the total assets lagged at t-1 year.

To begin with, the Total Accruals magnitudes can be used in order to measure the

manipulation of earnings between the time periods. Financial managers use accruals to

transfer earnings from one year to another. Therefore, we will make use of descriptive

statistics to examine when profits are ascending or descending for the firms of FTSE100.

Particularly, we will start our analysis with the distribution plots of each time period so as

to discover the specific techniques that have been used and have a first look at our data.

In the case of the Total Accruals being zero, the absence of EM practice can be concluded

regarding the sample under consideration. However, Total Accruals capture a larger

portion of managers’ manipulations.

Having accomplished the previous procedure, the next step to be taken is to determine that

Total Accruals are divided into Non discretionary accruals and Discretionary Accruals.

Generally, Discretionary Accruals (DA) are easier to practice than Non Discretionary

Accruals (NDA), which are difficult to manage. Hence, TA = NDA + DA. (2) We have to

pinpoint Jones (1991) assumption that Non Discretionary Accruals are regarded as

constant. This assumption lessens the difficulties in the computation of the formula.

37

Subsequently, based on the Jones Model (1991), the following model should be estimated:

TAi,t = a x(1/At-1) + b x(ΔRevi,t) + c x(PPEi,t) +εi,t (3)

where,

ΔRevi,t : change in revenues scaled by total assets at t-1 year.

PPEτ : gross property plant and equipment in year scaled by total assets at t-1 year.

At-1 : total assets at t-1.

a, b, c : firm parameters.

Being at this point, we should use the TAi,t we found in equation (1) and replace them as

an dependent variable in equation (3). In order to do so, we should use the data from pre-

adoption period 2002-2003 of IFRS implementation. The use of that period has been

selected, because it is closer to the event window period.

Having accomplished the tasks described up to this point, our aim now is to estimate the a,

b, c parameters by using the Eviews econometric software. In particular, we are using

Ordinary Least Squares method to find our firm-parameters a, b, c. Afterwards, the

estimated parameters are used so as to construct the following formula:

NDA = a x(1/At-1) + b x(ΔRevi,t) + c x(PPEi,t) (4)

Where,

ΔRevi,t : change in revenues scaled by total assets at t-1 year.

PPEτ : gross property plant and equipment in year scaled by total assets at t-1 year.

At-1 : total assets at t-1.

a, b, c : firm parameters.

Thence, having estimated the a, b, c parameters and using the data (2003-2004 now) we

can find the Non Discretionary Accruals that are considered to be constant for all of our

periods (Jones’ assumption). Subsequently, as Non-Discretionary Accruals variables have

already been estimated, the Discretionary Accruals can easily be found (for each period)

by using formula (2): DA = TA – NDA (subtracting NDA from TA).

38

Quantitative analysis for Discretionary Accruals will be used again with the purpose of

analyzing and comparing their magnitudes for each time period.

3.4 Research Ethics

It is generally accepted that using secondary data and thus secondary analysis raises very

few or no ethical considerations. However, those considerations are based on the use of

quantitative data sets when documentary analysis and archival research is conducted.

Therefore I have to take into account the implications of Data Protection Art (1998). In

other words I check the consent when collecting data. In addition I have to ask myself on

what are my responsibilities towards the researchers who first collected the data and if I

need to take any permission in order to use them in this paper. An ethical approval form

was completed and can be found in the Appendix B.

39

4 Analysis of findings

4.1 Descriptive statistics: Total Accruals

We begin with an analysis of the trends over time in Total Accruals. Our data is panel data

consisting of 67 observations and 4 time periods, which each of them considered as cross

sectional data. The 67 firms of the FTSE100 sample have an ascending average revenue

growth, which is approximately 30% for the 2003-2004 time period, 40% for the 2004-

2005 and 87% average growth for 2005-2006 time period [graph 1]. It is surprising the

fact that after the IFRS implementation the revenue growth has rapidly increased. Taking

into consideration the new accounting event and comparing the two results prior and after

the adoption, it would be said that it is odd enough when a specific list of companies has

big percentage difference in revenues from one period to another.

Graph 1. Revenue Growth for 2004, 2005, 2006 years

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2004 2005 2006

Revenue Growth

Revenue Growth

40

4.1.1 The Distribution

For each time period it can be plotted a distribution graph to obtain a first impression

about the data. The distribution shows the frequency of specific values for a variable. It is

important then to see whether data are normally or skewed regarding their distribution, or

have a kyrtosis to be considered. The reason is that if the data are normally distributed,

this means that the majority of our firms may use EM but we cannot discover whether

they are using ascending or descending techniques for increasing or decreasing their

earnings level respectively. This happens, because all the magnitudes may be equally

around ‘zero’. In short, it would be interesting not to see a bell-shaped graph.

In the next graphs we can see the distribution graphs of Total Accruals for the 3 time

periods 2002-2003, 2003-2004 and 2005-2006. The vertical axis represents the frequency,

while the horizontal axis represents the Total Accruals magnitude.

Graph 2. The Total Accruals distribution

for the 2002-03 time period.

Graph 3. The Total Accruals distribution

for the 2003-04 time period.

41

Graph 4. The Total Accruals distribution

for the 2005-06 time period.

We have to determine that when Total Accruals are equal to zero, no EM practice detected.

As can be seen from the distribution plots above, the majority of the observations, Total

Accruals are found to be on the left of the mean (zero value). That means that Total

Accruals are negative for the majority of observations. Furthermore when looking at the

plots there is no significant difference between the 2003-2004 time period and the 2005-

2006 time period, apart from the fact that many firms from the time period of 2002-2003

have decreased their earnings management techniques noticeably by making negative or

positive accrual decisions. Then, simple descriptive statistics analysis (Table 2) was used

in order to assess the data.

TAi,t = (ΔCAit – ΔCLi,t – ΔCashi,t + ΔSTDi,t – Depi,t)/Ai,t-1

TA 2002-

03

TA 2003-

04

TA 2004-

05

TA 2005-

06

Mean -0.070825 -0.045337 -0.053117 -0.037313

Median -0.045793 -0.049506 -0.057167 -0.043462

Maximum 0.401350 0.711584 1.417391 0.411547

Minimum -0.977612 -0.475206 -0.71179 -0.685726

Std. Dev. 0.166938 0.153123 0.243846 0.166109

Skewness -3.371846 1.735342 3.316020 -0.455179

Kurtosis 19.97906 12.65493 22.67939 6.922279

Observations 67 67 67 67

Table 2.A Total Accruals Descriptive Statistics for all time periods

0

5

10

15

20

25

30

-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6

F r e

q u e n

c y

T A 2 0 0 2 _ 0 3

0

5

10

15

20

25

-.6 -.4 -.2 .0 .2 .4 .6 .8

F r e

q u e n

c y

T A 2 0 0 3 _ 0 4

0

10

20

30

40

-0.8 -0.4 0.0 0.4 0.8 1.2 1.6

F r e

q u e n

c y

T A 2 0 0 4 _ 0 5

0

5

10

15

20

25

-.8 -.6 -.4 -.2 .0 .2 .4 .6

F r e

q u e n

c y

T A 2 0 0 5 _ 0 6

42

TA 2002-

03

TA 2003-

04

TA 2004-

05

TA 2005-

06

Jarque-Bera 931.7626 293.8600 1203.940 45.26137

Probability 0.000000 0.000000 0.000000 0.000000

Sum -4.745286 -3.037587 -3.558837 -2.499977

Sum Sq. Dev. 1.839314 1.547477 3.924427 1.821077

Observations 67 67 67 67

Table 2.B Total Accruals Descriptive Statistics for all time periods

It can be noticed from the table above that in the TA 2002-2003 period and the TA 2005-

2006 period, the skewness is negative, which suggests that more values of residual series

are grouped at the left of the mean. However the most striking observation to emerge from

the data comparison is that for the time period of 2003-2004 (pre IFRS adoption period)

the skewness is positive (1.735342) while it is negative (-0.455179) for the 2005-2006

period (post IFRS adoption period).

Generally speaking, a normal distribution has a kurtosis of three (3). Any noteworthy

deviation from this value is described as an unusual shape. Therefore, the shape of the

graphs can be described as having a kurtosis. Strong evidence of unusual shape existence

was found when we calculated the Jarque-Bera test by combining skewness and kurtosis:

[

]

So, as we can see below the Jarque-Bera row probability for all the time periods is equal

to zero (Probability=0) which is less than 0.05 (Probability=0.00<0.05). Then, we reject

the null hypothesis and conclude that the data are not normally distributed.

43

The hypothesis development is:

H0: data are normally distributed

H1: data are not normally distributed

4.1.2 Basic statistics

The average values of Total Accruals were compared in order to see whether there is any

deviation among the time periods. As expected then, TA mean scores are negative for all

the time periods. However, in the post-adoption period (2005-2006) the average TA (-

0.037313) has increased slightly in contrast to the pre-adoption period (2003-2004) for

TA (-0.045337). It is apparent from the combination of the found statistics that the

managers’ intention after the IFRS adoption was to change their accrual technique so as to

increase their earnings. In other words, they use income-increasing accruals techniques to

manipulate their results and show bigger earnings.

Now, it would be useful to examine the Quartiles of the data:

TA 2002-03 TA 2003-04 TA 2004-05 TA 2005-06

Lower (25)

quar. -0.087172 -0.079564 -0.1209 -0.078631

Median -0.045793 -0.049506 -0.057167 -0.043462

Upper(75)

quar. -0.01645 -0.018427 -0.023586 0.0108511

Quartiles split the observations into four (4) groups. In reality, 25 per cent of the

observations lie below the 25 quartile. In our case 25% of the observations, more

specifically 17 observations out of 67, lie below -0.087172 in the 2002-2003 time period

while 17 observations have a Total Accrual value of more than -0.01645. In other words,

75% of the observations lie below -0.01645 in the 2002-2003 time period. Particularly,

their magnitude range is from -0.977612 to -0.01645 for 75 per cent of our observations,

which means that the majority of companies (75 per cent) use negative EM techniques.

Table 3. Total Accruals Quartiles for all time periods

44

The data that should be compared at this point are the ones before and after the IFRS

adoption in 2005. It is clear from the table that 25 per cent of our observations in 2003-

2004 and 2005-2006 time periods are below -0.079564 and -0.078631 respectively. These

two numbers are significantly similar which means nothing has changed pre and post the

new implementation.

However the big difference seems to be found in the upper quartile (Q3) where the 25 per

cent of the observations’ values is higher than +0.0108511 for 2005-2006 time period.

While for the time period 2003-2004 the things are totally different, as total accruals

values are negative (-0.018427) for the majority (75%) of the observations and have

turned to positive (+0.0108511) after IFRS adoption. The quartiles enable us to see that

more and more firms have changed their EM techniques after the IFRS adoption. This

gives us the impression that many firms of our sample turned their technique from

decreasing to increasing accrual accounting in order to present larger earnings.

This is obvious when examining the mean of Total Accrual pre and post the time period of

2005. In specific, in 2005-2006 the Total Accrual is bigger than that of the 2003-2004

period (-0.037313>-0.045337), which shows an attempt of firms to use positive accruals

for the EM practice. These results show again that accruals tend to increase in order for

managers to show bigger earnings.

4.2 Non-Discretionary Accruals regression results

As we said in the methodology part, we have to find the a, b and c parameters of Non-

Discretionary Accruals by using the Ordinary Least Squares regression method from

Eviews 7. In table 3, the values of our parameters can be found.

45

NDA = a x(1/At-1) + b x(ΔRevi,t) + c x(PPEi,t)

Variable Coefficient Std. Error t-Statistic Prob.

X1 -715.049 11.02815 -64.83852 0

X2 -2.50E-01 3.50E-02 -7.14118 0

X3 1.38E-01 3.52E-02 3.924927 0.0002

R-squared 0.894589 Mean dependent var -0.202146

Adjusted R-

squared 0.894107 S.D. dependent var 1.193761

S.E. of regression 0.150492 Akaike info criterion -0.906068

Sum squared resid 1.449466 Schwarz criterion -0.80735

Log likelihood 33.35327 Hannan-Quinn criter. -0.867005

Durbin-Watson

stat 1.910392

As can be seen from the p-values, the probabilities of all variables are less than 0.05

which indicates that all variables are statistically significant. Furthermore, R2= 0.894589

which indicates that almost 89 per cent of the dependent variable can be explained by

independent variables, in our case more specifically, 89% of the Total Accruals can be

explained by the reciprocality of the Assets, changes in revenues and Property, Plant,

Equipment. From the actual, fitted and residual graph (Figure 2) below, it can be seen

how our model fitted the sample data and the remaining 11% of the Total Accruals is the

error term.

Table 4. Statistical Characteristics of Parameters: a, b, c

Table 5. Statistical information for a, b and c parameters

46

So our estimated parameters are a= -715.049, b= -0.250076, c=0.137988. In order to

examine the coefficients we would say that reciprocal of the one period lagged Assets are

negatively correlated with Total Accruals. A change in revenues also negatively affects

Total Accruals, while Property, Plant, Equipment positively affects the Total Accruals.

Since we divided the right side of the equation by At-1 to reduce heteroscedasticity, it is a

useful to check our residuals for heteroscedasticity (Table 5) in order to see if we have

achieved our goal. There are a lot of tests that can be performed to check for

heteroscedasticity. But the widespread one is the White Test (see Appendix A, Table E).

The null and alternative hypotheses are

H0: There is no heteroscedasticity

H1: H0 is false. There is heteroscedasticity

It is obvious that probability of F(6,60)=0.0 is less than 0.05 (see Appendix A, Table E),

so we reject the null hypothesis and conclude that there is heteroscedasticity problem in

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

-10

-8

-6

-4

-2

0

2

5 10 15 20 25 30 35 40 45 50 55 60 65

Residual Actual Fitted

Fig. 2: Actual, Fitted and Residual Graph

47

the residual. If we look at the probability of t-statistics (

)

(see Appendix A, Table E), are statistically significant, meaning that if we

would include those variables to the model we wouldn’t have a heteroscedasticity problem.

However heteroscedasticity doesn’t create complications as it doesn’t affect the estimated

parameters so parameters. So parameters a, b and c are unbiased, the only item

heteroscedasticity affects, is the variance of the estimated parameters (and hence standard

errors, t-values). It is common to have a heteroscedasticity problem in cross-sectional data

and this does not affect our results.

48

4.3 Descriptive statistics for Discretionary Accruals

Discretionary Accruals are the part of Total Accruals that are easy for managers to change

in order to meet their target. By saying that, we mean that our sample should have non-

zero Discretionary Accruals values.

DA 2003-2004 DA 2005-2006

Mean 0.030379 0.038403

Median -0.004848 0.004683

Maximum 0.952637 0.475596

Minimum -0.518003 -0.59246

Std. Dev. 0.205251 0.202168

Skewness 1.508753 0.178544

Kurtosis 8.187439 3.58521

Jarque-Bera 100.5415 1.312034

Probability 0 0.518914

Sum 2.035421 2.57303

Sum Sq. Dev. 2.780443 2.697554

Descriptive statistics for the Discretionary Accruals were calculated (Table 6). It is

obvious that the magnitudes of discretionary accruals, obtained from the table above,

appear more realistic than that of Total accruals. The reason is that Discretionary Acruals

are not biased by the Non-Discretionary Accruals, as we have to subtract them from total

accruals to find a more appropriate measure (DA= TA-NDA).

Table 6. Discretionary Accruals Descriptive Statistics pre and post IFRS adoption

49

While the Total Accruals are negative, we find that Discretionary Accruals are totally

different. In particular the average Discretionary Accruals are positive, but in absolute

terms their magnitudes are smaller than that of Total Accruals before the IFRS adoption

(2003-2004: 0.030379 < |-0.045337|) and after the IFRS adoption the average magnitudes

of Discretionary ones is slightly bigger than that of Total Accruals in 2005-2006

(0.038403 > |-0.037313|). Thus, it appears that smaller earnings increasing DA are

followed by larger TA, which is probably larger due to the NDA existence.

From the Probability of Jarque-Bera it is realised that in none of the periods, Discretionary

Accruals are normally distributed. Since their skewness is greater than zero in all periods,

the distribution plots are right skewed. In all periods it holds that median is smaller than

the mean (-0.004848 < 0.030379 and 0.004683 < 0.038403 for 2003-04 and 2005-06

periods respectively). So the distribution plots are indeed right skewed and more data are

located on the right side of the average (Figure 3 and Figure 4).

0

5

10

15

20

25

30

35

-1 0 1 2 3 4 5 6 7 8 9 10 11

Fre

qu

en

cy

DA2003_04

Graph 5. Discretionary Accruals Frequency Histogram for 2003-2004 period

50

As the table 7 illustrates, there is no significant difference between the two time periods

(pre and post IFRS adoption periods regarding their magnitudes). To be more specific,

after the adoption of IFRS the discretionary accruals mean (0.038403) is increasing, when

compared to the pre adoption mean (0.030379). At the same time, the standard deviation

is ranging at the same level for both periods. What is interesting in these numbers is that

our sample has higher discretionary accruals values in the post IFRS adoption period than

before the adoption. Undoubtedly this shows that rising earnings management techniques

have been used by the managers.

Another indication of the ascending EM techniques is the aggregate sum of Discretionary

Accruals. Actually, before the IFRS adoption (2005) the sum of the Discretionary

Accruals magnitudes is equal to 2.035421 whereas after the adoption there is an increase

for the sum of Discretionary Accruals magnitudes to 2.697554. This measure confirms

that the same situations exist in our sample, as the statistic average shows. However, the

percentage increase can be calculated more easily and is equal to 32% overall. Therefore,

we can recognize a 32% increase in the use of Discretionary Accruals as a method for

earnings growth.

If the change in accruals is measured in isolation, we would say that managers are making

income by increasing accrual decisions. Nonetheless, it would be helpful to see the table

of quartiles (Table 7) in order to indicate how this works. The 25% indicates that even the

0

10

20

30

40

50

-1 0 1 2 3 4 5 6 7 8 9 10 11 12

Fre

qu

en

cy

DA2005_06

Graph 6. Discretionary Accruals Frequency Histogram for 2005-2006 period

51

companies’ managers that used income decreasing accruals decisions (Q1=-0.088265)

have made an attempt to change their technique and approach the zero value.

However, Q3 shows that managers (approximately 17) who prior to the IFRS adoption

would use increasing accrual decision, after the IFRS implementation have increased their

accrual practice even more, so as to show larger income. In particular, it is clear from the

table that for the 2003-2004 period approximately half of the observations have negative

discretionary accruals, while for the 2005-2006 period this variable is only negative for

one quarter of our sample. This obviously indicates that firms are active practitioners in

the use of EM as the magnitudes of accruals are “far away” from the zero value.

Ultimately, managers like to play that ‘financial numbers game’ by using either positive

or negative accruals accounting in order to meet their expectations.

DA 2003-2004 DA 2005-2006

Lower (25) quartile -0.088265 -0.080186

Median -0.004848 0.004683

Upper(75) quartile 0.090488 0.113564

In agreement with our outcome, Kaplan (1985) said that alterations in accruals might

depend on financial conditions of the firm. For instance, if Non-Discretionary Accruals

are a function of income, then the negative change may be due to changes in Non-

Discretionary Accruals and not Discretionary ones.

4.4 Change in Discretionary Accruals

The table below illustrates how many companies changed their decreasing accrual

practice to increasing accrual practice and opposite.

Table 7. Discretionary Accruals Quartiles pre and post IFRS adoption

52

Differences between discretionary accruals before and after IFRS

2003-2004

2005-2006

Positive DA 29

37

Negative DA 38 30

The table above proves how many firms of our FTSE100 sample have used increasing and

decreasing accrual techniques. In the 2003-2004 time period more companies used

decreasing accruals in order to manage their earnings but this totally changed after the

IFRS implementation. It is noteworthy that after the IFRS implementation more

companies tend to use increasing accrual decisions (56% of our sample). Especially, 8

firms (out of 67) have altered their EM technique in order to show bigger income rather

than show lower income for a future purpose. These results (Table 8) supplement the

outcomes we exacted from descriptive statistics in Table 6 and help us conclude that after

the IFRS adoption firms desire to show better financial results.

4.5 Discussion of results

After the obligatory implementation of IFRS in the chosen FTSE100 sample, the results

that have been found show that Discretionary Accruals have increased. These results seem

to support the view that principles-based accounting standards leave more opportunities

for earnings management (Callao and Jarne, 2010). Nelson (2003) believes that new

accounting standards, for instance IFRS in the EU, seem to be principles-based as they do

not have ‘’plenty’’ of time to include rules. In addition, the transition from a rule-based

system to a principles one brings many significant changes in the business world that can

affect not only the results, but also the whole economy.

Table 8. DA differences pre and post IFRS-firms

53

Even though, it is not correct to say that accounting standards with principles can easily

create EM, Nelson (2003) examines the problem from two perspectives: constraint and

communication. For the first perspective, he believes that principles-based standards and

rules-based standards are information biased, which means that there are motives for

earnings manipulation. Regarding the ‘’communication’’ perspective he said that rules

could be inferred in an awkward way and each additional rule is too complicated to be

adopted in an appropriate way. Consequently, this is the reason that principles and rules

can easily be applied in the interest of better financial results.

Moreover, these rules are trying to align the differences that exist between multinational

companies from all over the world by creating a common language. As we have realized a

new common accounting language can lead to other complications that are known as

earnings manipulations. No matter if the country is based on common law, like the UK,

and its priority is the protection of investors, the IFRS cannot guarantee the transparency

of the financial numbers. This is apparent from our existing research with the chosen

FTSE 100 sample. Therefore, we can easily conclude that managers try to exploit certain

gaps in the principles or rules in order to achieve a desired result.

Another logical explanation for the increase in EM is that bigger companies implement

more manipulation techniques because of the agency theory. This means that the larger

the firm the bigger the gap between management and shareholders, stakeholders. In

addition, bigger firms have more motives to manage earnings as they are more visible

than small ones (Watts and Zimmerman, 1990).

We have already mentioned that Healy (1985) states that there is evidence when the

accrual mechanisms are connected to managers’ motivation. We can easily speculate that

in our sample, when looking at the revenue annual growth before and after the IFRS

adoption. Especially, there is a positive correlation between Discretionary Accruals and

annual growth of revenues in the 2005-2006 period. This may indicate that managers

manipulate earnings, probably within the limits available, for self-fulfilment purposes.

Moreover, the results of this study are in agreement with those found in the study of

Tandeloo and Vanstraelen (2005). In particular, the current study found that the

magnitude of Discretionary Accruals has increased significantly after the IFRS adoption.

54

Hence, these findings further support the idea that IFRS adoption does not necessarily

mean lower EM or better accounting quality. There are also similarities between the

attitudes expressed by the current study and those described by Goncharov and

Zimmerman (2006) who found that IFRS involves more EM that domestic standards.

The findings of the current study do not support the previous literature that discusses the

IFRS benefits. In other words, it is difficult to correlate our results with the theory that

supports IFRS as a system of transparency. Some authors, as an example Ewert and

Wagenhofer (2005) said that IFRS lessen managers’ discretion and avoid opportunistic

behavior and advance accounting quality. It is obvious that our findings differ from many

published studies that corroborate the concept of IFRS “excellence”.

However, we already said in literature review that EM is categorised in three parts. First,

the EM then accounting fraud and thirdly the legal use of accounting discretion. Therefore,

it is believed that the difference is based on the managers’ motive (Deschow and Skinner,

2000) and it would sometimes be unfair to judge their real intentions. Additionally, having

a small sample size, caution must be applied and results should be interpreted carefully.

The topic of EM deserves further research as it is one of the most doubtful not only in a

theoretical level but also in its research. This occurs because authors have not concluded

yet whether EM is regarded as being legal or illegal method. It is therefore likely that

accounting standards are important for the quality of accounting information and for

determining the difference between legal and illegal. However, we should not undervalue

the importance of other factors such as firms’ characteristics, auditing role, managers’

incentives and countries’ policies or rules. Many suggestions are discussed at the

following chapter.

55

5 Conclusion

5.1 Summary of Findings

The main aim of this dissertation was to discuss, contributing to the debate that exist on

the field of accounting, if the IFRS adoption has had an impact on the quality of financial

reporting and disclosure, and to assess the magnitude of the impact (and on what

direction) on the EM.

A review of the existing literature reveals that the IFRS did not have a positive impact on

the accounting quality, as there is no indication that the new accounting system decreased

the EM. On the contrary, some experimental literature refers that after the adoption of

IFRS, firms are more involved with the management of earnings. This suggests that the

introduction of the IFRS has led to an opportunistic behaviour by firms’ managers.

EM can be explained by a variety of definitions, as it lacks a specific and common

definition in the literature. There are several negative aspects associated to the

manipulation of financial information to the level that the disclosure of such information,

when managed, does not serve its purpose, which is to provide to the investors and other

stakeholders with the essential information to support their investment decisions or

improve the accounting quality. However, the management of earnings does not receive as

importance as it should in the academic world because it is difficult to detect.

The EM and the associated management of information, performed by managers, are

motivated by the performance review of managers. In many cases, managers are based on

their performance and on the financial outcome of their management. Thus, the

management of earnings allows companies to display a better condition for the firm, and

therefore they indicate that the management performance has been effective.

An important technique is used for the management of earnings is the use of accruals.

This technique is based on the discretion of accruals to manage the performance of the

firm when exercising the profitability in many firms’ stocks. Furthermore, as previously

56

mentioned this is also strongly linked to bonus contracts. This means a lot about the

linkage between managers’ bonuses and firm’s performance.

In order to pursue such research aim, this dissertation has used a methodology held by the

events studies. Data was collected for the period between 2003 and 2006 (with the

exception of the period between 2004 and 2005, when the IFRS were introduced). The

analysis was presented based on a sample of 67 UK firms, listed in the FTSE 100 (London

Stock Exchange index). The selection of the sample was done for two main reasons. The

first one was to guarantee access to data more easily, and the second one was to include in

the sample a majority of large firms, as there are certain requirements for firms to become

listed in the FTSE 100. This research strategy had an important assumption – that larger

companies are more likely to practice EM due to their better financial knowledge and

ability of proficient executives.

The empirical models used in this dissertation were inspired in the literature. One of the

models was the Healy Model (1985) where the Total Accruals were estimated with a

number of variables (current assets change; current liabilities change; cash and cash

equivalents change; long term debt change; expenses in depreciation and amortization;

and the 1 year lagged total assets). The second model, which has been object of regression

– the Jones Model (1991) – considered, for independent variables, the change in the

increase in 1 year lagged revenues; the 1 year lagged total assets; and the gross property,

plant and equipment.

A variety of statistical methods was employed to the data and the results were presented in

line with these statistical procedures. However, in this chapter, in order to summarise and

discuss the findings, the evidence will be presented on a more general manner.

The empirical evidence found in this dissertation suggests that after the introduction of the

IFRS there has been an increase in the Revenue. In particular this revenue was deflated for

the period 2005-2006, and it is likely that the inflation effect may explain part of this

accruals increase.

The analysis of the regression estimation resulted in some findings. The first one is that

the model seems to be statistically significant and robust (despite some problems of

heteroscedaticity but they did not affect the overall quality of the model). The regression

57

equation has also showed that the total accruals are negatively influenced by the

reciprocal 1 year lagged assets and the changes in the revenue.

An analysis of the impact of the introduction of the IFRS has also emerged an important

finding that the discretionary accruals have increased, and this provides an indication that

the IFRS have increased the opportunity for managers to manipulate the data. This finding

raises a very important question that can be seen as paradox: although the IFRS were

introduced in order to resolve some problems associated to the convergence of the

financial reporting, and to increase the transparency of financial information (in order to

guarantee that a wider audience can use such data internationally) it has raised other

problems that put the initial objective, i.e. it has created an effect that compromises the

feasibility of the financial information.

The literature review provided in this dissertation has shown some contradictory evidence

and results. However, the majority of the findings presented in this dissertation seem to be

coherent with part of such literature, confirming our findings.

5.2 Limitations and further research opportunities

This dissertation and empirical research also presents a number of limitations. Although a

link between the earnings management and the incentives of managers in manipulating

information has been made, no evidence was presented in what concerns these managers.

Although this approach to the issue would require a different methodological design, it

would be important to understand to what extent some managers are more willing to

manipulate information and practice earnings management. In addition, the practice of

earnings management may also differ across industries based on the assumptions that

certain industries, where the competition is high, managers are more inclined to perform

earnings management.

One important limitation, in the present study, is that the companies of the sample have

disclosed their annual reports under IFRS not only in 2005 but also in the year of 2006.

Specifically, there are some firms that have started using IFRS in the first months of 2006.

58

Therefore, this might create complications to our research because many companies that

disclosed in 2006 have not had the time to adapt to the new accounting standards, thus

make it hard for us to find proper results.

Furthermore, this dissertation that it has been based on the FTSE 100, based on the

assumption that EM is more likely to be found in larger companies than in medium sized

companies. However, an exploratory analysis to the differences of the EM across different

types of companies could reveal important information. In addition, the basis of this

dissertation has been organized in companies where there is a separation between

ownership and management. In the cases where management is conducted by the owner,

the motivation of management may significantly differ, and therefore, different

mechanisms in EM could be found. Therefore, this dissertation raises some questions for

further research and, apparently, the size and the type of management may be important

determinants for understanding the motivations and the forms of EM.

In addition, the formulas that are used in bibliography have many gaps owing to

limitations and biases that clearly exist. It would be fruitful then, to further study the topic

of EM by including more variables than the usual ones (that extracting from balance

sheets). In other words, new variables such as managers’ intention and auditing role

would be valuable on examining the increase of EM. The problem is that is hard enough

to quantify these two variables in a short paper and mix them with the balance sheet

variables. In short, there are too many researchers that have already used numerous

models for that purpose but they do not take into account qualitative data. This

methodological approach would require to collect data on the characteristics of the

managers and to identify what particular characteristics can be more relevant to explain

EM. In addition, and in order to gain in-depth the issue, a qualitative research approach

would allow to better understand the real motivations of managers who manipulate

information, the forms and mechanisms used for such manipulation; how it is seen by

shareholders and stakeholders; what barriers they face or how it is seen in the world of

finance.

59

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Appendix A

Company Industry

First annual

report under

IFRS

A.B.FOOD Consumer goods 17/09/2006

ANGLO AMERICAN Basic Materials 31/12/2005

ANTOFAGASTA Basic Materials 31/12/2005

ASTRAZENECA Health care 31/12/2005

BAE SYS. Industrials 31/12/2005

BG GRP. Oil and gas 31/12/2005

BP Oil and gas 31/12/2005

BR.AMER.TOB. Consumer goods 31/12/2005

BR.LAND Consumer services 31/03/2006

BSKYB Consumer services 30/06/2006

BT GROUP Telecommunications 31/03/2006

BUNZL Industrials 31/12/2005

CAPITAL SHOP Industrials 31/12/2005

CABLE AND WIRELESS Telecommunications 31/03/2006

CADBURRY-SCHWEPPES Consumer goods 31/12/2005

CENTRICA Utilities 31/12/2005

COMPASS GROUP Consumer services 30/06/2006

DAILY MAIL AND GENERAL

TRUST Consumer services 31/03/2006

67

DIXONS Gr. (DSG Int'l) Consumer services 30/04/2006

DIAGEO Consumer goods 30/06/2006

EMAP Consumer services 31/03/2006

ENTERPRISE INNS Consumer services 30/09/2006

GALLAHER GROUP Consumer goods 31/12/2005

GLAXOSMITHKLINE Health care 31/12/2005

GUS (EXPERIAN) Consumer services 31/03/2006

HAMMERSON Consumer services 31/12/2005

HILTON GROUP (LADBROKES) Consumer services 31/12/2005

HAYS Industrials 30/06/2006

IMPERIAL CHEM. INDUSRY Industrials 31/12/2005

IMP.TOBACCO GRP Consumer goods 30/09/2006

INTERCON. HOTEL Consumer services 31/12/2005

INTL POWER Utilities 31/12/2005

ITV plc Consumer services 31/12/2005

JOHNSON,MATTH. Basic Materials 31/03/2006

KINGFISHER Consumer services 31/03/2006

LAND SECS. Consumer services 31/03/2006

MARKS & SP. Consumer services 31/03/2006

MORRISON (WM) Consumer services 30/01/2006

NATIONAL GRID Utilities 31/03/2006

NEXT Consumer services 31/12/2005

PEARSON Consumer services 31/12/2005

RECKITT BEN. GP Consumer goods 31/12/2005

REUTERS PLC Consumer services 31/12/2005

RENTOKIL INITIAL Industrials 31/12/2005

REXAM Industrials 31/12/2005

68

RIO TINTO-HOME Basic Materials 31/12/2005

ROLLS-ROYCE HLG Industrials 31/12/2005

SABMILLER Consumer goods 31/03/2006

SAGE GRP. Technology 30/09/2006

SAINSBURY(J) Consumer services 25/03/2006

SCOTTISH POWER Utilities 31/03/2006

SCOTTISH & NEWCASTLE Consumer goods 31/12/2005

SEVERN TRENT Utilities 31/03/2006

SMITH&NEPHEW Health care 31/12/2005

SMITHS GROUP Industrials 31/07/2006

SSE Utilities 31/03/2006

TATE & LYLE Consumer goods 31/03/2006

TESCO Consumer services 28/02/2006

UNILEVER Consumer goods 31/12/2005

UTD. UTILITIES Utilities 31/03/2006

VODAFONE GRP. Telecommunications 31/03/2006

WILLIAM HILL Consumer services 31/12/2005

WPP GROUP Consumer services 31/12/2005

WHITBREAD Consumer services 31/03/2006

WOLSELEY Industrials 31/03/2006

YELL GROUP Consumer services 31/12/2005

XSTRATA Basic Materials 31/12/2005

Table A. Companies included in the study

Source: Aisbitt (2006)

69

Company Industry Status

ALLIED DOMECQ Taken Over Taken Over

BHP BILLITON Not using IFRS Not using IFRS

CARNIVAL Not using IFRS Not using IFRS

EXEL Taken Over Taken Over

SHELL Not using IFRS Not using IFRS

SHIRE PHARM. Not using IFRS Not using IFRS

Company Industry Not available data

ALLIANCE UNICHEM Consumer services

BAA Industrials

BOOTS Consumer services

BOC Basic Materials

BRITISH AIRWAYS Consumer services

CORUS GROUP Basic Materials

HANSON Industrials

O2 Tellecomunications

Table B. Companies excluded from the study

Source: Aisbitt (2006)

Table C. Companies excluded from the study due to unavailable data

Source: Aisbitt (2006)

70

Company Industry

First annual

report

under IFRS

ALLIANCE&LEICESTER Financials 31/12/2005

AMVESCAP Financials 31/12/2005

AVIVA Financials 31/12/2005

BARCLAYS Financials 31/12/2005

FRIENDS PROVIDENT Financials 31/12/2005

HBOS Financials 31/12/2005

HSBC Holdings Financials 31/12/2005

LEGAL & GENERAL Financials 31/12/2005

LIBERTY Financials 31/12/2005

LLOYDS TSB Financials 31/03/2006

MAN Group Financials 31/03/2006

NORTHERN GROUP Financials 31/12/2005

PRUDENTIAL plc Financials 31/12/2005

OLD MUTUAL Financials 31/12/2005

ROYAL & SUN

ALLIANCE Financials 31/12/2005

RBS Financials 31/12/2005

SCHRODERS plc Financials 31/12/2005

STANDARD

CHARTERED plc Financials 31/12/2005

3i Group Financials 31/12/2005

Table D. Financial Companies that excluded from the study

Source: Aisbitt (2006)

71

Heteroskedasticity Test: White

F-statistic 836.3068 Prob. F(6,60)

Obs*R-squared 66.20832 Prob. Chi-

Square(6)

Scaled explained SS 199.8433 Prob. Chi-

Square(6)

Dependent Variable: RESID^2

Method: Least Squares

Included observations: 67

Variable Coefficient Std.

Error

t-

Statistic

C 0.015757 0.008338 1.889871

RECIPROCAL_A_LAG1^2 6798.317 272.8253 24.91821

RECIPROCAL_A_LAG1*DELTA_REV 923.6083 88.93542 10.38516

RECIPROCAL_A_LAG1*PPE 407.3733 83.80383 4.861034

DELTA_REV^2 3.193397 0.112572 28.36766

DELTA_REV*PPE -0.958925 0.091426 -

10.48852

PPE^2 -0.012142 0.023598 -

0.514548

R-squared 0.988184 Mean dependent

var

Adjusted R-squared 0.987002 S.D. dependent var

S.E. of regression 0.046988 Akaike info

criterion

Sum squared resid 0.132475 Schwarz criterion

Log likelihood 113.504 Hannan-Quinn

criter.

F-statistic 836.3068 Durbin-Watson

stat

Prob(F-statistic) 0

Table E. Heteroscedasticity test descriptive statistics

Note: Where, RECIPROCAL_A_LAG1 equals to 1/At-1, DELTA_REV equals to ΔRevi,t and PPE equals to

Property,Plant and Equipment.